China's copper crisis

Nov 18th 2005
From The Economist Global Agenda

Soaring copper prices have caught China’s government out on trades made by an employee of the organisation that stockpiles commodities for the nation's needs. The market has grown restless as China has frantically tried to cool the price of the metal and assure traders that it can deliver on its contracts. Ironically, the mess is largely due to China's economic success

THE story sounded more appropriate for a spy novel than a sober financial broadsheet: rogue copper trader goes missing, as the Chinese government denies he ever worked for it. Yet in this case, truth has turned out to be at least as strange as fiction. Liu Qibing, a trader for China’s State Reserve Bureau (SRB), which accumulates stockpiles of commodities for the nation’s needs, has disappeared, leaving his employers on the hook for massive short positions in copper on the London Metal Exchange (LME).

Because the orders are likely to have been parcelled out among various brokers, it is difficult to assess the scope of China’s problem. But most seem to think that Mr Liu’s short-selling (sales of copper he did not own in the hope of buying it back later at a lower price) has left China short of the metal by some 100,000-200,000 tonnes—which is unfortunate, as it is due for delivery in December. Nor is it clear how Mr Liu was able to make such a big bet that prices would fall, since the SRB is saying little. Indeed, as rumours of Mr Liu’s folly began to spook the markets, the organisation seemed to be denying any such person worked for it, even though he is well known to other LME traders; this fuelled speculation that the SRB would refuse to cover the trades. Others say that it has forced Mr Liu to go on leave. No one has heard from him for weeks.

On Tuesday November 15th, copper hit a record $4,174 per tonne on anticipation of massive buying by China’s government to cover the short positions (see chart). The contracts are thought to have been undertaken in April, when copper traded between $3,100 and $3,200 a tonne; that would translate into a loss of roughly $100m-200m if prices are at current levels when the copper must be delivered. China has been trying hard to cool prices to more manageable levels. Over the past few days, it has taken the unusual step of announcing sizeable sales of the metal on the domestic market, and late last week it announced that it had 1.3m tonnes of copper on hand, a figure roughly 1m tonnes higher than most independent estimates, according to the Financial Times.

Though these early efforts to take the heat out of the market were unsuccessful, on Wednesday the copper price dropped by more than 2% on news that the SRB was seeking permission to export up to 200,000 tonnes of the metal. But by Friday it had hit another new high, topping $4,200 per tonne, as traders once again began to doubt whether China can, or will, deliver.

Estimates of how much copper the SRB actually holds run from as little as 100,000 tonnes up to 500,000. Most observers think it probably has enough to cover the trades. But that doesn't mean it will; the SRB has said that Mr Liu acted without its authority, which may be a sign that it is preparing to disown the trades, lumbering the brokers with whom he traded with huge losses. But even if the SRB decides to honour the transactions, it will be hard to move such a huge volume of copper to LME warehouses by next month, as required by the contracts. Buying the necessary copper could prove equally difficult, since analysts estimate global exchange stocks amount to only 140,000 tonnes, of which the LME holds 65,000.

This is not the first time a mess has appeared in the metals markets, though previous scandals have tended to involve long positions (bets on rising prices, the opposite of short-selling) and attempts to corner the market. The most notable case in the copper market was the $2.6 billion loss that Sumitomo Corporation, a Japanese firm, reported in 1996, thanks to the shenanigans of its erstwhile star copper trader. Metals markets are particularly attractive for sharp operators because, unlike some other commodities, or equities, the underlying asset can be stored indefinitely without spoilage or change.

Another striking difference in this case is how quickly it seems to have unwound. Previous “rogue trading” scandals, such as the Sumitomo debacle, or Nick Leeson’s destruction of British bank Barings in 1995, went on for years before they were discovered. If traders are right that Mr Liu’s contracts were purchased in April, his reign of terror will have lasted for only a matter of months. Such are the perils of short-selling. While long trades have a limited downside—the trader can only lose the money he invested—losses from short sales can theoretically balloon towards infinity, as each dollar increase in the price of the underlying asset multiplies the trader’s loss. In practice, of course, bankruptcy intervenes before the losses become too enormous.

Perhaps because of the speedy denouement this time around, so far there is no sign of the sorts of reckless cover-ups that ultimately brought previous rogue traders low: no fraudulent financial records or desperate double-or-quits on bad bets in the hope of recouping mounting losses. Mr Liu is simply a trader who made a big, bad call as to which way the market would move. This was not entirely unreasonable—copper prices had been soaring for quite some time, and it was not crazy to think that they would have to come down. But even reasonable short-sellers can end up with empty pockets; it is a maxim of traders that “the market can stay irrational longer than you can stay solvent”.

Hoist by their own petard

In some sense, China is a victim of its own success. As with other commodities, the price of copper, a key component of things like electrical wire, has been driven up by insatiable Chinese demand. This year was supposed to see a softening of that demand, as the economy, which grew by 9.5% last year, slowed to a slightly more sustainable pace. But growth has exceeded expectations: the World Bank has raised its projections for China three times this year, from 8.3% in April to 9.3% this month. Thanks in part to this unexpected boom, Standard Bank Group, a South African lender, predicts that copper production will fall 343,000 tonnes short of demand this year. Though increased production is expected to generate a surplus of 263,000 tonnes next year, this will come too late to help the SRB.

Other countries, too, are beginning to worry about China’s effects on commodity markets. In Chile, where copper is the main export, soaring prices have raised fears of “Dutch disease”, a situation in which high prices for natural-resource exports cause the currencies of resource-rich countries to appreciate, making their manufacturing exports uncompetitive and stalling industrial development.

But the SRB’s problem is more immediate: how to get out of the short contracts without losing its shirt. Simply repudiating the contracts may seem attractive, but it would carry stiff costs later on, for who would agree to trade with the organisation in the future? Yet covering the trades looks financially difficult, and perhaps physically impossible. It seems safe to bet on more sensational headlines in the days ahead.

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