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China syndrome

18 January 2013 By John Foley

Rio Tinto’s $38 billion purchase of aluminium producer Alcan has cost the company billions of dollars in write-downs, leading chief executive Tom Albanese to fall on his sword. But it’s not all Albanese’s fault. Rio’s biggest customer, China, shares some of the blame.

The rationale for buying Alcan was that China’s urban growth would prompt it to consume more aluminium and produce less. Albanese was right about demand. Fixed asset investment has grown 26 percent a year on average since 2007. The silver metal figures heavily in China’s plans – such as a project to expand the national grid with aluminium cables.

But on the supply side, Rio’s reckoning was dead wrong. In 2007, Albanese argued that the company’s low production costs – around $1600 a tonne – gave it an edge over Chinese producers, whose average cash costs were then around a quarter higher. China’s uneconomic aluminium producers were likely to be squeezed out, reducing supply and keeping prices afloat.

China’s state capitalists had other ideas. While prices have fallen, the government has propped up suppliers. Energy costs are subsidized, while banks offer cheap loans and roll them over when they can’t be paid back. Earnings have evaporated: the average cash cost of production of $2400 per tone is roughly the same as the price for which aluminium is sold in China, according to AZ China. The consultancy reckons a quarter of Chinese producers are now on life-support funding.

The result has been a disaster for Alcan. Far from tailing off, China’s production of aluminium has increased by 10 percent a year since November 2007. China now makes up 43 percent of world production, compared with 33 percent in 2007, according to the International Aluminium Institute. To add insult to injury, Chinese producer Chinalco is also now Rio’s biggest shareholder.

Albanese can take comfort that his other big career bet, iron ore, fared better. There, China’s high costs and fragmented supply have kept market prices elevated, and delivered Rio healthy profits. By contrast in aluminium, China’s decision to put jobs before profit has just made a bad situation worse. Future dealmakers underestimate that penchant for market meddling at their own risk.


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