China’s Great ‘Commodities for Cash’ Scheme

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The big news yesterday was the Chinese trade data, which blew expectations out of the water. The Aussie dollar surged, as did opinions over whether the data was ‘real’ or not. Being a China bear, our first reaction is to pooh-pooh the data. After all, it’s widely acknowledged you need to take much of the official data releases with a grain of salt and a shot of tequila.

But retreating to confirmation bias isn’t good analysis, so we looked around to try and find out the real story behind the data. We’ll get to the bottom of that in a moment; it’s an interesting story!

First though, let’s take a look at CBA boss Ian Narev’s self-serving comments after the announcement of the bank’s record half-yearly profit. Self-serving comments by CEOs are nothing new, but when it comes from a banker it’s worth examining, because the view they have of their organisations is just as inflated as the profits they are making.

As reported by the Financial Review, Narev had this to say:

‘“When you have banks and major banks growing this well, that is a good sign for the economy and when you look back over the past five or six years and you look at the fact that the Australian economy has managed to do so well, notwithstanding all the trials and tribulations offshore, one of the factors behind that is that you have a very solid banking system anchored by large scale players," Mr Narev said.

‘“Our view is that is good for everybody. In conjunction with all the other major banks, we are providing a very secure financial platform. We feel very comfortable that there is a lot of competition with the current parameters of the Australian banking structure.”’

OK. On the surface it’s hard to take issue with that view. Australia banks are well run and well capitalised…and so they haven’t blown themselves up. Strong banks, strong economy and all that.

But that is flimsy and shallow analysis. That the big four banks make up over 25% of total stock market capitalisation is representative of the complete financialisation of the Aussie economy over the past few decades. It represents the increasing indebtedness of Australian households as property speculation has become our number one sport. Household debt levels remain near all-time highs at 150% of disposable income.

This is not directly the fault of the banks. It’s government policy that ultimately sets incentives for people to act. Banks don’t stuff a mortgage down your throat, although they certainly work on your appetite.

Banks have benefited from poor policy because the answer to every problem or setback our economy has faced over the years has been lower interest rates. Combined with the income boost from the China boom (which came in two distinct phases – 2003-2007 and 2009-2012) these forces unleashed waves of inflation that washed over the Aussie economy.

The banks simply had to stand still and not do anything stupid to take advantage of it. And the oligopolistic structure of the banking sector meant no one had to do anything stupid. There were plenty of spoils to share around and no aggressive competitors to compete away ample returns.

The global credit boom changed this cosy market set-up slightly. Securitisation (the packaging of illiquid assets and selling them as high interest ‘money’ accounts) shook the market up a little, and banks like Babcock and Brown turned the risk dial up in their lending practises. So when the credit bubble burst, the banks were in genuine trouble and the government had to put billions of taxpayer money on the line to provide confidence to the sector and avert a destabilising run.

With this support behind them, the banks cleaned up after the crisis, buying up competitors and consolidating their large market shares. And when the fruits of China’s second stage boom began flowing through to the Aussie economy, the punters leveraged those gains. The banks did the same. The result, record profits and profitability.

We don’t mean to suggest that banks should be losing money…that wouldn’t be a good thing. But to imply that such massive profits are good for everybody is ridiculous. There is a large swathe of Australia that is struggling right now. Those locked out of the property market, those with poor job security, or those who have imposed high burdens on themselves to cling to the property ladder in the promoted belief that they have to ‘get in’.

They’re all contributing to the banks’ bottom lines, and we would doubt they’d feel ‘good’ about it. So go easy with your self-serving comments; most Australians can see through your rhetoric and explicitly understand that when the interest rate stimulus runs out and China rebalances, you’ll be in a spot of bother. And if push comes to shove, you’ll have your hand out asking taxpayers to help…again.

About this China rebalancing though…is it even happening? Will it ever happen?

Yesterday’s trade data was very strong, with exports rising 10.6% year on year and imports increasing 10%. The trade flows produced a monthly surplus of nearly $32 billion, well above expectations. Exports to Europe, the US and Japan all grew strongly while a massive month for iron ore helped on the import side.

The naysayers thought the strong data must be due to dodgy trade invoices issued via Hong Kong to get around China’s capital controls. This issue has in the past distorted the trade data. But exports to Hong Kong actually declined in January, putting paid to that theory.

There were more working days in January 2014 compared to last year, which would have boosted the numbers a little, but not considerably.  While the data looks too good to be true (especially given the weak manufacturing and services data for January) it undeniably shows that growth is still traveling at decent levels in China. We’ll know just how well when China’s loan growth data comes out later today.

For Australia, the real interesting point about China’s trade figures was the absolutely huge iron ore import figure of 87 million tonnes, a 33% year-on-year increase. At the same time, China’s ports are bulging with near record levels of iron ore inventories.

So what’s going on? Bloomberg has the story…

‘China’s iron ore imports climbed to a record in January as some buyers used the commodity as collateral to get credit, swelling inventories that are already approaching the highest level ever.

‘Companies seeking funding amid government efforts to rein in lending and shadow banking are shipping more ore to use as collateral, said Xu Xiangchun, chief analyst at researcher Mysteel.com. Rising purchases by China, the world’s largest user of the material, may reduce a global glut forecast for this year by Goldman Sachs Group Inc. and Credit Suisse Group AG.

‘“Steel prices have fallen sharply and demand remains weak, so there are no fundamental reasons supporting such a big jump in the raw material imports,” Xu said by phone from Fuzhou today. “The only plausible reason is financing deals.”’

Copper imports rose to a record monthly level in January as well, so we assume that the punters in China are using ‘commodity collateral’ to get their hands on cash for use elsewhere in the credit casino.

So they get a short term letter of credit from a bank or whoever, buy a boatload of iron ore (or a few slabs or copper) and sell it for cash. They punt with the cash for a few months, then repay the loan, presumably making a nice profit along the way. 

What could possibly go wrong?

This is the sort of shenanigans that happen when the authorities lose their grip on a credit boom. Attempts to tame it prove elusive…until it eventually tames itself.

By the way, another trust product in China just defaulted. They’re trying to ‘restructure’ it to avoid investor panic. Expect more of this to come.

Your remaining China-bearish analyst,

Greg Canavan+
for The Daily Reckoning Australia  

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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2 Comments on "China’s Great ‘Commodities for Cash’ Scheme"

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slewie the pi-rat
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Copper Collateral.
Boy George, right?
i’m singing it as i type…

gab csillag
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Dear Greg,

Always worth reading, but…….a great contrarian indicator you have been. Good luck…… eventually you’ll get there.

wpDiscuz
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