What Is Copper Decline Indicating?

03/13/2014 11:00 am EST

Focus: COMMODITIES

Jim Jubak

Founder and Editor, JubakPicks.com

Copper is often a key indicator of Chinese growth and MoneyShow's Jim Jubak thinks the three-day drop in the price of the metal could be indicating a lot about the country's financial system.

Copper is known as a key indicator, so the 9% three-day drop in copper prices for three-month delivery on the London Metal Exchange is worrying. On Wednesday, March 12, copper in London fell to its lowest price since July 2010, before rebounding slightly. In Shanghai, the metal fell the maximum 5% allowed for a day.

But exactly what is copper indicating right now?

Most of the time, copper is an accurate indicator of fears and hopes about economic growth, especially economic growth in China. Demand for the metal closely tracks construction activity, for example. Part of the drop in copper is related to worry that China’s economy will slow below the 7.5% official target for economic growth in 2014.

But more of the current decline is related to worries about the Chinese financial system.

I don’t know whether this makes the drop in copper more or less worrying to you, but given increasing evidence of stress in China’s financial system, I’m inclined to the more, rather than less, worry end of the scale.

It’s not a coincidence that the rapid drop in copper comes on the heels of China’s first ever-corporate bond default on Friday. That’s because, although copper may remain a key commodity in China’s physical economy, it has become a crucial source of credit in the country’s financial system as well.

Chinese traders have increasingly turned to copper as a source of collateral. Traders can buy copper on credit by using their holdings of the metal as collateral for US dollar loans. The profits from that trade result from the arbitrage on the lower cost of those US dollar loans and what traders can earn from assets in China’s market. Much of the money from this copper arbitrage has gone into real estate deals in China.

Copper imports have soared in recent months, even as economic growth in China has slowed slightly. Imports of copper into mainland China hit a record 536,000 metric tons in January 2014, up 53% from January 2013. Imports in February slowed to 379,000 metric tons but that was still above imports for February 2013. Estimates are that some 60% to 80% of imports may have been used as collateral.

Which has left warehouses in China bulging with copper. Copper in warehouses tracked by the Shanghai Futures Exchange is up 65% since early January to about 200,000 metric tons. Anther 745,000 tons could be held in bonded warehouses, analysts estimate.

Two big worries from these numbers.

First, if the trades that have made buying and borrowing on copper start to become unprofitable with a falling yuan or with a retreat in real estate and other asset prices, traders could begin to liquidate those copper holdings. That would bring big volumes of copper onto the world market, sending copper prices even lower.

Second, and this is the bigger worry in my opinion, falling copper prices could trigger margin calls on traders and perhaps even send some trading companies into default. New letters of credit to import copper have just about dried up, so traders don’t have the option of doubling down on their bets. (Which is probably a good thing.) And given the downward trend in copper prices, it’s unlikely that a trader would be able to get a lender to agree to roll over a loan. (Which is certainly a bad thing in the near term.)

The specific situation in the copper market, and among traders with big copper-based loans, is enough by itself to rattle markets.

But in the context of worries about bad debt in China and corporate bond defaults, the speculative excesses in copper aren’t just about copper. At the moment, the market sees copper as an indicator of the extreme stress in China’s financial system.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund does not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund see the fund’s portfolio here.

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