Credit not steel, China's new use of iron ore props up demand

By Manolo Serapio Jr

SINGAPORE (Reuters) - Chinese steel mills and traders are buying more iron ore to use as collateral to secure loans, helping imports and stocks of the raw material defy expectations for a slowdown in demand by the world's biggest consumer.

The increasing use of iron ore for financing explains why China is maintaining its voracious appetite even as a slowing economy threatens to curb demand for steel.

Commodities such as copper and rubber have been commonly used for financing in China, but Beijing's tightening of lending in sectors plagued by overcapacity such as steel has made it harder to secure bank loans, spurring financing demand for iron ore, according to industry sources familiar with the practice.

Robust Chinese imports are supporting prices and underpinning expansion plans at top miners such as Vale, Rio Tinto and BHP Billiton.

But there is also a risk that Beijing could crack down on the practice and take out a big chunk of demand rapidly.

"I think some steel mills and traders could not stop importing iron ore, because once they stop, they will lose their financial support from banks," said an iron ore trader in Tianjin in northern China, a major delivery port for iron ore into the country.

China's iron ore imports reached a record 86.8 million tonnes in January, topping a previous high of 77.8 million tonnes set only two months ago.

The surge in shipments also inflated stockpiles at Chinese ports to an all-time high above 100 million tonnes, suggesting that actual domestic consumption was anything but brisk.

Steel mills have turned to Chinese state-owned enterprises for funding by pledging iron ore as collateral, said an official with a state-run iron ore trading firm based in Hangzhou.

"Steel mills come to us for financing support because we can get a loan from the bank. They give us iron ore which we give back when they pay back the money plus interest," he said.

"Our interest is a bit higher than the bank but they cannot get a bank loan themselves."

There are also traders who obtain cheap U.S. dollar-denominated loans via letters of credit overseas, import the iron ore and then sell it in the spot market.

They can invest the cash, which they only need to pay back in three to six months, in other sectors such as real estate.

The use of iron ore for financing is similar to schemes using copper, which also helped lift China's copper imports to an all-time high of 536,000 tonnes in January.

"Financing activity is definitely quite strong and the fact that there's tight credit in China has helped spur demand," said Citigroup analyst Ivan Szpakowski.

The People's Bank of China is trying to engineer a gradual rise in the cost of money to encourage firms to deleverage and discourage high-risk shadow banking activity.

RELIEF AND RISK

More financing deals may help offset a global seaborne supply surplus that Citigroup and UBS see reaching 90 million tonnes this year.

Iron ore prices, now trading above $120 a tonne, are forecast to average at a five-year low this year, according to a Reuters poll of 14 analysts in January.

"We could see some more records as the year progresses. We do expect to a see a slowdown in demand but it should still remain fairly robust," said Jeremy Platt, analyst at UK steel consultancy MEPS. He added that the bulk of the iron ore remains tied to steelmaking rather than financing.

The risks that come with financing deals also mean it is likely to be an unreliable source of import growth.

A trader in China's eastern Shandong province said he had stopped the practice because of the losses that it entailed.

"If you cannot make good use of the money within three or six months, you incur a loss plus you pay the interest rate. It's really not a good idea," he said.

Last year, some Chinese banks stopped funding smaller copper importers who use the metal in trade financing after Beijing moved to crack down on fake trades amid signs that hot money inflows have helped push the yuan to record highs.

(Editing by Ed Davies)