CHINA June 09 2014 6:23 PM
SHANGHAI (Scrap Register): An official investigation of a major Chinese commodity port of Qingdao, in north eastern China, has rattled markets this week. These investigations are fuelling concern s about the allegedly fraudulent use of warehouse receipts.
Deutsche Bank believes that current investigation is likely to raise market awareness of risks involved in commodity financing. In this report, we present our initial take on the short term and medium implications of this investigation.
Short term: A “freeze” in activity and the increased difficulty to obtain repo financing is likely to ease the temporary tightness in the physical market. Deutsche Bank believes that the immediate impact is negative on the copper market with a sharp fall in bonded zone premium and a rapid flattening of backwardation at the front end of copper term structure. We note that the copper spot to 3m spread has fallen significantly from multi-year highs.
While there is still considerable uncertainty regarding the extent of alleged fraudulent transactions, Deutsche Bank believes this is another step in cleaning up commodity financing in China.
Over the medium term, Deutsche Bank believes that much tighter audit rules for warehousing receipts could raise the cost of repo deals, with the knock - on effect of declines in bonded warehouse premiums.
There is a loose positive correlation betwee n the China copper bonded premiums and LME inventory outflows over the past year. If this correlation holds, the decline in bonded premiums will result in a reversal of LME inventory draws with materials flowing out of China’s bonded warehouse zone. The inflow of metal into the LME has tended to weigh on copper prices, with the copper market still most sensitive to these movements.
Over the long-term however, Deutsche Bank believes the tighter control on the use of copper as a financing medium will add a degree of confidence to the copper market, limiting the divergence between real and apparent demand.
As a knock-on effect, L/C issuance by western banks may be affected, resulting in a reduction in the number of financing deals. This is possible if the loss incurred o n the repo leg by western banks has resulted in a general loss of confidence.