Chinese Soybean Defaults Reflect Underlying Weaknesses

In mid-April, news began spreading that Chinese importers were backing out of soybean purchases. Some defaulted on their contracts because the penalties and lost deposits were less than they would lose by accepting the soybeans. As usual, the situation is murky, Chinese industry leaders are blaming the foreigners and calling for more subsidies and protection from the government. But the root of the crisis lies in the immaturity of the Chinese economy:

1. Everyone makes money as long as prices go in the same direction, but everything freezes up when prices go in the opposite direction.
2. Rigidities and interest rate controls create black market arbitrage opportunities that distort markets for real commodities. 

Chinese Commerce Ministry officials have been in Shandong Province--ground zero for the crisis--talking to soybean importing companies to find out the extent of contract defaults and whether importers are being denied letters of credit.

According to the news media report, the officials found that rumors exaggerated the number of defaults, concluding only 100,000 metric tons was actually in default, not the 2 million metric tons or more rumored. Companies told the Commerce Ministry officials they are operating normally.

The Shandong Sunrise Group--China's largest soybean importer--has been at the center of the crisis. It was rumored to have defaulted on multiple cargoes with others en route lacking letters of credit, but Sunrise's chairman claims the company has not defaulted on any shipments. Sunrise claims to have a 70-billion-yuan (over $10 billion) line of credit adequate to import soybeans despite incurring big losses on them.

With prices rising at the Chicago Board of Trade, and Chinese vegetable oil and soybean meal prices down, losses on processing soybeans in China are said to be at an historic high of 300-to-500 yuan per metric ton. Importers admit they have been backing out of shipments, but more often through wash-outs or transferring the cargoes to other buyers. The Sunrise chairman claims his company sold cargoes to an American company at a loss of 100 yuan per metric ton--they would have lost 800 yuan processing them in China.

Chinese buyers had been contracting for excessive volumes of soybeans despite a depressed market. Chinese vegetable oil companies cut retail prices in 2013 and cut them again in March 2014. Demand for feed and soymeal has been down since last year and was hit again by fears of H7N9 that severely reduced demand for chicken in 2014.

The actual monthly demand for imported soybeans in China is estimated to be 5-to-5.5 million metric tons a month, but buyers had reportedly contracted for as much as 20 mmt in the first three months of 2014. On March 29, the Chinese Food and Native Product Import-Export Association called a meeting where soybean industry representatives agreed to cut back on soybean imports to reduce processing volume and eliminate excess supply. Nevertheless, imports increased in March and April and within weeks rumors of soybean defaults began circulating.

According to industry insiders, imports of soybeans were driven by profits from underground lending and one-way bets on the exchange rate that divorced soybean-importing from the actual supply and demand for the commodity. Importers got funds from a letter of credit from a commercial bank that had to be repaid in 90-to-180 days. Until the soybeans arrived, the importer would make short-term loans to other borrowers in need of cash at high interest rates. The importers also took advantage of the rise in the Chinese currency against the dollar during the period from the signing of the contract to delivery of the soybeans to make profits.

An industry insider told Company News that this was a virtually risk-free way to make money on a 60,000-metric ton cargo worth 250 million yuan, and it was widely practiced in ports in Shandong, Jiangsu and Guangdong Provinces. The Sunrise Group chairman complains that people in other lines of business piled into the soybean-importing business to make money in this way. (The Sunrise chairman himself reportedly made his stack of cash in the petrochemical business but he views himself as a bona fide soybean-processor.)

For whatever reason, the banks stopped issuing letters of credit. The conventional explanation is that they were deterred by the negative processing margins. One company representative denied that the government ordered banks to stop issuing the letters of credit. The exchange rate arbitrage was reversed when the Chinese currency began falling against the dollar this year.

A Heilongjiang soybean industry association official (nearly always quoted in soybean articles) blamed the problems on excess soybean processing capacity. The Sunrise chairman is calling for the government to give soybean importers subsidies or tax breaks and to "raise the threshold" for entry into the soybean processing industry.

The news media doesn't acknowledge it, but the excess capacity is itself a distortion created by government-directed bank lending. In 2008, officials were alarmed that multinational companies had nearly half of the country's soybean processing capacity. They launched a campaign to finance more capacity construction by state-owned companies like COFCO and Sinograin. The credit from state-owned banks created the excess capacity, depressed returns from processing soybeans, and induced operators to find other ways to earn profits. The big gap between official interest rates (paid by state-owned companies) and gray market rates created the "soybean finance" arbitrage opportunity that further divorced soybean import decisions from basic supply and demand.

The Sunrise Group chairman blames the lack of pricing power for the crisis. He laments that the Chicago Board of Trade determines the price of soybeans with no say from Chinese companies. In addition to his demand for subsidies, he recommends that Chinese authorities establish a soybean futures market in the new foreign trade zone in Shanghai as an alternative to CBOT. But doesn't China already have soybean futures trading at the Dalian commodity exchange? Didn't China start futures trading 20 years ago only to shut it down within a couple of years?

According to one report, Chinese authorities began the "temporary reserve" program to gain soybean pricing power when prices crashed in 2008. That attempt to divorce Chinese prices from the international market failed badly and is being eliminated this year.

China will never have a well-functioning commodity market as long as prices are tightly controlled with non-transparent government intervention and without timely, reliable market information. The Sunrise chairman also laments the power of USDA reports to influence the market. But Chinese statisticians don't report their soybean production  guess  estimate until a year after the soybean harvest.