A quite fascinating blurb in FT.com's Alphaville popped up yesterday, calling into question the reasoning behind the huge copper stores in China. If one is to believe this report, it appears copper - generally used as an indicator of economic activity due to it's use in so many applications (hence the term Doctor Copper) - is now being used as a form of fiat currency, by property developers trying to work around the Chinese government's tightening actions.
With China being the dominant force globally in the purchase of the red metal, [May 13, 2009: Commodities - It's China's World: We Just Live in It] [Mar 23, 2009: FT.com - Chinese Stockpiling Spurs Copper Price Rally] this report indicates not only is so much copper in storage, they can't even fit it all inside the warehouses in Shanghai.... but anywhere from 40-80% of the copper sitting around (at those locations) is not even being for construction but for rather as some sort of fiat currency, almost like gold. So is Doctor Copper now Banker Copper in China?
Of course it goes without saying what sort of havoc could incur if the value of your form of 'financing' - which is now a commodity - ever fell substantially
[please note, anything in italics below is from the original research note]
- We’re calling it the “The Great Chinese Commodity-as-Collateral Financing” fiddle. That is, the purchase of commodities like copper on deferred payment terms for the sole purpose of raising cheap financing for reinvestment in higher yielding assets.
- The latest comes in the shape of a Standard Bank note by a team freshly back from a Chinese field trip. Not only do they provide excellent new estimates of just how pervasive the practice in China really is, they’re sounding the loudest alert to the copper market yet.
- Here are some particularly useful anecdotes we found from the note:
- We 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.
The big news of course is that Standard Bank attributes the lion’s share of the commodity “fiddle” to property developers. That means, in their opinion, not only is the arrangement exposed to falling copper prices, it’s equally vulnerable to falling Chinese real-estate prices. Potentially, more so.
- A scenario of falling Chinese property prices, perhaps combined with a government clampdown on alternative sources of funding, would therefore be a devastating outcome for the copper market, simultaneously robbing the metal of an end-user and leading to a mini credit crunch. The obvious home for the bonded material would then be the LME warehouses in the Asian region, with very negative implications for sentiment towards copper prices.