Steel Defaults Seen by S&P as Yuan Ruins Ore Loans: China Credit

The Chinese steel industry’s ability to survive 1 billion yuan ($161 million) of losses per month without more defaults is under threat as a slump in iron ore and the yuan undermines a key source of financing.

The currency has weakened 2.4 percent this year and a measure of exchange-rate swings reached a record, prompting Goldman Sachs Group Inc. to predict funding that uses the steelmaking ingredient as collateral will drop over the next two years due to foreign-exchange hedging costs. Iron ore prices fell 11 percent in the past five months as cash shortages at closely held mills prompted what Morgan Stanley says is panic selling.

Chinese steelmakers, which account for almost half of the world’s production, can ill afford a funding squeeze as an industry association reported 43 percent of them made losses in January amid an 8.6 percent slump in demand from a year earlier. Nanjing Iron & Steel Co. told investors on March 22 its bonds will be delisted, while Caixin magazine reported on March 25 that Shanxi-based Haixin Iron & Steel Group can’t repay loans.

“Private steelmakers will see very significant operational problems and funding issues this year, so we could see another default,” Sangyun Han, a Hong Kong-based credit analyst at Standard & Poor’s Ratings Services, said in a phone interview yesterday. “Higher volatility of the currency is another negative factor in their financing in addition to volatile iron ore prices and weak demand.”

Commodity Finance

About 40 percent of the iron ore at China’s ports are part of commodity finance deals, according to Mysteel Research, as cash-starved companies bring in cargo to secure lines of credit. Stockpiles have reached a record 108.45 million metric tons, up 41 percent in the past year, reflecting both increased use in funding and declining demand from mills. The ore is priced in dollars and usually bought using letters of credit, which means any decline in the yuan causes losses at the time of repayment.

One-month implied volatility in the onshore yuan, a gauge of expected moves in the exchange rate used to price options, surged to a record 2.75 percent on March 17, when the central bank doubled its daily trading limit to 2 percent. The gauge was at 2 percent today. The yuan gained 0.02 percent today to 6.2056 per dollar after rising 2.9 percent last year before the central bank encouraged it to fall to discourage inflows driven by one-way appreciation bets.

Financing Deals

“Most of the iron ore financing deals are in dollars because of lower costs,” said Roger Yuan, a Hong Kong-based commodity analyst at Goldman Sachs. “While some steelmakers have been using iron ore financing deals to improve their working capital as they need the raw material for production anyway, the biggest problem still lies in their operations. That’s big supply and shrinking demand.”

China’s economy is slowing as concern over defaults pushes up corporate borrowing costs. Closely held Xuzhou Zhongsen Tonghao New Board Co. averted a bond default after its guarantor said it would step in to help, two people familiar with the matter said. Shanghai Chaori Solar Energy Science & Technology. Co. became the first company to default on onshore debt last month.

Metals and mining companies in China face a bulge of repayments with the equivalent of $25.25 billion of bonds due this quarter and next, falling to $14.9 billion in the following two quarters, data compiled by Bloomberg show. They issued $23 billion of bonds in the past two quarters.

Manufacturing Slows

Chinese companies pay an average yield of 6 percent to sell yuan debt on the mainland, 0.76 percentage point more than a year ago, according to Bank of America Merrill Lynch indexes. That compares with 2.84 percent on corporate bonds globally. The yield on China’s 10-year government bonds has risen 97 basis points in the past 12 months to 4.50 percent yesterday.

China’s manufacturing contracted last month. The Purchasing Managers’ Index fell to 48 in March, the lowest reading since July, from 48.5 in February, HSBC Holdings Plc and Markit Economics said yesterday. A separate PMI from the government, with a larger sample size, was at 50.3 from 50.2 the previous month.

The nation plans to eliminate 27 million tons of iron and steel production capacity this year, Premier Li Keqiang said in a government work report on March 5. That follows a proposal to cut 10.44 million tons in 2013. The nation currently has the ability to produce 1 billion tons.

Shang Fulin, chairman of the China Banking Regulatory Commission, said banks won’t grant loans to highly polluting and energy-consuming companies which don’t meet environmental requirements, after Premier Li told the nation’s top legislature in March the country has “declared war” on pollution.

Earnings Slide

The quarter which ended on March 31 could be the worst in terms of earnings for China’s steel companies since 2000, according to a statement posted on the China Iron & Steel Association website citing Vice Chairman Liu Zhenjiang. Production fell 3.2 percent in January from a year earlier while demand dropped 8.6 percent, Liu said. China’s major steel plants recorded a combined loss of 1 billion yuan in January, according to the statement.

“Small- and medium-sized steelmakers are not making money in steel production, and I’m not expecting any potential recovery,” said S&P’s Han. “There is some political pressure in lending to the steelmakers out of environmental concerns.”

Default Risks

China is studying the default risks to companies that use iron ore as collateral to obtain financing, and may warn banks about the dangers of lending money in such cases, people with direct knowledge of the matter said on March 13. Regulators, including the China Banking Regulatory Commission and the State Administration of Foreign Exchange, are weighing the risk to banks from the falling price of iron ore and a weaker yuan, said the two people, who asked not to be identified because the deliberations haven’t been made public.

SAFE enhanced the supervision of commodity financing deals in May last year, asking commercial banks to conduct detailed background checks to ensure the same collateral is not used for multiple loans. It issued another notice in December requiring the deals to be based on real trading of goods.

“Some steel mills have been relying on iron ore financing for cheap funding as bank loans are already expensive and difficult to get,” said Huang Huiwen, a Shanghai-based steel industry analyst at Shanghai CIFCO Futures Co. “The policy trend is to tighten credit to the industry, hoping to alleviate overcapacity, and control pollution and energy consumption.”

Payment Failure

Haixin Iron & Steel, a privately-owned steelmaker in Shanxi province, halted production on March 20 and is seeking investors for restructuring, Caixin magazine reported on its website. The company failed to pay back overdue bank loans, the Financial Times reported on March 14. Three calls to the company’s offices to seek comment went unanswered yesterday.

Some steelmakers will be forced out of the market within the next three years, Dai Zhihao, general manager of Baoshan Iron & Steel Co., said in an online chat with investors on March

31. The whole industry will continue to see little profit, he added.

“Iron ore financing provided cheap loans to steelmakers, so if it becomes more difficult, then their cashflows could worsen in the second half,” Shanghai CIFCO’s Huang said. “I’m not optimistic about the industry’s outlook.”