Tuesday, April 21, 2015

Michael Komesaroff on Chinese Sovereign Investing, Drawing Lessons from the Example of the Aluminium Sector

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, here, and here.

Mr. Komesaroff has developed one of the finest eyes for analyzing the operation and strategies of Chinese sovereign investing. He has recently produced an excellent analysis of China's sovereign investing strategies within the aluminum sector. His essay, "Aluminum: Coping With Excess Capacity," Dragonomics, March 9, 2015) provides and insightful analysis both of China's sovereign investment strategies in the natural resources sector, and also of the West's continuing inability to understand it (in large part because of the insistence on wearing increasing antiquated ideological blinders).  The analysis is critically important for providing an application within a specific investment sector of Chinese sovereign investing--coordinating private market transactions through SOEs with national regulatory authority applied extraterritorially.  That model continues to increase its impact outside of China and in shaping global markets and markets behaviors.
This post considers some of the more interesting points made in that essay.
Komesarooff starts by noting that the commodity super cycle of the last decade is over.  The sustained increases of earlier in this decade have now been replaced with depressed prices for commodities. Yet he notes an anomaly in this commodities markets super cycle.  "After massive and sustained increases during the early part of this decade, prices for most metals are now thoroughly depressed. The one exception to this trend is aluminum—not because its price is not low, but because it never went up strongly during the heights of the commodity boom."(Komesaroff, "Aluminum: Coping With Excess Capacity," supra., p. 1). This leads to Komesaroff's thesis: "that China and supply-side discipline were the key factors behind the boom in commodity prices, and will continue to shape the fallout from the bust. " (Ibid). 

Komesaroff starts the analysis by situating aluminum within the last commodities super cycle.  That cycle began, he tells us, when "cautious producers were slow to respond to the surging demand from China, and ended when exuberant producers came to expect that high prices would be sustained forever." (Ibid.).  While aluminum participated in the cycle (growing at an average rate of 7.2% during the last five years, it was different because China was able to meet much of its own demand for aluminum.  That was accomplished through a huge investment in expanding capacity within China.   "While the global aluminum industry has long been known for being reckless about expanding capacity, China’s local government-driven investments set new standards for excess." (Ibid.).  
Indeed, Komesaroff tells us, 90% of the growth of aluminum production occurred  in China, resulting in Chinese dominance of the global aluminum industry  Currently China produces 50% of global aluminum supply.  The downturn in commodity prices will not affect China's dominant role, because of technological and cost advantages that western industry competitors have persistently underestimated, perhaps because they were too busy basking in the glory of their past while Chinese industry (supported by state policy) looked to the future. The result is consolidation of Chinese dominance and the likelihood of continued diminution of competitor capacity (mostly fractured and without objective other than short term profit perhaps) in the face of China's sovereign united front.
The persistence of large Chinese capacity will put pressure on the rest of the global aluminum industry to restructure and consolidate to survive. Already, major players inside and outside China are pursuing strategies like combining assets and spinning off operations, a trend that will only accelerate in the coming months and years.(Ibid., pp. 2).

The other problem, Komesaroff notes, is that western industry players, so accustomed to viewing events through their ideological blinkers, failed to see the logic and thrust fo Chinese policy, even when it was staring them in the face. 
Western industry players have long believed that China’s enormous expansion of aluminum capacity defies economic logic. Aluminum production is one of the most electricity-hungry industries in existence, with energy accounting for 40% of production costs. So many analysts have long argued that it makes no commercial sense for China, a country with relatively high-cost electricity, to produce so much aluminum. Global producers like Alcoa and Rio Tinto have expanded because of their belief that sooner or later economic logic will prevail and Chinese aluminum smelters will start shutting down in droves. But this analysis has proved to be mistaken, because it ignores other sources of cost savings, downplays the adaptability and resourcefulness of Chinese producers, and misunderstands how industrial policy drives China’s decision-making. (Ibid., pp. 2).
Komesaroff then goes through the factors seriatum.  With respect to costs, he notes that a willingness to support experimentation over a long period of time has produced some excellent results for the Chinese. "Chinese engineers can now erect a new plant for just one-third of the standard international cost. So while their operating costs may be above that of international competitors, this disadvantage is more than compensated for by significantly lower capital costs." (Ibid., pp. 2). Moreover, because Chinese smelters are about 45% larger than the international standard, the Chinese are able to reduce their average production costs by spreading fixed costs over more output. (Ibid., pp. 3).  The Chinese have also reduced costs by pairing smelting with abundant power supplies. Either smelters are located near cheap energy sources (for example in Xinjiang where coal is abundant and electricity costs 40% per MWh than elsewhere in China ) or by engaging in projects where smelters are constructed with their own power stations (producing substantial savings over grid purchases of electrical power). (Ibid).  Andin the context of sovereign investing this serves Chinese public interests even as it enhances economic power.  The move to Xinjiang, for example, is consonant with the Go West policy (西部大开发) and serves political and societal interest as well (see e.g., here).

Innovation has also outstripped western competitors.  Komesaroff notes in particular the development of Chinese computer models to perfect large capacity electrolytic cells, with significant cost savings potential.  (Ibid., pp. 3).  Here innovation combines with investment in capacity to produce lower costs. 
Rio Tinto has patented a similar technology, but because it and other Western companies have not made much investment in new capacity they have not been able to incorporate it into actual facilities. As a result, China’s aluminum smelters are operating with the world’s most efficient technology, saving 1 MWh of electricity per ton of aluminum by comparison with global peers. At average power tariffs this is equivalent to a cost saving of RMB500 per ton of aluminum. (Ibid.).
The picture is not entirely rosy, of course.  Chinese strategies come with a price.  Overcapacity means even Chinese smelters are operating on average at 68% of capacity in 2014. (Ibid., pp. 4).  Chinese overcapacity has also cost this sector "around RMB 10bn during 2014." (Ibid., pp. 4).  These losses will likely continue into the future. (Ibid.). As a result China's largest aluminum producer, Aluminum Corp. of China Ltd. (Chalco), have championed restructuring grounded in mutually supporting quasi oligarchies. "Chalco has championed the formation of a coalition with eleven other local smelters, which aims to support domestic prices by selling only directly to customers and not to the Shanghai Futures Exchange. But given the volume of excess supply in China it is doubtful if even Chalco and its allies have enough power to influence market prices." (Ibid.). Others have attempted different forms of restructurings and alliances, or have chosen to go out of business (Ibid.,, pp. 5).

And there are conflicts between the macro economic planning objectives of the central government and the macro economic needs of provincial officials worried about the effects of factory shutdowns on employment and the local economy.
The central government has long been aware of this problem, and issued various orders to shut down the excess, but local governments have found that their interests are better served by ignoring Beijing’s directives. Since local officials are rewarded for their ability to foster local economic growth and maintain social stability, shutting down plants that provide employment and tax revenues is rarely an attractive option for them.(Ibid., 4)
The result is that while governmental subsidies may be harder to obtain at the central government level, provincial officials may provide subsidies to keep smelters in operation. The central government appears to be acquiescing in many cases, if only to keep stability.  While that that policy  may not indicate future action, it does expose the policy considerations that Beijing appears to be balancing.
A February report by the Ministry of Industry and Information Technology (MIIT) acknowledged the difficulties in shutting down local facilities, such as a loss of tax revenue that would make it harder for local governments to pay back  their debts. Rather than calling for more closures, it urged efforts to help smelters lower power prices and form industry alliances to ride out the slump (Ibid., pp. 4).
Thus it is levering capacity strategies with technical innovation in the service of state driven economic and societal objectives--wedding technology, politics, macro- and micro-economic policies--that gives Chinese sovereign investing its unique character. Komesaroff suggests that it is the West's inability to understand the key features of China's approach, for example in its aluminum production policies, that continues to cost the West dearly. (Ibid., pp. 4)  And this is a problem of the West's own making, bound as it is by arrogance and an unwillingness to take the sort of risks that once brought them to prominent in global markets. Komesaroff offers in proof Rio Tinto's purchase in 2007 of the Canadian aluminum producer Alcan. Rio Tinto's miscalculation and bad analysis of markets, their failure to innovate appropriately resulted in the need to"write doen two thirds of its US $38Bn Alcan investment." (Ibid., pp. 4).

Komesaroff ends by suggesting ways in which Western companies might survive in a profitless industry now dominated by the Chinese approach to capacity and public policy driven economic objectives. These focus on joint ventures and aggregated production and production chain alliances on a model similar to that employed by Chinese companies. But the difficulty is that Western companies do not serve national interests directly, as they do in China.  Nor do western companies frame thier operations around public policies related to social responsibility within long term projects of economic development.  These companies, untethered form the state, now must learn to operate without the benefit of public protection.  If they do not develop, functionally at least, some of the aggregating long term objectives now central to Chinese sovereign planning and economic policy, they will likely continue to shrink, especially as critical resource sectors run the risk "that for the foreseeable future there is no money to be made in aluminum smelting." (Ibid., 5).

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