Today, the blog launches a major new Research Note in the ‘Your Compass on China’ series, produced in association with leading Hong Kong-based financial advisory firm Polarwide.
Titled ‘Here today and gone tomorrow – a simple guide to China’s world of trade finance’, it is probably the single most important paper it will publish all year – please click here to download a free copy.
The bottom line – China’s vast imports of commodities such as iron and copper have, in reality, often been used to finance today’s property bubble. This is how it worked:
Sardine tins were scarce during World War 2 in the UK, and often became tradable items in their own right. Then one day, a company decided to open some for a celebratory lunch, only to find that the sardines had decayed, and were uneatable. On complaining to their supplier they were told – “That’s not our fault. Those sardines were for buying and selling, not for eating.”
This is perhaps the best analogy to explain what has been happening in China with its so-called ‘collateral trade’ since 2009. The world wanted to believe that China’s rise to consume two-thirds of the world’s iron ore, and 40% of its copper, was due to its superior economic policies and long-term growth prospects. But the truth is somewhat different. A major part of these imports have instead been used as collateral for loans to support its housing bubble.
News agency Reuters has suggested, for example, that 100 million tonnes of iron ore are currently tied up in such financing deals. This would be enough to build 1200 buildings the size of New York’s Empire State building. A wide range of other commodities have also become involved more recently, including polymers such as polyethylene and polypropylene. As the Wall Street Journal reports:
“In mid-2013, authorities limited how much traders could borrow against commodities like iron ore and copper. But that only pushed investors to start using a wider range of collateral, including soybeans and palm oil”.
The concept behind the ‘collateral trade’ was simple, though its various mechanisms are complex. Its aim was to finance speculation in China’s property sector as it reached bubble-like proportions, with central Beijing apartments selling for 34 times average earnings. This is four times the ratio seen at the height of the US sub-prime boom.
Property developers have been offering sky-high returns for short-term loans. And one easy way to participate has been to use imported commodities as collateral for letters of credit issued offshore – often in Hong Kong. Investment bank Goldman Sachs estimate that up to $160bn may have been involved in such schemes.
Now, however, China’s new leadership has begun to steer a new course with the economy. The $10tn lending programme developed since the Crisis began in 2009 is being wound down. Property development, currently almost a quarter of the economy, is being drastically scaled back. As state-owned China Daily has highlighted:
“If the country is to eliminate up to half of its industrial base to make way for business based on the mobile Internet, it will have to keep the credit line really tight for local development projects.”
Thus the ‘collateral trade’ is fighting for survival as China’s government and central bank clamp down. China’s 3rd largest port, Qingdao, was closed in early June, with news reports suggesting that up to $1.6bn of allegedly fraudulent deals were under investigation. Qingdao had already started to see property price declines of 20%-30%, as the government’s new policies hit home. Now, as The Diplomat notes:
Qingdao’s commodity and asset market troubles offer an example of how the decline in the shadow banking and real estate markets is playing out in China. It reveals that interconnected degradation is eminently possible and potentially circular, as one shock reinforces another in turn. It is likely that we will see other similar situations emerge in the near future. Qingdao also shows that after-the-fact policies such as loosening mortgage lending are too small to combat full-on market retrenchment. It is hoped that larger reform policies will stimulate economic growth where defensive economic policies cannot. Much is likely to play out through the end of this year.
Investors and companies are now discovering, the hard way, that a large part of China’s commodity imports have not been used for their proper purpose. Instead, like wartime sardines, they have simply been collateral for buying and selling – this time, in support of a gigantic property bubble.
