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China and Copper—A Dangerous Carry Trade

What would you do if you were a property developer or businessperson in China and needed to borrow money—but because loan demand was so strong and the government so concerned with easy credit, that normal financing was unavailable?

According to Michael Pettis, these cash strapped business folk in China got incredibly creative with copper as their unwitting accomplice.

Before I exchanged emails with Pettis, I wanted to know if he was credible. His credentials put any concern to rest: he is a Senior Associate at the Carnegie Endowment for International Peace’s Asia Program and a finance professor at Peking University’s Guanghua School of Management as well as a former member of the faculty at Columbia University’s Business School.

Copper Tubing
Macduff Everton | Iconica | Getty Images
Copper Tubing

And since he lives in China, he is in the middle of it all.

Here’s how this pervasive scheme works: The trader/businessman buys copper using a 180-day letter of credit, which is extremely cheap financing. They then turn around and use the copper, which is being stored in a bonded warehouse in China, as collateral for a bank loan at rates much lower than the typical 10-20%.

Conclusion: Chinese demand for copper has been significantly inflated by its use as a financing mechanism. In fact, one legitimate source estimates that these warehouse stashes are equivalent to 11% of refined copper consumption and up to 40% of demand—perhaps as much as 700,000 metric tons according to some estimates.

Chinese banks love these transactions because they are apparently off-balance sheet and the loan officer gets a commission. (Sound familiar? Think 2008.)

Here’s where it got bearish for copper.

Sometime around April, the government got wind of these technically legal transactions and tightened the rules that led to demand falling and copper coming back on the market, suppressing prices as other commodities rose.

Pettis is unsure how effective the new regulations are but in commodity markets, you don’t need much change to drive prices—up or down.

Bottom line: We can never know with certainty when commodity demand is real, speculative or just a function of a creative mind.

* Stephen Weiss is partner at Short Hills Capital and author of The Billion Dollar Mistake, Learning the Art of Investing Through the Missteps of Legendary Investors.

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Trader disclosure: On May 16, 2011, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders; Stephen Weiss is short (X). Stephen Weiss owns (DVN), (COP), (QCOM), (BRCM), (TEVA), (KO), (RIG), (HK), (AKAM), (UUP), (DE), (UAL), (MRK), (HBAN), (KEY) and (JPM); Terranova owns (VRTS); Terranova owns (AAPL); Terranova owns (JPM); Terranova owns (V); Terranova owns (BX); Terranova owns (UPL); Terranova owns (BAX); Terranova owns (PFE); Terranova owns (PEP); Terranova owns (MCD); Terranova owns (TM); Terranova owns (DIS); Terranova owns (BJ); Terranova owns (APA); Terranova owns (OXY); Terranova owns (XOM); Adami owns (AGU); Adami owns (C); Adami owns (GS); Adami owns (MSFT); Adami owns (NUE); Adami owns (BTU); Karabell owns (RIMM); Karabell owns (SLV); Karabell owns (AAPL); Karabell owns (GE); Karabell owns (GOOG)

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