We noted last night that Iron Ore futures prices were in free-fall as the vicious circle of China's commodity-collateral-backed shadow banking system unwind hits home amid fears of contagion from the Chaori Solar default. The first domestic Chinese corporate bond default has retail investors running scared as surprise spreads that the local government did not come to the rescue. The deleveraging is now spreading to copper prices (remember the massive cash-for-copper schemes of last year) as borrowers are forced to sell to meet cash calls which in turn drops copper prices, reducing collateral values and tightening credit conditions even more. This is the biggest copper price drop since Dec 2011...
More on Chaori and the fallout...
As Deutsche Bank notes,
On the topic of China, according to the WSJ the country’s first onshore corporate bond default has occurred earlier today in the form of Shanghai Chaori Solar Energy’s missed/incomplete RMB89.8m coupon payment. As we have written over the last couple of days, the bond is relatively small (RMB1bn or US$160m in face value) and the issuer is small (US$1.2bn in assets) but it’s an interesting case for a number of reasons.
Firstly, it’s a bond where the majority of bondholders are retail investors (WSJ, citing company management) which widens the scope of the impact from the market’s typical institutional investor base. Weibo, China’s version of Twitter, is showing photos of retail investors at a local Shanghai government office protesting the authorities’ lack of action in assisting the issuer (21st Century Business Herald).
Secondly, it should be highlighted that Shanghai Chaori avoided a default on its annual coupon payment last year due to the intervention of a local Shanghai government who persuaded banks to roll over loans. This time around, the policy appears to have changed with no last-minute assistance on the cards. Indeed, state-affiliated news agency Xinhua wrote in an opinion piece that a default would be the “the market playing its own decisive role”.
Interesting, given that the Chinese solar energy market was heavily subsidised by the Chinese government in recent years. The Xinhua article also commented that Chaori was not going to be China’s “Bear Stearns moment”.
In addition, domestic media are reporting that the company’s bankers and bond underwriters will not be helping the company make interest payments (21st Century Business Herald). Though this is a relatively small bond, there are potentially wider ramifications.
Bloomberg reports that China’s renewable energy industry faces US$7.7bn in bond maturities this year, and already three domestic bond issuances have been postponed or cancelled in recent days according to Reuters. This is certainly a macro story to watch in 2014
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.
But what does it mean for the actual Copper Financing Deal? The below should explain it:
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.
Step 2) onshore entity B sells and 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.
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.