We have made further visits to warehouses and market players over the past month, following our recent observations of a significant rise in inventories and the growing popularity of finance deals in China (see Commodity Outlook, 7 March 2011, ‘Copper – A reality check from China’).
We found that traders were still delivering copper to bonded warehouses in mid- to late March, using metal as collateral for bank loans, although inflows slowed in April.
As of this week, we estimate that total copper stocks in bonded warehouses in Shanghai (usually 80% of the national total) have hit 650 thousand tonnes (kt) – equivalent to roughly four weeks of China‟s domestic use, a record-high level (Chart 2). This is significantly higher than 550kt in late February and the 200kt average over the past three years.
What is worrying for bulls is that the majority of these copper stocks are tied to finance deals, meaning either that they were bought for the purpose of collecting bank loans, or they were unable to find immediate buyers. Either would indicate that there is no real demand backing these stocks; hence, we believe a surplus of the metal in China is imminent.
Finance deals at bonded warehouses have been extremely popular this year – their total volume has jumped roughly 70% since the end of 2010. Copper is the most popular collateral due to its high liquidity in the market. While other metals, including aluminium and zinc, are also used as collateral to obtain cheap financing from commercial banks in the domestic market, copper is the only metal being lent to banks in bonded warehouses.
The turnover of these finance deals is closely related to monetary policy. The last time China had very tight monetary policy was from end-2006 to early 2008, and copper finance deals rose during that period. But at times when liquidity is ample and it is easy to obtain loans through normal channels, the ratio of finance deals to total bonded stocks is generally very low.
Over the last three months, we have met three metal producers, six manufacturers and 10 trading firms. All reported problems acquiring the necessary financing. While trading firms apparently have an advantage in doing finance deals due to their exposure to the copper market, other corporates take advantage of copper finance deals. According to anecdotal reports, small to medium-sized property developers have also been using copper for this purpose since February.
The short version: Businesses can't get loans because the Chinese government has made it harder to borrow in order to fight inflation. However, Chinese companies are finding a way to borrow money anyway using copper (and aluminum and zinc) as collateral. "[T]he 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." Some of the companies are property developers themselves, so it's no secret at all where they've put the money.
None of this is currently illegal. While commodities are going up, and property is going up, it's a great way to make more money. You can't lose: your investments are going up, the collateral against which you've borrowed becomes more valuable, and the nominal value of your loans stays the same.
Everyone knows that property only goes up in China. And of course commodities will keep rising as long as the property boom in China continues to increase demand.
What could go wrong?