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 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….
“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.