NANJING - Steel is the backbone of China's economic miracle. Last quarter,
China's economy grew by a blistering 11.9% from a year earlier. More than 43%
of this growth was from investment in fixed assets, such as roads, factories,
houses, and machinery. These fixed assets rely heavily on steel, whether as a
building material or construction machinery.
Iron ore is a raw material critical to steel production. As such, maintaining
stable iron-ore prices is vital to economic growth, essentially giving
stability to the cost of building a modern economy. However, in recent years,
China has struggled to maintain stable iron-ore prices, as increasing demand
for ore from abroad has made China vulnerable to shifts in the global
marketplace.
For the past 40 years, major global iron-ore suppliers and buyers
have used an annual benchmark pricing system to decide iron-ore contracts. In
this system, the first contract price negotiated with major iron-ore suppliers
and buyers for the year would be used by all future contracts between steel
mills and suppliers in the same year. This helped steel mills hedge against the
risk of price rises in the cost of steel production, and as steel is the
building block of industry, this also ensured stable prices in a wide range of
modern production, such as automobiles, ship building, construction, and
industrial machinery. This system was only beneficial to suppliers so long as
there was no certain guarantee of significant demand for iron ore that would
outstrip supply and cause rapid price rises.
However, in recent years, increasing steel production in China has driven up
demand for iron ore, leading suppliers to consider changing the system to
shorter contracts based more closely on market prices. In 2009, China demanded
almost 60% of the world's iron ore to produce 47% of world's steel production.
The steel industry in China is a pillar industry that is highly fragmented and
prone to over-production. In 2005, an attempt by the National Development and
Reform Council to consolidate the industry had the unintended consequence of
boosting steel production, as entrenched political powers fought to boost
output to protect local steel mills. As a result of increasing Chinese demand,
iron-ore prices have risen from an average of US$37 per tonne on the Brazilian
spot market in 2004 to an average of $101 per tonne for 2009. Today, more than
half of China's iron-ore demand is met through imports, primarily from Brazil
and Australia.
Brazil, Australia, and China are the world's largest producers of iron ore.
Despite China's massive production, it is a net importer of iron ore, a
testament to the country's strong demand. On the other hand, Brazil and
Australia have comparatively low domestic demand for iron ore, allowing them to
dominate global exports of the commodity. Moreover, Brazil and Australia are
producers of a high grade iron ore, with over 50% of it being iron, whereas
only 32% of Chinese ore is iron. This has allowed the "big three" iron-ore
suppliers, Brazil's Vale and Australia's Rio Tinto and BHP Billiton, to gain a
dominant stake in the marketplace of 68.5% of global iron-ore shipments.
The "big three" have taken advantage of their position as global exporters to
shift to a shorter term pricing system. On March 30, Vale announced it reached
an agreement with Japan's Sumitomo Metal Industries Co for a quarterly contract
at a price 90% higher than the previous year to take effect April 1.
Subsequently, Rio Tinto and BHP Billiton announced they will also seek
shorter-term price contracts in future deal with Asian mills, effectively
shifting to a quarterly market system.
As the world's largest buyer of iron ore, China is attempting to leverage its
position to resist shorter-term contracts. Last year, the China Iron and Steel
Association (CISA) attempted to use the country's massive demand as a
bargaining chip to push the "big three" to lower prices.This failed, as
individual Chinese steel mills were more desperate for iron ore than the "big
three" were to sell it to them. As a result, mills made their own agreements or
purchased iron ore on the spot market at a much higher cost.
Similar tactics this year have continued to leave China in a stalemate on price
negotiations. Chinese negotiations have been led by Baosteel Group Corp,
China's largest steel producer, rather than the CISA. China opposes shifting to
a shorter-term pricing system and the 90-100% price increases suggested by
Vale. China is trying to play hard ball. The CISA had called on domestic steel
mills and traders to stop buying iron ore from Vale, BHP Billiton, and Rio
Tinto for two months, and rely on existing inventories iron ore temporarily.
China has also announced that it may conduct an investigation into a possible
iron-ore oligopoly of Rio Tinto, BHP Billiton, and Vale.
China's long-term strategy to reduce dependency on iron ore from the "big
three" is to increase investment in overseas iron-ore mining. China's
Metallurgical Industry Planning and Research Institute has called for enhancing
exploration for domestic iron ore and increasing investment in overseas mining
operations.
China's overseas investment in iron-ore mining has been concentrated in West
Africa, Russia, Australia, and Southeast Asia. On April 1, China Railway
Materials Commercial Corporation agreed to work with African Minerals to
develop the Tonkolili iron-ore deposit in Sierra Leone. Chinese steel mills
have also turned to smaller iron-ore miners to secure cheaper price contracts.
On April 22, Sinosteel Corp, the nation's largest iron-ore trader, announced it
would buy half the output from Brockman Resources Ltd's Marillana project in
Western Australia.
However, China will not have any leverage in price negotiations until it can
wean itself from fast-growing demand for iron ore. China has relied on fixed
investment to provide employment and maintain economic growth by building real
estate, infrastructure, and expanding industrial capacity throughout the
country. In 2009, Chinese banks lent a record 9.59 trillion yuan (US$1.4
trillion) to keep the country's economy afloat during the economic crisis. As a
result, fixed investment reached a record 66% of gross domestic product (GDP)
in 2009, up from 54% in 2008. This helped to maintain overcapacity in the
domestic steel industry, while global demand for steel was low.
A significant increase in iron-ore prices could be detrimental for China's
domestic steel industry. China has more than 700 steel mills across the
country, with the top five producers controlling less than 30% of output.
Despite a licensing system designed to monitor iron-ore importers, many traders
buy iron ore at lower contract prices and resell on the spot market for a
higher value.
Shanghai Securities News reports that price growth in iron ore this year will
lead to a 90 billion yuan increase in costs for steel producers. Many steel
mills are still recovering from low profit margins in 2009 in which a 1.69%
rise in costs would have put most state-owned mills in the red. Significant
consolidation would be at the expense of employment in many localities,
especially in relatively inefficient inland mills.
Despite China's resistance to shorter-term contracts, domestic mills will be
forced to accept price rises and pass on prices to domestic manufacturers to
maintain profitability. Many smaller steel mills have already signed quarterly
contracts, signaling another failure at this year's price negotiations. In
April, the domestic price of high quality iron ore was up 11.4% from March and
steel prices were up over 5.5% from March.
Traditionally, China has been able to resist price rises in raw materials by
forcing state-owned steel mills to temporarily book the losses on price rises.
However, as stimulus money is withdrawn, shaky profit margins in the steel
industry may force state policymakers to allow mills to increase prices. On
April 19, Baoshan Iron & Steel, a unit of Baosteel Group and the largest
publicly trading Chinese steelmaker, announced it would increase prices of
cold-rolled steel pipes in May. It is likely that other still mills will follow
suit.
This move could potentially fuel price inflation in the world's third-largest
economy. In the first quarter of 2010, producer prices were up 9.9% from 2009
mainly driven by a rise in nonferrous metals, such as iron ore, of 30.2%. While
China's consumer price index rose by 2.2% from the same period in 2009 there is
some concern that this could translate into rising domestic inflation by
increasing prices in a variety of goods, from cars to appliances, that use
steel for manufacturing. More importantly, this might also mean increased costs
of infrastructure and real-estate development for a country that has is still
highly dependent on fixed investment for economic growth. Indeed, despite
government efforts to slowdown housing prices, China's real estate prices rose
11.7% in March from the same period in 2009.
Ryan Rutkowski is a masters student studying international economics at
the Johns Hopkins-Nanjing University Center for Chinese and American Studies.
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