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”.”