For China, contracts are meant for breaking

Clouds of uncertainty are hovering over China’s airspace amidst signs of a confrontation brewing between the Chinese government and six foreign banks over state-owned airlines’ wrong-way bets on oil prices that resulted in losses, which the state wants the banks to bear.

Three of China’s leading airlines — Air China, Shanghai Airlines and China Eastern — slipped into the red after taking losses on derivatives contracts they had taken as hedge against aviation fuel price hikes. The losses came about because the airlines made market bets without hedging against prices moving the other way — because they wanted to save money on the additional fixed cost of insurance on those hedges.

But rather than pay up, as they are bound by the contract, it appears that the airlines may be allowed to walk away, leaving foreign banks to absorb the losses — or litigate and lose lucrative mainland banking licences.

The State-owned Assets Supervision and Administration Commission (Sasac), the powerful regulator that oversees state-owned enterprises (SOEs), said in a statement that it would conduct an internal investigation into the contracts that banks sold these airlines.

“The purpose of this move,” the statement said, “is to protect our own interests by resorting to legal actions in commercial activities.” Last week, China’s reputed Caijing magazine claimed that Beijing would allow the airlines to default on the derivatives contracts. It reported that Sasac had written to six foreign banks to warn them that SOEs “reserve the right to default on commodities contracts.”

It isn’t immediately clear how serious the threat is, given that the contracts between the SOEs and the foreign banks are enforceable in jurisdictions outside of mainland China, principally Hong Kong and Singapore.

But even if the threat of litigation isn’t serious, bankers are bracing for bad news in the form of requests for ‘negotiated termination’ of the derivatives contracts. As with most things about doing business in China, the choice for the banks is between yielding ground to Sasac and opening themselves up to refund claims from others whose own bets have gone the wrong way or standing their ground and losing out on goodwill and the prospect of lucrative mainland banking licences.

Chinese companies have a particularly undistinguished record when it comes to honouring their contractual obligations when prices turn against them. In the 1990s, Chinese steel mills dishonoured contracts to buy iron ore when the spot price slipped below the prices at which they had entered into a contract. Likewise, even now, buyers have refused to take delivery of steel after the price fell in recent weeks.