Sunday, December 28, 2014

Michael Komesaroff on the Shape of Chinese Sovereign Investing: "Beijing Will Call The Shots In Resource Sector Battle Royal"

Michael Komesaroff, principal of Urandaline Investments, a consultancy specializing in China’s capital intensive industries, and a former executive in residence at the School of International Affairs, Pennsylvania State University, whose insights on Chinese economic activity has been featured here in prior posts.  See Here, here, here, and here.

He has recently produced an excellent analysis of China's political economy of the leadership of state owned enterprises.  His presentation, "Beijing Will Call The Shots In Resource Sector Battle Royal," Gravekal Dragonomics, Ideas, Dec. 17, 2014, discusses the increasingly important role of Chinese state owned enterprises in tandem with Chinese administrative agencies on the shaping on global markets for control of extractive industries enterprises.  The analysis is critically important for providing a window on the way in which Chinese sovereign investing--coordinating private market transactions through SOEs with national regulatory authority applied extraterritorially--will have a growing effect on the shape of globalization. This post considers some of the more interesting points made.
The thesis is straightforward, though many in the West have been oblivious as its premises have been quite openly developed within Chinese governance circles:
In October the world’s fourth largest mining company, Glencore,  launched an audacious merger bid for the world’s second biggest miner, Rio Tinto. The approach was rebuffed, and United Kingdom takeover rules—both companies have London listings—forbid Glencore from making any further overtures for the following six months. Yet few in the
mining business believe that is the end of the story. Glencore’s chief executive officer Ivan Glasenberg has long had his eye on Rio Tinto. Come April, industry analysts expect him to be back with a new proposal. However, any battle over Rio Tinto will be about far more than Glasenberg’s deal-making prowess. It will shape the global mining industry in the post-commodity-boom world. And the outcome will be determined in large part by Beijing, whose anti-monopoly regulators haveshown themselves both willing and able to use their growing international clout to further China’s global resource strategies by forcing the sale of prize assets like copper mines to Chinese state-owned companies. (Kamesaroff, supra, 1.).
But it is about more than that; it is about the way in which China is refining its policies of coordinating public and private market interventions to advance national economic policy not just within China but within global markets of strategic interest to China as well (e.g., Backer, Larry Catá, Sovereign Investing in Times of Crisis: Global Regulation of Sovereign Wealth Funds, State Owned Enterprises and the Chinese Experience. Transnational Law & Contemporary Problems, Vol. 19, No. 1, 2009; Penn State Legal Studies Research Paper No. 12-2009).  It is that coordination, made possible because of the integrated functioning of economic planning, regulation and operation, that  poses a  challenge to Western economies grounded on a more or less strict separation between public and private market activities (e.g. Backer, Larry Catá, The Private Law of Public Law: Public Authorities as Shareholders, Golden Shares, Sovereign Wealth Funds, and the Public Law Element in Private Choice of Law. Tulane Law Review, Vol. 82, No. 1, 2008).  As a consequence, globalñ contests for corporate control will now include national public policy as a substantial factor in economic decision making.

Komesaroff explains how this will manifest itself by looking closely at the contest for Rio Tinto. China is both Rio Tinto's largest customer and its biggest investor.  It has suffered through a number of years of disastrous investment decisions by Rio Tinto in global markets for control of natural resources. (Kamesaroff, supra, 1-2). The new management team was somewhat successful in reducing costs bit continues to make a hash of its global operations.  As a result, Rio Tinto has had to fall back on its core iron ore operations (ibid).
That dependence means Rio Tinto has been brutally exposed to this year’s collapse in iron ore prices, which have fallen more than 45% to their lowest level since early 2009. The slump has been propelled in large measure by the actions of the major producers, including Rio Tinto itself, which have flooded the market with low cost ore as a deliberate strategy to force higher cost competitors, particularly those in China, to shutter their operations. The big miners defend their strategy on the grounds that their costs are much lower than those of the smaller competitors they hope to drive out of business (Ibid., 2).
Rio Tinto has thus backed itself into a corner in which its global operations mandate conduct that tends to seriously affect the economic productivity and development policies of its largest shareholder and customer. It is at this point that private economics and public policy will collide.  On the one hand, Rio Tinto's policies has opened it up to hostile acquisition by Glencore.  On the other it has exacerbated tension with its largest shareholder (Chinalco, and through it, the Chinese state). (Ibid., 3).
Chinalco’s stake in Rio Tinto has long been a contentious issue within China’s bureaucracy. Apart from the steady loss in value of their investment, two particular issues grate with the Chinese. Firstly, despite being Rio Tinto’s largest shareholder they have never been invited to join the company’s board, which many in Beijing regard as an anti-Chinese slight. The second matter that irks the Chinese is that in 2009 Rio Tinto abrogated a US$19.5bn deal that would have seen Chinalco double its stake in Rio Tinto and in the process gain two seats on the company’s board as well as joint venture status in several key mines, including Rio Tinto’s flagship iron ore mines in Western Australia. At the time Rio Tinto was struggling under a mountain of debt acquired as a result of its
disastrous 2007 tilt at Alcan, and the Chinese saw themselves as the company’s saviors. (Ibid).
The Chinese are not fond of the current CEO, whose policies have negatively affected Chinese policies toward internal development, and under whose leadership the Chinese convicted a Rio Tinto employee, Stern Hu, on charges of theft fo state secrets (see, e.g., HERE and HERE). At the same time the Chinese state is wary of Glencore, whose trading policies they see as potentially detrimental to Chinese interests, even if they were undertaken to maximize the profits of Glencore itself (Ibid., 3-4).

That wariness translates from public policy to regulatory action through the application of Chinese competition law rules. 
 Apart from the magnitude of the combined entity’s current copper production, the regulators would also be concerned with the potential of several large development projects to expand each company’s copper output. Rio Tinto has a 33.5% stake in Mongolia’s Oyu Tolgoi, the world’s largest copper project, which is slated to produce 450,000 tons of copper per year before the end of the decade. A large share in both the world’s largest existing copper mine and its biggest copper development project is hardly likely to go unnoticed, especially in China where copper is near the top of the list of commodities nominated as a strategic priority. (Ibid., 5).
Kamesaroff suggests that the end of a process of active examination by Chinese authorities (in addition to that of other regulators),  will inevitably lead to the break up of Rio Tinto.  Komesaroff suggests the ikely elements of breakaways--copper, aluminum, and thermal coal. (Ibid., 6).  But divestment produces an added value for Chinese operations--while Chinese regulators will seek divestment in accordance with an application of its competition laws, Chinese SOEs will be waiting to buy the stripped assets.  In effect, the combination of Chinese regulatory and market power will produce net gains to China as it buys up assets it requires Rio Tinto to divest. (Ibid., 6-7).  Glencore, interested in the core iron ore business according to Kamesaroff, can live with this result.  But Rio Tinto's joint venture partners may extract a price. (Ibid., 6). Kamesaroff notes that this coordinated result may be less a product of coherence than of competition within Chinese state and private sectors. 
Whether China’s political masters will be quite as enthusiastic about picking up Rio Tinto’s assets as the managers of their state-owned enterprises is less immediately obvious. China’s state resource companies are plagued by inefficiency and tainted by corruption scandals. Chinalco’s new head, Ge Honglin, was appointed last month with a brief to improve the company’s disastrous bottom line—its listed subsidiary lost RMB4.12bn in the first half of the year—and has hinted that employee numbers will be heavily reduced. Meanwhile at least two of Chinalco’s senior managers are being probed by the Central Commission for Discipline Inspection for “serious violations of discipline and law”. (Ibid., 6).
Kamesaroff also notes that such coordinated investments have sometimes proven disastrous from a financial perspective.  (Ibid., 7).  It is not clear, however, that Chinese state officials would value those acquisitions using the same metrics as private firms.  The value of control of natural resources to the Chinese economy may have a value to China that is not reflected in purely private financial calculus.  That inability to understand the financial calculus, one grounded in long term public policy, may cause Western analysts to misunderstand Chinese strategic calculations, and underestimate Chinese pricing strategies. This strategy, that Kamesaroff identifies as Chines pragmatism will manifest itself in the Rio Tinto acquisition and dismemberment.    
As the world’s largest consumer of iron ore, China deems the future of Rio Tinto to be of national importance. An approach to Chinalco by a potential suitor for Rio Tinto would certainly be reported to the National Development Reform Council, which would need to approve the involvement of a state entity, or the purchase of any assets divested by the miner’s new owner. That approval may well be forthcoming. Xiao Yaqing, who as president of Chinalco first proposed a shareholding in Rio Tinto to the NDRC back in 2008, is now an influential deputy director at the State Council. It is highly likely that he would be keen for Chinalco to participate in any takeover of Rio Tinto as a vindication of his original strategy. Similarly, Chinalco’s recently replaced President, Xiong Weiping, is now chairman of the board of supervisors at the State-owned Assets Supervision and Administration Commission. Although not as powerful as the NDRC, SASAC would also be consulted if any state enterprise were to participate in a takeover of Rio Tinto. Like his predecessor Xiao, it is probable Xiong would back the involvement of his former company. (Ibid., 7).
These considerations, Kamesaroff contends, work to the benefit of Glencore as well.  That entity may see in Chinese interest a means of purchasing those parts of Rio Tinto it wants, leaving the rest to the Chinese.  (Ibid.). With Glencore looking  to make money from flabby businesses unable to adapt to new economic cinditions, and with China increasingly adept at coordinating itrs regulatory and market power to advance its eocnomic interests, it is likely, Komesarff suggets, that Rio Tinto will cease to exist. (Ibid).  More importantly, perhaps, the Rio Tinto acquisition will set a pattern for global markets in control neither Western companies nor the states from which they operate understand or are prepared to counter to advance their own economic and public policy interests. 


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