China's commodity demand tied to risky credit deals

Gold, iron ore and soya beans are increasingly used to get access to non-traditional financing

PUBLISHED : Saturday, 19 April, 2014, 1:09am
UPDATED : Saturday, 19 April, 2014, 1:52am

In an otherwise upbeat report on the outlook for China's gold demand, the World Gold Council (WGC) slipped in some details about the use of the precious metal for credit deals.

The use of gold for financing probably amounts to about 1,000 tonnes since 2011, the council said on page 56 of a 64 page report released on April 15 on the state and outlook for China's gold market.

In doing so, gold has become the latest commodity where Chinese imports appear to have been bolstered by demand for credit, as opposed to any actual consumption or investment.

While it has been known for some time that copper imports were often used as collateral in order to get financing outside of the traditional banking channels, this year has seen iron ore, soya beans and now gold added to the list.

So far the apparently increasing use of commodities to access lines of credit hasn't had as much impact on markets as might be expected.

But surely the risks must be mounting as it becomes clearer that significant parts of China's commodity demand is tied to increasingly risky credit deals, many of them in property, a market that analysts believe is at risk of a sharp correction.

It may be that iron ore producers, traders and consumers have little to do with their counterparts in copper, soya beans and gold and they are unaware of the risks mounting in parts of the market other than their own. But even within markets, the views may be too sanguine.

Take the WGC's report on China's gold market for example. Much of the report focuses on how China's rising wealth is likely to boost gold demand in the world's largest producer and consumer of the precious metal. The report said it expects gold demand to rise by 25 per cent to at least 1,350 tonnes by 2017, although this year may see more muted growth following last year's record purchases.

China overtook India as the world's largest gold consumer last year, with demand reaching 1,065.8 tonnes, a gain of 32 per cent over 2012 and ahead of India's 974.8 tonnes. Using WGC statistics, China's gold demand for the three years from 2011 to 2013 was 2,652.4 tonnes. If about 1,000 tonnes of this was related to financing deals, that represents about 38 per cent of the total.

This ought to be of massive concern to any gold bulls, given much of the optimistic case for gold is built on ongoing Chinese demand. To learn that 2 out of every 5 tonnes bought by China was for use in an inherently, and increasingly, risky shadow banking practice doesn't augur well for arguments that Chinese demand is moving sustainably higher.

Last year's 28 per cent plunge in gold prices was largely put down to investors selling out of exchange-traded funds, with the WGC saying that 880.8 tonnes was liquidated.

While it's unlikely that Chinese finance deals would be unwound as quickly, there is still 1,000 tonnes of gold that could potentially have to be sold if financing deals go sour. The value of this gold is more than US$43 billion at current prices, and this dwarfs the value of iron ore inventories at Chinese ports that may also be at risk.

Total iron ore inventories at Chinese ports stood at 107.65 million tonnes in the week to April 5, with at least 30 million tonnes believed to be linked to financing deals.

This 30 million tonnes has a market value of about US$3.5 billion, using the current Asian spot price and even the threat that it may be sold quickly is causing consternation in the iron ore market.

There are of course other factors driving prices, but if mainland Chinese demand for commodities like iron ore, soya beans and gold does decline as financing is unwound, or even as new credit deals dry up, then it removes part of the reason to be bullish.