06/25/2012 02:54 PM

Imagining the Unthinkable

The Disastrous Consequences of a Euro Crash


As the debt crisis worsens in Spain and Italy, financial experts are warning of the catastrophic consequences of a crash of the euro: the destruction of trillions in assets and record high unemployment levels, even in Germany. By SPIEGEL Staff

It wasn't long ago that Mario Draghi was spreading confidence and good cheer. "The worst is over," the head of the European Central Bank (ECB) told Germany's Bild newspaper only a few weeks ago. The situation in the euro zone had "stabilized," Draghi said, and "investor confidence was returning." And because everything seemed to be on track, Draghi even accepted a Prussian spiked helmet from the reporters. Hurrah.

Last week, however, Europe's chief monetary watchdog wasn't looking nearly as happy in photos taken in front of a circle of blue-and-yellow stars inside the Euro Tower, the ECB's Frankfurt headquarters, where he was congratulating the winners of an international student contest. He smiled, shook hands and handed out certificates. But what he had to tell his listeners no longer sounded optimistic. Instead, Draghi sounded deeply concerned and even displayed a touch of resignation. "You are the first generation that has grown up with the euro and is no longer familiar with the old currencies," he said. "I hope we won't experience them again."

The fact that Europe's top central banker is no longer willing to rule out a return to the old national currencies shows how serious the situation is. Until recently, it was seen as a sign of political correctness to not even consider the possibility of a euro collapse. But now that the currency dispute has escalated in Europe, the inconceivable is becoming conceivable, at all levels of politics and the economy.

Collapse of Currency a 'Very Likely Scenario'

Investment experts at Deutsche Bank now feel that a collapse of the common currency is "a very likely scenario." German companies are preparing themselves for the possibility that their business contacts in Madrid and Barcelona could soon be paying with pesetas again. And in Italy, former Prime Minister Silvio Berlusconi is thinking of running a new election campaign, possibly this year, on a return-to-the-lira platform.

Nothing seems impossible anymore, not even a scenario in which all members of the currency zone dust off their old coins and bills -- bidding farewell to the euro, and instead welcoming back the guilder, deutsche mark and drachma.

It would be a dream for nationalist politicians, and a nightmare for the economy. Everything that has grown together in two decades of euro history would have to be painstakingly torn apart. Millions of contracts, business relationships and partnerships would have to be reassessed, while thousands of companies would need protection from bankruptcy. All of Europe would plunge into a deep recession.


Governments, which would be forced to borrow additional billions to meet their needs, would face the choice between two unattractive options: either to drastically increase taxes or to impose significant financial burdens on their citizens in the form of higher inflation.

A horrific scenario would become a reality, a prospect so frightening that it ought to convince every European leader to seek a consensus as quickly as possible. But there can be no talk of consensus today. On the contrary, as the economic crisis worsens in southern Europe, the fronts between governments are only becoming more rigid.

The Italians and Spaniards want Germany to issue stronger guarantees for their debts. But the Germans are only willing to do so if all euro countries transfer more power to Brussels -- steps the southern member states, for their part, don't want to take.

The Patient Is Getting Worse

The discussion has been going in circles for months, which is why the continent's debtor countries continue to squander confidence, among both the international financial markets and their citizens. No matter what medicine European politicians prescribe, the patient isn't getting any better. In fact, it's only getting worse.

For weeks, investors and experts demanded a solution to the Spanish banking crisis, preferably in the form of a cash infusion from the two Luxembourg-based European bailout funds, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). When Madrid finally decided to request what could ultimately amount to almost €100 billion ($125 billion), the experts realized that this would suddenly send Spain's government debt shooting up from 70 to 80 percent. As a result, interest rates started rising instead of falling.

The experience of the last few days describes the entire dilemma faced by European politicians trying to rescue the euro: A step that was intended to provide relief only exacerbated the problem.

The same thing happened with the next proposal, which made the rounds last week. Italian Prime Minister Mario Monti wanted the European bailout funds to intervene on behalf of Spain and Italy to bring down their borrowing costs.

But that would have required the affected countries to submit to a program of reforms, a path Monti and his Spanish counterpart, Mariano Rajoy, want to avoid. They would prefer to have the money without conditions. But the German government is unwilling to accept this, which puts Europe at its next impasse. Furthermore, the rescue strategists' resources are limited.

Although the Luxembourg bailout funds still have more than €600 billion in uncommitted resources, it is already clear that the money would be used up quickly if what many experts now believe is unavoidable came to pass, namely that not just the Spanish banking industry but in fact the entire country required a bailout. The bailout funds would be completely overtaxed if Italy also needed help.

Even ECB Has Largely Exhausted Resources

Until now, the defenders of the euro have been able to resort to the massive funds of the ECB, if necessary. If things got tight, the monetary watchdogs could inject new money into the market. But now even the ECB has largely exhausted its resources. It has already bought up so much of the sovereign debt of ailing countries that any additional shopping spree threatens to backfire, causing interest rates to explode instead of fall. At the same time, the conflict between Northern and Southern Europe in the ECB Governing Council is heating up.

Last week, the head of Spain's central bank managed to convince the ECB to ease its rules to allow Spanish banks to use even weaker collateral than before in exchange for borrowing money from the ECB. This could set off a tiff with the central bankers from the donor countries, who are loath to look on as the risks in the central bank's balance sheet continue to grow.

Indeed, the European leaders seeking to save the euro are in a race against the clock. The question is whether the economy in Southern Europe will recover before the euro rescuers' tools are exhausted, or whether it will be too late by the time the recovery arrives. It's a question of growth and the economy, but also of character. How willing are the Spaniards and Italians to accept reforms and hardship, and how willing, on the other hand, are the donor countries of the north to provide assistance and make sacrifices?

Not willing enough, say many experts. As a result, the world is imagining the unthinkable: the withdrawal of several Southern European countries from the monetary union, or possibly even the general collapse of the euro zone. It isn't easy to predict how such a tornado would affect the global economy, but it's clear that the damage would be immense.

Companies Envision Possible Scenarios

It's also clear, says Hamburg economist Dirk Meyer, that the timetable for a euro exit in the affected countries would begin on a Monday, or "Day X." Over the weekend, the governments would have issued the surprising announcement that banks would remain closed on Monday. The bank holiday would be needed to include all savings and checking accounts in the operation.

On Tuesday, the banks and savings banks would begin stamping their customers' bank notes with forgery-proof ink. Capital transactions would be monitored. Black market prices would quickly develop in what the scenario defines as an "unofficial, virtual currency market." Another bank holiday would be needed to convert accounts and balances to the new currency. But at least another year would pass before new bank notes could be printed and distributed. The stamped euro banknotes would remain legal tender in the meantime.

But these are merely the technical consequences of a monetary reform. The economic consequences, which many German companies are now assessing, would be more serious. What happens if, in addition to Greece, other countries have to leave the euro zone? What will be the consequences if Spain, Portugal or Italy reintroduce their own currencies? Experts in the finance departments of some companies are already envisioning the possible scenarios.

For instance, they are examining whether the "euro" is explicitly defined as the agreement currency in contracts with customers from problem countries, so that they don't suddenly find themselves being paid in drachmas or escudos for their products. They are also looking into whether the costs incurred by a possible currency crash would be tax-deductible. And they are examining the potential need for write-offs if claims against business partners from southern countries are suddenly denominated in new currencies on their balance sheets. "The demand for consulting services has risen considerably in recent months," says Gunnar Schuster, an attorney with the law firm Freshfields Bruckhaus Deringer.

Germany Would Be Hard Hit

Germany, the great exporting nation, would be especially hard hit by monetary reforms in the southern countries. Exports to Italy and Spain alone are valued at about €100 billion a year. Although sales of cars, machinery, electronics and optical devices would not be eliminated altogether in the event of a euro collapse, there would be sharp declines, because customers in Southern Europe could no longer afford German products.

As soon as lira or pesetas were in circulation once again, the currencies would be devalued against the euro. Some expect their value to decline by 20 to 25 percent, while others believe that as much as 40 percent is likely. German goods would automatically become more expensive and would hardly be competitive anymore.

When BMW CEO Norbert Reithofer warns that a collapse of the euro "would be a catastrophe," and says that he "doesn't even want to imagine" the possible consequences, he isn't just thinking about declining exports. Reithofer fears that regionalism could return to Europe, and that countries could reintroduce customs barriers to protect domestic industry. And the current uniform environment protection rules would be replaced by a large number of national regulations. All of this would plunge the German export economy into a crisis.

The consequences would be extensive for companies that don't just sell products to Southern Europe, but also maintain branches there or hold partnerships in local companies. The German industrial conglomerate ThyssenKrupp, for example, earns about €1.6 billion in revenues in Spain, where it also employs 5,500 people, mostly in elevator production. Even more important to the company is Italy, where it makes €2.3 billion a year, mostly with the production of stainless steel.

ThyssenKrupp's business in Italy and Spain makes up 9 percent of total sales, which illustrates the importance of the two countries in terms of profits. If a reintroduced lira and peseta were devalued against the euro, the amount of money that the subsidiaries transferred to the parent company in the western German city of Essen would shrink.

A look at the statistics of Germany's central bank, the Bundesbank, illustrates the amounts of money at stake for the economy. They show that in 2010, German companies achieved sales of about €218 billion in Italy, Spain, Portugal, Greece, Ireland and Cyprus, with Italian subsidiaries alone accounting for €96 billion. The value of foreign direct investment in these countries is about €90 billion.

German companies would also benefit from a euro crash, because labor costs would decline in their Portuguese or Spanish factories, but on balance the consequences would be negative. After the last appreciation of the currency in Germany, when the deutsche mark was flying high in the mid-1990s, the export economy suffered the consequences for years.

Massive Shock for Banking Sector

The effects of a euro crash on the financial sector would be hardly less devastating. If Southern European countries left the euro zone, customers would raid their accounts in those countries, says Christopher Kaserer, an expert on capital markets at the Technical University of Munich. This could lead to "a bank run that Spanish and Italian banks would not survive." And because financial companies in these countries are closely intertwined with the rest of the euro zone, customers would also be lining up in front of German banks. "Without capital controls, this sort of a situation could spin out of control," says Michael Kemmer, head of the Association of German Banks. Economists anticipate that German banks would also have to be closed.

But even if there were no major bank run, the withdrawal of several countries from the euro zone would shake the European banking system to its very foundations, analysts with the major Swiss bank Credit Suisse have calculated in a study.

According to the study, if Ireland, Portugal, Spain and Italy joined Greece in leaving the euro, 29 large European banks would see a total capital shortfall of about €410 billion. "If the peripheral countries withdraw from the euro zone, a few of the large, publicly traded banks would come to a standstill," reads the analysts' sobering conclusion. In their predictions, the experts did not even take into account the likelihood that France would come under pressure if Italy withdrew from the euro.

Banks in the crisis-ridden countries would be especially hard-hit, but so would investment banks like Deutsche Bank. According to Credit Suisse, the market leader in Europe's largest economy, which prides itself in having survived the financial crisis without government assistance, would face such heavy loses that it would suffer a capital shortfall of €35 billion.

Whereas Greece is now almost irrelevant for Deutsche Bank, Italy and Spain account for a tenth of its European private and corporate banking business. The bank estimates the credit risks in these countries at about €18 billion (Italy) and €12 billion (Spain).

Large insurance companies are also active in Spain and Italy. Allianz, for example, holds Italian government bonds with a book value of €31 billion, which could create losses for the German insurance giant if Italy withdrew from the euro and had trouble paying its debts. Allianz also holds direct investments in banks in debt-ridden Southern European countries.

Companies, sensing the potential risks, are already doing as much as they can today to prepare for a European monetary storm. For instance, they are financing deals in the peripheral countries locally, so as to avoid currency risk. Investment bankers report that companies are receiving loans almost exclusively from banks in their own countries. Where cross-border transactions are unavoidable, banks are engaging in hedge transactions. IT systems are being prepared for a Europe with multiple currencies. And whenever they can, banks are establishing liquidity reserves or depositing money with the ECB.

'Consequences of Disaster Would Spread Like a Tidal Wave'

 In the real economy, companies are also doing what they can to prepare for a worst-case scenario. If possible, they are only doing business in the crisis-ridden countries that they can finance locally. Investments in Southern Europe are being scaled back, and instead companies are trying "to accelerate growth outside the euro zone, such as in the emerging economies of Asia and Latin America," says one investment banker. This explains why mergers and acquisitions have virtually ground to a halt in Europe.

It's understandable that companies want to protect themselves from a euro crash. But if things get serious, all of these efforts could be worthless, because the consequences of a monetary disaster would spread across the entire economy like a tidal wave.

Economists with the Dutch bank ING have calculated that in the first two years following a collapse, the countries in the euro zone would lose 12 percent of their economic output. This corresponds to the loss of more than €1 trillion. It would make the recession that followed the bankruptcy of investment bank Lehmann Brothers seem like a minor industrial accident by comparison. Even after five years, say the ING experts, economic output in the euro zone would still be significantly lower than normal.

The consequences would also be catastrophic in Germany, as the German Finance Ministry concluded in a study commissioned by Finance Minister Wolfgang Schäuble, a member of the center-right Christian Democratic Union (CDU). The recovery and economic miracle would abruptly come to an end, and instead banks and companies would start collapsing like dominoes, after having to write off receivables and investments.

The German Finance Ministry's prognosis is even grimmer than that of the ING experts. According to their scenarios, in the first year following a euro collapse, the German economy would shrink by up to 10 percent and the ranks of the unemployed would swell to more than 5 million people. The officials were so horrified by their conclusions that they kept all of their analyses under lock and key, for fear that the costs of rescuing the euro could spin out of control. "Compared to such scenarios, a rescue, no matter how expensive it is, seems to be the lesser evil," says one Finance Ministry official.

Costs of Crash for Germany Could Be More than €500 Billion

The dream of balanced budgets would be dead for years. Government debt would rise sharply as tax revenues declined and government spending, on everything from bank bailouts to unemployment insurance, increased. Hundreds of thousands of jobs could be outsourced to other countries, and thousands of companies could go under.

According to a scenario by the major Swiss bank UBS, if the financial risks resulting from the decline in exports, the necessary bank bailouts and the company bankruptcies are added together, the total cost to the German economy could amount to a quarter of Germany's gross domestic product -- well over €500 billion.

And this doesn't even reflect the biggest financial risk, which remains hidden. In the last two years, the ECB has bought up more than €200 billion in sovereign debt from crisis-ridden countries. It would have to write off some of that debt in the event of a euro crash, which would also spell losses for the ECB's largest shareholder, Germany's Bundesbank central bank.

The so-called Target2 balances pose another threat. Through this internal payment system in the euro zone, the Bundesbank has accumulated about €700 billion in claims against the central banks of countries like Greece, Spain and Italy. This is more than five times the Bundesbank's own capital.

"If the monetary union collapsed, these claims would turn into thin air," says Hans-Werner Sinn, head of the Munich-based Ifo Institute for Economic Research. "Then the Bundesbank would have to write off this amount." Given that central banks are not normal enterprises, though, Sinn's conclusion is debatable. This is because central banks have different accounting options. It is conceivable, for example, that the Bundesbank could replace the Target2 asset on its balance sheet with an equalization claim against the German national budget. This would balance the equation on paper.

As long ago as 1948, the Bank Deutscher Länder (Bank of the German States, the forerunner of the Bundesbank) resorted to this accounting trick when, for example, it gave every German citizen 40 deutsche marks following monetary reform. Some of these claims have been on the central bank's books for decades.

But this time the amounts in question are different. It will likely trigger skepticism among international trading partners if the central bank simply conjures the claims from the Target2 system out of its books. It would jeopardize the reputation of the bank's executive board members as stability oriented monetary watchdogs, and possibly even the image of the new currency.

A Conundrum for Investors

Not surprisingly, German depositors and investors are worried. What happens to their assets once the dust has settled and the euro zone has been replaced with a multitude of currencies in Europe once again?

In the short term, the prices of almost all even slightly risky securities would plunge, predicts Andrew Bosomworth. He runs the German portfolio management division of Allianz subsidiary PIMCO, one of the world's largest asset management firms. Should the euro collapse, which Bosomworth still considers unlikely, he expects investors to suffer losses for several reasons. "First, they would suffer currency losses with almost all securities that were converted back to national currencies following a euro withdrawal," says Bosomworth. "Second, they would have to expect countries and companies to default more frequently on their bonds."

Asset managers see only two ways to protect themselves against a crash of the euro zone: to invest the money in tangible assets or to get it out of Europe. "Investors should nationalize their investments, with a focus on emerging economies," advises Bosomworth.

German citizens haven't recognized yet what an abyss they are facing. If the euro collapses, not only will many people lose their livelihoods, but German retirement pensions will also be threatened. The economic success of the last few years would be destroyed, and Germany would fall back into the crisis status of the 1990s.

On the other hand, if the German government gave in to the Southern Europeans' pressure to communitize debt, the risks could even be greater. Instead of an uncontrolled euro crash, Germany could be confronted with an uncontrolled transfer union. Year after year, the Germans would have to transfer sums in the double-digit billions to Southern European countries.

Time Remains to Save Euro

The worst can still be prevented, and Europeans still have the ability to save their common currency without overtaxing the solidarity of the donor countries.

But it is a massive task. Europe's politicians must surrender power to Brussels to supplement their common currency with the political union that's been missing until now. At the same time, the Italians and the Spaniards would have to prove that they could successfully reform and modernize their economies.

So far, it has seemed as if the quarreling nations of the old continent would prove equal to the challenge, as has so often been the case in their postwar history. As experienced Brussels observers know, solutions are only reached in Europe when the continent has run out of options.

But apparently the euro crisis is now so dire that it could even sweep away the oldest European certainties. Even die-hard European politicians now believe that it is no longer inconceivable that the monetary union could soon have fewer members than before. "To push Europe forward, we have to reform the euro," says Luxembourg Finance Minister Luc Frieden. "This doesn't just apply to the management of the monetary union, but, if necessary, to its geographic composition, as well."


Translated from the German by Christopher Sultan

June 24, 2012 9:15 pm

China: Dug in too deep

Overspending and project delays reveal many mining groups are ill-prepared for global expansion
rare earths in Australia©AFP

Chang Zhenming, chairman of Citic Pacific, is unambiguous about the significance of his company’s Sino Iron mine in the desolate, red-soiled Pilbara region of Western Australia. “The whole of China is watching this project,” he says.

More to the point, China is watching with some trepidation as his Hong Kong-listed company faces increasing cost overruns and delays. The stakes are high. Mr Chang says Sino Iron is four times bigger than any iron ore project at home.

While outside observers often fear Chinese companies are unstoppable juggernauts in their ravenous pursuit of the world’s minerals, much of this perception is inaccurate. China’s int­ernational resource expansion is not running smoothly.

The world’s second-biggest economy had hoped it would more easily control its economic destiny by taking huge mineral stakes, robbing companies such as BHP Billiton, Vale and Rio Tinto of the ability to dictate commodity prices.

But the Sino Iron project, far from being a showcase for China’s might, has become instead a cautionary tale of the difficulties Chinese enterprises face as they seek to expand abroad. When it was first conceived in 2006, the total cost was estimated at under $2bn. By now, it has already cost Citic Pacific $7.1bn. Analysts at Citigroup calculate the bill could swell to a possible $9.3bn, while others say they expect the ultimate bill will be closer to $10bn. The mine is at least two years behind schedule.

“This is no longer about commercial goals,” says a senior executive at one leading Asian trading company with extensive sourcing operations in Australia. “It is about Chinese machismo. They have plonked down too much money to pull out now.”

In fact, it is about more than machismo. China imports about 60 per cent of its iron ore and the project was a fundamental attempt to break free of foreign suppliers, which Chinese steelmakers accuse of driving prices too high.

China has always been captive to a few players. Now the country no longer wants just to passively receive the offtake from projects,” says James Cameron of HSBC, describing the trend. “They want to develop new sources of raw materials and they want equity in projects.”

But the problems at Sino Iron show China is struggling to do this. Its companies are straining to prove they have the knowhow and managerial skills to work in environments very different from their homeland.

Chinese enterprises are often unprepared for the rigours of foreign competition after spending so long operating cosily under government protection at home. Cultural problems over labour laws and the nature of contracts cause particular angst.

Sino Iron is not the only Chinese project in trouble in Western Australia. There are 14 important iron ore projects in the region. Eight of them have Chinese money and bankers say several are plagued by similar delays and cost overruns.

The $2.6bn Karara iron ore joint venture between China’s Anshan Iron and Steel and Australia’s Gindalbie Metals has been weighed down by infrastructure design changes, rising material and labour costs, and currency movements.

In some cases, there is simply bad luck. But in most, the problems are partly due to overly optimistic estimates of everything from the productivity of local workers to the environmental sensibilities of their host governmentall considerations that are not problems at home.

China’s difficulties in forecasting realistic costs for foreign projects stretch beyond the mining industry.

China Railway Construction Corp, the Hong Kong-listed unit of a mainland enterprise, said last year it expected to lose about Rmb4bn ($628m) on the construction of a light railway line between Mecca and other cities in Saudi Arabia, after construction cost overruns.

Embarrassingly, the deal was a high profile one. Both President Hu Jintao and the Saudi king were at the signing ceremony. The project was eventually transferred to its state-owned parent, limiting the listed company’s losses and future liabilities. Beijing is now expected to help compensate the company for unexpected project adjustments and changing requirements from the Saudi government.

China certainly has successfully managed some foreign enterprises – such as Volvo cars, acquired by Geely in 2010. Its oil companies are also establishing an international presence in areas as far afield as Africa and Latin America.

But mining projects are a special concern for Beijing’s strategy makers and there is a regular set of difficulties that repeatedly undermines its companies abroad in this sector. Labour at mines causes particularly deep misunderstandings.

China’s mining plans call for the use of Chinese labour with its lower cost and higher productivity. But Australian labour laws and visa requirements made that impossible. Instead, projects rely on expensive Australian workers. Even truck drivers can be paid $200,000 each year, receive three-room housing and free home, leave every two weeks, which in some cases means flights to Bali. Despite what the Chinese regard as generous pay packages, they still have to contend with labour strife.

More broadly, Chinese companies want to control their own fate in projects, which is why they head abroad in the first place. This is in contrast to the Japanese, who have learnt to opt, at least initially, for minority stakes and rely more on local players. By seeking control, negotiations can become confrontational, especially since the Chinese are generally reluctant to pay high fees for local advisers on the ground.

Moreover, the Chinese have a preference for vague language in contracts, lawyers say. That makes sense in China, where conditions change rapidly and both sides understand that contracts are a starting point for talks rather than rules set in stone.

One of the less well-known drawbacks of Chinese businesses is that they sometimes fight among themselves and are hardly monolithic executors of a central mission statement from Beijing. This is partly because Chinese enterprises are evolving into commercial animals with competing interests. “China and its banks are growing out of the posture of China Inc,” says one banker working in project finance at a leading international bank.

More specifically, all the main participants in the Sino Iron saga, Citic Pacific, with 80 per cent of the equity, China Development Bank, its principal lender, and China Metallurgical, the main contractor with the remaining 20 per cent equity in the project, are squabbling. CDB wants to pull out of the project, while Citic Pacific has considered suing China Metallurgical for the delays and budget overruns, according to people familiar with the matter. Recently, the dispute went to the State Council, or cabinet, where Wang Qishan, the vice premier in charge of financial matters, adjudicated, according to a person with direct knowledge of the matter. Citic Pacific declined to comment.

The project is a source of particular frustration for its financiers at CDB, which has lent almost $5bn. Sino Iron was exactly the sort of undertaking CDB, an unlisted policy bank whose priorities are set by Beijing, was meant to finance. When the project was first envisioned six years ago, China was desperate for iron ore to turn into steel, the innards of everything from cars to capital equipment, from residential towers to railway tracks.

The market has changed, however. Chinese developers are coming to the chilling realisation that they are planning to churn out iron ore at the wrong point of the steel cycle. Over the five years since the project was first conceived, China’s steel demand growth has dropped and prices have fallen. In 2010, for the first time in more than a decade, China imported less iron ore than the previous year. In 2011, tight money policies and harsh restrictions on property construction continued to put downward pressure on steel prices.

If this were not enough of a headache, miscalculations over currency have played a role in increasing costs. The Australian dollar appreciated over the life of the project and controversial hedges that Citic bought went wrong, causing a $2bn loss and the departure of senior executives.

The Mineral Resources Rent Tax that the Australian government plans to introduce on July 1 will further dent the profitability of mining projects, as will a plan to levy fees on carbon emissions.
The troubles at Sino Iron mean Citic Pacific, which officially sits directly under China’s State Council, carries a junk rating from Standard & Poor’s, despite its august parent, China’s Citic Group. Brokerage CLSA says the shares of the conglomerate, which also owns utilities, should trade at a 45 per cent discount to its net asset value because of the mine.

In the past, the Chinese government has not held its enterprises accountable for their failure to deliver. That is changing now both at home and abroad, as losses from projects gone wrong mount up.

Indeed, the State Assets Supervision and Administration Commission recently called on its charges to improve the management of their overseas operations. In an unusually public denunciation, Chinese media quoted the commission berating state companies for frittering away cash.

For example, Sinosteel last June stopped work on another iron ore project, its Australian Weld Range mine, which it had acquired in 2008 for A$1.36bn. This depended on the Oakajee Port and Rail project to transport the iron ore, but this has also run into difficulty. One of the proposed solutions was that Sinosteel should buy half of the Oakajee project. But Beijing has removed Sinosteel’s president, Huang Tianwen, and sources in the industry say it is unlikely that the Chinese government will approve such a deal.

This all gels with signs that China is now reining back its high-spending ambitions. CDB is becoming palpably more cautious. The state-run China Railway Engineering Co has formed a joint venture to build a railway to transport coal in Indonesia. While in the past this would have seemed a very straightforward CDB project, it is now seeking that the sponsors, including foreign partners, guarantee the loan in order to avoid a repeat of the Sino Iron debacle.

One person involved in the deal says: “It is a good project but slow progress means the Koreans may spoil the party.”

As the Chinese become more wary about expansion, it will not just be the Koreans who seek to fill the gaps they leave behind.


Steelmaking: From pig iron to pigs


Fifty years ago, China had one goal: to produce more steel than the US. Schoolchildren hunted for steel scraps on the street, families melted down their pots and pans, and villages tried to build rudimentary smelters.

As Chairman Mao Zedong launched the “Great Leap Forward” in 1958 – an industrialisation programme that ended in disastrous famine – he declared that steel production was the most important measure of industrial progress.

Decades after Mao’s death, his wish has come true: China is by far the world’s largest steel producer, accounting for nearly 45 per cent of global production. Not only does China make more steel than the US – it makes eight times more.

But there are signs that it has overstretched. Chinese steel mills report their worst losses in more than 10 years collectively losing Rmb1bn in the first quarter of this year – and many have decided it might be time to turn their focus elsewhere.

In a striking vote of no-confidence for the outlook on steel, Wuhan Iron and Steel, one of China’s largest producers, has even taken up pig farming.

As China’s economic growth begins to slow down, the country has become a victim of its own steel-producing success. This year China cut its economic growth target for the first time in three years, a move that has sent ripples through global commodities markets.

The slowing growth has had a particularly strong impact on steel – and by extension iron ore, a key ingredient in steel – because building activity has cooled. Construction and infrastructure account for 55 per cent of Chinese steel demand. Government controls on the property sector have helped stem property growth sharply over the past year.

Iron ore prices have fallen to about $135 per tonne, down from an all-time high of about $200 in early 2011.

Global trading houses are not the only ones affectedsome Chinese state-owned resource companies have been caught out by the shift too. China’s giant steel mills, which have enjoyed double-digit demand growth for steel over the past decade, are now struggling to cope with demand growth of about 4 per cent this year.

Abroad, Chinese mining companies that have spent the past decade trying to develop mines overseas now find themselves exposed to the risks of slowing demand.

Additional reporting by Leslie Hook

Copyright The Financial Times Limited 2012.