Almost every day brings new revelations about the growing evidence of major fraud in China’s ‘collateral trade’. Yet the world’s financial markets remain very complacent. They have forgotten the basic rule, that the first example is usually the tip of the iceberg – not a one-off mistake.
They have also forgotten that the real problems only emerge when the bubble finally bursts. As Warren Buffett warns: “Its only when the tide goes out, that you learn who’s been swimming naked”. Until then, everyone is making too much money to be worried about how exactly it is being earned.
This, the blog fears, will be the situation with China’s ‘collateral trade’. Investors wanted to believe it was all part of its superior economic policies and long-term growth prospects. So they didn’t ask too many questions if they found some of China’s commodity imports were in fact being used to fund its housing bubble.
As always, the initial alleged fraud appeared relatively small when it appeared back in April:
- Investigations at Qingdao suggested the total problem was perhaps $1.6bn
- This involved the same imports of copper and iron being used as collateral for multiple loans
- The borrowing was aimed at financing property development with potentially sky-high returns
This investigation is still continuing. Last week it emerged that the government has moved on, announcing that the chief auditor has found $15bn of fake loans backed by gold. This week we have learned that officials from Beijing have become involved, and that the Hong Kong Monetary Authority (HKMA) is keeping a close eye on developments:
“The HKMA has been closely monitoring the credit exposure, including those incurred from the business of commodity finance, of the banking sector. Authorized institutions are expected to maintain sufficiently robust system of controls to manage the specific risks that they are facing,” an HKMA spokeswoman said.
The issue is that the ‘collateral trade’ has been very profitable for everyone till now, as the blog’s new ‘Your Compass on China’ research note describes (produced with leading Hong Kong-based financial advisory firm Polarwide):
- A China-based company buys a commodity such as copper, or iron, or gold or soy beans
- An associate offshore company (often based in Hong Kong) then uses a letter of credit (L/C) to “buy” this product
- The commodity is then put in bonded warehouses, and taken off-market
Those involved are thus able to use the money from the L/C to invest in the property bubble at rates of up to 60%. They have also, until recently, been able to add an exchange rate gain by moving offshore money into China to benefit from the rising value of the renminbi. Crucially, also, the deal appears to be a normal “buy/sell” to Hong Kong lenders, and not directly connected to the ’collateral trade’. So the HKMA can’t yet know which deals might be suspect.
“Too good to be true”, you might say! And you would of course be right.
But if everyone else is doing it, then people feel foolish turning down the prospect of easy money. And until the new leadership came into power a year ago, rising property prices were a core part of government economic policy. So your friends would argue, “Where is the risk”, especially as the ‘collateral trade’ itself is not illegal in China.
We don’t yet know how much of China’s commodity imports have been used in this way. But we do know that the range of products now involved is very broad, including plastics such as polyethylene as well as metals and gold.
Equally, as the chart above from the Wall Street Journal shows, offshore bank loans into China totalled $1.2tn at the end of last year, up two-and-a-half times since 2010. And the vast majority came through Hong Kong.
So as the scandal broadens, from $1.5bn initially and now to $15bn, it would be no surprise at all to find that perhaps 25% or even 50% of these loans were in someway involved with financing the ‘collateral trade’.
So far, however, many commodity traders are missing the point. They look at the volume of copper sitting in bonded warehouses (as shown in this Financial Times chart), and imagine everything will soon be back to ‘business as usual’.
But it won’t be, if the blog is right that the ‘collateral trade’ was all about financing the property bubble – NOT about creating future income from economic growth.
‘Ghost towns’ have been built all over China during the post-2008 stimulus period, as this Bloomberg article describes. And now downside momentum is building in the property market, with new home sales in Beijing down 50% in H1.
The key question is therefore around the likely depth of the downturn underway in China’s housing market and its duration
- One leading analyst told the blog last week that he believes the new leadership are targeting a 30% fall in prices, in order to clear up the mess they have been left
- If that is true, a lot of collateral loans will end up being underwater
- And a lot of commodities will come rushing back onto the market in a potentially quite disorderly manner
In turn, this has the clear potential to trigger a major financial panic outside China, as the blog described earlier this month in China’s earthquake opens fault-lines in debt-fuelled ‘ring of fire’.
The issue facing us is very simple. China has been buying 40% of world copper supplies, 2/3rds of world iron ore and large percentages of most other commodities.
If a large part of this volume was actually used to finance the property bubble, as looks more and more likely, then there is trouble ahead once investors wake up and start to rush for the exit.