Dangerous Dynamics

Probably the most important thing to understand about China’s ongoing effort to tighten and thereby squeeze leverage out of the country’s financial system is that the implications for global markets go beyond the obvious.

That is, pretty much everyone understands that China’s credit impulse is tied inextricably to global growth but what still isn’t well understood by most market participants is the extent which the country’s batshit crazy shadow banking complex facilitates rampant speculation in all manner of assets.

Thanks to the repackaging and sharing of risk, there’s really not any concrete way to pin down what all of the credit extended via these backchannels ends up financing and so, when interbank rates get squeezed, you see dramatic unwinds in seemingly random places. That’s exactly what happened across the metals complex earlier this month and it also goes a long way towards explaining recent distortions and anomalies in the Chinese yield curve.

This is obviously dangerous for any number of reasons, not the least of which is that it creates a situation where it’s impossible to disentangle fundamentals from speculation as one ends up influencing the other.

Well, in an effort to alert you to the precarious nature of what’s going on here, we thought the following from Citi was worth a skim.

Via Citi

Chinese commodity futures markets experienced rapid growth of open interest and daily turnover (in dollar notional and contract terms) over the past 18-24 months, with total margin deposits in local futures exchanges more than doubling from ~$6.5Bn in mid-2015 to ~$16Bn as of early May 2017. We suspect most of the surge was due to increasing speculative interest in the local futures markets (e.g. Dalian Commodity Exchange, Shanghai Futures Exchange, Shanghai Gold Exchange, Zhengzhou Commodity Exchange) particularly since March 2016 when commodity prices surged unexpectedly on robust local demand and domestic supply-side discipline.

China and its growing herd of commodity traders and financial exchanges are clearly having greater influence on world commodity pricing, particularly for certain bulks and base metals (e.g. iron ore). However, issues related to China’s market structure and liquidity hamper price discovery, keeping its benchmarks more ‘local’ than ‘global’. With much of the recent growth in OI due to speculative activity, Chinese futures markets need more hedge flows via corporates and external (offshore) physical players, in our view, to better balance spec traders with end-users and producers.