China’s slowdown hits PE imports from N America and NE Asia

China PE Jan15manufacturing slowdown is now well underway in China, as the latest official and unofficial Indices confirm.

The government is mitigating this via its policy of self-sufficiency – which means a steady reduction in the need for imports – as well as by increasing exports of higher value-added products such as polyethylene (PE).  PE is the largest volume plastic, used in a wide variety of food, agricultural and other applications.

Full-year data also confirms China’s strategic decision to focus its remaining import need on the Middle East and SE Asia (SEA), at the expense of imports from the West and NE Asia (NEA), as the chart based on data from Global Trade Information Services shows:

  • It highlights developments in total demand, Chinese production, imports and exports since 2009
  • Over the period, total demand has risen 41%, whilst domestic production has jumped 58%
  • As a result, imports have only grown 26%, whilst exports have soared 162% (from a small base)
  • Equally important is that imports from the Middle East and SE Asia have gained major market share
  • Imports from NE Asia, N America and Europe have been the key losers

This is very bad news, of course, for the proposed US expansions based on shale gas developments.  The return of oil prices to more normal levels has already undermined the economic logic for these developments.  China’s continuing pivot away from NAFTA imports only adds to my long-lasting concerns about the lack of export potential for the major volumes that would be involved.

COLLAPSE OF IMPORTS IN H2 ALSO CONFIRMS END OF ‘COLLATERAL TRADE’
The data is also revealing in terms of my worries last summer about the growing link between import demand and the ‘collateral trade’.  This has involved the use of vast quantities of PE, as well as copper, iron ore and some other commodities, as collateral for loans to finance speculation in the property sector:

  • H1 data had suggested that China’s total demand had suddenly jumped 12%
  • This was obviously impossible for such a mature product as PE
  • The key issue was a 20% rise in imports to 5MT
  • Clearly a significant import volume was being used as collateral, and not for industrial purposes

Since July, the unwinding of this mess has been underway: full year import volume was up just 4% versus 2013 at 9.5MT.  Sadly, many companies have as a result suffered costly write-downs on unsold imports as oil prices collapsed.

China sees $13.5bn of fake September ‘collateral trade’ invoices

China PE Oct14China’s ‘collateral trade’ is still a major force in world markets for iron ore, copper and even plastics such as polyethylene.  September’s data suggests $13.5bn of fake invoices added 56% to the value of China’s exports to Hong Kong, as property developers strove to raise cash to finish their buildings.

Full details of the trade are given in our June Research Note, and you can read a quick summary here.  There are 2 major reasons why it matters so much:

  • Investors had thought China’s vast imports of copper and iron were due to its rapid industrialisation.  But it is now clear that much of the volume has instead funded speculation in China’s housing bubble
  • China’s government is now aware of the problem.  It has identified increasing amounts of fraud and is investigating the fake invoice problem.  As a result, Letters of Credit have become hard to obtain

What does this mean for you and me?  It means that companies have made a terrible mistake by expanding capacity to supply apparent demand in China.  Not only does this new production have no home to go to.  But all the product sitting on China’s docksides has no home either.

I simply cannot see any way in which this story does not end badly.  The only questions are around exactly when the end comes, and how bad it is.  Clearly, it could be very bad indeed, and I fear the Worst Case Scenario identified back in June risks becoming ever more probable.

Developments in plastics markets are only a small part of the story.  But trying to unravel them seems valuable, as their smaller scale helps to make the bigger picture easier to understand.

THE PE IMPORT SURGE SEEMS TO HAVE BEEN BASED ON THE ‘COLLATERAL TRADE’
The chart above identifies the key problem, namely the impossibly large rise in China’s apparent polyethylene (PE) demand this year.  Data from Global Trade Information Services shows:

  • Demand apparently surged 22% this year (red column) versus 2012 (blue column), with imports up 20%
  • Production also rose 22%, in line with increases for polypropylene (up 24%) and PVC (up 19%)
  • But China’s PP imports have actually fallen 2% over the same period, and it has become a net exporter of PVC
  • Why would PE suddenly require a 20% increase in imports?

The only rational explanation is that imports have been used as collateral to finance property market speculation.

The really worrying point is that it seems this game may be coming to an end.  China’s housing market is slowing fast, with prices falling in 69 of 70 cities last month.  So PE producers and consumers, like those in metals markets, now need to worry about what happens next.

They are the innocent victims.  But being innocent will not help if, as seems more and more likely, there is a disorderly unwinding of China’s “collateral trade”.   Where will all this stored volume go, and what will happen to global prices?

Self-preservation means companies must urgently develop a strategy to deal with this risk.  Waiting until it happens will be too late

Polymer markets at risk if China’s ‘collateral trade’ unwinds

Dalian Sept14

Global metal markets are at growing risk from developments in China’s ‘collateral trade’, as yesterday’s post highlighted.  Worryingly, so are products such as polyethylene and ethylene glycol, as it seems likely these have also been used as collateral more recently.  This will be bad news for producers already suffering from slowing demand:

  • China’s economy continues to weaken as the government tackles the housing bubble
  • Major new capacity is starting up within China, reducing the need for imports still further

As the blog noted recently, the background is as follows:

“More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.  None of this used to matter when the Chinese economy was booming.  Why ask too many questions, when the profits are rising?  But now China’s economy is slowing fast under the new leadership.

“So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013″.

VOLUMES DOUBLED ON THE DALIAN FUTURES MARKET BETWEEN FEBRUARY – JULY
The blog highlighted one of the potential mechanisms in a July post for Beyondbrics in the Financial Times as follows:

“Strange things are happening in China’s polyethylene (PE) market. Despite a slowdown in the economy, demand is surgingOur research suggests that PE, like copper and iron before it, is the latest instrument of China’s ‘collateral trade’, in which spurious imports are helping to drive one of the world’s great credit bubbles….

“The key to success for the PE collateral traders is the availability of a liquid futures market contract for polyethylene at Dalian, where the product can be turned into cash very quickly. As we described in a recent China Compass research note, one common mechanism is as follows:

  • The potential lender buys a PE cargo on normal 180 days credit from an overseas seller
  • He then turns around immediately and sells the cargo on the Dalian futures market
  • Now he has cash to lend into the shadow banking market at interest rates of up to 60%
  • In turn, the property developer now has the cash to finish his building work
  • As the 180 day period ends, the lender can ‘roll over’ the purchase by selling to a Hong Kong-based company
  • By opening a letter of credit, it can then use the proceeds to ‘roll over’ the previous trade

“Naturally, there are risks in this. But China is coming to the end of one of the world’s great credit bubbles. And when this type of bubble is under way, greed is a far more powerful emotion than fear. Who would want to be known as the only business in town that hasn’t done this type of clever deal?

“Of course, it will not end well. The government is unlikely to change its mind about bursting the bubble. And so at some point, all this surplus PE will have to come back onto the market. That will be very bad news for everyone connected to the PE business, be they buyers or sellers.”

The chart above of PE volume traded on China’s Dalian futures market appears to confirm this mechanism.  It shows that volume doubled between February and July from 17 million to 35 million tonnes:

  • Maybe February’s volume was artificially low due to Lunar New Year (but January volume was only 22 million)?
  • Maybe some of the upturn was people taking a punt on higher oil prices, and therefore higher PE prices?
  • But even so, a doubling of volume is still extremely unusual and suggests something else was happening

Today, of course, the opposite is happening.  Volume is weakening and market prices are falling, as oil weakens and demand slows still further.  As ICIS Pricing reported on Friday:

China’s domestic PE prices dropped this week. The market sentiment was weighed down by the plummeting LLDPE futures prices at Dalian after the anticipated economic stimulus policy by the Chinese government failed to materialise. Physical spot traders were seen cutting down their offers to offload cargoes to the market.”

Plus, of course, major new domestic capacity is now starting up in China, as the government aims to achieve self-sufficiency.

None of us can know if the potential Unwinding of the ‘collateral trade’ will indeed take place.  But the risks are rising all the time, especially with official fraud investigations now underway.  As the blog has long feared, polymer producers and consumers may well end up being the innocent victims of circumstances beyond their control.

China’s $10bn trade deal fraud hits iron ore and copper markets

Commods Sept14b

Iron ore prices on China’s futures market were at 5-year lows yesterday.  Copper prices also weakened in Australia.  This adds to the blog’s concern that China’s ‘collateral trade’ market is getting closer and closer to its ‘moment of truth’.

This will come as an awful shock to most outside observers, who have been led to believe China’s vast imports of key raw materials such as copper and iron ore have been used for economic development.  It has been, for example, importing 2/3rds of internationally traded iron ore.

Mining companies have dramatically over-expanded capacity as they, and their investors, wanted to believe that China’s demand was somehow real.  And all this new capacity is now starting come online, just as the problems with the ‘collateral trade’ are becoming more widely known.

As the chart shows, price moves since China’s stimulus programme began in late 2008  have been mind-bending:

  • Iron ore prices peaked at 1250% above their January 2003 level (blue)
  • Copper prices peaked at 500% of their January 2003 level (black)
  • Both have since been weakening, particularly since the new government began to burst the housing bubble
  • But the return to historical levels has been delayed by their use in the ‘collateral trade’

This is potentially about to change.  Last week the government announced they had uncovered nearly $10bn of trade deal fraud.  Banks have been ordered to tighten rules for issuing Letters of Credit, and there are growing fears that China’s vast stockpiles may soon be released back onto the open market.

In turn, this would impact metals markets around the world, and open the fault lines of the debt-fuelled ‘ring of fire’ created by the world’s central banks.

THE COLLATERAL TRADE HAS BLINDED COMPANIES TO REAL DEMAND LEVELS
The blog’s ‘Your Compass on China’ Research Note highlighted the key issues and risks back in June.  Published in association with leading Hong Kong-based financial advisory firm Polarwide, the blog warned then:

Titled ‘Here today and gone tomorrow – a simple guide to China’s world of trade finance’, it is probably the single most important paper it will publish all year – please click here to download a free copy.

“The bottom line – China’s vast imports of commodities such as iron and copper have, in reality, often been used to finance today’s property bubble.” 

Confirmation of the blog’s analysis came from Chinese authorities last week, as Bloomberg reported:

China uncovered almost $10 billion in fraudulent trade nationwide as part of an investigation begun in April last year, including many irregularities in the port of Qingdao, the country’s currency regulator said today.

“Companies “faked, forged and illegally re-used” documents for exports and imports, Wu Ruilin, a deputy head of the State Administration of Foreign Exchange’s inspection department, said at a briefing in Beijing. The trades have “increased pressure from hot money inflows and provided an illegal channel for criminals to move funds,” Wu said, adding that those involved in such fraud would be severely punished.”

The ‘collateral trade’ itself is not illegal in China.  But as the new leadership’s credit squeeze has tightened, it seems property developers may have become more desperate to raise funds and turned to fraud.   They also seem to have begun to use other commodities such as polyethylene in the ‘collateral trade’, as the blog noted last month:

“More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.  None of this used to matter when the Chinese economy was booming.  Why ask too many questions, when the profits are rising?  But now China’s economy is slowing fast under the new leadership.

“So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013″.

THE GREAT UNWINDING OF THE COLLATERAL TRADE MAY NOW BE VERY CLOSE
The government’s moves to investigate the potential fraud add a new dimension to the issue, and could have major ’second-order effects’.

Until recently, prices appeared to have stabilised in metals markets outside China.  But this was a false calm, caused by the fact that official investigations meant that the vast stocks of copper and iron ore in Qingdao could not be moved.

After last week’s official announcement, there is a clear risk that this calm may be replaced by panic:

  • Imports of new volumes of copper and iron ore (and other commodities) has become much more difficult
  • Banks have been told to check all requests for future Letters of Credit (LCs) very carefully indeed
  • This on its own is leading to delays of several weeks
  • And at the same time, rollovers of existing LCs have effectively been stopped, as they can no longer be issued against warehouse receipts

This means that all the new capacity coming online outside China is struggling to find a home.

And the truly frightening fact is that global output from the world’s 5 largest producers of iron ore is about to grow 40% by 2017 to 1.5bn tonnes.

Thus we are coming close to entering Phase 1 of the ‘Worst Case Scenario‘ described by the blog back in June:

“First to be hit would likely be the global commodity markets, if they wake up one morning to find that China’s vast ‘collateral trade’ is starting to unwind, perhaps rather suddenly:

  • The prices for those metals and other commodities caught up in the trade would be hit first
  • Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking

“Investors may begin to put 2 and 2 together and start to worry, as the BBC described in February, that “China Fooled the World”.”

 

 

Eliminating the impossible in China’s polyethylene market

China PE Aug14Very large amounts of copper, iron and other commodities are in long-term storage in China as part of the ‘collateral trade’.  More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.

None of this used to matter when the Chinese economy was booming.  Why ask too many questions, when the profits are rising?  But now China’s economy is slowing fast under the new leadership.

So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013, as the chart above shows, based on Global Trade Information Services data:

  • Could total demand in a large, nature market like China’s really have grown 12% in H1?
  • It was already nearly 20 million tonnes in 2013, and now it seems to have grown another 1.2MT in 6 months
  • We can certainly believe that production has grown 6% as China continues to support its job market
  • But can import demand really have grown 20% over the period to 5MT?

The blog, like many others, is left scratching its head about what is happening.

The likely answer comes from the insight of the famous fictional detective, Sherlock Holmes:

When you have eliminated the impossible, whatever remains, however improbable, must be the truth?”

If we apply this rule, then we must eliminate as impossible the idea that China’s demand could have grown 12%.  Instead we must accept that the imports have been used for some other purpose, however improbable this may seem.

Luckily, however, there is good support for this conclusion when we look at what has been happening in other commodity markets such as copper and iron.  Vast amounts of these commodities have been stored in warehouses as part of the ‘collateral trade’, as the blog described in its recent China Compass research note.

Fellow-blogger John Richardson has described recently how ethylene glycol also appears to be involved.  And in a “must read” post yesterday, he describes how polypropylene also appears to have been used – via the establishment of full-scale BOPP lines – for the same purpose.

The logical conclusion from the import data is that PE has become part of this trade, which appears to work as follows:

  • A company buys PE from an overseas supplier on 180 days payment terms
  • They immediately sell the volume on the Dalian futures exchange
  • Now they have money to invest in the property market at rates of up to 60%
  • They can then ‘roll over’ the purchase after 180 days by selling to a Hong Kong-based company
  • This company opens a letter of credit and can use the proceeds to ‘roll over’ the previous trade

The risks of a disorderly unwinding of China’s “collateral trade” are now rising day by day, as the leadership tackles the housing bubble.  As the Wall Street Journal reports, 17 cities now have inventories of unsold housing that will take at least 5 years to clear at current sales rates.

PE producers and consumers need to urgently develop a strategy to deal with this possibility.  Waiting until it happens will be too late.

 

Polyethylene, shadow banking and China’s ‘collateral trade’

The blog’s latest post for the Financial Times, published on the BeyondBrics blog is below.

By Paul Hodges of International eChem

Strange things are happening in China’s polyethylene (PE) market. Despite a slowdown in the economy, demand is surging.

Our research suggests that PE, like copper and iron before it, is the latest instrument of China’s ‘collateral trade’, in which spurious imports are helping to drive one of the world’s great credit bubbles.

It can only end badly.

China PE Jun14

As our chart shows:

  • Imports  have increased by 1m tonnes, or 34 per cent, versus 2012 levels so far this year
  • They were 4.2m tonnes in January–May versus 3.1m in 2012 and 3.4m last year
  • This would be an extraordinary increase at any time, but especially now with  the economy slowing
  • It also comes at a time when China’s own production is continuing to increase, up 17% versus 2012

As a result, implied demand was up 25 per cent versus 2012. This is impossibly high in relation to on-the-ground market reports, which suggest instead that growth is slowing due to the weakening economy. Buyers at the major ChinaPlas Fair in April were talking about credit shortages and weak downstream demand, while reporting that imports of PE were instead being used to buy condos.

These reports are confirmed by detailed trade statistics from Global Trade Information Services, which show that imports began to increase in November last year:

  • October had seen 690KT of imports, but November saw 870KT and December 908KT
  • Then January jumped to 1.1m tonnes, followed by 741KT in February, 786KT in March, 793KT in April and 811KT in May

The key to the puzzle is almost certainly to be found in the ‘collateral trade’, whereby metals such as copper and iron have been used to support lending into China’s property bubble. Given the way that the government has been steadily clamping down on this activity, and the various scandals that have already emerged at Qingdao and elsewhere, it is no surprise to find plastics such as polyethylene are now being drawn in to keep the trade alive.

It is also a logical development from the auto market reports highlighted by Merryn Somerset Webb in FT Money:

“Everyone’s offering 0% financing now and in some cases buyers end up with their car for free. How? The buyer pays for the car but with the guarantee of the money back in two years. The seller invests the money in the shadow banking system where he hopes for returns of 60% a year or so before selling up and giving it back. Not bad.”

The key to success for the PE collateral traders is the availability of a liquid futures market contract for polyethylene at Dalian, where the product can be turned into cash very quickly. As we described in a recent China Compass research note, one common mechanism is as follows:

  • The potential lender buys a PE cargo on normal 180 days credit from an overseas seller
  • He then turns around immediately and sells the cargo on the Dalian futures market
  • Now he has cash to lend into the shadow banking market at interest rates of up to 60%
  • In turn, the property developer now has the cash to finish his building work
  • As the 180 day period ends, the lender can ‘roll over’ the purchase by selling to a Hong Kong-based company
  • By opening a letter of credit, it can then use the proceeds to ‘roll over’ the previous trade

Of course, there are risks in this. But China is coming to the end of one of the world’s great credit bubbles. And when this type of bubble is under way, greed is a far more powerful emotion than fear. Who would want to be known as the only business in town that hasn’t done this type of clever deal?

Of course, it will not end well. The government is unlikely to change its mind about bursting the bubble. And of course, at some point, all this surplus PE will have to come back onto the market. That will be very bad news for everyone connected to the PE business, be they buyers or sellers.