KALEVOR: Global vertical integration personified – The China Model

China maybe ruled by the Communist party but there’s hardly anything communist about the way the country is run. China has become a global behemoth over the last few decades since Deng Xiaoping begun economic reforms in 1978. Their government is a well oiled machine that runs with blistering efficiency. Decisions are taken quickly and executed with just as much dispatch. The communist party runs the country like a corporation.

In the second quarter of 2010 China surpassed Japan to become the world’s second largest economy after posting a second quarter GDP of $1.337 trillion. Undoubtedly this caps China’s meteoric rise from rural communism to being a global economic force. But the story of China is just beginning. The reasons are simple. Over the past decade, China has been on a relentless mission to control the critical resources that drive its growth – steel, iron ore, oil, agriculture, technology and rare earth elements. At the same time, the artificially devalued renminbi (the Chinese currency) effectively ensures that China controls its export prices, making its export led growth a smooth sail - for now at least. A vertically integrated model that worked successfully for western business moguls such as John D. Rockefeller, Andrew Carnegie, US Steel, BP, Exxon Mobil, etc. Simple strategy, effective results.

BHP Billiton’s (the world’s largest mining conglomerate) $39 billion bid for Potash Corp in August 2010 was not the only time the Australian mining giant attracted China’s unwelcome attention. In November 2007, BHP’s bid for iron-ore giant Rio Tinto crumbled under China’s “dawn raid” on Rio Tinto. BHP had proposed a 3 for 1 share swap for the deal which Rio unequivocally rejected as undervaluing it. At the same time, China’s steel industry, the largest in the world was worried that a BHP-Rio merger would cause a monopoly in global iron-ore production. The combined enterprise would control at least 60% of global iron ore production. Such a monopoly could cause the price of steel to rise and effectively stifle China’s export led growth. China, eager to have control of a crucial ingredient to its expansion would stop at nothing to keep Rio Tinto out of BHP’s hands. BHP raised the bid for Rio to $147 billion on February 6, 2008 but it was too little too late. Just 5 days earlier, China Aluminum Company (Chalco), China’s state owned aluminum producer had launched a dawn raid and bought a 9.3% stake in Rio Tinto. Making it the biggest shareholder, China gained two advantages – they could acquire Rio at a depressed stock price or they could gain enough clout to outvote BHP’s bid. So with a simple strategic move, China now controls an essential ingredient to its growth. They played it beautifully!

It looks like BHP is going to get burned by China yet again. Sinochem Corp, China’s state owned chemicals company has been keenly following BHP’s bid for Potash Corp. (a Canadian mining giant and the world’s largest producer of fertilizer) Why is China so interested in Potash? Simple - agriculture! Potash is a key ingredient in fertilizer and as the world’s population expands and food security becomes important, whoever controls potash production is likely to be laughing to the bank. BHP knows this, but unfortunately for them, so does China. Secondly, as a top consumer of potash, China wants to keep prices for the vital crop nutrient low and does not want Potash in BHP's hands. That situation is still unraveling and it will be interesting to see how it plays out.

Needless to say, this strategy has been very successful for China. Buying foreign companies with the technology they need, moving production to China and eventually owning the technology. A few decades ago the best PC brands were made exclusively in the US. Today, superior brands such as Lenovo and Asus are manufactured in China. Lenovo bought IBM’s PC division a few years back, took production home and now Lenovo is a widely used brand in US markets.

China is getting its hands on everything. Last week state-owned oil refiner Sinopec paid $7.1 billion to the Spanish oil company Repsol for a 40% stake in its Brazilian unit. The new funds will allow Repsol to develop its discoveries in the Guara y Carioca blocks, both located in the Santos Basin off the Atlantic coast, where Petrobras is also actively exploiting one of the largest oil finds in recent history. Petrobras (Brazil’s state owned oil giant) raised $67 billion in a secondary stock offering – the largest such offering in history on September 24 2010. And China will be there, getting a piece of that wealth. It’s remarkable to say the least. But the most impressive story of China’s quest to “vertically integrate” is how it managed to control 97% of the world’s production of rare earth elements (REEs) – a key input needed for its military and technological expansion.

Rare earth elements are a group of 17 naturally occurring chemical elements on the periodic table. They represent a family of minerals found in commercial products ranging from TV displays, cell phones, superconductors to green technologies such as hybrid electric motors and wind turbines. For instance, the rare earth element neodymium is very magnetic and is used in everything from computer hard drives to Toyota's Prius hybrid car. Military technologies such as guided bombs and night vision goggles rely heavily upon rare earth elements. Promethium is a highly radioactive rare earth element and is used in making nuclear batteries.

Since the 1990s, China has been buying up mining companies that own rights to rare earth mines around the world. They gained global market share at an exponential rate by reducing the price of REEs and effectively controlling the market after a few years. Through learning effects and scale economies, China acquired the technology to mine REEs efficiently and the bulk of the 97% of global output comes from the Inner Mongolia region of China. The United States was once the main source of REEs. The Mountain Pass, CA rare earth mine is perhaps the largest non-Chinese source of REEs. In 2005, the China National Offshore Oil Corporation (CNOOC) made a bid to acquire Unocal Corp, the US oil company that owns the Mountain Pass, CA mine. Had the US Congress not blocked the deal, the mine would have slipped quietly into Chinese hands and they would be controlling a near 100% of global REE production.

An April 2010 report by the US Government Accountability Office (GAO) states that this situation poses a serious national security risk. "Defense systems will likely continue to depend on rare earth materials, based on their life cycles and lack of effective substitutes," the GAO reported. The report further stated that it could take at least 15 years for the US to wean itself of its dependence on REEs from China.

The Department of Defense (DOD) and military officials have stressed how rare earth elements form a currently irreplaceable part of devices such as lasers, radar, missile-guidance systems, satellites and aircraft electronics. And many military systems rely on commercial computer hard drives that use rare earth magnets. Even more specific examples of rare earth-driven technologies include the navigation system for the M1A2 Abrams battle tank, and a new hybrid electric drive in the works for the Navy's DDG-51 destroyers. According to the GAO report, rare earth elements might eventually become part of the US National Defense Stockpile. Again, China was one step ahead as they seem to be in recent decades. The rare earth unit of China's Baotou Iron & Steel Group gained official approval in February 2010 to begin building a strategic reserve of rare earth elements, China's official newspaper, People's Daily, recently reported.

Clearly with the amount of control China now holds on these key resources it will become a global superpower without much doubt. China is clearly attempting to backward-vertically integrate the inputs needed for its expansion. In some cases it has set quotas on REE exports to satisfy its own demand for the resource. They set quotas or outright bans for other reasons as well. And they do it because they can.

In September 2010, China imposed a ban on exports of REEs to force the release of a detained captain of a Chinese fishing trawler whose boat collided with two Japanese coast guard ships off the East China sea. Within days of the ban, Japan which was initially adamant, released the boat captain. Now this may seem like a minor diplomatic row, but if China can exercise such leverage, then what it can do with this power remains to be seen.