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Last week FT Alphaville drew attention to a seemingly ingenious financing strategy being implemented by some Chinese commodity firms — the use of copper inventories as collateral for loans.
We only had a few sketchy details at the time, but to our understanding the arrangement’s main purpose was serving as an elaborate inflation hedge.
Since then, however, we have stumbled across a note from Barclays Capital (H/T Jack Farchy) outlining another slightly different (yet equally savvy) strategy. Namely, firms in China taking advantage of the delayed payment function in letters of credit to…
(Now bear with us.)
…buy copper on credit, take delivery of said copper, sell said copper at full price to market, then post the returns in higher yielding assets until the due date for the full payment of the letter of credit arrives — in most cases some 180 days later.
A nice risk-free carry in effect.
Now, if only we knew more, right?
Luckily for us someone well-informed has obliged us with a few answers — thanks in part to the open questions we posed on FT Alphaville in a previous post.
The source in question is a commodities trader in China. The information provided sheds an amazing light on what’s been going on and to what degree.
Here’s the gist of it.
In the first instance, our source says, the strategy is not exclusive to copper markets but goes on across most commodity markets.
The banks call it “inventory financing”. And of course, we should stress, it is completely legal. The practice mainly involves pledging an asset in return for an exchange warrant or cash.
According to our source, traders can deposit copper in an exchange warehouse in order to receive a warrant which can then be used to gain financing, usually via a broker, and less a 15 or 20 per cent haircut needed to cover futures margin deposits (sometimes called margin or warrant financing).
It’s a very useful facility, says our source, for any trader that needs to short-hedge but who does not want to face massive margin calls in the event that prices increase. The funds released by the exchange go directly to a broker account, and so cannot be misappropriated.
So that’s all fine and dandy.
It’s the use of the funds, however, that might be more of a concern.
For example, our source says it’s bad enough that it could be skewing analysts’ estimates of the global economic landscape and leading to a buildup of excess stocks in China.
But the open secret is that a lot of the money used from this strategy has gone into other assets like real estate, commodity futures and stocks.
Meanwhile on the LC front, our source says companies importing copper are indeed buying it on deferred payment terms. For example, 1,000 tonnes of copper bought using a 180-day LC means the companies don’t have to pay the bank issuing the LC for 180 days after the shipment arrives in China.
During that time, though, the copper can be pledged as collateral for cash — and the funds raised are free to be invested any which way the company wishes.
As our source points out, with real estate and commodities having gained 20 to 30 per cent, or more, in some six-month periods, this could have been an extremely profitable activity in the last couple of years.
Here, meanwhile, are our source’s responses to our specific questions (abridged).
1) Exactly which banks and lenders are in the business of extending loans against copper collateral?
A comprehensive doesn’t exist but most of the major domestic banks, including some of the big A1 international banks with operations in China, and even some futures brokers with financing departments offer inventory financing for their clients.
Again, much of this is perfectly legitimate. The most established practice is in copper, but the lenders allow invoice financing for other commodities as well.
2) What are the terms and conditions of such deals?
[No comment]
3) To what degree are authorities aware of the issue?
They are aware of it, and it has been made very clear to the entire market that bank loans of any sort are not to be used for speculation in commodities, stocks or real estate.
So rather than being concerned about inventory financing per se, the authorities aim to prevent bank loans and hot money of any sort from entering asset markets. Punishment for violating this policy includes the loss of your trading license and probably worse (punishment for such transgressions is not entirely transparent).
Despite this the practice goes on regardless. If the main concern with such financing were simply misleading analysts and leading to overstocking of copper inventories, the authorities would not be as concerned.
Since large amounts are going into other assets, the concern and monetary policy response — to bring down the price of many assets — is stronger, which indicates the authorities' awareness. Indeed, some people think the current monetary tightening and other administrative measures are explicitly intended to break this kind of activity (not just in copper but in the asset markets in general).
4) How pervasive is the practice exactly?
The practice is well-known among commodity traders in China, which indicates that it is widespread.
5) Where can we find a list of Chinese bonded warehouses who may be safeguarding copper collateral in this way? From a copper trading company, although it wouldn't be available in a transparent list format but rather word-of-mouth as to which warehouse has copper for sale.
6) What sort of companies are involved?
Domestic trading companies are the primary user of invoice financing. Most are entirely domestic entities; others are the subsidiaries of big international trading houses. The domestic entities are the ones that would be channeling any resources into other activities; the international subsidiaries are too concerned about government rules to channel funds into other assets, and are very wary of doing anything that would jeopardize their access to the domestic market.
7) What copper price level would trigger a mass "negative copper equity" sell off?
No one can answer this question with precision but it's possible that we're pretty close right now. The inability of a number of Chinese domestic commodities prices to keep up with stronger rises in overseas markets since November shows that current monetary and administrative policies are biting.
How much of Chinese stimulus spending went into such stockpiling?
It's not that the government itself is engaged in this behavior (they are trying to limit it as above) but that the stimulus and massive bank lending in general went in part to private companies that engaged in this trade. Precise numbers are again, alas, difficult to quantify.
Illuminating stuff, no?
Related links: More proof the Chinese have been using copper as collateral - FT Alphaville What really drove Chinese commodity imports? "“ FT Alphaville China, the currency factor and copper "“ FT Alphaville Contingent liabilities, letter of credit edition – FT Alphaville
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