Saturday, February 28, 2009

The Global Strategy of the Dragon (Part 1)

In February 2009, China made several significant domestic and international business deals focusing mainly on the material sector which undermined China’s leadership in expanding its natural resources investments and efforts in aiding cash-thirsty companies. By doing so, China appears to be showing the rest of the world that it still has sufficient cash on its balance sheet to rescue its domestic economy and has excess resources to take advantage of any foreign business opportunities available. Therefore, after the current financial crisis passes, China will be well prepared for rapid economic expansion. Taking advantage of the current low prices for natural resources is only the first step of China’s long term investment plans that China is undertaking, beginning this month.

China made a series of international investment in natural resources starting early February 2009. In early February, Aluminum Corp. of China (aka: Chinalco) invested US$19.5 billion in Australian mining giant Rio Tinto in exchange for $7.2 billion convertible bonds. If all the bonds are exercised, Chinalco will take up to 18% stake and 2 board seats in Rio Tinto. In addition, Rio Tinto can use the investment to repay part of its $40 billion debt generated by its acquisition of Canadian aluminum company Alcan Inc. in 2007. Then, a week after, in mid-February, China Minmetals Corp. launched a takeover bid of US$1.71 billion for Australian zinc miner OZ Minerals Ltd. This deal can help OZ Minerals refinance its US$560 million debt by the end of this month. On the other hand, China can increase its exposure to the zinc, a major material for anticorrosive coating for steel, to meet the potential rising demand of steel in the rapidly developing China after reversing course from the current economic downturn. In the same week, China Development Bank announced the completion of two international deals. First of all, China Development Bank reached a deal to lend a total of $25 billion to two Russian state-owned energy companies, OAO Rosneft and OAO Transneft, in exchange for an additional 15 million metric tons of crude oil a year for 20 years under the terms of the deal. Second, China Development Bank will finance $10 billion in Brazilian state-owned oil company, Petroleo Brasileiro SA (aka: Petrobras), for its deep-water oil reserves. With China’s financing, Petrobras will be able to pay for its oil and gas discovery costs. Recently, in late February, China’s Hunan Valin Iron & Steel announced that it will buy 16.5% of Australian iron ore miner Fortescue Metals Ltd. for US$770 million thus becoming Fortescue’s second largest shareholder. Fortescue will use the funds to expand its Western Australia’s operations. On top of gaining easier access to natural resources by investing in those companies, the key of those deals is to establish an international business relationship politically and strategically with the involved countries (Australia, Brazil and Russia). This approach will undoubtedly support a more rapid and robust economy in the continuing politic, social and economic reforms for the post-capitalism in China.

In addition to China’s international investments, Chinese government is also aware of the overcapacity in its domestic iron and steel industry. In response to the plunging demand of steel in China, in mid-February, Chinese government announced a consolidation plan in its steel industry – financed by China’s natural resources government-backed funds – by combining three major steel groups to stabilize iron and steel price and to reduce excess capacity by 24% in steel making capacity by 2011. The three groups are as follow: Baosteel Group Corp., Wuhan Iron & Steel Corp., and the combined group of Anshan Iron & Steel Group Corp. and Benxi Iron & Steel Corp. Furthermore, under the 4 trillion yuan stimulus plan released by China in late 2008, to encourage technological improvement in both sectors, the Chinese government recently approved a plan to help petrochemical producers and light industrial companies by increasing export-tax rebates, improving the energy-pricing mechanism, speeding up the expansion in its strategic oil reserves, and curbing coke production projects. By implementing this plan, China’s international investments will provide benefits to the material sector, which will also spill over to the industrial sector. In late February, China agreed to buy $15 billion of machinery, automobiles and food products from Europe. These investments include jet engines from Rolls-Royce Group PLC, cars from Jaguar and Land Rover, and railway equipment and olive oil. All these government spending and investment projects illustrated China’s determination in fostering its domestic economy and its reputation of helping the global economic recovery in the current financial turmoil.

While many countries are suffering from their shrinking balance sheets when they pumped capital into their domestic market, we can see that financially, China is well-prepared to turn itself into an economic superpower during this global financial turmoil. For example, in observing all these expensive deals, some may wonder if China has enough money to pay for them. However, according to Chinese government’s statistics, China will have sufficient “ammunition” for the investments. Even with a slowdown in China’s GDP in 2008, its current account surplus – the sum of foreign trade and income surpluses – in the end of 2008 still had US$440 billion. Moreover, with China being the biggest holder of the U.S. Treasury bill in the world, China does not have any credit risk exposure as the U.S. Treasury bill is seen by the global market as a default-free security. In addition, the current high demand in U.S. Treasurys will allow China to use them as a medium of exchange for its foreign investments.

In my opinion, China is making the right choices. Securing natural resources is only the first step of its economic expansion plan. By politically and strategically expanding through a better control on natural resources production, its price and quantity supplied can be stabilized. As natural resources are the basic raw materials of any given consumer and industrial products, securing the ownership of sufficient natural resources will increase China’s leverage in negotiating the production price of raw materials. The second step will be the industry consolidation that we saw. This consolidation not only stabilizes the production price but also limits its manufacturing output to better match the supply and demand equilibrium. Consequently, the flow of raw material will be controlled and price will not be depressed by excess supply, which will hurt raw material companies’ revenues. If I were China, my next step would be to secure a stable output of agricultural products. If China wants to expand its economy rapidly, it needs more labor, ensuring sufficient food source will minimize the adverse impact from natural disasters such as drought or flood which potentially leads to famine, depends on the duration and extent of the disasters. An adequate food supply will ensure a sustainable economic production in the long run. Once the economy starts recovering, the large amount of liquidity that was injected by the 4 trillion yuan economic stimulus plan last year will allow inflation to come in and lower the real money value. However, with the Chinese government controlling the appreciation of the Chinese yuan, it can slow down the rise in inflation more effectively together with a steady increase in its central bank interest rate.

In conclusion, China’s investment and consolidation strategies will be sustainable only if all the investment strategies and economic policies are interrelated and feasible based on the realistic economic environment. If successful, the combination of investments and industry consolidation strategies with the relatively cheap Chinese yuan will ultimately amplify the effect of the recovery in its economy and will boost its economic expansion.

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