China is the world’s largest consumer of copper and it is also the largest consumer of gold (although consumption is in some ways a strange way to describe society’s ‘use’ of gold), so it should perhaps come as no real surprise that on the back of the multiple pledging of copper scam something similar is being reported in gold. The National Audit Office has revealed that it has discovered that perhaps as much as RMB94.4 billion ($15.2 billion) has been advanced against gold collateral which apparently does not exist. Whereas the copper game largely seems to involve importers, the suggestion of this latest scandal is that it has been domestic gold producers who have been borrowing against exaggerated production figures in order to invest in high-return assets. Just to put the numbers in perspective, an estimate by Goldman Sachs puts the total amount of commodity-backed loans in China at around $160 billion, with gold representing perhaps half that total and copper around $46 billion; these are significant amounts.
The underlying business is quite straightforward and understandable. After all, if an importer of copper or a refiner of gold has stocks in hand, in a port or in a refinery, then why not use them as collateral to secure finance for other projects? The banks are far happier to lend where there is easily tradable security at hand, meaning that the interest rate differential (between the secured borrowing cost and the achievable investment rate) can be maximised. Copper and gold are both easily hedgeable commodities, so that the value of the underlying security can be protected. This is not a cutting-edge business: it’s pretty standard.
So what’s gone wrong? I suppose in one sense you could describe it as over-enthusiasm - the borrowers think they see such good opportunities for investment that they want to increase their leverage, presumably hoping that they could clear a healthy profit before the loans became repayable, in which case the scam may well have passed completely unnoticed. Equally, maybe the lending banks became a little lax in their verification procedures, although I’m not completely convinced by that. Presented with what was to all intents and purposes a valid warehouse receipt or holding certificate for the material, it’s difficult to see how they would have been able to arrive at any conclusion other than that they had good security for their loan. Even physical checking would be unlikely to reveal the scam, unless by chance two lenders arrived to check the same parcel simultaneously.
...and a Systemic Problem
The beneficiaries of the fraud - which is what we should call it - are clearly the pledgers of metal and borrowers of money. They are the ones who are receiving double (or more) value in loan for their metal stock. But the facilitators of the fraud must include those who issue multiple certificates covering parcels of metal, and the fact that this scam extends from the originally discovered copper and aluminium now to include gold, iron ore and, I’m led to believe, soft commodities as well, makes it very difficult not to come to the conclusion that there is a systemic problem. If it were, as originally touted, confined to one entity in one port, then perhaps one could accept that that it was a one-off; but that’s demonstrably not the case. It’s more widespread than that and while it’s understandable that banks will make soothing noises about how this will not affect their financing business in China - after all, they’ve got open loan books to protect from panic - that can’t really be the case. Anybody who was at any sort of major trader or broker during the 1990s will recall that Chinese customers tended to be more demandingly margined than, say, major western miners, as there was perceived to be a greater risk of default. Some were indeed a hundred percent margined. As with trading and broking, so with banking. I’m sure the margin on these financing deals has been fine tuned to reflect the perceived level of risk; I’m equally sure that the emergence of this problem will focus minds in two ways in particular. First, a greater scrutiny of the warehousing and storage companies; secondly, an increase in the cost of funds against this kind of collateral. Because, however you look at it, the reality is that the level of risk has just got higher.
Just another thought. There’s been a lot of discussion about the methodology of price setting, in both base and precious metals. The LME has recently declared itself as continuing to be the bastion of open outcry trading; the bullion market hasn’t decided, but participants when polled preferred an electronic system. Nevertheless, apparently the biggest threat to the integrity of the markets is the ‘lack of transparency’ of the price setting mechanisms. Really? Not the uncertainty of knowing what you actually own? Or knowing whether or not you can get hold of it in a timely way? Mmm; price setting is an essential part of a properly functioning market, nobody would seriously dispute that, but so is an adequate system of storage.