Will China set off a derivative meltdown?

September 24th, 2009

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In Satyajit Das’s book, Traders, Guns & Money, he started off with a story of an Indonesian noodle making company getting embroiled in a complex currency derivative contract (that it did not fully understand) with a bank. Unfortunately for that company, a currency Black Swan event turned up and as a result, under the obligations of the derivative contract, the financial viability of the company was threatened. Big shot lawyers and experts were called up from both sides. The defence alleged that the Indonesian company was deceived into entering the contract whereas the bank’s lawyers insisted that the company signed the contract out of its own accord in full knowledge of its obligations. The bank’s lawyers screamed expletives, insisting that the Indonesian company honour its end of the derivative contract, or else the matter will go to court.

Today, many Chinese state-owned enterprises (SOE) found itself in the same situation. SOEs like China Eastern Airlines, Air China and shipping giant Cosco had entered derivative contracts with Deutsche Bank, Goldman Sachs, JP Morgan, Citigroup and Morgan Stanley. The Chinese are not happy with the derivative contract. So, those SOEs (assumed to have the backing of the Chinese government) sent legal letters to those American investment banks and told them, in effect, to get stuffed with the derivative contracts.

The question, as this article said,

In that case, have the banks taken advantage of them or is it simply a case of caveat emptor?

Would the SOEs end up in a court dispute with the banks (as the banks believe, the derivatives contracts are legally enforceable ones struck in Hong Kong, Singapore and London)?

The situation is much more complicated than that just a few court cases. If the banks dragged the Chinese into court, the Chinese government can retaliate by withholding the banks’ banking license in China, which will result in a tremendous loss of their businesses in China. On the other hand, if they negotiate with the Chinese, then it will set a dangerous precedent for their other counter-parties who are in the same situation as the SOEs. Should that happen, US$2 billion derivative contract default can set off a chain-reaction of other defaults.

Such a chain reaction will light up a bigger time-bomb. There are still hundreds of trillions (in notional value) worth of derivative contracts in the global financial system. As we explained with an example in Chained together, for better for worse, defaults can beget even more defaults.

As this article wrote,

Yet any escalation of the defaults to multiple countries could see a second wave of bank failures and, at the very least, a bad double-dip recession. And that’s without the increasingly worrying creeping protectionism around the globe.

An escalation is certainly deflationary.

Would the Chinese government attempt to light up such a fuse? We don’t know, but we can imagine that such an outcome will benefit them greatly. You see, during the Panic of 2008, deflation led to a surge in the US dollar and US Treasury bonds and a collapse in the prices of stocks, gold, silver, oil and other commodities. The Chinese would love for that to happen again because it will give them another golden opportunity to sell their US dollars and US Treasuries to buy real assets (e.g. gold, silver, commodities and resource/energy stocks).

This is something worth watching.

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