Three months after China launched a probe of illicit financing of imports, investigators are still trying to get to the bottom of a growing form of fraud.
In April, the China Banking Regulatory Commission (CBRC) warned banks and local officials to be on the lookout for illegal schemes to raise loans on iron ore imports.
According to the official Xinhua news agency and foreign media, some steel makers have been using letters of credit for iron ore shipments as an alternate source of funding after the government ordered state banks to rein in their loans.
The credit squeeze has been part of the government's drive to cut overcapacity in steel and other energy-intensive industries since last year, driving indebted producers into riskier financing to stay afloat.
Some have reportedly borrowed against the commodities, invoices or letters of credit to earn higher returns in the shadow banking market while unused ore piles up at China's ports due to falling demand.
Now, the schemes appear to be having an opposite effect on stockpiles of copper, aluminum and other metals that have been pledged as collateral, as banks fear that the commodities may be missing from port warehouses.
The controversy has focused on Qingdao port in eastern Shandong province, but other import points may be involved, The Wall Street Journal said in a series of reports.
Major banks suspect that duplicate invoices for cargoes were used to obtain multiple loans.
In June, bank inspectors tried and failed to gain access to port warehouses to see if imported metals listed on invoices were actually there.
On July 8, CITIC Resources Holdings Ltd. said it had filed suit against a Qingdao bonded warehouse, seeking to recover copper and alumina, a compound used in aluminum smelting, supposedly stored at the port.
The commodity trading arm of China's largest state-owned financial group said it was unable to assess potential losses pending further investigation, Reuters reported.
On July 10, Standard Bank Group Ltd. of South Africa said it had started legal action to recover U.S. $170 million (1 billion yuan) worth of aluminum at Qingdao and another U.S. $40 million (248 million yuan) worth at other Shandong warehouses.
Last month, authorities named Qingdao-based Decheng Mining Ltd. as a target of an official probe. The metals trading company and its parent Dezheng Resources Holding Co., have not commented, according to news agency reports.
On July 14, London-based Standard Chartered Plc announced a suit in Hong Kong against Decheng Mining owner Chen Jihong for U.S. $35.6 million (220.9 million yuan) plus costs in connection with a loan, Reuters reported.
The Standard Chartered suit is at least the fourth after a coal company in northern Shanxi province filed claims against Decheng Mining and Dezheng Resources in June for imported aluminum.
Several foreign lenders may be forced to declare loss provisions of over U.S. $500 million (3.1 billion yuan), The Wall Street Journal estimated initially.
"Until they open up for us to go and look at it, we don't know the extent of the damage," the Journal quoted one unnamed executive as saying.
Costs could run into the billions if importers default on loans to Chinese banks that extended credit on phantom commodities, the paper said. Possible exposure of various parties who have dealt with Decheng and its parent could reach U.S. $2.8 billion (17.3 billion yuan), Reuters said.
Last week, Bloomberg News cited two unnamed government officials, saying that Chinese banks could be exposed to losses of 20 billion yuan (U.S. $3.2 billion).
Fallout from loan ban
While the extent of the fraud is unclear, it appears to illustrate the unplanned consequences of blocking traditional loans under the government's crackdown on industrial overcapacity and enforcement problems in a high-risk lending environment.
Last July, the Ministry of Industry and Information Technology issued sweeping orders to over 1,400 companies in 19 industries, demanding that they close outmoded facilities and eliminate excess production capacity by the end of 2013.
Prime targets included major energy-consuming and high-polluting industries including steel, electrolytic aluminum, cement, and plate glass, as well as copper and lead smelting.
Compliance has been spotty, as companies cling to sinking profits and local officials fret over lost jobs.
The central government has ordered steel makers to cut 80 million metric tons of capacity by 2017 with 27 million tons of closures this year. But in April, Xinhua conceded that "things have not gone entirely to plan."
The industry has continued to pursue new projects, said China Iron and Steel Association (CISA) vice president Zhang Changfu, who called the development "worrying."
Smaller steel makers have grown desperate as prices decline and the top 10 companies reap 97 percent of industry profits. Business outside the steel sector accounted for nearly 80 percent of industry earnings last year, CISA said.
Nicholas Borst, China program manager at the Peterson Institute for International Economics in Washington, said it is no coincidence that some companies that are threatened by capacity cuts have turned to alternative financing schemes.
"This has been a lifeline for some of these overcapacity industries," Borst said. "If they're cut off from their source of finance now, they might have trouble repaying some of their loans to the formal financial system."
The repayment problem has the potential of passing the losses onto China's banks. International lenders could also grow more cautious about financing trade transactions in China if the costs of fraud spread.
Although the losses are climbing, the impact so far appears to be limited to the metals, trade finance and banking sectors.
Borst sees the damage from the metals scandal as paling in comparison with the larger risks to the financial system from the spread of wealth management products and shadow banking, which could extend to individual investors and the economy as a whole.
"I think this could definitely result in some non-performing loans, but I don't think it's big enough to have systemic implications," he said.
The growth of wealth management products has far more serious implications.
Depositors have turned in droves to the unregulated instruments, which offer higher rates of return than regulated accounts at state-owned banks.
Although the products are often marketed by back-room operations of the same banks, there has been little disclosure of risks to investors or opportunity for due diligence.
Borst said that about 15 percent of China's deposit base is now tied up in wealth management products.
"These bank-offered wealth management products have gotten very, very big," said Borst.
By the end of May, over 400 financial institutions were offering more than 50,000 wealth management products with a book balance of nearly 14 trillion yuan (U.S. $2.25 trillion), the official English-language China Daily reported.
"In my mind, that's a level where you have a significant systemic risk," Borst said.
On July 11, the CBRC issued a circular requiring banks to notify clients that the investments are not guaranteed, China Daily said.
"Wealth management products are not deposits. This product involves risks, and investors are advised to be cautious when making investment decisions," said the CBRC.