- Lord Copper
China Woes….and a Question about Ukraine
The recent failure of an obscure solar panel manufacturer in China is suggestive of a major shift in policy in that country, as it is the first occasion when the issuer of a domestic corporate bond has not been bailed out when it could not make due payments. (That word ‘domestic’, of course, is quite important – plenty of metal traders have suffered when international corporate due payments have not been made.) What it means, though, is that domestic investors can no longer look to governmental agencies to make them good when their investments fail. It’s a big deal, because the so-called shadow financial institutions that have proliferated to satisfy the needs of the increasingly wealthy investor class have grown mightily in recent years. Nobody – probably not even the officials responsible for directing the State’s economy – knows how much is tied up in these deals; worse, they probably have even less idea of how much leverage is involved. That’s the most disturbing part of it; products exposed to financial leverage that were regarded as ‘safe’ now have to be re-assessed as highly risky.
Why ‘highly’ risky? Well, look for example at a typical commodity-based deal. You buy the commodity on a term letter of credit, sell it for spot cash with a buyback and use that cash to invest in a speculative property venture. Like many of us, a lot of Chinese recognise that many fortunes have been founded on land and property, but of course it can also go wrong; I haven’t been to China for a little while, so this bit is hearsay, but I see no reason to doubt those who report block upon block upon block of empty apartments, built as a punt. And it goes further than that; municipal authorities have been involved, as well as private citizens. We are all impressed with the splendid infrastructure developments across many Chinese cities, but you get a cold shiver down your spine when you think about how little chance many of them have of paying their way. When those property ventures and infrastructure developments fail to return the capital that is mortgaged against commodity deals, that metal, or oil, or whatever is going to hit the market. We know it’s there, because import figures run comfortably ahead of industrial production.
Now, a word of caution; I am obviously not suggesting that all development in China is financed in this way. Of course it’s not. By far the majority of projects are conservatively and responsibly managed; the risk lies with the small proportion that are not. But because of the size of the economy, even a small proportion represents a substantial risk.
It may be that an acceptance of corporate bond defaults is just part and parcel of a rapidly developing economy, and that the authorities have taken a rational decision to let investors know that they should not simply expect the Government or state-owned banks to protect them, and as yet, there is no sign of any sort of panic developing. Perhaps it’s all part of a intended wake-up call to help prevent the economy running out of control.
The commodity-backed leveraged loans, though, fall into a different category. Their impact cannot be contained internally because of the implications for price. In other words, if a solar panel manufacturer defaults on bond payments, domestic investors will get hurt. If, however, those investors have been playing with money borrowed against copper or iron ore or any other internationally-traded commodity, then the default has the potential to spread outside China as the collateralised metal has to be liquidated against international prices. The danger to fragile markets is the uncertainty of the amount of metal which may or may not need to be liquidated. The issue is in fact broadly similar to that facing the aluminium industry with respect to the potential unwinding of very high levels of stock financing -unspecified quantities of metal overhanging the market, with no clear way to assess when they will be released.
The concept of collateralising metal is not a new one – metal has always been attractive to financiers, because, by and large, it doesn’t deteriorate (provided storage is correct), it’s easy to allocate and it’s of (relatively) high value. The instability is caused by lack of knowledge about the amounts involved and changes – like the threat of defaults in China – breed more of that instability.
And on a Different Subject…
Now, a different subject; something I’m struggling to get to grips with, where perhaps readers may be able to point out the right direction. There was an elected government in Ukraine – not a very nice one, but elected. That was overthrown by what you would have to call a coup. Crimea was part of Russia for a very long time, and only became Ukrainian in the 1950s, when Khrushchev handed it over. At that time, since both Russia and Ukraine were part of the Soviet Union, that change was basically administrative. So is the West right to be so firm in its support for the new Ukrainian government and so dismissive of the Crimean referendum? I can understand the ethnic tensions, particularly the concerns of the Tatar population of Crimea, after their previous experience under Stalin, but I’m genuinely stuck in the middle, unable to decide who is right and who is wrong in this one. Any readers got any insight into it?