Analysis: The problem with China

Australia has a China problem far deeper than the legal dispute which broke out this week between mining entrepreneur, Clive Palmer, and Sino Iron.

On the surface, Palmer vs. Sino Iron is a simple squabble about money. Specifically, it’s about the size and timing of royalty payments to Palmer’s principal company, Mineralogy.

Less obvious is the bigger issue of the deep financial hole into which Sino Iron has fallen, and its desperate attempt to climb out.

In some ways, the plight of Sino Iron is synonymous with that of China itself, with the country (and the company) following a business development recipe which appears to have reached its use-by date, with potentially unpleasant consequences.

For the past 20 years no-one questioned the China growth miracle. The country expanded dramatically, lifting hundreds of millions of people out of poverty. We all applauded and Australia enjoyed the ride on the coat-tails of the Chinese dragon.

But, what can now been seen is that the basis of the growth miracle was a combination of cheap labour, a degraded environment, dictatorial government, and a massive flow of exports, mainly to Europe and the U.S.

The miracle days of cheap labour and an endless flow of exports are over. Labour has become expensive relative to other countries, Europe has stopped buying, and the U.S. is heading into a period of massive debt repayment, the so-called fiscal cliff.

China, however, is stuck with the same sort of government it had before the global economic change, and it must either adapt or face a crisis identical to that which eventually brought down the last great experiment in communism, the Soviet Union.

Sino Iron is at the cutting edge of the crisis building in China. It is an iron ore mining business conceived in boom conditions, badly managed as cost overruns and completion delays demonstrate, and now desperately trying to re-write the original deals on which it was based.

Times have changed for Sino Iron. It is carrying a capital cost which has ballooned from $2.5 billion to $7 billion and it is about to start delivering iron ore into an already over-supplied market.

On top of the higher capital servicing cost, Sino Iron has a 10 per cent per tonne legacy royalty agreement with Palmer, and must also pay royalties to the WA Government, meaning that a punishing 15 per cent of revenue goes on royalties before the business itself can book any profits.

It is the cost burden which has caused Sino Iron to seek a revised royalty arrangement with Palmer, leading to Palmer threatening legal action because he has been assuming a flow of royalties which Sino Iron regrets agreeing to, and which it would prefer to not pay.

China itself is heading down the same pathway as Sino Iron. It structured itself to deliver goods and services to a world which no longer wants as much as was assumed when the plan was hatched.

Now it is up to the recently appointed politburo in Beijing to plot a new course, and that will not be easy for a group of ageing bureaucrats who grew up expecting to inherit great wealth only to find they have nothing but trouble on their hands.

The reason China’s changing fortune is a potentially huge problem for Australia is obvious on one level, but not so obvious on another.

The obvious is that a slower China will require fewer commodities from Australia, a fact that also lies at the heart of the Sino Iron crisis.

The less obvious is that watching the recent power change in China was like watching the power changeovers in the Soviet Union in the 1980s when a remnant of the old guard took their turn on top, not really knowing what to do, just hoping to bumble through.

Timing in this comparison between China and the Soviet Union is interesting. The Soviet experiment lasted roughly 70 years. China has been run by a communist dictatorship now for 63 years, and the same evidence of arterial sclerosis seen in the Soviet Union can be seen in the latest government changes in China which involved the appointment of older men, not younger, as happens in most countries.

Australian business leaders with close China ties deny there is a problem but the attempt by Sino Iron to re-write the Mineralogy royalty is an early warning of the pressures being felt in China are being transferred to Australia – as Clive Palmer is discovering.