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By Fayen Wong, Polly Yam and Melanie Burton
SHANGHAI/HONG KONG/SYDNEY, June 26 (Reuters) - A warehousefraud at China's third-largest port has forced banks and tradinghouses to consider new controls in the country's massivecommodity financing business, which traders say could lead todrying up of credit for all but large firms and state-ownedcompanies.
China's commodities trading is dominated by the large andstate-owned companies but there are thousands of small firms inthe market. Faced with tougher bank requirements for financing,they could sell down stockpiles, squeezing demand for metals andother raw materials such as rubber in the world's biggestconsumer of commodities.
Any new requirements would also ratchet up the risk thatcustomers who do not regain credit lines may default on paymentsfor services such as hedging, or for imports.
"The fear is not so much about the big boys, but some of theother smaller, newer players, who may have only been in thiscommodity financing game for the last 2-3 years," said JeremyGoldwyn, a director with commodities broker Sucden in charge ofAsia business.
"If all of a sudden the tap is turned off to them, theymight have more of a crisis. Is it having an effect on themarket? Yes, people are very nervous. We obviously have a lot ofbusiness in China so we are watching it very closely," he said.
According to sources, Standard Chartered Bank hassuspended some commodity financing deals in Qingdao port afterauthorities there launched a probe into a private trading firm,Decheng Mining, that is suspected of duplicating warehousecertificates to use a metal cargo multiple times to raisefinancing.
For Western banks such as Standard Chartered, HSBC and BNP Paribas, which are restricted in the domesticloan market in China, the metals financing business is alucrative alternative but the Qingdao scandal has renewed focuson counterparty risk.
Goldman Sachs estimates that commodity-backed deals accountfor as much as $160 billion, or about 30 percent of China'sshort-term foreign-exchange borrowing.
Besides metals, the banks are now taking a fresh look atloans backed by other commodities such as iron ore, soybeans andrubber, fuelling concerns that any drying up of credit couldspark a series of defaults on trade loans, or force othercash-strapped firms to cancel term shipments in the second halfof this year.
"In the next two months, some smaller companies may defaulton term copper shipments if they cannot receive letters ofcredit or if they can't find a bank to do inventory financing,"said a trader at a large international trading house.
As they review their commodity lending business, someforeign banks are considering measures such as getting financeguarantees from Chinese banks for letters of credit issued tolocal firms and taking on insurance with more comprehensivecoverage, bank sources said.
"If we are signing contracts with their Singapore or HongKong-registered company, we may also start demanding guaranteesfrom the Chinese parent," said an executive at a Western bankaffected by the port scandal.
In the case of Decheng, there are worries among exposedbanks that they would have difficulties recovering the lossesbecause most of the financing agreements were signed with itsSingapore-registered unit, which has limited assets to pay backcreditors, said the executive.
Neither Decheng Mining, nor its parent Dezheng Resources,could be reached for comment.
WEEDING OUT SMALLER FIRMS
For smaller end-users and trading firms, both local andWestern banks are also thinking of imposing loan restrictionsthat will require shippers to prove that they already havedomestic buyers lined up for the metal, sources said - a movethat could weed them out of the commodity financing business asthey struggle to meet these tougher requirements.
These measures are set to make commodity financing in China- already under scrutiny by authorities - even harder andcostlier, in turn helping large players, such as state-ownedChinese firms and large end-users, get even bigger.
Chinese state-owned firms, such as Minmetals, Jiangxi CopperInternational and Founder Commodities, are favoured by local andforeign lenders alike as trading partners because of theirfinancial muscle. There is also a perception that Beijing wouldbail out these companies if things go awry.
Authorities have not yet disclosed the amount of metalinvolved in the Decheng financing probe, but sources familiarwith the matter said it was about 20,000 tonnes of copper,nearly 100,000 tonnes of aluminium ingots and about 200,000tonnes of alumina, the raw material for aluminium production.That quantity of metal would be worth about $390 million atcurrent prices.
According to Chinese business daily Caixin, Decheng's parentcompany, Dezheng Resources, and its subsidiaries had borrowed atotal of 14.8 billion yuan ($2.38 billion) from Chinese banksfor trade and other loans, part of it for metal imports.
Chen Jihong, a veteran trader and chairman of DezhengResources, has been detained by authorities since April and isbeing investigated as part of a corruption probe unrelated toQingdao port, trading sources and bankers who have dealt withDecheng said.
With the incident putting China's sprawling warehouse sectorunder scrutiny, foreign banks are also likely to demand morestringent requirements of warehousing companies from whom theyaccept inventory receipts.
IMPORT SQUEEZE AND DEFAULT RISKS
Pledging commodities to a bank using a warehouse receipt asproof of ownership, while agreeing to buy the cargo back at aset point in future, is a popular way to raise finance in globalcommodity markets.
It took off in China as traders sought to profit from thedifference in global interest rates in the wake of the 2008credit crisis: borrowing in dollars to invest in China'ssizzling shadow banking markets - often through non-traditionalwealth management products linked to property - where the gapbetween returns and funding costs could be as much as tenpercentage points.
While the Qingdao scandal has rattled global metals markets,investigations so far suggest this is an isolated case, withseveral bank sources saying that stock checks at other Chineseports have not found any wrongdoing.
Still, the episode has already made banks more reluctant togrant letters of credit, even when legitimate, raising thespectre of loan defaults and cancellation of copper imports inthe later part of this year.
Worries of a worsening credit crunch have led some companiesto sell their refined copper stocks in bonded warehouses inShanghai, trade sources said, putting pressure on futures and onpremiums which fell by nearly half after news of the scam broke.
Since then, banks have taken longer to approve finance forcopper imports, boosting demand for Shanghai copper stocks andbuoying futures prices. Shanghai copper hit a fourmonth high of 49,690 yuan ($8,000) on Tuesday.
To be sure, no foreign banks - even those that have hit bythe Qingdao saga - are thinking of exiting the lucrativefinancing business permanently.
"Foreign banks are largely shut out of the domestic loansmarket, with restrictions on funding and products we can offer.But offshore trade financing, however, is one that plays to ourstrength," said an executive at another Western bank.($1 = 6.2090 Chinese Yuan) (Editing by Raju Gopalakrishnan)
