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Sancho Panza

Commodity As Collateral-

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MIT 11/3/14

'Although ocial data are unavailable, industry estimates suggest that substantial

amounts of production commodities are used for financing purposes in China.

The Economic Observer (2012) estimates that 90% of copper

stored in the tariff-free zone in Shanghai are for financing purposes, with the total

amount more than 500 thousand tons. Shanghai Metals Market, a research rm, esti-

mates that between 400 and 600 thousand tons of copper has been used for nancing

in China in 2013. To put these estimates into perspective, a half million tons of cop-

per are approximately 5.7% of China's annual copper consumption and 2.4% of world

consumption in 2012.1 Given that world copper consumption has been growing at

3.4% per year over the last century, the estimated amount of copper used as financ-

ing collateral in China is equivalent to 70% of the annual increase in global copper

consumption.

A domestic Chinese rm in the import-export business applies for US

dollar credit from a bank to buy commodities in the international market. These

commodities are shipped to China and pledged as collateral to raise CNY (the Chinese

currency) funding on a secured basis, with a haircut. The CNY cash is subsequently

invested, on an unsecured basis, in assets, loans or projects that generate a higher

expected return. At the maturity of the US dollar loan, all legs of the trades are

unwound, and the commodity is sold in the spot market.As long as the return on the

unsecured loan in CNY is suciently high, this trade is protable. In other words,

commodity is used as the means to capture the risk premium in China's credit market.

We emphasize that the attractiveness and viability of importing commodity as col-

lateral relies on a couple of key frictions in China. First, capital

ows are restricted.Second, large Chinese lenders such as

state-owned banks may be unwilling or discouraged to lend to small but high-return

rms on an unsecured basis.

Our model predicts that the demand for commodity as collateral leads to higher

concurrent commodity prices. The larger is the interest rate spread between China and

US (as commodities are traded in US dollars), the higher is the demand for collateral

commodity, and the higher are the commodity spot prices in both the exporting country

and the importing country.A higher spot price crowds out some real demand for

commodities, but the overall effect is a higher inventory level in China and globally.

Frankel (1986, 2008) nd evidence that a higher interest rate (i.e.,

a tighter monetary policy) in the US and other countries tends to reduce commodity

prices by lowering the real demand and increasing the inventory costs. By contrast, our

model shows that higher interest rates in commodity-importing countries can increase

commodity prices by making them more attractive as collateral for financing.

2 Commodities as Collateral in Practice

First, a Chinese importing firm signs a contract to buy copper from an overseas firm

and obtains credit.The importer can sell futures contracts in the Shanghai

Futures Exchange to hedge the price risk of holding copper

Second, the importer ships copper to bonded warehouses in Shanghai and obtain

the warehouse receipt. Note that at this stage the copper does not have to enter

China customs, and the importer does not have to pay the associated taxes yet. The

warehouse receipt is subsequently provided to a domestic bank as collateral to obtain

a CNY loan.

Third, after 3 or 6 months, the copper importer receives the high uncollateralized

return from its CNY investments and then sells the copper in bonded warehouse in

Shanghai. The importer also closes its futures position.

7 Concluding Remarks

The mechanism and predictions of this paper are distinct from those of the theory

of storage in three aspects. First, a key prediction by the theory of storage is a

negative relation between convenience yield and inventory. By contrast, our model

shows that increasing collateral demands (hence an increasing inventory) cause more

hedging activity (selling futures) and hence increase the convenience yield. Thus, all

else equal, the commodity-as-collateral channel predicts a positive relation between

inventory and convenience yield. Second, in the theory of storage, a higher interest

rate tends to reduce the inventory level due to a higher opportunity costs of storage.

However, our model shows that a higher interest rate in the importing country results

in a larger amount of collateral and hence increases the inventory level. Third, more

collateral demands lead to a higher total inventory and a higher commodity price

simultaneously. This is again opposite to the prediction from the theory of storage

that a higher inventory indicates the abundance of commodity and hence a lower

price.

The eect of using commodity as collateral also challenges the conventional belief

regarding the relation between commodity prices and macroeconomic policy. If com-

modities are used exclusively as a production asset, a contractive macroeconomic policy

diminishes the production demand for commodities and reduces commodity prices. In

sharp contrast, if investors use commodity as collateral to mitigate funding frictions,

a tighter monetary policy in importing countries tends to increase the collateral de-

mands for commodities and raise commodity prices. The net eect on commodity

prices depends on which demand, production or collateral, reacts more to a higher

interest rate. To the extent that nancial investors are nimbler in deploying capital

than rms that produce goods, we may well expect the collateral demand to react

sooner and in a larger magnitude to a higher interest rate than does the production

demand. In this case, a tighter monetary policy in importing countries may end up

increasing commodity prices globally, before prices eventually drop following the sale

of collateral commodities to production demand. Overall, our results suggest that a

tighter monetary policy may have an ambiguous, and unintended, effect on commodity

prices.

Our current analysis does not yield directional implications regarding the welfare

consequences of using commodities as collateral. On the one hand, the collateral

demand of commodity can crowd out part of the real demand of commodity for pro-

duction. On the other hand, the high uncollateralized interest rate is presumably

associated with protable investment opportunities elsewhere in the economy. In par-

ticular, if rms can pledge commodities as collateral to relax their funding constraints,

this practice may well reduce ineciency caused by funding frictions. Analyzing the net

welfare implication, therefore, requires a richer and more general equilibrium model,

which we leave for future research.'

The maths in this paper needs a more enlightened mind than mine but it does highlight some potential weaknesses for both China and the importers going forward if-as seems likely- rates start rising.

Edited by Sancho Panza

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