The hidden crisis behind copper and iron ore price collapses

The dramatic fall in the copper and iron ore prices plus the fall in China’s currency reflects much deeper forces than simply one set of bad China trade numbers.

The fall goes to the heart of the Chinese banking system and to the trading activities of the shorting hedge funds trying to exploit perceived weaknesses.

And, as always, if prolonged, troubles in China soon affect Australian tax revenues and prosperity.

In China copper is much more than a simple commodity where demand rises and falls with economic activity. In the last two years Chinese property developers were using copper as a security for real estate loans and so it became interwoven in the Chinese banking system. The copper loans were clearly artificial and were usually made by second tier lending institutions. Many have been repaid but not all.

Right now the Chinese banking system is under stress. Over the last five years the Chinese banking sector has increased credit by some $US13 trillion to $US15 trillion. A big chunk of the extra funds, particularly in recent times, have come from borrowings in US dollars (usually via Hong Kong) as the Chinese took a slice of US money printing. But that US dollar borrowing has now given the Chinese banks exposure to a falling Yuan, which in turns makes lenders nervous. This a completely new experience for the Chinese banking system and means a lower Chinese currency will not have its normal stimulatory effect.

And the sharp growth in lending means that inevitably there has been a myriad of strange bank lending deals -- many of which, like the copper based real estate funding, are now under pressure. But no bank lending games are more strange than the amazing iron ore gymnastics of recent months.

In iron ore, Chinese steel mills are under pressure from falling steel prices, managed to get letters of credit to fund iron ore purchases, which assisted in gaining bank loans to keep the steel mills afloat.

We now realise that this created an artificial boost in iron ore demand that sent the price of iron ore jumping along with BHP, Rio and Fortescue shares and profits -- not to mention Australian tax revenue.

Now as iron ore stocks rise and exports are curtailed iron ore prices are falling, so that will put incredible pressure on the mills and their banks, made worse by the falling China exports.

Enter the massive hedge fund shorting game. The shorters look for a currency, commodity, or share market where they see weakness and then short the securities.

In February they saw weakness in BHP and went short but they were too early and were swamped by the good reports that came out of the iron ore price raises linked to the artificial China bank lending. At the end of February a few shorters panicked and that led to a stampede of BHP short covering and we saw a big rise in BHP shares. The shorters see the current crisis as the chance to recover their February losses.

Accordingly copper has now become a shorter’s picnic and the metal is being hammered, falling last night to its lowest level in nine months. Add that to the iron ore slump and BHP and Rio Tinto shares are also being shorted heavily.

And once a particular set of securities is the subject of massive shorting then the game multiplies and the effect on those exposed becomes much greater.

What is surprising is that the shorters have not yet latched onto the Australian dollar. But they will, especially when they realise that the recent bullish economic forecasts for Australia do not understand what is happening in the employment market (The overlooked truth in Australia's jobless recovery, March 7).

Finally what has always happened in the past is that when Chinese banking or some other crisis gets too serious, the Chinese government and central bankers jump and ‘fix’ the problem. But it can be very tense waiting for that to happen.