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Another worrying sign for Chinese economy: Commodity Financing and Underground Lending

Let's first look at a recent Bloomberg news on China's commodity financing:

June 23 (Bloomberg) -- At a time when China is restricting
access to credit, commodities companies are building record
inventories to gain access to loans.

Copper inventories reached an all-time high in April and
have declined in the past two months after the State
Administration of Foreign Exchange introduced rules to make it
harder to use the metal as collateral...Now soybean stockpiles are
rising to record highs as perishable foodstuffs are used to back

"We saw such commodity financing activities spread from
traditional bankable collateral material such as copper sheets
to non-typical commodities," said Judy Zhu, analyst at Standard
Chartered Plc in Shanghai. "Soybeans and cotton, which have a
shelf life, are normally not considered collateral material."...

Domestic soybean inventories have reached 7 million tons,
higher than the 4 million tons to 5 million tons required to
meet demand from food processors, said Yongan's Li. Loans backed
by the commodity are re-lent in the "underground" market at
rates of more than 6 percent per month, he said.

"The importers buy the soybeans and get them in a month,
and because the line of credit is often 90 days, they don't need
to pay back right away, so they can lend the money," Li said.
"Demand has increased because of the credit tightening." ...

Letters of credit issued by Chinese banks listed in Hong
Kong in 2010 jumped 70 percent, faster than the nation's overall
trade growth of about 25 percent, suggesting funds were being
redirected into the black market, Bank of America Merrill Lynch
analysts led by Winnie Wu wrote in a note in May...

As the money market is getting tighter with ever hiking RRR (21.5%), Chinese underground lending is now expected to surpass housing flipping to be the most lucrative business in the country. This commodity-backed borrowing is only one way to get around the tightly government-controlled lending policies. Other sources show that many state-owned enterprises with easy access to bank credits increase their inter-company lending activities because, with the short rate reaching above 50%, it's much more profitable than doing anything else.

According to Michael Pettis, a well-known American professor at Peking University specializing on Chinese economy and financial markets, this type of practices, so called Zaiteku in Japan before its economic debacle 20 years ago, tends to increase systemic risk when corporations turn to speculative financial transactions as a source of earnings. This reminds me of the widespread inter-bank lending & borrowing business among Chinese financial institutions that I participated back in 1990s. The consequence: exploding bad/non-performing loans, massive banking bail-outs and the creation of the Big 4 Asset Management Companies at the end of the decade.

In a recent presentation done by one of my colleagues, economic units worldwide can be categorized into hedge, speculative and ponzi finance, depending upon if their incomes can cover interests and principals of their liabilities, interests only, or neither. Comparing US and China, we can argue both countries are running ponzi finance at their macro level with blowing national debts in US and massive hidden ones in China (taking 14 trillion RMB local government debts as an example). What differentiate the two lie at the micro level: US is much more disciplined and hedge-typed at the corporate level while China is way more robust at the household level. If the difference in households partly explains why China economical miracle has lasted so long while US is still suffering from the Subprime Crisis and the subsequent Great Recession, could the differences at the corporate level also foretell us something in the future?

With the underground interests between 20-50% a year (compared to official rate of about 6%), Chinese main-stream economy is shifting more toward massive ponzi schemes since no any normal business even in China can afford such high interest rates. That explains why the central bank (PBOC) is so reluctant to raise interest rates to fight inflation. This is also why I predicted last year Chinese government will eventually bail out local government debts to avoid banking crisis.

(Why? Let me ask you this: what is the most important in a ponzi scheme. Investor Confidence it is, of course. Another banking crisis, and the third massive banking bail-outs within 15 years (after 1998 and 2003), will definitely blow off investor confidence and scare away global investors. If that happens, we should expect to see "the mother of all black swans").

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.