Traders in the raw

Ready access to cheap bank credit will lead to another commodity crisis in China, warn Hong Kong financiers.

Global commodity prices are at 10-15 year highs and the market tipping the scales on demand is China. China's appetite for steel, petroleum and downstream petroleum products has doubled in two years. The country has become the world's largest consumer of copper, aluminum and cement, and last year overtook Japan as the world's second largest importer of oil. It is also the number one buyer of soybeans.

The Chinese government is aware of the need for raw materials to fuel its economic growth and is passing new rules to facilitate more trade. In January last year the number of categories of import commodities subject to licensing controls was reduced from eight down to five.

Financing this trade is inherently more risky than traditional trade finance of manufactured goods. There is volatility in the underlying spot price of the materials, production is subject to cyclical and seasonal swings, some materials (like foodstuffs) are perishable, and the trades are much larger in overall size. The other risk is bad behaviour by opportunistic middlemen. "There has been a tendency for some small Asian trading companies to dodge off their obligations," says one Hong Kong banker. "They like to make a profit on the growth in demand for certain commodities but when prices go against them they sprint for the woods."

China is no stranger to commodity crises. In June last year 90%, of Brazil's soybean exports to China were blocked following accusations that the shipments were contaminated. Media speculated that China was reneging on contracts in order to bring down the world price in soybeans. Eventually the ban was lifted and trade resumed, but only after several commodity trading companies renegotiated the price of their shipments - dropping their prices by as much as 20% in some cases. The incident also left underwriting banks waiting nervously until outstanding letters of credit had been settled.

Before the soybean crisis there was a steel crisis and a copper crisis. One of the common characteristics of these crises is the involvement of smaller trading companies. Opportunists that speculate on a commodity regardless of their expertise in the product. These speculators squeeze the margins made by the trading community, flood the market with the product, push up the global price of the commodity and cause a collapse.

The fever currently surrounding commodity trade with China has some people worried that the mistakes made in Russia might be repeated in Asia. In the mid to late 1990s Russia was where China is today, an emerging market with a large population to feed and supply electricity to, and billions of dollars of infrastructure projects under construction. Trading companies of all shapes and sizes began speculating on commodities, particularly oil. Banks were offering five-year financing at 3% over Libor. When the supply/demand balance tipped, banks and traders were hit.

The activities of smaller unscrupulous trading outfits are a frustration to larger more sophisticated international commodity traders such as Noble, Cargill and ADM. Today, these traders are very active in China. They play both sides of the game, selling to end users around the world but also controlling the supply by signing off-take agreements with producers in China and guaranteeing the purchase of a product for a certain period of time. This has been an effective way for producers to finance their expansion. The large trading companies also act as suppliers to processing plants, importing raw materials to mills and refineries and then purchasing the output for export.

The presence of these large traders, and China's growing demand for commodities, has brought a lot of interest from banks. Specialist banks like Rabobank, Fortis and BNP Paribas have been financing commodities in the region for many years. And now the big global banks are reshuffling their desks to take advantage of the trade. HSBC has set up a global commodities business in London under Jean-Francois Lambert and in April will appoint a regional manager for Asia. Meanwhile, Citigroup hired Willem Klaassens from Fortis in London and moved him to Hong Kong where he is building a dedicated team. Other banks are dipping their toes in the water via their structured trade finance divisions. "Like many others, we are responding to the increased volumes in commodity trade in Asia," says Alistair Currie, head of trade services for HSBC in Asia Pacific. "We already provide commodity financing for clients, but are now stepping this activity up within a standalone structured trade finance unit covering the region. Client demand justifies the separate focus in addition to our standard trade business."

While the big foreign banks have cut their teeth on financing exports from China, they are now keen to finance imports, and that means taking on more risk. It's a risk that only a few will stomach - those big players with the backing of large balance sheets or the specialist banks that are masters at risk assessment. This ultimately means more finance is being made available to Chinese buyers. "In the past, the receivables had to be offshore before banks were prepared to take the risk," says Klaassens from Citigroup. "Now some banks don't mind getting repaid in China."

At the same time, banks are moving into different commodities. While base metals are less risky to finance because they don't get stolen and don't perish, there are other raw materials that have attractive risk dynamics. "Commodities that are being bought for the long-term economic betterment of the country, rather than for pure price speculation, are generally good bets," says Currie at HSBC. "Oil and foodstuffs are in high demand and all concerned in this trade for direct consumption have an interest in keeping these financing activities viable and scandal free."

The big banks are doing what they can to keep their powder dry. Assessing the risks of a commodity trade involves more than just conducting credit analysis on the trading company and the buyer. The credit department needs to look at the risks of the underlying commodity and the logistics of delivery. Banks are following different risk mitigation strategies from sticking with a core group of large trusted clients to financing certain commodities. "We only deal with buyers who have a significant relationship with our key MNC customers and we tend to stick to commodities listed in the London Metal Exchange like gold and copper," says Astar Saleh, regional head of structured trade for JPMorgan, explaining the bank's strategy. "We don't offer pure inventory financing in Asia unless we partner with a local bank."

Risks can also be mitigated by dotting Is and crossing Ts, says Currie at HSBC. "If you meticulously manage your operations, ensuring that the trade is supported by the right documentation and other key aspects like legal, insurance and compliance have been properly covered, then you can usually avoid trouble, but not always."

Following strict risk guidelines becomes harder when the competition for commodity business is so hot and margins are being squeezed. While the big banks make it a policy of following procedures regardless of market sentiment, the fever pitch is a concern, says Klaassens at Citigroup, who lays some of the blame for commodity crises, like the 2004 soybean mess, on banks. "As a banking community we should stick to our pricing and stick to our standards," he says. "If finance is too easily available to disreputable companies and at a cheap price then more people get hurt when a crisis hits."

Nobody is prepared to say whether a commodity finance crisis truly is looming in China and what impact a bust would have on the rest of the world. Back in the late-1990s Russia was able to export its way out of the crisis, an option not open to China now that it is so reliant on imports. "These sort of calamities can take 10 years to turn around," says one banker. "The big banks may not lose money because they stick to their pricing regimes and their risk controls, but it isn't much fun trying to do business in a commodities market that booms and busts."