Reform can never stop

Written by June Wang

In China, there is an old saying that adversity leads to prosperity. Another simple interpretation could be that poverty gives rise to the desire for change. For China’s aluminium industry, the “poverty” is getting worse. Because of surplus capacity and high energy cost, smelters can’t find a way to save themselves.

A tough competitive environment accelerates change. Reform met a lot of resistance despite the pain. We have mentioned subsidies many times in our blog. Subsidies appeared to be heroic in that they tried to rescue smelters, but in fact they did nothing of the sort. Smelters who got a subsidy from local government still are suffering heavy losses (you can find the details from our Q2 China Cash Cost). To some degree, it like a drug. If they can’t get more, the result must be facing shut down and close, especially for any small scale company.

But reform is imperative. The longer you struggle, the more pain you get. If you want to go forward, change must start at once. And it is good to see that some big groups start to take action.

According to our sources, Chalco Guangxi Branch, with annual capacity of 150kt, plan to close the smelter because they have suffered a heavy loss for a long time. Instead, they will built a power plant to serve their other facilities, such as their 2.4mt alumina refinery. Such decisive decision is very rare.

In addition, diversification is gradually emerging. Sichuan Qiya Aluminum, with annual capacity of 350kt, had halted 150kt recently and they will now close the smelter completely. Instead, they will build high quality aluminium downstream facilities  with RMB10.2 billion investment. And they intend to build a downstream industry zone around their plant.

Hence, reform is not impossible. Reform is going on,, which hopefully will create a better tomorrow for China’s aluminium industry.

Qing Dao – ripple effect

Written by Paul Adkins

The scandal at Qing Dao port is having a ripple effect way outside its initial sphere of activity in alumina and aluminium.

It now emerges that at least 18 domestic China banks were allegedly hoodwinked by the perpetrators, with an unknown number of foreign banks and international traders.   As well, the whole process of using Letters of Credit for commodity trading is now under attack.

It is alleged that the company at the centre of the scandal, Dezheng Resources, allowed one of its subsidiaries to forge the company seal and other documents used by the Qing Dao Port Authority.   Those items were then used to create documents showing “ownership” of commodities, such documents being sufficient to convince these banks and traders to issue credit.

Essentially, anyone holding one (or more) of those fake documents is now out of pocket.

There’s a whole line of argument as to whether the banks and traders who got conned deserved what has happened to them.   Did they get greedy?   Did they have proper due diligence processes in place, and were those processes used?

Whatever one’s view on that, there’s no doubt that those banks and others who avoided getting caught will now retightening their systems to avoid a future occurrence.

It has been reported that 300,000t of alumina, 80,000t of aluminium and 20,000t of copper were involved.   Although the actual material has a value of roughly $300 million, the losses are likely to be 10 times that amount.   With at least 18 banks involved, it suggests these parcels of material were presented as collateral multiple times.

The ripple effect extends even further.    The Industrial and Commercial Bank of China (ICBC) has now applied to a court for the right to not honour a Letter of Credit (LC).   LC’s are at the heart of commodity trading.   They are relatively safe, not too expensive (usually about 1% of the transaction), and readily convertible. But it seems that trading of LC’s has also been part of the Qing Dao story, where the LC’s value can be recycled several times within the life of the LC.   The effect of being caught is that banks are now also slowing the LC issuance process, and now also (legally) defaulting on payment of the LC.

This will impact all commodities, from metals to maize.   It will also have some impact on the availability of credit within China.   Credit remains the single most important “asset” that companies can attain, and credit has fuelled China’s economic growth for years.   Perhaps players will find new means of obtaining credit and playing the system, but meantime, the screws just got turned a little more on China’s economy, thanks to one or two rogue players in a small city.


Where’s Heisenberg when you need him?

Written by Paul Adkins

Today China announced that Q2 economic growth came in at 7.5% year-on-year.

There are two possible responses to this announcement.   Some will look forward to increasing demand for iron ore, coal, copper – generally speaking a return to the paradigm that has been in place for so long.   Others will look back and cast a more critical view of this number.   In a sense, both positions are right.

Those who care to look more closely will find it hard to verify such a strong result.   The pillars of GDP growth are simply not there.   Property sales and construction growth have slowed. International trade is still not back to full health. Domestic consumption is not at the levels that the government hoped for.   But the Communist Party says it is achieving what it set out to achieve, so who are we to question the result.

And that is just the point. While Beijing has pinned its flag on the pinnacle of 7.5% growth, most likely before it arrived there, meantime, credit supply and money growth are quietly being primed for the sprint to the finish line. M2 money supply rose to  14.7% y-o-y from 13.4%, while new total social financing (TSF) also rose strongly to RMB1.97trn in June from RMB1.40trn.

In other words, we probably will see increased activity in infrastructure and housing and other investment-led economic activity in the second half of this year, and we almost certainly will see that China achieves its target of 7.5% growth in 2014.   Iron ore, coal, copper and aluminium will all gain from the renewed optimism outside and inside China as a result of announcing this Q2 score.

But it was Heisenberg that said that the more you measure a phenomenon, the less you can measure its velocity.   In other words, you can measure one but not the other at any given observation.   Which leads me to suggest to Beijing that they stop talking about 7.5%, and stop predicting it, because it’s more important to be travelling at that speed than to chalk up the correct score.


Cost of Chinese aluminium decreases

Written by June Wang

AZ China has completed its analysis of the cash cost curve for Q2 2014. Overall, costs went down, but not enough to save many producers.

The analysis threw out many interesting details:

  • The average cash cost of production came in at RMB14,150/t (US$2,280). This is a reduction of 2% over Q1.
  • The spread of costs ranged from below RMB11,000 (US$1,775) to over RMB16,500 (US$2650).
  • Costs went down primarily due to government subsidies reducing the cost of electricity, though the falling price of coal helped some smelters to achieve a lower electricity cost without bureaucratic intervention.
  • Surprisingly, alumina costs went down. Cutbacks in primary metal production earlier in the year left the market long in alumina, forcing the price down.  With Indonesia no longer supplying bauxite, this input cost is set to rise.
  • Other input costs also went down. Anode prices fell thanks to the cost of carbon falling, while over-supply of ALF3 caused that market to reduce prices.

Across the quarter, Shanghai metal prices rose 5% over the lowest price seen in 2014.   This and the falling costs have provided relief to the financial performance of smelters.   The “break-even point” along the x-axis has shifted right a little, crossing at about the 30% point.


cash cost

For the record, AZ China has 129 smelters in the total population, but we exclude any smelter which has less than 2 years of data. This means new smelters which are still “bedding down” are excluded, as are smelters which have been idled. Based on our selection criteria, 73 smelters qualified for this analysis.

There will be a more detailed analysis issued to our subscribers.   If you are not on our mailing list, please contact us at



Sorry I’m late

Written by Paul Adkins

Indonesia stopped bauxite exports back in January, so we were a little surprised to see a shipment of Indonesian bauxite arrive in China in the latest import data.

The cargo, a parcel of 45,000t arrived at Yantai port in May.   The arrival port was the first thing we checked – perhaps this cargo was an escapee from the Qing Dao financing fraud scandal.   Yantai is just around the corner (so to speak) from Qing Dao, but our investigations suggest this cargo had nothing to do with the recent scandal.

Perhaps it was a cargo from a company with an exemption from the Indonesians?   No, and in any case, we aren’t aware of any exemptions being granted.   Perhaps it arrived in China months earlier but was not cleared through Customs until May?   No, the import data captures the arrival of the cargo, not when it is cleared through Customs.

After much digging, we have discovered that the vessel that was carrying this cargo broke down.   Huge inconvenience for the owner of the cargo, not to mention for the shipowner, but not unheard of.

So if anyone tells you that Indonesia is still slipping some bauxite out to China, have them check their facts.



Why it pays to check your sources

Written by Paul Adkins

I was scanning the daily email from Alcircle today, when two successive stories caught my eye.   The first story announced “Chinese aluminum surplus likely to contract in 2014″, while the second said “Chinese aluminum production moving into balance”.

While at first glance these headlines appear to be telling the same story, the detail proves to be a bit more devilish.   For a start, there’s at least 500,000 tonnes of difference between the two stories, and a whole different outlook.

The first story comes from SMM, based in Shanghai.   As usual, they make the mistake of quoting the official aluminium production numbers, saying that China had produced 9.59 million tonnes to May.   It’s actually closer to 11 million tonnes, because they have forgotten to add the “unreported production” figure in their number.

SMM also falls for the old trap of quoting unnamed analysts and sources.   But at least they got it right when reporting that semis exports are rising.

The second story comes from Metalminer, a blog run out of the USA.   They at least quote their sources, Reuters in this case, but still manage to get the picture wrong.   They claim that market forces are driving the balancing act in the industry, when those of you who read this blog regularly will know that it’s local governments who are driving what’s happening. And what the local governments are doing is to drive the surplus wider, not closer.

The also somehow come up with an estimate for 2014 output of 28 million tonnes.   If that number were true, it would mean a growth rate of 17% – an amazing rate of growth and well up on the best years of the previous decade. For the record, AZ China’s prediction for 2014 output is a little less optimistic than the folks at Metalminer. We predict 26.5mt, up slightly on our original forecast. We expected smelters to close when we set our original target, but didn’t expect subsidies to re-emerge, bringing some smelters to restart.

When it comes to getting real, accurate and knowledgeable insight into what’s happening in China’s primary aluminium space, AZ China at least has its feet on the ground in China.   We don’t mind if you use another source for your information, but please check that they know what they are talking about. And that they are not just a news aggregator

Pollution measures starting to bite

Written by Paul Adkins

It seems that China’s efforts to push through a solution to the pollution problems is starting to hurt China’s aluminium industry.

At a conference in Qinghai last week, local smelters told the audience that the environmental regulatory bodies have now set up online monitoring systems, to track each smelter’s emissions.

Previously, smelters had to report their output to the regulator on a monthly basis, while inspection teams went around to check for themselves.   But a visit by an inspection team was a highly visible thing, so it wasn’t difficult for factories to turn on their scrubbing equipment in time for the visit.

That’s no longer possible, now that the regulator has ordered smelters to connect their scrubbers to the online system.

I suppose it’s only a matter of time before some bright spark figures out a way to send false readings to the regulatory body. Certainly these seems to be a motive to do so, because the speakers at this conference complained that the cost of making aluminium went up as a result of having to run the scrubbers full time – a tacit admission that they had not been complying with the regulations in the first place.

AZ China in the news

Written by Paul Adkins

AZ China was quoted in this morning’s Wall St Journal.   For those of you who subscribe to the WSJ, turn to the Heard on the Street section on the back page.   For those of you who do not, here is a screenshot of the article.

WSJ 20140702

Alba Line 6 – Long time coming

Written by Paul Adkins

An article in a Middle Eastern newspaper has revealed that Aluminium Bahrain, better known as Alba, is set to begin construction of its 6th potline.

A detailed feasibility study is close to being finished, according to Alba’s Chief Executive Tim Murray, and power contracts have to be negotiated.   Line 6 will also mean a new power station to be built.

This has been one of the great unanswered questions of the aluminium industry for a decade.   When line 5 was built, it was done so in a way that allowed line 6 to be “bolted on” without too much additional infrastructure having to be constructed.   But every year since, the question of when has done the rounds with no answer.   I remember visiting Alba in 2004, when line 5 was being built.   Back then, the hope was that line 6 would be announced by the time line 5 was finished, allowing construction crews a seamless transition to the new project.   Hopefully they haven’t been waiting.

It’s a good time for Alba to finally bring this line into reality.   There is precious little new capacity coming, despite a steady growth in demand.   Metal prices are likely to rise strongly through the next few years, so one only hopes that the construction phase is completed quickly, so that the company can harvest good returns.

For the record, line 6 will add 400,000t to the smelter, taking it to 1.3 million tonnes.   According to the newspaper story, construction should start by the end of this year, and be finished by Q1 2016.


Written by Paul Adkins

Anne Stevenson-Yang is a highly respected commentator on the Chinese economy.   In her most recent publication, she examines the Qing Dao commodity trading scandal in context of China’s shadow banking and credit industries.

Several of you have asked us about the Qing Dao scandal, so I am posting Anne’s report here, with her permission.


By Anne Stevenson-Yang
June 30, 2014

The irregularities around copper and aluminum financing in Qingdao started small and local. But the incident soon transformed into yet another story of China’s fraught banking sector, another story of credit creation based on assets that were simply not there.

At first, what seemed to be an investigation into an issue involving an insignificant amount of copper opened the door to a systemic problem of widespread, multiple and fraudulent hypothecation of commodity inventories. Discovering that the same inventory had been used repeatedly to collateralize large borrowings, international banks quickly began to withdraw from providing letters of credit to finance China’s commodities trade, and Chinese banks quickly moved to call loans secured by collateralized commodities.

The extent of the problem is now recognized to run into the billions: a widely quoted report by Goldman analysts estimates that about USD 160 bln in short-term foreign-currency loans outstanding are backed by commodities. The market value of the underlying commodities may never be fully known, but it is certain that a lot of the cash lent against them is now out of reach.

Any “naked” debt that defaults will be absorbed into various institutions managed by the central government. But constraining the use of imported commodities for borrowing would be of greater and more lasting impact to the international economy than the debt itself. If China’s importation of commodities were untethered from financial manipulations and tied more closely to China’s real economic demand for them, it would truly mean the end of the great commodities inflation cycle driven by Chinese global procurement.

Where the TSF went

As far as financing is concerned, no one should mistake this month’s focus on commodities hypothecation to be a government crackdown on the shadow market. Of necessity, the wide-ranging alternative financial system will remain a key platform for the Chinese economy to continue headline growth. Instead, the commodity scandal indicates the unique speed and flexibility of the Chinese system, both the core formal system and its shadowy extensions, in finding new financing and wealth extraction mechanisms when old ones become compromised or constrained.

What has looked this year like a return to slow credit growth under guidance by a conservative central bank actually turns out to be an externalizing of the credit bubble. It began with aggressive bond issuance in overseas markets, and now it turns out that hard-currency trade financing has patched in where domestic Renminbi loans were constrained. How much of this credit growth ultimately lurks on the balance sheets of foreign banks is hard to tell; they are exposed via open letters of credit, via commodity-backed cross-border and onshore loans, and via claims on partner banks in China. Whether or not their exposure is extensive, the Qingdao incident exposes the fact that the commodities trade is a fundamental strut in the hot-money infrastructure. Trade partners will not be able to escape being caught when the shadow system crumbles.

Not as good as gold

The Chinese economy specializes in investing: some might say that is the only economic activity at which the government is successful. Given government’s laser focus on collecting and deploying capital, China has developed stunning excess capacity in just about everything; the ghost cities ranged across every part of the land are the latest instantiation of that tendency. Commodities are another: the Chinese press estimates that 30 mln tons of iron ore sit in warehouses collateralizing debt before being deployed in steelmaking. As much as 70% of copper stores are being used as collateral, according to copper traders. Estimates put the amount of soybeans held as collateral at about 10 mln tons, against 63 mln tons of imports in 2013; the 33% spike in soybean imports in Q1 this year was almost certainly done in reaction to tightening of domestic credit. Further reports have exposed extensive and likely multiple hypothecation of palm oil, aluminum, zinc, nickel, titanium, and just about every other traded commodity.

Importing commodities has little to do with market demand. It is a way of generating free cash. The 250% growth in copper trading that occurred in the first quarter of 2014 is not explicable by increased demand. Defaults by Chinese importers on contracted soybean imports in April suggested that not all soy is for consumption either. The soy defaults were a warning sign that banks may be over-confident about the value of commodities held as collateral. The campaigns against corruption may also have been the proximate cause of the Qingdao investigation. Whatever it was, the ultimate cause is the tightening of domestic credit, leading agile financial innovators to conjure up new mechanisms to seek international sources of cash.

The Qingdao scandal

Current revelations began in Qingdao, when metal used to collateralize debt for a company called Desheng Mining turned out not to be in the warehouse. Desheng Mining was wrapped up in a corruption investigation targeting the Party secretary of Xining, the capital of Qinghai Province. Initially, it seemed that the damage would be limited: traders said that Qingdao was a very small port for copper, and that counterfeit warehouse certificates (used to back the trades) are uncommon in copper. Consensus suggested that the whole Qingdao operation might be part of a political vendetta expressed in a focused anti-corruption initiative.

Then reporters noticed that China’s National Auditor’s Report for 2013 had highlighted over RMB 94 bln in falsified gold trades. The 2013 audit report section 6 on State-Owned Financial Institutions reads:

“1. Financial innovation is irregular, and some institutions circumvent regulation and supervision of loans. . . . There were companies that used “empty transfers” as an arbitrage method, and a sample of accounts since 2012 of 25 gold and jewelry companies indicated that they used “virtual” trading platforms to engage in repeated cycles of cross-border, cross-currency trades worth RMB 94.4 bln and earn RMB 900 mln on the currency and rate spreads.”

This terse formal report raises all key aspects of the problem—the virtual trading platforms, the related-party interests, the evasion of regulation and supervision, the involvement of local government financing platforms, and ultimately the goal of arbitraging interest rates. The only dimension not explored is the massive embezzlement of the proceeds.

In 2013, China became the world’s largest market for gold, buying 1,132 tons, for 26% of global private sector demand. The World Gold Council attributed this buying to a cultural belief in gold and rising real incomes, and it projected the 2017 market at 1,350 tons; that may turn out to be less cultural than they thought. Incidentally, the previous year in which China accounted for such a high portion of global demand was 1997, just before the Asian financial crisis.

After gold came rubber: stores of rubber have fallen about 10% in June, as authorities scrutinized the hypothecation of rubber for loans; Chinese news reports say that about 14% of rubber is used as collateral for loans.

The copper story is evident from the three charts below. Copper traders fund import of the metal with an LOC, sell a warrant to an offshore subsidiary, and then collateralize the shipment for debt, the proceeds of which go into high-yield loans in the property sector. In January, tighter credit meant that developers and LGFVs were forced to pay escalating rates for short-term loans. Imported commodity-based borrowing financed a lot of those loans. It was not just a coincidence that copper imports rose to record highs as domestic sources of credit declined.

Toward the end of February, weakening currency depressed the appetite for traders to hold losing positions. Copper trading activity rose, warrants fell, and the price of copper started to slide down, gearing up the exposure to foreign debt held with RMB sources of revenue.

In general, commodity imports soared in January and February, as it became harder to capture loans for purely domestic projects. The currency, which depreciated through March, made those trades unattractive in April and May.

Foreign banks

To what extent foreign banks are exposed to speculative finance that has been hypothecated many times over is perhaps impossible to untangle. At the end of 2013, the Hong Kong Monetary Authority published an estimate that HKD 3.6 tln, or 22% of Hong Kong’s banking assets, were exposed to the mainland, HKD 313 bln of that in trade finance and HKD 441 bln in off-balance-sheet items that are mostly related to trade.

Standard Chartered, in its June 26 report, warned obliquely of exposure to China but told investors that it has only USD 250 mln exposed to the Chinese copper trade. Stanchart said that impairment on loans from other territories would be in the high teens, even as it said that it would see high earnings from the Chinese wealth management market.

Quiet defaults?

Between the start of May and mid-June, the PBOC injected RMB 1.08 tln through various channels and left RMB 437 bln in the market indefinitely. The new re-lending facility created through the Construction Bank also added higher-quality backing to much of the credit in the market. Monetary authorities seem to be selling some reserves, working as well to maintain an exchange rate of 6.22, just above the 6.23 level at which QE3 commenced in 2012, bringing the latest rush of hot capital into the country.

All this monetary activity was directed at the June 25 audit date on which, in 2013, interbank defaults occurred. But expanding the long-term money supply by half a trillion RMB suggests that the bank was doing more than preventing new defaults: deep in the background, there must be local banks in danger of going broke under the combined impact of the commodity-related defaults and property defaults.

Chinese commodities traders say that foreign banks will no longer finance commodities deals and that Chinese banks have become much more conservative in opening letters of credit, shortening the average term to 90 days and refusing LOCs to small companies with low capitalization. The unwinding of these instruments seems likely to express itself in lower volumes of trade and tighter financing conditions in China.

For the rest of the world, that means that the great Chinese commodities expansion is over. On the other hand, the growth and risks of China’s foreign borrowing may just be beginning.

What does this say about quality of debt generally in China? We resolve the measure down to two things, the creditworthiness of the borrower and the market value of the assets that collateralize the debt. In China, the former is a political question for entities that borrow at scale, because their solvency ultimately depends on whether their outsize debt is likely to be ‘sovereignized’ or diffused by the powers that be.

For the latter, the troublesome reality is that the commodity borrowing crisis has revealed not only large-scale fraudulent use of warehouse receipts and letters of credit but a pervasive lack of controls in the use of commodity stocks as bank assets across the board.

Ultimately, in the commodity-based banking market, how much real market value underlies how much debt? We saw with Credit Equals Gold #1 one answer to that question for a coal-based wealth management product that was wildly out of line.

Moreover, we ask this same question about the property market which we have discussed at length in these reports. Ultimately, how much real value underlies how much debt? For pricing purposes, property lacks the fungibility of commodities, so the underlying value calculation is distorted by a different set of devices.

The risks of the commodity-based and property-based credit markets in China are additive, and a risk assessment for the economy overall needs to encompass both. Between these two colossal monuments of debt, commodity-based and property-based, China finds itself facing real asset insufficiency that might well eclipse the Great Wall in gobsmacking scale.