We noted last night that Iron Ore futures prices were in free-fall as the vicious circle of China’s commodity-collateral-backed shadow banking system unwind hits home amid fears of contagion from the Chaori Solar default. The first domestic Chinese corporate bond default has retail investors running scared as surprise spreads that the local government did not come to the rescue. The deleveraging is now spreading to copper prices (remember the massive cash-for-copper schemes of last year) as borrowers are forced to sell to meet cash calls which in turn drops copper prices, reducing collateral values and tightening credit conditions even more. This is the biggest copper price drop since Dec 2011…
More on Chaori and the fallout…
As Deutsche Bank notes,
On the topic of China, according to the WSJ the country’s first onshore corporate bond default has occurred earlier today in the form of Shanghai Chaori Solar Energy’s missed/incomplete RMB89.8m coupon payment. As we have written over the last couple of days, the bond is relatively small (RMB1bn or US$160m in face value) and the issuer is small (US$1.2bn in assets) but it’s an interesting case for a number of reasons.
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.
Copper ownership and hedging: Through the whole process each tonne of copper involved in CCFDs is hedged by selling futures on LME futures curve (deals typically involve a long physical position and short futures position over the life of the CCFDs, unless the owner of the copper wants to speculate on the price).
Though typically owned and hedged by Party A, the hedger can be Party A, B, C and D, depending on the ownership of the copper warrant.
As Goldman further explains, the importance of CCFD is “not trivial” – that is an understatement: with the implicit near-infinite rehypothecation in which the number of “circuits” in the deal is only a factor of “the amount of time it takes to clear the paperwork”, there may be hundreds of billions, if not more, in leverage resulting from this shadow transaction that has been used in China for years. Now, that loop is about to end. The reality is nobody can predict what the impact will be, but whatever it is – i) it will extract tremendous leverage from the system and ii) it will have adverse impacts on both China’s ability to absorb inflation and grow its economy.