‘Fake’ aluminum stocks highlight the perils of China’s commodity finance

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The opaque world of commodity trade finance in China is once again in the spotlight.

This time, metals markets are obsessed with an incident in the southern province of Guangdong, in which several traders claim they were tricked into extending credit for fictitious amounts of aluminum. More than 500 million yuan ($75 million) may have been loaned, backed by stocks of metal stored in a warehouse in the city of Foshan that were worth much less than that.

The amounts in question are relatively small, certainly in the context of the aluminum market in China. Last year, the world’s largest producer produced more than $100 billion worth of lightweight metal, for everything from window frames to auto parts. But what scares traders is the similarity to a much bigger scandal eight years ago in the northern port city of Qingdao that sparked a crisis of confidence in China’s metals markets.

What could cause inventory mismatch?

Commodity trading, whether wheat, copper, or oil, is typically a high-volume, low-margin business. To optimize cash flow, traders often pledge their assets against loans. In the metal industry, this security takes the form of warehouse tickets, which record details such as quantity, quality, ownership and location of goods.

Making multiple warrants for a single metal stock would allow the owner to access loans from multiple lenders, a practice sometimes referred to as “over-commitment”. A discrepancy between receipts and the actual amount of metal could occur in such a procedure.

Why would a trader take this risk?

Merchants operating on already wafer-thin margins have operated under even tougher funding conditions in recent months. Banks have become more cautious about lending due to larger price swings caused by the Russian invasion of Ukraine, as well as nervousness over some high-profile losses in the nickel market.

This has encouraged some to seek alternative financing, including the practice of small private companies pledging their wares to larger state-run traders for cash. Commodity prices are also generally higher due to the war in Ukraine, which means stocks may be worth more as currency for other investments.

The risk now is that large merchants will not lend to their smaller counterparts unless they are confident that their loans are secured by valid warehouse warrants.

How was the potential fault discovered?

This market volatility may have rattled the nerves of creditors. The sharp drop in aluminum prices after the latest virus outbreak brought the entire city of Shanghai to a standstill has led some to try to grab the pledged metal, fearing borrowers may not be able to repay their loans. That’s when the disconnect between too many warrants and not enough aluminum became apparent, according to people familiar with the matter, who declined to be identified discussing a private matter.

What happened during the Qingdao scandal?

The Foshan incident is a relatively small beer and has only involved traders so far. In Qingdao, it was banks, including international institutions, that found themselves most exposed to a trader and his affiliates who repeatedly pledged the same stock of metals for loans of over 20 billion. yuan.

But that in itself is probably instructive. Banks have learned lessons from Qingdao and other commodity finance scandals, making them more cautious lenders and pushing traders to seek alternative arrangements, including borrowing from larger peers. China’s regulator has also urged banks to step up oversight, and the use of metals as funding collateral has since declined.

Other similar frauds outside of China include French and Australian banks hit by 2017 loan losses totaling more than $300 million after discovering fake documents for nickel stored in Asian warehouses owned by Access World. , a subsidiary of Glencore Plc. And in 2020, Singaporean oil trader Hin Leong (Pte) Ltd. falsified documents to obtain trade financing for products he had previously sold.

What are the potential results?

Guangdong local police are investigating and will determine if fraud has taken place, but since the warrants in question have not been registered with the Shanghai Futures Exchange, China’s largest commodity exchange will not be required to review the regulatory angles of the case. Instead, creditors will likely go after warehouses for inventories first, pending investigations to decide whether borrowers are responsible for the losses.

The incident led to a domino effect in which more warehouses in China suspended operations to check on-site metal stocks. The market is facing a loss of confidence, with global commodities giants Glencore Plc and Trafigura Group among traders rushing to check their stocks, according to people familiar with the matter.

Although the Chinese government and its state-owned banks are preparing to increase lending to counter the adverse effects of the virus on the economy, their largesse is unlikely to extend to commodity trading. As such, small businesses may find it more difficult to secure funding in the wake of yet another scandal.

The incident also has a detrimental effect on prices. Aluminum has fallen since news of the possible fraud began circulating, and traders will continue to be wary of buying the metal as this uncertainty around ownership persists. There is also the risk that confidence will be undermined in other important markets for materials that depend on warehouse warrants, such as copper, nickel or zinc.

(Updated with details of traders checking inventories in 14th paragraph)

More stories like this are available at bloomberg.com

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