Increased Scrutiny Into Chinese Warehousing Slows Down International Commodities Trade

Qingdao port in China was recently at the epicenter of a B2B bill scandal wherein a metals trading firm duplicated warehouse certificates in order to use a metal cargo multiple times to raise financing. Qingdao is a major warehouse hub for commodities, and the recent investigation and crackdown on financing by Chinese banks and lenders in response to the scandal has financing and payments through out the Chinese commodities market. This, in turn, is starting to have global ripple effects.

So how does a single scandal at a single port in China affect the entire international commodities market in metals? It is a process both complex and simple.

The popular but largely under-regulated port in Qingdao province made it possible for one minerals trading firm to duplicate storage certificates from said under monitored.  As metal cargo is often used as collateral for loans, the double dipping allowed for large amounts of money to be raised through fraud-tinged financing.

Where the port has failed to finance, the Chinese banks are stepping in, and are tightening credit while they attempt to get a look under the hood in Qingdao. This has in turn touched off a ripple effect that leaves small traders unable to secure financing, pulling out of the market. This financing squeeze thus leads to two foreseeable but troubling results. First, the commodities market in China, particularly as it is based in the massive warehousing facility in Qingdao, very likely faces being wiped out or will be severely diminished in 2014. Second, because of this gap, share in commodities in iron ore is starting to flood the market, which is in turn drenching the international market for iron and driving down the price of ore everywhere.

The Trouble With Qingdao

The double dipping on physical commodity reserves, in this case metals, have put pressure on Chinese banks to push for tighter lending and verification standards.

This will likely pull business out of Qingdao, as some lenders have already asked clients to shift metal storage to more regulated London Metal Exchange (LME) warehouses outside China. Others are asking for metal storage to be undertaken at a complex of warehouses owned an operated by a single player, reports Reuters.

“The banks still haven’t looked under the hood,” said an executive at a bank involved in commodity financing in China, referring to China’s warehousing sector, reports the source.

There are many firms involved in the management of warehouses in China, though there has been outsourcing to local firms to cut overheads and avoid dealing with complex local regulations. However complex, Chinese regulations are still widely viewed as more lax than in other places—chiefly the LME, where banks are urging storage in the wake of the financing scandal.

“Warehouse receipts are not title documents, they are documents of entitlement. But they are being used as title documents for sales and purchase and transfer of ownership,” said a person at a warehouse company with operations in Qingdao, according to Reuters. “Everywhere else outside of China, a warehouse receipt is cut for one party.”

Further, the issue could spread, according to Business Day.  So far the issue has been linked only to aluminum and copper deals, however, non-regulated commodities storage has led to concerns that the issue could easily spread to other commodities like soybeans.

Starving Chinese Metal Merchants

In an unsurprising turn of events, the credit pipeline to metal trading firms in China has shut down precipitously since the news of the scandal broke. As banks are investigating how they were defrauded by falsified documents, financial instruments such as letters of credit have largely evaporated.

China’s banking regulator has urged more checks on iron ore financing deals to cut default risks, which occurs at the same time an official probe into suspected metal financing fraud at Qingdao ‘s port.

“It is very troublesome and time-consuming getting letters of credit from Bank of China now and we basically have stopped trying,” said an iron ore trader based in Shandong, who further noted that traders who fail to get credit had sold off iron ore stocks, reports the South China Morning Post . “Many iron ore traders will be wiped out this year and next due to the cut-off in credit.”

The Global Impact Of A Local Problem

Analysts widely predict that given China’s role as a large buyer and seller of iron ore, the sudden dump off in share in the Chinese market caused by smaller traders and sellers unable to get financing will likely further depress the price of iron ore globally—which has already been in decline in during the first half of 2014, reports Reuters.

The effect, interestingly, seems to be pulling in the opposite way in copper prices, where the investigation started.  Since the announcement of the probe, copper has been trading at a higher price.  London-traded futures in the commodity started rising June 20 and have kept going up ever since, representing the longest winning streak this year. Moreover, because the Qingdao has put supply the physical supply of copper in question, the commodity has been commanding a premium over front-month futures, when earlier this year it was trading at a discount.