The Self-Defeating Rio Spy Case: A Bad Bargain

China¡¯s arrest of four employees of Rio Tinto has sent shockwaves through the international business community and led to widespread speculation that the move is in retaliation for the break up of Rio¡¯s unceremonious rejection of a $19.5 billion investment by Aluminum Corporation of China earlier this year.  As appealing as such a tit-for-tat explanation is, the likely motivations are more subtle and more alarming.

Chinese officials were quick to deny any political dimensions to the case.  ¡°The Chinese government is executing the case according to the law,¡± Mr. Qin said.  ¡°As for economic and trade cooperation between China and Australia, China will keep a positive attitude toward it, as we always did before.

In the Western media and especially in Australia, the leading explanation for China¡¯s heavy-handed treatment of Hu is payback for the dissolution of Chinalco¡¯s bid to double its stake in Rio.  Following months of negotiations to sell Chinalco an additional 9% stake in Rio for $19.5 billion, on June 4 the Australian mining giant abruptly cut off discussions and instead announced a fully-subscribed $15 billion share issuance as well as an iron ore production joint venture with rival miner BHP-Billiton (BHP).  Had the deal gone through, it would have been China¡¯s largest ever acquisition.

While the breakup of the Chinalco-Rio deal certainly did nothing to improve Sino-Australian relations, it is unlikely that the failed bid was sufficient to provoke China¡¯s arrest of a foreign national on such debatable charges.  Beijing¡¯s actions were almost certainly provoked by two more significant issues:  the price of long term iron ore contracts and China¡¯s commodity insecurity. 

As the world¡¯s largest maker of steel (according to the World Steel Association, China accounts for almost half of the world¡¯s production), China relies heavily on imported iron ore, predominantly from Australia and Brazil.  Each year, the three largest producers (Brazil¡¯s Vale and Australia¡¯s Rio and BHP) negotiate the contract price of ore for the upcoming 12 months.  This benchmarking process provides price stability for both parties, who would otherwise have to rely on the volatile spot market.

China Iron and Steel Association (CISA), a trade association with close ties to the Ministry of Commerce, headed the ore negotiations, demanding a 40-45% reduction in the price of ore.  CISA cited the effects of the worldwide economic downturn and their dominant position in steel production as justification for this reduction. 

From the outset, CISA handled the negotiations badly, basing their negotiating strategy on the threat that, as the world¡¯s largest producer, China could simply walk away from any agreement that didn¡¯t meet CISA¡¯s price targets.  The fact that such a strategy would inflict greater harm on Chinese steelmakers than on the ore producers was not lost on the mining companies, who refused to agree to CISA¡¯s demands, offering instead a 33% reduction from the previous year¡¯s price.  Asia¡¯s other major producers, in South Korea and Japan, quickly agreed to the 33% reduction.

CISA also failed to meet other challenges during the negotiations.  Their attempts to regulate the spot market through an agency scheme meant to control spot sales of ore was widely ignored and a new iron ore spot trading center opened in the port of Rizhao.  The trade association was dismayed by efforts made by the Australian¡¯s to manipulate shipping rates (thereby driving up the effective price of Brazilian ore) and to persuade Vale not to enter into separate contracts with Chinese mills.  The state run China Securities News decried a ¡°conspiracy of Australian ore miners.¡±

As talks dragged on without any signs of progress, China¡¯s smaller producers began making side deals with the big mining companies, further undermining CISA¡¯s efforts.  On Wednesday of last week, China Business News reported that CISA had agreed to a face-losing deal to accept the same 33% price reduction already agreed to by other Asian steelmakers.

This explanation of events points to an even larger preoccupation for Beijing, namely the security of China¡¯s access to commodities.  The Chinese growth miracle, with an economy growing at a blistering 8% per year, is vitally dependent on basic materials like metal ore, petroleum and wood.  Witness this year¡¯s extraordinary activity among China¡¯s oil companies and metal producers, which have been busily scooping up foreign assets made cheap by the world economic downturn.

The detainment of the Rio employees suggests that these business deals are no longer merely commercial transactions but have, rather, assumed the importance of national security matters.  Hence the involvement of the state security apparatus, as well as the allegations of spying. 

The sad irony of China¡¯s draconian reaction is that it is self-defeating.  Rather than increasing China¡¯s access to commodity supplies, the arrest of the Rio employees will fan the flames of sinophobia in Australia and elsewhere, providing justification to those who see China as a threat rather than a partner.  Political opposition to the expansion of Chinese companies, like the kind that scuppered the Chinalco deal, will inevitably rise.  Foreigners will generally feel less easy about living and working in China, which can only increase the cost of doing business with countries outside of China. 

All of which is a bad bargain for China, for Australia and for the rest of the world.

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