China VS Australia Part 2.

Last year I wrote an editorial about the new cold war beteeen these two - here is the link

Interesting update on this whole issue in the Wall St Journal

Key points - all is not as it seems in the world of commodity trading and shipping. Relationships are key. Corruption is out there under many guises.

The point made was that 'corruption was not why this blew up. It was the breakdown in trust'. Sad but true.

I have spent lots of time in Chinese Steel Industry board rooms staring at a bust of Chairman Mao negotiating iron ore freight deals. Interesting times

Here is the article - very balanced

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By HUGO RESTALL


Yesterday a Chinese court sentenced four executives of Australian mining company Rio Tinto to lengthy prison terms for bribery and stealing commercial secrets.

In the eight months since Australian citizen Stern Hu and his Chinese colleagues Wang Yong, Ge Minqiang and Liu Caikui were arrested, we've learned a great deal about the lack of rules not only in China, but also in the global commodities trade. Some of that is China's fault, but hardly all of it.

Foreign media coverage of the arrests and trial has focused on whether the Chinese authorities pursued this case for political reasons. Remember that early last year, cash-starved Rio Tinto angered China by inviting Aluminum Corp. of China, or Chinalco, to take a $19.5 billion equity stake and then backed out of the deal under a combination of shareholder, government and public pressure. Rio was also driving a tough bargain in iron-ore price negotiations with Chinese buyers. Many observers speculated that the four executives were pawns in a high stakes game of tit-for-tat orchestrated from Beijing.

Certainly the timing of the case makes such suspicions inevitable. But the reality is probably more complicated. The Chinese justice system may be manifestly unfair, and once it gains momentum a guilty verdict is a foregone conclusion. Yet Rio itself put forces in motion that led to four men losing their freedom.

It all started with the boom in the global iron-ore market in the early 2000s. That's when China's steel industry embarked on a significant expansion of capacity, turning the trade in ore from a buyer's market to a seller's market. China's large state-owned steelmakers bought at the benchmark price negotiated by Japanese and Korean mills, while smaller firms had to pay the higher spot price. This created an incentive for arbitrage and corruption, but unfortunately both the Chinese government and the mining companies were slow to take account of this in their internal controls.

As demand soared, the benchmark and market prices for iron ore diverged and the system came under increasing stress. In 2008, the Brazilian mining giant Vale negotiated a new benchmark price, only to see its two Australian rivals, BHP Billiton and Rio Tinto, refuse to follow it. Vale reacted by tearing up its agreed benchmark price and renegotiating with producers who were over a barrel.

Then Rio Tinto also began to back out of its contracts, for instance by invoking clauses in contracts to hold back 10% of deliveries, which could then be resold at the spot price. Since Rio was facing a hostile takeover bid from BHP, the company's managers pushed especially hard for every last dollar at the expense of their trading partners to show that they could deliver higher returns for shareholders.

Rio's Mr. Hu himself acknowledged the problem. In 2008, after Rio negotiated a 87% price increase, Australian reporter John Garnaut interviewed him: "He said he had no qualms with driving as hard a bargain as he could on price. But he had misgivings about whether Rio Tinto should risk its integrity in China by claiming 'force majeure' to wriggle out of long-term contracts to chase higher prices elsewhere. 'We acted in accordance with the letter of the contracts, but not the spirit,' he said."

This weakening of the bonds of contract naturally infuriated Chinese steelmakers. So when the economic crisis hit at the end of 2008 and demand for iron ore evaporated, it was payback time. Enjoying a buyer's market again, the Chinese firms simply walked away from contracts.

The turnabout didn't last long. Beijing's fiscal stimulus program quickly revived demand for steel by the middle of 2009, and the Australians were able to start raising prices again. Negotiations over new iron-ore benchmark prices were particularly acrimonious, given the bad blood created over the past couple of years. And that was the state of play when Mr. Hu and his colleagues were arrested on July 5, 2009.

One past participant in the iron-ore business, who insists on anonymity because of the sensitivities on both sides, believes that the investigation into the Rio Tinto executives was ongoing for many months before the arrests, meaning they were not directly related to the Chinalco fiasco or the ongoing price negotiations. The authorities likely started sniffing around as a result of a tip-off from someone on the Chinese side of the industry. The ill will created by the whipsawing prices and huge losses suffered by some firms supplied plenty of motivation for someone to drop the dime on Rio.

And some dirt was found. Rio Tinto has severed its relationship with the executives, saying they engaged in "deplorable behavior," effectively accepting the verdict that they were taking kickbacks from steelmakers to arrange preferential access to iron ore. The charges of stealing commercial secrets are much more murky, as evidenced by the fact that they were heard in a totally sealed courtroom. But these too probably originated from lower down the ladder of officialdom, rather than a Beijing-led witch hunt against Rio Tinto.

The bosses in Australia made the mistake of leaving their Chinese executives in place for too long with too little supervision. But the bigger mistake was destroying the trust of the handshake deals made with Chinese partners in the quest for a little extra margin. That is bad practice anywhere, but especially in China.

Chinalco has not held a grudge against Rio for the failed equity deal. The two companies continue to negotiate joint projects in countries like Mongolia and Guinea. The Chinese government's own post-mortem report on the affair is relatively kind to Rio and admits that the Chinese side could have handled the deal better.

However, the government of Prime Minister Kevin Rudd does not come off so well. Treasurer Wayne Swan ran scared from public perceptions of being too soft on China and politicized the approval process for Chinese investments, making it clear that the Chinalco deal would not go through and future acquisitions in the natural resources industry would face strict limitations. The lack of transparency and hostility toward China came as a complete surprise to Beijing and has created lasting tension between the two countries.

It was bad luck that around the same time, Xinjiang dissident Rebiya Kadeer was invited to Australia and Canberra issued a defense white paper that singled out China as a potential threat around which to base future strategy. From Beijing's perspective these all suggested that Australia was turning hostile and there was no certainty about the rules for Chinese companies doing business there. Had this not happened, it's possible that greater leniency would have been shown to the four Rio Tinto executives.

Everyone doing business in China should be clear by now on the rules—there is no rule of law. Deals can be done on the basis of mutual trust, which creates some level of certainty. The four Rio Tinto executives may be guilty of corruption, but the real reason they are in prison is because that trust broke down.

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