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China, Chemicals And Interest-Rate Arbitrage

Business, China, Company Strategy, Economics, Polyolefins
By John Richardson on 16-Jun-2014


By John Richardson

WHACK A MOLE on the head and another one pops up somewhere else. This is  tremendous fun as an arcade game but not that much fun, metaphorically speaking, for the Chinese government.

“The commodity-backed loans at the centre of a probe into an alleged financial scam at a Chinese port [Qingdao] are part of a ramp-up in offshore borrowing by Chinese companies that Beijing is looking to tamp down,” wrote The Wall Street Journal in this article.

“As Chinese authorities tightened credit at home in the past year, local firms instead looked abroad for financing. Asian-Pacific banks alone had $1.2 trillion in loan exposure to China at the end of 2013, up two-and-a-half times from 2010, according to Fitch Ratings.

“A chunk of the borrowing has been by Chinese firms taking out short-term overseas loans backed by commodities, part of an effort to lock in gains by borrowing offshore at lower rates, and investing the money at higher rates on the mainland.”

This investment has been into the shadow-banking system – hence, the rise in shadow lending during Q1 that we  highlighted in Part  I of our whack a mole saga.

And loans into the shadow banking have been mainly via wealth management products (WMPs) that are being used to fund real-estate development.

So let’s work backwards from this.

As the government deliberately deflates the property  bubble in order  to make homes more affordable and  restructure the way that local governments raise money, we may be in for a nasty shock.

We may discover that substantial volumes of imports were not aimed at meet real and immediate demand but were instead all about this interest-rate arbitrage game.

In the case of iron ore, Reuters has suggested that 100 million tonnes is  “off-market” as it is tied up in collateral trades that we described above. This volume is enough to build 1200 buildings the size of New York’s Empire State building.

We think that the 26% rise in polyethylene (PE) imports in January-March of this year over the same months in 2013 was  largely down to traders playing the same interest-rate arbitrage game.

They took out foreign letters of credit, brought the cargoes into China and immediately sold them into the Dalian Commodity Exchange’s linear low-density PE (LLDPE) futures market in order to invest the money into WMPs.

What if the same thing has happened in polypropylene (PP)?

As we discussed last week, the 11.3% rise in January-April imports PP coincided with the huge initial success of a PP futures contract, which was launched by the Dalian in February. The above chart shows the rise in the number of contracts sold since February (each contract is for five tonnes).

And  the volume of methanol futures contracts on the Zhenghau Commodity Exchange jumped by 318% in January-April 2014 year-on-year. Is this mainly down to gambles on a strengthening in methanol prices or does it again have more to do with the interest-rate arbitrage game?

Why have we become even more suspicious?

“In mid-2013, authorities limited how much traders could borrow against commodities like iron ore and copper,” wrote the WSJ in the same article we linked to above.

“But that only pushed investors to start using a wider range of collateral, including soybeans and palm oil, according to Goldman Sachs.”

Could it be that investors have also been pushed into PE, PP and methanol futures?