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When four Rio Tinto PLC (NYSE ADR: RTP) executives stunned observers by pleading guilty to bribery charges in a Shanghai courtroom, it brought to light the unorthodox and complicated nature of doing business in China's iron ore industry.
Unlike corrupt transactions in other resource-rich countries where customers often receive bribes or kickbacks in exchange for arranging lucrative contracts, in China just the opposite is often the case.
The Rio Tinto executives, for instance, were accused of receiving bribes in return for delivering supplies of highly-desirable iron ore - the key commodity in China's burgeoning steel-making industry.
The four executives admitted receiving $13.5 million (92.18 million yuan) between them in bribes, China's state news agency Xinhua reported, citing court documents. They could face up to 20 years in prison.
But the gist of the story revolves around China's chaotic iron-ore trading system.
China spent $50.14 billion importing iron ore last year, more than any other nation, to feed the ravenous appetite of the largest steel industry in the world - one with over 800 companies that together fabricate around 40% of global output.
The sudden explosion in demand from China's steel industry has undercut the benchmarking system - where prices are set every April. Negotiations between the steelmakers and the big producers recently reached an impasse, after the big mining companies tried to extract a 90% price increase.
Since none of China's steelmakers control more than 5% of the market, they are left with little leverage to negotiate pricing or buy in a systematic way from the big iron ore producers - led by Rio Tinto, Brazil's Vale SA (NYSE ADR: VALE) and BHP Billiton (NYSE ADR: BHP).
Efforts to restructure the global pricing system are in the works. But in China, cutthroat competition and volatile pricing leave steelmakers continuously fighting over access to the mineral.
The fragmented state of China's steel industry - combined with extreme volatility in shipping rates and supply shortages - opens the door to bribery.
Simply put, many Chinese steelmakers put more value on guaranteeing their supplies of iron ore to maintain production than how much it costs to obtain it. In trading worth billions of dollars each day, relationships are often cemented with cash, according to The Wall Street Journal.
Many Chinese steelmakers approach sellers directly to negotiate prices, hampering various efforts by Beijing to convert exploding national demand into a cohesive bargaining strategy. Rio Tinto's Australian iron ore is especially high grade and highly sought after.
The chaos created by the lack of a structured trading market has led some customers to sometimes pay suppliers.
"You are paying the buyer to buy the goods but the buyer is going to take care of you as well," a Shanghai-based minerals dealer who has dealt extensively in iron ore and says he has witnessed numerous corrupt deals told The Journal.
In a kickback scheme described by the dealer, a potential buyer might tell a would-be supplier that he will pay the supplier $2 a ton personally for every ton sold at a certain price.
"That's essentially a bribe," the dealer said.
Dealers can also game the system by agreeing to adjust invoices or deliver more ore than a buyer demands, giving the employee a chance to broker the product privately, the dealer told The Journal.
In addition to the complexities of the trading market, the nation's language and culture can make China a difficult place to do business. Many of the miners, including Rio Tinto, hire Chinese nationals to bridge the gap.
"Companies like Rio Tinto rely heavily on people...who were brought up in China or are citizens of China, who understand the cultural complexity of the system," Pradeep Taneja, a former consultant to the Chinese steel industry who lectures on Chinese business and politics at the University of Melbourne told The Journal.
But even growing up in China didn't keep the Rio Tinto executives from running afoul of the complicated rules governing the iron ore market.
"The reality in China is that areas which are black and white in Australia are much greyer over there," Andrew Forrest, chief executive officer of Fortescue Metals Group Ltd. (ASX: FMG), Australia's third-biggest iron ore producer, said yesterday at a conference in Perth.
News & Related Story Links:
Iron-ore Benchmark System
- Money Morning:
Iron Ore Negotiations Reach an All-Too-Familiar Impasse
- Wall Street Journal:
Rio Tinto Trial Highlights Chaos of China Trading System
Rio's China Bribery Trial Set to End Today After Closed Session