We’re calling it the “The Great Chinese Commodity-as-Collateral Financing” fiddle.
That is, the purchase of commodities like copper on deferred payment terms for the sole purpose of raising cheap financing for reinvestment in higher yielding assets.
We’ve raised the alert before, but now thankfully more and more analyst research seems to be catching on.
The latest comes in the shape of a Standard Bank note by a team freshly back from a Chinese field trip (H/T the FT’s Jack Farchy).
Not only do they provide excellent new estimates of just how pervasive the practice in China really is, they’re sounding the loudest alert to the copper market yet.
For one, the note is entitled “China trip report — copper market a real cause for concern”.
Here are some particularly useful anecdotes we found from the note (our emphasis):
We visited China last week, with the aim of gauging Chinese sentiment, the impact of monetary tightening measures on consumers and also investigating the scale and implications of copper’s use as a financing tool. We were already fairly bearish towards copper’s near term prospects before the trip. That negative feeling has intensified, with significant downside risks to copper prices emerging.
• Anecdotally, something in the region of 600,000 mt of refined copper is currently sat in bonded warehouses in Shanghai, with perhaps another 100,000 mt in the southern ports. This is equivalent to around 11% of China’s total refined consumption and around 40% of China’s net refined copper demand.
• Bonded stocks have climbed by around 300,000 mt since the beginning of this year, pointing to the absence of end use demand at the moment. The amount of metal is so high, that spare capacity at some bonded warehouses is running out, with some metal being stored outside.
• The scale of the refined inventory casts into doubt the size of the expected refined deficit in the copper market this year, and raises the prospect of a balanced market, or even a small surplus.
• More worryingly however is that the primary use of copper in bonded warehouse appears to be as a financing mechanism to provide cheap working capital for various types of business often unrelated to the metallic industry.
Initially via a letter of credit and then by using deferred payment LC, they create a borrowing vehicle. Estimates for the amount of metal tied up in such a way range from 40-80% of total bonded stocks. Our estimates are towards the upper end of this range.
• Property developers (or the property developing arms of conglomerates), appear to be behind the lions share of this type of activity, driven by an unwillingness by domestic banks to extend finance, or the imposition of interest rates of anything from 10-20% when they do. On that basis, interest rates on metal of LIBOR + cost of funding look very attractive indeed.
The big news of course is that Standard Bank attributes the lion’s share of the commodity “fiddle” to property developers.
That means, in their opinion, not only is the arrangement exposed to falling copper prices, it’s equally vulnerable to falling Chinese real-estate prices. Potentially, more so.
As they note:
A scenario of falling Chinese property prices, perhaps combined with a government clampdown on alternative sources of funding, would therefore be a devastating outcome for the copper market, simultaneously robbing the metal of an end-user and leading to a mini credit crunch. The obvious home for the bonded material would then be the LME warehouses in the Asian region, with very negative implications for sentiment towards copper prices.
As for the Shanghai-London arbitrage — which traditionally sends copper China bound when prices are higher in Asia than in London — the volumes have, as we have noted, for a while been flowing towards Shanghai regardless of lower prices.
Now Standard Bank says that scenario only emphasizes the use of copper imports as a financing tool, as the arbitrage loss is clearly seen as a natural hike in the cost of financing.
Or as they put it:
In terms of the SHFE-LME arbitrage, the level remains depressed. With copper also now regarded as a financing tool, the arbitrage is likely to be artificially depressed for some time to come. Arguably, any arbitrage losses on metal that is brought into China, if financing deals are wound up, is perhaps more akin to an interest rate than a trading loss, i.e. an additional cost for the facility to that already paid to the financial institution.
• With the SHFE-LME arbitrage remaining in negative territory, even more of the spare metal in bond, (not held on finance), may be re-exported and delivered into LME warehouses over the coming weeks and months. This alone should keep a lid on prices and prevent the market getting too carried away, even without any potential implosion in China.
Now account for that when you’re the People’s Bank of China…
China’s bonded-warehouse copper mystery – FT Alphaville
China’s copper as collateral addiction – FT Alphaville
Copper’s rise slowed by Chinese oversupply – FT
Simply amazing commodity collateral shenanigans in China – FT Alphaville