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China sees $13.5bn of fake September ‘collateral trade’ invoices

Financial Events
By Paul Hodges on 29-Oct-2014

China PE Oct14China’s ‘collateral trade’ is still a major force in world markets for iron ore, copper and even plastics such as polyethylene.  September’s data suggests $13.5bn of fake invoices added 56% to the value of China’s exports to Hong Kong, as property developers strove to raise cash to finish their buildings.

Full details of the trade are given in our June Research Note, and you can read a quick summary here.  There are 2 major reasons why it matters so much:

  • Investors had thought China’s vast imports of copper and iron were due to its rapid industrialisation.  But it is now clear that much of the volume has instead funded speculation in China’s housing bubble
  • China’s government is now aware of the problem.  It has identified increasing amounts of fraud and is investigating the fake invoice problem.  As a result, Letters of Credit have become hard to obtain

What does this mean for you and me?  It means that companies have made a terrible mistake by expanding capacity to supply apparent demand in China.  Not only does this new production have no home to go to.  But all the product sitting on China’s docksides has no home either.

I simply cannot see any way in which this story does not end badly.  The only questions are around exactly when the end comes, and how bad it is.  Clearly, it could be very bad indeed, and I fear the Worst Case Scenario identified back in June risks becoming ever more probable.

Developments in plastics markets are only a small part of the story.  But trying to unravel them seems valuable, as their smaller scale helps to make the bigger picture easier to understand.

The chart above identifies the key problem, namely the impossibly large rise in China’s apparent polyethylene (PE) demand this year.  Data from Global Trade Information Services shows:

  • Demand apparently surged 22% this year (red column) versus 2012 (blue column), with imports up 20%
  • Production also rose 22%, in line with increases for polypropylene (up 24%) and PVC (up 19%)
  • But China’s PP imports have actually fallen 2% over the same period, and it has become a net exporter of PVC
  • Why would PE suddenly require a 20% increase in imports?

The only rational explanation is that imports have been used as collateral to finance property market speculation.

The really worrying point is that it seems this game may be coming to an end.  China’s housing market is slowing fast, with prices falling in 69 of 70 cities last month.  So PE producers and consumers, like those in metals markets, now need to worry about what happens next.

They are the innocent victims.  But being innocent will not help if, as seems more and more likely, there is a disorderly unwinding of China’s “collateral trade”.   Where will all this stored volume go, and what will happen to global prices?

Self-preservation means companies must urgently develop a strategy to deal with this risk.  Waiting until it happens will be too late