China Flags 'Improper' Gold-Backed Loans

By Enda Curran and Sarah Kent 

HONG KONG--Chinese authorities raised concerns about the use of gold to back loans, saying they had discovered billions of dollars of "improper" transactions, as companies exposed to a separate case of potential fraud involving copper and aluminum-linked lending discussed a deal to share the possible losses.

The Swiss trading house Mercuria Energy Group Ltd. is assisting in brokering a deal with traders and banks to split any potential losses linked to metals stored at the port of Penglai, in eastern China, according to people familiar with the matter. Chinese authorities are investigating whether metals stored at Penglai and Qingdao, another eastern port, have been fraudulently used as collateral for multiple loans.

The discussions come after China's National Audit Office said in a report released this week that a check among 25 gold processors uncovered 94.4 billion yuan ($15.2 billion) of loans linked to potentially illegal gold financing. It said the loans, designed to profit from interest-rate and foreign-exchange differentials, resulted in combined profits of more than 900 million yuan for the processors.

The office didn't disclose details of the gold-financing deals, which it described as "improper," including who was involved with them, how they were structured or why they weren't legitimate.

The wording of the statement, which referred to the gold processors as engaging in "fictitious trade," suggested the deals could be illegal. The agency didn't respond to a call for comment. There is no evidence indicating the companies involved in the problems at Penglai and Qingdao and the gold financing are linked.

Geneva-based Mercuria, the company that is assisting in brokering a deal at Penglai, is one of the largest commodities traders in the world. It has long-standing links to China and a metals-trading business there.

Foreign banks with exposure at Penglai include BNP Paribas SA, Citigroup Inc., Standard Bank Group Ltd. and Standard Chartered PLC, people familiar with the matter said. It isn't clear whether Mercuria and other trading houses or banks have suffered losses as a result of the alleged fraud.

If all sides agree on a deal at Penglai, it could prevent disputes over who is liable for any missing collateral in a situation clouded by uncertainty over which companies are exposed and the size of the possible losses. At Penglai, the volume of collateral involved is smaller than at Qingdao, these people say.

The discussions over a possible deal have drawn mixed responses from the banks. "I told our lawyers we are not interested," said one person familiar with the matter.

Both Western and Chinese banks have lent hundreds of millions of dollars to commodities traders in recent years, using copper, iron ore, aluminum and other commodities as collateral.

Banks including Citigroup, Standard Bank and Standard Chartered have previously acknowledged potential problems with commodity financing in China but have given no further details. Peter Sands, chief executive of Standard Chartered, told reporters Thursday that the bank's preliminary assessment is that the matter won't have a material effect on its financial condition.

State-owned Citic Resources Holdings Ltd. said this month that about half of the alumina stockpiles it had stored at Qingdao port couldn't be located.

Contributing to the uncertainty is the fact that the banks haven't been able to access storage facilities at either port, people familiar with the matter say. The two port operators haven't provided any details about the status of collateral that has raised concern among lenders, these people say.

In one instance, inspectors for the lenders had to take photographs of aluminum stockpiles at Penglai from outside the storage facility's gates, said one person familiar with the matter.

The operator of Qingdao port has said Chinese authorities are investigating an alleged fraud, but port official haven't commented further. Penglai port officials declined to comment.

"It's the most complex issue I've ever seen. Just to figure things out is going to be complicated," said another person familiar with the situation.

Banks are also investigating the role played by metals trader Decheng Mining Ltd, which they say is at the center of the probe. Executives at Western banks said they made loans to entities linked to Decheng Mining and are now trying to determine whether these entities issued more than one receipt for the same collateral to back multiple loans.

Attempts to reach Decheng Mining haven't been successful. The Chinese government hasn't commented on its investigation.

For the foreign lenders, the overall exposure at Qingdao and Penglai is thought to amount to several hundred million dollars, executives say.

The auditor's report on gold financing covers a period that begins in 2012, but it didn't clearly specify the time frame. Analysts say banks have begun to tighten supervision over gold-backed financing in recent months, suggesting that lenders may have been warned about the loans.

In a typical gold-backed financing deal, as described by analysts, a manufacturer on the mainland would obtain a letter of credit from Chinese banks backed by imported gold held in bonded warehouses on the mainland or Hong Kong. The manufacturer would use the letter of credit to raise a U.S. dollar loan from an offshore bank, usually via an offshore subsidiary, which is then converted into Chinese renminbi and reinvested in higher-yielding financial instruments on the mainland.

The deals hinge on profiting from differences between the interest rates on the dollar-denominated loan and funds invested in China. Traders have used metals as collateral to bring some $110 billion into China since 2010, Goldman Sachs Group Inc. estimates.

Write to Enda Curran at [e-mail] and Sarah Kent at [e-mail]

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