Collateral Damage in China’s Commodity Pileup. For now, the rot seems limited to the surface. But that is only because investors have little visibility of what is at the heart of China’s financial system

Collateral Damage in China’s Commodity Pileup

AARON BACK

June 23, 2014 7:10 a.m. ET

The mysterious case of missing metals at a Chinese port is a headache for the global banks involved. It is also an omen of more widespread risks in the country’s financial system.

Several foreign banks including Citigroup Inc. C +1.52% and Standard CharteredSTAN.LN +0.95% PLC are investigating whether the same stocks of copper and aluminum, stored by a trading company at a Qingdao port, were pledged to all of them as collateral for loans. Deepening the intrigue, a major state-owned enterprise, Citic Resources Holdings Ltd. 1205.HK +0.79% , says some metals that it has stored at the Qingdao port can’t be located.

Borrowing against imported metals has been one of the key ways to filter cheap foreign money into the country, where speculators had been benefiting from higher interest rates and gradual appreciation of the currency. Analysts atGoldman Sachs Group, Inc. estimate that commodity financing deals accounted for about 30% of China’s short-term foreign borrowings since 2010, adding up to between $80 billion and $160 billion. Those flows are now drying up, as slowing growth in China weighs on commodity prices, and a more volatile yuan exchange rate cuts into arbitrageur returns.

For foreign banks, aside from the embarrassment of not keeping track of collateral, the fallout should still be limited. Data from the Hong Kong Monetary Authority, covering banks including the Hong Kong units of HSBC HoldingsHSBA.LN -0.49% PLC and Standard Chartered, shows that trade finance accounted for just 8.6% of total loans at the end of April. CLSA analyst Derek Ovington estimates that only a small portion of that total, perhaps 10%, is related to the metals trade in China.

The bigger worry is what episodes like the Qingdao port fiasco say about China’s lenders. Regulators have issued repeated warnings on lending against commodity stockpiles to the domestic banks. And while regulators may be able to prevent borrowers from pledging, say, a pile of iron ore or, more worryingly, a shopping mall, as collateral to multiple, closely watched mainstream banks, it is less clear if they can prevent collateral from being pledged to multiple shadow lenders.

Defaults this year by borrowers in the trust sector, part of the shadow banking system, and in the country’s bond market, showed regulators are determined to slowly expose frailties in the financial system to failure. Cracking down on commodity lending appears to be part of that effort.

For now, the rot seems limited to the surface. But that is only because investors have little visibility of what is at the heart of China’s financial system.