Is China set to roar in commodities trading?

As the world increasingly tilts from West to East, the corresponding economic shift has not been all-inclusive.

China, the world’s largest consumer of commodities, has largely been left on the sidelines with regard to the setting of global commodity prices.

China operates futures exchanges in Shanghai, Zhengzhou, and Dalian that, collectively, make up the world’s largest by volume, according to data from the Chinese Futures Association.

In spite of this, exchanges in the West – such as those in London, New York, and Chicago – continue to drive price discovery, or the determination of the price of a commodity. The continued reliance on Western markets to set prices is the result of implicit trust in established legal systems and in the security of pricing contracts in a freely convertible currency: the US dollar.

Commodities futures form the backbone of the global marketplace since raw materials form the basis of everything on the market. As a result, commodities futures are used by many businesses to set prices and predict costs for an array of products, ranging from clothing to food to electronics. These futures are used by farmers to determine what to grow, and they are used by manufacturers to determine levels of production. Price discovery is the resulting price that is gleaned from current and anticipated supply and demand.

Since price discovery continues to be driven by a handful of markets in the West, markets in Asia are forced to take prices that are based on factors that do not take local or regional market conditions into account. This means that Chinese buyers are often forced to purchase commodities at prices that are artificially high since these prices do not reflect real supply or demand within China. From a Chinese perspective, it also means that prices fluctuate arbitrarily and without explanation.

The basic reason that China has been sidelined in price setting is that there is not a lot of faith in China’s adherence to the rule of law – something that isn't helped by the restrictions on the influx of foreign money and the lack of foreign players. China’s markets are inherently inward-looking and lack transparency.

It’s a missed opportunity for China because despite all of its buying power, it remains a follower, or a price taker. This leaves the country in an especially precarious position as its reliance on commodity imports only continues to grow.

In 2009, China consumed almost half of the world’s coal and steel and around 40 percent of its aluminum and copper. Project forward and by 2025, according to a report by McKinsey, it is estimated that China will have 221 cities with more than 1 million inhabitants, of which 23 will have populations over 5 million.

This continued drive toward urbanization on an unprecedented scale has already resulted in higher global demand for commodities, and with the additional burden of rising inflation, China can ill afford to remain on the sidelines when it comes to having more of a say in the setting of commodity prices.

Fortunately for China, it may soon wield more clout in the global commodity market.

On May 18, the Hong Kong Mercantile Exchange (HKMEx) opened for business after almost three years of planning. The exchange takes advantage of Hong Kong’s highly-regarded regulatory and legal environment to give China a globally significant futures exchange to challenge the global leaders in London, New York, and Chicago.

Appropriately, trading hours for HKMEx span 15 hours, from 8 a.m. to 11 p.m. Hong Kong time, to overlap with trading hours in the US and Europe.

“Global demand for core commodities has in recent years been driven by Asia,” said Barry Cheung, chairman of HKMEx. “Our new platform will offer Asia a bigger say in setting global commodity prices.”

Indeed, HKMEx offers the advantages of the huge mainland exchanges minus their associated impediments. Hong Kong’s high degree of autonomy under the post-1997 “one country, two systems” principle has granted it license to continue operating as a freewheeling capitalist haven where the rule of law is practiced resolutely.

It therefore offers a jurisdiction in which contracts can be bought and sold in a transparent manner, and where buyers and sellers can trust the consistency of the underlying rule of law.

In addition, HKMEx boasts a stable of powerful shareholders including ICBC, the world’s largest bank by market capitalization, and Cosco, China’s largest shipping company. The backing of HKMEx by these Chinese state-owned giants offers the exchange access to enormous sums of capital that will ensure that trading volume remains high, a necessary condition if the exchange is to have any say in price discovery.

The success of HKMEx hinges largely on how well it is able to tap into the huge commodities spree going on in mainland China.

“I think, given the rise and people’s awareness of commodities and natural resources in this part of the world, that it will be an exchange for people in the region to use,” said Andrew Ferguson, CEO of APAC Resources, a Hong Kong-listed natural resources investment and commodities trading company. “I suspect the exchange will be nothing short of a success on the basis of the fact that it’s going to capture a lot of the business which goes on in this corner of the world.”

Whether the exchange can capitalize on its geographic advantage remains a looming question. Other regional exchanges – including those in Tokyo, Singapore, and in mainland China – have failed to challenge the dominance of the incumbent exchanges due to various barriers to entry that include issues of currency, jurisdiction, taxation, and local rules and regulations. HKMEx is betting on the fact that Hong Kong will provide a more viable venue for a dominant exchange.

“The major financial players come here to interface with China, and China comes to Hong Kong to interface with the internationals," said Albert Helmig, president of HKMEx. "So we think this is a leverage scenario.”

Trading volumes have so far averaged around 2,500 contracts per day for the sole product currently on offer: a US dollar-denominated one-kilogram gold futures contract with physical delivery in Hong Kong. Admittedly, this daily volume is minuscule when compared with the overall volumes churned out by exchanges in Chicago and New York, but Mr. Helmig sees this as the starting point for what he hopes will be a sustainable, vibrant market in the long run.

To this end, HKMEx is not wasting any time in rolling out additional products to meet burgeoning Chinese demand for commodities and to boost trading volume, having already indicated that it plans to offer futures in base and precious metals, energy, agriculture, and commodity indices.

Additionally, a launch of yuan-denominated gold futures later this year has already been announced. Trading of the Chinese currency in Hong Kong has exploded since last July when restrictions on its usage and circulation within Hong Kong were removed. “It will make it a lot easier for those trading in China, which is obviously where most of the end consumers are,” said Mr. Ferguson.