The Chinese Copper "detour"

There's an old Irish joke about a guy who's lost and desperately looking for the road to Kilearney. When encountering a farmer and asking for the right direction, the answer comes straight : "If you're heading for Kilearney, I wouldn't depart from here". Chinaman's dilemma is identical. The detour however is not without any danger.

We have touched the Chinese issue over the past couple of months in various ways : bubble econonomics, currency wars, UST ownership (London calling), Japanese angle etc. And China deserves attention because it has become a major global player. And to make our life more difficult, China is a questionmark on the issue of statistics. Briefly, they send into the world what they want the world to believe. In the meantime, we get however some info from insiders which is troublesome.

Last year, we posted some comments on the Chinese real estate frenzy, underpinned by numbers and plain facts : price/income ratios in certain big cities by far exceding Western standards in the glorydays of London and NY, and youtube movies of ghost towns (over-investment feeding economic "growth"). The more troublesome part came from a Chinese professor teaching in the US with the following numbers :

"Many of the stimulus projects undertaken this past year have been financed, not by the central government directly, but by local governments, including cities, counties, and provinces. For the most part, however, they have limited funds and face official restrictions on their ability to borrow directly. To circumvent these limits, they set up special investment vehicles to borrow the money instead. Because these debts are supposedly guaranteed by the local governments (meaning they would step up to pay if the immediate borrower couldn’t), banks and other lenders tend to treat the loans as essentially risk-free.

Northwestern University Professor Victor Shih calculates that local governments have already accumulated RMB 11 trillion (US$ 1.7 trillion) in outstanding debt, with RMB $13 trillion (US$ 1.9 trillion) in available credit lines, belying China’s low reported levels of public debt...Whether regulators will really leave banks holding the bag for the loans that have already been made is another matter. The government has no interest in undermining the balance sheets of the big banks, which it would be forced to bail out in any event.

But I found the Bloomberg article’s allusion to the 1998 collapse of Guangdong International Trust & Investment Corp (GITIC) potentially prophetic. Besides the “big four” banks, China has literally hundreds of smaller lending institutions, from municipal banks to trust companies to rural credit co-ops. I wouldn’t be surprised if many of these institutions, with their close ties to local governments, own a big piece of the loans being called into question. It’s too early to say, but if GITIC offers any precedent, we could see a handful of less-favored institutions cut loose and allowed to implode. Depositors, creditors, and investors might be well advised to start asking, who is the next GITIC?"

Bloomberg, 08/03/10

Now this is not new and in the nineties, China in fact experienced a financial crisis which in those days was already quite substantial. Coming back to today and the current state of play. We have seen China wrestling the "inflation & growth gorilla" over the past couple of months. And in the light of currency wars, China has avoided to prick the bubble by means of interest rates through other channels. The main channel was to crick up the the balance sheet of banks or lift capital reserve requirements and tighten lending conditions (no more loans for second home etc). And we also have evidence of "late bubble financial technology" through securitrization and off-balance sheet operations which have seen the light in Bejing as well. But for the latest trick, we have to turn to the copper market. The chart underneath pictures the evolution of the 3 month futures on copper :

Now looking at this chart, several thoughts come to mind. It is revealing on volatility and risk-off-risk-on trades. An implosion and a trippling of prices in 2 years. The credit crisis is over ? Copper, next to zinc, is the preferred indicator for construction sentiment. So if copper is booming, the business cycle is OK and happy days are here again. The problem is that construction sentiment now is totally different from 2008. We no longer have a bullish real estate frenzy in the US - witness Case Shiller home prices, unsold existing US home stock, NAHB confidnece etc - and we no longer have UK, Irish nor Spanish optimism. The sole survivors up until now are Canada and Australia, potentially next to China. Nevertheless, for which bubble-like argument whatsoever, copper prices now are 10% higher than in pre-crash 2008. China bubble or something else ?

It could be that copper is functionning as a funding device in China because the usual ways of bank funding have reached their limits. In fact, some recent research papers seem to point in that direction (copper collateral for loan). An on the field note from "Standard Charters" :

"W e visited China last week, with the aim of gauging Chinese sentiment, the impact of monetary tightening measures on consumers and also investigating the scale and implications of copper’s use as a financing tool. We were already fairly bearish towards copper’s near term prospects before the trip. That negative feeling has intensified, with significant downside risks to copper prices emerging.

Anecdotally, something in the region of 600,000 mt of refined copper is currently sat in bonded warehouses in Shanghai, with perhaps another 100,000 mt in the southern ports. This is equivalent to around 11% of China’s total refined consumption and around 40% of China’s net refined copper demand. Bonded stocks have climbed by around 300,000 mt since the beginning of this year, pointing to the absence of end use demand at the moment. The amount of metal is so high, that spare capacity at some bonded warehouses is running out, with some metal being stored outside. The scale of the refined inventory casts into doubt the size of the expected refined deficit in the copper market this year, and raises the prospect of a balanced market, or even a small surplus. More worryingly however is that the primary use of copper in bonded warehouse appears to be as a financing mechanism to provide cheap working capital for various types of business often unrelated to the metallic industry.

Initially via a letter of credit and then by using deferred payment LC, they create a borrowing vehicle. Estimates for the amount of metal tied up in such a way range from 40-80% of total bonded stocks. Our estimates are towards the upper end of this range. Property developers (or the property developing arms of conglomerates), appear to be behind the lions share of this type of activity, driven by an unwillingness by domestic banks to extend finance, or the imposition of interest rates of anything from 10-20% when they do. On that basis, interest rates on metal of LIBOR + cost of funding look very attractive indeed."

So property developers - or business in general - using copper for collateral financing ? If this holds, than watch out for price movements in copper. If a crisis situation should trigger volatilitity on the downside in the near future - cfr 2008 and accelerating unwinding of positions- we have a China syndrom on our hands with ripple on effects all over the place.