‘Fake’ aluminum stocks put the spotlight on the dangers of Chinese commodity finance

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The opaque world of commodity trade financing in China is once again in the spotlight.

This time, metals markets are fixated on an incident in southern Guangdong province, with several traders claiming they were tricked into lending against fictitious amounts of aluminum. More than 500 million yuan ($75 million) may have been borrowed, helped by metal stocks stored at a warehouse in the city of Foshan that turned out to be worth significantly less.

The volumes that are being talked about are relatively small, certainly in connection with the aluminum market in China. The world’s largest producer spent over $100 billion on the lightweight metal last year on everything from window frames to auto parts. But what spooks traders is the resemblance to a much larger scandal eight years ago in the northern port city of Qingdao that sparked a crisis of confidence in China’s metals markets.

What could be causing the inventory discrepancy?

Commodity trading, be it wheat, copper or oil, is typically a high-volume, low-margin business. To optimize cash flow, traders often mortgage their assets for loans. In the metals industry, these securities are warehouse receipts that record details such as the quantity, quality, ownership, and location of the goods.

Manufacturing multiple warrants for a single metal stash would allow the owner to access credit from more than one lender, a practice sometimes referred to as “over-pledging”. Such a procedure could result in a discrepancy between receipts and the actual amount of metal.

Why would a trader take this risk?

Merchants already operating on razor-thin margins have been operating under even tougher funding conditions in recent months. Banks have become more cautious about lending as major price volatility has been caused by the Russian invasion of Ukraine and jitters over some high-profile losses in the nickel market.

That has encouraged some to seek alternative sources of financing, including the practice of smaller, privately held companies pawning their wares to larger, state-run dealers for cash. Commodity prices are also generally higher due to the war in Ukraine, meaning stockpiles may be worth more as currency for other investments.

The risk now is that larger dealers will not lend to their smaller competitors unless they can be confident that their loans are backed by valid warrants.

How was the potential foul discovered?

This market volatility may have gotten on the nerves of creditors. The sharp fall in aluminum prices after the recent virus outbreak put the entire city of Shanghai on hold has prompted some to try to grab the pledged metal, fearing borrowers would be unable to repay their loans. At that point, the mismatch between too many warrants and not enough aluminum became apparent, according to people familiar with the matter, who declined to be identified to discuss a private matter.

What happened during the Qingdao scandal?

The Foshan incident is relatively small and so far has only affected retailers. In Qingdao, it was banks, including international institutions, that ended up having the largest exposure to a trader and its affiliates, which repeatedly pledged the same metal stocks to obtain loans of more than 20 billion yuan.

But that alone is probably instructive. Banks have learned the lessons of Qingdao and other commodity financing scandals, making them more cautious lenders and prompting traders to make other arrangements, including borrowing from larger competitors. China’s regulator also urged banks to increase supervision, and the use of metals as collateral for funding has since declined.

Other similar scams outside of China include French and Australian banks, which suffered loan defaults totaling over $300 million in 2017 after discovering fake documents for nickel stored in Asian warehouses owned by Access World, a subsidiary of Glencore Plc , were stored. And in 2020, Singaporean oil trader Hin Leong (Pte) Ltd. Documents to obtain trade financing for products already sold.

What are the possible outcomes?

Local police in Guangdong are investigating and will determine whether fraud has taken place, but since the warrants in question have not been registered with the Shanghai Futures Exchange, China’s largest commodity exchange will not be on the hook to investigate the regulatory aspects of the case. Instead, creditors are likely to first target warehouses for inventories while awaiting investigations to decide whether borrowers are to blame for the losses.

The incident has led to a domino effect, with more warehouses in China shutting down to check on-site metal inventories. The market is facing a dip in confidence as global commodity groups Glencore Plc and Trafigura Group among traders are quick to check their inventories, according to people familiar with the matter.

Although the Chinese government and its state banks are preparing to expand lending to counteract the negative impact of the virus on the economy, their scope is unlikely to extend to commodities trading. As a result, another scandal could make it harder for smaller companies to get financing.

The incident is also having a devastating effect on prices. Aluminum has fallen in the days since news of the possible scam broke and traders will remain wary of buying the metal as long as this ownership uncertainty lingers. There is also a risk of confidence being shaken in other important markets for materials that rely on warehouse receipts, such as copper, nickel or zinc.

(Updated with details on merchants checking inventory in paragraph 14)

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