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Why China Jailed 4 Rio Tinto Employees For Spying
Author’s note: If you want to watch the video for this one, it is below
China is Australia's largest trading partner. Over $180 billion Australian dollars of trade flow between the two countries each year.
Some of the Sino-Australian trade comes in the form of education. The education export industry is estimated to be worth around $32 billion Australian dollars a year. But the vast majority of this trade comes in the form of iron ore.
Australia has a lot of Chinese citizens. Australia has around 25 million citizens. Surprisingly small for such a massive island. Taiwan for instance has 23 million. But anyway, 1.2 million of those citizens are of Chinese descent. Almost half of them were born in the People's Republic of China and many hold close ties to their motherland.
Australia's political parties have also become dependent on foreign funding. Two of the largest donors to major Liberal (which leans center-left) and Labor (which leans center-right) parties were Chinese-born billionaires. One of those, a Chinese citizen. Chinese money in Australian politics remains a concern.
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Rio Tinto went back on its word in a tense situation and ended up paying the price. In the early 2000s, China began a magnificent economic growth trend at a scale unlike anything before seen in this world.
That growth, however, found itself dependent on a single valuable commodity. China, the world's biggest maker of things as varied as cabbages to door knobs, does not have enough good iron ore. But Australia did, and so was born a very rich relationship.
But as iron ore prices exploded upwards, tensions erupted between China and the big mining companies. And that led to a monumentally bad situation for everyone involved.
In this video, we are going to explore the tensions that would eventually lead to the Sino-Australian kerfuffle known as the Stern Hu affair.
I start this video in times of tension between China and the West. Ties between China and Australia are particularly sensitive, and very complicated. And I am shoveling up dirt in a corner of particular misfortune. Needless to say, it leaves me a little anxious.
So I want to get started by first saying that I am going to treat this matter as neutrally as I can. You might say that I could be nicer to this side or the other. Maybe. You do a twenty minute video and someone objects to one sentence somewhere and declares the whole thing corrupt. That is how it is. I know that my work can't ever satisfy everyone on all sides.
China Iron Ore Problem
Driven by a need for steel, China has been the world's biggest importer of iron ore since 2013. Their imports today account for a vast majority of the global total: nearly 70% in 2019.
On the supply side, the majority of global supply is controlled by a small number of companies. Through consolidation, Rio Tinto, BHP, and Brazilian mining giant Vale grew their share of the iron ore market from 31% in 1990 to 65% by 2003.
Before 2002, iron ore was cheap and anyone could buy it. The price got to as low as $13.83 per dry ton in some markets.
China's emergence in the global iron ore industry quickly turned it into a seller's market, with prices drastically spiking throughout the 2000s.
In the perspective of the Chinese, controlling so much global share essentially lets the big three miners act as a cartel. An iron ore cartel with more control over the market than OPEC has over the oil market - they have 40%. Such a situation would be frustrating to anyone.
In 2012, Wang Xiaoqi, the vice chairman of China's Iron and Steel Association, CISA, commented that:
The iron ore market should be determined by, and reflect, real supply and demand. However, monopoly practices and price manipulation have exerted a big impact on prices
Naturally, the three companies pushed back against this criticism. But is there really a cartel?
Is There Actually a Cartel? Part 1: OPEC
When we talk about "cartels", we are really talking about two different things.
The first is a supply-withholding cartel. This is kind of like OPEC, where parties hold back supply from the market in order to keep prices high.
BHP executives point out that they sell 100% of what they develop and mine. So at the surface this type of cartel seems unlikely. But companies can slow-foot the development of certain mines so that they come online later.
One such situation came up in 2008 when the Republic of Guinea in Africa reassigned several blocks in its Simandou mine - one of the biggest high-grade iron mines in the world - from Rio Tinto to an Israeli company. The Guinean government implied that Rio Tinto was hoarding the deposit ever since 1997.
With that being said, the sheer number of overseas iron ore projects being developed make it hard to argue that the Big Three is trying to "keep supply" away from China. In 2012, there were 1,328 global iron ore projects outside of China. The Big Three owned stakes in just 110 of them.
Any illegally-struck supply agreement between the Big Three companies would also create incentives for one of them to break it. It would create incentives for fringe companies to come into the market and win market share.
So I would say that a supply-withholding cartel is very unlikely.
Is There Really a Cartel? Part 2: Negotiating With a Monopoly
But there is another type of cartel. The second type of cartel is a price negotiating cartel. More like collusion between the companies as they negotiate with buyers on prices. And for that, the evidence is a bit more interesting.
Starting in the 1970s, buyers in Japan and miners in Australia negotiated benchmark iron ore prices face to face. Kind of like a trial by combat from Game of Thrones, each side would choose a champion and they would hammer something out together. Whatever gets decided, both industries go with.
Usually for these showdowns, Japan has traditionally chosen Nippon Steel. Australia, Rio Tinto. And so it goes.
This cartel arrangement brought peace and stability to the market. But the entry and rise of the Chinese steel industry destabilized everything.
Unlike with the Japanese, Taiwanese and Koreans, the Chinese steel industry is very fragmented. In Japan you have five large steel producers, with Nippon being by far the biggest.
In Korea and Taiwan, it is even more concentrated. In Korea there's pretty much just POSCO - though Hyundai Steel gives them a run for their money. In Taiwan you have only the peculiarly named China Steel.
But in the People’s Republic, the situation is different. You have many very large steel producers all over China. The reasons for this are not too clear but my best guess is that it has to do with ties to the local city or provincial governments.
Such governments would resist consolidation as it means they no longer have control over their area’s economic growth model - i.e. capital buildup.
Anyway, back to the fragmentation. None of these local steel firms talked to or collaborated with each other, and there was no single national champion.
They competed with one another, actually. Sometimes larger steel mills will resell their iron to their smaller cohorts at 3 times the price. This naturally engendered resentment.
So what results is a situation where they all have to go to the miners one by one to get the iron ore they so desperately need.
Remember what Caesar said in that movie? "Apes together strong." China's steel mills did not listen to Caesar.
Thus, China's fragmented steel industry allowed the miners to push for consistent price increases, starting with a nasty 71% price increase in 2005 and a steady upwards march there after. This sucks of course, but is it evidence of a sinister cartel coordinating to raise global prices? Or just a function of insufficient supply in a period of unprecedented demand?
Whatever it was, the Chinese had their answer. The 2005 price increase especially alarmed them. In 2006, Chinese Premier Wen Jiabao appealed to the Australian government for:
A fair, open and reasonable market order as well as ... a pricing mechanism that is in accordance with international practices
Prices for iron ore from 2002 to 2012 rose by 588%. Now that does not mean steel prices rose the same amount. Like with oil and gasoline prices, prices rising 10% here does not mean prices rising 10% there. But overall, Chinese steel prices did rise nation-wide by 38% over the same time period.
Looking to find some way to exert some control over this critical aspect of their economic growth engine, the Chinese government embarked on a series of actions.
They sponsored industry consolidation and mergers. They aggressively underwrote investments in iron ore projects abroad - 35 after 2005 alone. And they also attempted to create an importers' cartel equal in power to that of the iron ore Big Three - the aforementioned CISA.
Eventually though, people decided that China had to have more agency in these decisions. That means taking an equity stake in one of the big mining companies. They sought such a deal with Rio Tinto.
## Rio Tinto
Based in both the United Kingdom and Australia, the 148-year old company is one of the biggest mining companies in the world.
Rio Tinto's history is well documented. In 1873 a consortium of investors bought a mine along the Rio Tinto river in Spain.
Over the next fifty years, the company exploited the mine for its vast copper resources and enjoyed financial success.
Then in 1925, the market prices for its ores crashed, forcing the Rio Tinto company to diversify into Africa and Australia. A variety of mergers and acquisitions resulted in one of the world's biggest mining companies.
I am not going to lie or sugarcoat it. Rio Tinto has had a ... controversial history of actions with regards to human rights, labor and the environment.
The Wikipedia page alone dryly notes that the company collaborated with the Axis powers during World War II, demolished a 46,000 year-old sacred site in Australia in 2020, and is one of the top 100 industrial greenhouse gas producers in the world.
Rio's relationship with the Australian government is complicated, especially in the late 2000s. The company generates half of its income from Australian assets, but 75% of its shareholders are based in the United Kingdom.
And while the company might be headquartered in both the UK and Australia on paper, they gutted the Australian office in 1996 and moved the majority of its global management to London. This broke a promise made just a year earlier and did not endear the company to the Aussies.
So all in all, Rio Tinto is a controversial company in Australia. But also an immensely powerful one.
The Rio Tinto Investment
In February 2009, Rio Tinto agreed to take a $25 billion AUD or $19.5 billion USD investment from Chinese state-owned company Aluminum Corporation of China or Chinalco. Chinalco is China's largest mining company and is majority owned by the government.
By now, Chinalco already owned over 10% of Rio Tinto. They had partnered with Aloca in 2008 - at the height of the commodities boom - to spend $14 billion on the open market for Rio shares. That investment quickly lost 70% of its value, on paper. This 2009 strategic investment was to try to help recoup some of those losses and strike a real partnership.
The strategic investment came in the form of real assets and convertible debt. In the real asset part of the deal, Chinalco got 49% ownership of a selection of copper, aluminum, and iron ore mines across Australia.
The high-interest convertible bonds that Rio Tinto issued to Chinalco gave the state-owned company 18% of Rio Tinto and the chance to nominate two of the company's 17 board members.
Why would Rio do this? In short, they were afraid of being acquired. Despite being so big, Rio Tinto has long been the target of acquisition rumors. Particularly from BHP, the world's biggest mining company and itself the product of another UK-Australia merger.
In an attempt to bulk up to a heavyweight class, they acquired Canadian company Alcan in 2007 for $49 billion AUD or $38 billion USD after a bidding war with Vale and Alcoa. The horrendously timed acquisition did help this massive company get even bigger, but also burdened its wallets with $34 billion of debt.
BHP launched an acquisition bid for Rio in November 2007 anyway. The $195 billion AUD or $150 billion USD bid would have exchanged 3 BHP shares for 1 Rio share. Rio rejected this offer and BHP in turn raised their offer to 3.4 shares.
If the merger had gone through then it would have created the biggest mining company in the world. Though I am not sure if it would have have passed anti-trust scrutiny.
2008 and the Global Financial Crisis ended BHP's takeover attempt. But it also brought immense financial strain on Rio Tinto as they attempted to navigate a way around their considerable debt.
Some $19 billion in bonds were maturing in 2009 and 2010, less than 2 years away, and nobody wanted to refinance it. Combined with the massive drop in global commodity prices, Rio was finding itself on the ropes. Share prices in London trading fell to under 10 British pounds in early 2009 from over 70 pounds just a few months earlier.
This investment from Chinalco would have simultaneously helped Rio pay off its onerous debt and keep BHP from trying another takeover.
Regulatory authorities in the United States, China, and Australia had to approve the transaction. The deal also had to pass a shareholder vote in both the UK and Australia.
At first, it seemed like things were on the right track. But significant challenges emerged out of the woodwork.
The response from the mostly UK-domiciled shareholder base was very negative right from the start. They felt that Chinalco was getting the company on the cheap, essentially vulture capitalism.
Specifically, Rio was selling the family jewels at a bargain. They sold stakes in the aluminum and copper mines at a small 12% premium, which is alright.
But it sold a 15% stake in its one-of-a-kind Hamersley iron mines in Western Australia at no premium to its current net value. Not alright.
The negative shareholder response was so strong that Rio CEO Tom Albanese had delay his trip from London to Australia a few weeks to address it.
The Chinalco deal led to the resignation of Paul Skinner as chairman of the board and the appointment of South African Jan du Plessis, a move with big future implications.
In the regulatory and public domain, Rio Tinto advocated for the deal by saying that it would save Australian jobs. About 2,150 current jobs and 750 planned ones.
Almost all of these jobs were in Queensland, the home state of then-Australian Prime Minister Kevin Rudd. The state heavily depends on mining and tourism revenue so they favored allowing the deal to pass.
The Australian competition regulators announced in March 2009 that it would not oppose the deal. Now the Australian government needed to give its final approval. So by April 2009, prospects for the deal were looking quite good. But at the same time, the winds of the market had started to shift.
Bond and stock prices were turning as zero-rate monetary stimulus policies started to take effect. Rio Tinto shares leapt 16% since February, allowing the company to raise $2.4 billion AUD or $2 billion USD from the markets at rates lower than those from the Chinalco deal.
Now suddenly this Chinalco deal was not looking so good anymore. Up until then, Tom Albanese and Rio Tinto management were saying that they had no other way to pay down this debt. But the markets were proving them wrong.
May 4th 2009, Rio Tinto shares continued their recovery and closed at the dollar equivalent of $49.50 AUD. This was higher than the $45 strike price of the Chinalco convertible bonds. By now it was becoming super-clear that Chinalco had struck a fantastic deal for itself. But a deal was a deal right?
Management was rapidly losing their will for the deal. Market options and even a possible joint venture with BHP were looking like friendlier options.
Chinalco Company president Xiong Weiping came to Australia to lobby for the deal, downplaying the company's state ties. They also hired a lobby firm with ties to the Labor Party so to try to get the deal through.
Li Changchun, then the fifth most powerful person in China, came to meet with Prime Minister Kevin Rudd in March 2009. He lobbied for the deal to close too.
But the political messaging against selling such critical national assets was also quite powerful. Politicians in the opposition argued against the deal, citing Australia's national interest.
Opposition member Barnaby Joyce condensed the matter quite succinctly:
The Australian Government would never be allowed to buy a mine in China. So why would we allow the Chinese government to buy and control a key strategic asset in our country? Stop the Rudd government from selling Australia
BHP, the other massive mining company, knew that if the Chinalco-Rio deal went through they would be out in the cold. So they tapped their own government and corporate connections to influence Rio's decision making. Rio's new chairman at the time Jan du Plessis turned out to be amenable to such talks.
The Australian government found itself in a tough situation. China was pushing hard for this deal, and Australia did not see a good legal reason to stop it. The government had already approved the earlier 2008 investment. Why not this one? In the end, Rio Tinto itself had to be the one to stop the deal.
In June 2009, a week before the Australian government was to give its final decision, Rio went back to renegotiate the deal in light of the new market conditions. But Chinalco rejected that proposal because it removed the mine stake sales and the board seats. Rio then canceled the deal unilaterally.
Rio ended up raising $15 billion from the markets and another $5.8 billion through a joint venture with BHP in the Pilbara mines. But they had also kicked a massive hornets’ nest.
The Stern Hu Arrest
Reaction to the deal falling apart was pretty negative back in China. The anger worsened when news came out that Nippon Steel secured a 33% discount during that year's iron negotiations. This was less than the 45% discount that the Chinese side were calling for, and implied that Japan was colluding with the Australians to spite the Chinese. It represented a pretty big loss of face.
The State Council, the chief administrative authority in the People's Republic, accused BHP of inflaming Australians' fear of "Chinese color". In other words, being racist.
The Chinese media launched a campaign denouncing westerners and Australians as evil capitalists taking advantage of the Chinese people and hindering their rapid economic development.
Then in July 2009, Stern Hu, an Australian citizen of Chinese birth, and three other Rio Tinto employees were arrested in Shanghai. Stern had been the assistant and translator to Rio's chief iron ore price negotiator.
The authorities accused the employees of stealing state secrets and taking bribes. This was based on them having critical data that was too detailed to have been legally acquired. Which people at the time saw as dubious. The former charge holds the death penalty. Hu's villa in a fancy Shanghai expat community was raided. His data logins were used to download information from the company.
The arrests made things between Australia and China awkward. Kevin Rudd and the Australian government declined to intervene on a personal level. The minister of trade said that the trial would have no impact on Australian trade relations with China. They were aware that retaliation would only invite escalation.
Rio Tinto executives worked hard behind the scenes to repair relations with the Chinese. This involved consulting with top Party officials and includes, among other things, giving Chinalco a joint equity share in the aforementioned Simandou mine in Guinea.
Rio Tinto’s work behind the scenes did manage to blunt the government’s anger. At the trial, prosecutors dropped the charges of state secret theft, but kept the bribery charges. Which the employees pled guilty to. Rio Tinto fired Stern and the other employees on the basis of having accepted bribes.
Looking back at it, there is little doubt that the Chinalco deal took advantage of Rio’s momentary weakness. It was a raw deal. Shareholders hated it from the outset and that more than anything else was the thing that killed it.
But I think it is also just as true that this annual price negotiations system did not favor the Chinese. The Stern Hu affair did change this. BHP and the rest of the industry shortly dropped the old structure, pointing out that they were spending 7-8 months to negotiate a 12-month benchmark. From then on, they would use the spot market price.
Rio Tinto generated $44 billion of revenue in 2020. Good money but far from the $60 billion it made during the peak of the commodities boom. Likely due to this change in iron price negotiations.
Stern Hu was released in 2018, having served 8 years of his 10 year sentence. I am not entirely sure where he is now. My best bet is that he is probably living a quiet life somewhere in Australia today.
Rio Tinto continues to closely collaborate with Chinese mining companies in projects around the world. And China still imports a lot of iron ore each year. Most of it sold to them by the Big Three mining companies. But it is pretty clear who is who in the relationship.