A crackdown in China aimed at curbing distorted credit growth has triggered growing demand for the use of commodities as collateral to raise cash, causing distortion of another kind in the international trade of copper.
China's copper imports rose to a nine-month high in June and are likely to stay strong through the third quarter on growing demand for using copper-backed financing as a cheaper and more accessible alternative to bank borrowing.
Financing demand led copper imports into China in June to buck the wider trend of falling shipments in industrial raw materials as economic growth slowed. In contrast to copper, the volume of iron ore and crude imported into the world's second-largest economy fell from the previous month.
New rules to control credit growth have encouraged demand for copper for collateral for financing, partly by making banks and firms hold the physical metal. Companies have also turned to the practice after being blocked from other credit sources.
(Read More: Weak China data flags more bad news for copper)
China is the world's top consumer of copper and more imports flowing into financing are offsetting soft industrial demand for the metal and lending some support to weak global prices, which have dropped 14 percent so far this year.
"Demand for copper financing will continue to stay robust in the third quarter since credit in China will remain tight. Banks may be told to lend more to the small and medium-enterprises, but that won't happen because banks want to manage risks," said Lian Zheng, a copper analyst at Xinhu Futures.
"If the arbitrage for imports remains attractive, we may see strong imports for the rest of the year."
Since the imports are not actually consumed, they inflate China's copper demand and yet remain in storage, an overhang that would pressure prices if copper financing is unwound.
The use of copper for financing could undermine what is widely regarded as Beijing's most drastic credit clamp down in two decades to rein in shadow banking networks fuelling lending.
(Read More: Shadow banking bolsters China as credit tightens)
"Because of the latest liquidity crunch, we've actually seen more companies come to us and say they are interested in copper financing," said Jing Chuan, chief researcher at Citic Futures.
For the broader economy, the persistence of China's 'cash for copper' financing scheme underscores the difficulties Beijing face in controlling the grey credit market.
The International Monetary Fund has said that shadow banking, which the People's Bank of China estimates to account for over 20 percent of total outstanding loans, as one of the key risks in China's increasingly complex regulatory system.
Copper is dollar denominated, so importers can obtain loans at lower interest rates than yuan loans by using the metal as collateral. To get the cash, importers pay a small percentage of the value of the metal upfront and get bank credit for the rest.
The bank then pays for the copper. The importing firm sells the metal and can invest the cash where it wants until it has to repay the credit to the bank, usually six months after issue.
One of the areas that Beijing has targeted is credit to firms involved in buying and selling of goods in bonded warehouses in China's tariff-free areas. Beijing has, since May, forced banks to provide more documents detailing transactions before foreign currency loans can be issued.
(Read More: 'Dr. Copper' attempts some self-healing)
The aim was to curb overstated trade invoices that disguised movement of funds into China as payments for goods and services.
The new rules have impacted trade using bonded warehouse receipts for collateral rather than the actual metal. That has forced firms to go back to importing copper rather than using receipts for loans.
Demand for imports has also increased because banks now require warehouse receipts to show that the borrower is holding physical metal to justify existing loans, industry sources said.
(Read More: Pro: Here's what's really driving copper)
That has led to a scramble for copper. China's refined copper imports in May rose 27 percent from April and climbed another 6 percent in June to a nine-month high of 379,951 tonnes.
Those lacking physical metal to back existing loans risk their trade status being downgraded by the foreign exchange regulator and losing the right to transact cross-border yuan trade.
Hard to snuff out
The stricter checks have affected roughly 2,000 smaller copper trading firms, He Jinbi, president of Maike Metals, told a recent industry conference in Hong Kong.
Banks have also shortened the repayment period to 90 days from six months and are demanding higher loan deposits of 20-30 percent for some smaller firms, up from 10 percent previously.
(Read More: China to keep credit growth stead: Central bank)
But for large companies, it is business as usual. Those firms are acting as intermediaries for some of the small firms that are struggling to gain access to credit.
"The new regulations have made it more expensive to get trade loans," said Standard Charted analyst Judy Zhu.
"But it will not stamp out copper financing because it is almost impossible to determine which are proper trading firms and which are investors using copper imports as a way to profit from various arbitrage."
(Read More: China banks may need 'sticky' tape' to hold together)
Banks are said to be encouraging the trade, as the loans are off the balance sheet and allow them to circumvent Beijing's monthly lending quota.
"We have bank managers explaining to us how we can make more money via interest rate or foreign exchange differentials or how we can invest the money in their financial products for quick cash," said a manager at a local copper trading firm.