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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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