China’s Ore War

Expect it to be a long one. A lot’s at stake.

U.S. Commerce Secretary Gary Locke may urge China to follow “due process” and communicate with the Australian government in the Rio Tinto case. Australian Prime Minister Kevin Rudd may warn China that its foreign trading partners will be closely watching the outcome of the incident, and will draw their own conclusions as to how it is conducted. And Australian Financial Services and Corporate Law Minister Chris Bowen may argue that China should be concerned that its handling of the case could change the way that foreign businesses around the world approach business in China and make foreign businesses less willing to base executives in the country. However, no one should underestimate the importance of iron ore to China and its economy.

In a bizarre sequel to Rio Tinto’s rejection of Chinalco’s proposed $19.5 billion investment, four employees of Rio Tinto, including an Australian citizen, were arrested by Chinese authorities in Shanghai on July 5. Chinese authorities said the Rio Tinto employees illegally obtained “state secrets” from Chinese steel companies during price negotiations. Chinese media reports said that Rio Tinto and other major international ore suppliers may have bribed Chinese steel executives to get access to figures such as stock levels, production schedules and volumes, financial information and purchase plans – sensitive data that places China at a disadvantage during price discussions. A senior executive in charge of iron ore imports and exports at China’s eighth-largest steel mill, Shougang, was also arrested on July 7 for alleged commercial crimes, and five major Chinese steel makers are reported to be under investigation. Chinese officials say that the actions of the Rio Tinto employees and the steel executives threaten the country’s economic security.

Without knowing the details and seeing all of the evidence, it’s impossible to determine whether China’s actions were, in fact, justified. Rio Tinto officials, of course, deny any wrongdoing on the part of their employees, but in disputes like this, there is typically a bit of truth to all allegations. Where there is smoke, there is usually fire.

The fact that China has arrested its own citizens and is investigating its own steel companies would suggest that there is some legitimacy to the claims of the authorities. Under high pressure from their bosses at headquarters to negotiate favorable terms and with billions of dollars at stake, is it likely that Rio Tinto’s Chinese employees resorted to bribes to gain access to sensitive data? Who knows, but it wouldn’t be the first time that’s happened.

Although Chinalco’s proposed investment into Rio Tinto was rejected by the company’s shareholders, it was already facing resistance in Australia and may have been turned down by the Australian government anyway. Are the arrests then merely a form of retaliation for what China perceives as political tampering in economic matters important to the country? Perhaps.

The two clear facts, though, are that iron ore is of vital interest to China and its economy, and the relationship between China and the world’s iron ore suppliers has been thrown into disequilibrium by the planned joint venture between BHP Billiton and Rio Tinto in iron ore production.

China is a manufacturing-based economy that is still in an industrialization phase of development where steel is one of the most important commodities for the country. Steel is used in everything–from the manufacture of cars and appliances to the construction of residential and office buildings and major infrastructure projects such as roads, bridges and railways. For this reason, China is the largest consumer of steel in the world, accounting for approximately one-third of global demand. Iron ore is no less important to China than oil has historically been to Western economies.

The rub with Rio Tinto and Australia comes because China does not have sufficient domestic supplies of iron ore, the basic raw material used in steelmaking, to feed its hungry mills, and instead must rely on global producers of the mineral. Unfortunately, three large producers–Australia’s BHP Billiton and Rio Tinto in the East and Brazil’s CVRD in the West–account for three quarters of global iron exports and represent the iron ore equivalent of OPEC. It is in this context that the planned joint venture between BHP Billiton and Rio Tinto pits Australia, the world’s largest iron ore producing country, against China, the world’s largest steel consuming nation.

While Australia’s iron ore production is now effectively coordinated by one economic entity, China’s steel industry is fragmented with an estimated 1200 producers, resulting in potentially unbalanced negotiations. In many respects, China recent actions may be seen as an attempt by the government to rein in the country’s own steel industry and present a united front to its large iron ore supplier. Any attempts by Rio Tinto or others to destabilize or interfere with this coordination process can be expected to elicit a strong reaction.

Because the use of steel is so pervasive in China’s economy, increases in the price of iron ore have a ripple effect throughout the country. Whether you believe that the arrests of the Rio Tinto employees are justified or not, the fact is that the planned joint venture between BHP Billiton and Rio Tinto has fundamentally changed the dynamic between China’s steelmakers and its iron ore suppliers. We have yet to see the final chapter in this story.

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