Why BHP Billiton Should Demerge Its Operation From China

| About: BHP Billiton (BHP)

BHP Billiton (NYSE:BHP) is currently focusing on the growing Chinese demand to increase its top-line in the immediate future. Though there seems no doubt that the company will be able to achieve good results because of the Chinese government's spending plan, I am particularly doubtful about the probable effect on the bottom-line. The reason behind my concern is the currency translation effect.

Planned Chinese spending on infrastructure

The Chinese government is all set to speed up its infrastructural projects, including but not limited to expansion of railway lines by 1200 km, costing around $150 billion. Along similar lines, China has approved $23 billion for steel projects for which BHP Billiton and Rio Tinto (NYSE:RIO) could be the ultimate beneficiaries.

BHP Billiton has an edge for winning the Chinese projects over its competitors. The company operates in a wide range of products, from iron ore, oil, metallurgical and energy to coal, zinc, copper and aluminum, etc. The fundamental requirement of infrastructural projects are steel and energy. BHP, with its iron ore and coal production, can meet the steel demand and with oil production can fulfill the demand of energy for the upcoming projects. Thus the company provides a complete package, which is always cheaper and less troublesome than sourcing from multiple providers.

Currency concerns

With the raw materials demand increasing in China and the company's ability to win projects over its competitors, there is a clear indication that the company is going to increase its total revenue. However, there are a few concerns that I have about what might affect the company's bottom-line.

First, a look at the developments that are all set to happen in China-

  1. An increase in the demand of raw materials like iron ore and coal (to make steel) and oil and coal for energy purpose.
  2. A huge government expenditure, which will increase the supply of yuan in the market from the government treasury.
  3. In March 2013, China reported a trade deficit of $884 million, as imports rose more than exports. With increase in demand of raw materials, imports in China will also increase. As most of the imported raw material is going to get utilized in internal projects, export volume is not expected to increase at the same pace. Therefore, the trade-deficit of the country is going to get wider.

Effects from these incidents will be twofold:

  1. Economic activities increasing
  2. Yuan getting depreciated with respect to the U.S. dollar, because of the increase in the supply of yuan and because of the widening trade-deficit.

The overall take away for BHP Billiton will be an increased top-line from its Chinese operation. But because of the second and third factors the currency value of the Chinese Yuan will depreciate substantially to offset the gain at the company's top-line.

Translation Effect: Upon converting its yuan earnings into its dollar earnings, there will not be a significant gain for BHP Billiton, because yuan would have depreciated by a large extent.

Just to give an idea about the probable effect of Yuan getting depreciated on BHP Billiton balance-sheet:

At the current GDP growth rate of China of 7.7, the dollar to yuan rate is USD/CNY = 0.16208. The projected rate of China in 2013 and 2014 is 8.1 and 8.5 respectively. This was the level in the first quarter of 2012, then the currency rate was USD/CNY =0.15625. That is a depreciation of about 4% for yuan. Other factors like trade deficit will add extra pressure on Yuan.

What BHP might do about it

  1. BHP Billiton should demerge its 100% owned subsidiary in China, and leave it to do work by itself for the next one-and-half years. Until that time, it would not have to calculate the converted currency gain in the company's main balance-sheet. Once the currency comes back in favor, the company should call off the demerger and make it a 100% subsidiary again.
  2. Proper hedging - BHP Billiton should take extra positions on currencies - short on yuan future for 6-months, 1 year and 1.5 year.

Current dollar to yuan rate: USD/CNY = 0.16208. Going short on yuan will create a position for the company where it can gain from the depreciating Yuan. This will offset the currency translation effect, which could negatively impact the company's earnings.

BHP can also take a position in an interest rate swap involving yuan and USD.

Some Opposite Arguments

I can identify many counter arguments to my position. Firstly, it might be argued that although China is spending on infrastructure projects, however, demand for raw materials is not going to be the same as it was between 2000 and 2010. Also, China is moving towards consumption-led growth as evidenced by recent GDP data. My response is that while both points might or might not be true, it is not material to my argument as long as we see considerable demand in raw materials.

"A huge government spending which will increase the supply of yuan in the market from the government treasury." It can be objected that yuan is not a free floating currency. The Chinese government will intervene anytime it feels the yuan has depreciated or appreciated too much. However, I based my assumption on the possibility of future global pressure on China to regularize its currency.

As for my point about the trade deficit, it can be argued that what is right in theory does not apply here. China has huge dollar reserves. Therefore it might not have any major impact on the currency. But again, that depends on how much of a deficit there is in the long term.


Demand surge in China has not only created an opportunity for companies like BHP Billiton but also posed a challenge for its management to maintain net profit margins under the headwinds of negative currency impacts. I prefer the company to demerge and then merge in the future, because hedging arrangements are not fool-proof solutions. Moreover, there are tax benefits that could be there for the company demerging its subsidiary. Therefore, if not managed properly, the overall gain for the companies will be unsubstantial or may be even negative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: StockRiters is a team of analysts. This article was written by Vaibhab Srivastava - B.Tech, Information Technology, MBA in Finance, IIFT - one of our analysts, and edited by Shas, StockRiters' Editor-in-Chief. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.