HONG KONG/QINGDAO, China/SYDNEY, June 13 (Reuters) - The trail that led investigators to a suspected metal financing scam at China's Qingdao port which has spooked Western banks and hit global metals prices began with a Communist Party corruption probe 1,000 miles away in the old Silk Road city of Xining.
The Central Commission for Discipline Inspection (CCDI) said in late April that it was investigating the city's Party secretary, Mao Xiaobing, for suspected "serious discipline violations" - a term generally used to denote graft.
What was not made public at the time was that the authorities were also investigating Mao's business associate Chen Jihong, a veteran aluminum and alumina trader and chairman of Qingdao-based Dezheng Resources Holding Co. Ltd.
Dezheng's trading unit, Decheng Mining, is now at the center of a separate probe into the alleged duplication of warehouse receipts to obtain multiple loans secured against a single cargo of metal, according to police sources with direct knowledge of the matter.
The use of commodities as collateral to raise finance is common practice in China and is not illegal. But duplicating receipts to repeatedly mortgage the full value of an asset is fraud and could leave more than one creditor holding claims to the same collateral.
Industrial metals prices have fallen since authorities at Qingdao, the world's seventh largest port, announced the probe last week, amid concerns it could prompt Western banks to tighten controls over commodity financing.
It has also played on Western investors' fears that lifting the lid on even a seemingly isolated case of fraud may uncover more landmines lurking within China's opaque "shadow" financial system, and sent global banks and trading houses scrambling to check their exposure.
"Like anything, the more you dig, the deeper you get," said Jeremy Goldwyn, a director in charge of Asia business at commodity broker Sucden. "They have uncovered something unwittingly and to some extent it fuels the argument, held by some, that 'who knows what other problems are out there, it's all going to end in tears'... I don't think there's any evidence of that at all."
China's President Xi Jinping has launched a purge against corrupt officials after warning that endemic graft threatens the very survival of the Communist Party.
While the CCDI has revealed no details of the investigation into Xining Party boss Mao beyond a terse one-line statement on its website, such political probes are typically wide-ranging and often involve investigators trawling through the affairs of dozens of the target's business associates and allies.
That's how Chen first came to the attention of the corruption watchdog, according to six people who have done business with him.
A native of southern China's Guangdong province who has since taken Singapore citizenship, Chen has been trading metals since the 1990s, and is a well-known figure in Qingdao, a major metals hub on the eastern seaboard, according to industry sources.
His business ties to Mao were through Western Mining Co Ltd , a Shanghai-listed subsidiary of state-controlled Western Mining Group. Mao was chairman of the parent group from 2000-09, and of the listed company from 2004-09, according to its 2007 IPO documentation. Chen was an executive at Western Mining Co until 2006. One of Chen's companies, Hubei Hong Jun Investment, was also a shareholder of Western Mining Co between 2004-06.
Trading company sources and bankers who have previously dealt with Decheng said Chen has been detained by authorities since late April, having initially been investigated as part of the Mao inquiry that was unrelated to Qingdao port.
Western Mining Co did not respond to phone or email requests for comment.
Industry sources say Decheng had initially tried to keep operating as normal, but by May some Chinese banks had learned of Chen's detention and started cutting credit to the firm and asking for outstanding payments. By late May, Chinese and foreign banks and traders scrambling to check their Decheng-linked metal stocks found that single cargoes appeared to have been used for multiple financing, said a source at a bank with knowledge of the investigations in Qingdao.
Calls to Decheng Mining went unanswered, and a staff member at the firm's Qingdao office, who would only give his surname as Liu, would not comment on the police investigation or Chen's whereabouts. Calls to Chen's cellphone went to voicemail.
Singapore-registered Zhong Jun Resources, an associate company of Decheng, did not respond to a series of calls requesting comment. Chen is a director of Zhong Jun.
A woman, who said she was Chen's wife, said by phone from his home number in Singapore that she had not heard from her husband in many weeks and did not know where he was.
Decheng had imported aluminum and alumina for financing over the past decade and added copper to imports in recent years, trading sources said.
When a cargo has arrived at a bonded warehouse in China, the warehouse company typically issues a receipt as proof of the stocks. The firm can then use the receipt to obtain short-term finance from a bank, with the metal as collateral.
This has become a popular method of raising finance in China, often to skirt higher local borrowing rates and other credit restrictions, and is not illegal. The short-term funds raised might be invested in other markets, such as property, or re-lent via the regular or shadow banking system.
Two police sources said authorities were investigating whether Decheng had raised multiple loans using duplicate warehouse receipts backed by the same cargo, which, if proven, could potentially leave its creditors exposed.
Authorities have not yet disclosed the amount of metal involved in the financing probe, but sources familiar with the matter said it was about 20,000 tonnes of copper, nearly 100,000 tonnes of aluminum ingots and about 200,000 tonnes of alumina, the raw material for aluminum production. That quantity of metal would be worth about $390 million at current prices.
Spooked by default worries, around a dozen Chinese bank representatives held a meeting in Qingdao with local government officials on June 6 to discuss the situation, said an official at the local Qingdao branch of Industrial and Commercial Bank of China , who asked not to be named.
"We're not the only one with a big exposure. Quite a few other banks at the meeting said Decheng has outstanding loans of over several hundred million yuan with them," said the official, who did not attend the meeting but said members of his team did.
Two sources said the local banks decided at the meeting that they would not press charges against Decheng and would not freeze its assets.
"Decheng has a lot of physical assets, so the thinking for now is that the assets can be sold and Decheng can pay down some debt," said an industry source familiar with the situation.
It is unclear how competing claims on Decheng's assets would be resolved if any fraud were proven.
Foreign banks have said little for now while they try to assess their potential exposure. New York-based Citigroup Inc , Standard Bank Group and Standard Chartered are among the main players financing copper on behalf of clients at the port.
Standard Chartered has said it is reviewing metals financing to a small number of firms in China. Citigroup said it would work closely with relevant authorities, warehousing companies and clients in the event that its clients were affected. South Africa-based Standard Bank said it was investigating potential irregularities at Qingdao, but could not quantify losses, if any.
"All the stakeholders, including representatives from the foreign warehouses, banks and trading houses affected, held a meeting last week to get a handle of the situation," said a source at one of the Western banks. "We are still assessing our exposure because we don't know if there have been fake receipts issued."
The ICBC official in Qingdao said Decheng has defaulted on loan repayments since April and owes the bank more than 100 million yuan ($16 million) for its onshore business unrelated to metals financing at Qingdao Port. No one at ICBC's head office could be reached for comment.
Qingdao port has sealed its Dagang bonded metal storage area and suspended delivery of metals from the section after companies sought court orders to sequestrate the metal.
($1 = 6.2151 Chinese Yuan Renminbi)
(Additional reporting by Rachel Armstrong in Singapore; Writing by Alex Richardson; Editing by Ian Geoghegan)