FEATURE: The bursting of China’s steel financing bubble

At the end of May, Metal Bulletin published an article posing the question: “Could shadow financing disrupt China’s steel market?” Two months later, the answer seems to be: “Yes”

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The collapse in China’s steel prices in the past few months has undermined confidence in the country’s economy, sparked concerns about a surge in Chinese steel exports, and provided further ammunition to those with a sceptical take on the iron ore market.

But the most immediate victims are the legions of Chinese steel traders who, saddled with steel-backed debt, have led a sell-off that has brought prices down to levels not seen in nearly two years.

“The financing bubble has burst, leading to panic sales of steel stocks and a large price decrease as a result,” a trader in Shanghai said.

The disruption in the steel trade has even gone mainstream, with China Central Television (CCTV) recently devoting two half-hour documentaries to the troubles of small steel traders, many of whom are on the run from threats of violence made by debt collectors.

China’s steel traders have been under great pressure with steel prices and profit margins at low levels since early 2011 amid weaker demand, especially from China’s slowing real estate sector.

But a poorly regulated and opaque web of lending has made things worse.

A large chunk of China’s steel supply chain is still made up of small-scale businesses that place annual margins with steel mills. They also pay up a month in advance for material. But their own customers, the end-users, may pay up to one or two months later, and frequently delay or cancel delivery.

These risks are usually financed by banks.

“[Traders] normally borrow huge sums of money from banks through repeat mortgages of steel. With abundant capital, these traders sell a great amount of steel to end-users at aggressive prices or even on credit,” an analyst at Shanghai Sunchao steel group told Metal Bulletin.

But a clampdown on official lending pushed many steel traders to instead seek high-interest unofficial loans backed with steel as collateral. Bigger traders also repeatedly mortgage the same steel to get more loans from different lenders.

When steel prices are rising, this so-called system is workable. When prices start to fall – as they have recently, and rapidly – the cycle is disrupted. The price of hot rolled coil has dropped about 17% in the last four months.

Many of those who have to pay back bank loans in this scenario will also turn to “unofficial” lenders in an attempt to tide them over until prices start to rise again.

But the lower prices fall, the more acute the problems become.

“It seems to be a death spiral for traders, who have been running short on liquidity as they fail to sell much cargo when steel prices keep falling,” a major stockist in Tianjin said.

The “death” in death spiral can apply literally: there have been anecdotal reports of suicides among steel traders being chased by debt-collecting thugs.

Clearly, too much steel production and disappointingly weak demand play a pivotal role in price volatility. But an unregulated and improperly financed supply chain makes things a lot worse.

In the CCTV programme, one couple operating a small steel trading company in Songjiang, Shanghai’s biggest steel marketplace, had run away. They left behind a shop smashed up by their unhappy lenders and, what’s worse, two children to fend for themselves.

Not all disputes were so heated, but a law firm at Songjiang claimed to be doing brisk business these days, with a caseload from steel-related cases nearly twice as big as a year earlier.

Meanwhile, the documentary showed grass growing around some steel stockpiles at the market, and lines of delivery trucks standing idle by the roadside instead of coming and going with the latest loads of cargo.

State television in China does not devote an hour of prime-time programming to any subject without an underlying policy message.

The intention here may have been to show that the government is aware of the problems in the steel trade, paving the way for further action to rein in the shadow banking system, and an ill-disciplined steel supply chain.