Wednesday, July 09, 2008

The 1981-2 Malaysian tin market fiasco 28 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
It is interesting to read about another speculators' attempt to control a particular segment of the commodities market, given all the heated arguments recently about how much oil price dynamics are being driven by futures speculation.

This attempt was in 1981 and ironically it wasn't long after the Hunt Brothers' failed attempt to corner the silver market. The Malaysian government(!) was the main protagonist, and its objective was decidedly altruistic: to support tin prices to "protect the national interest" (Malaysia was the world's largest tin miner).

Then, there was actually a global organisation, made up of tin consumer and producer countries, to maintain tin prices. This was known as the International Tin Council (ITC); it acted on behalf of the various members to buy up surplus tin stocks to maintain the price at a steady level. New substitutes for tin had emerged within its traditional applications: the advent of aluminium containers, the use of protective polymer lacquers inside cans, and increased recycling by industry, had all caused the demand for tin to stagnate considerably in the early 1980s. In 1981, the ITC consumer members rejected producer demands for higher prices. The Malaysian government, on advice from a Swiss commodities broker Marc Rich, then unilaterally commenced secret operations to buy tin futures on the London Metal Exchange (LME) from July 1981 till early 1982.

Initially the operations succeeded in supporting tin prices, which rose sharply from <7000 GBP/ton to nearly 9000 GBP/ton within 8 months. The tin price did not rise more because traders on the LME were short-selling on the other end. But cracks began to appear, as the natural consequence of rising prices was rising supply; in addition, the US announced its intention to sell part of its 200,000 ton stockpile in November 1981 --- which drew more short-sellers.

It was around this time that the Malaysian/Swiss partners switched tactics from a price-support operation (through buying futures) to attempting to corner the tin market through making spot purchases of physical tin for cash. This would, hopefully, squeeze the short-sellers into paying much higher prices when they would find no tin to cover upon contract expiry. But the switch in strategy dramatically increased the stakes, because as opposed to only needing to post 10% margin for futures, the cornering operation's spot buying needed 100% cash for immediate settlement. Then all this physical tin needed insurance and storage --- additional costs. Where did the money come from? Loans from state-linked banks Bank Bumiputra and Maybank of course --- another example of the many legendary shady interlinkages between industry and government in Malaysia.

It turned out that the people who got squeezed were the aspiring cornerers themselves. Those who had sold short futures contracts did indeed find it hard to locate tin to deliver as settlement day approached. This created a crisis on the LME, with traders facing the prospect of default and ruin. As the short squeeze loomed in February 1982, the LME changed its rules --- it declared that traders who failed to meet sales contracted could pay a fine --- 120 GBP/ton --- instead of supplying physical tin, meaning short sellers could avoid paying steep premium to the cornerers, which could have been >1000 GBP/ton. There was a collapse in tin prices following the ruling, culminating in massive losses for the Malaysian/Swiss partners. At the same time, tin supplies continued to come from the US stockpile while tin users began reducing stocks due to high prices and a continuing global recession.

The subsequent price collapse from 9000 to 7000 GBP/ton within a month due to the rule change cost the partners a paper loss of >500M RM even as they were stuck with 50000-60000 tons of tin in physical stock that they had never meant to keep long-term. Worse was to come, as fast falling tin prices forced the ITC (the earlier-mentioned tin cartel) to begin massive intervention to protect the artificially high floor price until it too ran out of funds in 1985, defaulting on 900M GBP(!) loans and triggering another tin price collapse.

Ultimately, thousands of Malaysian mine workers were laid off and hundreds of mines closed due to the collapsing tin prices that rendered many mining operations no longer viable. The "good intentions" of the Malaysian government had boomeranged cruelly back on itself, and from the mid-1980s onwards tin would no longer be a key export for Malaysia that it had been for decades extending back to British colonial rule as an indirect result of the 1981 fiasco. For bystanders it was a lesson not to interfere in or manipulate normal operations of the market and attempt to go against the fundamentals of demand/supply. For the Malaysian government and Dr Mahathir (the cornering operational plans and political support went up to the highest levels), it reinforced their belief that the West was not to be trusted --- in 1986 when the scandal was finally publicly admitted by the Malaysian government, on persistent allegations by opposition leader Lim Kit Siang, Mahathir defended the intervention by contending that only "massive cheating in the London Metal Exchange" had deprived the government of profits from its trading (the LME defended itself by asserting that the exchange was required by its own rules to block an apparent attempt to corner the market).

There was an accompanying scandal following the 1982 fiasco where the Malaysian government scrambled to find funds to cover back the loans it had taken from the state-linked banks to finance its cornering operations, which involved the use of Employee Provident Fund (EPF) pension money to play the local stock market. That is another story for another day. A key lesson from the 1981-2 fiasco, together with the similarly ill-fated Hunt Brothers' silver corner around the same time, is the wild card of exchanges making rule modifications in response to extreme market conditions that can instantly crush any market manipulation operations. Tin or silver were relatively small markets. It is hence difficult to imagine someone attempting to manipulate the oil markets, for example, with its infinitely bigger liquidity on top of wild losses should the exchange decide to tweak its rules again if it should perceive market irregularities. Who says you can't change the rules?

(1) M Way -- Mahathir's Economic Legacy (Jom K.S.)




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