Using Commodities as Collateral: The Case of China
Antonio Cesarano
Head of Market Strategy, MPS CAPITAL SERVICES
Background
In recent years, commodity prices have experienced significant fluctuations, with different reactions from financial markets. In particular, the dynamics of commodity prices showed significant differences during the economic and financial crisis that began in September 2008 (i.e., the month of the default of the former government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac). In response, in the following months, the U.S. Federal Reserve (FED) spent billions to buy back Treasury notes and mortgage-backed securities. During the two years after the crisis began, the U.S. government was forced to create the TARP (Troubled Asset Relief Program) fund to recapitalize banks. In fact, the first two years of the crisis were characterized by a strong correlation between injections of liquidity by Central Banks and the resulting sharp increases in raw materials. This dynamic is the result stemming from several other factors.
The strong monetary expansion practiced—predominantly—by the U.S. Central Bank had increased the expectation of a rapid recovery of the world’s largest economy. Consequently, it also increased the expectations of the recovery of the Chinese economy, which, in turn, was highly dependent on the U.S. demand. This aspect appears to be particularly relevant. In fact, in the years before the financial crisis, China was among the main consumers in the world of many different commodities. Therefore, when supporting the U.S. growth, the FED expansionary policies indirectly supported the Chinese economy, increasing the expectation of a strong growth in demand for commodities.
Besides these dynamics, the financial market reacted by generating strong price fluctuations and high volatility conditions, especially if compared with the precrisis phase, as we can see from Figures 8.1 and 8.2.
We refer here not only to the speculative component, but also to the stronger presence of some institutional investors, characterized by interests in long-term investments. This was the case of pension funds investors, which, in that period, increased the exposure of this asset class, with different purposes. First was the chance to take advantage of the increase in global demand, increasing the performance of their portfolios. Moreover, commodities appeared to be an asset potentially capable to “hedge” against the risk of higher inflation and market rates, driven by monetary policies.
Figure 8.1 Copper price fluctuation between 2007 and 2016
Source: Trading economics.1
Figure 8.2 Brent crude oil price fluctuation between 2007 and 2016
Source: Trading economics.2
However, since 2010 the situation changed. In fact, raw material price dynamics started experiencing minor fluctuations. During the second phase of the crisis the Euro-zone suffered much more than other regions. The beginning can be traced back to the default of Greece in mid-2010, followed by similar cases in Portugal and Ireland, with a subsequent wide and deep spread to Italy. In this phase there were the first signs of a slowdown in the Chinese economy, with the simultaneous gradual downsizing of the global demand for commodities. Despite further monetary policies on a global scale, in this situation commodity prices did increase. Speculation did not find the support of the demand increase for Chinese commodities anymore, which was relevant during 2008 to 2010. Moreover, major central banks expressed an explicit commitment in maintaining low interest rates, allowing a gradual increase of pure carry trade deals. Further the financial markets have increasingly preferred bonds carry trades, rather than directional trades in the commodity market.
The downsizing of Chinese demand, and the resulting major stability of the main commodities (with respect to the first 2 years of the crisis), has gradually reduced commodity price risk perceptions. Consequently, companies reduced the demand for hedging products. In addition, higher regulatory constraints have been imposed to the world’s leading brokers, with consequent higher trading costs for commodities. Many financial operators, which had introduced and/or increased the weight of commodities in their asset allocation, changed strategies. Moreover, investors perceived that the risk of disinflation/deflation was significantly higher than commodity price risk. All these factors influenced a global reduction of the commodities trading.
In the context of declining interest rates, some financial institutions started considering asset liability management (ALM) investments. This is the case of pension funds, for which the aging population trend leads to an increase in the pensions to be paid. At the same time, the strong and rapid decline in market interest rates resulted in an equally sharp decline in asset yields, boosting the issues of risk from an ALM perspective. Consequently, some pension funds have begun to downsize the total return portfolio assets, which were able to generate good performances in terms of capital gains. This downsizing has most likely affected commodity markets. This was maybe due to the expected low performance—in terms of flows—linked to commodities.
The Use of Commodities as Collateral
In recent years the use of commodities as collateral to obtain loans has increased. The phenomenon has spread particularly in China and has concerned mainly industrial raw materials (in particular copper, aluminum, iron, and gold) because of their characteristic of being nonperishable. Some analysts estimate the amount of foreign exchange loans in China with commodities as collateral to be about $109 billion. This amount is equal to the 31 percent of total Chinese short-term currency loans, and the 14 percent of all foreign currency loans regardless of maturity.3
This phenomenon (so-called commodity-based financing) has become a crucial driver of shadow banking in China. It is a kind of parallel system of funding for Chinese companies, in addition to traditional banking. According to an analysis produced by ANZ bank, the assets in the hands of “shadow banks” reached about $4,900 billion, representing approximately 50 percent of the country’s gross domestic product (GDP).4 The most common form of “shadow banking” is represented by the “Trust companies” that are companies specialized in investing in sectors with high potential returns. As reported by the China Trustee Association, the assets managed were the equivalent of about $2,500 billion at the end of December 2015, a 16.6 percent over the same period in 2014.
A typical scheme for connecting commodity-financing to Chinese trusts includes the following main steps:
A Chinese company (A) specialized in import–export subscribes a commodities purchase contract with a foreign company.
The same company (A) uses the commodities purchase contract to request a credit note (with maturities typically between 3 to 6 months) to a domestic or foreign bank. The loan is in U.S. dollars, the currency needed to pay for commodities. To get the credit, the Chinese importing company will have to pay a margin, generally between 20 and 30 percent of the total loan. In turn, the importer may sell futures on Chinese markets to protect itself from the risk of a decline in commodity prices.
Commodities are shipped to storage sites located in China (usually adjacent to the ports). The importing company receives a certificate attesting the arrival of the commodities by the storage site operator.
With this certificate the company (A) goes to a domestic bank to obtain loans in yuan, offering the deposited commodities as guarantee. The bank grants the loan in yuan, typically applying a fee (the so-called haircut) of around 30 percent, which means a lower rate than in the case of absence or other guarantee.
The company (A) invests the loan in yuan by offering the borrowed funds to small organizations operating in high growth sectors. Often the investment is made through the purchasing of trust units. Therefore, by the expiring date, the company (A) will gain the differential between the low cost of funding in yuan (thanks to the collateralization effect offered by commodities) and the high expected returns from investments. Figure 8.3 represents a typical process of commodity-based financing.
Figure 8.3 The process of commodity-based financing
Source: Commodities as collateral.5
Sectors that represent typical investment destinations are those in the composition of the assets of the Chinese trust, as shown by the China Trustee Association. At the end of June 2014, 50 percent was invested in industrial companies and infrastructure industry, and about 11 percent in the real estate sector. One of the fundamental points of a commodity-financing scheme is the presence of a low level of the Libor rate in U.S. dollar compared to Shibor rate.6
The close connection between the world of Chinese trusts and the trend of commodities used in commodity-financing has been evident during 2014. Two have been the most striking episodes.
On March 5, 2014, a Chinese company producing solar panels (the Shanghai Chaori Solar) declared it was not able to pay interests of about $15 million on some bonds near to maturity. After this announcement, copper recorded a decline of about 9 percent in a week. It was the first default on Chinese corporate bonds, which increased the perception that the phenomenon could be more widespread. The default could have probably led the domestic financing bank to use the collateral for the loan offered in yuan, in this case leading to a sharp decline in the copper price.7
On June 4, 2014, an ongoing investigation by the Chinese authorities was reported about port of Qingdao—offering copper as collateral for various loans. An investigation was opened after a complaint made by CITIC Resources Holdings Limited (one of China’s most important financial companies publicly owned).
Summary
The strong link between commodity financing and shadow banking has attracted the attention of the government that is trying to curb these transactions. At the beginning of Chinese Lunar New Year of 2014, there has been a marked depreciation of the yuan, partly induced just to make investments in commodity financing less convenient.
From the aforesaid considerations, the attempt to control the phenomenon (already partially evident from the abovementioned sharp decline in growth of the assets of the Chinese trusts) turns out to be critical. There are—in particular—some potential consequences in terms of credit reduction to small–medium Chinese companies, and in terms of new price reduction trends, similar to the dynamics of 2014.
This chapter started describing what recently happened in the financial market, particularly after the crisis of 2008 and the FED’s reaction. Since 2010 the situation has changed, and the use of commodities as collateral to obtain loans has increased. In particular, the chapter aimed at describing how this phenomenon has spread, particularly in China, and has involved mainly industrial raw materials. In parallel, during the last years, the Chinese economic slowdown caused a general reduction of the global commodities’ demand, strongly influencing commodity prices. Looking at the future, we expect that two drivers will determine the commodity price volatility: the Chinese market dynamic and the use of commodities for financial speculation.