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COLUMN-Time to end commodities as finance tools in China: Clyde Russell

--Clyde Russell is a Reuters columnist. The views expressed are his own.--

By Clyde Russell

LAUNCESTON, Australia, June 6 (Reuters) - The mad dash by banks and traders to see who owns what metal inventories at China's Qingdao port should help bring a swift, and much-needed, end to the practice of using commodities for credit.

For the past few years one of the known unknowns in China's metals markets has been the use of imports as collateral to secure financing for investments in higher yielding assets, such as construction.

This has been most apparent in copper, with iron ore, gold, soybeans and other commodities also affected, with the consequent building up of so-called dark inventories, which are stocks being held for purposes unrelated to supply and demand fundamentals.

It was revealed this week that banks and trading houses are checking their exposure to metal financing at Qingdao, the world's seventh-largest port, amid concern that single cargoes of metal have been used several times to obtain financing.

This means there are potentially cargoes with more than one owner, raising the possibility of defaults on loans and complex legal actions.

The authorities have yet to confirm they are investigating, but it seems more likely than not that any foul play will convince them to crack down further on the shadow banking system.

For physical commodities, the increasing concern over financing means that Chinese markets may be disrupted in the short term, especially if there is distressed selling of stocks.

This may serve to dampen imports for a few months as the inventory overhang is worked through, but thereafter the market should be more reflective of actual supply and demand.

Iron ore would appear to the commodity currently most vulnerable in the short term, given the high inventories at Chinese ports, the softer economic growth being experienced and the weak spot prices.

Inventories at Chinese ports stood at a record 106.9 million tonnes last week, which is roughly 1.4 times the average of monthly imports between January and April this year.

The Asian spot price <.IO62-CNI=SI> has lifted slightly since reaching a 20-month low of $91.80 a tonne, closing on Thursday at $94.30.

However, it is still down almost 30 percent so far this year, which is likely to put pressure on any loans secured by iron ore inventories.

ANY RALLY MAY BE MUTED

The possible unwinding of financing deals, coupled with high port inventories may serve to limit any rebound in iron ore prices that has in past years happened as Chinese steel demand for construction ramps up for the peak building season over summer.

Supply is also increasing, particularly from top exporter Australia, where the capacity additions by major miners BHP Billiton and Rio Tinto are starting to come on stream.

However, further price weakness looks unlikely with both the Singapore Exchange iron ore swaps curve <0#SGXIOS:> and the Dalian Commodity Exchange futures <0#DCIO:> pointing to a steady to slightly bullish outlook.

The backwardation of Dalian futures has eased in the past 10 days, with the second-month contract now at a premium of just 1.7 percent to the six-month, down from a premium of 8.7 percent on May 26.

This has largely been achieved by the shorter-dated future losing value, with the second month contract dropping from 769 yuan ($123.04) a tonne on May 26 to 698 yuan in midday trade on Friday.

The Singapore swaps have moved from mild backwardation on May 26 to extremely mild contango. The six-month swap was at $94.38 a tonne on Friday, a premium of 0.13 percent to the second-month.

While such a tiny premium hardly indicates a rally, the move from backwardation to contango is supportive of the view that prices are near the bottom and may gain in coming weeks.

While market participants tend to focus on possible short-term price moves, the main takeaway from the concern over possible abuses in the shadow banking sector is that the Chinese authorities clarify their position and implement clear regulations.

While the market would be better served by ending the practice altogether, even an unambiguous set of rules and supervision by the authorities would boost confidence among producers, traders and buyers.

(Editing by Ed Davies)