A more severe crackdown on the use of commodities as collateral to finance deals in China could lead to heavy losses across the asset class, analysts warn.
"The profitability of the [commodity financing] schemes is being eroded, and the authorities are stepping up efforts to curb some forms of shadow banking," said Caroline Bain, senior commodities economist at Capital Economics in a note.
In typical commodity financing deals Chinese companies obtain a letter of credit, use it to import a commodity - copper for instance - sell that commodity in the local market or deploy it as collateral and use that money to invest in higher yielding assets before paying back the original loan.
The practice isn't new but recently came into focus following reports that such deals accounted for one third of China's money supply growth in 2013. Commodity financing drives hot money inflows which can negatively affect the economy, creating a credit boom and driving inflation, while eventual outflows could lead to sharp asset price deflation.
The resulting buildup of large unofficial commodities stockpiles in China makes markets look artificially tight. Unofficial copper stocks, for instance, could be as high as 700,000 tonnes, according to Capital Economics.
"A disorderly unwinding of the deals could lead to sharply lower prices as stocks are offloaded to the market," Bain said.
Chinese authorities took action in May, with the China Banking Regulatory Commission warning banks to tighten controls on letters of credit for iron ore imports.
Is copper next?
"It appears to be just a matter of time before the authorities target the copper financing deals, resulting in the release of copper stocks," Bain said.