A V Rajwade: China and commodity prices

The recent boom has already shown up cases where China's risk management system failed

Fuelled by its rapid economic growth, China has become the dominant force and importer in many commodity markets. The rise in crude oil prices is blamed on Chinese (and Indian) demand. As the largest producer and consumer of steel in the world, its imports led to a sharp surge in steel prices "" and rescued the Indian steel industry (also its main banker IDBI). China has since turned exporter, and prices have softened. It is also a major force in the aluminium, copper and nickel markets. This apart, the Chinese are also known for their risk-taking (gambling?) instincts. Rapid growth, huge volumes, weak systems and derivatives which allow leveraged bets, can be a dangerous combination.

Take the Chinese corporate bond market in the early 1990s. Apparently, several brokers took to proprietary trading somewhat too enthusiastically and, in the process, bankrupted themselves as defaults multiplied. The authorities were forced to close down the exchanges. Now, all corporate bonds require bank guarantees.

There are other examples from commodity markets. One case involving a loss in excess of $500 million (China Aviation Oil) was discussed in this column on June 27. Currently making headlines is another case involving trading in copper futures on the London Metal Exchange (LME). These trades are being blamed for the sharp spike in the price of copper, up by more than $600 per tonne in less than three months, to $4,250 approximately. A big Chinese trader, initially supposed to be the government-owned State Reserves Bureau (SRB), had built up a huge (100,000 to 200,000 tonnes) short position in the contract which matures on December 21. Since the Chinese would have to buy the metal to close the short position, the spot price shot up.

While the case has been making headlines for some time, there is still considerable confusion about what exactly happened. SRB has denied that it is involved although the trader was its employee. It claims that the transactions may have been conducted by the trader on his own. In that case, there is a major question mark about whether the risk management systems of the brokers failed. Like other exchanges, LME (or its clearing house) would have margin requirements on all the clearing members who, in turn, are expected to recover similar margins from their clients while making trades. Some exchanges allow clearing members' margin to the calculated on net, that is long minus short, positions, but insist that the client's margins with the clearing member should be on a gross basis. (Incidentally, the margin system is the reason why Refco's regulated business, conducted on exchanges, was not much affected by the recent scandal (see World Money, November 7), and has in fact already been sold.)

But to come back to the Chinese copper trader, if he was acting on his own, how did he manage to provide adequate margin to the clearing member(s) through whom he was trading on the exchange? Did the clearing members' risk management systems fail? While the names of the clearing member or members concerned have not yet come out, if adequate margin had not been recovered, there could be a substantial loss: at current prices, the out-of-the money value of the short position is estimated to be in excess of $100 million. Somebody clearly is having sleepless nights.

The case also illustrates a major difference between commodity and financial futures. The future or forward prices of financial assets (currencies, bonds, shares and so on) are based on the spot price adjusted for the "cost of carry" "" that is, the net cost or yield of holding the asset. (This is the familiar interest parity principle in the forward exchange market.) This does not apply to commodity futures or forwards (as illustrated by the spot and futures copper prices on LME), mainly because the contracts call for physical deliveries at specified locations. And, unlike financial assets which can be transferred anywhere in the world virtually cost-free, physical deliveries of commodities at specified locations can be costly. In theory, to square the short position, physical deliveries of 100,000-plus tonnes of copper will be needed at any of the locations specified in the LME contract! (There are, however, rumours that the position has been quietly rolled over.)

These cases also illustrate the need for systems and trained professionals before the Chinese exchange rate becomes more "flexible", and derivatives are introduced, a point I made last week.

Even as the case evolves, a couple of points are worth pondering:

With trades on our newly established commodity exchanges booming, are their (credit) risk management systems up to mark?

As the rise in the stock market tempts a lot of short-term day traders, do the brokers through whom they trade possess foolproof risk management processes and systems?

We can ill-afford a scandal!

avrco@vsnl.com