China will learn from failed Chinalco-Rio deal

The collapse of the planned $19.5bn investment by Chinalco in Anglo-Australian miner Rio Tinto is a serious blow to China’s self-esteem. The state-backed aluminium company was proposing the country’s biggest foreign investment as part of efforts to secure a stable, cost-effective supply of the natural resources it needs in vast quantities to continue its rapid growth.

China will learn a bitter lesson from this. The speed of global expansion has given its corporate behemoths little practice of the pitiless reality of western-style acquisitions.

The mooted deal shows China’s financial firepower, however. Chinalco spent $14bn buying 9 per cent of Rio, the world’s third largest miner, in February 2008, at almost the peak of the market. A year later, when Chinalco offered to make the second-round investment, mining shares had plunged and with them the paper value of its first purchase. The planned $19.5bn (€14bn, ?2.2bn) deal ?designed to solve Rio’s debt problem and double Chinalco’s stake ?was in part intended to recoup earlier losses. The move also disrupted a planned takeover of Rio by rival BHP Billiton.

By setting out to scupper the BHP move, which would have created a duopoly in iron ore supply between Rio/BHP and Brazil’s Vale, Chinalco was seeking to ensure that China ?the world’s biggest steel producer ?would retain a significant say in the pricing of iron ore and bauxite. The deal’s failure is a setback on the long march of China’s big businesses into the global economy. It also reflects the international inexperience of its business leaders, mostly politicians.

The $19.5bn proposal was put on the table in February, when markets were badly hit by the world financial crisis. Chinalco should have pressed its negotiating advantage harder and not given Rio time to seek alternatives. In the past four months Rio’s share price has doubled, providing a chance for it to court two lovers at the same time ?openly with Chinalco and secretly with BHP again, in the form of a joint venture in Western Australia.

The episode may further benefit Rio. Its attempt to revive a partnership with BHP is arguably now more likely to overcome regulatory opposition because of public and political hostility to the Chinese alternative.

But China is not about to abandon its aggressive global investment strategy. And it is difficult to overestimate its economic might ?shown by the financial structuring of the Chinalco deal. Had the company been private, banks would never have lent so much on such easy terms. The losses on its first investment in Rio led profits to drop 99 per cent last year. The collapse of global demand for aluminium this year could result in a loss in 2009.

Yet four of the biggest state-owned Chinese banks lined up to lend the company more than it required for its planned second investment. They charged interest close to zero and did not set a time for Chinalco to pay its debts. Such lending activity is possible only in China, where state-owned banks and businesses are treated as the left and right arms of the state, working together to achieve national long-term development objectives.

Until a few years ago economists talked only about foreign direct investment into China; but direct investment originating there has leapt from almost nothing six years ago to $52bn last year. Had Chinalco’s plan succeeded it would have doubled this year’s outgoing direct investment.

Chinese leaders have been reminded of the challenges they have to face in making foreign acquisitions and strategic partnerships. Even with the support of the state banking sector, even with the damage the global financial crisis has inflicted on western business, China cannot expect to implement its investment strategy unopposed. But this will not be the last time its investment strategy creates a global furore. The dragon has woken and learnt it needs to be brutal ?Chinalco’s failure to press home its advantage is unlikely to be repeated.

It should either choose to buy shares in Rio’s right issues for short-term gain; or abandon its stake and dump Rio in revenge. If it takes the second option it should work with Vale or smaller miners. Other big Chinese businesses should acquire a thorough understanding of global acquisitions or look for more covert ways of gaining power through joint ventures with more savvy western private equity businesses.

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