Monday, February 16, 2009

The Successful SOE Leader + More on Protectionism

John Garnaut, a Beijing-based reporter for the Sydney Morning Herald/The Age, reveals in an editorial today that Xiao Yaqing, current chief of Chinalco, edged out Baosteel president Xu Lejiang for his soon-to-be position with the State Council.

For those not put off by the unpronounceable names, there is an interesting nugget on Chinese business-government relations in this story. There is also an important commentary on Western protectionism.

I'll address the BizGov point first.

Xiao's firm, Chinalco is China's largest state-owned aluminum company, and through its proposed purchase of part of Rio Tinto, an Australian miner, it is also seeking to become a mining giant. (For a little backstory on the Chinalco-Rio Tinto deal, please see this previous post.)

It is an interesting phenomenon in China that the CEOs of SOEs are rewarded with political positions. As Garnaut writes:

The likely promotion of Chinalco's Xiao Yaqing to the position of deputy secretary-general of the State Council illustrates how Communist Party politics is enmeshed with China's state-owned enterprises. ...

Chinalco and Baosteel are institutional rivals that compete for influence and favour within the system. Executives at Chinalco, the aluminium industry leader, enjoy nothing more than ridiculing the steel industry leader, Baosteel. ...

Chinese state-owned enterprises are evolving away from their command economy roots and opening to the market. Paradoxically, the best way for a state-owned company to outperform its rivals is by pursuing profit even if it means circumventing political wishes.

Baosteel made the mistake of satisfying government ambitions for making high-technology steel for cars, ships and planes — the very industries that suffered most when the steel sector tanked last year. Now the private steel makers, which followed the market, are making money from construction steel and Baosteel's Xu has nowhere to go.

As a reward for his success in enlarging an already massive SOE, Xiao will be moving up to the State Council, and while Xu of Baosteel will not necessarily be punished, Garnaut hints that his future will not be as bright as Xiao's. If the past is any indication, Xu may be more likely to move down a provincial Governor or Vice-Governor position rather than up to a State Council position.

Here is the most important point: Xiao is being rewarded, not for profit (Chinalco's 2008 profit was down 50 percent), and not for increased market value (Chalco's market value is about where it was when Xiao took over in 2004), but for SIZE (Chalco's assets grew by 46 percent in 2008).

Despite the tremendous amount of marketization that has taken place over the past three decades, there still lingers a lot of the old command economy mentality of "bigger is better" in Beijing.

And now for the second (and completely unrelated point)...

Garnaut's editorial message is that Australia would be making a huge mistake by erecting political barriers to Chinalco's increased ownership percentage in Rio Tinto. There are, of course, a lot of populist reasons for doing exactly that, but Garnaut gets at why Australia need not be worried.

The important issue revolves around one of the most boring problems I ever encountered during my finance career: transfer pricing. In short, the idea is that affiliated companies cannot artificially cause losses and/or gains by charging each other non-market prices for goods and services. When this happens, all sorts of interested parties will come out of the walls threatening lawsuits. (At least that's how it works in free market economies with mature legal systems.)

For example, Australia's tax authorities would take action if they were convinced that Chinalco were forcing Rio to sell its iron-ore to China at a loss. This would mean a loss of tax revenue for Australia.

Furthermore, Rio's individual shareholders would also take action if they believed market value was being expropriated by Chinalco.

The point here is that, in an open economy, there are plenty of market/regulatory mechanisms to prevent dominant shareholders from taking advantage of minority shareholders. Australia should be happy to take China's money for an increased share in Rio and allow its market and legal infrastructure to serve its intended purpose.

The same would have been true in the case of the CNOOC-Unocal deal back in 2005. Unfortunately many US Congress members either couldn't, or wouldn't, allow their better judgment to guide their actions, thereby damaging the free trade credentials of the US.

To those who would argue that China deserved a stiff-arm due to its "currency manipulation", I would argue that the US cannot talk out of both sides of its mouth. Either the US supports free trade, or it does not. Do extenuating circumstances require the US to abandon its commitment to free trade? (In an analogous argument: Do extenuating circumstances require the US to abandon its commitment not to torture?)

China got burned by the US in 2005. Will it happen again at the hands of Australia in 2009? And if so, what lesson should the Chinese take from their experiences abroad?