Should Industrial Metals Buyers Worry About This?
Surely, it is an internal Chinese matter; if a few Western banks have got themselves caught up in it and get burned as the clients default, the underlying commodity proves to not be there or pledged elsewhere, well, some may say, that’s their fault for lending in such an unregulated market.
But yes – we should be worried on a number of levels.
1. How this impacts the commodity price. If the banking sector, already clamping down on all forms of lending, withdraws these LC facilities as well, the metal in question will very probably have to be sold – and with physical demand down, that means exported from China into the Southeast Asian market. (Back to Reuters: so far the LME copper price has done no more than wobble in response to the unfolding events, but the real impact can be seen in the spread structure. The benchmark cash-to-three-months period was last week deeply backwardated, meaning the spot price was trading at a premium of $100 per ton to the forward price.)
That tightness reflected the simple fact that LME stocks are at multi-year lows because so much metal is located in China’s bonded warehouses. Today that spread is close to level as traders price in a potential mass relocation of copper out of China back to LME warehouses in South Korea and Taiwan. We are already seeing a reaction to the news and, as yet, nothing has been proven regarding even the one firm under investigation. That alone illustrates the acknowledgment that this is a widespread problem.
2. Beijing has been trying to clamp down on these shadow banking activities for some time, it looks like they may be finally making some headway. The size of the problem though, is probably unprecedented and it’s questionable if the system will be able to absorb it without bankruptcies among traders, dealers and processors.
Banks, for the most part, are well-funded and have the state standing behind them, but the trade is not so well-protected. This funding, open to corruption, fraud and embezzlement as it is, has kept the wheels of commerce rolling for many firms that would otherwise not have been able to access the cash to operate. Without it, there could be many firms that go to the wall with a corresponding impact on metals demand.
Beijing is right to lance the boil of this collateralized financing; they should have started two years ago when fears were first raised, but better late than never. The fallout, however, could be more widespread than it currently appears.
by Stuart Burns