By staff reporters Chen Huiyin and Xu Ke, and intern reporter Wang Duan

The venerable Chinese investment firm Citic Pacific (HKSE: 00267) earned a place in financial history October 20 by reporting the largest loss ever for a blue chip listed on the Hong Kong stock exchange.

But the staggering HK$ 14.7 billion in red ink expected to bleed from leveraged foreign exchange contracts, including an immediately realized HK$ 800 million loss, may have been only the first of many costly debacles among Chinese companies that bet on currency exchange markets.

“The Citic Pacific case is the tip of the iceberg,” said a senior executive who works in a foreign exchange department at a major Hong Kong bank.

An unknown number of Chinese companies speculated on shifting exchange rates of the Australian dollar and New Zealand dollar over the past two years. Now, because of high leverage and market volatility, their losses are multiplying.

A corporate finance expert who refused to be named told Caijing, “Citic Pacific made the same mistake as many Chinese companies.”

“In foreign exchange and exchange rate risk management, the goal of hedging is to lock in trading cost,” the expert said. “But many Chinese companies gambled on their analyses of market trends, which only led to speculation.”

Rating agencies and analysts wagged fingers at Citic Pacific, some citing weak internal control. JP Morgan Securities lowered its earnings estimate for the firm 11 percent for 2008, and 44 percent for 2009, while switching the stock call from “buy” to “sell.”

Meanwhile, Hong Kong market regulators launched a probe into possible insider trading, based on the fact that Citic Pacific’s two largest individual shareholders – possibly including company Chairman Larry Yung -- frequently raised their stakes before the derivative losses occurred and suddenly stopped these moves in early September.

The Accumulator

Hedging and speculating are two sides of the same investment coin. But a lack of risk control in these derivative products can be dangerous.

Before Citic Pacific’s loss came to light, derivatives called “accumulators” were planted like land mines throughout the investment landscape. Among hedge funds and financial investors that signed these high-risk contracts exposure, hedging arrangements were made to lock in maximum risks.

Market analysts argue Citic Pacific signed an accumulator contract that not only set the highest gains but failed to include a floor for losses. The contract’s pricing model was complex and risks difficult to estimate. On the other hand, the Australian dollar’s value was rising when the contract was signed.

When the foreign exchange rate rose above 1 Australian dollar (AUD) to 0.87 U.S. dollars (USD), Citic Pacific made money.

Because the U.S. currency had weakened since the beginning of 2008, and market players tended to think the AUD would continue turning stronger, the accumulator became popular.

Under the deal, Citic Pacific would receive AUD against USD deliveries. Outstanding AUD leveraged exchange contracts had a weighted average strike price of 1 AUD to 0.87 USD. The remaining maximum aggregate profit under the outstanding AUD target redemption forward contracts equaled US$ 51.5 million.

Each AUD target redemption forward contract would be knocked out when the stipulated maximum profit was reached. However, there was no similar knock-out feature for losses.

After July, the AUD’s value against the USD declined, sliding as low as 1 to 0.65. And according to a Citic Pacific statement, this slide contributed to the HK$ 800 million loss when the company terminated leveraged foreign exchange contracts between July 1 and October 17.

The firm also said its highest, market-to-market loss could reach HK$ 14.7 billion. But some analysts say if the AUD continues to slump and falls to 1 to 0.50 USD, the market-to-market loss would rise to HK$ 26 billion.

The losses have shaken Citic Pacific, which last year reported HK$ 10.8 billion in revenues and HK$ 64.7 billion in net assets. After reporting the loss, the firm was downgraded by rating agencies as market confidence slipped. Now, higher default rates can be expected for its bonds, and skepticism among banks will rise as bankruptcy fears mount.

Citic Pacific shares fell 82 percent on the Hong Kong exchange to HK$ 5.06 a share on October 24, compared with HK$ 28.20 a share July 2.

But Citic Pacific is not the only investor suffering huge losses from foreign exchange derivatives. A report by CLSA Asia-Pacific Markets said several companies were involved in the speculation, and market experts predict more trouble in the future.

For example, China Steel Construction (HKSE: 00390) and China Railway Construction Corp. (HKSE: 01186) also recently reported losses tied to foreign exchange investments.

Citic Pacific’s losses led to market concerns about potential turmoil throughout the Chinese financial system – fears that parallel worries amid the global financial crisis. Investment firm managers are finding decisions more difficult to make.

Citic Pacific said its major shareholder, state-owned Citic Group, has pledged to coordinate a standby loan of US$ 1.5 billion. But the support fails to allay the ethical risks that may pose the biggest test for Hong Kong and mainland China financial companies in dealing with the global crisis.

Pinning the Blame

In a public letter, Citic Pacific Chairman Yung said he was not aware of the leverage foreign exchange contracts until September 7. Some contracts were terminated at that time, he said, but the rest accrued the HK$ 14.7 billion loss.

Yung said the contracts were signed “without proper authorization” and the potential exposure was “not evaluated correctly.”

Some critics raised questions about possible fraud, but an internal audit committee said there was “no reason to believe fraud or other illegal activities were involved.” Instead, the committee blamed two executives who later resigned.

The finance director, Li Hsien, for neglect in connection with the company’s hedging policy as well as failure to obtain approval from the finance chairman before conducting foreign exchange transactions.
 

The financial controller, Chau Chi Yin, also was cited for a failure in oversight. “In particular, he failed to bring to the attention of the chairman of the company any unusual hedging transactions,” said the audit committee.

Nevertheless, a Hong Kong-based analyst who refused to be named said the firm’s involvement in these high-risk investments should not have been a surprise. The firm’s historic positioning, nature and recent transformation led Citic Pacific into the high-risk financial arena.

“Citic Pacific stepped into complex derivatives, (and) although it may be coincidental, it also happened naturally,” the analyst said.

Yung and Citic

Based in Hong Kong, Citic Pacific has been involved in a broad range of businesses, from steel manufacturing and iron ore mining to property development.

The firm dates to 1987, when Yung – who was born Yung Chi Kin – became general manager and vice chairman of Citic. Under his leadership, Citic (Hong Kong) acquired 49 percent of a little-known, listed company in 1990 by injecting assets, including a 38.3 percent equity stake in the airline Dragonair and two industrial plazas. Yung became the chairman of what became a new company and renamed it Citic Pacific.

Yung is the only son of legendary Chinese capitalist Yiren Rong (in Mandarin spelling), who ran fabric and flour factories in Shanghai before the Communists took power in 1949. Entering politics, the elder Yung was named vice mayor of Shanghai in 1957.

The father earned the nickname “red capitalist” after taking the helm of Citic Group, which was established as China International Trust Investment Co. in 1978 as part of former Prime Minister Deng Xiaoping’s economic reforms. He ran the business on the mainland until 1993, when he was named vice president of China in charge of economic development.

Against this backdrop, the younger Yung – now 66 -- and Citic Pacific have cultivated a deep relationship with the Communist Party leadership.

Before Britain handed over Hong Kong to China, Citic Group used Citic Pacific as platforms for financing as well as strategic acquisitions. The firm focused on mainland businesses but also facilitated the merger of Hong Kong’s Dragonair and Cathay Pacific airlines.

Among other deals, Citic Group’s subsidiary Citic Hong Kong handed Citic Pacific a 12.5 percent equity stake in Cathay Pacific and a 20 percent stake in Macaw Communications. The Yung family acquired 36 percent of the Macau-based communications company CTM as well as a 36 percent stake in Dah Chong Hong Holding Ltd. via Citic Pacific before turning it into a wholly owned subsidiary.

In the mid-1990s, Yung rose to become one of the richest men in China. He now owns 29 percent of Citic Group and 19 percent of Citic Pacific. The rest of Citic Pacific is controlled by institutional and retail investors.

Meanwhile, Citic Pacific increased its steel and iron ore industry investments. After acquiring equities in several mainland steelmakers, Citic Pacific obtained the rights to mine billions of tons of iron ore in Western Australia, with potential annual production of 23 million tons of refined ore – enough to supply the firm’s specialty steel companies in China through 2010.

The firm’s mid-2008 financial statement said specialty steel, logistics and airlines had contributed 59 percent, 15 percent, and 11 percent of the company’s revenues, respectively.

Citic Pacific has been getting involved in steel, infrastructure, real estate and other businesses for 20 years. Its search for expansion has been motivated by soaring liquidity from profitable mainland businesses bumping up against limited room for growth in the Hong Kong real estate and airline sectors.

Nevertheless, a Hong Kong markets expert who asked to remain anonymous said the firm remains a mere investment company lacking management skills in these industries.

Hedging or Speculating?

Buying equipment and material from Australia and Europe for the mine required Australian dollars and euros. So with the objective of fixing the costs in U.S. dollars, Citic Pacific signed several foreign exchange contracts.

“However, these contracts were done without proper authorization, and the potential maximum exposure under these contracts was not evaluated correctly,” Yung said in his October 20 statement.

But Yung’s explanation doesn’t sit well with the market or experts. Citic Pacific needs Australian dollars for the mine and should hedge the risk of the currency appreciation. But the firm’s trading involved far more currency than it needed for the mine.

A corporate finance expert said Citic Pacific was driven by “a mixture of greed and a gambling mentality” to use the accumulator -- high-risk foreign exchange forward contracts -- rather than simply buying less risky futures.

The accumulator may have been a trap for unwary investors. Finance professor Ming Huang of Cornell University said some institutions made structured investment products extremely complex in a move to “confuse investors, gain profits and reallocate risks of the banks.”

Thirteen banks including HSBC, Citibank and BNP Paribas signed leveraged foreign exchange forward contracts with Citic Pacific. None responded to media inquiries for comment.

The AUD value was soaring in July when Yung said his firm signed more contracts. But the potential for an AUD slump was neglected.

Indeed, the AUD’s value slipped faster than the market expected. Foreign exchange analysts said the slump was related to fundamentals and contingencies. Amid the global financial crisis, prices of iron ore and other natural resources fell, so that the currencies of major producers Australia and New Zealand went south. At the same time, the Wall Street crisis triggered a large backflow of USD to America as investors cashed out of emerging markets.

Besides, counterparts who had long positions in AUD trading dumped these dollars to close their positions. Thus, in three months since July, the AUD’s value fell 40 percent.

Wealthly private investors also lost money due to the AUD depreciation, but apparently none were seriously hurt. A spokesperson for developer Hutchison Property, for example, said the company traded future contracts to hedge against foreign exchange forward risks when operations needed certain foreign currencies.

Suspicions about Citic Pacific’s risk management and corporate governance have emerged. Standard & Poor’s downgraded the company to BB from BB+ and posted “negative outlook.”

Likewise, Moody’s downgraded the company because it holds contracts with high exposure risks, and said the trading losses exposed internal control weaknesses.

Standard & Poor’s said Citic Pacific would in the next two years experience a negative cash flow, and that the loss would affect the flexibility of the company’s financing and may delay some projects and investments. Nevertheless, parent Citic Group pledged bridge loans to provide flexibility and time, since other types of financing are tough to find in the current market environment.

Citibank, Goldman Sachs and Merrill Lynch all cut their ratings for Citic Pacific to “sell” or “below average.” Citibank analyst Anil Daswani described the foreign exchange deal as “a cowboy hedging strategy,” adding “we have lost confidence in the executive abilities of Citic Pacific.”

A JP Morgan report said Citic Pacific would pay a high price for the damage to its image. As domestic manufacturers such as automakers have cut growth, the report said, the specialty steel industry is facing enormous pressure.

Guotai Junan Securities analyst Luo Lei told Caijing that the biggest challenges for Citic Pacific at the moment are liquidity and rebuilding investor confidence. As of June 30, the firm had cash and bank savings of HK$ 10.7 billion, and nearly HK$ 42 billion in debt, resulting in a 37 percent asset to liability ratio – which Luo said could rise to 90 percent due to the currency trading loss.

The Moody’s report said although Citic Pacific said most banks agreed to maintain its current credit status, the firm’s overall financial situation should be monitored.

At the time, Citic Pacific has hired accounting firm PricewaterhouseCoopers for a project to improve internal controls. It’s also considering selling equities in Dah Chong Hong Holdings Ltd., which would generate no more than HK$ 1.3 billion.

Restructuring Calls

Citic Pacific’s finances will be stabilized thanks to support from its parent, the firm’s executive director Harry Fan told the Singapore newspaper Singtao Daily.

Yet the nervousness continues. Some market players argue that the government should intervene to prevent systemic problems. Citic Pacific’s debt is spread among several banks that could be at risk from repayment woes. And other Chinese companies were apparently burned by foreign exchange derivatives.

As a matter of fact, some market players say Citic Group should restructure Citic Pacific. If that happens, the parent would negotiate with trading parties and even litigate to minimize losses. Additional shares could be issued as well, although Citic’s current shareholders may object.

As the end of the day, however, even if Citic Pacific gets through this difficult time, litigation will follow. The Hong Kong Securities and Futures Commission and the Hong Kong Stock Exchange have announced an investigation of the Citic Pacific case to see if trading rules were broken.

Hong Kong lawyer Jin Tao told Caijing the regulatory investigation should focus on whether Citic Pacific’s information disclosure is false or misleading. He was referring to the firm’s September 7 statement that it saw potential risk in its foreign exchange forward contracts and on September 9 said in a public statement that the “finance and trading have no significant negative” impact.

Regulators also will seek to determine whether any insider trading occurred. This suspicion is based on the fact that the largest two shareholders frequently increased their stakes before the derivative losses occur but suddenly stopped increase in early September.

Additionally, regulators say, traders at brokerage firms should have known that huge losses were inevitable. Thus, insiders likely benefited.

To prevent any conflicts of interest during the regulatory investigation, Fan said he would not attend regulators meetings, since he also serves as an executive director at the Hong Kong Stock Exchange. But Hong Kong media has noted that Yung will remain in charge of Citic Pacific.

1 yuan = 14 U.S. cents