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Commodity finance in China: An assay-light strategy; A fraud investigation casts a shadow over China’s metal imports

Commodity finance in China: An assay-light strategy; A fraud investigation casts a shadow over China’s metal imports

Jun 14th 2014 | From the print edition

AT THE best of times, seizing collateral on defaulted loans in China is a fraught task, plagued by patchy enforcement. These are not the best of times in the port of Qingdao, a trading hub in the north-east. Police are investigating whether companies have committed fraud by pledging the same holdings of copper and aluminium to multiple banks, multiple times. The banks are scrambling to see how much of the metal sitting in Qingdao’s warehouses actually belongs to them.

More than just a fraud, the tale exposes China’s financial idiosyncrasies and the lengths to which firms sometimes go to borrow money. Regulators have tried to choke off credit to metal traders in recent years as part of efforts to slow pell-mell construction. Traders have devised a simple workaround. Banks have been willing to grant them letters of credit to fund purchases of metal. The traders have used the credit to buy some and then, on occasion, immediately resell it, leaving them with cash to invest in high-yielding shadow-bank products.

This ruse can earn enticing returns. The gap between the traders’ investment returns and their funding costs can reach ten percentage points. And that is before fraud enters the picture. By obtaining letters of credit from different banks to buy the same copper again and again, traders amplify their returns.

The crucial ingredient in this deceit is a receipt of ownership issued by the warehouse where the metal sits. The 21st Century Business Herald, a Chinese newspaper, said receipts tied to the same stash of metal had been issued ten times.

Financial alchemy of this kind is common on the margins of China’s banking system. But in this case, it comes with global connections. First, there is China’s demand for commodities. The Qingdao investigation will make banks more reluctant to grant letters of credit, even when legitimate, hampering imports and so weighing on prices. Second, foreign banks have been big issuers of letters of credit to Chinese metals traders. Goldman Sachs estimates that commodity-backed deals account for as much as $160 billion, or about 30%, of China’s short-term foreign-exchange borrowing. Only a tiny sliver of that is believed to be at risk in Qingdao, but foreign creditors may become more skittish. Call it collateral damage.

 

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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