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Hong Kong Exchanges' Bid For LME Will Give China More Power In Global Commodity Trading

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Last week’s bid by the Hong Kong Exchanges (HKE) for the London Metal Exchange (LME) flew under the radar, but its underlying importance is paramount.  In the most expensive bid ever for an exchange, HKE is looking to acquire the world’s largest metals market place for more than $2 billion, shifting the global hub for metals trading to the East.

Furthermore, as China gradually becomes the world’s most important player in the gold and commodities markets, it will strengthen its grasp on the global gold trade, which it set out to do in its latest Five Year Plan.  As the world economy muddles through, China is consolidating its international position in the world of financial markets.

In what Morgan Stanley has called an “extremely expensive” bid, HKE reached an agreement to buy all of LME’s shares for 1.39 billion pounds (about $2.15 billion), or 107.6 pounds per share.  Hong Kong outbid major players like NYSE Euronext, the CME Group, and especially the ICE to buy the LME, one of the last member-owned exchanges, founded in 1877; the transaction still requires the approval of the U.K.’s financial regulator, the FSA.

Why would the Hong Kong Exchanges pay so much, about 160 times net income (compared with 66 times for the CME’s bid for CBOT) for the LME?

The answer is right on the HKE’s letter announcing the deal.  Once they gain control of the LME (which requires the backing of 50% of the shareholders), HKE will leverage its contacts in mainland China to get the government to allow them to operate local warehouses in China, which currently isn’t allowed by the People’s Bank of China (PBoC).  They are also looking to clear trades in Asia, and raise the number of Chinese participants in the exchange, currently below 25%.  Essentially, they are looking to dominate China's commodities trade with the rest of the world.

Getting the deal done would result in a win-win situation both for HKE and the Chinese government, and it will result in amazing profits for LME’s shareholders (JPMorgan Chase and Goldman Sachs collectively own 20.4% of the exchange, worth about $436 million if the deal goes through).

China is quickly becoming the world’s commodities and gold buying powerhouse.  In the first quarter of 2012, China surpassed India with the highest consumer demand for gold, having bought 265.7 tonnes in that time, according to the World Gold Council.  As China's stellar growth has pushed it to become one of the largest and most influential players in the global commodity markets, it has strengthened its grip of gold markets as well.

Investment demand in gold surged 13% to 98.6 tonnes, and China currently holds 1,0541.1 tonnes of gold in reserves, making up only 1.7% of its massive foreign exchange reserves, compared with more than 70% for the nations above it in the list; the U.S. tops the list with 8.133.5 tonnes, 75.3% of its reserves.

It is no coincidence that China is becoming one of the dominant forces in the global gold market.  The Chinese Communist Party has made it clear that it wants to develop its domestic gold market in the latest five year plan, as my colleague Robert Lenzner has reported.  A group of institutions including the PBoC, the National Development and Reform Commission, the Ministry of Finance, and the China Securities Regulatory Commission, among others, co-authored a report titled Opinions on Promoting the Development of the Gold Market which specifically cites the opening of new channels for importing and exporting gold, developing a gold leasing market, and improving foreign exchange policy for the gold market.

China is sitting on $3.3 trillion in foreign exchange reserves, a big chunk of that in U.S. dollars.  The PBoC understands the inherent risk in holding dollars backed by a highly indebted government (the U.S.), they also understand the political dangers of having so much financial power over the U.S., and the U.S. having so much power over them.  Furthermore, investing in gold is part of a cultural tradition in China, a widespread custom across the population.

There is no doubt that the Chinese are taking steps to increase their presence in the global commodity markets.  Given how much money they have, and are willing to spend, it is difficult to imagine that they will not achieve their goal.  Beyond gold, the LME is a major player in several commodity markets, particularly industrial metals like aluminum, copper, zinc, lead, and others.  Given China’s poor record for transparency and its fear of liberal markets, the successful completion of the HKE-LME merger could usher a new world of global commodity trading, with China in control.