Sitting in China's copper and steel warehouses is a hidden risk to the world's second-largest economy -- banks' indirect exposure to a property market that is showing signs of stress.

Since late 2010, Chinese entrepreneurs and state firms have used trade loans to import goods such as copper and soybeans, which they have then quickly sold or used as collateral for further loans, skirting government credit curbs.

Many lent that cash in informal markets, earning as much as 70 percent interest -- a nice return given that bank fees and commissions on letters of credit (LC) can be as low as 3 percent for established companies, and allow payment some six months down the line.

With a chunk of their loans business in lockdown after Beijing clamped down on lending, especially for the property sector, banks found such trade financing an attractive alternative as it had not fallen under the central bank's ever-tightening restrictions.

While Beijing has moved to clamp down on the practice, banks are still exposed to an unexpected batch of bad loans should a slump in property prices and sales coincide with another sharp fall in commodity prices.

Banks are already heavily exposed to the property sector and if a chunk of their trade finance books is also exposed to real estate, they could be in for a double whammy, said Stanley Li, China banking analyst at Mirae Assets.

The end-game may be very nasty if higher financing costs, a property price correction and a slump in commodity prices trigger waves of defaults, said Li, who has researched extensively into the risk of this cash-for-commodity phenomenon in China.


Banks will already be breathing a sigh of relief that they have made it through one potential crisis.

A brutal commodity rout in September, which saw London copper prices down by more than a third at one point to a 14-month low and Shanghai steel prices down 20 percent, sparked warnings that some firms would be unable to meet margin calls on their LCs and force banks to auction off commodities held as collateral.

Prices did fall below our covenant so we had to get clients to top up margins or increase inventories. But we haven't had people who can't pay up, said a senior executive at a foreign bank that focuses on loans to the commodities business.

The pricing formulae for copper, which allow buyers to set prices after the cargo arrives, as well as the extensive use of hedging instruments, have helped blunt some of the price gyrations.

Prices for Shanghai copper futures fell by 20 percent in September, to as low as 51,580 yuan a tonne.

Prices didn't fall enough for defaults to happen and the decline was also quickly arrested. If it (copper) had fallen to around 40,000 yuan a tonne, a lot of small trading firms might not have made it, said an executive at a trading firm.


However, there are still plenty of such loans outstanding to smaller trading firms in copper and steel, exposing banks and traders to the risk that the once-frothy property market could start to see a serious correction.

The property market, once a favorite of speculators, is now starting to see prices fall and, with them, revenues for those who had invested in developments, impacting the ability of some investors to repay their loans.

Some housing projects in Shanghai have already lowered prices by around 30 percent in recent weeks and some developers have run into problems repaying their debt, according to local media reports.

Though it will try to keep the market steady, Beijing risks holding on too long to its tightening policies aimed at reining in home prices and inflation even as it faces slowing economic growth and strong external headwinds.

Should the traders who have borrowed through trade finance start to lose money on their property deals or not be repaid what they lent to others to speculate on property, that could potentially be a catalyst for a chain reaction of defaults, analysts say.

You'll need a convergence of a few events to unleash this can of worms: a sustained, sharp fall in copper or steel prices that coincides with a large amount of these trade-related loans maturing, said the loans executive from the foreign bank.


There is no reliable data on the extent of such trade financing -- inventories of commodities can be anything from poorly catalogued to a state secret -- but what is sure is that it is widespread enough that it has expanded beyond copper into the markets for steel and soybeans.

With steel prices still in the doldrums and a significant portion of the country's 610 million tonnes of rebar inventories used as collateral, it is now the weakest link in this elaborate scheme.

For steel, which is largely domestically traded, merchants tend to either use their warehouse stocks as collateral for loans, or to turn to acceptance bills, an equivalent to a letter of credit for domestic markets.

The proceeds obtained from financing by steel traders are usually used in other sectors such as property and underground loans, said a trader with a Shanghai-based steel firm, the owner of which is from Wenzhou, which has become a hub of informal financing that has started to see defaults.

Some of the smaller players have already started to be weeded out.

There have been more than 15 steel trading firms, with most of the owners from Fujian province, being forced to shut down as their financing chain was broken this year, said a trader based in Wuxi, Jiangsu province who was in direct contact with one of the firms that closed.

Around three steel trading firms have been sued by banks now, as they used the proceeds from financing for extending private loans, but now can't get those loans repaid, the trader said.


The practice extends to agricultural commodities.

Faced with tepid domestic demand, some soybean crushers in Shandong province have also used LCs to import beans, then sold the beans into the market, even at a loss, to get cash that they can channel back into the underground banking system.

A lot of that money poured into Wenzhou, a city in eastern Zhejiang province known for savvy entrepreneurs that has now become the center of concerns over systemic defaults in such informal lending networks.

Lin Shunfeng, a futures manager at Shenyin & Wanguo Securities who travelled to Jiangsu, Anhui, Hubei and several other provinces to research the topic, said the practice was most prevalent around June, when the market was oversupplied and port stocks were filled to the brim.

He estimated that around 10-15 percent of the 6 million tonnes of soybean stocks held at ports in June were used as a tools for cheap yuan.

Based on soybean prices at that time, those stocks would imply at least 1.23 billion yuan was rolled on to underground loans, but the actual value could have easily been in the tens of billions as firms could use the cash received as a leverage for larger sums.

It is difficult to estimate the scale of such funds involved in the steel and copper markets, but the figures are clearly much bigger, as traders well connected with warehouses often are able to use the same batch of cargo to repeatedly get bank loans. Some could even inflate the value of their stocks to land fatter loans.


This ingenuity in circumventing capital controls has not gone unnoticed in Beijing.

In August, the government included deposits for bank acceptance bills and letters of credit -- previously deemed as off-balance-sheet assets -- for calculating their reserve requirement ratio.

The effect was instant. Trade financing costs quickly tripled for some mid-sized companies and the move mopped up an estimated 800-900 billion yuan ($125-$141 billion) of deposits from the banking system.

Recent earnings reports from Chinese banks also showed that the volume of such loans issued in the last quarter had dropped, while a steady decline in Shanghai warehouse stocks suggests fewer firms were able to use this sort of backdoor trade financing.

Some bigger trading firms that themselves have been extending credit have also been forced to tighten up.

We've been lending out money to peer trading companies and using their cargoes as collateral. But as credit conditions have become tighter and tighter, we have increased our interest rates from 15 percent earlier this year to around 22 percent now, said a Shanghai-based steel trader.

We are also only lending to a select few ore trading companies that we are familiar with and find trustworthy.

Although that is good news for the larger economy, it could be the reverse for commodity markets since it means China's ability to scoop up global copper supplies during any price routs will be limited.

Going forward, the sort of buying would be more rational and driven by actual demand instead of a means to get cash, said Helen Lau, an analyst at UOB-Kay Hian in Hong Kong.

It's bad for sellers but not a bad thing in the eyes of Beijing, which has long been worried about commodity speculation at home driving up raw materials prices for its own people.

(Additional reporting by Niu Shuping in BEIJING; Writing by Fayen Wong; Editing by Jason Subler and Michael Urquhart)