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China’s “double impact” on commodity prices

China consumes about one third of the world’s commodities. However, its influence on commodity prices goes beyond that. Chinese institutions are also major users of commodities as collateral. Empirical evidence shows a significant link between domestic lending and global commodity prices, particularly through so-called commodity financing deals.

Roache, Shaun K. and Marina Rousset (2015), “China: Credit, Collateral, and Commodity Prices”, HKIMR Working Paper No.27/2015, December 2015
also reporting results from Tang, Ke and Haoxiang Zhu (2016), “Commodities as Collateral,” MIT Sloan Working Paper.


The below are excerpts from the HKIMR paper. Technical acronyms have been replaced. Headings, links and cursive text have been added.

The consumption channel

“China’s presence in global commodity markets began to take off only around the time of its World Trade Organization (WTO) accession in the early 2000s. Three related structural shifts have been important.

  • First, China began to emerge as a large exporter of commodity-intensive manufactured products…
  • Second…a widening urban-rural income gap has increased the pace of China’s urbanization as rural workers flood into the factories located in or near cities…This migration had to be accommodated by a large and sustained rise in commodity-intensive infrastructure and real estate.
  • Third, the income levels of China’s urban workforce have risen…As countries become richer, their commodity demand increases at a rising rate until eventually stabilizing at a much higher level—sometimes described as the S-curve.”“Between 1996 and 2014, China’s contribution to changes in global demand are consistently positive for crude oil, and are particularly sizable for base metals, accounting for nearly all the growth in refined copper, nickel and tin.”

“[In] 2013, China accounted, on average, for about one-third of global consumption of a basket of important commodities. China’s share of global consumption has reached 22 percent of primary energy, 26 percent of agricultural crops, and 47 percent of base metals. Its share of global trade…is high, and rising, for many food, metal, and energy products.”


The credit channel

“Credit shocks—specifically, unexpected changes in lending by banks—may now be an important and underappreciated source of Chinese influence on commodity markets…Credit shocks may impact commodity prices…through collateral demand.”

Collateral assumes a pivotal role in China’s banking system…The asymmetric information problem for the lender-borrower relationship in China’s formal financial sector remains acute. Banks have for a long time directed a substantial proportion of credit to state-owned enterprises and therefore lack a long and reliable credit history for private sector borrowers…This information problem is compounded by a predominance of small and medium enterprises among private borrowers [whose] accounting practices, internal control, and governance…often [are] informal and difficult to audit.”

“The World Bank’s 2012 enterprise survey for China shows that for a sample of 2,700 firms, about 80 percent of loans required some form of collateral which, on average, was valued at twice the loan amount…These figures are substantially higher than for OECD economies where collateral is required for about 64 percent of loans with an average collateral-loan value ratio of about 150 percent… Surveys have found that lack of collateral is often the main constraint for firms’ access to bank loans, particularly for private SMEs.”

“Banks had long preferred, and even required, property or land as collateral. However, a watershed moment for the financial sector came with the 2007 Property Rights Law. This law made it much easier for firms to use “movable assets” as collateral and some commodities are ideally suited for this purpose.”

“Inventory data covering aluminum and copper stocks in China’s bonded warehouses suggest it is indeed possible to identify structural breaks soon after the new law’s introduction…These ratios increased and remained higher until the Qingdao port scandal in mid-2014.”


Commodity finance deals

“China’s endowment of some basic resources is limited and domestic firms often need to import commodities to use as collateral. A popular way for firms to finance these imports is by borrowing offshore and arranging a commodity financing deal. A simplified structure for a financing deal starts with a Chinese firm drawing a U.S. dollar-denominated letter of credit from the offshore subsidiary of a domestic bank. The firm then exchanges the letter of credit for the commodity with a trading house—in practice, the firm acquires a warrant or certificate of ownership for a physical commodity that is either being shipped to, or is already located in, a bonded duty-free warehouse in China. At this point, the firm has a short-term dollar liability which is financing a commodity asset that can now be used as security for domestic borrowing. The letter of credit may be rolled over a number of times to allow the firm to maintain ownership of the commodity. These deals have become popular because they allow firms to relax their domestic collateral constraints, arbitrage the difference between onshore-offshore collateral (or margin) requirements and interest rates, or take a long (carry trade) position in the domestic currency.”

“Letters of credit are regarded as a lower risk credit exposure than a regular loan as they are shorter in maturity and potentially self-liquidating if the commodity is held as inventory. This lower risk status is reflected in a credit conversion factor of just 20 percent for the purposes of calculating capital ratios under Basel.”


“Market participants…have estimated that commodity financing deals arranged by Chinese firms may have accounted for as much as USD160 billion or 31 percent of China’s total short-term foreign-exchange loans and 30 million tons of iron ore and 1 million metric tons of copper or about 1 percent and 5 percent of annual production, respectively.”

For more on China’s commodity finance deals and their role in FX lending view post here.

Empirical evidence

“Tang and Zhu (2015)…find evidence consistent with a significant impact of commodity finance deals on commodity prices. They estimate a regression in which the dependent variable is the change in the commodity price and the independent variables include a proxy for the incentive for carry-trades and collateral demand (deviations from covered interest rate parity) and other controls. Their results indicate that higher collateral demand increases the price for some base metals and gold with this effect accounting for about 12-15 percent of the rise in the price of major base metals between 2007 and 2014.”

“We define credit shocks as changes that are unanticipated by an econometric model…We use four separate series to measure credit in China. The first is total social financing (TSF), a broad measure of financing for the non-financial private sector which includes bank loans, trust loans, lending by firms, bankers’ acceptances, and net bond and equity issuance. We also use bank loans and non-bank credit separately. We complement this with the use of the M2 monetary aggregate.”

“We estimate a reduced-form vector auto-regression (VAR) with recursive shock identification. The baseline VAR estimating the impact of aggregate activity and credit shocks includes seven endogenous variables… A recursive ordering will provide sufficient restrictions on the contemporaneous relationships between the variables to exactly identify the structural shocks from the residuals of the reduced-form equations…Our sample period starts in January 2002 and ends in May 2015.

  • A shock to China’s real credit aggregates has a large and statistically significant impact at the 5 percent level…on most base metals, including copper, lead, nickel, and tin. a one-time unanticipated 1 percentage point (unit) change to the real month-on-month growth rate of bank lending leads to an increase in the real price of these commodities that ranges from about 10 percent to over 13 percent after 4 quarters. This impulse to bank lending growth is equivalent to a 1.6 standard deviation shock. The impact on commodity prices typically peaks after 4 quarters and moderates slightly thereafter. Bank loans have the largest impact on commodity prices, followed by M2 money supply.
  • Industrial production in China exerts an important influence on commodity prices with a large and statistically significant impact on oil, aluminum, and copper. This contrasts with the credit shock which had an even larger impact across base metals that are more likely to be used as collateral for loans…A one-time 1 ppt (unit) shock to the real month-on-month growth rate of China’s industrial production leads to an increase in the real price of these commodities that ranges from about 6½ percent to almost 9 percent after 4 quarters…with some slight moderation thereafter.”
  • “Over the full sample period, lagged values of China’s industrial production have been a better in-sample predictor of commodity price changes than credit aggregates. At the same time, the results change when using a sample that starts in November 2007 at the time the property law came into effect.”

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