Corporate profile: Containing risk at China’s CSCL

Containing risk

One of CSCL's fleet, CSCL Africa

China Shipping Container Lines (CSCL), a unit of state-owned China Shipping (Group) Company, is one of China's top two largest container shippers. It reported a net profit attributable to shareholders of 4.2 billion yuan ($656 million) in the financial year 2010, reversing the company's net loss of 6.5 billion yuan in 2009. The Hong Kong stock exchange-listed company raised 15 billion yuan from an A-share IPO in 2007, significantly improving the company's financial position and enabling it to successfully weather the 2008 global financial crisis, according to Zhao Xiaoming, CSCL's chief financial officer.

As of April this year, the company had a fleet of 158 ships, with total shipping capacity of 559,000 twenty-foot equivalent units (TEU) and its loaded container volume amounted to 7.21 million TEU in the year 2010. As a major global shipping line, the company has substantial foreign exchange holdings and, consequently, exposure to FX risks. This was particularly evident during the post-crisis period when turbulence swept through the global currency markets. But CSCL faces substantial risks once more as the company made a loss for the first six months ended June 30, 2011, stating adverse effects in the global economy, the debt crisis in Europe, the March 11 earthquake in Japan, a substantial increase in the crude oil price and newly added capacity in the shipping industry.

FX risk
The volatility in the global currency markets during the past year has affected companies that have high volumes of transactions and settlement in foreign currencies. This includes the container shipping industry, which uses the greenback as a settlement currency.

"Foreign exchange risk is a big risk for us. In particular, these days, renminbi appreciation imposes big challenges," Zhao says. According to the company's financial reports, 20% of its income is in renminbi and 80% is in foreign currencies, of which about 80% is in US dollars. In terms of capital expenditure, however, 50% is denominated in renminbi and 50% in foreign currency. "Within this financial structure, when the renminbi appreciates quickly against other currencies, our income shrinks in relative terms, while expenditure expands," Zhao adds.

This presents the shipping company with a problem that it is trying to address by changing its business mix and actively managing its FX exposures. "Income and spending are pretty much fixed on the income statement, meaning we cannot change the source of income currencies, so we figured the best way to hedge the negative effect of appreciation of the renminbi is through balance sheet structure adjustment," says Zhao.

Financial derivatives products could solve problems at some time in the future, but they are not able to reduce treasury risks, all in one

In current market conditions, the firm's FX risk management strategy centres on expanding domestic business – to gain more renminbi income – and increasing renminbi holdings. It also converts more US dollars into renminbi when the renminbi is appreciating against the greenback. "We try to effectively reduce the foreign exchange risk in these two ways, like natural hedging," says Zhao.

To illustrate the effectiveness of this strategy, although 20% of the firm's 2010 income was in renminbi, 57% of its total currency reserves of 10.6 billion yuan were held in renminbi cash or assets. Most of the capital holding exchange takes place via CSCL's Hong Kong entity.

CSCL has also taken steps to borrow in foreign currency, mainly US dollars. Because of the renminbi's expected appreciation versus the greenback, US dollar debt principal should become relatively cheaper. Moreover, with interest rates close to zero in the US, dollar debt is considered the best choice for natural hedging of forex risk.

Of CSCL's 13.8 billion yuan debt, 70% is in US dollars (equating to around $1.5 billion), while 30% is in renminbi. Besides a 2.2 billion yuan loan for a port under construction in China, which has to be in renminbi, the other 1.8 billion yuan is mostly corporate bonds. Of this dollar-denominated debt, 60%-70% is in short- to medium-term notes (1-3 years), while 30% is in long-term notes.

Again, CSCL makes use of its Hong Kong entity – in this case, to manage the US dollar borrowings because the cost of borrowing US dollars in Hong Kong is much lower than in China, says Zhao.

Phillip Chow, analyst at brokerage and research firm CLSA, says historically, compared with the airlines sector, shipping lines are more conservative in terms of financial management. Shipping is a capital-intensive industry, he says; globally, a net debt-to-equity ratio of 60%-80% would be deemed manageable and not risky. By the end of 2010, CSCL's net debt-to-equity ratio was 10.6%, and its debt-to-asset ratio stood at 39%.

Zhao says that for shipping lines, if the net debt ratio is higher than 65%, it shows the company's treasury risk is high; 55% to 65% counts as relatively high; lower than 40% is considered a stable and conservative treasury management strategy.

When it comes to using derivatives to manage risk, Zhao is not yet convinced. "Financial derivatives products could solve problems at some time in the future, but they are not able to reduce treasury risks, all in one. We believe optimising our balance sheet structure on the macro level is a better way to manage overall treasury risks," Zhao says.

In 2008, the company did two non-deliverable forward (NDF) transactions. At that time, the onshore/offshore USD/CNY currency exchange rate difference was 1,000 basis points. It sold $50 million via an NDF in the Hong Kong market. The second time it also sold $50 million, but in three tranches: $20 million, $20 million and $10 million. The two transactions together netted the company 16 million yuan in profit, although it is unclear how this mitigated risk. "Nowadays, the arbitrage gap between CNY/USD is smaller, so there is not too much commercial sense in buying NDF now," he adds.

CSCL is also taking a cautious stance regarding the introduction of cross-currency swaps (CCS) and FX option products in the domestic China market. While Zhao says the company is studying the products, he is not convinced of their benefits. "These transactions rely on predicting future prices at this moment," he says. "The success of the investment relies purely on whether the market price is going the direction we predicted... we are still looking for products that contain suitable structures."

The company has not engaged in any CCS transactions and new products need to gain approval from CSCL company management. This means that not only does the treasury department need to understand how derivatives instruments function, but also the board. "So it would have to be simple," says Zhao. "Once it gets complicated, it would be hard for other operational managers to understand it. The ability to understand complex financial derivatives products becomes very important; otherwise it leaves all the risk on our corporate side." Zhao adds CSCL executives are still in the process of obtaining this understanding.

Fuel cost hedging
As a large global shipping company, fuel costs remain one of the biggest risks for the company. In 2010, CSCL's fuel costs were 7.9 billion yuan, or 27% of total costs. In 2009, fuel costs were 5.6 billion yuan, accounting for 22% of total costs.

CSCL does try to control its fuel costs. This involves slowing down the speed of its ships as they travel through the water as well as trying to buy stockpiles of fuel when the price is considered cheap. The company has also bought fuel futures.

The trading of derivatives by corporates was largely stopped by the State-owned Assets Supervision and Administration Commission (Sasac) after state-owned enterprises suffered huge losses in 2007/08. However, in November last year, Sasac issued new guidelines to state-owned corporates such as CSCL to encourage them to use derivatives products for appropriate business reasons.

"Our hedging strategy should be determined by the physical demands of our operations - different shipping routes, long haul or short haul, geographic expansions, etc. As with other firms, it comes down to financial choice: we need to buy the products that benefit our business," says Zhao. "But our corporate risk management is just at an initial stage, there is a lot of room for improvement. For now, there wasn't massive use of financial derivatives products."

CSCL fact box
Founded: 1997
Headquarters: Shanghai
Parent company: China Shipping (Group) Company – a state-run entity
Listed: Hong Kong Stock Exchange (in 2004), Shanghai Stock Exchange (in 2007)
Fleet: 158 vessels
Capacity: 559,000 TEU
Volume: 7.21m TEU (2010)

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