Polyethylene, shadow banking and China’s ‘collateral trade’

Financial Events

The blog’s latest post for the Financial Times, published on the BeyondBrics blog is below.

By Paul Hodges of International eChem

Strange things are happening in China’s polyethylene (PE) market. Despite a slowdown in the economy, demand is surging.

Our research suggests that PE, like copper and iron before it, is the latest instrument of China’s ‘collateral trade’, in which spurious imports are helping to drive one of the world’s great credit bubbles.

It can only end badly.

China PE Jun14

As our chart shows:

  • Imports  have increased by 1m tonnes, or 34 per cent, versus 2012 levels so far this year
  • They were 4.2m tonnes in January–May versus 3.1m in 2012 and 3.4m last year
  • This would be an extraordinary increase at any time, but especially now with  the economy slowing
  • It also comes at a time when China’s own production is continuing to increase, up 17% versus 2012

As a result, implied demand was up 25 per cent versus 2012. This is impossibly high in relation to on-the-ground market reports, which suggest instead that growth is slowing due to the weakening economy. Buyers at the major ChinaPlas Fair in April were talking about credit shortages and weak downstream demand, while reporting that imports of PE were instead being used to buy condos.

These reports are confirmed by detailed trade statistics from Global Trade Information Services, which show that imports began to increase in November last year:

  • October had seen 690KT of imports, but November saw 870KT and December 908KT
  • Then January jumped to 1.1m tonnes, followed by 741KT in February, 786KT in March, 793KT in April and 811KT in May

The key to the puzzle is almost certainly to be found in the ‘collateral trade’, whereby metals such as copper and iron have been used to support lending into China’s property bubble. Given the way that the government has been steadily clamping down on this activity, and the various scandals that have already emerged at Qingdao and elsewhere, it is no surprise to find plastics such as polyethylene are now being drawn in to keep the trade alive.

It is also a logical development from the auto market reports highlighted by Merryn Somerset Webb in FT Money:

“Everyone’s offering 0% financing now and in some cases buyers end up with their car for free. How? The buyer pays for the car but with the guarantee of the money back in two years. The seller invests the money in the shadow banking system where he hopes for returns of 60% a year or so before selling up and giving it back. Not bad.”

The key to success for the PE collateral traders is the availability of a liquid futures market contract for polyethylene at Dalian, where the product can be turned into cash very quickly. As we described in a recent China Compass research note, one common mechanism is as follows:

  • The potential lender buys a PE cargo on normal 180 days credit from an overseas seller
  • He then turns around immediately and sells the cargo on the Dalian futures market
  • Now he has cash to lend into the shadow banking market at interest rates of up to 60%
  • In turn, the property developer now has the cash to finish his building work
  • As the 180 day period ends, the lender can ‘roll over’ the purchase by selling to a Hong Kong-based company
  • By opening a letter of credit, it can then use the proceeds to ‘roll over’ the previous trade

Of course, there are risks in this. But China is coming to the end of one of the world’s great credit bubbles. And when this type of bubble is under way, greed is a far more powerful emotion than fear. Who would want to be known as the only business in town that hasn’t done this type of clever deal?

Of course, it will not end well. The government is unlikely to change its mind about bursting the bubble. And of course, at some point, all this surplus PE will have to come back onto the market. That will be very bad news for everyone connected to the PE business, be they buyers or sellers.


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