Unraveling the Threads of a Currency-Hedging Failure in Hong Kong


Impact on the Global Economy

This story caught my eye because, ever since the acute financial crisis began around Labor Day, news about how China is handling it has been very sparse.

And that matters a great deal, because China’s reactions to the crisis are key to understanding whether the global financial system has fundamentally changed in recent years. The question, of course, being this: has the economic dynamism of the world shifted away from the United States? Or does distress here still cause major problems elsewhere?

Citic Pacific Ltd. makes steel and does some real estate development. Its shares are listed on the Hong Kong stock market, and its billionaire board chairman is one of China’s richest people.

Citic Pacific is 29% owned by Citic Hong Kong, which is a wholly-owned subsidiary of CITIC Beijing, which in turn is owned by the Chinese government.

You probably remember these guys. CITIC Beijing almost invested $1 billion in Bear Stearns, but Bear collapsed before the deal could close. And they invested $3 billion in Blackstone Group shortly before the latter went public and started falling in value. In short, and greatly to the annoyance of the Chinese authorities, CITIC have earned a reputation as “dumb money.”

So what’s the news item? Citic Pacific has lost about $2 billion, trading currency derivatives. (All money figures in this post are US dollars, not HK dollars. 2 billion USD is about 15 billion HKD.)


What are they going to do? That’s easy. They go to their sugar daddy, the Chinese state, and recapitalize around $1.5 billion. In return, some senior managers of Citic Pacific will be dismissed, and some will probably be shot. (For once, I’m not using a metaphor when I speak of death in managers.)

Of course, this being Asia, the company won’t go out of business, although the amount of the trading loss was considerably larger than the current total value of the company’s stock.

What’s interesting about this is that it points out some of the less visible aspects of the global credit crisis.

Citic Pacific isn’t the only relatively small trading company that has created an awful lot of pain in Asia with currency derivatives. In this case, they appear to have speculated on a continued rise in the value of the Australian dollar, which has been one of the world’s star currencies.

Citic Pacific apparently has major iron ore operations in Australia, so they wanted to hedge their exposure to the Australian currency. This makes sense if you want to smooth out your native-currency cash flow, and every major trading company in the world does it.

But Citic Pacific appears to have screwed this up, not managing their risk properly. And they got caught in the downdraft that has caused the Australian dollar to plunge in value over the last several weeks. All of a sudden, their currency hedges appear to have become exposed to nearly unlimited risk.

This isn’t a unique story about bad decision-making in one relatively small firm in Hong Kong. Similar things have been happening in South Korea, Brazil, and elsewhere. Even in Iceland, where the collapse of the entire country’s banking system broke above the media radar and got fifteen minutes of fame.

Why is this typical? Well, there’s a big contrast between what happens to the US dollar in times of financial stress, and what happens to every other currency. The dollar goes up as everyone seeks the safety of the world’s highest-quality money. And money flows out of high-growth emerging economies like air out of a balloon, which drops their currencies like a rock.

Further evidence that this is the dynamic at work: the value of the Japanese yen. Because yen is the lowest-yielding major currency, it’s a favorite source of funds for “carry trades,” in which you get paid for holding a high-yielding currency. Like the Aussie dollar, the New Zealand dollar, the Brazilian real, or the Icelandic krona.

As high-yielding currencies deflate in the global crisis, money flows out of carry trades and back home to Japan. Right on cue, the yen has joined the US dollar as the only major currencies to appreciate sharply during the current phase of the crisis.

One thing that the Chinese try very, very hard to avoid, is for foreign speculators to deposit money into Chinese banks. Since their interest rates have been incredibly high (in order to damp out the powerful inflation they’ve been suffering for two years or so), they’re theoretically vulnerable to inflows of “hot money” (including carry-trade money), which can exit the country on a moment’s notice and crash the banking system.

So unlike South Korea and even Brazil, which now face extreme financial disruptions from adverse currency movements, Citic Pacific and companies like it ought to be fine.

Still, what the whole episode appears to be telling us, is that the global economy still depends on final demand from the United States.

That, in fact, will be the most interesting thing to watch for as the aftermath of the crisis plays out over the next three years or more. The countries that respond to the crisis with increased regulation and control (which axiomatically includes Europe and Asia), will return to growth much more slowly than the countries that quickly shift back to free markets and light regulation.

At this point, however, political risk enters the calculus. We may elect a President who has already promised higher trade barriers, taxes, and regulations. It’s not a forgone conclusion that America will be a country that returns quickly to free markets and light regulation.

If we do, we’ll emerge from this crisis in a very strongly enhanced position vis-à-vis our economic competitors. We’ll have by far the strongest and most commanding economy on earth, a position that will be unchallengeable for years or even decades.

But if we go down the Democrat path of protectionism, high taxes, and regulation, that won’t happen. And who knows? Given the way the Democrats talk about wanting the rest of the world to love us for our charm, rather than respect us for our strength, the weaker outcome might actually be what they want.

-Francis Cianfrocca


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9 Comments Leave a comment

Amen to that...

Aaron Weatherford (Diary) Tuesday, October 21st at 8:48AM EST (link)

Do you mind if I send this to my liberal econ professor. Maybe if I get an intelligent response I will post it. I will be sure to post it if it not intelligent.

“My friends, it is coming to my attention that a great number of you are fearful of an Obama win. I must stress that you have nothing to fear from Obama winning the election as I have the greatest confidence he would be a most benevolent dictator.” – Hopefully John McCain

 

Hot money won't crash china

Joliphant (Diary) Tuesday, October 21st at 9:26AM EST (link)

But a slow down in demand might have real dangers. Their entire economy has been predicated on ever increasing growth. IIRC correctly one of the stated goals of their current government has been to double the income of the population in the next ten years or so. If demand slows they will go from a situation of being under capacity to having tremendous excesses of capacity that are financed with no way to pay the notes.

No matter how China plays out though anything that puts more burdens on our financial markets/business activity will only hurt us in the long run. What has always gotten us through is that the mass of Americans can adapt overwhelmingly faster than our elected overlords can dream. Things change we do our math and make our adjustments.


“Those who expect to reap the blessings of freedom must, like men, undergo the fatigue of supporting it.”
-Thomas Paine: The American Crisis, No. 4, 1777

Excess capacity

Francis Cianfrocca (Diary) Tuesday, October 21st at 9:31AM EST (link)

It’s long seemed to me that China has tremendously overbuilt manufacturing capacity. I think they figure they can just pretend their banking system isn’t backed with bad debt.

The really interesting question is whether they will suffer from a US demand slowdown, or whether (as has been the recent conventional wisdom) they can make up the slack from demand generated internally and elsewhere in Asia. The latter is looking very unlikely, but as I said in the post, we don’t really know.

 
 

Interesting mental image.

skorrent Tuesday, October 21st at 10:52AM EST (link)

While we have our troubles with “golden parachutes”, it may be, in China, poor managers are cast out of the airplane with no parachutes! :>)

They use bullets.

Francis Cianfrocca (Diary) Tuesday, October 21st at 10:57AM EST (link)

Much cheaper. Easier to report as “suicide,” too.

 
 

Any chance you drop enough C-Notes to explain this bit to McCain

The_Gadfly (Diary) Tuesday, October 21st at 10:59AM EST (link)

in such a way that he can use it on the campaign trail?

But if we go down the Democrat path of protectionism, high taxes, and regulation, that won’t happen. And who knows? Given the way the Democrats talk about wanting the rest of the world to love us for our charm, rather than respect us for our strength, the weaker outcome might actually be what they want.

If it weren’t for the fact that it would violate campaign law, I’d be willing to send a few Franklins your way to offset some of the cost. I’m not sure what it is, but he just doesn’t seem to be able to clearly communicate this.

They bill the victims family for the bullet

jyalai (Diary) Tuesday, October 21st at 11:17AM EST (link)

They did this to families of those they executed at Tiananmen square.

It keeps costs down that way.

 
 

Thanks, Blackie.

itrytobenice (Diary) Tuesday, October 21st at 11:45AM EST (link)

nt

Proper grammar saves lives.

Let’s eat Grandma.
Let’s eat, Grandma.


Activists Taking Action: Unified Patriots

 

Question

chrisqbn Tuesday, October 21st at 12:57PM EST (link)

I wonder which method of stimulus makes more sense?

Chine is trying to use export rebates to keep exports going. Sometimes I wonder if that is better then us trying encourage further leverage in an already over leveraged US system. I see so many of the stimulus actions not addressing our root problem,

We spend too much and then turn around and borrow to finance that spending.