Kicking Out Rio: China's Killer Strategy in Breaking the Iron Miners' Collusion

China's iron ore supply is jointly dominated by three international giants. China should make good use of its large demand to expand its interest in the iron ore trade, and to cut its development costs by forcing a lowering of iron ore prices. According to the average iron ore price Rio Tinto charged Chinese steel makers in 2008, 790 yuan per ton, China paid out nearly 320 billion yuan on 440 million tons of imported iron ore. Every one percent discount in the iron ore price would save Chinese steel makers about 3.2 billion yuan.

In the game with the three iron ore giants, China may be able to break the alliance among them if it stops purchasing iron ore from one company and continues buying from the other two, who may then come to a greater appreciation of the opportunity to do business with China.

China could start with Rio Tinto. If it refuses to cut its iron ore price, cutting off the Rio Tinto tap might prove a useful response.
 
Of course China will suffer, but such losses it sustains make sense if for they help to break pattern of dominance. China's steel industry consumed 1.25 billion tons of iron ore last year, 92 million tons of which were imported from Rio Tinto, accounting for 7.4% of the total, and 21% of the 440 million tons China imported. If China were to discontinue buying from Rio Tinto this year, it would find itself short by about 90 million tons. But this could be offset if China increased imports from India and Brazil by 20 million to 30 million tons, and made use of its iron ore inventory, which runs to the tens of millions of tons. What’s more, effects of an iron ore shortage could be mitigated if it prompted steel makers to increase their efficiency. So cutting off one of the iron ore giants will not necessarily affect China's total iron ore supply this year.

And Rio Tinto? What happens to it if it fails to sell its wares to China?
 
First, Rio Tinto's profit would be cut by over 30%, from last year's $10.3 billion to about $6.5 billion. Rio Tinto's income from its iron ore business totaled $16.5 billion, and profits reached $6 billion. Iron ore exported to China contributed 53% of the total income and 31% of the total profit. Without China, Rio Tinto would see a steep decline in sales income and profit.
 
Second, a large decline in profits would see a huge decline in cash flow. Rio Tinto's total sales would drop about 20% if it lost orders from China. Rio Tinto's cash flow totaled $20.6 billion last year, so the 20% cut in the cash flow means about $4 billion.

Third, a $4 billion cut in cash flow would be debilitating to its efforts to pay down its debt. Rio Tinto's asset liability ratio now stands at 70% and its short-term liability ratio of current assets at 120%, meaning the company wouldn't be able to repay its current liabilities. Even if it sold all of its $18.4 billion of current assets it would face a shortage of $3.7 billion. What is worse is that $5.4 billion of its current assets are iron ore inventory. If China were to refuse to buy it, it would that much more difficult for Rio to liquidate its inventory, and the repayment of current liabilities would total around $9 billion. If Rio Tinto maintains its cash flow, the $9 billion shortage can be offset by the company's daily operation. However, without the Chinese market, Rio Tinto's operations cash flow would fall from $20.6 billion last year to $16 billion yuan. And this would still include a $1.5 billion annual interest payment and $2 billion company tax payment. After deducting these costs, the company would have only $12.5 billion to repay the $9 billion of current liabilities.
 
Rio Tinto would not go into cardiac arrest immediately if China stopped buying its iron ore, but its debt servicing ability would be greatly weakened and the company put at increased financial risk, weakening its ability to draw on the capital markets. Rio Tinto might just be looking at another, and more dire, debt crisis.
 
Rio Tinto is more dependent on China than China is on Rio Tinto. If the two break completely, Rio Tinto stands to lose more than does China's steel industry.

China needs to rework the rules for iron ore import and reform the current disorder in the iron ore import. To break the dominance of the three, the government should intervene and integrate the iron ore import market, and this is the most effective and direct way.

China's next step is to consider resisting Rio Tinto!
 
(The author works at the Fudan University and Brunel University)