Is structured commodity finance a hidden bubble?

Commodity markets focus on bringing commodities from their place of origin to the centres of demand in the most efficient manner. Banks, trade houses, consumers and producers all aim to bring efficiency to this flow, but there is always room for improvement.

Structured finance, the activity of lending against inventory held as collateral, focuses on ameliorating and streamlining two aspects of the commodity business – cash flow and flow of goods.

Structured finance has usually been the forte of large financial institutions, but recently commodities trading firms have entered this business. This has resulted in excess lending capacity, which has led to lower costs of capital for borrowers.

These structured transactions help borrowing firms when commodity prices are rising, but they also lead to the lending firms overextending their balance sheets. A sudden contraction in lending can stop the commodity trade cycle, forcing sales of inventory to generate cash, causing commodity prices to drop below long run equilibrium prices.

A prime example in the recent past was the collapse of copper prices in the global markets led by demonetisation of commodity financing deals in China. I will explain this mechanism from the context of producers and consumers. Let us consider Brazil and China as examples. Brazil is a large producer of commodities such as iron ore and soyabeans, while China is a large consumer of both these commodities.

A structured lending program (an expansionary commodity policy) in China incentivises firms to consume more of these commodities (as the structured lending rates are lower than market rates). This mechanism leads to a situation where inventories are built beyond the necessary optimal stock level.

Thus, in a rising commodity price market, the lending institution is over collateralised and is incentivised to lend more, extending its balance sheet. But once the commodity price falls, these lending institutions are under pressure to unwind these deals as quickly as possible by liquidating the inventories leading to a downward spiral.

Brazilian producers are lent money by institutions against collateral of the goods they produce.

Again, in the case of the rising market, this fares well as producers are able to lock in greater gross margins and the lending institutions are able to take on collateral that is undervalued. This incentivises the lender to lend more and the borrower to borrow more, as return on capital for both sides increases with increasing commodity prices.

Now, let us focus on a sudden contraction in lending to consumer firms in China (initiated by change in regulations or contraction of balance sheets) and how that affects the commodity markets. A withdrawal of lending to consumer firms in China signals lower demand, and often, liquidation of prior collateralised inventories.

Once these inventories are liquidated by lenders, underlying commodity prices fall initiating more liquidation as lending institutions race to protect the existing commodity assets on their balance sheets. This leads to a spiralling liquidation by those institutions that have monetised the producer assets in Brazil as well, leading to these producers losing valuation. Thus, markets collapse not purely because of supply and demand but because of structured finance mechanisms that were well intended but went wrong.

I believe we are at the helm of these upheavals in the commodity markets. We have seen an expansionary phase led by growth of money supply in the world in the last five years. This has created an excess lending capacity. We need to see a correction, so that supply of credit better matches the demand for goods.

Until such equilibrium is attained, we will witness volatility in these commodity markets, and the originators of the structured commodity transactions will need to hedge against this volatility in order to protect their balance sheets.

COMMENT NOW