The great Chinese collateral trade, illustrated We've seen explanations of how the famous Chinese copper (and other commodity collateral) LC financing trade works in the past. But here's a particularly good one from Goldman Sachs" big report on China's credit environment, which was out last week. The diagram also explains how SAFE's new regulations are likely to restrict the trade from now on: As Max Layton, from Goldman's commodities research team, explains... over the last few years Chinese firms have been able to benefit from cheaper US interest rates by using various commodities with high value-to-density ratios, such as gold, copper, nickel and "high-tech" goods, as collateral. The deals were motivated by the fact that borrowing US dollars in this collateralised fashion was cheaper than borrowing in the domestic Chinese market. Goldman estimates that in the copper collateral scheme alone, something in the region of $35bn-40bn may have been raised as of June 2013. Total funds lent using other commodities, however, are likely to be a multiple of this figure, they add. Interestingly, one of the reasons SAFE cracked down on these deals, Goldman says, is because the trades were beginning to distort Chinese balance of payments figures and, importantly, placing upward pressure on the CNY due to related capital inflows. That is to say, they were in effect propping up the CNY exchange rate. As Goldman also very importantly conclude (their emphasis): Specifically, we estimate that roughly 10% of China's short-term FX lending could have been associated with copper financing deals since the beginning of 2012. The end of these deals likely has negative implications for commodity prices through direct (freeing up physical metal) and indirect (tighter financial conditions) channels, and also provides insight into the regulators" struggle with credit crackdown. As to how it worked: The commodities involved in the financing deals were shipped into special Chinese customs areas located on the Chinese mainland, called bonded zones (where the material is exempt from Chinese VAT), and stockpiled (high value to density means you don't have to ship as much tonnage in order to raise funding.) This contributed to a buildup in Chinese copper and nickel inventories held at bonded warehouses in early 2013, with copper stocks in particular rising to more than double their early 2012 levels. Thus, with financing deals beginning to wind down, we are seeing more bonded copper and nickel becoming available relative to what otherwise would have been the case, which is having a bearish impact on copper and nickel prices. One thing not mentioned by the analysts, which is worth considering, is that a SAFE-fuelled unwind will have had an impact not only on underlying commodity prices, but also on the CNY exchange rate. As the trade unwinds, credit conditions are likely to get increasingly tight, just as support for the renminbi is also removed from the market. Related links: More proof the Chinese have been using copper as collateral - FT Alphaville What really drove Chinese commodity imports? - FT Alphaville China, the currency factor and copper - FT Alphaville Contingent liabilities, letter of credit edition - FT Alphaville Standard Bank says Chinese copper market cause for concern - FT Alphaville