Commodities as Collateral∗

This paper proposes and tests a theory of using commodities as collateral for financing. In the presence of capital control and financial frictions, financial investors import commodities and pledge them as collateral to capture the higher expected return in the importing country. The collateral demand for commodities increases commodity prices globally; it also increases futures risk premium in the importing country but reduces that in the exporting country. We test the theoretical predictions on eight commodities in China and developed markets. The evidence supports our theory. The results suggest that collateral demands can explain up to 11.9%–15.0% price increase of major industrial metals since 2007. Overall, our theory and evidence complement the theory of storage and provide new insights to the financialization of commodity markets.