We have written extensively about the problem surrounding the rehypothecation of "non-existent" Chinese commodities [15], the bulk of which have been used in some form of Commodity Funding Deal over the last few years [16]: something which various banks have said would be the tipping point that finally launches China's long delayed Minsky Moment. After all, if there is one thing China has taught the west, it is how to kick everything that is broken about one's financial system as far as the eye can see, and then also eliminating any living witnesses just in case. And further, since virtually the entire Chinese financial sector is partially state-owned, it is rather easy for the politburo to reallocate funds from Point A to Point B in order to preserve that all important commodity - confidence.
But for all the theoretical explanations about China's profound commodity rehypothecation problems, the one thing that was missing was an empirical case study framing just how substantial the problem is. After all, it is one thing to say banks expect "X millions in losses", but totally different to see the rehypothecation dominoes falling in practice.
Today, courtesy of Bloomberg we got just such an example.
Meet Decheng Mining.
Decheng is a well-known name to those who follow developments in China's murky shadow banking system. It is the company which was sued by China's Shanxi Coal International Energy Group a week ago over missed payments. As Reuters reported [17]at the time, "Shanxi Coal said in a statement to the Shanghai Stock Exchange it was suing six clients over a total of more than $177 million in missed payments. Of that total, $120.4 million of overdue payments were in dollars, plus a further 352.5 million yuan ($56.77 million)."
Sadly, that was as far as Shanxi Coal went - it did not specify how much it was owed by Decheng Mining and its parent company, Dezheng Resources. Arguably because the last thing Shanxi wanted was to spook some of its own vendors and creditors, especially as Chinese coal prices fell to record lows over the past week exacerbating the plight of the local coal industry.
Yet one reason why Decheng's sudden insolvency did not come as a surprise is that it was one of the main companies investigated by Chinese authorities over precisely the rehypothecation scandal that was engulfed China's third largest port, Qingdao, having been accused of obtaining multiple loans secured against a single cargo of metal.
As of today we know exactly why Decheng was unable to pay its bills.
As Bloomberg reports, Decheng Mining pledged the same metals stockpile three times over to obtain more than 2.7 billion yuan ($435 million) of loans in China’s Qingdao port, a person briefed on the matter said, citing preliminary findings of an official investigation.
From Bloomberg [18]:
Local authorities are checking metal inventories worth about 1.54 billion yuan including 194,000 tons of alumina, 62,000 tons of aluminum and some copper, the person said, asking not to be identified as he isn’t authorized to speak publicly. Two calls to Decheng Mining, a metals trading house based in Qingdao, went unanswered.
Foreign and local banks are examining lending linked to metals at Qingdao amid concern that risks are more widespread in China, where traders use commodities from iron ore to rubber to get funding. Steps by the Chinese government to rein in credit raised companies’ borrowing costs in recent years and triggered a surge in commodities financing deals that Goldman Sachs Group Inc. estimates to be worth as much as $160 billion.
“The whole Qingdao probe will just keep fermenting, inevitably leading to banks increasing their scrutiny of commodities-backed financing activities,” Fu Peng, chief strategist at Galaxy Futures Co., said by phone from Beijing.
Bank of China Ltd., Export-Import Bank of China, China Minsheng Banking Corp. and 15 other Chinese banks have lent a total of about 14.8 billion yuan to Chen Jihong, Decheng Mining’s owner, and his companies, the person said.
Well that is a little over $2 billion that the lenders will never recover as the money has almost certainly been (re-re-) used to purchase commodities which were then repledged countless times in order to generate the arb we first described in May of 2013 [19].
Chen, a Singaporean national, has been detained and the city-state’s foreign ministry is providing consular assistance to him and his family, the ministry said June 11. He is also involved in a separate inquiry in northwestern Gansu province, two bankers assisting with the probe told Bloomberg last month.
The collateral ratio for loans to Dezheng Group, Decheng Mining’s parent, was 55 percent as of June 13, Minsheng Bank said in a text message in response to questions last month. That means for every 100 yuan of collateral offered by the borrowers, 55 yuan was given in loans.
Unfortunately for Minsheng, that number is a clear fabrication considering the real collateral to loan ratio is more like 300%.
Press officers at Bank of China and Minsheng Bank based in Beijing declined to comment, while spokesmen for Export-Import Bank weren’t immediately available.
Local government officials are updating creditors about the probe on a weekly basis, with the latest meeting held on July 1, the person said.
Lenders are tightening their commodity financing criteria in the wake of the probe. Some Chinese banks have raised margins for letters of credit for iron-ore financing to 30-to-50 percent from 15-to-30 percent previously, people familiar with the matter said June 10. Others reduced overall credit available for iron-ore financing and have set up a cap on credit used in some locations, the people said.
As for the punchline, we hardly doubt we need to note it: if one trader effectively managed to "evaporate" half a billion in collateral and three times as many derivative loans, what does that mean for the entire Chinese rehypothecation industry? And keep in mind this is China - what is presented for public consumption is without doubt far better than what has really happened.
Recall from our CFD flowchart explanation a year ago [19], that the practical rehypothecation limit is, well, non-existent.
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.
Get that? A rehypothecation limit upward of 15x and as much as 30x. Now imaging the millions of tons of copper, aluminum and various other funding metals just sitting there, and collateralizing some 30 times their notional value in loans.
Surely this explains why foreign banks operating in China are starting to sweat profusely, especially since not only Qingdao, but a second port, Penglai, has now been implicated. From the WSJ:
Local authorities in Qingdao, and Penglai, another port city also in Shandong province, have been investigating whether the metals have been reused several times as collateral by traders and companies seeking funding. Already, a major state-owned enterprise, Citic Resources Holdings Ltd. , said some metals that it has stored at the Qingdao port can't be located.
But because banks can't get access to the storage facilities at Dagang in Qingdao and Penglai port where the probes are under way, the scale of any possible losses can't be tallied up. "I have the impression that a lot of people do not know where it stands, which makes me nervous," said one executive at a Western bank.
Bingo. Actually, it can, and one word can be used to explain the losses: "lots." Or "lots, lots" if the problem is not just contained to ports but, as we also warned over a year ago, is spread across the fabric of China's entire financial system.
There is some indication that the probes may no longer be local. In recent days, one of the banks that has been seeking to access the storage facility at Penglai has been informed that the probe now include authorities from Beijing, according to a person familiar with the matter.
The Hong Kong Monetary Authority, or HKMA, said it is keeping a close eye on developments amid concerns that banks in the city have become dangerously exposed to China's economy through excessive lending.
"The HKMA has been closely monitoring the credit exposure, including those incurred from the business of commodity finance, of the banking sector," a spokeswoman said in an emailed response to queries Friday. "Authorized institutions are expected to maintain sufficiently robust system of controls to manage the specific risks that they are facing," an HKMA spokeswoman said.
But why would the Hong Kong central bank be concerned? Doesn't it know that the addition of 800,000 part-time jobs coupled with the collapse of over half a million full time jobs was just spun as the most positive jobs report in the US since 1999 and led to the first Dow Jones close over 17,000 ever? After all, can't the HKMA just BTFATH and watch its problems disappear? After all that is precisely what the US administration beckons the local middle class to do. Because who needs a job, be it full or part time, when one has an E*trade terminal.
