If you’re reasonably well informed about global trade issues, then you know that the U.S. and China disagree politically on the relative value of the Chinese renminbi in U.S. dollars, and that the renminbi’s exchange rate with the U.S. dollar is set by the Chinese government.
This is because the world market has chosen not to make the renminbi freely convertible (exchangeable for other currencies at a rate set by a free market, not by the issuing country). This is itself because the Chinese government exclusively sets the exchange rate, and its power to do so is based on the immense size of its trading economy surplus (of export value over import cost), and on the fact that China has now built up the world’s largest (ever in history) reserves of "hard" currency (convertible to U.S. dollars), in the form of U.S. dollars themselves.
These two factors allow the Chinese to keep their currency pegged artificially low, relative to the value that the free market would give it in terms of U.S. dollars. The U.S. government, for all of its bravado and the ranting of internationally powerless members of the U.S. Senate, can do nothing to force the Chinese to strengthen the yuan (the basic unit of renminbi).
China is thus enjoying a powerful advantage in that it takes fewer dollars to buy a yuan, than it should if the global free market operated in China. This is because China has accumulated so much ability -- not just potential -- to affect the world trading (export/import) markets.
With that introduction I am going to issue a caution, perhaps even a warning, to all of those calling for sustained increased prices for the rare earths: Be careful what you wish for.
“China speeds up yuan’s globalization" is a headline that appeared in the International Business Times last week. It joins a flood of other stories on this topic, now filling the news prior to a meeting between the U.S. and Chinese presidents in this coming week. My first thought was to wonder how this Chinese move will affect the rare-metals market.
The U.S. dollar supplanted the British pound sterling between World War I (a war which essentially made the U.K. insolvent) and the end of World War II (which made the U.K. bankrupt). Note well that the British Empire gave up a century and a half of economic gains in a 31-year (1914-45) effort to decide the mastery of Europe, which the combatants started out believing would decide the fate of most of the world. Southeast Asia was a backwater in both wars as far as the issuer of the world’s de facto reserve currency (the U.K.) was concerned, in 1914 and in 1939. In 1947, Imperial Britain had been replaced by a fundamentally still-isolationist United States as the absolute center of the financial world. That same year, the U.S. held for its own account or for safekeeping half of all the gold in the world. No greater accumulation of gold had ever before been seen, nor has it been since ... at least so far.
The Chinese Empire collapsed in 1912, in a series of events more noticed in Hollywood than Washington, D.C. Yet no Communist revolution immediately followed the fall of the last dynasty in China, as it did in Imperial Russia six years later. China literally seethed in revolutions and dictatorships until Japan, emulating European empires in their death throes, decided to create a protectionist trade zone with a complete self-sufficiency in the supply chains for metals, minerals and energy. It called its plan the "Greater East Asia Co-Prosperity Sphere." The first move by Japan was to try to conquer China, piece by piece, to get its resources and acquire control of its population for use as labor.
The Japanese were defeated in China by the U.S., which belatedly came to Southeast Asia’s rescue when the Japanese miscalculated the consequences of going to war with a far-off enemy with a larger manufacturing economy. The Chinese, in all their suffering, noticed the Japanese error and resolved to never let it happen to it again. Note that the Communist revolution and ascendancy in China started during the attempted Japanese conquest, which went on for 14 years. The Communists were successful in 1949, and China became The Peoples’ Republic of China, as it is still called today.
America, sitting on a massive hoard of gold in 1949 and enjoying the greatest industrial manufacturing-based consumer boom in history, ignored the devastated economy of China as too big a problem to solve in a reasonable time. It decided instead to revive Europe (and as it turned out, Japan) as a hoped-for market for American goods and services, to be paid for with cheap labor at first. Even though no one in the McCarthy era of anti-Communist knee-jerk political correctness would admit it, there was a feeling that the Soviet Union could and would now get bogged down for generations in China, which was seen as a basket case.
Unfortunately, many Americans of the political and economic class are now basing their decisions with regards to China as if the U.S. can catch up with Chinese politics and economics by simply adjusting America’s 1960s view of China. It is too late for that.
The Chinese renminbi has now begun a journey that I think ultimately will result in the yuan and the dollar both being reserve currencies, then in the yuan surpassing the dollar as the stronger reserve currency. This will occur in lock-step with the U.S. reducing its ability to create wealth, through the production of natural resources and their conversion into finished goods in surpluses that can be exported, while the U.S. maintains its standard of living.
This will probably not happen overnight; it could take a generation, because we are still in the period where Chinese investors are accumulating the U.S. dollar as the reserve currency, because they still fear using their own currency as a safe harbor, and because they have so much of the reserve currency that they are able to affect the political choices of the issuer of that currency.
The Chinese are well aware of the fact, conveniently forgotten by American politicians, that while the U.K. was the issuer and guarantor of the world’s reserve currency, it was also on the gold standard, and it was the world’s policeman, whether it liked it or not. Britain was the world’s policeman in order to protect its imperial trade routes.
America did not take over this role after World War II. Instead, it immediately went to Cold War to prevent the "spread" of Communism. The greatest defeat in that Cold War was considered to be "the loss of China," although no one suggested war either to prevent or redeem China’s "fall," even when China went to war with the U.S., by proxy, in Korea, which the U.S., then as now, refers to as a “police action.” In all fairness to the politicians of 1949 and the U.S., we had just concluded a massive effort that destroyed China’s attempted conqueror, Japan, and the American people did not perceive the "loss" of China as a near-term problem.
China is today still not a credible, conventional military threat to the U.S. As in the Middle East, technology and training beat ill-equipped, ill-trained masses, every time. This means that militarily, without the direct and credible threat of mutual atomic annihilation, China cannot prevent the U.S. from acting anywhere in the world -- even as close to its own shores as Japan or Taiwan. China’s recent probing of Japanese resolve on sea floor rights to energy and minerals has been cast as a rare-earth issue by myopic viewers of the international scene, and self-interested parties looking for drivers for investment in non-Chinese rare earth production. In fact, the confrontation was merely a skirmish in a larger war for natural resources, begun nearly a century ago by Japan, in emulation of Britain.
In the world of international trade of utilitarian commodities, metals, minerals, and energy sources, China is the demand driver overwhelmingly. Essentially, all investment in new productive capacity for utilitarian commodities is to add supply for serving Chinese demand. If this is a slight exaggeration, at least it is true that no one would make anywhere near this level of investment, if it were not for the collateral of massive Chinese demand growth.
To put it mildly, China is in the driver’s seat (excuse the pun).
At the moment. China is the dominant player in the rare-earth space, which is where the operation of Western free-market capitalism, always seeking the lowest price, placed China. This cannot and will not change for two to three years, the least time it will take, if everything goes according to plan, for new or restarted production and refining in significant quantities of rare earths produced outside of China, refined outside of China, and incorporated in end-use products outside of China to come to the world market.
So what has this to do with the value of the U.S. dollar and the Chinese yuan?
If China continues to hold the price of the yuan where it is against the U.S. dollar, then the only pressure to produce rare earths outside of China will be for strategic advantage to ensure security of supply, to maintain both civilian industry and military uses free of Chinese influence and control.
China today controls the rare-earth supply chain, because its price structure has moved that entire supply chain to China up to the point where high-purity metals and alloys are delivered to end users. Even there, at the point of end-use manufacturing, China is today the low-cost producer and so today, China is not only the monopoly producer of the rare earths, it is the dominant end-user of rare earths in the manufacturing of finished goods.
At least half or more of these rare-earth-containing finished goods are made in China for the export market. Therefore, it is in China’s economic interest to prevent the export of rare earths as raw materials. This has been the exact direction of Chinese export controls on rare earths since the beginning of this century.
If you believe, as the Chinese do, that the only remaining threat to their total control of the rare-earth supply chain is the Japanese rare-earth end-use products industry (such as batteries, permanent magnets and lasers), then you will put pressure on Japan to move the last of the world’s non-Chinese, high-value-added sectors of rare-earth-based product manufacturing to China, or give the Japanese a reason to allow Chinese manufacturing competitors to compete in Japan (which today Japan does not do, in the case of magnets).
Either of these moves would create jobs in China, which is always the goal of the Chinese economy, as it is the goal of the Japanese economy, and as it should be the goal of the U.S. economy.
The point of all of this is that it is China who will benefit most from price increases, for the rare earths as fabricated forms for industrial manufacturing end-use.
Chinese analysts predict that by 2015, China will produce just two-thirds of the world’s supply of new rare earths. Chinese analysts assume that Lynas (OTCPK:LYSCF), Molycorp (NYSE:MCP), and perhaps, Toyota (NYSE:TM) in Vietnam, will produce the remaining third.
The Chinese analyst community is silent about the overall percentage of the total value-add rare-earth supply chain that this one-third will represent.
I think that China will be completely self-sufficient in domestic rare-earth production for its supply chain in 2015 as it is today. I also think that higher prices for rare earths are inevitable as China cleans up the environment in general and in mining in particular. The one -- the greening of rare earth mining -- adds costs to rare-earth mining; the other -- the greening of the Chinese economy -- adds demand. Both are upward price drivers.
The real question is how much of the higher costs of rare earths can be absorbed by the Chinese supply chain, before increases in cost for value-add rise, to where a competitive supply chain can be economic in a foreign (to China) country other than Japan. Note that as rare-earth prices go up in China, they will also go up in Japan and that Japanese labor and overhead is vastly greater than that of China today. The gap will close, if it closes, only slowly even at Chinese rates of growth of costs. Those who think they will operate in the U.S. to add value to rare earths mined and refined in the U.S. need to demonstrate that their supply chain total costs are below those of foreign competitors. Historically, it is the very fact that this has not been so that has driven the rare-earth supply chain to Japan and China in the first place.
China, in my opinion, has always wanted higher prices for rare earths, but has been prevented from getting them by fierce internal competition for supply from both legal and illegal sources. The elimination of unethical, dirty, and illegal competition is the target of the current consolidation and environmental remediation (of the rare earth mining sector) initiatives within the PRC.
Now, what about the value of the yuan?
Chinese goods bought in China must be purchased in renminbi; that is the law. In order to buy or trade goods within China a foreign company must place a hard-currency deposit in a Chinese bank, as collateral for being allowed to purchase renminbi for use only in commercial transactions, at an exchange rate set by the Chinese Ministry of Finance.
So, if the Chinese re-value the renminbi up to reflect its strength as the U.S. demands, then the number of dollars to buy the same number of renminbi will increase. Thus, without doing anything at all, the costs of Chinese goods to foreigners in the dollar/euro/yen economic zones (all of them are hard currencies exchangeable at market rates for one another), including rare rare earths, will rise, but the renminbi price will not rise just on that account.
If China, after imposing an increase in the value of the renminbi, then sees its internal rare-earth prices go up in renminbi, there will be a larger proportionate increase in the number of dollars it will then take to purchase the renminbi, to purchase the rare earths.
I believe that the cost of the rare-earth fabricated forms necessary to make end-use products in mass production, is only a small part of the final cost of the finished goods.
Therefore I believe that an increase in the prices of the rare earths in renminbi, without a contemporaneous increase in labor rates in China for workers who produce the finished goods, does not change China’s competitive advantage in the value chain for rare-earth-based products.
Unfortunately, such an increase will serve in the above case to make non-Chinese value chains even more uncompetitive, since other than in Japan, they will need to invest large amounts of capital to start or restart operations to refine, fabricate, and utilize rare earths in consumer products, and will at the same time have to train largely inexperienced engineers and workers to do jobs for which there is little or no domestic prior experience base to draw upon for instructors. Even if these barriers of capital and skilled labor are overcome, they will now have to play catch-up in technology and compete economically with long-established Chinese and Japanese industry, which has not been standing still waiting for them.
The best market plan for non-Chinese miners who plan to produce rare earths, is to acquire or JV with existing companies that already have the skill sets needed. These will be Chinese, Japanese, French, British, Indian, or Estonian companies. Some have already done this. Any mining venture that intends to go head-to-head with a Chinese mining venture, solely on the ability to produce ore concentrates or even separated and purified chemical compounds must, I think, fail.
There is also one more thing that all rare-earth end users must do. They must secure their supply of the total of the critical rare earths for their products or processes. This means to me, that they must secure their supplies of one or more of lanthanum, neodymium, samarium, europium, dysprosium, and terbium.
Since nature does not provide any one rare-earth deposit with commercial quantities of all of the rare earths, or all of the above critical rare earths, it is necessary always to choose one from "Column A," a producer of the light rare earths, and one from "Column B," a producer of heavy rare earths. This is even true for the contemporary Chinese rare-earth-containing finished-goods industry.
The most critical of the current rare earths are dysprosium and terbium, two of the heavy rare earths, today produced only in China and historically produced only in the former Soviet Union and in China.
There are only a small number of rare-earth projects outside of China capable of producing commercial quantities of dysprosium and terbium. Some or all of these must be brought into production as soon as possible, because it is said by the Chinese themselves that their heavy-rare-earth production has less than 25 years remaining at present levels, and much less if demand increases. China, like the rest of the rare-earth-using countries, is therefore also seeking out heavy-rare-earth production.
I believe that for heavy rare earths, and only heavy rare earths, strategic need will overcome simple economics, or at least the capitalization of strategic need will create the necessary economics to bring heavy-rare-earth-themed mines into production.
There will be no non-Chinese, rare-earth-based, mass-produced devices utilizing rare-earth permanent magnets, until a reliable steady supply of dysprosium can be secured. The lighting industry outside of China will founder ,without a secure supply of the heavy rare earth terbium.
Therefore, if there is to be a non-Chinese, rare-earth-utilizing manufacturing industry, one or more of the heavy-rare-earth deposits that are technically feasible, must be brought into production even if it is not economically sensible on a freestanding basis as a business.
You need to look at the TMR Advanced Rare-Earth Projects Index, produced and maintained by my colleague, Dr. Gareth Hatch, as a metric to decide which rare-earth mines are going to be critical to Chinese and non-Chinese rare-earth supply chains. I am going to make my own selections in a separate article, so that I can explain to you why I chose some over others.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.