China Buys Out London's Crown Jewel

As China becomes more and more a leader in the global economy it is not only purchasing the largest amounts of commodities, but is also starting to buy up strategic assets. This time China bought a legacy of 135 year, right in the heart of London.

Over this weekend (16 June 2012), China bought out the London Metal Exchange (LME) for 1.38 billion pounds. This means that J.P. Morgan, Goldman Sachs and Metdist are giving up on their shares of the LME. The LME is now part of the Hong Kong Exchange (HKEx).

This event will increase China's monetary flexibility on the base metals front. It is an important addition to China's assets because China is the largest consumer of commodities in the world. The LME isn't a small exchange as it has an 80% share in global futures trading in key base metals like aluminum, copper and zinc. The plans for China with the LME acquisition is to incorporate more Chinese companies on the exchange and to introduce Chinese currency based contracts trading. It will also enable China to use local warehouses for their customers as the warehouses in China are already over capacity (see my previous article about copper in Chinese warehouses in Shanghai).

It is interesting to note that there were other bidders for the LME, namely the CME and NYSE, but they couldn't compete against the Hong Kong Exchange. The LME only makes about 10 million pounds a year in profit, while the buy out price is at 1.38 billion pounds. That's a multiple of 138! Nobody would buy a company with a P/E ratio of 138, but China did. If we look at another metric (trailing net income), China actually bought the LME at a price of 180 times trailing net income, which is the most expensive deal since 2000. This is because the LME has a lot of strategic value in it for China. One of the most important values is that China now can set the pricing and warehousing of commodities around the world. This is because the LME has 732 approved storage facilities in 37 locations in 14 countries from Singapore to the U.S. This fits perfectly with their strategy in becoming the largest commodity consumer in the world.

Following this highly dilutive transaction by the Hong Kong Exchange, investors should first know that the earnings forecast of the HKEx isestimated to go down around 3-5%. Not only due to the high premium of the buyout of the LME, but also due to costs that will occur during the roll-out of the Asian platform to boost the LME's business in China.

Second, I expect that tariffs on contracts will be increased over time. This is because HKEx has the ambition to become the leading exchange platform in China, competing with the Shanghai Futures Exchange. However, the increase in tariffs will not occur before 2015 as confirmed by the HKEx.

Third, due to an inflow of new Chinese customers to the LME, China-related trading will start to increase. Currently, China-related trading volume on the LME stands at only 20%. This buyout event will enable countless Chinese businesses to start trading on the LME. Where in the past, Beijing had restricted Chinese domestic firms to trade on foreign exchanges. As a consequence, China can reduce delays, transit times, business costs and enhance commodity trade flows to China. In other words, China, who accounts for consumption of 40% of the world's commodities, will be able to acquire commodities at a faster pace in the future. It will also be able to start trading in other essential metals like iron ore and steel making coal. I believe this is bullish for commodities in general. Investors can bet on commodities through ETF's like the PowerShares DB Commodity Index Tracking Fund (DBC).

But the most important aspect is that China will have the power to create products on the LME that are denominated in yuan. This is again another step forward for China to compete agains the U.S. dollar as reserve currency of the world. Investors should take this opportunity to invest more of their money in RMB by buying funds that track the yuan, e.g. Market Vectors Chinese Renminbi/USD ETN (CNY).