Hypothecation

By Anne Stevenson-Yang
June 30, 2014

The irregularities around copper and aluminum financing in Qingdao started small and local. But the incident soon transformed into yet another story of China’s fraught banking sector, another story of credit creation based on assets that were simply not there.

At first, what seemed to be an investigation into an issue involving an insignificant amount of copper opened the door to a systemic problem of widespread, multiple and fraudulent hypothecation of commodity inventories. Discovering that the same inventory had been used repeatedly to collateralize large borrowings, international banks quickly began to withdraw from providing letters of credit to finance China’s commodities trade, and Chinese banks quickly moved to call loans secured by collateralized commodities.

The extent of the problem is now recognized to run into the billions: a widely quoted report by Goldman analysts estimates that about USD 160 bln in short-term foreign-currency loans outstanding are backed by commodities. The market value of the underlying commodities may never be fully known, but it is certain that a lot of the cash lent against them is now out of reach.

Any “naked” debt that defaults will be absorbed into various institutions managed by the central government. But constraining the use of imported commodities for borrowing would be of greater and more lasting impact to the international economy than the debt itself. If China’s importation of commodities were untethered from financial manipulations and tied more closely to China’s real economic demand for them, it would truly mean the end of the great commodities inflation cycle driven by Chinese global procurement.

Where the TSF went

As far as financing is concerned, no one should mistake this month’s focus on commodities hypothecation to be a government crackdown on the shadow market. Of necessity, the wide-ranging alternative financial system will remain a key platform for the Chinese economy to continue headline growth. Instead, the commodity scandal indicates the unique speed and flexibility of the Chinese system, both the core formal system and its shadowy extensions, in finding new financing and wealth extraction mechanisms when old ones become compromised or constrained.

What has looked this year like a return to slow credit growth under guidance by a conservative central bank actually turns out to be an externalizing of the credit bubble. It began with aggressive bond issuance in overseas markets, and now it turns out that hard-currency trade financing has patched in where domestic Renminbi loans were constrained. How much of this credit growth ultimately lurks on the balance sheets of foreign banks is hard to tell; they are exposed via open letters of credit, via commodity-backed cross-border and onshore loans, and via claims on partner banks in China. Whether or not their exposure is extensive, the Qingdao incident exposes the fact that the commodities trade is a fundamental strut in the hot-money infrastructure. Trade partners will not be able to escape being caught when the shadow system crumbles.

Not as good as gold

The Chinese economy specializes in investing: some might say that is the only economic activity at which the government is successful. Given government’s laser focus on collecting and deploying capital, China has developed stunning excess capacity in just about everything; the ghost cities ranged across every part of the land are the latest instantiation of that tendency. Commodities are another: the Chinese press estimates that 30 mln tons of iron ore sit in warehouses collateralizing debt before being deployed in steelmaking. As much as 70% of copper stores are being used as collateral, according to copper traders. Estimates put the amount of soybeans held as collateral at about 10 mln tons, against 63 mln tons of imports in 2013; the 33% spike in soybean imports in Q1 this year was almost certainly done in reaction to tightening of domestic credit. Further reports have exposed extensive and likely multiple hypothecation of palm oil, aluminum, zinc, nickel, titanium, and just about every other traded commodity.

Importing commodities has little to do with market demand. It is a way of generating free cash. The 250% growth in copper trading that occurred in the first quarter of 2014 is not explicable by increased demand. Defaults by Chinese importers on contracted soybean imports in April suggested that not all soy is for consumption either. The soy defaults were a warning sign that banks may be over-confident about the value of commodities held as collateral. The campaigns against corruption may also have been the proximate cause of the Qingdao investigation. Whatever it was, the ultimate cause is the tightening of domestic credit, leading agile financial innovators to conjure up new mechanisms to seek international sources of cash.

The Qingdao scandal

Current revelations began in Qingdao, when metal used to collateralize debt for a company called Desheng Mining turned out not to be in the warehouse. Desheng Mining was wrapped up in a corruption investigation targeting the Party secretary of Xining, the capital of Qinghai Province. Initially, it seemed that the damage would be limited: traders said that Qingdao was a very small port for copper, and that counterfeit warehouse certificates (used to back the trades) are uncommon in copper. Consensus suggested that the whole Qingdao operation might be part of a political vendetta expressed in a focused anti-corruption initiative.

Then reporters noticed that China’s National Auditor’s Report for 2013 had highlighted over RMB 94 bln in falsified gold trades. The 2013 audit report section 6 on State-Owned Financial Institutions reads:

“1. Financial innovation is irregular, and some institutions circumvent regulation and supervision of loans. . . . There were companies that used “empty transfers” as an arbitrage method, and a sample of accounts since 2012 of 25 gold and jewelry companies indicated that they used “virtual” trading platforms to engage in repeated cycles of cross-border, cross-currency trades worth RMB 94.4 bln and earn RMB 900 mln on the currency and rate spreads.”

This terse formal report raises all key aspects of the problem—the virtual trading platforms, the related-party interests, the evasion of regulation and supervision, the involvement of local government financing platforms, and ultimately the goal of arbitraging interest rates. The only dimension not explored is the massive embezzlement of the proceeds.

In 2013, China became the world’s largest market for gold, buying 1,132 tons, for 26% of global private sector demand. The World Gold Council attributed this buying to a cultural belief in gold and rising real incomes, and it projected the 2017 market at 1,350 tons; that may turn out to be less cultural than they thought. Incidentally, the previous year in which China accounted for such a high portion of global demand was 1997, just before the Asian financial crisis.

After gold came rubber: stores of rubber have fallen about 10% in June, as authorities scrutinized the hypothecation of rubber for loans; Chinese news reports say that about 14% of rubber is used as collateral for loans.

The copper story is evident from the three charts below. Copper traders fund import of the metal with an LOC, sell a warrant to an offshore subsidiary, and then collateralize the shipment for debt, the proceeds of which go into high-yield loans in the property sector. In January, tighter credit meant that developers and LGFVs were forced to pay escalating rates for short-term loans. Imported commodity-based borrowing financed a lot of those loans. It was not just a coincidence that copper imports rose to record highs as domestic sources of credit declined.

Toward the end of February, weakening currency depressed the appetite for traders to hold losing positions. Copper trading activity rose, warrants fell, and the price of copper started to slide down, gearing up the exposure to foreign debt held with RMB sources of revenue.

Foreign banks

To what extent foreign banks are exposed to speculative finance that has been hypothecated many times over is perhaps impossible to untangle. At the end of 2013, the Hong Kong Monetary Authority published an estimate that HKD 3.6 tln, or 22% of Hong Kong’s banking assets, were exposed to the mainland, HKD 313 bln of that in trade finance and HKD 441 bln in off-balance-sheet items that are mostly related to trade.

Quiet defaults?

Between the start of May and mid-June, the PBOC injected RMB 1.08 tln through various channels and left RMB 437 bln in the market indefinitely. The new re-lending facility created through the Construction Bank also added higher-quality backing to much of the credit in the market. Monetary authorities seem to be selling some reserves, working as well to maintain an exchange rate of 6.22, just above the 6.23 level at which QE3 commenced in 2012, bringing the latest rush of hot capital into the country.

All this monetary activity was directed at the June 25 audit date on which, in 2013, interbank defaults occurred. But expanding the long-term money supply by half a trillion RMB suggests that the bank was doing more than preventing new defaults: deep in the background, there must be local banks in danger of going broke under the combined impact of the commodity-related defaults and property defaults.

For the rest of the world, that means that the great Chinese commodities expansion is over. On the other hand, the growth and risks of China’s foreign borrowing may just be beginning.

What does this say about quality of debt generally in China? We resolve the measure down to two things, the creditworthiness of the borrower and the market value of the assets that collateralize the debt. In China, the former is a political question for entities that borrow at scale, because their solvency ultimately depends on whether their outsize debt is likely to be ‘sovereignized’ or diffused by the powers that be.

For the latter, the troublesome reality is that the commodity borrowing crisis has revealed not only large-scale fraudulent use of warehouse receipts and letters of credit but a pervasive lack of controls in the use of commodity stocks as bank assets across the board.

Ultimately, in the commodity-based banking market, how much real market value underlies how much debt? We saw with Credit Equals Gold #1 one answer to that question for a coal-based wealth management product that was wildly out of line.

Moreover, we ask this same question about the property market which we have discussed at length in these reports. Ultimately, how much real value underlies how much debt? For pricing purposes, property lacks the fungibility of commodities, so the underlying value calculation is distorted by a different set of devices.

The risks of the commodity-based and property-based credit markets in China are additive, and a risk assessment for the economy overall needs to encompass both. Between these two colossal monuments of debt, commodity-based and property-based, China finds itself facing real asset insufficiency that might well eclipse the Great Wall in gobsmacking scale.