China is a source of endless fascination to the financial markets; and it’s not surprising - it’s the big target. Car makers, wine sellers, bankers, traders - everyone wants a piece of the action. Looking specifically at metals, it’s the biggest consumer of things like copper and iron ore, and to a very large extent prices these days are set by Chinese demand. Or at least, they’re set by the market’s best guess as to what Chinese demand is. Back in March, I wrote a piece about the use of commodities as a means of securing finance which was then used to speculate in other areas, notably in property and construction. The concern to which I referred then was that the leverage granted to borrowers on the back of metal stocks - paid for and imported on forward letters of credit, remember - created a risk of serious default problems should the property market react adversely to excess speculative inflation. The fact that the government had recently declined to bail out a bond repayment by the (bankrupt?) Chaori solar cell manufacturer brought those concerns sharply into focus.
A Different Issue
Now, it seems, there is another issue that should be concerning us. The financing activities I referred to are, in my view, probably unwise, with a strong possibility of destabilising the economy in a similar way to that achieved by sub-prime and its allies, but there is no real suggestion of deliberate fraud. Not very smart, certainly, but ticking all the boxes of legality.
It seems now, though, that another potential problem has swum into focus: is all the metal being used as collateral against these loans actually in place? (First, a small word of caution. Qingdao is an important port for the import of alumina and iron ore, but the amount of copper which passes through it is dwarfed by that going through Shanghai, which is China’s major copper port.) What has actually happened at Qingdao is not completely clear, but one thing that does seem to be accepted wisdom is that certain parcels of metal seem to have been pledged as security to more than one counterparty, thus increasing the amount of money the borrower has been able to raise.
Solving Cashflow Issues?
So far, attention appears to have fixed on one trader who apparently saw multiple pledging of assets as a neat way out of a cash flow issue. Well, of course it is - until it gets spotted, at which point the cash flow becomes the least of your problems. Now, if this were happening in a western port, then I have a very strong suspicion that it could relatively easily be contained. Lenders would be disturbed, but the suspicion of contagion would probably not taint the financing business as a whole. After all, the RBG scam - multiple pledging of metal in Singapore warehouse - did not immediately cause the industry to distrust everything in that port. It was accepted as a one-off fraud. Unpleasant for those involved - including a raft of trade finance banks - but seen as unfortunate rather than systemically threatening.
More General Problems
Whether the industry will be equally sanguine when faced with the same problem in a Chinese port is an interesting question. There are a number of banks with a long and distinguished history of involvement in Asia in general and China in particular; I wouldn’t expect them to react precipitously to this event. They will take a phlegmatic view. Others, though, have in relatively recent times used this kind of quasi-physical activity (although it isn’t really) as a bolt-on to support their brokerage activities in the Chinese market; I fear they may catch a serious cold. And then there are the major global players, involved in this area simply because they are major global players. But we already know that for a number of them the commodity business no longer holds the same allure that it did a few years ago; from their perspective, I suggest that problems in Qingdao port may well be read as a proxy for problems in Chinese commodity inventory financing generally. They may well decide enough is enough, or at the very least that the margins have got to be a great deal higher.
So - and I realise that this pure conjecture - I could foresee the availability of western finance for this type of deal tightening, in a combination of reduced funding and increased cost. That could result in a decline in the business as a whole, but, as was pointed out by a trader at a major house in a comment at the end of last week, this trade has become seriously significant and the government may well feel it needs to keep it alive, because of the risk to the economy as a whole of cutting off this funding. How do they keep it alive? By making it more possible for Chinese banks to take a yet larger share - hence the reduction in the reserve ratio. Is that a good thing? I would say not - it’s another opportunity not grasped to control the shadow banking business in China. That sector has been growing apace; while everything remains on an even keel, it helps keep the Chinese economic motor running - but the more it starts to stutter, for whatever reason, the more potential problems it raises. This Qingdao incident is another warning bell but I’m not sure the world is yet fully awake to it.