Research on the impact of the China (Shanghai) Pilot Free Trade Zone on the Chinese base metal commodity market. Name of Student: Jean Reinders

Transcription

1 BERLIN SCHOOL OF ECONOMICS AND LAW Institute of Management Berlin (IMB) Research on the impact of the China (Shanghai) Pilot Free Trade Zone on the Chinese base metal commodity market Name of Student: Jean Reinders Matr. No.: Master s Thesis Submitted in partial fulfilment for the degree of "Master of Arts" Supervisor: Prof. Dr. Hansjörg Herr Prof. Dr. Yan Dong Date: June 2014

2 2

3 Acknowledgement and foreword The master thesis is inspired by my deep interest in the worldwide commodity markets and my goal to set up my career in the metal commodity business. The commodity metal markets are constantly influenced by many factors and China is a big and important factor in these markets. Last year I experienced the introduction of the China Shanghai Pilot Free Trade Zone and I got very curious about this zone, which has similar characteristics with the Special Economic Zones of Deng Xiaoping of the late 70 s. But besides we learned about the zone during the lectures of the CEEBS programme, I really wanted to know how the zone will change a market such as the metal commodity market and what influences such a zone would have on commodity trading companies. Doing research and writing the thesis improved my knowledge about the commodity markets and taught me much about macro- economic research and fundamental analysis. Furthermore, through conducting the interviews I got the rare possibility of getting an inside view of a commodity trading company and I also had the experience of visiting a metal warehouse. I would like to thank the interviewees for their time, help and openness and I also would like to thank the supervisors prof. Dong and prof. Herr of the MA Chinese and European Economics and Business Studies programme who helped me along the research. 3

4

5 Abstract- Chinese Version 中 国 经 济 高 速 发 展 的 表 现 之 一 是 经 济 大 宗 商 品 消 费 需 求 的 急 剧 上 升, 其 中 对 基 础 金 属 需 求 的 上 升 速 度 尤 为 明 显 在 2013 年, 中 国 政 府 建 立 了 上 海 自 由 贸 易 试 验 区, 其 目 的 是 规 划 出 一 片 区 域 作 为 试 点, 积 累 经 验 以 适 用 于 国 内 其 它 地 区, 为 进 一 步 的 经 济 发 展 和 转 型 做 铺 垫 目 前 来 看, 中 国 经 济 正 逐 步 由 以 出 口 为 导 向 转 变 为 高 附 加 值 产 业 为 主 的 增 长 模 式, 其 中 服 务 业 ( 第 三 产 业 ) 扮 演 了 重 要 角 色, 成 为 拉 动 内 需 的 增 长 的 新 力 量 自 贸 区 的 建 立, 涵 盖 了 金 融 业 管 理 制 度 以 及 贸 易 等 领 域 的 改 革, 是 中 国 政 府 经 济 改 革 的 信 号, 其 目 的 是 吸 引 外 商, 将 自 贸 区 建 立 成 为 全 球 重 要 的 大 宗 商 品 交 易 市 场 之 一, 越 来 越 多 的 机 会 和 改 变 将 会 呈 现, 尤 其 对 于 从 事 大 宗 商 品 交 易 的 企 业 自 贸 区 的 改 革 还 在 进 行 之 中, 详 细 的 改 革 方 案 还 未 披 露 但 是 金 属 行 业 公 司 已 经 积 极 准 备 希 望 于 改 革 方 案 会 带 来 改 变 和 新 的 机 遇, 尤 其 是 中 国 基 础 金 属 交 易 市 场 存 在 问 题 的 纠 正. 本 文 主 要 研 究 中 国 基 础 金 属 交 易 市 场 中 存 在 的 问 题, 以 及 上 海 自 由 贸 易 区 对 于 中 国 基 础 金 属 市 场 的 影 响 其 中 基 础 金 属 主 要 指 有 色 金 属, 例 如 铜 铝 镍 锌 铅 和 锡 从 自 贸 区 的 建 立 初 始, 关 于 建 立 更 加 有 效 的 大 宗 商 品 交 易 市 场 的 呼 声 就 不 绝 于 耳, 相 关 监 管 机 构 对 此 非 常 的 慎 重 证 监 会 (CSRC) 在 新 规 的 制 定 中, 对 于 新 增 期 货 商 品 以 及 引 导 中 外 投 资 者 在 大 宗 商 品 交 易 市 场 投 资 更 是 谨 慎 中 国 大 宗 商 品 交 易 市 场 初 期 发 展 非 常 迅 速, 然 而 由 于 监 管 的 问 题, 导 致 九 十 年 代 发 生 了 几 起 过 度 投 机 事 件, 其 中 1995 年 至 1998 年 间 发 生 的 几 起 事 件 很 大 程 度 上 影 响 了 中 国 大 宗 商 品 交 易 市 场 的 发 展, 例 如 著 名 的 9407 事 件 1

6 基 础 金 属 全 球 价 格 波 动 较 大, 极 易 受 到 多 重 因 的 影 响 对 中 国 来 说, 作 为 主 要 的 进 口 国 之 一, 在 基 础 金 属 交 易 过 程 中 扮 演 了 极 其 重 要 的 角 色 如 果 中 国 宏 观 调 控 能 够 稳 定 基 础 金 属 需 求 的 波 动, 那 么 基 础 金 属 价 格 将 会 趋 于 稳 定 这 一 情 况 的 前 提 条 件 是, 中 国 能 够 允 许 更 灵 活 的 汇 率 制 度 以 及 加 快 利 率 市 场 化 进 程 目 前, 中 国 有 三 个 大 宗 商 品 交 易 市 场 其 中 之 一 是 上 海 期 货 交 易 所, 多 种 不 同 的 金 属 均 可 在 此 进 行 交 易 中 国 是 较 大 的 基 础 金 属 进 口 国, 在 交 易 市 场 中 扮 演 了 重 要 角 色,2013 年 占 据 了 全 球 46% 的 基 础 金 属 消 费 总 额 虽 然 如 此, 中 国 基 础 金 属 交 易 市 场 的 发 展 依 旧 任 重 道 远, 许 多 问 题 急 需 解 决 总 体 来 说, 无 论 是 前 期 文 献 综 述 还 是 相 关 学 者 采 访 情 况, 上 海 自 贸 区 的 建 立 对 于 中 国 大 宗 商 品 交 易 市 场 将 会 有 三 方 面 的 影 响 首 先, 中 国 政 府 的 资 本 管 制 将 会 带 来 创 新 性 的 金 融 交 易 : 中 国 企 业 的 商 品 金 融 交 易 会 得 到 更 高 的 信 用 保 证 例 如 中 国 企 业 用 铜 作 为 抵 押 品 加 入 到 金 融 交 易 之 中, 将 会 拉 高 基 础 金 属 交 易 的 需 求 量, 却 并 不 是 实 际 经 济 需 求 的 反 应 这 一 情 况 的 出 现 将 会 有 多 种 套 利 机 会 和 问 题 : 其 一 是 伦 敦 金 属 交 易 所 同 上 海 自 贸 区 存 在 的 市 场 间 套 利 机 会, 利 率 及 货 币 的 套 利 潜 在 可 能 性 将 会 在 中 国 大 宗 商 品 交 易 市 场 中 的 金 融 交 易 中 体 现 出 来 金 属 交 易 的 套 机 会 是 买 卖 过 程 中 价 差 引 起 的, 根 据 对 相 关 专 家 的 访 问 反 馈, 套 利 只 是 数 种 在 中 国 金 属 交 易 市 场 赚 取 利 润 的 方 式 之 一, 却 是 主 要 的 获 利 手 段 同 时, 人 民 币 对 美 元 的 汇 率 优 势, 加 之 中 国 金 融 市 场 的 资 本 管 制 制 度, 利 率 套 利 机 会 同 样 存 在 中 国 企 业 在 此 背 景 下, 会 获 得 更 多 利 率 套 利 机 会 以 及 外 国 资 本 的 资 助 其 二 是 中 国 商 品 交 市 场 的 仓 储 问 题 仓 储 问 题 是 基 本 金 属 交 易 中 主 要 的 环 节, 但 是 企 业 通 过 延 长 仓 储 时 间 在 大 宗 商 品 交 易 市 场 中 获 利 的 方 式 引 起 了 许 多 问 题 伦 敦 金 属 交 易 所 宣 布 了 关 于 仓 2

7 储 的 新 规 定, 中 国 也 颁 布 了 数 条 关 于 此 问 题 的 条 例, 但 是 同 伦 敦 金 属 交 易 所 没 有 交 集 这 一 问 题 的 出 现, 中 国 方 面 的 交 易 者 将 会 在 伦 敦 获 得 许 多 获 利 机 会 另 外, 中 方 允 许 投 资 者 在 境 外 期 货 市 场 中 投 资, 却 将 外 资 在 中 国 期 货 交 易 市 场 的 大 门 紧 闭 原 因 在 于, 中 国 目 前 在 金 属 价 格 定 价 中 处 于 劣 势, 为 了 影 响 基 础 金 属 的 价 格, 其 中 一 个 方 式 便 是 合 理 的 运 用 本 国 的 期 货 交 易 市 场 上 海 期 货 交 易 市 场 应 该 对 外 国 投 资 者 以 及 机 构 投 资 者 开 放, 这 一 情 况 的 发 生 可 以 在 上 海 自 贸 区 中 试 点 第 一 步 是 建 立 原 油 交 易 平 台, 并 对 外 国 投 资 者 开 放 更 重 要 的 是, 随 着 资 本 管 制 的 放 松, 对 于 大 宗 商 品 金 融 交 易 的 依 赖 可 以 降 低, 中 国 公 司 不 再 依 靠 大 宗 商 品 金 融 交 易 获 取 更 多 的 信 用 虽 然 目 前 没 有 允 许 伦 敦 金 属 交 易 所 在 区 内 建 立 仓 储, 但 是 未 来 存 在 改 变 的 可 能 性 上 海 自 贸 区 的 建 立 对 于 大 宗 商 品 交 易 市 场 有 着 重 要 的 意 义, 最 重 要 的 是 其 改 善 了 中 国 的 金 融 环 境, 对 于 大 宗 商 品 交 易 商 来 许 多 帮 助 上 海 自 贸 区 的 优 势 和 机 遇 并 存, 许 多 大 型 企 业 已 经 开 始 进 驻 试 验 区, 例 如 铜 陵 有 色 金 属 集 团 控 股 公 司 以 及 金 川 集 团 有 限 公 司 ( 大 型 金 属 制 造 商 ) 关 键 词 : 基 本 金 属 上 海 自 贸 区 套 利 上 海 期 货 交 易 所 3

8

9 Abstract English Version As a result of its economic growth, China experienced an amazing growth in commodities consumption. The demand for base metals increased in a sharp pace. Last year, to further develop its economy, China created a test zone for the rest of the country, the China Shanghai pilot Free Trade Zone (CSPFTZ). The new trade zone possibly has several changes for the Chinese base metal market. In this thesis, research has been done about the current problems in the Chinese base metal markets and the effects of the CSPFTZ on these Chinese base metal markets. In the thesis is been focused on the non-ferrous base metal markets, such as copper, aluminium, nickel, zinc, lead and tin. Since the opening up of the Chinese economy, the Chinese commodity market developed always with much involvement of the regulatory institutions to create effective commodity markets. The China Securities Regulatory Commission (CSRC) still acts careful in implementing new regulations, adding new futures products and let Chinese and foreigners respectively invest in foreign and Chinese futures markets. The commodity market developed very fast and in the 90 s this resulted in several cases of over- speculation of the market. China has now three commodity exchanges and one of them is the Shanghai Futures Exchange (SHFE) where different metal contracts can be traded. China is nowadays an important player in the base metal markets. China accounted last year for 46% of the world s base metal consumption. However, there are still several problems in the Chinese base metal markets. At first, the capital controls of the Chinese government resulted in creative financial deals; Chinese commodity financial deals by Chinese companies in order to get credit. And they use base metals, such as copper as collateral for these financial deals. This causes a higher demand for base metal contracts, which is not a reflection of the real economic demand. And there are arbitrage possibilities in several ways: physical arbitrage between the London Metal Exchange (LME) and the SHFE and interest and currency arbitrage possibilities through the commodity financial deals. Another problem is the warehousing. For several years, the London Metal Exchange (LME) tries to put foot in China. The entry of LME warehouses in China would open many opportunities for Chinese participants of the market. 1

10 In addition, Chinese people are in general not allowed to invest in foreign futures markets and foreigners are not allowed to invest in the Chinese futures markets, as is stated in the Qualified Foreign Institutional Investors regulations (QFII). Because China is not the price maker at the moment, it wants more influence on the prices of base metals. To solve this problem, China could develop the SHFE and allow it to open up its doors for foreign investors and institutions. A first step is being made by setting up the oil trading platform in the zone which will be open for foreigners as well. Furthermore, the CSPFTZ plans to change the capital controls in the zone which could lead to changes in the metal market, because there is no more need for commodity financial deals when Chinese firms could easier get credit. Moreover, it originally was the plan to allow the LME to set up warehouses in the zone, but this plan has now been cancelled by the authorities, however this could change in the near future. The CSPFTZ is important for the commodity market because it improves the financial environment in China and it plans to help commodity market participants in several ways. Keywords: China (Shanghai) Pilot Free Trade Zone, base metals, arbitrage, Shanghai Futures Exchange(SHFE) 2

11 Table of Contents Acknowledgement and foreword... 3 Abstract- Chinese Version... 1 Abstract English Version... 1 Table of Contents... 1 Figures and Tables... 4 Abbreviations Introduction Problem definition Research Question Motivation and research gap Methodology and research approach Commodity market indicators The base metal commodity market What are the base metals? Base metal commodity market terminology Futures, options and other products in the metal markets Base metal commodity market participants Commodity exchanges, clearing and warehousing in the base metal markets Pricing, demand and supply of base metals Theory of Storage, Contango and Backwardation The current global base metal market The Chinese base metals commodity market The role of the government in the development of the commodity markets in China

12 3.1.1 The Chinese development compared with other countries Regulations in the Chinese base metal commodity market China in the global metal market Shanghai Metal Exchange and the other exchanges A comparison between the SHFE and the LME Macro- economic policies Influence of the Chinese monetary policy on metal prices Challenges in the Chinese base metal market How metal commodity firms in China make profit Arbitrage in the base metal market Transit Trading The problem of LME warehouses and the warehouses in China The capital control problem China s commodity financial deals in focus QFII limits foreign participation in the futures market China s shifting economy The China (Shanghai) Pilot Free Trade Zone The purpose of the China (Shanghai) Pilot Free Trade Zone The CSPFTZ compared with the Special Economic Zones Comparison with zones of other countries What details of the CSFTZ concern the base metal commodity market? Capital controls in the China (Shanghai) pilot Free Trade Zone Warehouses in the China (Shanghai) pilot Free Trade Zone The China (Shanghai) Pilot Free Trade Zone and its opportunities and changes for the base metal market LME warehousing Capital controls Changes in QFII and more consequences Conclusion Bibliography

13 Appendix 1. Interviews

14 Figures and Tables Figure 1: Futures price of a contract due in one year Figure 2: Industrial metal prices changes in 2013 Figure 3: Consumption of selected base metals Figure 4: Chinese trading volume on commodity exchanges Figure 5: Chart of a Chinese copper Financial Deal Figure 6: China (Shanghai) Pilot Free trade Zone Table 1: Commodity Market indicators Table 2: Commodity exchanges in China and its traded products Abbreviations CSPFTZ LME QFII SHFE ZCE DCE China (Shanghai) Pilot Free Trade Zone London Metal Exchange Qualified Foreign Institutional Investor Shanghai Futures Exchange Zhengzhou Commodity Exchange Dalian Commodity Exchange 4

15 1. Introduction Last year on the 29th of September 2013, the China (Shanghai) Pilot Free Trade Zone (CSPFTZ) was created in Shanghai by the Chinese government. With the creation of the zone, China sends out a strong signal to the rest of the world. The Chinese economy is transforming from an export-led economic model towards a higher value-added industry, based on services and driven by domestic demand in which service sectors play an important role. With the creation of the zone China wants to set out a reform which covers finance, regulation and commerce. And it is no surprise that the zone was created in Shanghai, the most important place for commodities trading in China and a city in the possession of the Shanghai Futures Exchange, where everyday metals are traded. Metals are a commodity group. And a commodity is a primary resource or a basic good, which is expressed in quantity and has minimum quality standards. There is always demand for commodities. When Karl Marx writes about commodities, he describes it as an external object, a thing which through its qualities satisfies human needs of whatever kind (Marx,1990). Examples of commodities are oil, copper, gas, iron ore, coffee, corn and many others. Commodities help to satisfy the basic needs of human people; food, building materials and energy. According to Marx a commodity has two values, a use-value and an exchange-value. The usevalue is the value of how useful the commodity is to fulfil the human needs and it can be defined in use or consumption. Besides a commodity having use-value, it also has exchange value. The exchange value is the quantity of other commodities that one would exchange for it. Therefore all commodities could be exchanged in return for an amount of other commodities. Most commodities are fungible, which means they are interchangeable with other commodities of the same type. Wherever the commodity comes from, it is worth the same quantity. Nowadays in the commodity markets, the exchange value is important and two different commodities can be traded because both commodities are equated to a 5

16 third universal commodity. The function of the third universal commodity is nowadays fulfilled by money. Most commodities can be categorized into three groups: metal commodities, agricultural commodities and energy commodities. Metal commodities are commodities such as gold, copper, zinc and nickel. Metal commodities are often used in manufacturing, electronics and jewellery. Agricultural commodities are wheat, sugar, grains, cocoa, coffee, soybeans and more. Energy commodities consist of gas, oil and coal among others. Some type of commodities cannot be categorized into one of the three groups. In the last decades China developed into a powerful and remarkable player in the commodity markets; agricultural, energy and metal commodities. Indeed, China is an important factor in the commodity markets, but still dependent on the commodity resources of other countries. And the Chinese commodity markets still experience many restrictions for both domestic firms and foreign firms. The Middle Kingdom imports a huge amount of base metals, such as copper, aluminium and nickel through its ports, like the Yangshan Deep See port in Shanghai, which is part of the CSPFTZ. China has much influence on the metal markets and its pricing mechanism, but it is not the price maker. Prices in the base metal market are very volatile and are influenced by many factors from all over the world. China as a huge importer of base metals is very important in the base metals trade processes. It is expected that China s demand for base metals will continue to increase in the future and an efficient base metal market is in China s own interest. If China want to transform and develop its economy, it is vital that it can do that with good functioning base metal markets, so it can widely predict prices that reflect the real demand and supply of the market and which are affordable for its buyers. A good functioning base metal market is important for many participants and sectors. With the CSPFTZ China tries to open up its service sectors and further develop its financial industries. One goal of the CSPFTZ is to develop the Chinese commodity markets. The metal market in China is still experiencing several problems. The zone wants to attract players of the commodity markets to the zone, which is constructed as a primary international commodities trading zone. With the creation of the zone, there will possibly new opportunities and changes appear for commodity trading companies. 6

17 In this thesis research will be done about the Chinese commodity markets, with a focus on the non-ferrous base metal markets, which are very complicated markets. The Chinese economic structure is heavily dependent on metals. In China, most of the base metals are traded in Shanghai; where the Shanghai Futures Exchange and the new created zone are created. Therefore, this thesis will show the effects and influence of the China (Shanghai) Pilot Free Trade Zone in the Chinese base metal commodity markets. 1.1 Problem definition When The China Shanghai pilot Free Trade Zone (herein after called: CSPFTZ) was announced it created many expectations in the global commodity market. The new zone could be beneficial for the commodity market. China is still in the phase of developing its commodity markets and exchanges and the metal markets in China are still experiencing difficulties and problems, not only because of the Chinese authorities. With the CSPFTZ, the Chinese government want to further open up the financial service sectors and part of the attention is mentioned towards the commodity markets. The CSPFTZ is created this year and much of the plan is not implemented yet, however; many metal industry participants are eager to hear about new changes and opportunities in the zone and whether it could solve their problems in the Chinese base metal commodity market. 1.2 Research Question What impact will the China (Shanghai) Pilot Free Trade Zone have on the Chinese base metals commodity market? The thesis will largely relate to the Chinese commodity market and the non-ferrous base metal markets in particular. As such, much of the thesis will be based on conducted interviews and existing research and information about the Chinese metal markets. There will be a special focus on the CSPFTZ in relation to the base metal market. Because deeper knowledge about commodity markets, China and the China Shanghai pilot Free Trade Zone is necessary, the research consists of 4 sub questions. With these sub questions in mind the research will be leading to the knowledge necessary to answer the research question. 7

18 1. What are the basics of commodity markets? 2. How did China develop its commodity market and what outcome has it on today s market? 3. How do the Chinese base metal markets look like nowadays and what are its difficulties? 4. Why is the China Shanghai pilot Free Trade Zone created and why is it important for the commodity markets? 1.3 Motivation and research gap Studying the dual CEEBS master s programme has given me great insight about the Chinese economy and after the Chinese government created the CSPFTZ I was curious about the influences on the Chinese commodity markets. Through the years I learned how important China is in the metal markets. The plan of the zone stated possible changes for the commodity industry and I also learned that China wants to create a commodity hub in Shanghai, exactly the place of the zone. Having the goal to pursue my career in the commodity sector and my deep curiosity in the development of the CSPFTZ and its influence on the commodity markets are important drives to do this research. Doing this research about the impact of the CSPFTZ on the base metal commodity markets in China I combine two fields of interest: Chinese economics& business and the commodity markets. Furthermore, I wanted to write about a new topic and something that could be valuable for commodity trading companies. As the new zone is just implemented months ago, it is still unknown what will change in the base metal commodity market and how it could help or threat commodity trading firms. This also functions as the research gap for writing the thesis. 1.4 Methodology and research approach The thesis is the last part of the Chinese and European Economics and Business dual master s programme and therefore a lot of the thesis content is in addition to commodities, about macro- economics, international trade relations and Chinese economics. The research approach will include qualitative data research. Secondary data will be analysed first through the university library using several sources such as the EBSCO system, academic and commercial abstracts and bibliographic databases. Also 8

19 primary research will be done by conducting interviews with base metal commodity trading companies and other market participants. I will connect my own primary research and analyse broader themes and analyses of already existing literature. At first will be looked into the basics of commodities and commodity markets in chapter 1, after that will be continued with the development of the Chinese commodity markets. Than to answer sub-question 3 and 4, research will be done and interviews will be conducted about the CSPFTZ, the Chinese base metal market and the challenges within it. The next chapters are constructed through economics and further literature reviews. The last step is to analyse what will change for the base metal commodity markets after the implementation of the CSPFTZ. 1.5 Commodity market indicators Commodity markets and its prices are influenced by many different indicators. The indicators are technical indicators or fundamental indicators (Frush,2008). The commodity market participants can do respectively technical and fundamental analysis to research the market, trends and prices. The fundamental indicators are macroeconomic and connected with supply and demand. The technical indicators are more connected with prices and changes in prices. In the next table several indicators are mentioned, however more indicators exist. In this thesis, research will be done about the fundamental indicators instead of the technical indicators. The CSPFTZ could be fundamental indicator for changes in the base metal market. Table 1. Commodity Market indicators Fundamental indicators Gross domestic product Exchange rates Oil Purchasing Managers Index Commodity indexes Rates Technical indicators Trend lines Averages Prices Volumes Support& resistance 9

20 2 The base metal commodity market Because the thesis will explain the influence of the CSPFTZ on the Chinese base metal markets, there is first some general understanding of commodity markets and the metal markets in particular provided. Metals can be separated in three different groups; the base or industrial metals, precious metals and rare metals. Precious metals are valuable metals that have a very high melting point, such as silver, gold, platinum and palladium. The scarce rare metals are metals like lanthanum and cerium which we need for devices such as phones, memory chips and military equipment. This thesis will not focus on the precious and rare metals, but on the (non-ferrous) base or industrial metals. The base metals are metals that corrode or oxidize easy compared to the precious metals and rare metals. The base metals are copper, nickel, aluminium, zinc, lead, tin and iron. The base metals are used in all kind of manufacturing, construction and production activities and products. As an investor or trader you can engage with metals by investing in companies who produce metals or trade in futures, options or other related products. 2.1 What are the base metals? To get a better understanding of the base metal markets, some basic information about the characteristics of the base metals will be given. At first, a metal that is used a lot, iron ore. Iron is important in the production of steel. Iron ore is unlike most of the other base metals, a ferrous metal and cheaper than the other metals. Until recently, iron ore was one of the few metals which were not tradable on exchanges. One problem is that iron is available in plenty different kind of quality standards and it is difficult to set a standard that is tradable. Because iron ore markets are very different than the other base metals; the thesis will mainly focus on the non-ferrous metals, such as copper, aluminium, zinc, nickel and tin. Aluminium is important in the industrial world, for example the car and airplane industry. The production process of aluminium is cost and energy demanding. Energy prices have therefore also influence on the prices of aluminium. Compared with iron ore, aluminium is a heavily tradable metal and can be traded on many exchanges such as the LME and the NYMEX. 10

21 Also copper is an important metal in a wide range of industries such as the construction industry, electrics and transportation industry. The price of copper is influenced by many macroeconomic indicators. Copper is produced mostly in Chile and other South American nations. Copper can also be traded on several metal exchanges. At fourth, the base metal zinc. Zinc is mainly used to avoid steel from corroding and to protect other metals. Zinc is also produced in China and can be traded on several metal exchanges included the Shanghai Futures Exchange (SHFE). Furthermore, we consume a metal named tin. Tin is produced in many countries including South East Asian countries and it is used in many applications and as a metal that can protect other metals. Another base metal is lead, which is heavy, soft and a metal that can t corrode. Lead is used in many products, such as batteries. Both tin and lead can be traded on several exchanges. At last, the metal nickel that also can t corrode and it is used mainly in the production of steel. It can be traded on the LME and prices are also influences by the worldwide demand of steel. 2.2 Base metal commodity market terminology Many base metals are traded on the commodity market. The commodity market is a very volatile market. The volatility of a market shows how much and how fast the value alters. Commodities are bought and sold strictly on their prices. For a long time, the commodity markets have been volatile, because many commodity markets are tight and demand inelastic. The commodity markets are demand inelastic, which means that a change in the price of a certain commodity has not much influence on the demand of that commodity. Commodities are primary resources and are essential to the consumers. Even if prices increase, consumers will demand commodities. The volatility of the commodity market is responsible for the risk and the profit for the participant active on the market. Nowadays, commodity products, such as derivatives are available for much more investors. Also information about prices, supply and demand is more accurate and quickly available. The prices in the commodity market are very volatile and raised the question whether financialization of the market was the reason for the volatile commodity prices. Financialization is the growing influence of the finance industry in the economy: financialization is understood to mean the vastly expanded role of financial motives, financial markets, financial 11

22 actors and financial institutions in the operation of domestic and international economies, and in this case, the in-creasing role in commodities markets (Falkowski,2011).The financial institutions increase the commodity prices to such a level where the commodity price is no longer the real price of the commodity. Nicolas Sarkozy and Gordon Brown among others argue that the financialization and speculation has led to growing commodity prices and a bubble in the oil prices in 2007 and 2008 (Cheng and Xiong, 2013). However, many economists like Krugman disagree and explain that speculators and financialization are not the cause for the high volatility of the commodity prices (Cheng and Xiong 2013). Nowadays the base metal commodity markets contain of two connected markets, the physical market and the financial market (Ellefsen, 2010). The physical market, cash market or the spot market consists of the market players who sell or deliver the commodity in question. On the financial commodity market, the participant deals in derivative contracts (Ellefsen, 2010). The derivatives market is much bigger than the actual physical market. The volumes of the exchange-traded derivatives are now 20 to 30 times greater than the physical consumption of the commodities (UNCTAD. 2012). The derivative contracts are used to deal with the risks and businesses of the commodity investors, consumers and producers. Commodities are in this situation the underlining asset of a derivative. A derivative is a contract between the seller and the buyer which value depends on the underlying asset, in this case a commodity. The contract points out how much the commodity will change over a specific period. The purpose of the derivative is to hedge risk or to speculate. The derivative contracts appear as spot, options, futures and forwards Futures, options and other products in the metal markets Futures contracts on agricultural commodities on the commodity exchanges were first introduced in 1848, by the Chicago Board of Trade. A futures contract is a standard contract in which two different parties today agree to buy and sell a certain quality and quantity of a commodity for a certain price in the future. Also the payment and delivery is agreed in the contract. The commodity buyers will hedge against increasing prices. The price of the commodity can increase or decrease, but for the producer and buyer of the contract the prices will remain the same. For example, an airline company hedges and buys oil at agreed fixed prices for a certain 12

23 period to make sure oil is available at a stable price in the future. The airline company is less sensitive for changes in the oil prices. Or when a producer of an agricultural commodity agrees with the buyer the price in the future, so that the producer of the commodity has a secure income and the buyer has a secure amount of the commodity for the agreed price. The traders of futures can be troubled with losses and therefore have to put a deposit to make sure that the losses are paid whenever needed. This deposit is called the margin (Makus and Patterson, 2001). A margin is a small portion of the total value of the futures contract and has to be paid by the buyer and the seller. The minimum margin requirements are established by the exchange. Spot contracts are the opposite of futures contracts and are being sold or bought for direct delivery and are agreements than occur today. Similar to the futures contracts are the commodity forward contracts. These are also contracts in which the producer and the buyer agree to trade a commodity at a date in future at a specific place. However, the difference between commodity forward contracts and commodity futures contracts is that a forward is not traded on an exchange and the contract is not as standardized. Because the forward contracts don t need to fulfil the exchange requirements, they have a bigger chance of default risk. In addition to the futures, forwards and spots traders can also trade in commodity options. This is an agreement between two parties which will give the holder or buyer the right to take a futures position, however the trader is not obligated to do so (Makus and Patterson, 2001). The buyer of the option buys it at the given market price and if the spot commodity price negatively changes, the buyer can use the option to get protection related with a futures position. If the spot prices change positive for the buyer, he does not need to and does not want to get this protection related with a futures position (Makus and Patterson, 2001). In addition, on the commodity market can also be traded in commodity swaps. The commodity swap is an agreement between a buyer and a seller; it includes a series of commodity price payments. The payments are the differences between the agreed fixed price and the variable commodity market price. The payments result in a cash settlement. When the commodity market price increases above the fixed price, the seller of the swap will pay the settlement amount. On the other side, when the market price of the commodity decreases below in the agreement mentioned fixed price, the buyer is obliged to pay the settlement amount (Unicreditbank).Both exchange commodity swaps and OTC commodity swaps exist. 13

24 Besides the futures, spots, forwards and options traded on the commodity exchanges, investors can trade in commodity ETFs. These are Exchange Traded Funds with investments in commodity futures. An ETF consists of a bundle of commodities and the price decreases or increases along with the commodities in the ETF. Similar are Exchange Traded Commodities- ETCs. An ETC is a security that can be bought by any investor on a regulated exchange and which follows the performance of an underlying commodity. With trading in ETCs the investor will have exposure to commodities, however trading in ETCs does not involve the underlying futures contract or the physical commodity delivery Base metal commodity market participants Several sorts of participants engage in the commodity markets. The following selected participants are the most important ones. The producers or hedgers consist of companies who produce commodities, like oil producers, mining companies or farmers of corn. They are the spine of the commodity market and these producers want to protect their assets with price risks. For this reason, the producers who hedge against price risks are called hedgers. Another participant is the broker. A broker makes buying and selling possible between other players in the market. The brokers find appropriate buyers for the producers. Buyers of the commodities could be investors or speculators. The biggest part of the trading volume is done by the speculators. Speculators are active in commodity trading to speculate whether prices of the commodities increase or decrease. The speculators also put liquidity into the commodity markets. Investors and speculators buy and sell commodity contracts hoping to get a profit out of price changes. Often, they sell the contract before the actual delivery of the commodity should take place. The difference between investors and speculators is the level of risks they take. Speculators engage in more risk taking to get higher profits. Investors normally invest over longer periods. The commodity traders are those who make the trades possible and they put the transactions into effect. Nowadays, the commodity trading companies provide much more than being the price mediator. They are also involved in the supply chain, producing, storage, transport and other areas. Moreover, the exporters are the companies who distribute the commodities between different countries. The producers can fulfil the role of exporter themselves or they sell their assets to an exporter. Exporters produce or 14

25 buy commodities and export these to other countries. On the other hand, importers are those who get the commodities from outside the country into the country. Also the transportation companies are important. The transportation can be done through shipping vessels, pipelines and others. The transportation is also part of the total price of a commodity, often placed in the premium or discount of the price. Furthermore, commodities can be stored in warehouses before they are used and therefore warehouse companies do exist. Some commodities need to be stored some time in advance because they are more used in a specific time, such as gas, which is used more in European winters. 2.3 Commodity exchanges, clearing and warehousing in the base metal markets All the financial products which involve base metal commodities can be traded on commodity exchanges or Over-The-Counter (OTC). The producers, consumers, buyers and traders of metal commodities rely on good functioning commodity exchanges. Metals are traded on the commodity exchanges for economic reasons, so that the producers of commodities are able to hedge the values of their commodities against falling prices. The hedgers are the economic reason why commodity exchanges were built. Important exchanges are the Chicago Mercantile Exchange, the London Metal Exchange (LME) and the New York Mercantile Exchange (NYMEX). The exchanges have the responsibility to make sure that the traded commodities meet the required standards of quality and quantity. Moreover, a different entity of the futures exchange has the responsibility to settle the trade accounts, to regulate the delivery, report the trade data and clearing the trades. Clearing is the process bringing together the orders of the seller and the buyer. Traders of commodities can also use a clearinghouse to handle their trades, which is an organization closely related to the exchanges that offers clearing services for commodity derivatives trades. The clearinghouses handle their services for both the exchange trades as for the OTC trades. The reason to use a clearinghouse is to lessen the risk the other trading party not respecting the trade agreements, because the clearinghouse shifts the risks to itself. Many commodity exchanges have their own clearinghouses. Some clearinghouses offer services at several exchanges. 15

26 Besides the commodity trading on the exchanges, commodities can be traded between two parties in an OTC deal. OTC stands for Over the Counter and is a direct contract between two parties outside the exchange. The OTC trades have no or fewer regulations compared to the exchange trades. The commodity forwards are traded OTC for example. The products traded OTC, such as the commodity forwards have the advantage that the underlying asset can be modified and that the buyer and seller don t need to fulfil the marginal requirements which is required when one traded in futures for example. Only a small percentage of all the exchange trades are actually delivered. For delivery, the commodities are transported through various types of transportation. The transport of commodities is an important part of the commodity business and is part of the price structure of some commodities. Often commodities are shipped in bulk; in raw and unpacked quantity of commodities. This is called dry bulk commodities. The consignor is the company that delivers the shipment and the consignee is the company that receives the shipment. In addition to the shipment, the storage is also an important factor in the commodity markets. The commodity exchanges have approved a list of warehouses that should operate according the rules of the exchanges. The warehouses act like storage places and are important in the supply chain management, trading, distribution and physical delivery of commodities. In the warehouses is worked with the warehouse receipt or warrant. The warehouse receipt is the evidence of possessing the commodities which are stocked in the warehouse. Warehouse receipts can be negotiable which enable the change of ownership of the commodities. The warehouse receipts are also traded to settle futures contracts which expire soon. 2.4 Pricing, demand and supply of base metals The prices of the base metals are lower than the prices of the precious and rare metals, because the production of base metals is easier and there is much more available. In general, base metal markets are mostly influenced by macroeconomic developments. Basically, each price of the any of the base metals is different and is defined by demand and supply fundamentals (Chevallier et al, 2013). The supply side is production and stock available of the metal. The demand side is the consumption, how much of a metal is needed for consumption. There is a demand for base metals because of the ongoing development of economies worldwide. In emerging countries for example, where there is large demand for base 16

27 metals in order to build up their infrastructures and cities. Base metals are a good indicator for the economic development of a country, when the demand of the base metals is increasing; it means that the country has much confidence in the economic development. On the other hand, when the demand is low, there is not much trust in the economic development. Demand of metals depends on the stage of the economic growth of a country. When a country s economy develops, the use of base metals per capita will increase until a certain point of economic growth is reached when the increase of metal use will flatten and continue to grow slower. For instance, when economies over time will develop into a service economy, the usage of metals will not increase with the same rate as when the economy was dependent on heavy industries. However this is a general trend and is different for every metal and depends also on the structure of the economy, import-export and infrastructure. A good example in this case is Germany, where use of copper per capita is three times as high as that of someone from the United Kingdom. On the other side, to supply the demand, metals have to be mined, which can be an expensive process. For the mining of some metals much energy is used and transport can also be costly. The location of the mining process is an important factor. Investors who invest in the mining industry look at cost competitiveness of a certain mine location. The access to the mines, the conditions and risks are all important. At times, governments interrupt in investing decisions, because they want to secure the national supplies and national revenues and investments. We see this in Indonesia at the moment, where tariffs and certain measures are created for import and export of several metals. Often an imbalance exists between a country s demand for metals and the production of metals in that country. There is no country in the world that is completely self-supporting. Almost all countries need to import some kind of metal and in the base metal market can be spoken of a worldwideinterdependence. Some countries possess a strong concentration of base metals, like copper in Chile. Because of competitiveness and the worldwide-interdependence in metals it is not very plausible that the few countries who do possess metals can exploit their strong position for a long time. In this aspect, the base metal market is not the same as the oil market, where supplying countries formed the OPEC. Supply in most cases depends on the demand side of the market. Producers can produce more or less metals depending on the demand for that particular metal. 17

28 The supply and demand numbers and information is not always easy to get, precise and transparent. Privately held producers of metals do not need to publish information about their production volume. The prices will be more volatile when the lack of information is increasing. The pricing process assorts from the above mentioned products like futures, forwards and spots contracts and can be dealt with on several commodity exchanges. The prices are handled on the metal exchanges. The best known metal exchanges are the London Metal Exchange (LME) and the New York Mercantile Commodity Exchange (COMEX). Especially the LME is a very important exchange. On these exchanges the current prices are available and also the prices of several metals for a time in the future are expected on these exchanges. Differences exist in the prices people want to know. Analysts, traders, news reporters and economist want to know the macro- market metal prices. However, an end user would also like to know the price of the specific not tradable kind of the metal. Thus in some cases there is a difference between the metal market prices and the prices of metal products the manufacturers and consumers want to know. The researcher and an economist will check the prices of the LME and other exchanges. However, the manufacturers want to know the prices of non-tradable derived type of metals, such as copper powder, which are not available on the exchanges. Nevertheless, there is a connection between the prices of the metals that are traded on the exchanges and the specific derived type of metal products. The metal prices are also influenced by speculation of traders, currency changes and economic conditions. Furthermore, there is a familiar pattern of price reactions of metals to news (Chevallier and Ielpo, 2013). Most metals behave procyclical in times of recession and are specifically responsive to Chinese news in times of recession. Procyclical means that the value of the metal moves along the economy, the value of metals will grow when economies grow and the value of metals will decline in times of declining economies. In times of economic expansion metals tend to have a weaker reaction to news (Chevallier and Ielpo, 2013). 18

29 2.5 Theory of Storage, Contango and Backwardation Lately, there is a lot to do about the role of keeping stocks longer than necessary in warehouses, which influences the prices. Trading companies keep the metals longer in the warehouse to push up the prices. The LME plans to change its metal warehouse regulations because of this phenomenon. The current issues about the warehousing business involve the theory of storage. This theory explains the difference between spot and futures commodity prices in terms of storage cost, forgone interest and convenience yield (Carpantier, 2012). The convenience yield is the gain of keeping metals stored in the warehouses. The holder of the commodity storage is more flexible and able to answer to changes in the demand of commodities. The theory suggests that when the level of storage of metals in the warehouses is high, the futures prices are in contango. We speak of contango prices when futures prices are higher than the spot prices. For example, gold prices have been in contango since 1975, since the huge amount of reserves already mined. In a market of high storage, the volatility is lower than in a market with low storage. When the storage of commodities is on a low level, the prices are in backwardation. This is the pricing term for the time when futures prices are lower than the spot prices. When the storage level is low, the volatility of commodity prices increases (Carpantier, 2012). When the delivery time of the futures contract comes closer, the futures and the spot price will move towards each other for most base metals, called convergence. As is also visible in the next figure 1.: Futures price of a contract due in one year. Figure 1: Futures price of a contract due in one year 19

30 2.6 The current global base metal market To gain better understanding about the influence of the China (Shanghai) Pilot Free Trade zone on the Chinese base metal commodity markets, the current base metal market has to be analysed. In this part a short overview about the current base metal markets in general, however the base metal markets can be different in certain aspects. Information about the current metal markets is partly provided by the interviews conducted with experts of the metal- market (appendix 2, Interviews) and several institutional reports. In 2013, the European Union, China and the United States accounted for about 70% of the total world consumption of industrial metals. These three regions are the biggest consumers of base metals; however those regions are not the biggest producers of base metals. Southeast Asia and South America are important for the production of metals. Looking at the prices, last year was not a good year for the prices of metal. The following table shows that the prices of all the mentioned base metals in this thesis decreased year-on-year basis. The decrease in base metal prices last year is a reflection of modest growth on the demand side and a strong answer of the supply side. The higher supplies are also an outcome of increasing investments in mining business which was caused by higher metal prices (Worldbank, 2014). In addition to the decrease of the prices last year caused by fundamentals, the prices were also affected by nonfundamentals, like unstable political events, such as the war in Syria and by new measures of the Federal Reserve and the outcomes of the Chinese plenum. In next figure (2), the industrial metal price changes in 2012 are visible. Figure 2: industrial metal prices changes in

31 On the contrary of the decreasing prices last year, the base metal prices have been increasing last decade. The higher prices brought high revenues to investors, countries and mining and trading companies. Nowadays the prices of base metals are still higher than the prices of the same metals a decade ago. During the crisis of 2008, the prices also decreased. But after the crisis in 2011, the prices reached a peak (Worldbank, 2014). Before the crisis and after the crisis the base metal markets experienced increases in prices and increasing supplies. Also the amount of metals in stock is significant higher than the standard, especially for aluminium and copper. It is expected that the metal markets will be oversupplied in But on the other side the world economy is expected to perform better in the next year and this could mean an increasing demand for commodities, such as the base metals. In the long term, the growth in demand for metals will be very strong and much of the increase in the global demand has to do with commodity metal market in China, which will be the focus in the next part (ABN AMRO, 2014). 21

32 3. The Chinese base metals commodity market China started in 1978 to open its economy to the rest of the world. Until that time, it had like other planned economies, no financial markets. Since the opening 1978, the Chinese economy has been growing in a rapid pace. Since 1999, China has a GDP growth rate of more than 7.6% annually (Worldbank data). To fuel this rapid growth, China consumes enormous amounts of commodities. China is producer, exporter and importer of various commodities. China s demand for metals and other commodities has been increasing since the opening up of its economy. Because of China s massive consumption and demand, it plays an important role in the world commodity markets. Since the early 80 s China s commodity markets experienced a great transformation. China transformed its economy, embraced the market-economy and also commodity markets. In 1991, the stock market in Shanghai and the commodity market in Zhengzhou were established (Yu Xin et al, 2006). Together with China s rapid economic development, the commodity markets have developed as well. China s commodities futures markets have grown rapidly and the annual futures turnover totalled over bn Yuan in Soybean and copper futures are very successful, and, after 10 years of operation, they are ranked second largest in the world, being only slightly smaller than the Chicago Board of Trade (CBOT) and the London Metal Exchange, respectively (Yu Xin et al, 2006). China wishes that they are the pricing decision centre of most important commodities (Neftci, 2007). Nowadays, the prices are set by supply and demand, so there is a rise and fall of spot commodity prices again and participants of the commodity market are sensitive for risks again. Nevertheless, the Chinese government observes the commodity futures market very carefully. To discover what effect the China Shanghai Pilot Free Trade Zone might have on the Chinese commodity metal market, first an overview of the Chinese base metal market is been provided. In chapter 4, 5 and 6 several parts are the outcome of the conducted interviews being conducted in Shanghai with base metal commodity traders and business developers (Appendix 1). 22