Goldman Says Chinese Commodity Financing May Unwind in 24 Months

Financing arrangments in China using commodities from copper to rubber as collateral to obtain credit may be unwound in 12 to 24 months, driven by increased yuan volatility, Goldman Sachs Group Inc. said.

As much as 1 million metric tons of copper and 30 million tons of iron ore could be released if the deals unwind, the bank said in a report today. The unwinding would be bearish “given relatively limited physical liquidity to absorb the shock,” analysts led by Jeffrey Currie wrote. For now, the deals remain profitable and an “abrupt government crackdown” on them is unlikely given the potential effect on the country’s economic growth, they wrote.

“Our view is that Chinese commodity financing deals will gradually unwind over the medium term, driven by an increase in foreign exchange hedging costs, which would slowly erode financing deal profitability and eventually close the interest rate arbitrage,” the analysts wrote.

The transactions using commodities as collateral made as much as $160 billion, or 31 percent of China’s total short-term foreign-exchange loans, the report showed. Gold, copper and iron ore are most commonly used as collateral, followed by soybeans, palm oil, rubber, nickel, zinc and aluminum, the bank said.

‘Hot Money’

“We believe Chinese commodity financing deals are ongoing and facilitating ‘hot money’ inflows into China by providing a mechanism to import low-cost foreign financing,” the analysts wrote. The deals “create excess physical demand and tighten the physical markets artificially; in contrast, an unwind creates excess supply and thus is bearish to prices.”

With the exception of iron ore, profitability of most hedged arrangements remains “substantial” because of positive yuan- and dollar-based interest-rate differentials, limited depreciation of the yuan last month and abundant commodity supply, which limits hedging costs, the bank said. Continued weakening of the yuan may spur some of the deals to unwind sooner than expected, it said.

China’s yuan had the biggest three-day decline since at least 2007 on concern rising financial risks will weaken growth in the world’s second-largest economy. The yuan has dropped 2.4 percent from a 20-year high of 6.0406 per dollar reached on Jan. 14, after strengthening 2.9 percent in 2013.

1 Million Tons

Returns from using copper as collateral are still more than 10 percent and up to 1 million tons of the metal may be tied to such arrangements, Goldman Sachs said. That’s up from 500,000 tons nine months ago, it said.

Imports of copper and iron ore into China rose to records in January on financing demand, before sliding in February as the currency weakened and the state moved to rein in shadow banking. About 40 percent of iron-ore stockpiles at Chinese ports are linked to finance deals, Mysteel Research estimates.

Financing arrangements probably lie behind a surge in Chinese gold imports from Hong Kong, Goldman Sachs said. The deals involve physical imports of gold and exports of semi-fabricated products to bring foreign exchange into China, according to the bank.

The number of commodities used for financing increased since mid-2013 as the government cut the amount of money that could be borrowed per commodity unit, Goldman Sachs said. Copper financing may account for about $23 billion worth of short-term foreign exchange loans, iron ore for $10.4 billion and soybeans for $7.7 billion in a base case, the bank said.

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