FT Alphaville has recently focused on the rise in commodity-backed financing schemes in China as a response to the People’s Bank of China’s tightening measures, which shut credit off to many small- and medium-sized companies in the country, as well as real-estate developers.
But, we would say, this is only one side of the story.
The whole thing does potentially run much deeper.
Sean Corrigan of Diapason Commodities was the first to alert, back in January 2010, that there was a strange correlation between Chinese metal imports and cheap credit availability.
He suspected some of these imports could have been connected to schemes designed specifically to game cheap money from the system — either by circumventing capital controls to bet on yuan appreciation or alternatively to bet on commodity prices outright.
As he warned at the time:
… note that the relative prices of copper, aluminium, and zinc in Shanghai vis-à-vis that on the LME bear more than a passing resemblance to the volume of new loans concurrently granted by Chinese banks (including a rough estimate of ~CNY1 bln for January, as widely bruited on the newswires).
Now, if a high proportion of the commodities imported into China over that period had more to do with speculation than real demand — this does have important implications on recovery economics. Especially since so many respected analysts took Chinese commodity imports at face value, no questions asked.
It is possible, of course, that what started off as speculation paid off when real demand finally and definitively appeared on the scene. The idea that everything was hoarded isn’t actually all that viable.
But again, it’s how you interpret the concept of real demand.
If (additional) commodities — a base demand obviously always existed — were imported initially due to speculation but were eventually sold on to developers for use in the creation of, say, ghost cities — just how real is that additional demand really?
It might, though, explain why real-estate developers in particular– now frozen from traditional credit sources by the PBoC– have been so taken by the commodity collateral loan schemes.
It’s also worth asking about the role played by agencies like China’s State Reserves Bureau in driving up
fake demand through inventory stockpiling in the first place.
According to some reports China’s State Reserves Bureau built up very large stocks of copper in 2009 when prices ranged between $3,000 and $7,500 a tonne. Sums as big as 235,000 tonnes have been referenced, while overall it is estimated that the reserve holds some 1.2-1.3m tonnes of copper. A lot of which, it is feared, could be sold-off in the event of any anticipated price decline in order to book profits.
All things considered then, it does make sense to presume that high Chinese commodity imports over the course of 2009 and 2010 resulted from a mixture of real, ‘fake’, and speculative demand combined.
It’s the size of the speculative contribution that needs more rigorous assessment though.
These trades would have been done to take advantage of low commodity prices either as an ultimate inflation hedge, a pure commodity bet and/or a cheap financing scheme.
If and when price falls begin to threaten unrealised profits accrued from bargain-basement purchases, real interest rate performance, and/or call for additional collateral to be put up against leveraged positions — liquidation becomes a massive risk.
Which brings us to the potential spillover effect via the following.
It’s a note from Icis, the petrochemical news and price agency, regarding the impact of credit tightening on the Chinese petrochemical market. Please note our emphasis:
LACK of credit and inflation are becoming even greater problems in China, which is reflected in polyolefin markets that remain very quiet indeed. “It is ice cold out there with very little activity. Importers are waiting and hoping for some kind of improvement,” a Singapore-based polyolefin trader told the blog today.
A source with a major producer agreed and added: “Lack of credit continues to be problem for the small -and medium-sized companies (SMEs) due to the increases in bank-reserve requirements. “Many of the converters, who are SMEs, are struggling to get sufficient working capital to operate at full capacity.
“The other problem, if you can call it a problem, is that the speculators in eastern China are not able to open letters of credit to gamble in the market. “This is affecting activity in both the physical market and the Dalian Commodity Exchange, pointing to the fact that some of the strong volume growth we saw last year was the result of the ease of speculation.”
The point here obviously is the link between letters of credit, commodities and speculation.
Now, given that the bulk of these letters are provided by Chinese banks, we have to say we are surprised by the degree to which they are accepted unconditionally by international counterparties, often with no cash upfront at all. (Not that jitters about possible non-payment or fake letters do not abound… but they don’t seem to be getting in the way.)
Of course, the fact that Chinese letters of credit are increasingly being accepted as performance bond collateral in the West could have something to do with it. And the fact that Chinese banks are seriously striving to legitimise their operations internationally.
Back to the letter of credit point, though.
As HSBC noted at the end of last year, the PBoC’s tightening measures were in part directed on cracking down on exactly this sort of speculation — but the move created a couple of unintended consequences too:
The primary target seems to be speculation suspected to be occurring through otherwise legitimate onshore corporate activity. Besides closer inspection of FDI, letters of credit, trade declarations, and special purpose vehicles, the biggest near-term impact has been from the new rule limiting banks’ cash positions (capped at the level as it closed day prior to the announcement). In effect, this has prevented onshore banks from taking and clearing clients’ FX forward orders, by preventing them from hedging the currency exposure in the spot market (put more simply, it prevented RMB appreciation pressure in the forward market from being transmitted onto the spot market). The immediate impact was a collapse of the onshore USD-CNY forward curve, and a decoupling from the USD-CNY swaps curve.
Notably, banks were still able to grant letters of credit (LCs) on the condition collateral was put up against them, due to the balancing effect.
This means speculators without collateral (as per the petrochemical market) have been frozen out of the market, but those with collateral (say, real-estate developers) have been able to keep the financing loop going — driving demand for “quality collateral” like copper in China as they do.
The inability to hedge currency exposure effectively via the forward spot market has furthermore made using commodities to back financing exposure all the more logical. We can see why corporates were tempted.
So what happens when commodity prices fall?
As Standard Bank has pointed out, moderate price declines can and will be tolerated because corporates will view them as an increase in their funding costs more than anything else.
But, if prices fall seriously beyond the face value of their loan exposure — the risk of LCs being thrown into sudden and immediate ‘non-payment danger’ rises exponentially.
And we all know what happened to commodities last time the market lost faith in LCs.
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