Goodbaby shows mastery of risky derivatives is in its infancy
Goodbaby International, a maker of strollers and other children's products, issued a warning last week that its first-half profit would be hit by foreign-exchange losses associated with currency derivatives.
The company noted that in last year's first half it had booked a gain on its bets on how the yuan would move against the US dollar.
Goodbaby's warning underscores the fact that while more Chinese companies operating in the global marketplace need financial derivatives as a hedge, they can be unpredictable. What's more, some companies may not have enough understanding of the complex financial instruments, and flawed governance may turn such instruments into a speculative curse.
Several large companies, including Citic Pacific, a unit of the mainland's biggest state-owned investment company, were taught a lesson during the 2008 global financial crisis when their derivative positions incurred huge losses as they tried to profit by making big bets on market movements.
'I've seen a number of companies in China holding derivatives which, due to market rate movements, are exposed to mark-to-market losses, and that can cause issues,' said Simon Gleave, regional head of financial services at accounting firm KPMG Asia-Pacific.
Gleave said Chinese companies had been increasingly buying hedging products to manage their growing risks and using structured yield-enhancing products to improve their treasury management.
'But very few companies fully understand derivatives,' he said. 'Corporate treasurers don't always seem to have the required experience to manage the risks.'
Given the current market volatility, Gleave added, companies should consider carefully the cost of derivative hedging products and their risks and benefits before taking them out.
The yuan has steadily appreciated against the US dollar for the past two years. But now the expectation of that one-way bet has been broken as investors, spooked by the euro-zone crisis, have fled to the US dollar, pushing up its value.
Moreover, Beijing's financial reform is making bigger market swings possible. In April, the People's Bank of China widened the daily trading band for the yuan to 1 per cent from 0.5 per cent of the central bank's fixing rate in a bid to improve the two-way flexibility of the yuan-US dollar exchange rate in the spot market.
In Goodbaby's case, it said its derivatives were forward currency contracts for yuan and US dollars, and blamed the 'fluctuation of the exchange rate' of the yuan for the losses. 'Our company has been using currency derivatives since 2007, mainly as a hedge to lock in exchange rates,' a Goodbaby spokeswoman said.
Goodbaby, with about three-quarters of its HK$3.9 billion annual sales last year coming from Europe, North America and other overseas markets, is exposed to foreignexchange risks as much of its business is transacted in US dollars.
Due to fair value changes, Goodbaby booked HK$8.5 million of gains from yuan forwards in 2007, which was followed by three consecutive losses: HK$27 million in 2008; HK$175,000 in 2009; and HK$2.89 million in 2010, according to its IPO prospectus in 2010.
Last year it booked a HK$13.9 million fair value gain from derivative financial instruments.
The company's current derivative exposure is unclear. According to the spokeswoman, the management is now cautious about yuan forwards, given that expectations earlier this year that the Chinese currency would continue to climb against the greenback have changed.
Many analysts forecast the yuan will strengthen 3 per cent against the US dollar this year. Instead, it advanced 0.09 per cent in the first quarter and then fell 0.88 per cent from April through June, the biggest quarterly drop since the yuan was depegged from the US dollar in 2005.
The central bank has said it will improve liquidity of the yuan derivative market, encourage financial innovations and push ahead with the introduction of financial futures.
Analysts said the government measures were aimed at improving companies' risk management as they were being encouraged to tap into overseas markets.
But Zhu Chao, a professor at Capital University of Economics and Business, worries that many companies opt to make speculative bets rather than stick to derivatives to hedge risks. 'Corporate governance matters a lot in supervising companies' hedging initiatives, which is increasingly important as the Chinese underdeveloped derivative market is expected to grow fast and companies nowadays operate in an increasingly complex global economic context,' Zhu added.
Corporate treasurers don't always have the experience to manage the risks Simon Gleave, KPMG Asia-Pacific
The yuan fell this much against the US dollar from April to June, the biggest quarterly drop since it was depegged in 2005