China As A Cotton Exporter Would Draw WTO Attention
August 23, 2013 From the mid-1800s through 2008, the cotton industry was more stable than most other industries. Prices fluctuated enough to require hedging, and 200 years of technological advancement certainly had their impact in areas such as shipping, classing, computerized trading and textile machinery.
In one sense, even after 2008, the fundamental role of cotton merchants is much the same as it’s always been: They exist to provide distribution and risk management in the markets they operate in. Best practices and new technologies have made traders more efficient, but their reason for existing is largely the same as it’s always been.
But just because the players haven’t changed dramatically doesn’t mean that the game and its rules haven’t. Cotton is still considered a relationship-based business, but the financial bloodbaths that resulted from the stunning volatility in 2008 and again in 2010/11 have certainly put the emphasis on risk management. As a result, the top challenges for traders in today’s market environment are:
1. Counterparty risk. The most unbreakable rule is commonly referred to as “KYC”: Know Your Customer. More time and effort are being spent on vetting potential business partners than ever before, and many trading firms are trimming the number of partners they’re willing to do business with dramatically.
2. Liquidity risk. Merchants need to be prepared for high volatility in markets at all times. It always comes when it’s least expected, and more than a few companies are out of business today because they were unprepared and didn’t have sufficient credit lines to handle extreme market situations.
As far as external factors go, China’s impact on trading trends is undeniable. The country’s decision to outsource much of its spinning industry affects the entire chain, not only spinners. While China is and almost certainly will remain for the foreseeable future the world’s largest textile manufacturer, the trend toward importing cotton yarn (duty free) rather than raw cotton will have a lasting impact.
The United States went through a similar phenomenon in the 1990s, when domestic consumption collapsed and was replaced by imports. Despite the major changes that the cotton industry has endured in recent years, that consumption hasn’t returned. There’s no reason to think that China’s consumption won’t also keep moving to Southeast Asia, although part of it will be absorbed by India and Pakistan.
One major development to keep an eye on is whether or not China will become an exporter of cotton, and not just finished goods. At first, the thought is inconceivable, given its massive annual consumption of fiber. But the possibility is making the rounds in discussions between merchants.
If it happened, the impact on the global market likely would be profound.
The first hurdle would be how China’s government officials handle the payments to domestic farmers, given that the national reserve typically pays 30 cents/lb or more over the international price. That price is paid to keep people on the farms, rather than having them migrate to the cities for better jobs, but it would certainly not be competitive at that rate on the global market.
Even if the Chinese government were willing to pay the farmers more than the price supported by the international market, becoming a net exporter would undoubtedly expose China to sanctions from the World Trade Organization. The United States already paid – and continues to pay, pending a new Farm Bill – a heavy price for being found guilty of affecting international markets through farmer subsidies, a claim China is generally protected from because its subsidized cotton is all consumed domestically.
Another challenging development is the lessening influence that U.S. prices have in the global markets, which has renewed calls for a world contract that reflects than U.S. growths.
Movement toward a Global Cotton Contract
Fiber buyers and sellers have been talking about the possibility of a global cotton contract for years, but the discussions never moved beyond the hypothetical – until now.
Ben Jackson, president and COO of ICE Cotton Futures, told Cotton International that the organization “has begun consulting with a diverse range of market participants about the desirability and feasibility of listing a new contract that would allow delivery of non-U.S. origin cotton and also allow delivery outside the United States.”
It’s important to clarify that the intention is not to replace the current ICE Number 2 contract, but rather, it is about offering an alternative risk management tool for cotton grown outside the United States. If changes are coming, one of the first questions that needs to be answered is whether a new delivery point should be in a producing country or a consuming country.
To get a better understanding of the debate, Cotton International engaged one of the industry’s most experienced and respected traders: Cliff White, managing director of Omnicotton Australia and a former president of the International Cotton Association.
What’s the big difference about whether it’s a cotton-producing or -consuming country?
CW The big difference is about who plays. I think the feeling is that if the delivery is at origin, then mostly the merchants will be involved in making and taking deliveries because spinners globally probably do not want to get involved with logistics from origin, particularly in faraway places like Brazil. My concern about having it based in a producing country – and we are only really talking about three growths, USA/Australia/Brazil – is that it will not be attractive enough to bring in additional players, like the spinners. Therefore, there will not be enough liquidity, which would lead to the contract failing, and we revert back to what we currently have. By having the contract at destination, on the other hand, we have one set of rules for all growths that can be delivered to specific points. To me, that makes the contract easier for everyone and, by definition, more attractive to the market.
Is there a specific group who wants it to be a producing country, and a different group who wants a consuming country? What are their opposing motivations?
CW I believe that the majority of people in most of the international markets would like the delivery points to be close to consuming markets. To have any chance this global contract has to be attractive to as many people as possible, and thus increase liquidity in the contract.
Regardless of whether it’s a producing or consuming country, wouldn’t either of them be an improvement over having a single, U.S.-only-based contract? In other words, is this a case of perfect being the enemy of good?
CW There is no question that a global contract is required for cotton because the marketplace has changed and the cotton industry is probably the one that has changed the least, in terms of its risk management. Some people don’t like change and this is a perfect example. This is where the industry really needs some strong leadership, because we are at a crossroads and I cannot believe that a contract established so long ago – to reflect an industry that was much, much different than the one we have today – is the future. Just think about all the changes that have happened in the last 50 years! We might be able to trade on the computer today, but it’s really not that different if we still are using the same contract.
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