From Sandton to Shanghai

(Australian Mining Stocks on the Decline: S&P ASX 300 Mining and Metals Index showing a 49% drop over 6 months ended 1 December 2008)

‘Be bold on expanding overseas’ is the near official line hailing from China Daily’s front page yesterday.

After years of battling to keep input costs down amid a rampant commodity boom, the current global economic marketplace has swung round 180 degrees in China’s favour.

A strong sense of risk aversion is definitely needed after China’s baptism of fire on the international investment scene. Recent overseas equity purchases at the height of the business cycle have definitely burnt deep holes in the balance sheet: Rio Tinto, Fortis, Barclays and Blackstone have all been far from pretty.

“These are rare opportunities for Chinese enterprises which want to expand overseas,” emphasized Zheng Xinli, vice-director of the Policy Research Office of the CPC Central Committee. You can almost sense the anticipation in the air. Hard lessons have been learnt, but we seem to be in a strategic pause before a concerted buying spree in 2009.

Australia will be one of the first destinations.

In the past 6 months, listed Australian resource stocks have lost up to 60% of their market capitalisation. Over the same period, the Australian Dollar currency depreciation has moved over 30% in China’s favour.

Australia is China’s most successful resource investment destination. The market is efficient, well managed and transparent. Its proximity to China keeps logistics costs down. Iron and high quality coal - bountiful in Australia - are staple products for China’s manufacturing economy and in short supply back home.

What will make this investment period different from before is the move to M&As and significant ownership levels. This is a sharp contrast from China’s previous preference for a more hands-off policy of minority stakes, off-take agreements and long term contracts.

Here are a few more tangibles to look out for:

• Iron Ore and Coal Companies are priorities
• China’s SOEs will take the lead like Sinosteel, Baosteel, Angang Steel, CITIC, Yangzhou Coal, Shenhua and Chinalco
• Keep tabs on smaller, more nimble and internationally adept Chinese resource players like Jiangsu Shagang , Zijin Mining, Western Mining, Jinchuan and Hunan Nonferrous
• Expect large equity stakes in companies part of recent large-scale M&As who are now saddled with a huge debt burden like Rio Tinto, Oz Minerals

I am happy to say that my first big prediction in this blog has come to fruition. On 12^th November 2007, I wrote that:

“By purchasing a bigger stake in Rio, China Development Bank could thwart BHP’s acquisition plans. It would also as the perfect excuse for China to make its first big investment in a major mining stock. This would probably be one of the few times that a company like Rio would actually welcome China taking a significant stake in them.”

Almost 2 months later this is exactly what happened. On 31^st January, according The Wall Street Journal: “Chinalco and Alcoa managed to snap up 9% of Rio by purchasing London-listed shares overnight Thursday, while avoiding leaks that might have alerted the market to their plans and given BHP time to respond.”

The deal was valued at massive USD14.1 and surpassed China’s previous international investment deals by a huge margin. While there is still the possibility of BHP upping the ante, China has a strong hand with its 9% stake in Rio Tinto. This makes future BHP efforts more financially risky and complex and significantly narrows their window of acquisition opportunity. Even if this happens, China will be happy in the knowledge that they have their first ‘super-stake’ in a global mining company.

Living in China is a fascinating experience and gives me an ear closer to the ground. Far from being a mysterious and opaque country that making foreigners perceive, many things are quite straight forward on a macro level in China. It is the micro level that defies comprehension.

On many accounts, China’s interests in thwarting a BHP - Rio takeover are very straight forward. If you understand the dynamics that drive China’s growth and the direct threat that a mining mega merger poses, then the outcome (but definitely not how the outcome is achieved) is more certain. Add to this China’s centralized decision making ability (which means that if something is of national importance it will be dealt with as a key prerogative) and China’s burgeoning foreign reserves mean that all but the biggest deals are out of their reach.

(China has gone from zero to significant international investor in 3 years. Source: Wall Street Journal)

Hot off the press news according to the Telegraph is the ‘Blackstone is planning an audacious break-up bid for miner Rio Tinto’ The Times is running the same story ‘Blackstone, the American private equity firm, is to join the battle for Rio Tinto with a break-up bid’

Should these reports be accurate, it presents in my mind a viable and political savvy way that China can:

a) halt BHP’s hostile takeover of Rio Tinto
b) make its first significant investment in the multinational mining sector

In 2007, The China Investment Corporation invested USD 3 billion in Blackstone to secure a 10% stake in one of the world’s top private equity companies. Blackstone’s Rio consortium includes China’s USD200 billion sovereign wealth fund.

(Post Script: Unfortunately the Daily Telegraph proved to be an unreliable source and Blackstone entering the Rio space was officially denied later on the day this news broke) 

(A picture paints a thousand words as to why a BHP-Rio merger is bad news for China. As testimony to the staggering growth of China’s steel industry, an armada of 60 bulk carriers wait patiently off Australia’s Newcastle Harbour to receive coal and iron ore payloads. In May 2007, the line of ships at off Newcastle Harbour stretched to a record 79 vessels. Photo: James Croucher, The Australian)

After my predictions of a looming Chinese investment in Rio Tinto 2-weeks ago (Prediction 2: Chinese Investment in a Multinational Mining Company, November 12th, 2007), China has already fired the first salvo depending on which sources you want to believe.

According to a Forbes article released yesterday, “Shares of Rio Tinto jumped 7.5% Monday in Sydney on a report that China’s new state investment fund and some of its largest state-owned steelmakers could enter a joint counterbid to BHP Billiton’s offer for its mining rival. A state-owned Chinese weekly, China Business, reported over the weekend based on unnamed sources that China Investment Corp., which has been tasked with managing the country’s burgeoning foreign-exchange reserves, and the steelmakers Baosteel, Shougang Group and Angang Steel, were working on a $200 billion bid for Rio Tinto.”

In my mind the response from the China Daily (which when necessary can be heavily influenced by the powers that be) was a bit too quick for comfort. In these instances I tend to favour reading between the lines. This is what they had to say 12 hours after the Forbes report:

“China Investment Corporate Ltd (CIC), the country’s newly launched state foreign exchange investment company, said in a statement Monday that it had never been involved in a bid for Rio Tinto. The statement was intended to dispel market rumors started by a report in Chinese weekly newspaper China Business saying the CIC was leading a group of Chinese steel makers in a bid for Rio Tinto.”

Personally, I am still happy to stick to my initial reaction. A merger between BHP and Rio is not good news for China however you look at it. It is an area of strategic national interest when one company controls 40% of the iron ore in the world and you import most of that. I can assure you that as I write this, Chinese decision makers are doing anything but sitting on the fence. They will be actively pursuing every possible angle necessary to alter the status quo in China’s favour.

BHP has already engaged in some ‘ungentlemanly’ iron ore price negotiations with China. In 2004, BHP lumped the Chinese Iron and Steel Association with a 71.5% year on year price increase. Rather patronizingly, BHP also demanded an unprecedented surcharge of up to USD10 per ton. Their reasoning was that importing steel from its Australian mines would save on transport costs for the Chinese companies importing Brazilian Steel.

If this was the leverage BHP thought it had as a ‘Rio Tinto-less’ entity, China will definitely not be going gently into that good night…

Rather strangely, China has made virtually no investments in major multinational miners. In 2006, Larry Yung made a small blimp on the radar screen by purchasing a 1.1% (USD800 mn) stake in Anglo through his company China Vision Resources.

Investing in a multinational mining company is a highly sensitive, politically challenging task for China. Any Chinese company that has the ability to do so also has strong government ownership and this turns an equity purchase into an issue of national interest rather than a pure business transaction.

At the same time, China is finding itself in a difficult position. It is still heavily reliant on companies such as Rio Tinto, BHP Billiton and Anglo American for its supply of key resources such as iron ore, high grade coal, copper and nickel. Rising commodity prices are placing pressure on manufacturing costs and resource sustainability – the backbone of China’s current economic rise to fame.

The ‘hot off the press’ news that the China Development Bank has bought a 1% stake in Rio Tinto. It comes at a very revealing time indeed. Rio is currently subject to a hostile take over by BHP Billiton. According to a Daily Telegraph article, if successful, this super-sized merger would give the company a 40% control of the iron ore market. As a crucial commodity to its manufacture-driven economy, China currently consumes half the world’s iron ore supply.

A merger of this magnitude would definitely be detrimental to China’s iron ore bargaining power. By purchasing a bigger stake in Rio, China Development Bank could thwart BHP’s acquisition plans. It would also as the perfect excuse for China to make its first big investment in a major mining stock. This would probably be one of the few times that a company like Rio would actually welcome China taking a significant stake in them.

There will be some hard bargaining and Mandarin translation going on in the Rio Tinto boardroom. And if that fails then attention will shift to the next most likely prospect…

Photo courtesy of China Daily

DRC’s sun rises in the East

Julian Hewitt
05 October 2007

China’s recent announcement of a $5-billion loan to the Democratic Republic of
Congo to develop national infrastructure and mining interests seems to have taken
the world by surprise.

International mining companies and institutions such as the World Bank,
International Monetary Fund and African Development Bank have been scrambling
to find out more details of the Chinese deal that might have severe repercussions on
their own activities in the country.

China’s move, however, is far from unexpected. In fact it makes complete sense
from a Chinese perspective. The DRC is one of the most mineral-rich countries in
the world. It has an abundance of raw materials, such as copper, cobalt, diamonds,
uranium, manganese and gold. Of these copper, uranium and manganese occupy
top spots on China’s hit list of minerals that have strategic national value. The loan repayment terms will be primarily in the form of mining concessions to
Chinese companies.

China missed out on the first scramble for Africa and has had to settle on riskier
environments to satisfy its voracious mineral appetite. It took only two years after the
dust settled on Angola’s protracted civil war before Chinese oil companies were
setting up shop in the country. Further examples of China’s risk aversion include significant oil interests in Sudan and the recent purchase of a ferrochrome mining company in Zimbabwe.

What counts massively in China’s favour is the high-level diplomatic support that
accompanies its mineral and energy investments in Africa. Having direct government
backing helps to decrease the vulnerability of doing business with unstable regimes.
China has another ace up its sleeve that is unmatched by global mining companies.
This is the huge infrastructural backing it can lend to countries such as the DRC.
Instead of benefiting from its enormous mineral wealth, the DRC has been racked by
a 30-year-long civil war, leaving its economy in tatters and the country lagging near
the bottom of the world’s poorest nations list.

A 2005 Organisation for Economic Cooperation and Development country report
says 80% of the DRC’s population lives on less than $0,2 a day. Only 5,7% of the
population have access to electricity and less than 5% of the country’s 57 700km
road network is tarred. What mineral wealth the DRC has is being whisked out the
country’s porous back doors.

Although only 1% of the country’s arable land is under cultivation, the agricultural
sector was responsible for a staggering 50% of the country’s GDP in 2003.
As part of the loan agreement with China, $3billion will be allocated to infrastructural
projects. These include a 3 400km highway, a 3 200km railway link with Matadi on the Atlantic Ocean, 31 hospitals, 145 health clinics and two universities. One has to
wonder how much more favourable the global reaction would have been if it was the
World Bank announcing these terms rather than China.

The other major value add from the Chinese perspective is that the Zambian
Copperbelt cuts a swathe through the southeastern corner of the DRC. China has
invested more in Zambia’s mineral resources than in any other African country. The
Zambian Copperbelt is the location of China’s first special economic zone in Africa.
In addition, China’s proposed highway will link up to Zambia, which puts the DRC and
its mineral reserves in easy grasp of the TanZam Railway to Dar es Salaam.
Despite institutional misgivings about all things Chinese in Africa, China’s forays into
the DRC can only add value to a country that has been going nowhere slowly for
three decades. In fact, it is hard to imagine a better lifeline coming from anywhere
else.

China changes rules of resource game

Julian Hewitt: COMMENT
13 February 2007

When I left South Africa, a talk by Clem Sunter titled “China’s Game” was ringing in
my ears. Clem talked about the rules of the game China is playing in its
unprecedented drive to industrialise a 1,3-billion strong population. What struck me
was China’s dependence on natural resources to continue its impressive growth
trajectory. One of the major rules of China’s game requires it to establish massive
and sustainable supply lines to secure resources that fuel its vast factory-floor
economic model.

Of course, this is the major pillar behind African-Chinese trade. Africa has the
undeveloped resources China so desperately wants. In testimony to this growing
trade and development cooperation, Chinese President Hu Jintao has visited Africa
five times since 1999 and Premier Wen Jiabao has already toured the continent on
three separate occasions. Depending on which side of the fence you sit on, much
has been said about China’s new “colonial” role in Africa or the massive development
opportunity for the continent to dovetail on China’s great economic ambitions.

There are a couple of interesting factors that make up China’s drive to secure
mineral resources and energy assets. The first is the sheer scale of the undertaking.
China has a massive population and burgeoning economy to support. The other is
the role of the state in securing these resources. This is a national prerogative, which
is not unique in itself. However, the fundamental difference is that the Chinese
government plays a prominent role in meeting these strategic requirements, while
most other governments rely largely on the invisible hand to meet a rising supply and
demand needs.

At China’s disposal is an army of state operated enterprises (SOEs). Long a
backbone of a previous, more socialistically inclined, era, the more effective SOEs
have subsequently embraced a world of initial public offerings (IPOs), international
acquisitions and foreign contracts.

China’s ruling party has entrusted them with a mandate to pursue resources deemed
to be of strategic national interest — iron ore, nickel, zinc, oil and gas and copper,
among others. The SOEs have political backing, massive credit lines from local
banking institutions and increasing international business acumen.

A sign of things to come is the Belinga Project in Gabon. Purported to be the largest
untapped iron-ore reserves in the world, a Chinese consortium came head to head in
the contract bidding with Brazil’s CVRD — the world’s largest iron-ore producer.
Because Gabon’s iron-ore reserves are situated deep in equatorial forests, massive
infrastructural costs have excluded previous iron-ore suitors. Enter the Chinese
consortium, which offered to a) build a new railway line 560km into the jungle, b)
construct a deep-water harbour from which to export the iron ore, c) develop a
hydro-electric dam to supply electricity to the project, d) finance the initiative, e) bring
in Chinese labourers to build it and f) offer to buy the entire mined output.

Not surprisingly, CVRD got blown out of the water in the bidding process — few
companies on Earth would be able to compete with such a comprehensive undertaking.

A recent “secret” meeting at the World Economic Forum in Davos, Switzerland, was
held between the heads of more than a dozen of the world’s largest mining
companies. The six-hour think tank highlighted what a growing concern Chinese
encroachment in Africa was becoming. The group — ironically given the
colonialesque title of “the governors” — sought to find ways of curtailing China’s
immense interest in Africa, which is rapidly displacing their exposure on the
continent. They are considering appealing to the World Bank and United Nations for
help. What “the governors” are rapidly realising is that competing with
government-backed Chinese companies is beyond their capacity. The World Bank
estimates that, last year alone, China spent more than $10-billion on infrastructural
projects in Africa as part of its capacity for-resources exchange.

There is a flip-side to China’s foreign mining exploits. The debate started in earnest
when in 2005 China’s Minmetals made an audacious takeover bid to acquire
Canadian miner Noranda — then the world’s ninth-largest copper and third-largest
zinc producer. A strong nationalistic Canadian backlash revolved around the
argument that Minmetals was a state-owned company and local officials were not
comfortable with a foreign SOE acquiring an important industry on home turf. The
deal was eventually scuppered and other Chinese SOEs have faced many similar
subsequent acquisition challenges.

Bear in mind that China has more than a trillion dollars in foreign reserves from
spiralingtrade surpluses. One of the reasons it is reluctant to completely open its
currency to market forces is the inevitable appreciation of the Chinese yuan against
major currencies such as the United States dollar. Even a “small” 10% depreciation
will wipe off $100-billion from Chinese reserves — enough to finance the estimated
project costs of Gabon’s Belinga Project 169 times over. It has to be tempting for
China to reduce currency exposure on its monolithic foreign reserves by investing in
foreign resources, killing the proverbial two birds with one stone.

Whatever the future holds for China’s quest to build its resource supplies, the rules of
the game will definitely be different from those of the corporate game being played at
present.

And Africa will be a key part of the playing field making us all rather interested
participants or observers.