Chinese Commodity Financing Trade On Borrowed Time

BMI View: Used as a means for circumventing capital controls and importing low-cost foreign funding into the country, the commodity financing trade in China is unlikely to be sustained over the medium term as several issues come to the fore. The heightened volatility of the Chinese yuan, a looming surge in bankruptcies of unprofitable corporations and greater regulatory scrutiny by Chinese authorities suggest that an end to this trade practice is imminent. Crucially, an unwinding of the financing trade would be bearish for commodity prices as stockpiles of metals would be liquidated from China's bonded warehouses.

We expect a gradual unwind of the commodity financing trade in China to be a drag on industrial metal prices over the coming quarters. Commodity funding deals have proliferated following the credit crunch in China in mid-2013, when Beijing's first real attempt at tapering triggered a serious spike in the country's interbank lending rates ( see' Beijing's Credit Crunch Conundrum', June 20, 2013). Anecdotal evidence suggests that an increasing range of commodities are being used as collateral by credit-starved companies to circumvent capital controls and bring in low-cost foreign funding into the country. These include commodities such as copper, gold, nickel, iron ore, soybean, palm oil and rubber.

Broadly speaking, copper is the most widely-used industrial metal in the commodity financing trade. This is because it has a high value-to-density ratio (hence lower storage and transportation fee), long shelf life (collateral value will not depreciate significantly with time) and a highly liquid paper market (which allows effective commodity price risk hedging). These characteristics make gold an equally attractive metal for financing deals and could be the key reason behind the surge in gold imports over recent years. However, given the lack of clear data on the method and degree of gold's use as a financing tool, the full extent of gold's involvement in the practice remains unclear at this stage.

Boosted By Financing Demand
China - Bonded Warehouse Copper Stocks (LHS) & Iron Ore Total Ports Inventory (RHS)

Chinese Commodity Financing Trade On Borrowed Time

BMI View: Used as a means for circumventing capital controls and importing low-cost foreign funding into the country, the commodity financing trade in China is unlikely to be sustained over the medium term as several issues come to the fore. The heightened volatility of the Chinese yuan, a looming surge in bankruptcies of unprofitable corporations and greater regulatory scrutiny by Chinese authorities suggest that an end to this trade practice is imminent. Crucially, an unwinding of the financing trade would be bearish for commodity prices as stockpiles of metals would be liquidated from China's bonded warehouses.

We expect a gradual unwind of the commodity financing trade in China to be a drag on industrial metal prices over the coming quarters. Commodity funding deals have proliferated following the credit crunch in China in mid-2013, when Beijing's first real attempt at tapering triggered a serious spike in the country's interbank lending rates ( see' Beijing's Credit Crunch Conundrum', June 20, 2013). Anecdotal evidence suggests that an increasing range of commodities are being used as collateral by credit-starved companies to circumvent capital controls and bring in low-cost foreign funding into the country. These include commodities such as copper, gold, nickel, iron ore, soybean, palm oil and rubber.

Broadly speaking, copper is the most widely-used industrial metal in the commodity financing trade. This is because it has a high value-to-density ratio (hence lower storage and transportation fee), long shelf life (collateral value will not depreciate significantly with time) and a highly liquid paper market (which allows effective commodity price risk hedging). These characteristics make gold an equally attractive metal for financing deals and could be the key reason behind the surge in gold imports over recent years. However, given the lack of clear data on the method and degree of gold's use as a financing tool, the full extent of gold's involvement in the practice remains unclear at this stage.

Boosted By Financing Demand
China - Bonded Warehouse Copper Stocks (LHS) & Iron Ore Total Ports Inventory (RHS)

How Does It Work?

Under the most vanilla commodity financing deal, a Chinese company would first import copper using a letter-of-credit (LC) denominated in US dollar (USD). The copper will then be sold on the domestic market for cash, with the proceeds than invested into higher-yielding assets such as property or lent on in the country's shadow banking system. Subsequently, these investments will be liquidated and part of the proceeds will be used to repay the LC once it comes due.

More Than A Metal
Chart - Basic Copper Financing Deal

Unsurprisingly, the recent bond default of Chaori Solar Energy ( see 'Red Flag Raised On Chaori Default', March 10) was a watershed moment for both copper and iron ore. These metals underwent a price meltdown due to fears that more financing deals would unravel. According to market estimates, around 70% of China's refined copper imports and 40% of all iron ore at Chinese ports are locked up in financing deals. Ominously, the lack of established hedging tools for iron ore in China makes the metal particularly vulnerable to an unwinding of the financing trade, compared with other industrial metals.

Hit By Chaori Default
Three-Month LME Copper (LHS) & China Iron Ore Import Price (RHS), US$/tonne

While it is difficult to ascertain a specific timeframe, we believe the commodity financing trade in China is unlikely to be sustained over the medium term. Several factors including the heightened volatility of the Chinese yuan, more bankruptcies by unprofitable corporations and greater regulatory scrutiny by the Chinese authorities suggest that an unwind of this trade practice is imminent.

First, financing deals will become less attractive due to the rising volatility of the Chinese yuan and the subsequent hike in hedging costs. The recent decision by the People's Bank of China (PBoC) to widen the yuan's trading band ( see 'Wider CNY Band A Step In The Right Direction', March 17) is indicative of a resolute drive to increase foreign exchange volatility and reduce the pressure of 'hot money' inflows gradually. Indeed, commodity funding deals are among the three main drivers of 'hot money' inflows into China, alongside the black market and the over-invoicing of exports.

PBoC-Sponsored U-Turn
China - Exchange Rate, CNY/US$ & BMI Forecast Vs. Consensus

Crucially, a continued depreciation in the Chinese yuan will reduce the attractiveness of commodity funding deals as it becomes more costly to borrow in USD-denominated terms. While we expect the Chinese yuan to finish 2014 at CNY6.2000/US$, we note that downside risks to this forecast are on the rise.

Second, the looming surge in bankruptcies of unprofitable Chinese corporations should beget the liquidation of more commodity funding deals over the coming quarters. As spotlighted by the rising number of bond defaults in the heavy industries (with Chinese steelmaker Highsee Group being the latest example), the gradual embrace of free market economics by the Chinese government is calling into question the sustainability of many domestic companies.

With a growing number of Chinese banks refusing to step into the breach, the run-up in corporate debt since 2008 is threatening the solvency of many industries, particularly steel, shipping and construction. To be sure, at least 16 local steelmakers, or 10% of the total steel enterprises in China's Hebei province are on the brink of closure due to a deepening funding crisis.

Third, the economic slowdown in China will force more financing deals to be unwound due to lower mineral prices. Domestic banks will become increasingly risk-averse towards the weakening value of collateral, forcing borrowers to sell to meet cash calls thereby depressing commodity prices even further. Nonetheless, we are aware that short-term fluctuations in commodity prices are unlikely to spark an actual widespread unwinding of financing deals given that they are structured around 90-180 day letters of credit.

Dragged By China Slowdown
LME Three-month Copper & China Iron Ore Import Price (US$/tonne)

Finally, the Chinese government's intent on clamping down the commodity financing trade should eventually lay bare a weaker trade picture. For instance, Beijing has moved to reduce the amount of money that can be borrowed with each unit of commodity since mid-2013. While greater amounts of commodities are now needed to secure the same amount of low-cost foreign funding, we believe the deteriorating bottom line of domestic companies and greater regulatory scrutiny on the financing trade should eventually erode demand for commodity imports.

Further Weakness Ahead
China - Select Commodity Imports (% chg y-o-y)

Amongst a list of regulations, China has forced banks to provide more documents detailing transactions before foreign currency loans can be issued. This ruling was aimed at curbing overstated trade invoices that disguised the movement of funds into the country as payments for goods and services. Additionally, Chinese banks now require warehouse receipts to show that the borrower is holding physical metal to justify existing loans.

Bearish Impact On Prices

Overall, we believe an unwinding of the financing trade would be bearish for commodity prices. China's apparent consumption of commodities has been artificially inflated by imports to feed financing demand over the past quarters. Given its heavy presence in the seaborne market, an unravelling of the financing trade in China would thus adversely impact import growth for commodities. Furthermore, significant inventory overhang for certain commodities will increase with the release of stocks previously soaked up by collateral demand in Chinese bonded warehouses. In our view, prices for copper and iron ore are the most vulnerable to further price declines given their heavy use in financing deals compared with perishable products such as soybean, palm oil and rubber.

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