Bad elements

Copper and iron ore roil China capital controls

Copper and iron ore prices are falling, and the reason is China. The economy is not responsible for much of the nine per cent drop in both commodities over less than a week. China's capital controls deserve more of the blame. Rather than deflecting market swings, as they are supposed to, they have probably exacerbated them.

Industrial materials have become speculative tools. Specifically, phony copper trades can be used to exploit China's relatively high domestic interest rates and, until very recently, the strengthening currency.

The trick is to get foreign money into China. In its simplest form, an importer buys copper from outside of China, paying with a letter of credit from a bank. It then resells the copper to another, often related, offshore company for cash. Presto: a trade flow is created, and money can cross the border into China where it can be invested at relatively high interest rates, until the copper is sold back to its original owner.

Iron ore is harder to play with - it's bulkier and dirtier for one. But it's also tangible and useful, so banks lend against it. Iron ore imports grew 21 percent in January and February, even though steel production is declining year on year. So much for producers' claims that iron is the least speculative of commodities.

As yet, falling prices probably reflect fears those trades will unwind, rather than a massive actual unwinding. But the trick looks harder to pull off, now that China's currency is more volatile and its market interest rates have fallen. Also, it will be harder to unload metal in China, as real demand looks shaky.

If metal prices fall far enough, a wave of genuine selling could start up, pushing prices even further down. The result, cheaper iron and copper, would be good for China's economy in the long run but bad for the long chains of lenders who have metal as collateral, knowingly or not. Capital controls were supposed to protect China's economy from one kind of bad element, speculators. Instead, speculative behaviour has just taken a more devious form.