What Copper and Gold Say about Chinese Growth

Commodity-backed loans are vulnerable to a domino of defaults
By Daniel Lacalle, Chief Economist, Tressis Gestión
July 25, 2018 Updated: August 1, 2018    

Weakness in copper persists—down 15 percent from its six-month high in June—and it shows the risks to optimistic global-growth and inflation expectations.

But something else is happening in gold and copper apart from a global slowdown and dollar strength.

The Chinese bubble.

As credit growth has slowed down and conditions have hardened, Chinese firms have tried to raise funds via copper-backed financing.

Gold-backed loans have also become very popular. They are so popular that analyst estimates range from 250,000 to 1 million metric tons of copper alone that are being used as collateral. Chinese firms could have locked up as much as 1,000 metric tons of gold in financing deals, according to the World Gold Council.

The widespread use of commodities to raise financing includes gold and iron ore, where up to 20 percent of stockpiles have been estimated to be tied to high-risk, cheap financing.

This giant carry trade worked while the yuan rose and commodity prices soared. Now, one of the reasons for the recent sell-off is the yuan weakness versus the dollar, in addition to downward revisions for Chinese growth estimates and commodities prices falling in tandem.

Domino Effect

The risk of a domino effect is not dissimilar to other cases in history where risky loans have been tied to an underlying asset that rapidly loses value. Examples range from the 1990s “yen-denominated mortgages”—which triggered huge losses in European markets as the Japanese currency revalued and repayments became more expensive—to the asset-backed loans in housing and oil just before the collapse and Great Recession. The difference this time is that the amounts are enormous and certainly much less manageable.

The combination of weaker demand growth and strength in the dollar is making margin calls jump. This shows that these alleged “safe assets,” such as copper and gold, have become much riskier as the number of non-performing loans rises and repayment capacities diminish, triggering a significant sell-off in the underlying commodity.

In essence, the sell-offs in the yuan, gold, and copper are one and the same. They are a signal of rising capital flight and a much higher non-performing loan ratio than the surprisingly low official data. We are witnessing the unwinding of bets supported by excessive complacency about China, global growth, and risk.

In the case of gold, it is showing no sign of being a safe-haven asset or inflation hedge, given the abnormal amount of gold-backed loans in the riskiest sectors. Gold- or copper-backed loans are rarely tied to safe and sound loans, and they are a way to receive low rates for the riskiest projects in an economy that is clearly in a slowdown mode.

Copper is the commodity that is most linked to industrial production. Copper price is a good indicator of the global economy, since fluctuations in price are usually determined by industrial demand. Given that the Chinese represent approximately 50 percent of global copper demand, the slowdown of their economy has a big impact on the price.

Credit Crunch

Many of the lowest-quality loans in China use copper or gold as collateral—up to 30 percent according to HSBC—as it is an indicator of industrial activity and closely linked to Chinese growth. When the market begins to question the debt repayment capacity of many Chinese companies, margin calls are triggered and copper falls with it.

It is a double impact: financial and demand-led. What was supposed to be a good hedge is actually a double risk on the economic slowdown.

What about the impact on the rest of the world?

Chile accounts for 34 percent of world copper production, approximately 19 percent of the nation’s revenues. The United States is the fourth largest copper producer in the world, after Chile, Peru, and China, and Australia is fifth. All these countries are producing at near peak levels, and a small decrease of 3.5 percent year-on-year has failed to address the surplus.

In terms of demand, China accounts for 50 percent, followed by Europe at 17 percent, the rest of Asia at 15 percent, the United States at 8 percent, and Japan at 5 percent. The rest are minor consumers.

Risks to demand estimates for refined copper in China imply overcapacity increases—a risk exacerbated by the fact that current demand-growth estimates assume a stronger U.S. economy.

The decline in gold, copper, and the yuan versus the dollar also show how global investors were aggressively betting on a “weak dollar forever” carry trade.

Welcome to the bubble. This bubble does not need a crisis to explode, just a small downward revision of over-optimistic estimates, which leads leveraged bets to go wrong.

Even if we question the extent of the commodity-backed financing risk, there is one thing we simply cannot ignore: net length in the above-mentioned currency and commodities was financed by a dollar carry trade gone wrong. The pain may be far from over.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.