China's Ghost Steel

 What this means of course is that a warehouse receipt in China is nomore than an unsecured promise to make good. None of this reallymatters too much if the Chinese banks are happy to accept suchassurances.
Just do not try to sell these securities offshore and do not eventhink of buying such paper. What is described here is doubtfulcollateral with weak legal process and assured political interferenceshould due process ever be attempted. I think that I will pass.
We already knew that a lot of Chinese industry is unconventionallyfinanced and that has been sustained through the stacking on of loansultimately supported by the central bank. Remember though that theunderlying enterprises are continuing to operate and sustain cashflow independent of debt service. I suspect that cash flow isgenerally positive though grossly insufficient to service the bankloans.
Did anyone ever think that perfectly good steel would sit still in awarehouse? Steel is working inventory and only accumulates inpreparation for a large contract and very briefly at the beginning ofa recession. Just in time manufacturing has put an end to inventorybuildup of any kind.
In the meanwhile, unconventional financing has been the norm from thebeginning and it has worked for them. Similar anomalies existed inJapan and I am sure elswhere. They are difficult to accept and oneis forced to go back to basics.
How China'sRehypothecated "Ghost" Steel Just Vaporized, And What ThisMeans For The World Economy
Submitted by TylerDurden on 09/17/2012
http://www.zerohedge.com/news/how-chinas-rehypothecated-ghost-steel-just-vaporized-and-what-means-world-economy One of the key storiesof 2011 was the revelation, courtesy of MF Global, that no assetin the financial system is "as is", and instead is merely acopy of a copy of a copy- rehypothecated up to an infinite number oftimes (if domiciled in the UK) for one simple reason: there are notenough money-good, credible assets in existence, even if there aremore than enough 'secured' liabilities that claim said assets ascollateral. And while the status quo is marching on, the Ponzi isrising, and new liabilities are created, all is well; however, thesecond the system experiences a violent deleveraging and theliabilities have to be matched to their respective assets as they areunwound, all hell breaks loose once the reality sets in that eachasset has been diluted exponentially.
Naturally, among suchassets are not only paper representations of securities, mostly stockand bond certificates held by the DTC's Cede & Co., butphysical assets, such as bars of gold held by paper ETFs such as GLDand SLV. In fact, the speculation that the physical precious metalsin circulation have been massively diluted has been a major topic ofdebate among the precious metal communities, and is the reason forthe success of such physical-based gold and silver investmentvehicles as those of Eric Sprott. Of course, the "other side"has been quite adamant that this is in no way realistic and everyounce of precious metals is accounted for. While that remains to bedisproven in the next, and final, central-planner driven marketcrash, we now know that it is not only precious metals that are onthe vaporization chopping block: when it comes to China, such simpleassets as simple steel held in inventories, apparently do notexist.
From Reuters:
Chinese banks andcompanies looking to seize steel pledged as collateral by firms thathave defaulted on loans are making an uncomfortablediscovery: the metal was never in the warehouses in the firstplace.
This means that in aneconomy in which the creation of liabilities, and pledging of assetstook place at a furious pace in the past 5 years, nobody really knowsjust what the real state of credit creation truly was. What is 100%certain is that as a result of this revelation, the GDP number of thecountry, which is and always has been a derivative of creditformation and expansion (and heaven forbid contraction), is massivelyoverrepresenting what it is in reality, and that the Chinese economyhas been expanding at a far slower pace if defined not only by thecreation of liabilities, but by matched assets. Most importantly, itmeans that every single Renminbi in circulation is impaired as acountry-wide liquidation event would see huge lossesby every creditor class. It also would mean, naturally,zero residual value left for the equity.
And just like that theChinese growth "miracle" goes poof... as does its steelfirst, and soon all other commodities (coughcoppercough) that servedas the basis of "secured" liability creation.
Reuters continues,even if the punchline is already known:
China's demand hasfaltered with the slowing economy, pushing steel prices to athree-year low and making it tough for mills and traders to keep upwith payments on the $400 billion of debt they racked up during yearsof double-digit growth.
As defaults have risenin the world's largest steel consumer, lenders have found thatwarehouse receipts for metal pledged as collateral do not always leadthem to stacks of stored metal. Chinese authorities are investigatinga number of cases in which steel documented in receipts was eithernot there, belonged to another company or had been pledged ascollateral to multiple lenders, industry sources said.
Ghost inventories areexacerbating the wider ailments of the sector in China, whichproduces around 45 percent of the world's steel and has over 200million metric tons (220.5 million tons) of excess productioncapacity. Steel is another drag on a financial system struggling withbad loans from the property sector and local governments.
"What we haveseen so far is just the tip of the iceberg," said a trader froma steel firm in Shanghai who declined to be identified as he was notauthorized to speak to the media. "The situation will get worseas poor demand, slumping prices and tight credit from banks create adomino effect on the industry."
Ultra-rehypothecation101:
Police have arrestedan employee from Baoyang Warehouse in Shanghai and are investigatingdocumentation for steel stocks that the employee issued to a tradingfirm, said an official with the surname Ou at Baoyang. Baoyang isowned by China Railway Materials Shanghai Company Limited.
The trade firm usedthe stocks more than once as collateral to obtain loans, said anexecutive at Shanghai Minlurin, another trading firm that had steelstocks in the warehouse. The receipts used were for steel wortharound 380 million yuan ($59.96 million), the executive said.
Similar cases haveprompted some trading houses to temporarily halt transactions relatedto warehouse receipts, disrupting China's steel business, traderssaid.
If the above makesreaders queasy, it should: after all rehypothecation of questionableassets is precisely what serves as the backbone of that criticalcomponent of the shadow banking system: the repo market, whereanything goes, and where those who want, can create money virtuallyout of thin air with impunity as long as nobody checks if the assetsused for liability creation are actually in the system (and with JPMas the core private sector tri-party repo entity, secondary only tothe Fed, one can see why this question has never actually arisen).
In the meantime, theentire Chinese economy is unraveling:
Banks, too, are givingless credit against warehouse receipts.
"Fake warehousereceipts have become a problem for some banks and because of this,many banks have boosted monitoring of existing stocks at warehousesand temporarily stopped accepting steel stocks as collateral forloans," said a Shanghai-based branch manager from a Chinese bankwho declined to be identified as he was not authorized to speak tothe media.
Steel mills and endusers rely heavily on trading firms to keep steel flowing fromproducers to consumers. Steel traders often buy consignments withfull payment, ensuring cash flow to the mills. End users can buysmall volumes from the traders, more convenient for them than the bigvolumes the mills sell.
Industry sourcesestimated cases that have already come to light account for about 5billion yuan ($787.50 million) of bad debt in Shanghai, one ofChina's biggest steel trading centers.
At another warehouse,a logistics unit of giant steelmaker Baosteel rented a small officeto a company called Shanghai Yiye Steel Trade Market Management CoLtd. Documents were forged stating Yiye was the owner of some of thesteel stored in the warehouse, said Wang Xueying, the spokeswoman forthe unit called Shanghai Baosteel Logistics Co Ltd.
Yiye used thedocuments in dealings with two companies, China Railway HarbinLogistics and Wuhan Iron Yitong, the spokeswoman said.
The two companies cameto the warehouse to collect the stocks only to find that Yiye did notown the materials, she said. The case is still under investigation,she added.
Nobody answeredtelephone calls to Yiye made by Reuters to request comment for thisstory. Both China Railway Harbin Logistics and Wuhan Iron Yitongdeclined to comment when contacted.
In conclusion we canonly add that we hope none of this comes as a surprise to our regularreaders: we have been warning for years that i) the inventory of theworld's credible assets is literally evaporating in absence oftechnological efficiency and CapEx spending (which is also the reasonfor the ECB's endless lowering of collateral requirements) and ii)illegal rehypothecation of assets, which infinitely dilutes claims onreal assets, can and will lead to total losses even for investors whothought they had strong collateral backing.
We now know that thishas been happening in China with the most critical component of itseconomic growth miracle: steel. We will soon discover that all otherassets: stocks, bonds, commodities (including gold and silver) andfinally cash (think deposits) have been comparably rehypothecated andcriminally commingled. The end result will be the most epic bank runin world history, which incidentally is precisely what the centralbanks are attempting desperately to delay as much as possible bygenerating excess inflation to "inflate" away the debt,leading to rematching of finite assets andvirtually infinite liabilities. Alas, in a world in whichcredit-money liabilities are in the quadrillions, and in which thereal assets are in the tens of trillions, only hyperinflation canseal the deal.
Or, in other words,lose-lose.