China's Commodity Financing Deals
Saturday, 6/07/2014 11:11
Commodities like copper and iron ore are loan collateral in China's hot credit markets...
THERE HAS been a great deal written in the press over the past few years about Chinese commodity financing deals (CCFDs) and their effects (or not) upon various different commodity markets,
writes Tom Vulcan at Hard Assets Investor.
Most recently, particular focus has been on the iron ore and copper markets.
When writing about the FANYA Metal Exchange last month, I suggested that the exchange and the stocks of metal it "holds" may actually be a nifty way for China's State Reserve Bureau to complement – with "buffer" stock financed by exchange members – the country's national stockpile of such metals.
Looking at the whole subject of CCFDs, however, I started to wonder whether some of the stocks held in FANYA's warehouses might not also be collateral for commodity financing deals.
The use of various commodities in financing deals has been around since time immemorial; maybe, in the case of copper, for as long as the metal has been available to humans in tradable form. And that would be a very long time, as copper is the world's oldest mined commodity.
The simplest commodity financing deals involve the use of a commodity as collateral (or security) for a loan. Failure to pay results in the lender selling the commodity. In the early days, the "commodity" could have been anything: wine, grain, livestock, metal, precious stones etc.
These days, such collateral is much more likely to be something with a high value-to-density ratio, such as gold, silver, nickel. It should be as cheap as possible to store and, as importantly, should not degrade over time.
So, while both soybeans and palm oil and even rubber have historically and even recently been used as collateral in financing deals, they certainly are not favored as such. (Indeed, the recent default by Chinese importers on 500,000 tons of US and Brazilian cargoes of soybeans (being used as collateral) posed a threat to the soybean market itself.) In addition, an article in the mid-May Nikkei Asian Review mentioned that even semiconductors have been used.
Commodity financing deals these days can, but do not need to, be somewhat more complex. However, the basic principle underlies all such deals – the use of commodities to secure finance. In a "carry trade", a borrower uses the commodity not only as security for a loan, but also, at the same time, to make money.
For example, in a favorable contango market, a commodity can simultaneously be bought physically using borrowed money, and sold forward. If the price for which it is sold is sufficient to cover the interest on the loan, the loan itself, storage charges, insurance etc., and more, then, when it comes time to repay the loan and deliver the commodity, the "and more," will be locked-in profit.
As will be obvious, for as long as conditions remain favorable, such an arrangement can be extended simply by rolling it over, locking in a profit each time it is.
There are a number of reasons for raising financing in this way. Most obviously in China, for cash-strapped companies unable to secure credit in other ways outside traditional banking channels, deals involving the use of commodities as collateral may be an available option.
According to the Chinese state-owned newspaper the 21st Century Business Herald, quoting an unnamed industry expert, at the end of April, some 31 percent of the country's iron ore stockpile was being used as collateral to raise finance. And when it comes to copper, who knows how much is being used as collateral?
According to the
Financial Times back in March, it was Credit Suisse's opinion that, when it came just to Chinese copper imports (not even domestic production), up to a third may have been passing through financing deals. According to Reuters in mid-April: "While there are no statistics on tonnage held in financing deals, analysts estimates range rom 250,000 tonnes to 1 million tonnes that are being used as collateral."
Whether or not funds so raised are in fact used by those companies in the course of their businesses is, of course, a totally different question. There are certainly companies that are either lending them back into the market or investing them in other, higher-return, ventures.
For some companies, however, just engaging in such financing deals can, in itself, be a higher-return venture. In this riff, companies without access to loans from state banks at official interest rates turn to import financing as a source of cash flow.
Through the use of letters of credit, these companies are able not only to tap cheap US Dollar loans, but also exploit the arbitrage opportunities offered by the difference between local and international interest rates. Once again, it's often anybody's guess where the finance so raised goes: into nonbusiness-related high-yielding assets; the business itself; or, funneled into the shadow banking sector.
The scale of such deals has not been insignificant. And probably remains so, even after the fall in copper in March that must have shaken not a few players out of the market.
Indeed, according to Goldman Sachs, quoted by Bloomberg back in March, such transactions using commodities as collateral "made [up] as much as $160 billion, or 31 percent of China's total short-term foreign exchange loans." Of this total: "Copper financing may account for about $23 billion worth of short-term foreign exchange loans, iron ore for $10.4 billion and soybeans for $7.7billion in a base case."
For those playing this game, if the rates go the right way, there may also be the chance of additional profit from the foreign exchange side of the deals. But with "[r]eturns from using copper as collateral...still more than 10 percent," that's a pretty handsome profit to start with. (Drawing on Goldman Sachs' report, it's worth looking at the Systemic Risk and Systematic Value site for a lucid brief description of how, using copper, such a CCFD transaction works.)
Not surprisingly, the Chinese authorities are taking a dim view of CCFDs, not only because of their effects on China's short-term foreign exchange lending, but because of their quite-flagrant abuse of processes established to facilitate the financing of legitimate (and real, as opposed to "virtual") imports. Particular focus has been on iron ore and copper deals.
Starting this month, the State Administration of Foreign Exchange (SAFE) will implement a number of new regulations it believes will have the effect both of raising the cost to banks for issuing foreign exchange letters of credit, and reducing the scale of the country's short-term foreign exchange loans by increasing the level of deposits required by banks, thus reducing the scale of funding available for such CCFDs.
Will the government's "crackdown" on such financing activities see a flood of copper and/or iron ore onto the market? Probably not. Not least because it would be in no one's interest to have it happen. Quite apart from that, in many people's opinion, financing is, in the words of "one large physical trader" quoted in the Financial Times, "a red herring."
A slow unwinding of positions, rather than a crash, is much more likely. And, perhaps more importantly, as pointed out by Stephen Briggs of BNP Paribas in a piece – Copper: Broken Contacts – in The Economist at the end of March, "the "few hundred thousand tons" involved in these deals is only a small part of a 20 million-ton market." Also, it's not as if anybody knows for certain how much is actually locked away in such financing deals.
Maybe for copper and iron ore it's the end of the story. But perhaps not for some other commodities. Many would like to know just how much cobalt and/or nickel could be tied up in such deals. In the case of nickel, with what's happened recently in Indonesia, this could be quite a serious issue. And it's not as if the cobalt market is currently the most liquid in the world.
And then, of course, there are all those metals on FANYA. Are any of them tied up in financing deals? Again, who knows? Insofar as, in many of these transactions, no commodity actually moves an inch, anywhere, it could be so: everything stays neatly stored away in the exchange's growing roster of warehouses. But, some might object, the exchange is a just spot exchange. There's no way for people to hedge with forwards.
Now, if all that indium is, in fact, tied up in financing deals (frankly unlikely), and were they to be unwound rapidly, then that would be a very, very different story.
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