By John Richardson
“The companies are in trouble because they resold their inventories in order to invest directly in real estate, or indirectly in real estate via the shadow-banking system. This would have worked in the past, but not now, because of Beijing’s economic reforms,” he said.
Some of China’s biggest nationwide distributors have also greatly increased their speculative activities since the beginning of 2014, we were told by a second polyolefins industry source.
“As much as 50% of the activities of some of these distributors now involve using polyethylene (PE) as a financial instrument to raise credit for speculation in shadow banking and real estate,” he said.
His description of how this works was as follows:
- They import cargoes of linear low-density PE (LLDPE) and low-density PE (LDPE) film-grade resin.
- These cargoes are then immediately sold to converters in the Rmb physical market at slightly discounted prices.
- The distributors then use the cash to invest in shadow banking and real estate.
- They then have 60-180 days, or whatever the terms of their letter of credit (LC), to make a profit before they have to repay their LC to a foreign bank.
“They use LLDPE and LDPE film grades because these are the most liquid grades – i.e. they are easy to sell. High-density PE film grade, and HDPE in general, isn’t as popular because it is harder to sell,” added the second source.
He believes that this resin is then made into finished plastic film by the processors.
This raises the question of whether growth in the finished films market in China is sufficiently strong to fully absorb these opportunistic purchases of lower-cost resin. These purchases are probably being made by converters who, because of their scale and technical sophistication, are still finding it easy to source domestic trade finance.
Our second source believes that the market is strong enough to absorb these extra volumes of finished film because, despite China’s overall economic slowdown, “catch-up growth” in the less-developed provinces remains very strong.
We hope he is right, but worry that:
- The food packaging films market in China, into which LLDPE and LDPE films grades largely go, will never grow by more than around 6% per year overall, even taking into account the very rapid “catch-up growth” in the less-developed provinces. In the developed eastern provinces, food packaging is close to being a mature market.
- Thus, the 12% apparent demand growth for PE that we saw in H1 2014 over the same period last year involves some stock building – possibly at the finished films stage of the value chain.
- And/or these finished films have ended up in export markets. Exports could have been supported both by the cheaper resin costs and new government incentives aimed at boosting export trade.
We also think that another mechanism is at play here. This is where:
- Somebody again buys an overseas PE cargo, using an LC from a foreign bank.
- He then immediately sells the cargo on the Dalian LLDPE futures market.
- The seller looks as if he has gone short on the Dalian, and has probably sold to someone going long in the most liquid of the exchange’s contracts (as you can see here, the most liquid contract, as of today, was the one that closes in January 2015).
- But if the cash he then makes by investing in the shadow banking market is enough to a.) more than repay the interest on his LC and b.) cover any paper loss he makes on Dalian prices strengthening, rather than weakening, he is happy.
- At some point, cargoes sold into the Dalian will find their way on to the physical market.
More homework is clearly needed on all the above. This is work in progress. We will constantly re-examine our data, and market intelligence, to try and find the answers.
Like us, polyolefins companies cannot afford to, metaphorically speaking, tell the teacher when they turn up at school in the morning: “The dog ate my homework”.
This excuse will not wash with senior board members and investors if it turns out that 12% apparent PE demand cannot comfortably disappear into 6% real demand growth.
The blog has a confession to make: It once used this excuse whilst in primary school. The only problem was that its teacher lived on the same street as the blog, and knew that its parents didn’t keep a dog.