In essence, some Chinese market participants – particularly those that are highly leveraged – are buying non-domestic copper material in order to raise CNY cash, in a development we have not seen since mid- 2011. Specifically, CFC financing – which is allowed by SAFE, and has been a factor in the copper market for years – involves the purchase and importation of non-domestic copper into China, the immediate sale of this copper into the Chinese domestic market post-importation (for immediate CNY cash), and a 3-6 month loan at foreign interest rates issued by an onshore bank. In this way CFC’s are a combination of the China/ex-China price and interest rate differentials.
The recent increase in short-term Chinese rates has resulted in CFC’s being highly profitable. Put differently, the interest rate differential adjusted copper import arbitrage is now substantially open – raising China’s demand for non-domestic material, and likely contributing to the recent pick-up in Chinese bonded physical premia (to record highs of $180-$200/t), higher LME Asia cancellations, and tighter LME copper spreads. In this way, interest rates differential changes, via CFC financing, can change where global copper inventories are located (today there is a pull on non-domestic copper inventories into the domestic market).
While these developments are typically a sign of a tightening copper market, we believe that market participants should be wary of interpreting these recent ‘signals’ – including future resulting copper import strength – as bullish, since they are in large part driven by Chinese liquidity tightness, and not primarily driven by real Chinese demand/re-stocking.
So what happens if the price suddenly falls? I would have thought there’s a danger of a margin call meaning the collateral gets dumped into the market as the borrower needs more cash or the bank seizes and sells the collateral. All insights welcome here…