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.
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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.
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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.
Evidence of a crackdown on the use of copper is be growing. Qingdao - China's third-largest port - is being subjected to a government probe into stockpile financing, Reuters said this week. The probe will investigate iron ore warehouse receipts being used multiple times to raise finance by different banks at the port, Chinese reports say.
South Africa's Standard Bank Group and a part-owned unit of Louis Dreyfus warned of potential losses as a result of lower commodity prices.
Other commodities experts agree that the commodities outlook is bleak amid the more intense financing crackdown, given that China accounts for roughly 40% of world copper demand.
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"It's okay in commodities that have a good hedged market, but when you look at some of the primary import markets, such as iron ore, then it becomes a concern, because if there is a squeeze on those commodity loans then the commodity tends to get dumped," Jonathan Barratt, chief investment officer at Ayers Alliance Securities, told CNBC Asia's "Rundown" on Thursday.
Iron ore prices fell 14 percent in May and are down 32 percent year to date. Meanwhile copper prices recorded their steepest drop in seven weeks on Wednesday; Copper for July delivery, the most actively traded contract, closed down 1.4 percent at a three-week low of $3.0930 a pound.
Look out below
"We continue to expect another leg down in the copper price to $5,800 per tonne by end-Q3, from nearly $6,900 currently," said Capital Economics' Bain.
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"Meanwhile, we expect iron ore prices to end the year at $90 per tonne, only slightly lower than their current price," she added.
Ayers Alliance Securities's Barratt sees further weakness for iron ore prices.
"I generally feel that we will be going through a destocking stage. Port inventories are still at record highs, production of iron ore out of Australia is still at record highs, so I think it can only go one way. If we don't get that confidence in the economy I tend to think any rally will be sold and destocking will continue," he added.
