Shadowy Chinese loans behind copper’s decline

VANCOUVER — In recent years, as prices for many resources slide, copper has held its ground. Gold and silver stumbled, uranium and iron ore deteriorated, and coal and potash dragged, but copper simply settled from a five-year high of US$4.50 per lb. in early 2011 to average a respectable US$3.50 for the next few years.

Now, suddenly, copper is falling. On March 11 copper futures on the London Metal Exchange closed at US$2.958 per lb., down 8% in four days and below US$3 per lb. for the first time since October 2011. The day before, the most-traded copper contract on the Shanghai Futures Exchange fell to its lowest level in more than four years.

Copper is supposed to be the metal with the PhD in economics, its price driven by a supply-demand balance that ebbs and flows according to global market realities. However, every well-supplied, liquid market provides traders and speculators the opportunity to profit — if they can just figure out the right trade.

Copper opportunists found that trade in China, but now the opportunity is coming back to bite.

It started in 2012, when Chinese authorities started cracking down on credit availability to curb inflation. With legitimate debt harder to come by, a shadow banking sector sprang up. The key collateral? Copper.

Companies that could not get regular bank loans could often still get low-interest letters of credit in U.S. dollars to buy copper. With a stack of copper as collateral, a company could then borrow more money and put those funds in a higher-yielding investment. In time the company would sell the copper to repay the debts, retaining the investment yields plus any U.S. dollar–renminbi arbitrage.

Chinese borrowers turned to these deals, known as “import financings,” soon after Beijing implemented the first wave of limitations on bank loans to property developers. Copper quickly became the most popular option for collateral because it is liquid and easy to store.

However, the trade gets risky when copper prices fall or the renminbi weakens, both of which happened in early March. Copper is now off 14% since the start of the year and the renminbi lost 1.4% from mid-February to March 5, stoking fears that many of these copper-backed financing deals might unravel.

If they do, vast quantities of copper held as collateral would be unleashed onto the market while the need for copper as collateral for loans would shrink, erasing a big chunk of China’s copper demand. None of the analysts or traders Reuters spoke to could say with certainty how much copper is tied up in Chinese financing deals, but they estimated that 60–80% of imports are due to financing demand.

China accounts for 40% of the global copper trade. If 60–80% of that evaporates along with copper-backed import deals, a quarter of current copper demand would be gone.

That is why last week’s bond default by Shanghai Chaori Solar Energy Science & Technology was so significant: it proved that Beijing is no longer backstopping Chinese corporate debts. Until Chaori’s default, global markets assumed Chinese regional governments could be counted on to bail out their local champion companies. Now that assumption is invalid.

Without an implicit state guarantee, Chinese debt is far riskier. That means credit — both official and shadow — will tighten. Slower growth means less copper demand from actual users. A slower credit market means less copper needed as collateral.

That is why one Chinese corporate bond default triggered a sell off in copper of more than 8%.

A second bond default appears imminent in China: solar-panel manufacturer and power company Baoding Tianwei Baobian Electric has been suspended from trading in Shanghai after announcing net losses.

Baoding may default on its bonds. It also may not. Other Chinese companies with copper-backed loans likewise may or may not default. If they do, copper could fall further.

However, many analysts think the sell-off is already overdone. Referencing recent comments from Chinese Premier Li Keqiang, Chris Chang of Laurentian Bank Securities notes China maintains a 7.5% growth rate, and will employ monetary and fiscal policies to maintain that growth if necessary.

As such, Chang says more Chinese bond defaults are a concern, but a 7.5% growth target “should continue to foster strong demand out of China and absorb additional excess inventory that may come to the market.”

Other analysts pointed to copper’s tight supply-demand balance as a reason prices will not fall much further. In February Morgan Stanley analysts said they were “optimistic about copper prices in contrast to consensus views of substantial oversupply.” Instead of oversupply, Morgan Stanley’s group sees a high probability that new mines and expansion projects will encounter delays, hindering supply growth notably.

Similarly, Ray Goldie and his team at Salman Partners see a copper sector impacted more by shortfalls than oversupply in the coming years.

“Shortfalls in supply in the West are becoming more important — the Western world has woefully under-invested in finding new mines,” Goldie said. “And we have become surprisingly inept at operating the mines we have.” By way of evidence, Goldie notes that every year since 2005 the Western world’s copper mines have produced 830,000 tonnes, or 7% less copper than forecast.

“Every year, Dr. Copper falls short of what she thought she could do,” Goldie concludes.

That failing could prove to be copper’s best bet for a price recovery.