Call up the coppers

Potential warehousing fraud draws attention to commodity financing

Zheng Minghui, chairman of the board of the Qingdao Port Group, reacts after hitting the gong during the debut of Qingdao Port International Co. at the Hong Kong Stock Exchange

His IPO went off with a bang: Qingdao Port’s boss Zheng Minghui

As he sits in a cell pondering his fate, the owner of Qingdao Decheng Mining might well mull Shakespeare’s maxim, “Foul cankering rust the hidden treasure frets, but gold that’s put to use more gold begets.” If the allegations against Chen Jihong are correct, his company has been hiding plenty. His firm stands accused of fraud after generating multiple receipts on stockpiles of metals in the port of Qingdao and then using them to get funding from banks.

As Shakespeare’s verse from the poem Venus and Adonis attests, the the notion of fractional reserve banking began when the promissory notes payable on demand issued by London goldsmiths – in return for deposits of gold coin – began to be accepted in trade, and the goldsmiths realised that they could then lend money on the assumption that not all of the notes would be redeemed at once. By the late seventeenth century the notes were freely circulating alongside coin and many of the Lombard Street-based goldsmiths were morphing into banks.

Back to today, and startled lenders have been racing to Qingdao to check whether their collateral actually exists. The timing of the revelations has been excruciatingly embarrassing too. Reuters first flagged the police probe on June 2, four days before Qingdao Port International was due to start trading on the Hong Kong Stock Exchange. Perhaps regulators saw the timing as a way of highlighting concerns about fraudulent behaviour in the commodity-backed financing business. But investors who purchased the IPO are likely to be extremely unhappy. They’d committed their money on May 29, before the news broke (if the company had stuck to a normal two-week roadshow, the debacle would have been public knowledge by the time the deal was priced; as it happened this process was replaced and the transaction’s timetable was instead moved forward via a three-and-a-half day burst of accelerated bookbuilding. Reuters describes the method as “unusual” for an IPO but quoted a source saying the company chose it as a “more efficient, simpler” approach.)

Institutional orders for the HK$2.91 billion ($373 million) deal are said to have closed three times oversubscribed, although just under half the offering was already allocated to six cornerstone investors. Retail investors shunned it, applying for only 15% of the stock on offer.

Qingdao Port has underperformed the market since it started trading last Friday, sliding 5.58% from its offer price of HK$3.76 as of Thursday.

Reuters journalists visited the port – China’s third largest for foreign trade (and its largest iron ore terminal) – and report that a bonded warehouse is the focal point of the investigation. The facility in question is the size of two football pitches, but has been padlocked and is under the watch of security guards. However, the widespread rumour is that there are huge shortfalls of the metals recorded as stored there – as much as 20,000 tonnes of copper, 100,000 tonnes of aluminium ingots and 200,000 tonnes of alumina.

One company already acknowledging involvement is Citic Resources, which released an announcement to the Hong Kong Stock Exchange on Tuesday saying it has applied to the Qingdao courts to secure the metal assets it owns in the warehouses.

Other international firms are said to be exposed.

Standard Bank, a South African lender – which is part-owned by China’s biggest bank ICBC – has also said that it has “commenced investigations into potential irregularities at the port” and that it would “be working with the local authorities as part of its investigations”.

In the domestic press, 21CN has pinpointed Qingdao Decheng Mining, a subsidiary of the Decheng group and one of China’s lowest cost producers of aluminium, as a potential culprit.

“Third parties like warehousing officials and even some banks collude with companies to issue more than one receipt for the same batch of goods,” an official from one state-owned enterprise explained.

“Then the companies defraud the banks by seeking multiple loans.”

Decheng’s operations are relatively small, although the broader concern is that they may have been replicated at other locations and with other commodities across the country. Industry estimates for commodities-backed lending since 2010 have reached as high as $160 billion.

21CN highlights the difference between the companies trying their luck for multiple loans on single stockpiles, and those which legitimately obtain letters of credit (which they then arbitrage by selling the underlying stock as quickly as possible and investing the proceeds in higher-yielding assets before they have to repay the letters of credit). Both practices have fallen foul of the economic downturn, which has turned profitable arbitrages into loss-making ones, pushing some traders out of business.

Meanwhile the Financial Times says that traders have been trying to move stock out of the port since the probe was announced. “They are taking copper to South Korea or Shanghai, also Japan, because they are afraid it could be seized,” one warehousing manager reported.

Other commentators worry that the crisis in Qingdao will curtail appetite for commodity-backed finance in general, which will weigh down metal prices.

Iron ore and copper have both come under selling pressure this year on fears about China-related commodity financing. The downward slide has got much worse following the events of the past week. On Monday, copper for June delivery had declined 4.2% over the previous eight trading sessions. And back in China, the investigation seemed to be spreading, with inspectors said to be trying to get access to Penglai port, also in Shandong province.

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