China sovereign wealth can profit from storms

The estimated $7.5 billion economic loss from China's devastating snowstorms "" not to mention the loss of at least 60 lives "" underscores the need for weather derivatives in China.

Encouragement of (or, for that matter, tolerance for) financial innovation may have fallen to a new low following the unraveling of securities tied to the US sub-prime mortgages. Which emerging-market central banker can now be blamed for taking a hawkish stance on credit derivatives?

However, as the scale of devastation in China has demonstrated, the case for using modern finance to deal with the consequences of adverse weather remains strong, especially with scientists warning us of the link between climate change and a dramatic increase in the frequency of disasters.

Asia has so far been a minor player in the 10-year-old, $19 billion annual trade in contracts linked to climatic conditions such as temperatures and precipitation.

The Asian market is dominated by Japan, which even has products linked to typhoons. In October 2004, the Taiwanese monetary authority allowed banks to trade weather options.

China, too, is very susceptible to volatile weather, as is India, the other emerging Asian economic powerhouse.

There was intense speculation last week over British Broadcasting Corporation's forecast that the temperature in New Delhi would fall to zero degrees Celsius on February 1. Finally, it didn't. Still, this year's bitingly cold winter is reported to have caused significant losses to farmers in northern India.

China's risk
Speculators would have loved to have been able to take a view, giving businesses an opportunity to hedge their risk. Thanks to the meticulousness of the British colonial administration in record-keeping, India also has much more robust long-range climate data than China.

But China's need is greater. Its economy is 2.5 times bigger than India's, with businesses ranging from utilities and transportation companies to retail stores and insurers carrying very large exposures to inclement weather.

Public order, too, could come under strain as became evident this week. Millions of migrant workers in industrial hubs such as Shenzhen go to their villages during the Lunar New Year holidays, which have been ruined this year.

Frustrated and angry, these workers are stranded. A woman was killed in a stampede at Guangzhou railway station.

It was the second death as a result of mass overcrowding at the platforms.

Black swan
The Chinese authorities should make the Dalian Commodity Exchange quickly implement the plan that it announced in mid-2006 to start trading weather futures.

The government should even help generate interest in the market by asking China Investment Corp, the $200 billion sovereign wealth fund, to wager a small sum on behalf of the government.

The authorities should impose only one restriction on the fund manager. The bet should be on the occurrence of what former options trader Nassim Nicholas Taleb calls the "negative Black Swan", a relatively rare, unfavorable outcome that "" like this year's snows, the most in 50 years "" may have a large impact.

And no, there won't be a firing squad waiting for the investment manager if the disaster never materializes. In fact, the bet should be small enough for the government to happily lose the money year after year.

The occasional winnings should be transferred to the government so it can repair the damage to public property from bad weather and to ease the people's suffering.

Risk diversification
As word goes out that the wealth fund is expecting to see, say, temperatures that are substantially higher or lower than normal, there won't be a dearth of speculators willing to take the opposite bet.

Banks will lobby to play, too. But their participation should be carefully regulated.

They should, however, be allowed to hedge their own exposure to weather. The standard contracts would trade on exchanges, while companies that need more-complex solutions would find them in over-the-counter structured products where the counterparty risk is borne by non-bank companies.

Chinese equity investors stung by losses this year will be glad to have an asset class that offers them real risk diversification as the weather market probably won't get blown away either by a US recession or China's inflation.

(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.)