London 01/02/2016 - The surprise increase in Chinese copper imports in December did not reflect growth in demand but was due to currency arbitration, expectations of further deprecations in the yuan and a "negative" LME/SHFE arbitrage, analysts said.
Copper imports surged in the final month of 2015 across the supply chain, with month-on-month increase in refined metal, scrap and concentrate imports. December's total contained copper net imports of 949,000 tonnes were the highest on record, Barclays estimated.
One of the key contributors was the continued devaluation of the Chinese yuan, which started in August last year. Afraid of further interventions by Beijing, copper producers may have stockpiled material from global markets, participants suggested.
"[It] is a logical move and one that we think offers a compelling explanation of the import surge," Barclays said, noting that the recovery in copper imports correlates with the start of the of the China devaluation.
But even after these high import levels, the copper LME/SHFE import arbitrage window remains open, albeit at a narrower ratio of around 1:7.85.
This was because the expectation of further deprecations had meant that the normal arbitrage of buy LME and sell SHFE had become too risky due to potential losses in currency exchange rates.
By reversing the exchange arbitrage, traders can avoid the risk of deprecation and even profit from it.
"[Depreciation pressure] makes domestic market players chose to build long positions in Shanghai Futures Exchange (SHFE) and probably build a short position in the London Metal Exchange (LME) at the same time," Macquarie said.
Copper was favoured for this trade due to its backwardation in its forward curve, which makes it easier for investors to carry their long position, Macquarie said.
Copper's benchmark cash/threes spread is currently backwardated at $8, having spent much of the last 12 months at various levels of tightness.
"As long as the broad renminbi depreciation expectation persists and people have the motivation to hold metal inventory, we would expect robust metal imports to continue in China," Macquarie said.
But this could have two very different outcomes on the LME price. Increased imports are positive for the physical market and would support prices but an increase in "reverse" arbitrage could lead to more shorting on the LME.
"In the short term the negative factor should be a bigger role as its effect is immediate but in the longer term the positive factor may be able to show some impact," Macquarie said.
(Editing by Mark Shaw)