Sino Iron May Run Over Budget by $8 Billion
In an analysis published on June 24, the Financial Times remarked that China’s international resource expansion is not running smoothly. While most outside observers may consider China as unstoppable in its pursuit of the world’s resources, major Chinese mining groups are actually ill-prepared for global expansion. Beijing hoped it would be able to control its economic destiny by taking huge mineral stakes and limiting the ability of companies like Vale (VALE), Rio Tinto (RIO) and BHP Billiton (BLT) to drive commodity prices. Its ambition, however, looks unrealistic at the moment as Chinese mining groups face a number of problems with their projects abroad.
While the chairman of Citic Pacific, Chang Zhenming, is confident about the significance of the company’s Sino Iron mine in the red-soiled Pilbara region of Western Australia, China is concerned about the project, as the company faces increasing delays and cost overruns. When the mining project plans were first made in 2006 the forecast showed a total cost of less than $2 billion. By now, however, the project has already cost $7.1 billion and Citigroup’s analyst calculated the spending could reach $9.3 billion. There are even expectations the bill to be closer to $10 billion. On top of that, the mine development is two years behind schedule.
A senior executive at one leading Asian trading company commented that the Sino Iron project is not about commercial goals any more as Citic Pacific’s financial loss is too big for it to be able to make a profit. Consequently, the mining project is still under development only because of “Chinese machismo,” the commentary quoted by the FT further states.
The reality, however is that it is not just about machismo. The Sino Iron project was planned as an attempt to reduce reliance on foreign suppliers of iron ore, which currently account for about 60 per cent of the total used in China. As James Cameron of HSBC said, Beijing wants to develop new sources of raw materials and they want equity in projects. But the Citic Pacific’s trouble shows that China is struggling to do this. In fact, most Chinese companies, used to operating under government protection, are often ill-prepared for competition.
A Cultural Bridge Too Far?
First of all, labour at mines causes some particular misunderstandings. China’s plans call for the use of Chinese labour due to its higher productivity and lower cost, but the Australian visa requirements and labour laws make that impossible. Consequently, projects have to rely on expensive and less-productive Australian labour. Another problem is often caused by the Chinese preference for vague language in contracts, which is acceptable in China, where the conditions can change and both sides take contracts as a starting point for talks rather than defined rules. But this is in contrast with other, particularly western, nations, where contracts represent clear and final conditions. Another problem that often makes negotiations confrontational is the fact that Chinese enterprises seek control over their projects, which is actually one of the reasons they aim to expand abroad.
Another drawback of the Chinese businesses is caused by internal problems, or the fact that due to competing commercial interests, Chinese enterprises and their partners often argue between one another. For example, the participants in the Sino Iron project, Citic Pacific with 80 per cent of the equity, China Metallurgical, the main contractor with the remaining 20 per cent equity, and China Development Bank, the project’s principal lender, are in a conflict. Citic Pacific has even considered suing China Metallurgical for the budget overruns and delays. At the same time, China Development Bank (CDB) wants to pull out of the mining project.
Sino Iron is a source of frustration for CDB, because when the project was first envisioned six years ago, China desperately needed iron ore for steel. And as CDB’s priorities are set in line with the Chinese government, the bank lent almost $5 billion for the realisation of the project. But the market has changed. Over the last five years, China’s steel demand growth has declined and prices have dropped. In 2010 China’s iron ore imports were even less than the previous year. In 2011, restrictions on property construction and tight money policies continued to put downward pressure on steel prices. On top of that, miscalculations over currency led to overspending on the Sino Iron project. The Australian dollar appreciated over the life of the project and controversial hedges that Citic Pacific miscalculated, caused a loss of $2 billion. And while in the past China’s government did not hold its companies accountable for their failure, now this is changing, as losses from foreign projects have spiralled. The State Assets Supervision and Administration Commission have recently publically called on its charges to improve the management of China’s overseas operations.
Proceed With Caution
This overall situation in the world’s second-biggest economy shows that China will now become more cautious when it comes to its high-spending ambitions for global expansion, especially when projects are being funded by national banks. An example of the recent changes is the state-run China Railway Engineering Co which has formed a joint venture to build a railway for coal transportation in Indonesia. And while in the past this would be CDB-funded project, the FT analysis notes China Railway Engineering Co is now seeking finance from sponsors, to avoid a potential repeat of the Sino Iron project failure.