Growth in Chinese Metals Demand Behind BHP’s Bid for Rio Tinto


Here’s a question we’re tackling in your next issue of Outstanding Investments: is buying Rio Tinto’s (ASX: RIO) future production of commodities a better way for BHP Billiton (ASX: BHP) to increase earnings than new projects?

You figure BHP has a couple of choices. It cannot unilaterally increase production of base metals and iron ore to meet Chinese demand. It would take too long. And capital and energy costs for new mines are rising quickly. So take the shortcut and buy Rio’s production.

“BHP believes it can offer Rio cost savings of US$3.7 billion over the next six years. It would achieve this mostly through higher production of the materials both companies sell,” reports our own Al Robinson.

Synergies then, is it? BHP and Rio are both on record as saying they cannot satisfy Chinese demand. BHP clearly thinks that demand will remain constant enough (or grow) to justify paying a hefty premium now for Rio’s future production, with the merged entity banking the profits from higher export volumes at higher metals prices (or at least at gradually declining metals prices, aided by the aforementioned synergies.)

Of course the fates of BHP and Rio are bound up with what happens in China.

While we’re on the subject of China, we thought we’d take a quick peak at yesterday’s Statement on Monetary Policy from the Reserve Bank. There were no bombshells or Molotov cocktails. But there was a fascinating little bit on, ahem, the composition of Chinese economic growth.

You’ll recall that we broached the subject by wondering how vulnerable China’s industrial economy is to higher oil prices. China has been investing heavily in fixed assets… metals-intensive infrastructure, real estate, and factories.

“The growth in investment,” reports the Reserve Bank, “appears to be quite broad-based. Not surprisingly, a significant component has been in manufacturing. However, much of the growth has also been development-related, such as the building of extensive subway systems and inter-provincial highways.”

“Notwithstanding the limited quality of the data, the urban fixed- asset investment survey (which measures spending rather than value- added) suggests that around one-quarter of investment has been on infrastructure, utilities and water and environmental management; the real estate category, which includes housing construction (and the purchase of land) accounted for an additional one-quarter.”


China continues to urbanise. And this urbanisation drives the structure of investment and growth. Another tidbit from the RBA: “China’s coal-fired power generating capacity is now increasing each year by around the size of the entire British electricity grid. This growth has substantially added to world demand for resources, which has put upward pressure on commodity prices. China now accounts for around 40 per cent of world iron ore imports, between 10 and 20 per cent of copper and nickel imports and 4 per cent of coal imports.”

This makes you wonder what the natural limits of it are… and how soon we’ll reach them. It makes you realise, too, how unimportant Australia’s non-signing of the Kyoto treaty is. China’s going to burn coal no matter what anyone else says or does. Believing otherwise is pretty naïve, even for unemployed diplomats.

And here’s a thought, China has probably misallocated billions in trade-surplus generated capital. As the table above shows, a good chunk of current Chinese investment (10% in 2006) was in real estate. Is this market-driven investment with solid rates of return for investors? Or is it a bubble?

And another thought. You can argue about how deliberate the policy is, but there’s no doubt China has over-invested in productive capacity. If it was deliberate, it was so Chinese producers–aided by state subsidies, low labour costs and a currency pegged to the dollar– could put a lot of higher-wage foreign business out of competition.

China was simply more competitive on cost of production, and decided to aid the migration of the world’s manufacturing capacity to its shores. But in a world where Americans are maxed out on debt, does China have too many goods and not enough customers? Was the investment in production based on patterns of consumption that are changing?

Heck if we know. But even the best-laid five year economic plans won’t survive their first contact with reality. Still, if you want to know what we think, here it is: China DID over invest in production. In the coming global recession, many Chinese factories will be idled.

Higher energy prices combined with America’s credit crunch could knock global growth for a loop for a good two to three years. This includes China, Australia, and resources.

From a long-term perspective, however, China has the factories. While much of the West has de-industrialised, China has the manufacturing base to serve the needs of the 3 billion aspiring human beings in this part of the world. It’s a little like buying real estate outside of a ring road surrounding a growing city. You know that sooner or later you’ll grow into it.

The only wildcard in this master plan is whether or not rising energy costs prohibit the kind of growth it will take to raise standards of living in Asia to the same per capita levels as Western Europe. We don’t know the answer to that. But we’re working on it.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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