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Commodities and the European banking crisis

20 October 2011  •  Source: Michael Derks, FxPro

As so often occurs during a crisis, a multitude of unforeseen forces are unleashed which end up making the situation much worse. Unfortunately, Europe’s sovereign debt and banking crisis is now resulting in numerous unintended consequences, especially in the commodities space.

In terms of obvious first-order effects, the marked tightening of financial conditions and the weakening growth picture in Europe is restraining demand for imports from the emerging world, especially Asia. Not surprisingly, commodities-demand has also been dragged down. Investors, cognisant of the risks of weaker growth both in Europe and throughout the emerging world, have also sharply reduced their exposure to high-beta assets such as commodities over the past few months.

Rather pernicious is growing evidence that Europe’s banking crisis is impinging severely on trade finance. French banks such as BNP Paribas, SocGen and Credit Agricole are the main financiers of the big commodity trading houses, many of which are run out of Switzerland. In recent weeks, as these lenders engage in significant asset contraction, they are reducing the availability of credit, and raising its cost. Some of these French banks have confirmed that winding back commodity trade finance is definitely part of their efforts to deleverage their balance sheets. Three years ago, it was a freeze in trade lending which slowed global trade flows to a virtual crawl. Thankfully, the major trade financing players have more diversified funding sources these days, but certainly some of the medium and smaller-sized players will be vulnerable.

For commodities, it is yet another factor that is placing downward pressure on prices. Both copper and aluminium prices have fallen more than 20% in recent months, and the iron ore price has dropped 13% in the last eight trading sessions. Gold is looking suspect as well – earlier this week, it was threatening USD 1,700, but has since dropped back to near USD 1,600. For high-beta currencies such as the Aussie, the downward pressure on commodities remains a serious risk.