Since we first exposed the topic of China’s Commodity-Financing Deals (CCFDs) in May 2013, deals which some have since called China’s commodity “carry trades”, and warning of the looming “bronze swan” once said deals are unwound, copper (among most collateralized commodities) has been slumping.
The double-whammy of central-bank-inspired overcapacity, with a crackdown on the CCFD shadow credit markets has now flowed into the miners/producers – no more so than Glencore and Trafigura (as we have detailed).
A subsequent analysis by Goldman attempted to quantify just how big CFD “carry trade” is as follows:
Fast forward to the recent shocking developments involving Glencore, which recently crashed to a record low price as the market finally realized what we had been saying all along: Glencore is a levered bet on not only China’s economy, but the fate of copper pricing.
And while talking heads proclaim the worst is over, Bloomberg looks back at the carry trade first discussed here, and finds that as much as 70% of finished copper backs the “carry trade” whose upcoming unwind will lead to even more price pain.
As we introduced in 2013, the critical issue of how China uses commodities as financial assets was, and remains, largely ignored and vastly misunderstood: i.e., the fact that copper’s ubiquitous arbitrage and rehypothecation role in China’s economy through the use of Chinese Copper Financing Deals (CCFD) is coming to an end.
Copper, as China pundits may know, is the key shadow interest rate arbitrage tool, through the use of financing deals that use commodities with high value-to-density ratios such as gold, copper, nickel, which in turn are used as collateral against which USD-denominated China-domestic Letters of Credit are pleged, in what can often result in a seemingly infinite rehypothecation loop (see explanation below) between related onshore and offshore entities, allowing loop participants to pick up virtually risk-free arbitrage (i.e., profits), which however boosts China’s FX lending and leads to upward pressure on the CNY.
Since the end result of this arbitrage hits China’s current account directly, and is the reason for the recent aberrations in Chinese export data that have made a mockery of China’s economic data reporting, China’s State Administration on Foreign Exchange (SAFE) on May 5 finally passed new regulations which will effectively end such financing deals.
The impact of this development can not be overstated: according to independent observers, as well as firms like Goldman, this will not only impact the copper market (very adversely) as copper will suddenly go from a positive return/carry asset to a negative carry asset leading to wholesale dumping from bonded warehouses, but will likely take out a substantial chunk of synthetic shadow leverage out of the Chinese market and economy.
Naturally, for an economy in which credit creation is of utmost importance, the loss of one such key financing channel will have very unintended consequences at best, and could potentially lead to a significant “credit event” in the world’s fastest growing large economy at worst.
Read the full article here for the ugly reality details.
As we concluded in May 2013, “if you haven’t shorted copper after reading the above…. we suggest you re-read it.”
This is what happened next:
And while Glencore managed to hedge/survive its way through 18 months of commodity price declines, until the damn broke this year:
The recent dead-cat-bounce has been proclaimed by many as ‘proving’ the worst is over.
However, as Bloomberg reports, when it tears off the scab on the festering wound over China’s CFDs aka commodity “carry trade”, the pain for copper – and thus Glencore – longs may be only just starting:
The great mystery of metals is the amount used to finance the Chinese carry trade, or collateral used to borrow cheap dollars to buy yuan-backed high-interest-carrying notes. The Bank for International Settlements says this trade may be $1 trillion to $2 trillion, tying up tens of millions of metric tons of iron ore, aluminum and other metals. About a year of global copper consumption (22 million mt) equals just 5% to 10% of the estimate. The true figure will determine real China metal demand and future inventory.
Carry trade distorts China copper demand, leads to oversupply
The impact of the Chinese metal carry trade is in the distortion of the true underlying copper demand, and a buildup in the metal’s inventory, strictly for collateral in financing. China accounts for 46% of global copper demand, according to the Word Bureau of Metals Statistics. One question analysts must ask: What if it’s just 35%? The potential stopping of this trade, and normalization of the distorted demand, will provide understanding of China’s true copper needs and their potential growth.
If nickel is a guide, carry trade’s unwinding would roil markets
Nickel prices have fallen by half since year-end 2013, when they surged after No. 1 global exporter Indonesia banned exports of nonprocessed ore. Inventories are near record levels. The likely culprits for the higher inventory and price crash are the large amounts of the metal held off exchanges because they were used as collateral in a carry trade that took advantage of China’s high interest rates. A warehouse scandal at the Qingdao complex prompted banks to call in these trades, pummeling nickel prices.
China carry trade dismantling could be a $2 trillion unwind
The lucrative practice of using commodities as collateral to make money from interest-rate differentials inside and outside of China, a practice known as the carry trade, could cause significant pressure on commodity markets, were the trade to unravel. The Bank for International Settlements says this trade exceeds $1.2 trillion worth of commodities and could reach $2 trillion. Any major change in the direction of this trade could flood the market with more supply.
China traders’ yuan metals carry trade worked, until it didn’t
A depreciating yuan has hurt the carry trades of those who benefited from when the currency was strengthening, and the trades have begun to unravel, which may cause significant disruption in global metal markets. For almost a decade, the Chinese allowed the yuan to appreciate vs. the U.S. dollar and many other global currencies. In 2014, as the country began to open up its currency to foreign trading, it began to weaken, culminating with a 2% depreciation in August.
As China stokes economy with lower rates, carry hurts metals
The rise of the “carry trade,” which used metal as collateral to finance low-cost U.S. dollar-based capital sources to invest in high-interest- yielding yuan credit, could rapidly decline as China sharply cuts interest rates to stoke internal demand. Lower rates inside China may hurt the value of the yuan as the interest-rate differential with other currencies becomes less compelling. Massive amounts of metal could be tied up in this trade, and its unwinding may be the story to watch in 2016.
Up to 70% of copper imports may be caught in China carry trade
The Chinese have used various commodities to back the trillion-dollar carry trade, now the question is by how much. As much as 70% of finished copper imports may have been used, according to a report in the Financial Times. This would mean 15 million to 25 million metric tons of copper could be tied up in the carry trade. Any significant unwinding of this trade could cause significant disruptions to global copper markets.
In other words, if we, and now Bloomberg (whose Chairman Peter Grauer, incidentally, is on the Glencore board) , are correct, and if the CFD “carry trade” unwind has only just begun to impact the real supply/demand dynamics, and thus true price discovery, of copper, then we are only 30% of the way through said unwind and thus the ‘over-capacity’ concerns may be lethally – for Glencore – under-appreciated.
And while Glencore continues to shed assets, it remains dreadfully pinned to the value of the underlying commodities due to its very existence. Recall that even Bank of America said that Glencore has no equity value if commodity prices remain at current levels – one doesn’t have to be a rocket scientist (however, being an “evil” buyer of GLEN CDS would help) to figure out what will happen if 70% of China’s “fake” copper demand suddenly evaporates and the stocks of inventory have to be unloaded into an already over-supplied (and under-demanded) market.