Chinese Monetary Policy & Metal Prices

For the second time in less than a year, China's central bank - the People's Bank of China (PBC) - has moved to moderate the country's shadow banking sector by limiting lending to banks, leading to higher borrowing rates.

A similar effort was made in June of last year, which resulted in a sudden increase in demand for copper, as cash-strapped borrowers were able to get lower interest rates on USD loans financed using copper as credit.

This time, however, the PBC's effort to tighten liquidity was strategically coordinated with a significant depreciation in the RMB - USD exchange rate, the currency's largest depreciation against the dollar since becoming de-pegged in 2005. The depreciation was an effort to deter speculators who profited from the spike in interest rates last June.

With all this monetary action in the world's largest metals economy, SM Report has finally come back from a longer-than-planned break to look at the effects that these developments are having on the market for minor and strategic metals.

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The impact of the recent liquidity shortage was immediately reflected in the copper market, which has garnered most of the headlines over the past few weeks for its precipitous price decline.

Contrary to last June, when a crackdown on lending led to increased demand for copper to finance loans, the RMB appreciation that has accompanied this year's action has deterred such deals.

In fact, higher money market rates are the primary reason for the recent copper sell-off, as many of those in China holding USD valued copper (and more often copper financed debts) have seen their USD-valued debts increase 3-4 percent over the past month due to the RMB's appreciation, while at the same time have become increasingly starved for cash due to the PBC tightening liquidity taps.

Iron ore has also been impacted by China's new monetary environment, as steel mills, which are among a group of industries targeted by the bank lending restrictions, have reverted to declining spot and contracted orders. This, along with high stockpiles and expectations of greater global output this year, led the price of iron ore to it's largest decline since 2009.

A telling statistic about the significant relationship between monetary policy and metals demand is the quantity of metal now being purchased primarily for financial deals rather than for immediate or expected consumption.

Although difficult to quantify, some iron ore analysts believe about 40 percent of material heading into China is tied to financing deals. In the case of copper, 60 to 80 percent is the more generally accepted number. China is, by far, the largest market for both iron ore and copper.

The importance of monetary policy - particularly Chinese monetary policy - has undeniably become a critical part of understanding the short-term movements and volatility of pricing for not only certain base and ferrous metals, but also minor and strategic metals.

In our world, that is the world of minor and strategic metals, Chinese strategic economic policies and objectives rather than financial and monetary machinations are more often the driver of short-term price fluctuations, or at least that was until recently.

The rise of the Fanya Metals Exchange has become a central player in a number of markets since its inception in 2011.

In a previous post, SM Report looked at how the enigmatic exchange, which offers electronic trading of physical minor metals to individual investors in China, has played more than a small role in indium's rapid price increase over the past 12 months. Other markets, including that for bismuth, have also been impacted by the electronic exchange's activity.

Expansionary monetary policy, a closed financial system that severely limits options for investors, along with still developing investment policies and regulations in China, have all contributed to Fanya's ability to drive investors into an asset relatively little understood by common investors: Minor metals.

It is through the Fanya Metal Exchange where certain minor metals could become highly susceptible to Chinese monetary policies.

Seeing what havoc has been created in the copper market by China's clampdown on lending, the concern for players in the indium market should be what are the expectations of investors in Fanya's metal holdings? (Which, by the way, were estimated to be valued at roughly USD 2.25 billion at the time of writing).

While the amount of copper and iron ore now purchased for financial deals may seem high, by contrast, and based on the Fanya Metal Exchange's self-published numbers, 100 percent of indium production was directed towards financial and investment purposes in 2013. The trend for 2014 is similiar.

While indium may not be directly tied to financing deals, like copper and iron, prices are being driven by non-consumption transactions. And, if the recent copper and iron ore market activity is any indication, alarm bells may be sounding at Fanya's head office.

Rising prices for metals has proven a profitable market for the exchange, but it is unclear how, where, and at what price inventories can be sold if investor sentiment changes in reaction to a tighter monetary environment.

Beijing's recent policy trend towards stricter lending practices and more corporate accountability, which has led to the country's first corporate bond defaults, suggest that the era of easy money may be coming to an end. Those unable to renew bank loans have shown no hesitation towards selling positions in copper and iron ore to raise cash. I guess we will see if investors in minor metals will be forced to do the same.

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Report by: Terence Bell, SMI Ltd.
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