Nerves of steel

You have probably never heard of Zhouning County. But for bankers in Shanghai, it has been the source of a few sleepless nights.

WiC has written before about the tribal nature of business communities in China. Think of the miners from the small county of Shanglin who travelled en masse to Ghana in search of gold (see WiC195). Or the good folk of Guangfeng, who accumulated 70,000 excavators to lease to construction projects across the country (in WiC195 as well).

Usually a plucky individual hits on an idea. If it’s a success, friends and family join in. Then the idea snowballs to the wider community.

Something similar happened in Zhouning in Fujian province when two entrepreneurs discovered a way to profit from trading steel in Shanghai.

Xiao Jiashou (aka ‘the steel king’) and Zhou Huarui (nicknamed ‘big brother’) started their business in the 1990s. As their trading empire expanded, they brought in more and more of their trusted cohorts from their hometown.

It helped, of course, that Zhouning had a history of making iron products, says China Economic Weekly. But soon a 67,000 community had decamped to Shanghai to make its fortune by acting as middlemen between steel mills and the largest buyers of their products, like real estate developers.

As China’s construction industry boomed, Zhouning natives developed a reputation as savvy operators, and they were particularly aggressive after 2008 when the stimulus package led to a surge in infrastructure outlays, driving demand for more steel.

At the height of the credit fest, a steel trader simply needed to present the banks with an ID card from Zhouning to get start-up capital of Rmb5 million ($815,000), according to MoneyWeek. Typically the bigger Zhouning businessmen would guarantee the activities of more junior entrepreneurs from their home county.

This interlocking web of financial commitments was risky, but banks were happy as long as they were generating annual interest payments of Rmb25 billion on the back of Rmb200 billion of outstanding loans to steel traders, according to Shanghai Banking Regulatory Bureau figures.

But lending standards became increasingly slack. As one market participant tells MoneyWeek, “Banking officials didn’t bother checking steel traders’ inventories, or conduct onsite checks for loans, side-stepping risk management mechanisms.”

Soon Zhouning’s steel barons were relying on increasing amounts of leverage to keep the financing flowing. One report suggested that a single tonne of steel had been used 30 times to secure loans from different banks.

Where was this money going? Much of it was hunting for quick returns in the property market or heading into high-return loans in the shadow banking industry.

However, when the steel market went into severe downturn in 2012, the financial arrangements began to unravel. With fresh bank lending more difficult to find, loan defaults started to rise. MoneyWeek says in some months as many as half the court actions by banks in Shanghai related to steel traders.

Matters came to a head last month when the original two Zhouning entrepreneurs, Xiao Jiashou and Zhou Huarui, were sued for non-repayment by a group of Shanghai-based banks. In a subsequent telephone call to state TV broadcaster CCTV, Xiao said he was the guarantor rather than the debtor in 70% of the cases against him, underlining the tightly-woven web connecting the county’s steel trading community.

(The scale of the problem has also started showing up on bank balance sheets. CITIC Bank, one of the early pioneers of supply chain finance, was said to have had outstanding loans to steel traders totalling Rmb40 billion as of June 2013 – roughly 20% of the total – with non-performing loans running at 8%, a figure that’s much higher than the average.)

With the banks no longer willing to lend, the traders and their steel-producing clients started to look for other ways to raise funds. Smaller and more desperate mills found one particular avenue for short-term finance: purchases of iron ore.

This, rather than burgeoning economic activity, might explain why China has built up record inventories of the commodity. According to mysteel.com statistics, iron ore stockpiles at Chinese ports hit record highs of 107.2 million tonnes in February. (Back in 2008, before the $586 billion stimulus plan, inventories were closer to 40 million tonnes.)

At the same time, steel production has been declining (average daily production in mid-February was 1.96 million tonnes, versus a 2013 average of 2.2 million tonnes). This again points to a chunk of the stockpile being used as a commodity financing tool.

In fact, the 21CN Business Herald believes that as much as 30 million tonnes of iron ore inventory was bought as loan collateral rather than purchased for productive purposes. Mysteel.com has a similar view, speculating that about 40% of the iron ore at China’s ports is part of finance deals.

“Iron ore has replaced copper ore as the new financing instrument and its use is growing,” a trader told the newspaper.

21CN has also described how some of these trades work. One of the most popular arrangements is for a trader or mill to sign a contract to import ore through an offshore company, which it also owns.

It then secures a letter of credit (L/C) denominated in US dollars with a domestic bank – the latter being unaware that the same entity is behind both sides of the trade.

The offshore company uses this document to secure a second L/C with an offshore bank that provides financing to a genuine iron ore exporter.

The commodity arrives in China, and the upshot of all this activity is 90 days of cheap funding (typically priced at 2%).

A variety of things can then happen to the money. It might be used to repay another loan and buy time for the overleveraged party. Or it might go into a shadow banking product offering returns of 8% and more.

But in recent weeks there have been signs that this commodity financing trick is losing steam. A dramatic and unforeseen depreciation of the renminbi has exacerbated margin calls from lenders.

In a sign of how desperate steel traders have become to manage their debts, Bloomberg has reported that some bosses have been using their credit cards to tide over payment requests by lenders, prompting a probe by the central bank.

The self-fulfilling flaw in the financing ruse is the impact on the price of iron ore itself. As they struggle to meet margin calls, traders are forced to sell existing stockpiles, depressing iron ore prices further. Others indulging in similar activity then face further losses of their own.

This week iron ore saw its second biggest one-day percentage fall on record – on Monday it plunged 8.3% to $104.70 a tonne. That is an 18-month low (and significantly down on the peak price of $187 witnessed in February 2011).

All of this turbulence is of more than passing interest to the world’s biggest miners, who lost billions in market value at the start of the week because of the news from China. Weak export data and a fall in the rate of inflation – both signalling slowdown – were the immediate triggers. As the Financial Times pointed out, BHP Billiton’s pre-tax profit drops by $120 million each time the ore price falls by $1 a tonne.

The sheer scale of China’s ore inventories is likely to put further downward pressure on prices as their owners try to dump them on the market. That means that the unravelling of these commodity finance trades could prove as painful for the big three miners (BHP, Rio Tinto and Vale) as it will for some of the Chinese banks (which are now alive to the possibility they could be a fresh source of bad debts).

“Financing deals being unwound due to lower iron ore prices are driving lower iron ore prices, which is driving collateral values lower and necessitating further financing deals having to be unwound. Iron ore prices don’t fall 8.3% in one day due to slower Chinese growth. They fall because of a credit event,” Atul Lele, chief investment officer at Deltec, told the Sydney Morning Herald.

Steel traders also told the Financial Times late this week that Haixin Steel has failed to repay overdue bank loans, signalling the situation could be worsening.

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