Sunday, 29 June 2014

Loans backed by falsified gold transactions

What started in the copper market with the probe of alleged fraud at Qindao warehouses in China now spreads to the gold market. Bloomberg reported on Thursday that China’s chief auditor discovered 94.4 bn yuan ($15.2bn) were collateralized by falsified gold transactions. Although already widely suspected by many people, this was the first official confirmation that also gold is used in Chinese commodity financing deals. Goldman Sachs reports according to the media that up to $80bn false-loans may involve gold. Thus, the question is: how do these false-loans influence the spot gold market?

To answer this question, it is first necessary to analyze how commodity financing deals work. There are two possibilities. In the first kind of commodity financing transactions, the owner of the commodity uses warehouse receipts to get credit from banks. The proceeds from this collateralized loans can be invested in higher yielding assets before redeeming the debt. This transaction is only economical if the return on the investment is higher than the interest rate on the loan. Due to restrictions, this is currently the case for investments in the Chinese shadow banking system.

The second transaction involves the import of the commodity. The Chinese buyer places an order with a foreign company to buy the commodity. Then the buyer applies for a letter of credit from a lender, which is used to import the commodity. With opening the letter of credit, the buyer obtains the consignment, which he can sell in the domestic market. Again, the importer of the commodity can use the proceeds for investing onshore before paying back the original loan. As many commodities are traded internationally in US dollars, this type of financial deal involves cross-currency transactions. Funding costs in US dollars are quite low and the foreign exchange rate risk is limited due to the yuan exchange rate regime, which allows only limited daily fluctuations. In addition, as long as the yuan strengthens against the US dollar, the yuan appreciation even contributes to the return in local currency for the Chinese importer.

In the first type, if the loan is based on a falsified gold transaction, then the warehouse receipt is a fake. This implies that the lender has made a loan but the collateral is worthless. The lender could demand from the borrower to provide the promised collateral. Alternatively, the creditor could cancel the loan agreement and demand the repayment of the credit. For the borrower, it might be probably easier and cheaper to liquidate the domestic higher-yielding investment and to redeem the loan. Buying the gold in the spot market requires to have the funds available to pay the seller. Obtaining a loan in this situation is probably far more expensive. In addition, interest payments on the original loan are still due.

Therefore, the direct impact on the spot price of gold should be rather limited. Those who obtained a loan based on false-gold transaction are more likely to liquidate the investment and redeem the loan than purchase gold to provide the collateral. However, the process of selling the higher yielding investments probably leads to price pressures for those investments, which might induce other investors to purchase gold as a safe haven.   

In the case of the second type of commodity financing transaction, there should be a discrepancy between the gold import statistics and the volume of consignments. In international trade finance, after a letter of credit was opened, the bank of the exporter sends the documents to the bank of the importer. The importer’s bank examines the documents, makes the payment to the bank of the exporter and hands the documents to the importer. If the consignment is faked, the buyer of the consignment will notice the fraud with a delay of only a few months if the commodity never arrives at the port of destination. Furthermore, ships can be tracked easily nowadays. Thus, the chances of discovering a falsified gold transaction involving gold imports are higher. Therefore, it is more likely that a faked gold transaction occurs with warehouse receipts instead of consignments.  

In the case of a falsified consignment, it is also rather unlikely that it will lead to a higher demand for gold in the spot market. The buyer of the consignment would have to prove who faked the consignment. This could be either the exporter or the importer. Identifying the party who faked the documents is a time consuming process. But even if the buyer succeeds to obtain a legal title against the criminal party, it might be worthless in the case this counterparty went bankrupt in-between.

While the amount of commodity financing based on falsified gold transactions is impressive, the impact on gold prices should be rather limited. Unwinding the financing deals does not involve buying or selling gold as a necessary condition. However, other assets, i.e. those purchased with the proceeds from commodity financing might come under pressure. This is especially the case if lenders demand more and secure collateral or terminate the loan agreement.

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