Monthly Archives: July 2014
The phantom collateral that rocked Qingdao has left the metals market worried and uncertain, and raised serious questions about accountability and transparency in Chinese firms. What some observers haven’t acknowledged is that the methods used to secure the multiple loans are neither particularly new nor innovative. Whereas corporate malfeasance in the West can take the form of labyrinthine arrays of special purpose entities and porous contracts, Chinese accounting fraud tends to be relatively straightforward deception. Thanks to loose and opaque accounting practices, there’s little need for multifaceted networks of half-truths; simply inventing an entry in the books usually suffices.
It wouldn’t, however, if the companies took more a proactive management attitude.
The Qingdao scandal came to light when a corruption probe in Qinghai’s capital, Xining, came across questionable dealings at Dezheng Resources’s subsidiary, Decheng Mining. The central government happened to be investigating a business partner of Xining’s Party secretary. As is common knowledge by now, the allegations are that Decheng took out multiple loans on the same collateral. To outside observers, this seems like something that should have been avoided with a fairly routine warehouse check, but it’s not an uncommon trick. Real Gold Mining suffered in a similarly reckless way in 2011, as the company’s mines were used as collateral for the owner’s private loans, a fact that went unnoticed by their third-party auditor despite it having being a matter of public record for over a year.
Another example is the pig and animal feed company AgFeed Industries Inc., where it was discovered senior management had simply been keeping an outside book for years, falsifying numbers to manipulate their stock price and reported nearly $239 million in fake revenue. In the absence of adequate oversight, the deception wasn’t discovered until this year, despite having been going on since 2008. Their US-based executives, having already overcommitted to their Chinese partners without checking if the numbers matched reality, compounded the issue further by trying to perpetuate the cover-up.
Multinational companies are facing the consequences of having little representative or physical presence in China to keep an eye and report on obvious discrepancies. Many have relied on independent teams from the big auditing firms to conduct their reviews for them, but they’re often left to the mainland member firms, with the final audit sign-off coming from Hong Kong. When ordered to look at a foreign-traded company, these auditors run into a legal grey zone; the central government may or may not have classified Chinese company accounts as state secrets. When the SEC ordered the Big Four to turn over working papers, they refused for fear of angering Beijing, which resulted in the Chinese member firms’ six-month ban back in January. The third-party auditors can’t make up for strict internal overview on the mainland.
Companies operating in China could take a more aggressive stance from the get-go to avoid accounting nightmares and alleviate fraud risk. In the case of companies trading in physical goods, stocks should be checked thoroughly; warehouses have been known to rent supplies for the day to convince visiting auditors that the numbers are correct. China’s informal network of unofficial suppliers can also create nightmares for auditors; documentation and a serious vetting process should occur before any business dealings take place. Strict regulations in place for revenue recognition are imperative, and they should be crystal clear to everyone. After this latest scandal, double-check and verify receipts to make sure they haven’t been falsified.
Most importantly, companies should foster a corporate environment where employees are willing to blow the whistle, knowing they will have the full support of the management. Internal audits should occur regularly, but it’s important to have a plan in place for the minute a red flag is raised internally or externally.
Accounting fraud in China is pervasive, but it’s not particularly insidious. Clear and concrete accounting rules and management policies can nip the majority of scams in the bud. Those who fall afoul are usually the ones who were overeager and rushed in too quickly, only to find out the warehouses had been standing empty for months.
Editor’s note: this is a guest post by Michael Laridan, from accounting firm DX Consulting]
Sources:
https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370541102314#.U9HxSICSy_0
https://www.sjgrand.cn/alleviating-fraud-risks-china
https://uk.reuters.com/article/2014/06/13/china-qingdao-idUKL4N0OS1XO20140613
Editor’s note: This piece is by June Wang, from our office in AZ China. June was having trouble accessing the site, so I am uploading it for her.
According to the IAI, China’s aluminium production reached 2.2 million tonnes in June (including unreported production). That gives a daily rate of 73,500 tonnes per day, a rise of 6% over May.
In our view, the main reason for this is the return of idled smelters. With the price rising and subsidies guaranteed by the local governments in several provinces, many smelters restarted gradually in May and June.
For the first half of 2014, the total volumes of China’s aluminum production were 13.0 million tonnes. AZ China recently increased its forecast for 2014 production, from 26.0mt to 26.5mt, in response to the return of the idled smelters, and this revision is being supported by the most recent numbers.
As we know, because of the sluggish market, heavy losses and falling prices, helpless smelters chose to cut capacity levels, and some to even close permanently. The total volume of production cuts reached 1.4 million tonnes just in March to May, based on our statistics. However, entering into June, many smelters restarted their halted capacities. So far, the restarting is still in progress, as it’s not an instantaneous process to heat hundreds of furnaces back up to 950°. If nothing else, the production numbers will be bigger than the previous months even without new capacity being added. To a large degree, the production should remain at high levels over the next few months.
However, it is not only returning capacity that has boosted production. The additional capacity of new construction will also help push production levels to a new peak. According to our statistics, around 2 million tonnes of new capacities have been announced to come on-line by year-end, which is much larger figure than that of the total stopped or closed. Of course, it takes even longer for a new smelter to get up to speed, but that simply means new record levels in future months.
Supply remains ahead of demand in China, and although demand has shown a turnaround in recent weeks, supply is set to exceed demand by about 1 million tonnes, in our estimation.
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.
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.
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.
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.
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 blackchina@az-china.com.
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.
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
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 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.
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