The "Rio Tinto Four" have not wanted for coverage. Reports of the case – which saw four employees of mining giant Rio Tinto (RTP.NYSE, RIO.LSE, RIO.ASX) given prison sentences by a Chinese criminal court for accepting bribes and stealing trade secrets – usually end with a dire warning of the impact it will have on foreign business in China. Little is said, however, about what that impact might be.
The surface meaning is simple. When foreign businesses and their staff violate Chinese law, they will be prosecuted and punished in the same way as any Chinese company or individual. The days when foreign violations of the law would be swept under the rug with a discreet deportation order are over.
No one should be shocked or concerned by this. Every country has the obligation to enforce its own laws. In this way, the Chinese prosecution of the Rio Tinto employees is normal and predictable.
As usual, there is a much more complex and difficult issue lurking below the surface: China’s non-market economy. The failure to create a fully transparent mechanism for imports of essential raw materials has left the government in a bind, trying to strike a balance between price-driven foreign sellers and domestic buyers that operate almost regardless of price.
Given the scale of China’s iron ore imports, the structure of its steel industry and the politicization of the now-defunct contract pricing system, it isn’t surprising that iron ore provided the flashpoint.
Where most countries have one or two steel giants, China has hundreds of producers scattered nationwide – and they exist not to make a profit but simply to produce steel and create jobs. Since profit is not an issue, their primary concern is to maximize production, which means a steady supply of iron ore at any price is essential. Steel producers bid against each other for limited ore supplies, resulting in what Beijing describes as "ruinous price competition."
In a normal market economy, a steel producer that consistently overpays for raw materials will eventually be driven into bankruptcy and disappear. But in China, steel producers are protected from failure and never disappear.
Where the source of iron ore is domestic, the government can maintain control by imposing price controls. But where the product is imported, a different response is required. In this case, Beijing ordered that price negotiations be conducted by the China Iron and Steel Association on behalf of its members. Thus, a buyer cartel was formed under the direction of the central government.
As any textbook on antitrust economics will explain, buyer cartels are inherently unstable. This is because there is an overwhelming commercial incentive for companies to "cheat" by going behind their fellow cartel members’ backs.
Where most of the members of a cartel comply with the rules, a single member that purchases in violation of the rules can gain a tremendous competitive advantage. Moreover, it is common for buyer cartels to discuss the production and business plans of the member companies in cartel meetings. Access to such information can be very useful for a competitor that is able to make use of that information. This is exactly what happened (and continues to happen) with iron ore in China. It is a classic example of the instability and ultimate futility of using cartels to evade the basic principles of market economics.
Firms seeking to escape from the restraints of a cartel have a natural ally in the seller of the product. In case of China’s steel industry, young and independent companies seeking to gain market share found a natural ally in Rio Tinto. This inevitably turned into an expensive, rough and dirty game, with the Rio Tinto employees as the ultimate losers.
Rise of the cartels
The issue is likely to remain important. China is moving toward the creation of buyer cartels in many areas where import of critical raw materials threatens to create ruinous price completion between domestic companies. For example, the National Development and Reform Commission is reported to have recently ordered China’s six national petroleum companies to form "consortia" when bidding on foreign oil projects. The stated reason is to prevent the firms from driving up prices by bidding against each other. Similar measures are anticipated for the natural gas and coal import industries.
As we see more cartels in China, we will also see more companies trying to reach deals on the side. This then puts foreign sellers in a very difficult situation. When a Chinese company breaks from the cartel and offers to purchase product in obvious violation of the cartel rules, is that a violation of Chinese law? When a cartel participant provides information about its competitors obtained at cartel meetings, is use of that information a violation of trade secrets law? When a cartel participant reports on Chinese government planning for production and prices, is use of that information a violation of Chinese state secrets law?
There is currently no clear answer to any of these questions. This uncertainty places any foreign seller of raw materials to China in a very precarious position when working with Chinese companies operating outside cartel rules in defiance of express Chinese government policy.
While the legal rules are not absolutely clear, the underlying message is quite certain: China does not view imports of critical raw materials as a commercial matter, but as a matter of vital national interest. No foreign business that operates directly contrary to the government’s interests should expect to conduct this activity in China with impunity. In this case, we should reverse the old adage and say: Seller beware.