How Dangerous Is China’s Credit Bubble for the World?

Tyler Durden's picture

Submitted by Pater Tenebrarum of Acting-Man blog,

Global Meltdown Predicted by Charlene Chu

Following on the heels of a report that appeared in the Telegraph on the topic, William Pesek at Bloomberg has recently also written an article about Charlene Chu (formerly with Fitch, nowadays with private firm Autonomous Research) and her opinions on China's shadow banking system and the dangers it represents. The article is ominously entitled “China, the Death Star of Emerging Markets”. 

China has recently made unwelcome headlines, as one of the shadow banking system's countless 'wealth management trusts' which was evidently invested in a bankrupt venture (in this case in a coal company – reportedly a great many such investments in insolvent coal mines exist) was about to go belly-up and then was bailed out at the last minute. Here is a recent article by Mish on the trust that was ironically named “Credit Equals Gold Number 1”. At first it was reported that the trust wouldn't be bailed out, but in the end its 700 investors were able to 'breathe a sigh of relief' as Tom Holland remarked in the South China Morning Post (SCMP). However, Holland also cautioned  that by bailing out this trust, China has laid the foundations for a much bigger crisis down the road, as moral hazard has increased considerably as a result.



shadow banking china

The size of shadow-bank lending relative to China's GDP, via the SCMP



Interestingly, Holland actually disagrees on a major point with Charlene Chu and Pesek. Let us first look at what Pesek writes:

“On any list of banking accidents waiting to happen, China is assured a place at the very top. But could a crash there take the entire global economy down with it? Absolutely, says Charlene Chu, who until recently was Fitch's headline-generating analyst in Beijing. Chu has fearlessly trod into an area that China is trying desperately to keep off limits: its vast shadow-banking system. Now that she's working for a private firm that doesn't have to rely to governments for revenue, as do rating companies, Chu is free to speak completely openly. And is she ever.


"The banking sector has extended $14 trillion to $15 trillion in the span of five years," Chu, who is now with Autonomous Research, told the Telegraph. "There’s no way that we are not going to have massive problems in China." What's more, she added, China "could trigger global meltdown."


The travails of Greece continue to preoccupy the world, but its $249 billion economy is a rounding error compared to China's $8.2 trillion one. In December 2005, for example, China announced its output had unexpectedly grown by $285 billion. In other words, it had suddenly found an economy bigger than Singapore's that its statisticians hadn't known about. Today, simply put, a Chinese crash would make the 2008 collapse of Lehman Brothers seem like a mere market correction.


The kind of meltdown Chu suggests is possible would end Japan's revival, slam economies from South Korea to Vietnam, savage stock and commodity prices everywhere, force the Federal Reserve to end its tapering process and prompt emergency national-security briefings in Washington. So feel free to obsess over Turkey and Argentina, but the real "wild card" is the world's second-biggest economy.”

(emphasis added)

As noted above, that certainly sounds quite ominous.


Opinions Differ …

Not so fast, says Tom Holland. While agreeing that China will eventually face a credit crisis and quite possibly a severe economic downturn, he points to the fact that the closed capital account and China's vast foreign reserves make a 'global contagion' event of such enormous magnitude unlikely. This particular scare story he avers, is not something to worry about, which he inter alia tries to buttress by comparing China's situation to Indonesia's prior to the Asian crisis. Below are a few relevant excerpts from his article:

“As a headline, it was certainly eye-catching. "Currency crisis at Chinese banks could trigger global meltdown," declared a story in the Sunday edition of London's Daily Telegraph. The article noted nervously that foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than US$1 trillion. Any substantial appreciation of the US dollar – and many analysts are indeed expecting gains this year – could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders, the story warned.




The chance that China will suffer a currency crisis at any time in the foreseeable future is precisely zero. And even if the country were struck by crisis, there would be no danger of a global financial meltdown. It is certainly true that China's foreign liabilities have grown rapidly in recent years; a quadrupling since 2009 is about right. But, if anything, the Telegraph's figure of US$1 trillion is rather too modest. According to Beijing's State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a thumping US$3.85 trillion; roughly 40 per cent of its gross domestic product.


But the lion's share of those liabilities – some US$2.32 trillion – consists of highly illiquid inward foreign direct investment. That money is staying where it is. On top of that, a further US$374 billion is foreign portfolio investment in China's stock and bond markets. That's money that has flowed in under Beijing's qualified foreign institutional investor program, whose rules impose strict limits on the size and frequency of repatriation payments. However, that still leaves around US$1.15 trillion in short-term foreign liabilities, consisting largely of loans from international banks.




In 2014, China has no such problems [compared to Indonesia prior to the Asian crisis, ed.] . External debt is small relative to GDP. And with US$3.82 trillion in foreign reserves at the end of last year, Beijing can cover China's near-term foreign liabilities more than three times over. Sure, the shrinkage of the central bank's balance sheet were it actually forced to sell assets in order to fund the country's external liabilities would inflict a painful monetary tightening on China's domestic economy.


But with Beijing sitting on such a large pot of foreign reserves, such an extreme crisis is hardly likely. And even if it did happen, there would be no "global meltdown". Despite the opening of recent years, Beijing's controls on the free flow of capital mean China's financial sector remains relatively closed, and the exposure of the global financial system to the country is low.


That's not to say there wouldn't be casualties from a sudden strengthening of the US dollar against the yuan, or from a marked slowdown in China's domestic economy. At the end of October last year Hong Kong's banking system was owed US$300 billion by mainland banks and another US$100 billion by mainland companies. Clearly the local pain would be intense. But a Chinese currency crisis triggering global meltdown? Happily not.”

(emphasis added)

Readers may recall that we have also recently mentioned the exposure of Hong Kong's banks to Mainland China. We believe Mr. Holland is correct in one sense, but we also think he underestimates the contagion potential.


Contagion Through Many Different Channels

It is true that China's closed capital account as well as the government's tight control over the financial system makes China's situation fundamentally different from that of countries with open capital accounts from whence foreign investors can at anytime flee in droves if they get cold feet over an overextended bubble.

In fact, we have  pointed out in the past that the great degree of central control over the economy (and especially the banking system) which China's government enjoys makes it inherently more difficult to time a putative demise of the credit bubble than elsewhere – and such things aren't easy to time to begin with. 

However, a sharp decline in the yuan's exchange rate may be seen as necessary by China's leadership if a crisis threatens social stability (and with it the party's rule) in China. China has already devalued a great deal on one occasion (in 1994), an event that in hindsight seems to have precipitated a chain reaction (first the yen followed the yuan lower, and then the currency pegs in various 'Asian Tiger' economies went overboard).

Today, China is a far bigger player in the world economy than in 1994, and we believe that Mr. Holland underestimates how today's economic and financial interconnectedness may produce contagion effects even in light of the closed capital account and China's large reserves. We also don't necessarily regard  the exposure of Hong Kong's banks as a de facto 'internal affair', as the territory is outside of the ambit of China's capital controls and the yuan. It is not only Hong Kong's banking system that one must worry about though. Consider what would happen if China were indeed forced to draw down its reserves to serve the $1.5 trillion in short term foreign liabilities, or a sizable chunk thereof. Given that this would inevitably result in a much tighter domestic monetary policy (provided the PBoC doesn't take inflationary measures independent of its forex reserves), all sorts of malinvestments in China would be revealed as unsustainable. A number of industries would be faced with a major bust, and it is a good bet that commodity imports would plunge.

However, once that happens, one must immediately begin to worry about Australia's banks, which have financed a giant housing bubble  on the back of the country's commodities boom and in turn rely greatly on short term foreign funding. So there would immediately be a crisis in both Hong Kong's and Australia's banking systems, and it does not take a great leap of the imagination to see how contagion could spread further from them. Naturally many other raw materials exporting countries would also be hit hard, we mainly picked Australia as an example because its banks are so reliant on short term foreign funding, so they would presumably be among the first in line.

Lastly, here is a recent chart of NPLs in China's official banking system (listed banks only, i.e. the biggest ones):




NPLs at China's biggest banks – this looks good! In fact, it looks too good – click to enlarge.



As can be seen, NPLs at the major banks have declined to a negligible percentage (compare this with crisis-stricken Spain's near 13% or so NPL ratio, which is understated to boot). However, there are plenty of credible rumors that China's banks are keeping loans that would normally be regarded as dubious alive by all sorts of tricks. Not only that, they are definitely backing a great many of the 'shadow banking' businesses, which have developed in China mainly in order to circumvent  restrictions on banking activities.

In view of everything that is known about credit growth in China, we would regard this extremely low NPL ratio as a contrary indicator even if it were credible.



No-one knows for sure how big a problem China's economy will eventually face due to the massive credit and money supply growth that has occurred in recent years and no-one know when exactly it will happen either. There have been many dire predictions over the years, but so far none have come true. And yet, it is clear that there is a looming problem of considerable magnitude that won't simply go away painlessly. The greatest credit excesses have been built up after 2008, which suggests that there can be no comfort in the knowledge that 'nothing has happened yet'. Given China's importance to the global economy, it seems impossible for this not to have grave consequences for the rest of the world, in spite of China's peculiar attributes in terms of government control over the economy and the closed capital account.




Shanghai's A-share index (which is heavily weighed toward banks) continues to wallow near its lows of the past several years – click to enlarge.

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Johnny Cocknballs's picture

not so dangerous - the whole system is coming down.  Like adding a match to a bonfire, it really doesn't much matter.

0b1knob's picture

Since most of the debt is held internally by the frugal Chinese the meltdown might be more contained than the author contends.

Look at how long the Japanese meltdown has been drawn out.  A country where people save half of their income has a lot of resilience.  Not like the USSA.

ACP's picture

Click bang, oh what a hang(over).

X_mloclaM's picture

credit/debt asset bubble pop on prior mailinvestment / misallocation means Chu's internal economic CN collapse snorkles German exports, quite more than marginal (credit, td) the heart of the EZ project, which itself needs more collateral (ME/Africa?) . its not just Aussie banks and HK, the big 4 are funded overseas, and that'll tighten up pushing them to bailin/bankruptcy, cds tough for the issuers, as is Unicredit and the rest to em fx knockons from the CN collapse

your a "sell the Treasuries" kinda guy? not understanding a debt collapse wont mean a return to a gold standard, but rather an attempt at reflation, and Treasuries are the backbone to yuan value, the otherside of the ledger to their fiat, they have not many liquid assets to sell, really, and bailouts / take the people's savings isnt the pc way to handle it. A combo of bakruptcy and reflation is, and one asset that could aid in bolstering the banking system's proportion of good assets is the inclusion of newly acquired gold.


Chupacabra-322's picture

Hence the reason why Gold builds Countries & Silver is a Gentleman's currency.

AGuy's picture

"not so dangerous - the whole system is coming down."

Seems to me that China is following the "Bureacrats guide to a Failing economy", which has been in print before Rome was an empire. Here a quote from chapter 9:

When you have excessive unemployeed workers that are risk for causing a revolt that may overthrow your regime, start a nationism movement by blaming your neighbors for disrupting your  economy. If that fails to calm the masses, sent them to war, which will increase jobs and also kill many of the unemployed to restore balance. Even if you end up losing the war, it will delay the inevetable. You have nothing to lose, since your other option is to place your head on a chopping block, when the masses come for your head!

 Japan and the Philipines are the potential targets of this new campaign!


Lux Fiat's picture

When I saw the title, my first thought was "How dangerous is the US's credit bubble (Treasuries) for the world?"

ncdirtdigger's picture

Should I be stacking egg rolls?

Yen Cross's picture

  Freeze dried "egg rolls".

Yen Cross's picture

  I'm more worried about the ponzi in Europe! If in any way the usd caves in,credit markets to Europe will cease to exist! . {visa <> versa} TEOTWAWTI!

mt paul's picture

terra-cotta bankers

Winston Churchill's picture

Same applies to the USA.

China at has productive assets( what was the US manufacturing base) and a lot of gold,

When the tide goes out, who is it that is naked ?


Yen Cross's picture

 Winston, the Yuan has an "mid rate" fixing every day.  China has lots of precious metal and resources.

  Most people don't realize how resource rich America is.  Any smart investor knows Americas' value lies in it's vast undiscovered mineral wealth.

Citizen_x's picture

If debt is Rothchild control...

And China is saying F-U...

Is this the show down at the OK coral ?   AKA End game ?

Yen Cross's picture

   Go skydiving. Then ask the same question again/

andrewp111's picture

The laws of physics define what real wealth is - usable energy and edible food. Everything else is just a representation of wealth.

A massive and sustained oil/gas  price spike could crush China. And Japan too, now that Japan shut down all its nuke plants.

ncdirtdigger's picture

edible food is a manifestation of energy

ebear's picture

On a per-capita basis, who has the largest resource base?

Who can provide sufficient food and energy from domestic sources if/when TSHTF and global trade grinds to a halt?

As I see it, the USA/Canada/Mexico nexus, followed by Russia and its satellites.

No one else is even a contender.

Bindar Dundat's picture

You are so right ebear!  If Canada/U.S.A. and Mexico closed the borders we have enough food and resources to last for many centuries. FUCK the ragheads and the slant eyes...

FredFlintstone's picture

Productive asset in china: oversized shed with workbenches and soldering guns?

sunny's picture

Yet another Asian time bomb.  Folks have been predicting the imminent collapse of Japan for what--13 years more or less.  AND IT WILL HAPPEN --eventually.  At that rate China has at least 10 years before things get rough.  In the mean time lets all practice together.  On three, ready?  One, two, three:



Wake me when the fit hits the shan.

Kirk2NCC1701's picture

The Nordic version: when The Snow Hits The Fan.

FredFlintstone's picture

What about differences in the two populations temperments and educational levels not to mention governments?

buzzsaw99's picture

Chu is full of crap in saying China's internal problems will trigger a global meltdown. Holland is correct on several points. Very few people even here at zh can correctly draw the distinction or identify cause-effect relationships between China's internal problems and their external problems. One thing is sure, their banking system and even their stock and bond markets don't amount to a hill of beans on the global stage. If Goldman Sachs ends up holding any bad investments over there the fed will buy them under the table. These aren't the 'droids you're looking for. [/obi wan]

Yen Cross's picture

 Buzz always makes sense/sence.

Sven Sikztu's picture

uhh...what about the end-of-January meltdown in China that was all over these pages a couple weeks ago? wtf? This is just like all the lines in the sand that Greece was going to default and bring down all of the EU...yeah it'll happen in 3 weeks when they fail to do comes and goes over and over and over.

Anybody notice the Broken Record Effect going on here yet again?


Sorry Pater, th world was aleady supposed to end on 31 January in China, it's not fair for you to come along now and screw that up.

Schmuck Raker's picture

You disagree with the premise that the 11th hour bailout on Jan 31 increased moral hazard?

I don't see a 'broken record' so much as a 'slow motion train-wreck'.

andrewp111's picture

Very very slow motion. As long as the PBOC is willing to bail out all financial institutions in China with printed Yuan, they can keep their bubble going for a very long time. Far longer than anyone shorting China can stay solvent. The only thing that could break it is another mega spike in energy prices - one bigger than we had in 2008.

If you want China to collapse you should be working to start a major mideast war that uses nuclear weapons.

HulkHogan's picture

Always do the opposite of ZH, and you'll make money. That's what they're here for.

Kirk2NCC1701's picture

There are only two types of stock brokers or CFPs you can profit from: the ones who are almost always right (barometer), and the ones who are totally wrong (anti-barometer).

lakecity55's picture

PRC has Gold. Lots of Physical Gold.

Got Yuan?

RaiZH's picture

And the Chinese are importing tonnes and tonnes of gold... could there be a correlation here? hmm

billwilson's picture

The Chinese elites are all furiously trying to get their money out of China (witness for one the boom in foreign property purchases) - kind of a leading indicator me thinks

ebear's picture


A while back I had a conversation with a local bank manager about offshore money buying Vancouver real estate.  Chinese mostly?  Yup.  Paying cash, are they?  Yes.  In the form of cashier checks drawn on banks in the Seychelles and Cayman Islands, right?  She clammed up at that point, and it was clear I'd hit a nerve.

You want to know what's going on, as always, just follow the money.

China's principle advantage is also its greatest weakness - the size of its population.  History shows that things can get out of hand very quickly there, and like they say, if you fail to learn history's lessons, you're doomed to repeat them.  I'd say anyone moving money out of China these days understands this very well.

Kirk2NCC1701's picture

Perhaps, perhaps not. Ever heard of Global Diversification, or BTFD, or buy with USTs while they can still use them like Bearer Bonds to buy real stuff with?

q99x2's picture

The latest Keiser Report describes how Obama and Cameron are commiting treason against their countries via TTIP.

Pretty sure that is worse than a financial meltdown.

combatsnoopy's picture

You know the Ching Chongs cheated on their Engrish exams if they have an American first name.
Is "Charlene" really her mother given name?
Where did she find the name "Charlene"? 

Oh btw, China's exaggerating.
They can always go to Macau for liquidity.
As a matter of fact, the Bank bought off IRS can go to Macau and rob them, they have money.  Former Middle Class Americans don't.

Macrosan1's picture

She is actually a US citizen married to a Chinese gentleman.

jon dough's picture

<~~~~~Kick 'em when they're up

<~~~~~Kick 'em when they're down

logicalman's picture

Really, the whole thing comes down to people being incapable of looking at the world honestly.

It would appear that most humans are averse to making any effort for themselves and would like to have others make the effort for them, so they can sit on their arses and do fuck all.

I'm prepared to stand or fall based on what I know and what I can do.

Yes, nature can throw me a curve ball, at which point I'll be off for the 'earth nap' - but that's what awaits us all.

If you never put any effort into anything, you can never feel the satisfaction of achieving a goal. Might as well be dead at that point.

Just a thought.

Markets - Money - Derivatives - all bullshit really.

Once, you didn't exist - right now, if you are reading this, you do - soon you will revert to the don't exist category.

Do the best you can with what you've got, but please, do it responsibly. The 'other guy' is in the same situation as you are.

Music101's picture

Even in China, it's a WORLD OF DEBT!!! See Video Below "WORLD OF DEBT" -- Funny too:

Yen Cross's picture

 Good lord . Look at the curve of the PBOC financial system over 20 years! Shadow banking system.

  Who missed the copper fiasco in December?  Long (8) shot " Nail Guns"!

X_mloclaM's picture

Who missed the copper fiasco in December?

liked td's gs expose:

Our view is that the bulk of copper stored in bonded warehouses in China – at least 510,000t at present, as well as some inbound copper shipments into China – is being used to unlock the CNY-USD interest rate differential.This material has not been entirely unavailable to the market (deals can be broken if costs rise, such as a tightening of LME spreads), but the inventory has been effectively financed by factors exogenous to the copper market for some time.

After the SHFE-LME price arbitrage closes sufficiently, the remaining bonded stock (over and above day-to-day working flows) would likely shift from bonded warehouses to the LME. We expect that the ex-China (LME) market would likely see inventory increases as a result, as China draws on bonded stocks instead of importing and as excess bonded stocks are shifted back on to the LME. We estimate that the ex-China market will need to ‘carry’ a minimum of 200-250kt of additional physical copper over the coming months, equivalent to 4%-5% of quarterly global supply. The latter would most likely result in a widening contango, including downward pressure on cash prices.

 [measures are aimed] to:

i) Directly reduce the scale of China’s FX loans, thus reducing the scale of letter of credit (LC) financing (bank loans), thereby reducing the volume of funding available for CCFDs (though not specifically targeting CCFDs); and/or

ii) Raise banks’ FX net open positions (banks are required to hold a minimum net long FX position at the expense of CNY liabilities), thus raising LC financing costs, thereby increasing the cost of funding CCFDs.

To avoid being categorized as a B-list firm by SAFE, ‘trade firms’ may reduce their USD LC liabilities in the near term, with CCFDs likely impacted. It is not yet clear what happens to the B-list firms once they are categorized as such. However, if B-list firms were prohibited from rolling their LC liabilities this could increase the pace of the CCFD unwind, since these trade firms would likely need to sell their liquid assets (copper included) to fund their LC liabilities accumulated through previous CCFDs.


An example of a typical, simplified, CCFD

In this section we present an example of how a typical Chinese Copper Financing Deal (CCFD) works, and then discuss how the various parties involved are affected if the deals are forced to unwind. Exhibit 3 is a ‘simplified’ example of a CCFD, including specific reference to how the process places upward pressure on the RMB/USD. We believe this is the predominant structure of CCFDs, with other forms of Chinese copper financing deals much less profitable and likely only a small proportion of total deal volumes.

A typical CCFD involves 4 parties and 4 steps:

  • Party A – Typically an offshore trading house
  • Party B – Typically an onshore trading house, consumers
  • Party C – Typically offshore subsidiary of B
  • Party D – Onshore or offshore banks registered onshore serving B as a client

Step 1) offshore trader A sells warrant of bonded copper (copper in China’s bonded warehouse that is exempted from VAT payment before customs declaration) or inbound copper (i.e. copper on ship in transit to bonded) to onshore party B at price X (i.e. B imports copper from A), and A is paid USD LC, issued by onshore bank D. The LC issuance is a key step that SAFE’s new policies target. re-exports the copper by sending the warrant documentation (not the physical copper which stays in bonded warehouse ‘offshore’) to the offshore subsidiary C (N.B. B owns C), and C pays B USD or CNH cash (CNH = offshore CNY). Using the cash from C, B gets bank D to convert the USD or CNH into onshore CNY, and trader B can then use CNY as it sees fit. 

The conversion of the USD or CNH into onshore CNY is another key step that SAFE’s new policies target. This conversion was previously allowed by SAFE because it was expected that the re-export process was a trade-related activity through China’s current account. Now that it has become apparent that CCFDs and other similar deals do not involve actual shipments of physical material, SAFE appears to be moving to halt them. 

Step 3) Offshore subsidiary C sells the warrant back to A (again, no move in physical copper which stays in bonded warehouse ‘offshore’), and A pays C USD or CNH cash with a price of X minus $10-20/t, i.e. a discount to the price sold by A to B in Step 1. 

Step 4) Repeat Step 1-Step 3 as many times as possible, during the period of LC (usually 6 months, with range of 3-12 months). This could be 10-30 times over the course of the 6 month LC, with the limitation being the amount of time it takes to clear the paperwork. In this way, the total notional LCs issued over a particular tonne of bonded or inbound copper over the course of a year would be 10-30 times the value of the physical copper involved, depending on the LC duration. 

Copper ownership and hedging: Through the whole process each tonne of copper involved in CCFDs is hedged by selling futures on LME futures curve (deals typically involve a long physical position and short futures position over the life of the CCFDs, unless the owner of the copper wants to speculate on the price).

Though typically owned and hedged by Party A, the hedger can be Party A, B, C and D, depending on the ownership of the copper warrant.

TD: "As Goldman further explains, the importance of CCFD is "not trivial" - that is an understatement: with the implicit near-infinite rehypothecation in which the number of "circuits" in the deal is only a factor of "the amount of time it takes to clear the paperwork", there may be hundreds of billions, if not more, in leverage resulting from this shadow transaction that has been used in China for years. Now, that loop is about to end. The reality is nobody can predict what the impact will be, but whatever it is - i) it will extract tremendous leverage from the system and ii) it will have adverse impacts on both China's ability to absorb inflation and grow its economy."

How important are CCFDs? They are not trivial!

Chinese ‘financing deals’, including CCFDs, are likely to contribute to China’s FX inflows since they involve direct FX inflows through China’s current account. Specifically, for CCFDs, the immediate cross-border conversion of FX to onshore CNY after Party C pays Party B for the copper warrant (Step 2) directly contributes to China’s FX inflows. In terms of outflows, the issuance of LC (FX short-term lending) by Party D to Party A (Step 1) is not associated FX outflow by definition, and when the LCs expire they tend to be rolled forward. Step 3 occurs offshore, so there is no inflow/outflow related to this transaction.

In this way, the net Chinese FX inflows/outflows associated with CCFDs are equivalent to the change in the value of the notional LCs. We make some broad estimates of how much of China’s short-term FX lending could be accounted for by CCFDs.

Specifically, our best estimate suggests that roughly 10% of China’s short-term FX lending could have been associated with CCFDs since the beginning of 2012 (Exhibit 4). In April 2013, we estimate that CCFDs accounted for $35-40 bn (stock) of China’s total short-term FX lending of $384 bn (stock), making various assumptions. More broadly, Chinese bonded inventories and short-term FX lending has been positively correlated in recent years (Exhibit 5).

Two key questions remain: how the upcoming unwind will impact each CCFD participant entity...

How an unwind may impact each CCFD participant

As we discussed on pages 4 and 5, SAFE’s new regulations target both banks’ LC issuance (first measure) and ‘trade firms’ trade activities (second measure). Here we discuss how the different entities (A, B, C, D) would likely adjust their portfolios to meet the new regulations (i.e. what happens in a complete unwind scenario).

Party A: Party A, without the prospect of $10-20/t profit per Step 1-3 iteration, is likely to find it hard to justify having bonded copper sitting on its balance sheet (the current LME contango is not sufficient to offset the rent and interest costs). As a result, Party A’s physical bonded copper would likely become ‘available’, and Party A would likely unwind its LME short futures hedge.

Party B, C: To avoid being categorized as a B-list firm by SAFE, Party B and C may reduce their USD LC liabilities by: 1) selling liquid assets to fund the USD LC liabilities, and/or 2) borrowing USD offshore and rolling LC liabilities to offshore USD liabilities. The broad impact of this is to reduce outstanding LCs, and CCFDs will likely be affected by this. It is not yet clear what happens to the B-list firms in detail once they are categorized as such. However, if B-list firms were prohibited from rolling their LC liabilities this would increase the pace of the CCFDs unwind. In this scenario, these trade firms would have to sell their liquid assets (copper included) to fund their LC liabilities accumulated through previous CCFDs.

Party D: To meet SAFE’s regulations, Party D will likely adjust their portfolios by reducing LC issuance and/or increasing FX (mainly USD) net long positions, which would directly reduce the total scale of CCFDs and/or raise the LC financing cost, respectively.

... And what happens to copper prices (hint: GTFO)

Implications for copper - bonded copper moves from a positive carry asset to negative carry asset

Implications for copper - bonded copper moves from a positive carry asset to negative carry asset

We expect that a complete unwind of CCFDs, everything else equal, is likely to be bearish for copper prices, LME spreads, and bonded premiums.

CCFDs involve a long copper physical positions and a short futures position on the LME. The physical position would be sold if CCFDs unwound and the short futures positions bought back. The newly available physical copper would not be financed by the China and ex-China interest rate differential anymore (not a positive carry asset anymore), and would instead need to be financed by a natural contango (in the interim copper becomes a negative carry asset), everything else equal.

Theoretically then, the physical market, over a short period (say, one quarter), may need to absorb as much as c.400kt of copper, equivalent to 8% of quarterly global copper supply.

By contrast, the LME futures market would need to absorb buying of c.0.2%-0.3% of quarterly traded LME volumes and c.6% of daily average 2012 open interest. The impact on the physical market is therefore likely to be relatively large, in spite the fact that an unwind of CCFDs does not result in the creation of new copper (i.e. aggregate global copper inventory impact is 0/our inventory chart does not change).

What about in practice?

Since there are no comparable historical examples to make reference to, what happens when CCFDs unwind in practice is open for debate. We believe that since the downward pressure on the physical market is large, both in absolute terms and relative to the upward pressure on the futures market, near-term prices are likely to come under relatively significant pressure. Further, if the market fears the unwind of CCFDs, physical buyers may hold off on purchases, and futures sellers may bet on lower prices (offsetting either in part or more than offsetting the financing deal related unwind buying). In this way it is likely that in practice the whole copper price curve would be under pressure in the case of a complete CCFD unwind, at least until the contango widens sufficiently to compensate for the cost of carry.



The main caveat to the above is that a complete unwind in CCFDs is still subject to the implementation of the policy by SAFE, Chinese banks and ‘trade firms’, and the possibility that new financing deals are “invented”. As a result, we will continue to closely monitor implementation of the policy by banks via monitoring bonded physical premiums, SHFE spreads and bonded stock flows.

Finally, what does all this mean for explicit rehypothecation chain leverage (initially just at the CCFD level although a comparable analysis must be done for systemic as well) and CCFD risk exposure:

Leverage in CCFDs

Below is a demonstration of the LC issuance process in a typical CCFD. Assuming an LC with a duration of 6 months, and 10 circuit completions (of Step 1-3) during that time (i.e. one CCFD takes 18 days to complete), Party D is able to issue 10 times the copper value equivalent in the form of LCs during the first 6 month LC (as shown from period t1 to t10 in Exhibit 10). In the proceeding 6 months (and beyond), the total notional value of the LCs remains the same, everything else equal, since each new LC issued is offset by the expiration of an old one (as shown from period t11 to t20).

In this example, total notional amount of LC during the life of the LC = LC duration / days of one CCFD completion* copper value = 10. In this example, the total notional amount of LC issued by Party D, total FX inflow through Party D from party A, and total CNY assets accumulated by party B (and C) are all 10 times the copper value (per tonne).