CITIC Pacific: Are there More Coming?

CITIC Pacific Ltd., the Hong Kong-listed arm of China's biggest state-owned investment company, which announced US$2 billion in foreign exchange losses yesterday, probably won't be the only major listed company to be sideswiped by the global financial crisis, investors are warning.

Tantalizingly no names have been mentioned, but on Wednesday China Railway Group and China Railway Construction Ltd plunged to the daily limit down on the H-share market in Hong Kong on speculation of possible losses on currency bets similar to those at Citic Pacific. Certainly, lawyers involved in the restructuring trade reportedly are rubbing their hands together over the prospect of considerable business. And if indeed there are other profit warnings, as they believe will take place as soon as sometime this week, the spreading fallout could spell trouble for auditors who have qualified the books of companies without knowing what's in them.

The losses bring back memories of the debt crisis that China’s Hong Kong-listed investment trust companies kicked off in 1998 in the wake of the Asian Financial Crisis as investors bailed out after discovering that Guangdong International Trust and Investment corporation, or Gitic, and Guangdong Investment Holdings as well as other state owned red chip companies turned out to have massive debts exceeding US$12 billion. Gitic was ultimately placed in bankruptcy and foreign creditors were forced to take serious haircuts on their debt.

CITIC Pacific dropped its time bomb on the Hong Kong Exchange Monday with an announcement that the company’s results for the year ending 31 December would be affected by losses “arising from certain leveraged foreign exchange contracts entered into the group with a view to currency exposure.” The company’s shares promptly lost half their value when the market opened on Tuesday.

CITIC Pacific also announced its parent company had agreed to provide a US$1.5 billion standby loan facility while it seeks to coordinate loans up to US$1.5 billion, raising concerns of where the conglomerate would find banks during the current global credit crunch that would be willing or able to loan that kind of money. If state-owned Chinese banks stump up the money, according to Hong Kong-based investment gadfly David Webb, it would probably be at the government’s direction, which would place in doubt the banks’ pretentions to being true commercially-oriented financial institutions in the wake of their own massive restructurings and recapitalizations over the last five years.

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Beyond that, investors are concerned about how many more profit warnings are about to be issued in Hong Kong. One private investor told Asia Sentinel that at least one more major company is expected to deliver such a warning this week, although he did not name the company.

"I absolutely cannot believe that there will only be two companies," he added. "CITIC Pacific is not very likely to be the last." That, he said, should send investors scurrying to look at company annual reports from last year to see if they can determine how many of them have foreign exchange exposure.

Larry Yung, CITIC Pacific's long-time chairman, issued a statement apologizing for the financial disaster and saying that Leslie Chang, the company’s finance director, and Chau Chi-yin, the controller had resigned over the losses, which occurred through contractual obligations to buy Australian dollars and euros at A$1 to US$.87¢ and €1.44 to US$1. The Australian dollar is currently trading at US.69¢ and the euro at €1.32: US$1. CITIC Pacific is committed to buy A$905 billion monthly through October 2010.

Yung added that "disciplinary action will be taken against other staff members associated with this event" although he said there was no reason to believe fraud or other illegal activities had occurred.

Although CITIC Pacific has recognized more than US$100 million in losses on some foreign currency contracts, the open contracts out to 2010 mean the company will continue to bleed losses that could amount to as much as another US$1.8 billion. The company hasn’t yet decided if it will terminate the contracts and eat the losses.

"Why did CITIC Pacific's board wait for six weeks before telling investors that it had a huge exposure to exotic foreign exchange forward contracts?" asked David Webb on his website. "What does this say about the quality of its board, and the independent directors on its audit committee who, according to a separate statement by the Chairman, found time to complete an investigation of the incident even before the incident was announced?"

Webb points out that there was no sensitivity analysis to forex movements in the CITIC Pacific annual report. Indeed, according to the independent investor who spoke to Asia Sentinel, many auditors in Hong Kong who signed off on company books earlier in the year probably are frantically combing through company accounts to try to determine whether other companies tried to hedge forex payments at a time of frantic currency movements as the global financial crisis continues to unwind.

Country Garden, a major integrated property developer listed on the Hong Kong exchange, saw its first-half 2008 earnings dive drastically after it wrote off RMB 442.8 million earlier this year from losses on equity swaps and is expected to write off more in the second half.

"This episode has revealed deeply defective internal controls at a member of Hong Kong's blue-chip index, as well as disregard for the need and obligation to promptly inform investors of price-sensitive information. Investors should attach a discount for this, as should credit ratings agencies," Webb wrote in his newsletter.