No one perhaps expected the dramatic arrest of Rio’s chief iron ore price negotiator in China, the subsequent salvos against several top executives of major Chinese steel mills and even the Chinese Iron and Steel Association (CISA), the semi-state association that now manages the Chinese end of the negotiations on iron import prices. Such a determined frontal assault could only happen with blessing from elements in the top echelons in the Chinese political process.

What has made the Chinese government take such a dramatic action at a highly sensitive time in the iron ore negotiations?

Some commentators in Australia see it as a calculated insult designed to express China Inc’s displeasure over the failed Chinalco-Rio investment deal. This is no doubt part of the Chinese context. An overriding consideration appears to have been the determination of the Chinese authorities to consolidate and restructure China’s large and highly fragmented steel-making industry in an effort to increase its efficiency and to combat skyrocketing iron ore prices by developing a united front.  It is not clear whether or how the arrest of Mr Hu might achieve that objective.

Unlike the highly consolidated Japanese and Korean steel industry, the Chinese steel industry is highly fragmented with hundreds of small and medium sized firms built during the heyday of China’s economic boom to satisfy its apparently insatiable demand for steel. Boasteel, the big Shanghai-based  producer (which has been sidelined from its lead role in price negotiations) accounts for less than 5 per cent of national production, and the top national state-owned mills account for not much more than 10 per cent all together. Firms compete intensely with each other for supplies of iron ore, especially the prized long-term benchmark priced iron ore, which came in to China at two thirds of the price of local and other imported supplies through the boom. Disunity within the industry spelt disaster for the Chinese iron ore negotiating position. It is estimated in China  that the iron ore price increased by over 400 per cent over the last six years, and that as a result Chinese steel mills paid an extra 700 billion yuan ($A 140 billion).

The Chinese authorities have been on a course to reform the chaos in what they see as a strategic sector of the economy. In the past half month, Premier Wen Jiabao paid three visits to steel mills in the provinces and urged them to reduce overcapacity and consolidate. Wen also signalled Beijing’s desire to close inefficient, small industry players. Before and during this year’s iron ore negotiations, it is said that Rio and other miners had been pursuing a ‘divide and conquer’ marketing strategy in China by offering attractive long-term benchmark prices to small and medium sized steel mills without government iron ore import permits.

CISA was pleading for the government to intervene to put a stop to unauthorised transactions.  The Secretary-General of CISA said in an interview that it was useless for small and medium sized firms to sign agreements with the miners when they could not get custom clearance without import permits. CISA urged the regulatory authority to close down the newly opened Rizhao International Iron Ore Trade Centre in a bid to clamp down on speculation in iron ore. In a statement it released CISA alleged that unauthorised trade and speculation in iron ore was in direct contravention of State Council’s new ‘Guideline on Restructuring and Revival of Steel and Iron Industry’.  The guideline strongly encouraged industry bodies such as CISA to take a lead role in price negotiations, implying that the government took a dim view on any negotiation outside the officially mandated platform.

Many Chinese steel firms jumped at the opportunity to purchase lower priced ore, having long been victims of the parallel iron ore pricing system in China – the allocation of benchmark priced imported ore to the contracting principals with other supplies procured at much higher spot prices. Firms forced into the spot market for ore could pay up to twice as much as the long-term benchmark price. Private steel mills were often forced to purchase ore from large state-owned steel mills and traders with permits.

The embrace by small and medium sized Chinese steel mills of Rio’s tempting offer might have been the straw that broke camel’s back. Their actions significantly weakened CISA’s position and it is rumoured that CISA was ready to abandon the 40 per cent price reduction that it was demanding and was ready to accept a face-saving reduction based on the 33 per cent offered to Japanese and Korean steel mills.

A major Chinese news outlet, the Southern Metropolitan, reported that Rio would not budge from its equally hardline position on price reduction. There was also speculation that Rio was seeking US$9 billion in damages from Chinese steel mills for cancelled or deferred iron ore shipments. There is a strong belief in China that Rio’s confidence and aggressive demands on the negotiation table derived from its intimate knowledge of the Chinese negotiators’ bottom-line and details about production and storage in Chinese steel mills. Reports from China’s state media asserted that this information was found on Rio computers seized from Hu’s office in Shanghai.

The arrest of Stern Hu might be seen as part of a larger effort to stem the perceived leakage of sensitive information from the Chinese steel mills, which was undermining China’s position during iron ore price negotiations. It is also obviously a very powerful warning from Beijing to the Chinese steel mills that it is determined to bring order back into the iron ore import market and crack down on any unauthorised dealings with miners that weakens the negotiating position of big state-owned steel mills.

The arrest of Stern Hu carries with it a perception of retaliation. There is a general frustration and anger in China amongst government officials over Rio’s dealings with China. Not only has no special status been accorded to China as the largest customer, which imports more than 70 per cent of all seaborne trade in iron ore, but the rumoured Rio demand for compensation over delayed and cancelled ore shipments only rubbed more salt into the wound. In addition, Rio’s decision to invoke a force majeure clause in the supply contract to divert ore from long-term supply contracts to the spot market during the height of the mining boom also earned it enmity amongst its Chinese customers and officials. The outburst from the Chinalco executive that ‘Rio has no business credibility as a company’ may have been expression of a wider feeling in China.

What is unclear is exactly who instigated the proceedings against Hu and, given their collateral impact on China’s commercial standing more broadly, why and how it was allowed to proceed at this time.  Assessment of these questions will be very important in judging the fall-out from the affair and managing the long term interests in the Sino-Australian relationship.