By now we seem to have a fairly good grip on what has led to the spectacular fall in commodity prices over the course of the last year: it’s essentially a supply side problem. A supply side built to cater for the booming China of the 1990s has been paired with a demand side more reminiscent of the 1980s.
The market response has seen commodity prices slaughtered. But adding to the mayhem, could be something to do with interest rates and certain foreign exchange controls imposed by the Chinese Central Bank.
“My biggest driver in 2016 is the reversal of the Chinese carry trade,” says Ken Hoffman, head of metals and mining research at Bloomberg Intelligence.
A carry trade entails borrowing money from a jurisdiction at a lower rate of interest, and converting it into a foreign currency where it can earn a higher rate of interest – a simple arbitrage. But because the yuan is a closed currency system, no-one could do this, with one exception. “The Chinese government was so keen to promote manufacturing, they allowed manufacturers to borrow from foreign lenders using their inventory as collateral,” says Hoffman.
This saw hundreds of thousands of Chinese manufacturers going to places like Singapore and Hong Kong to borrow money in US dollars (the yuan is pegged to the dollar) at low rates of interest (2-3%) and repatriating the money to China where it could be invested in assets generating a far higher return. “So everything was aligned to enable this to happen. The problem is that no-one, apart from the Bank for International Settlements, has any idea to what extent this has been done,” says Hoffman. “But we think it’s being done in a big way.”
Because of the lack of information, this derivative of the carry trade has been named the ‘phantom trade’.
China capital account and stock market
One of the places the money could have been invested was in the Chinese stock market. Note in the graph above the tremendous run the Shanghai Composite Index enjoyed between the first quarter of 2014 (2 033 points) and the run up to June 2015, where it more than doubled to close at 4 277. Large capital withdrawals coincided with a sharp correction in the stock market towards the end of last year, with the market still ending in positive territory for the year.
Besides the stock market coming off quite sharply, China has also been forced to devalue the yuan – largely on account of the surging dollar. This implicitly increases the size of the loans to Chinese borrowers in US dollar terms. The quicker the yuan devalues, the more pressure it places on the carry trade.
Yuan/dollar exchange rate (weekly)
So the question we ask is how much is for speculation and how much is being used for manufacturing?
Coming back to the effect of the carry trade on commodities, Chinese customs data revealed last week that 530 000 metric tons of unwrought copper and products were imported in December – a rise of 26% year-on-year and the second-highest monthly figure on record. JP Morgan reported that imports of copper to China in volume terms jumped 11.9% month-on-month, seasonally adjusted (vs. +2.2% m/m in November).
The data eased investor fears after a string of recent economic upsets by the Asian powerhouse spooked the market.
China is the biggest global user of the base metal, consuming around 45% of world supply. This signalled to some that latent demand may be stronger than initially thought. “With inventories both on the Shanghai Futures Exchange and in bonded warehouses remaining relatively unchanged, there also appears to be some strong underlying demand behind this improvement,” said ANZ Research in a note.
But despite the healthy appetite, prices have been wholly unaffected. Could this be because inventory held as collateral in the carry trade is now being unwound and dumped on the market?
The curious case of nickel
The ban Indonesia instituted on mineral exports in January 2014 caused ruptures in commodity markets as Indonesia was the world’s largest producer of mined nickel (in 2013). The country’s exports accounted for more than 10% of all mined production and over 50% of all seaborne trade. But since the ban was instituted, nickel prices have fallen 70% and nickel inventories are near all time highs. So what is going on?
There is clearly a fundamental step change in the demand for resources from China. But the circumstantial evidence cited here might suggest that the hypothesis of the so-called ‘phantom trade’ could explain some of the anomalies in the price and stock movement.