How Iron Ore Markets Reveal China’s Mercantilist Approach To Trade

BHP billiton iron ore 04.jpg

The market for iron ore is rarely in the headlines like its downstream cousin, steel. It is, however, an important market, and one that tells us much about the underlying structure of the global economy and particularly China’s place in it.

Back in the 1980s and 90s the market for iron ore was fairly steady, with the price fluctuating annually between $10 and $15 per ton. In 2004 the price started to rise significantly, reaching $60.80 by 2008. After this the price began to rise further, reaching a peak of $187 per ton in 2011, while staying above $100 for several years overall. Then in March 2015 the price dropped below the 2008 level and stayed that way for much of the last year. It is now forecast to remain low for the foreseeable future.

The global price, therefore, largely tracked upwards with the growth of the Chinese economy, then again with the enormous Chinese stimulus rolled out in 2008/9, as new infrastructure boosted growth and demand for iron ore, about 80% of which is imported in China. Nevertheless, demand for iron ore has remained high in China, even as growth rates edge downwards.

One explanation for this can be found in the sheer volume of steel production in China, which needs its inputs, but the overcapacity problem means that the steel surplus is just being exported or stockpiled. Another explanation is simply that domestic Chinese iron ore production is relatively poor quality and expensive to produce by comparison with Brazilian or Australian (the chief sources) imports. The fall in prices therefore, is forcing consolidation in Chinese ore extraction and pushing up the import ratio as high as 86%. Why not, after all, buy cheaper imports while the price is low? And iron ore does not perish, so can be stockpiled for some future date when steel demand is high again.

Notable among all the numbers is a large surge in imports from Brazil in January, up over 7% – to 13m tons – from the previous year. The price paid for this is reported at $24.8 per ton, which was well below the market rate in January of $41.25, and certainly lower than the average production cost in China of between $50 and $60 per ton. Many reports put this down to the big iron ore producers seeking greater market share in China, the world’s biggest market.

The Brazilian company Vale is particularly interesting in this respect. The greater distance of Brazil from Asia has always put them at a disadvantage to BHP Billiton and Rio Tinto (the big Australian ore producers) due to higher shipping costs. Consequently Vale made a strategic decision in 2008 to build significantly larger ships, known as VLOC (Very Large Ore Carriers) or ‘Valemax’ to reduce per tonnage shipping costs. These giant vessels are among the largest in the world and were built in China and South Korea between 2008 and 2015, and now comprise a fleet of 35 ships, all contracted to ship iron ore from Vale mines in Brazil to the world’s big ore consumers, or, in short, China.

Unfortunately for Vale, these ships are at the centre of an administrative saga that is still not entirely over. Built to supply the Chinese market, they were refused permission to dock at Chinese ports until July 2015. Vale were obliged to set up ‘trans-shipment’ hubs in the Philippines and Malaysia, which, importantly, raised costs and undermined the commercial logic of the ships. In the background of these administrative and technical decisions sat the Chinese Shipowners Association (CSA) who own many of the smaller ore carriers that operate at a cost disadvantage to the Vale giants. It was also widely noted in the press that the decision to eventually allow VLOCs into 4 Chinese ports (Qingdao, Dalian, Tangshan Caofeidian and Ningbo) followed the signing of a contract to sell and lease back 4 of these ships to COSCO, the Chinese shipping giant.

What is perhaps more confusing is that these ships were largely built in China in the first place, financed by Chinese state banks, but with Vale on the hook to pay for them. In broad outline, therefore, China has financed the construction of a fleet of giant ships in Chinese shipyards using Chinese steel, which will in turn be paid for by a significant share of the revenue generated by China’s future purchases of Brazilian iron ore. If shipping costs are low, China can drive a hard bargain, safe in the knowledge that the ship finance costs are separate, and if the price of ore falls Vale absorbs the losses because after the capital costs are sunk the marginal revenue takes priority. Either way, China wins.

This, it seems to me, might explain rather better than mere stockpiling why China’s iron ore imports keep rising, especially from Brazil. However, what it reveals (as I have written about here and here) is that China’s approach to trade is not quite so ‘win win’ as their public diplomacy suggests. While Brazil still has much to gain from the upside of a future buoyant ore market, they also have much to lose from the downside. China, on the other hand, has insulated itself from the downside under normal market conditions, but at the same time demonstrated a willingness to play hardball in pursuit of absolute gains from trade.
Source: Forbes

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