Streetwise Professor

Despite happy talk from the government in recent months, Russia continues its downward economic spiral. The economy contracted by 4.6 percent in the second quarter. This is pretty appalling, given that oil prices had rebounded some. The Economics Ministry says this is “the lowest point” for Russia, but given the recent rout in oil prices, and the troubling signs coming out of Russia, this seems unduly optimistic. If anything Q3 and Q4 are likely to be worse. These therefore seem to be more realistic predictions:

“While second-quarter growth surprised on the downside, perhaps far more importantly is the fact that the outlook for the Russian economy has deteriorated so far in the third quarter,” Piotr Matys, a London-based foreign-exchange strategist at Rabobank, said by e-mail.

. . . .

“The economic prospects for the coming quarters look pretty grim,” Liza Ermolenko, an analyst at London-based Capital Economics Ltd., said by e-mail. “Industry appears to have been a major cause behind the deterioration in the second quarter, having gone from being a relative bright spot in the first quarter.”

The consensus is now that the current economic situation is more dire than 2008-2009, and that it is likely to persist far longer.

On top of this, China’s sudden devaulation of the Yuan has caused a further decline in commodity prices, with Brent now below $50/bbl. This has contributed to a further decline in the Ruble, which fell about 2 percent in the aftermath of China’s move.  The Russian currency is now around 65 to the dollar.  Russia is particularly vulnerable to an extended Chinese malaise, not to mention a hard Chinese landing.

The Russian Central Bank now faces the same conundrum that it confronted last summer and fall. It can choose between loosening monetary policy to spur the economy but would thereby spur inflation (already running at over 15 percent) and pressure the ruble even further. Or it can choose to defend the Ruble, which would hamstring the real economy, and potentially spur capital flight if the credibility of the RCB’s action is doubted. Which leg does it chew off?

Wherever Putin and his economic advisers look, the scene is bleak indeed. The situation in China is particularly ominous, because Putin had grabbed onto China like a drowning man, hoping it would rescue him from the blows raining down from sanctions and the commodity price implosion. But the Chinese devaluation, combined with a litany of other grim statistics coming out of China, suggests that if China is not drowning itself, it is struggling mightily to keep its head above water.  Russia is particularly vulnerable to an extended Chinese malaise, not to mention a hard Chinese landing. Putin counted on China’s economic support to allow him to continue his Ukrainian adventure and weather the resulting sanctions.  It’s not happening (Chinese direct investment into Russia has fallen by 25 percent), and the prospects of it happening anytime soon are diminishing daily.

Nor are the long run prospects particularly encouraging, not with Bloomberg running articles titled “Russian Workers Vie With Greece in Race for Productivity Abyss,” the upshot of which is that Russia has the lowest productivity in Europe, running at 50 percent of the European average and 30 percent below Greece. (Which makes this boast by the Russian Minister of Industry and Trade that Russia has overtaken the US in labor productivity even more hilarious.)

In brief, the Russian economy is doing an imitation of the Kursk, 15 years ago. The only difference is that Putin has yet to admit the economy has sunk.

This story is a Sino-Russian twofer:

The contract between Russia and China for gas supplied via the western route known as Power of Siberia-2 is being delayed indefinitely, Vedomosti cited Russian officials. They say China is reviewing its energy needs due to the economic slowdown.

The demand growth for gas in China is slowing, at the same time access to liquefied natural gas (LNG) is becoming more available in the country, for example from Australia, due to the fall in oil prices, Sberbank CIB analyst Valery Nesterov told Vedomosti on Wednesday.

Repeat after me: Gazprom finalizes about one out of a hundred of the vapor deals it announces. This is especially true where China is involved.

There are three basic problems. First, the pipeline is expensive, primarily because the Russians insist on building it. After all, how else could they tunnel out money? And if they can’t tunnel out money, what the hell is Gazprom good for?

“Gazprom offers CNPC a high price, explaining this by the high cost of the Power of Siberia – 2 construction. China is ready to build the pipeline at a cheaper cost and at public tender, so its companies could participate and for the construction price to be transparent,” the president of the Russia-China analytical center Sergei Sanakoyev said.

Second, the pipeline would go to the western part of China, which is convenient for Gazprom, but it isn’t where China needs the gas.

Third, China doesn’t need as much gas period, because (a) new (LNG) supply is coming on line in Australia, and (b) despite the happy talk of official statistics, every indication is that the Chinese economy is slowing:

The demand growth for gas in China is slowing, at the same time access to liquefied natural gas (LNG) is becoming more available in the country, for example from Australia, due to the fall in oil prices, Sberbank CIB analyst Valery Nesterov told Vedomosti on Wednesday.

So how’s that pivot to Asia working out, Vladimir? Timing is everything in life, and Putin is counting on China precisely when China has its own issues to deal with. If China was continuing to power forward, Putin’s pivot would have turned him into China’s pilot fish. Now even being a pilot fish looks out of reach.

To all those who hyperventilated at the announcements of huge Sino-Russian gas deals: when will you people learn to discount virtually anything Gazprom says down to just above zero? That’s especially true when there was a huge political reason for Putin to hype such a deal. I guess suckers never learn.

The second part of the twofer here is the further evidence it provides of China’s economic troubles. Look at the commodity carnage going around: oil, copper, iron ore, gold, platinum, you name it are in the dumper. China put them there. This is just another pixel in the image.

The invaluable Christopher Balding has been tracking closely the massive financial support the Chinese government has been injecting into the banking system, the shadow banking system, local governments, and the stock market. In a blog post earlier this week, he estimated that this support totaled at least $692 billion, rising to $933 billion if the Reserve Ratio cut is counted as a subsidy to the banking system.

These funds went to the local government bond program I wrote about in June, an  investment in pension funds, PBOC 6 month loans to banks, and PBOC loans to the Chinese Securities Financing Corporation, which in turn will lend these funds to buy stock on margin.

But it’s hard to keep up! Christopher kindly shared with me his most recent calculation, which shows that the Chinese government keeps pumping in the money, most notably an additional $200 billion in loans to intermediaries who will use these funds for margin lending, and a rumored (but not yet confirmed) $160 billion in additional support for provincial municipal bonds. This brings the total to $1.3 trillion.

In RMB, that totals over 8 trillion (with a “t”, boys and girls). To Sinofy Evertt Dirksen: A trillion here and a trillion there, and pretty soon you are talking real money.

Another metric: $1.3 trillion is approximately three TARPs. Maybe we should start using that as a new unit of measurement, as in, “Chinese authorities intervened in the market and banking system today, providing an additional .5 TARPs in state funding.”

Yet another metric: $1.3 trillion is almost exactly $1000 per Chinese citizen. TARP was about $1500 per American. But China’s per capita GDP is (depending on whether you use exchange rates or PPP) about 1/5th or 1/7th of US GDP per capita. Thus, a low middle income country is spending roughly 3 to 5 times more per person as a percentage of per capita income than the high income US did. (Given that Chinese GDP is likely overstated-another issue that Christopher has analyzed in detail-the true multiples are even higher.)

Such massive spending-arguably the most gargantuan stimulus package ever-is not the sign of a confident leadership. It is a clear sign of panic.

Remember the extreme panic in DC and Wall Street in the post-Lehman period that culminated with TARP? Even in that hysterical environment, people questioned the need for and advisability of TARP. But in the end panic won out. That is the only reason TARP passed: people were scared stiff at what would happen if it didn’t.

Now think of how panicked the Chinese must be to implement measures that dwarf TARP. That’s what economists call revealed preference. Or, in this instance, revealed panic.

This gives the lie to official statistics, which showed a (patently unbelievable even absent this massive stimulus) .1 percentage point decline in the growth rate. Also giving the lie to the official statistics is the collapse in China-driven commodity prices, notably iron ore and coal, and oil as well. The slowdown in commodity economies further discredits the official Chinese data.

The Chinese stock market is getting most of the attention. This is the drunk-looking-under-the-streetlamp-for-his-keys phenomenon. The stock market is visible, and people can relate to it: this is why the government is using massive carrots (notably the support for margin lending) and even bigger sticks to try to arrest the decline. This would suppress the most visible manifestation of crisis. But the real dangers are lurking out of sight, in the leveraged sector (most notably the rats’ nest of non-bank lenders, but the banks are concealing a lot too), SOEs, and a real economy whose performance is masked by dodgy official statistics.

I’ve long referred to China as the Michael Jackson Economy, kept going by intense dosages of economic/financial drugs, cosmetic surgeries, and stimulants. The Chinese authorities are now administering the biggest dosages ever. This is an indication that the patient is doing quite badly. Further, although such actions may delay the inevitable, they make the end all the more horrific.

Trying to staunch the bleeding in the stock market, China is unleashing the full power of a police state. A Securities Execution Commission, if you will:

China’s police ministry is teaming up with the securities regulator to probe short selling, as the government works to stem a stock plunge that has erased $3.9 trillion in market value.

The Ministry of Public Security said it will help the China Securities Regulatory Commission investigate evidence of “malicious” short selling of stocks and indexes, according to a statement on its website Thursday. Vice Public Security Minister Meng Qingfeng visited the regulator’s offices in Beijing on Thursday, the official Xinhua News Agency said earlier on its microblog.

The move comes after the securities regulator pledged to “strictly” punish market manipulation and China’s state-run media blamed short selling, rumor-mongering and foreign meddling for fueling the stock slide. The ruling Communist Party has announced an unprecedented series of measures to boost shares, including banningmajor shareholders, executives and directors from selling stakes.

Whenever a police ministry “teams up” with securities regulators, watch out. You can bet-and it wouldn’t be speculation!-that some poor schmoes are going to do hard time for manipulative short selling. And China being China, it is not beyond the realm of possibility that some really unlucky bastards will wind up in front of a firing squad or inside a mobile execution van.

And isn’t it always the way? Stock price declines are always blamed on short sellers. Always. And with stocks, manipulation accusations are thrown about on the way down, but never on the way up.

If the Chinese authorities want to find a market manipulator, they need to look no further than the nearest mirror.  Which is precisely why they are so intent on finding someone else to blame.

In the very early days of this blog, I told the story about what Chief Economic Advisor Beryl Sprinkel said on Black Monday, 1987, when a panicked Treasury Secretary James Baker wanted to close the stock market: “We’ll close these markets when monkeys fly out of my ass.” No monkeys flew, and the markets stayed open, eventually stabilized, and then recovered.

But many monkeys are flying out of many asses in China. Although the authorities have not closed the stock markets, individual companies have halted trading in their stocks: trading in more than one-half of the listings in China is currently suspended.

Halting trading more than for a short interval in order to resolve information asymmetries and permit the flow of liquidity to stocks that have just experienced an information event (as during a temporary stock halt in the US) is in general a bad idea. (Post-87, Greenwald and Stein wrote a paper published in the JOB laying out this argument.) An uncoordinated and extended halt of many stocks is a really horrible idea, because of the negative externalities. That is, uncoordinated flying monkeys wreak even more havoc than coordinated ones.

Halting trading in a large number of stocks increases selling pressure on stocks that are still trading. This happens for at least a couple of reasons. First, individuals who need to raise cash (e.g., to meet margin calls) are forced to concentrate their sales in the stocks that keep trading. This tends to concentrate selling pressure, rather than diffuse it. Second, individuals who want to rebalance their portfolios away from equity into cash or bonds have to concentrate their sales in the stocks that continue to trade. Again, this concentrates selling pressure.

This creates a vicious feedback loop. A number of companies halt trading, which forces selling pressure to spill over with greater force on other stocks, which leads some of these companies to halt trading, which intensifies selling pressure on other companies, and so on. The ultimate likely outcome is a protracted lockdown of the entire market. Protracted because who is going to be the firm to restart trading first, and risk having everyone sell the hell out of them?

The vaunted Chinese economic managers (ha!) have well and truly bungled this one. They should have prevented open-ended trading halts, or had a coordinated stoppage and restarting of trading. The coordination failure at work now is manifest.

Again, I believe that the sharp selloff is more of a symptom of a deeper economic problem than a potential direct cause of such a problem. The main adverse spillover that the stock selloff could cause is through the margin debt channel. Margin calls could lead to fire sales of illiquid assets. Again, the more stocks that are not trading, the more severe these fire sales in non-equity assets will be: this is another adverse consequence of uncoordinated monkey launches. Moreover, failures to meet margin calls will saddle the lenders (themselves often highly leveraged) with losses. Both of these channels could have adverse consequences in the brokerage, banking and shadow banking sectors. Their balance sheets are not that hale and hearty to begin with, and this kind of shock could spark broader financial distress throughout the sector.*

In other words, the stock market decline is less of a crisis in itself, than a potential catalyst to a crisis via informational and fire sale channels. And perversely, uncoordinated trading halts in the stock market are more likely to intensify than mitigate any such catalytic effect.

But the Mandarins know everything, so I’m sure it will turn out swell.

In the meantime, the Mandarins have a message for all investors in China. Good luck with that!

* Perhaps one could argue, as Michael Brennan did when trying to explain price limits in futures markets in the JFE in 1986, that halting trading could ease pressure on margin credit. I am skeptical though. Even if stocks stop trading, margin lenders are likely to demand additional security in current conditions. Indeed, trading halts that reduce the informational content of stock prices create a source of uncertainty to margin lenders which they are likely to compensate for by demanding additional margin based on their estimate of the stock price once trading recommences, plus a premium to compensate for the uncertainty.

The People’s Bank of China is effectively funding an effort by a group of brokers to buy equity (to the tune of about $20 billion) in an attempt to stem the massive selloff in Chinese stocks. The news barely checked the relentless decline, which I will expect will resume with a vengeance.

In other words, China is panicking, and attempting to catch a falling knife, as the phrase goes. And that almost never works out well.

Actually, I don’t think that the equity market decline is China’s big problem, except to the extent that it is a harbinger of a dramatic slowing of the growth in the economy, or perhaps an absolute decline in the economy. Countries survive equity market meltdowns. It is the leveraged sector that is the concern. In China, that includes not just banks, but the plethora of shadow banks, trusts, and local government funding vehicles, all with murky interconnections with the banks.

There are pronounced signs of economic stagnation besides the shuddering equity market. The lack of growth in electricity generation is one. The sharp declines in China-sensitive commodities, notably oil, iron ore, and copper are another: oil was down 8 plus percent today. (Cheers, Vlad!) If it was oil alone, one could write it off to the market deciding that a generous Iran deal was imminent. The broad fall suggests that it is China, China, China.

The equity market, and the government’s response to it, is therefore a symptom of this broader economic problem. What the Chinese (and those long energy and metals production) need to be especially concerned about is if a decline in growth sets off a banking or shadow banking crisis. Then the Chinese central bank and government will be in the unenviable position of catching a barrage of plummeting arrows.

The Chinese stock market and the Chinese economy are perplexing. The latter seems to be slowing rather dramatically, and there is widespread belief that the growth rate is, or soon will be, far below the 7 percent level the government is touting. Nonetheless, the stock market has been skyrocketing, with some periodic selloffs as occurred yesterday.

The government is allegedly intent on transitioning from the investment- and export-driven growth model towards a more consumption-oriented one: Fixed investment as a fraction of GDP is at stratospheric levels, and consumption as a fraction of GDP is extremely low. Its ability to navigate this transition, due to the inherent difficulties of trying to manage a huge economy as well as the political economy factors that tend  to impede change, is open to serious doubt. There is always the possibility that the government will respond to any growth slowdown the way it has in the past, through massive stimulus.

Further, the strength of the Chinese banking sector is always open to question. If the government (and the central bank) are concerned about it, that would also tend to bias them towards loosening credit.

Local governments are connected to all these issues. Local governments, through so-called Local Government Funding Vehicles, fund a substantial fraction (about 20 percent) of Chinese investment. These entities have exhibited signs of financial distress, as indicted by high yields. This reflects the dodgy quality of many of the investments these vehicles funded. This is a problem for Chinese banks, which have a large exposure the LTFVs.

The Chinese government recently provided a very strong indication that it is indeed deeply concerned. It announced a set of measures that look for all the  world to be a financial shell game intended to move local government risk onto the balance sheet of the People’s Bank of China and simultaneously create credit.

As originally announced, the banks were expected to swap LGFV debt for municipal bonds carrying a lower interest rate. The banks were obviously unenthusiastic about this, and the takeup was minimal. So the PBOC made it plain that this was not voluntary: banks were expected to buy the lower interest munis. To induce them to do so, the PBOC said that it would permit the banks to post these securities as collateral at the central bank, and use the proceeds of the collateralized borrowing to extend new loans.

The exact nature of the collateralized borrowing from the PBOC is about as clear as a Beijing sunset, but it is evident that this mechanism can serve as a way of passing the muni credit risk onto the PBOC. If the munis become distressed, and the loans are de jure or de facto non-recourse, the banks default on the loans, leaving the PBOC with the bad local government debt.

It is clear that this is a bailout of the local governments. They are now borrowing at below market rates: it wouldn’t have been necessary to coerce and induce the banks to buy the local government debt if they were sold at rates reflecting the credit risk. Since the banks now appear willing to lend, they must believe that the central bank is wearing the risk, and hence paying the subsidy. In other words, the pea is under the shell labeled “PBOC.”

The command that that banks lend the proceeds from the loans from the PBOC means that the overall effect of the program will be to expand bank balance sheets and increase credit. It is both bailout and stimulus.

Putting this all together, this suggests that the Chinese authorities are deeply concerned about the financial condition of local governments and the banks, and is also deeply concerned about growth prospects. It could also indicate hesitation about transitioning away from the investment/export-driven model. All of which makes the booming Chinese stock market all the more puzzling. Unless, that is, the betting is that the government will respond to weak growth by resuming the credit stimulus and blowing asset bubbles.

None of this are signs of a healthy economy, or healthy markets. It is instead symptomatic of massive distortions and imbalances produced by years of heavy-handed policies. The imbalances must correct eventually, but the Chinese are saying not yet, lord, not yet.

But they cannot defer the reckoning forever, and the longer it is delayed, the more brutal the correction will be. But like politicians everywhere, the current Chinese government no doubt is content that the blow up occur on the next guy’s watch.

Commodities are down broadly: Oil gets the headlines, but most major commodities-especially industrial commodities-are down, with iron ore leading the pack. The main driver is Chinese demand: perhaps it’s more accurate to say that the main brake is slackening Chinese demand. Forecasting the course of future Chinese demand is challenging, because there is a huge political component to it.

China has long followed a commodity-intensive, investment-focused (including construction and infrastructure), credit-fueled economic model. It has long been recognized that this model is unsustainable because it is fraught with imbalances. There have been signs that China has recognized this, and in particular the new Xi government is attempting to to navigate this transition, signaling a desire to transform to a consumption-based model with growth rates in the 6-7 percent range rather than 10 percent (though analysts like Michael Pettis say that growth rates in the 3-4 percent range are more realistic.)

One sign of that is the central government’s recent attempts to rein in local governments that borrowed heavily through “local government funding vehicles” (“LGFVs”) to support local infrastructure, housing construction, and industry. Clamping down on LGFVs would be one way of steering China’s economy away from the investment-intensive model:

China’s local government bond issuers face judgment day as authorities in the world’s second-largest economy decide which debt they will or won’t support.

Borrowing costs soared by a record amount last month before today’s deadline for classifying liabilities, on speculation some local government financing vehicles will lose government support after the finance ministry starts reviewing regional authorities’ debt reports. Yield premiums on one-year AA notes, the most common ranking for such issuers, jumped a record 98 basis points in December.

Premier Li Keqiang has stepped up curbs on local borrowings just as LGFVs prepare to repay 558.7 billion yuan ($89.8 billion) of bonds this year amid economic growth that’s set for the slowest pace in more than two decades. The yield on the 2018 notes of Xinjiang Shihezi Development Zone Economic Construction Co., a financing arm in a northwestern city with 620,000 people, climbed a record 63 basis points in December.

But there are mixed signals. Today China announced a $1 trillion stimulus:

China is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year as policy makers seek to shore up growth that’s in danger of slipping below 7 percent.

Premier Li Keqiang’s government approved the projects as part of a broader 400-venture, 10 trillion yuan plan to run from late 2014 through 2016, said people familiar with the matter who asked not to be identified as the decision wasn’t public.

. . . .

The projects will be funded by the central and local governments, state-owned firms, loans and the private sector, said the people. The investment will be in seven industries including oil and gas pipelines, health, clean energy, transportation and mining, according to the people. They said the NDRC is also studying projects in other industries in case the government needs to provide more support for growth.

The NDRC’s spokesman, Li Pumin, said last month China would encourage investment in those areas.

So which is it? A transition to a less-investment intensive model, implemented in large part by reducing the use of credit by local governments? Or continuing the old model, to the tune of $1 trillion over the next couple of years?

Commodity traders want to know. But given the opacity of the Chinese decision making process, it’s impossible to know. The signals are very, very mixed. No doubt there is a raging debate going on within the leadership now, and between the center and the periphery, and decisions are zigging and zagging along with that debate.

I see three alternatives, two of which are commodity bearish. First, there is a transition to a more consumption-based model: this would lead to a decline in commodity demand. Second, there is a crash or hard landing as the credit boom implodes due to the underperformance of past investments: definitely bearish for commodities. Third, the Chinese keep pumping the credit, thereby keeping commodity demand alive. The third alternative only delays the inevitable choice between Options One and Two.

In brief, for the foreseeable future, the most important factor in commodity markets will be what goes on in Chinese policymaking circles. And insofar as that goes, your guess is as good as mine.

If the vaults are in China, that is. Over the weekend I posted on the fraudulent commodity-based lending (collateralized by aluminum) in Qingdao. Now a Chinese government auditor claims that the gold used as collateral in $15 billion of loans does not exist.

To put this into context, Goldman (ha!) estimates that there are about $80 billion in loans in China collateralized by gold. Thus, the auditor’s report means that at least 20 percent of those loans are fraudulent. Given that it is likely easier to verify the existence of gold pledged as collateral than is the case for copper or soybeans, this suggests that even higher percentages of these other commodity-based loans (totaling another $80 billion) are backed by warehouse receipts that aren’t worth the paper they are printed on.

This situation creates the conditions for a horrific information contagion, which is the worst sort of systemic risk. Many analyses of systemic risk focus on counterparty credit risk, where the failure of one institution topples a set of interconnected dominoes. But historically, the domino problem has been less of a source of financial crises than information contagion. For instance, information contagion was arguably a far more important cause of the 2008 crisis than counterparty contagion.

Information contagion is a panic that results when the quality of assets in one part of the financial system leads people to question the value of other assets, usually similar but not always. For instance, in 2008,  the problems at Bear and Lehman were the result of bad mortgage investments by these firms. This raised questions about the solvency of other financial institutions that held, or were believed to hold, similar assets. Suddenly all banks became suspect, and had problems funding their assets. They started dumping assets to raise cash, which cratered prices and thereby created problems in institutions that had to mark their assets to a (now depressed) market. Banks that had extended liquidity support to SIVs had to bring them back on their balance sheets, threatening to make them undercapitalized.

Information contagion is most likely to occur, and is most severe when it does, when (a) asset values and balance sheets are opaque, and (b) financial institutions engage in a lot of maturity transformation (i.e., borrowing short to lend long). When asset values and balance sheets are opaque, market participants are more likely to draw inferences from revelations about the values of other firms/assets, because they can’t evaluate the firms/assets directly. In these circumstances, bad news about one firm or one type of asset can lead to a massive loss in confidence in other firms and assets. When these assets are funded with short term borrowings, firms can’t roll over their loans under these conditions, and are more likely to go bankrupt. Moreover, they are more likely to dump assets in fire sales that impose externalities on other firms holding similar assets.

China’s financial system is nothing if opaque. This is particularly true of the shadow banking system, but the banking system is also incredibly murky. For instance, the actual quality of loans on bank books is very difficult to assess. A lot of loans reported as performing are actually quite dodgy.

Information contagion is especially likely because the nature of the revelations about commodity loans raises serious questions about the monitoring of loans and the evaluation of the creditworthiness of borrowers and the quality (and existence!) of their collateral by financial institutions. If banks do a bad job at evaluating commodity loans and borrowers, and commodity collateral, it is reasonable to infer that they do a bad job at monitoring other loans and evaluating other borrowers. It is these sorts of inferences that lead to information contagion.

Moreover, maturity transformation is ubiquitous in China. This is especially true in the shadow banking system.

What this means is that although a few tens of billions of loans backed by non-existent collateral may not seem like a big deal in a financial system with about $17 trillion in credit outstanding (about 35 percent of which is in the shadow sector), the ramifications are far more serious than the value of these commodity loans suggest. There is a serious risk that doubts about the quality of the commodity loans will lead to growing doubts about the quality of other assets, especially in the shadow banking sector.  This creates the potential for panics and runs in that sector, and given the connections between shadow financial institutions and mainstream banks (connections which are themselves opaque) this could spillover into the conventional sector.

In other words, the potential for information contagion in a highly leveraged (with credit at about 250 percent of GDP), highly maturity transformed, and exceedingly opaque financial system is what makes the fraudulent commodity loans a big deal. Potentially a very big deal.

Back in the early-60s, a guy named Tino de Angelis*, owner of the Allied Crude Vegetable Oil Refining Corporation, carried out a huge scam based on commodity finance. He bought soybean oil, against with American Express issued warehouse receipts. De Angelis took the warehouse receipts to banks, who took them as collateral against loans issued to Allied. And not just banks. Companies like Bunge and Proctor and Gamble also lent against the warehouse receipts.

So far, this is routine: commodity traders and processors routinely use their inventories as collateral against loans they use to finance them. The scam came in the fact that Allied obtained loans on non-existent bean oil. De Angelis had a variety of schemes to fool Amex into believing he owned more bean oil than he really did. Some of the tanks at Allied’s facilities did have oil in them, and those would be shown to Amex inspectors. The inspectors would then be led through the firm’s labyrinthine facility, allegedly to another tank to inspect. Except they’d been led back to the tank they had already inspected, but the number on the tank had been changed. Another con was to fill the tanks with water, with some oil sitting on top of the water. Allied also linked the tanks with pipes, and would shuttle the oil between tanks to keep ahead of the inspectors.

Through these means, de Angelis amassed warehouse receipts for quantities of oil that exceeded the entire amount in the US, and borrowed about $200 million against the phantom inventories (well over $1 billion in current dollars). Eventually, inspectors figured out the scheme, and the fraud was uncovered. The revelation caused Amex’s stock price to plummet (Warren Buffet scooped up some and made good money off the deal). Moreover, soybean oil futures also crashed.

De Angelis went to jail. Went released, he tried to run a Ponzi scheme.

This all happened more than 50 years ago: the scam was revealed a few days before JFK was assassinated. But a replay appears to be occurring in China, in the port of Qingdao specifically (though there are concerns that other ports may have similar problems). One trading firm has found to have borrowed large sums collateralized by non-existent aluminum allegedly stored in the port.

This is a major concern because commodity-based lending is a big deal in China, and if the practice is indeed widespread it could result in large losses. Commodity-based lending has been used in carry trades involving using letters of credit to borrow dollars buy commodities (initially mainly copper, but now other metals, iron ore, and ag products) that are imported into China and put in warehouses. The warehouse receipts are then used to collateralize loans in China, the proceeds of which are invested in high yielding, speculative endeavors.

This entire structure was already very fragile (because carry trades are inherently fragile), but if it turns out that even of a modest proportion of the collateral doesn’t exist it could collapse altogether. This could impose substantial losses on many banks. CITIC and Standard Charter are facing losses on the loans to the Qingdao trader. If there are many others, many more banks (and perhaps some western trading firms) could be hit hard.

One note of caution: some (notably Zero Hedge) are saying that collateral has been “rehypothecated.” This is not correct. Rehypothecation involves the lender pledging the collateral received from the original buyer as collateral to a loan. This process may occur several times. This results in the issuance of gross debt that is a multiple of the value of the collateral (the multiple could be as large as the inverse of the “haircut” on the collateral). But the net debt is approximately equal to the value of the collateral, and fraudulent receipts are not created. These collateral chains are potentially fragile, but the fragility does not result from the creation of fraudulent receipts.

In contrast, as described, the Qingdao scheme is like de Angelis’s, in that receipts are issued on non-existent goods. In this scheme, fraudulent receipts are created, and the net debt exceeds the value of the actual collateral. Of course, if the fraudulent receipts are rehypothecated, things will get uglier still.

Dealing with this mess would be hard enough in a jurisdiction with a solid and transparent legal system, reliable judges, and the rule of law. One can just imagine how this will play out in China, which has none of the above.

Then there are potentially broader implications. The commodity loans are one part of China’s vast shadow banking system. Concerns about the fragility of this system abound. If (a) the commodity loan problems are more pervasive, and (b) these problems are symptomatic of shoddy and fraudulent practices in the shadow banking system more generally, there is an appreciable risk of a financial crisis in China.

* Interestingly, de Angelis made money primarily on government programs, namely the National School Lunch Act and Food for Peace.