china’s impact on the global aluminum industry

8/9/2019 CHINAS IMPACT ON THE GLOBAL ALUMINUM INDUSTRY

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CHINAS IMPACT ON THE GLOBALALUMINUM INDUSTRY

A STRATEGIC PERSPECTIVE

PREPARED BYINDUSTRY ANALYSIS DEPARTMENT ALCAN INC.OCTOBER 2002


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Some analysts have expressed the opinion that China could constitute a destabilizing force in the primary

metal market by becoming a significant net exporter of aluminum, beginning in 2002 and continuing in the

years ahead. Such an eventuality would increase the net imports of metal originating from the former East

Bloc, push up the Western World metal supply and thus have a depressing effect on the real long-term price

of aluminum. In the opinion of these analysts, Chinas aluminum industry might well play a role in the current

decade similar to the one played by Russias aluminum industry during the first half of the 1990s.

What are the facts? Do they support the view of these analysts? What would have to change for this view to be

a reflection of the future? These are the questions this text will attempt to answer from Alcans perspective.

WILL CHINA BE A DESTABILIZINGFACTOR IN THE YEARS AHEAD?


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Chinas Economic and Social Environment

The Peoples Republic of China is a country of 1.28 billion inhabitants

spread over an area of 9.6 million km 2 . It boasts one of the fastest

growing economies in the world with gross domestic product (GDP)

increasing at reported average annual rate of 7.9% since 1996. Chinas

recent admission to the World Trade Organization (WTO) has provided

the potential for a level playing field for competition, while creating

immense business opportunities and providing access to one of the

largest markets in the world.

A Capsule Look at Chinas Aluminum Industry

Given Chinas economic growth rate and the reluctance of its government

to rely too heavily on imports of strategic materials, the country has

evolved into a major player in the world aluminum industry. Highlighted

here in capsule form is Alcans assessment of key segments of the

Chinese industry.

A number of analysts have expressed the opinion that China could emerge as a significant net exporter of

aluminum over the next few years a development they fear would have a destabilizing influence on the

primary metal market, pushing up Western World supply and thereby driving down prices. In the opinion of

these analysts, China might well play a spoiler role in the current decade similar to the one played by former

East Bloc producers during the so called Russian metal shock of the early 1990s.

The China scenario is an admittedly complex one. What are the facts of the matter? In order to shed some light

on a situation that could have a crucial impact on the outlook for the global industry, Alcan industry analysts

undertook an intensive, segment-by-segment study of Chinas burgeoning aluminum industry.

Highlights of their findings are summarized below for your convenience.

EXECUTIVESUMMARY


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Bauxite:

Chinas bauxite supplies are abundant but expensive to process. Chinese

bauxite is predominantly diaspore, which is high in silica with an alumina

content of 55% to 65%. Because of its low quality and the high process-

ing costs entailed, Chinas bauxite is not exported, but refined locally

using a soda-lime sinter process.

Alumina:

For a variety of economic, financial and quality reasons, China will remain

a net importer of alumina in the years ahead. Current excess demand of

more than 3 million tonnes could reach the 5-million-tonne level by 2006.

Nevertheless, Chinas increasing reliance on imported alumina will be

gradual, as the government will almost certainly continue to protect

state-controlled Chalcos high-cost sintering facilities, notwithstanding

reduced import tariffs.

Aluminum Production:With production of some 3.5 million tonnes in 2001, China currently ranks

as the largest aluminum producer in the world, thanks to idled capacity in

the U.S. Pacific Northwest. However, most of its 130-plus smelters are

characterized by high costs, small scale, outdated technology and signif-

icant pollution problems. With the exception of four larger facilities,

Chinese smelters are all located on the upper right-hand side of the

aluminum cost curve. While there has been a rapid expansion of Chinas

smelting capacity, the surge has resulted largely from inducements

(mainly subsidies by provincial governments) rather than any natural

comparative advantages. Current government policy and WTO require-

ments should combine to reverse this surge in output.

2


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The Power Situation:

Despite being the worlds second largest generator of electricity, the

transmission of power from regions of China that enjoy surplus capacity

to areas which are short is constrained. Most of the countrys power

grids are still not interconnected. But this situation is changing and a

reduction in electricity rates is expected, provided that contemplated

reforms in the energy sector proceed. This should encourage even more

development of large-scale smelters in Chinas eastern provinces,

further exacerbating the comparative disadvantages of smaller-scale,

highly polluting smelters.

Aluminum Consumption:

Chinas aluminum consumption has been growing at an annual rate of

about 14% since 1997. The higher consumption has been driven mainly

by growth in the construction (32% of total aluminum use), trans-

portation (12%) and power (12%) sectors. Imports of remelt ingot, scrap

and semi-fabricated products fill the gap between Chinas surgingdemand and its domestic supply of aluminum.

Imports vs. Exports:

China has been a net importer of unwrought aluminum every single year

except in 1998. Over the past seven years, Chinas net imports of

unwrought metal averaged 230 thousand tonnes (kt). Imports dropped to

120 kt last year, reflecting a surge in aluminum production capacity,

increased tolling activity by Chinese smelters and a slowdown in metal con-

sumption. For the first eight months of this year, however, China has been

a net exporter of unwrought metal, with net exports amounting to 146 kt.


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Demand/Supply Situation (2002-2006):

Going forward, we expect that Chinas aluminum consumption should

increase by 10-11% a year. At that rate, consumption should exceed

5,800 kt by 2006. On the supply side, after increasing by 24% in 2001

and 2002, Chinas aluminum production also should continue to increase

but at a slower pace, in the range of 8-9%. Consequently, even if

production exceeds demand for the next two or three years, China

should once again become a net importer of unwrought metal by the

middle of the decade.

Summary:

Given the above assumptions, the possibility of China becoming a long-

term net exporter of unwrought aluminum seems remote. Thus, we

believe that China will not be a major destabilizing factor in the years ahead.


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CHINAS ECONOMICAND SOCIAL ENVIRONMEN

The Peoples Republic of China is a country of 1.28 billion inhabitants spread over an area of 9.6 million km 2.

It is divided into 22 provinces, five autonomous regions, and three municipalities (Beijing, Tianjin, Shanghai) under

the direct control of the State Council. Population density has increased by 37% over the last quarter of a

century to 133 inhabitants/km 2, which explains the priority accorded by the Chinese government to population-

control measures. This policy evidently has been quite successful, given that the population growth rate

declined from 2.6% during the 1960-1975 period to about 1% towards the end of the 90s. Chinas population

used to be essentially agricultural. In 1975, for instance, 76% of the population was classified in the agricultural

sector, while the industrial and services sectors accounted for 12% each. Today, the service sector provides

work for almost 35% of the population, while the relative share of the agricultural sector has dropped to 47%.

As concerns the economic environment,China is one of the fastest growingeconomies in the world with grossdomestic product (GDP) reportedly growing at an average annual rateof 7.9% since 1996. Chinas industrialproduction for August 2002 was up12% on a year-over-year basis, whichrepresented by far the best performancein Asia and a much higher rate than

in most Western World countries.

Using the purchasing power parity (PPP) concept, Chinas per-capitaGDP jumped from $US273 in 1975to more than $3,600 in 2000. On otherfronts, Chinas inflation rate is undercontrol. And it enjoys a substantialsurplus in its trade balance and cur-rent account,while its foreign reservesexceed $200 billion. Finally, Chinahas recently joined the World Trade

Organization (WTO), providing the

potential for a level playing fieldfor competition and creating immensebusiness opportunities, along withaccess to one of the largest marketsin the world. The following tablecompares Chinas performance witha selected group of developed anddeveloping countries for the years1975 and 2000:

1

ECONOMIC INDICATORS: CHINA AND A SELECTED GROUP OF DEVELOPED AND DEVELOPING COUNTRIES, 1975 - 2000

Public ExpenditureGDP Inflation Rate Debt Service/Exports on Education

Per Capita Annual Growth Rate($,PPP) (%) (%) (%) (% of GDP)

1975 2000 1975 2000 1975 2000 1975 2000 1975 2000

China 273 3,617 9.4 8,0 1.1 0.4 4.3 9.0 1.7 2.3

Developed CountriesCanada 7,339 27,389 2.9 4.8 10.8 2.7 7.6 6.9

Japan 5,626 24,835 3.8 1.9 11.8 -0.6 5.5 3.6

United States 9,132 35,048 3.0 5.2 9.1 3.3 7.4 5.4

Developing CountriesBrazil 2,302 7,037 2.9 4.2 28.9 7.0 41.3 110.9 3.1 5.1

India 464 2,248 5.9 6.4 5.7 4.0 15.3 15.0 2.7 3.2

Mexico 2,555 8,820 2.2 7.0 15.2 9.5 41.1 25.1 3.5 4.9

Thailand 809 6,132 7.3 4.3 5.3 1.6 12.0 22.0 3.5 4.8

Source: The World Situation , ditions La Dcouverte, Montreal, 2001.


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Because of the low quality, Chinadoes not export any metallurgicalgrade bauxite. Moreover, the miner-alogy and level of silica impurity inChinese bauxite mean that it cannotbe easily processed in conventionalBayer plants. This has forced theChinese to perfect a soda-lime sinterprocess. This Sintering and Hybridprocess requires a lot of energy up to 45 gigajoules (GJ) per tonneof alumina as against 13 GJ for atypical Western plant andlarge quantities of soda (114 kgper tonne of alumina on average).

In 2001, Chinas total bauxite con-sumption was estimated at 14 milliontonnes. The countrys bauxite minesmainly supply domestic aluminarefineries, which are all owned by Chalco, the state-controlled alu-minum company. Of Chalcos totalannual bauxite requirements in 2001,59% was sourced from small inde-pendent mines and 23% from theirown mines.

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Given Chinas economic growth rate and the reluctance of central authorities to rely too heavily on foreign

imports, the country has evolved into a major player in the world aluminum industry. After reviewing the main

characteristics of Chinas aluminum industry (bauxite and alumina, aluminum production and consumption, the

power situation, and the evolution of net imports during the last decade), this text will assess the main drivers

of future aluminum consumption and production in China and examine the conditions under which, going

forward, it might prove to be a net exporter or importer of unwrought aluminum.

2CHINAS

ALUMINUM INDUSTRY

a) Bauxite

Abundant but expensive to pro-cess is the best way to describeChinese bauxite.As of 2001, Chinahad total bauxite reserves of 2.27 bil-lion tonnes (representing roughly 2% of the worlds bauxite reserves).Of this total, 703 million tonnes wereclassified as proven reserves (equiv-alent to 50 times the current annualconsumption) and 1.57 billion tonnesas probable reserves.

Chinas bauxite deposits are concen-trated in two areas in the south andnorth of the country, with ShanxiProvince having the largest deposits,followed by Henan, Guizhou,Guangxi and Shandong Province.

Chinas bauxite is predominantly diaspore that is high in silica,with an alumina content of 55% to65%. Three-quarters of the reserveshave an average alumina-to-silicaratio of 6:1. By way of comparison,the typical ratio of commercially available bauxite in the West is 10:1.


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Guangxi

240119

Guizhou

240128

Henan

197178

Shandong

2420

Shanxi

750190

0 200 400 600 800

Possible reserves

Explored reservesHong Kong

Shanghai

Beijing

BAUXITE RESERVES IN SELECTED PROVINCES (in million tonnes)

Bauxite Summary:

Chinas bauxite is abundant but expensive to process. It is predominantlydiaspore, which is high in silica with an alumina content of 55% to 65%.Because of its low quality and the high processing costs entailed, Chinasbauxite is not exported, but refined locally using a soda-lime sinter process.

Various sources.


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Pingguo

0.400.44

Great Wall (Zhengzhou)0.95

1.06Bayer 68%

Sinter 32%

Great Wall (Zhongzhou)

0.440.53

Shandong

0.73

0.81Bayer 18%

Sinter 82%

Shanxi

1.201.32

Bayer 58%

Sinter 42%

Guizhou

0.45

0.50Bayer 61%

Sinter 39%Capacity

Production

Bauxite

0 1 2 3

Bayer 100%

Sinter 100%

8

As suggested above, four of Chalcossix alumina refineries use Hybridtechnology, one uses the Sinteringprocess and one (Pingguo) theBayer technology.

Those six refineries supply nearly

70% of Chinas total annual aluminarequirements. Given that domesticdemand for alumina reached 7 mil-lion tonnes in 2001, the differencemust be imported, mainly fromAustralia (86% of total imports in2000), India and occasionally fromthe Americas. In 2001, aluminaimports exceeded 3 million tonnes,as the market price remained below$150/t for most of the year. Totalimports for the first seven months

of 2002 reached 2.37 million tonnes.The gap between alumina demandand domestic production will mostcertainly increase over time, as alu-minum production (and thus alu-mina requirements) is expectedto increase faster than domesticalumina production. Import needsare expected to total about 5 milliontonnes by 2006.

All six of Chinas alumina refineriesare high-cost plants. Comparedwith other refineries around theworld, they would rank in the high-est cost quartile. Chinese aluminaalso tends to be relatively low quality

b) Alumina China is the second largest producer

of alumina in the world with pro-duction in 2001 reaching 4.7 milliontonnes. Chalco owns all of Chinassix alumina refineries.

Chinalco, representing Chinascentral government, is the con-trolling shareholder of Chalco,having assumed ownership of all shares resulting from a recentrestructuring (debt-to-equity swap). Chalcos ownership struc-ture now is as follows:

Chinalco 72%

Institutional investors 20%

Alcoa 8%

ALUMINA CAPACITY, PRODUCTION & TECHNOLOGY (in million tonnes)

Various sources.


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(the exchange of alumina for metal)has proved to be an effective meansto alleviate working capital require-

ments. This is particularly true if thealumina in question can be processedwithout the need for major capitalinvestment.Finally,bank financing isavailable to smelters with acceptableeconomies of scale.

However, everything else is not likely to remain the same. One shouldassume that the Chinese governmentsintention is to continue protectingChalcos high-cost alumina sintering

facilities. If tariffs are no longer afirst best option, several non-tariff trade barriers (import quotas, dual

exchange rates, procurement poli-cies, an alumina import registrationpolicy, etc.) are still available to helpdiscourage producers from switch-ing too fast from domestic toimported alumina.

in that it is fine, or floury, and rich inimpurities. On the other hand, aver-age freight charges from Australiato principal ports in China amountto about $15/t. An import duty of 12% (equivalent to $20.50/t in 2002)and average port-handling chargesof $10/t also have to be considered.Even when all these items are takeninto account (including a value-addedtax paid by Chinese producers), thedomestic price of alumina is stillhigher than the material importedfrom Australia.

Although Chinas demand for aluminaexceeds local production, resultingin a rapid increase and reliance onimports, the latter are subject toimport tariffs. By increasing the priceof alumina imports, these tariffs andquotas also have the effect of increas-ing the relative competitiveness of the domestic raw material. However,with China having recently joined

the WTO, the import tariff has beenreduced from 18% to 12% for 2002.Additional cuts are scheduled to takeplace over the next two years.

2001 2002 2003 200418% 12% 10% 8%

If everything else were to remainthe same, this would be an incentivefor Chinas aluminum producersto rely even more heavily on foreignimports in the years ahead, spurning

domestic alumina production. Afterall, it is well known that most smeltersprefer imported alumina for eco-nomic (cheaper) and quality (moresandy) reasons.Also, capital may no longer be a major hurdle in termsof switching to imports, as tolling

Alumina Summary:

Thus for economic, financial and quality reasons, China is likely to remaina net importer of alumina in the years ahead. Current excess demand ofmore than 3 million tonnes could reach the 5-million-tonne level by 2006.Nevertheless, Chinas increasing reliance on imported alumina will be gradual,as the government will almost certainly continue to protect Chalcos high-costsintering facilities, notwithstanding the reduced import tariffs.

2,000

4,000

6,000

8,000

10,000

12,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006('000

tonnes)

DemandSupply

HISTORIC, CURRENT AND PROJECTED SUPPLY AND DEMAND CHINA

ALUMINA SUPPLY/DEMAND

Various sources.


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10

ShanghaiYangtse River

Yellow River Beijing

< 50 kt (112 smelters)

Alumina refineries

Bauxite

50 - 100 kt (12 smelters)

> 100 kt (9 smelters)

Total Smelters: 133Total Installed Capacity: 3,850 kt

Total Operating Smelters: 133Total Production Capacity: 3,450 kt

Hong Kong

1,000

1,200

800

1,400

1,600

1,800

2,000

0 5 10 15 20 25

1) Pingguo

2) Guizhou

3) Qinghai

4) Qingtongxia

5) Lanzhou, LianCheng, Baotou

6) Yunnan

7) Fushun, Baiyin

8) Danjiang

9) Tongchuan

10) Zhengzhou, Jiaozuo Wanfang, Shandong

1) 2)3)

4)5) 6)

7)8)

9)10)

Excludes the roughly 100 smaller Chinese smelterslocated at the extreme right-hand of the cost curve.

Cumulative capacity (Mt)

2000 fulloperating cost(US$/t) Source: CRU International Ltd.

SMELTER CAPACITY AND LOCATION

CHINAS SMELTERS RELATIVE COST POSITION

Various sources.


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c) Primary Aluminum Production There are 133 smelters in China,

with a combined production capac-ity in 2001 of 3.5 million tonnes.A good number of them are locatedaround the Yangtse and Yellow Rivers.Most (112) have a capacity of lessthan 50 kt, and only nine of thesmelters have installed capacitiesexceeding 100 kt. Nevertheless, thatlatter group of large smelters isresponsible for almost 40% of Chinas total aluminum productioncapacity. Three of those large facili-ties (Guizhou, 230 kt/y capacity;Qinghai, 200 kt/y; Pingguo, 127 kt/y)are owned by Chalco, whose fivesmelters together accounted fornearly 20%,or 680 kt/y, of Chinasprimary capacity in 2001. The lowest-cost facilities are, in increasing order,those of Pingguo, Guizhou, Qinghaiand Qingtongxia.All smelters witha capacity of less than 50 kt can be

found at the extreme upper right-hand of the cost curve.

Between 1998 and 2001, Chinas pri-mary aluminum production grewat an average annual rate of 12.7%.Thus, total production has almostdoubled over the past six years, withnew investments adding 1.6 milliont/y of capacity. Total installed capac-ity reached 3.8 million t/y in 2001,while production reached 3.5 milliontonnes. More than 50% of overallproduction was attributed to thecountrys 18 largest smelters. Theadjacent table details the increasein smelting capacity over the 1997-2001 period. The additional capacity of 1.6 million tonnes is identified by technology, project type and approv-ing agency. A total of about $2.2 bil-lion was spent to bring forward thisadditional smelting capacity.

SMELTERS APPROVED BY CENTRAL GOVERNMENT BETWEEN 19972001

Additional Project ApprovedNo. Name of Plant Capacity (kmt) Type Technology by

1 Shenyang Kangping 10.00 G 60kA Soderberg Local

2 Baotou 30.00 B 60kA Soderberg Local

3 Luqian 20.00 G 135kA PB Local

4 Taiyuan Dongfeng 15.00 G 60kA Soderberg Local

5 Yangqian 30.00 G 60kA Soderberg Local

6 Zhengxin 15.00 G 60kA Soderberg Local

7 Jinxin 5.00 G 60kA Soderberg Local

8 Guan Aluminum 80.00 B 190kA PB Local

9 Shanhe 13.00 G 60kA Soderberg Local10 Shandong 10.00 B 80kA PB Local

11 Conglin 10.00 G 60kA Soderberg Local

12 Luxi 60.00 G 190kA PB Local

13 Zhouping 60.00 G 230kA PB Local

14 NanShan 25.00 G 160kA PB Local

15 Sanmenxia 60.00 B 190kA PB Local

16 Gongyi No. 1 Power 30.00 G 160kA PB Local

17 Jiaozuo 70.00 B 280kA PB Central

18 Shenhuo 60.00 B 200kA PB Local

19 Shangdian 15.00 B 75kA PB Local

20 Qingyang 12.00 B 60kA Soderberg Local

21 Xinwang 43.00 G 160kA PB Local

22 Huamao 15.00 G 60kA Soderberg Local

23 Huanghe 25.00 G 60kA Soderberg Local

24 Dengfeng Power and smelter 50.00 G 80kA PB Local

25 Long Xiang 50.00 G 155kA PB Local

26 Dengfeng Al Smelter 25.00 G 80kA PB Local

27 Changcheng 20.00 G 60kA Soderberg Local

28 Mianchi 60.00 G 160kA PB Local

29 Xin An 60.00 G 160kA PB Local

30 Gongyi No. 2 Power 20.00 G 160kA PB Local

31 Danjiangkou 35.00 B 120kA PB Local

32 Lanzhou 120.00 B 200kA PB Central

33 Haibei 25.00 B 120kA PB

34 Baihe (Huangzhong) 6.00 B 75kA PB

35 Qinghai 55.00 B 200kA PB

36 Changqi 30.00 G 60kA Soderberg

37 Qingtongxia 130.00 B 200kA PB Central

38 Pingguo 30.00 B 320kA PB Central

39 Guizhou 70.00 B 186kA PB Central

40 Yun Nan 110.00 B 186kA PB Central

1,609.00

* All projects denoted in blue are approved by the Central Government.* G = Greenfield

B = Brownfield Various sources.


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be increasingly difficult to apply and the number of small, uneco-nomic, polluting smelters willlikely decline substantially in theintermediate term.

What are the main reasonsbehind Chinas rapid expansionin smelter capacity?

- Average growth of aluminum con-sumption was about 14% per yearover this period, as China expe-rienced rapid industrializationcoupled with special policies imple-mented to encourage domesticconsumption and thus fuel highereconomic growth. For example,liberalization of the housing market,accelerated implementation of urbanization projects and large-scale projects aimed at upgradingthe national power network allhad a significant impact on alu-minum consumption.

- In order to strengthen the com-petitiveness of Chinese businessin preparation for the keen com-petition expected to follow WTOadmission, the government beganas far back as 1998 to provideinterest-free loans to develop thecountrys economic infrastructureand encourage modernization of capital equipment through technol-ogy upgrading, capacity expansionand new product development.Many such loans were approvedfor larger smelters, with capacitiesclose to or exceeding 100 kt/y.

- Moreover, in order to take advan-tage of the availability of interest-free loans and local government

More than 100 of Chinas smelters(totalling 1,600 kt/y of capacity) areoperating with less than 50 kt/y capac-ity.About 85 smelters (1,300 kt/y of capacity) use outmoded Soderbergtechnology. These small-scale smeltersare both uneconomic and highly polluting. Given the increasing pres-sure to comply with environmentalregulations and a reduced willingnessto continue financing substandardoperations in the wake of Chinasaccession to the WTO, it seems very unlikely that these small-scale smelterswill survive economically . Might they survive uneconomically? Shouldthe respective local governments optto continue subsidizing them withlow-cost electricity, while exemptingthem from environmental protectionrequirements, then they might sur-vive in the short term. Nevertheless,with China having joined the WTO,the local protective policies that havebeen keeping such facilities alive will

12

1,000

2,000

3,000

4,000

5,000

6,000

('000tonnes)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Aluminum

HISTORIC, CURRENT AND PROJECTED SMELTER PRODUCTION CHINA

ALUMINUM SMELTER PRODUCTION

Various sources and estimates.


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support for modernization projects,numerous other enterprises havebeen bypassing the required central-government approval procedures.Instead, they managed to gainapproval for smelter expansionsby phasing their projects intosmaller scale initiatives that fitwithin provincial and regionalgovernment loan limits.

- Whereas, in the Western World,

new smelter capacity requires aninvestment of between $3,500-$4,500/t-Al, recent projects inChina have averaged (accordingto Chalco) less than $1,500/t-Al.Thus, Chinese capital costs are atleast $2,000/t-Al lower than in theWest (using current exchange rates),which implies lower ($80/t-Al) inter-est payments and reduced require-ments in terms of return on capital.

- Finally, Chinas central government,towards the end of the 90s, restrictedthe purchase of large volumes of electricity from power plants oper-ating with unacceptable economiesof scale (below 50 MW), so as toachieve a better utilization of coalresources. In order to ensure their

Aluminum Production Summary:

To sum up, even though China currently ranks as the largest aluminum producer in the world (because of idled capacity inthe U.S. Pacific Northwest), with a production level of about 3.5 million tonnes in 2001, most of its 133 smelters are char-acterized by high costs, small scale, outdated technology and significant pollution problems. With the exception of fourlarger facilities (Pingguo, Guizhou, Qinghai and Qingtongxia), Chinese smelters are all located on the upper right-hand sideof the aluminum cost curve. True, there has been a recent, rapid expansion of Chinas smelting capacity. However, thesurge in output reflects much more a change in induced (mainly subsidies by provincial governments) rather thannatural comparative advantages. Current government policy and WTO requirements will likely combine to reversethis surge in output, as smaller, uneconomic smelters are closed in rough proportion to new capacity introductions.

survival and with the blessingof local governments thesesmall-scale power plants investedin aluminum smelters as a justifica-tion for maintaining full power-generation capacities to support thesmelters operational requirements.

What about the cost competitivenessof the larger Chinese aluminumsmelters? Despite a number of pref-erential electricity-supply policies

introduced over the years by the cen-tral government for the benefit of the15 largest smelters, electricity tariffsgenerally remain higher than forsmelters in the majority of industri-alized countries. Thus, operatingcosts would place most large Chinesesmelters in the top quartile of theworlds primary aluminum capacity.(Such costs exclude working capital,social welfare charges and transportof the metal to market.)

Given Chinas high relative positionon the industry cost curve, domes-tic producers have been protectedagainst foreign competition by atariff of 9% on imported primary aluminum. As a condition for join-ing the WTO, that tariff will decreaseover time. It has been establishedat 5% for the current year.


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Major smelters (over 100 kt/y) havebeen granted preferential rates inorder to maintain their competitive-ness relative to rivals abroad.A rateincrease in 2000 reflected a suddenincrease in the price of coal, whichresulted from a shortage caused by government actions to close small-scale coal mining operations (a pol-icy similar to that just announcedfor small, inefficient smelters).

Concerning the future, a furtherreduction in electricity rates isexpected, provided contemplatedreforms in the energy sector (aimedat facilitating free competition by separating the distribution networkfrom power generating stations)proceed. As stable, large-volumeconsumers, smelters will likely beconsidered as preferred customers.Major smelters have been able tonegotiate long-term, lower-pricedelectricity contracts. However,

since most of the installed smeltersare located in Central and WesternChina while demand is greatest withthe Eastern coastal provinces, Chinaneeds to continue with its upgradingproject so as to develop a more effi-cient and properly inter-connectedsystem for transmitting powerfrom west to east.

d) The Power Situation in China How about the power situation

in China? Since 1980, the country has added close to 12,000 MW per year to installed capacity, to thepoint where it has now exceeded300,000 MW, generating an out-put of 1,350 billion kwh. Chinasinstalled capacity should reach490,000 MW in the year 2010, withan output of 2,140 billion kwh. Butdespite being the worlds secondlargest generator of electricity, thereare still millions of rural residentswho are not connected to an electric-ity network. And many more peopleand businesses across the country have access to only an irregular orlimited supply. How to explain thisapparent paradox? Not unlike otherlogistics-related problems in China,this situation is related to the local-ization of power resources versusthe need to distribute power equi-

tably over a large geographic area. Representing the central govern-

ment, China National PowerCompany is owner of the NationalPower Network (NPN) as well asmajor power generation plants.The distribution of electricity isaccomplished through severalprovincial networks and six regionalgrids (Northwest Power Company,Northeast, North China, SouthChina, East China and Southwest),

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Power Summary:To sum up, despite being the worlds second largest generator of elec-tricity, the transmission of power from regions of China that have surpluscapacity to areas which are short (yet support nearly half of Chinassmelting capacity) is constrained. Most of the countrys power grids arestill not interconnected. This situation is changing and a reduction in elec-tricity rates is expected if contemplated reforms in the energy sectorproceed. That should encourage even more development of large-scalesmelters in Chinas Eastern provinces, near major markets and thus fur-ther exacerbate the comparative disadvantages of smaller-scale, highlypolluting smelters.

each of which encompasses a num-ber of provinces. Most of these gridsare not interconnected. But the gov-ernment has started a program tocorrect this and it is expected thata unified grid will be in place by 2010. In the mean time, the trans-mission of power from those regionsthat do have surplus capacity toareas that are short is constrained.Over all, electricity demand exceedssupply by 15% to 20% but the bal-ance varies from region to region.

How does this affect the develop-ment of the aluminum industry?For the time being, the most severepower shortages are in the East andSouth regions, the same areas thatcurrently support nearly half of Chinas aluminum smelting capacity.Nevertheless, the situation is improv-ing. A general increase in installedpower capacity has broughtprices down:

Average Price Range(mills/kwh) (mills/kwh)

1997 42.2 32.5 - 56.6

1998 38.6

1999 36.1

2000 37.3

2001 37.3 28.9 - 44.6Various sources and estimates.


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e) Aluminum Consumption Chinas aluminum consumption

grew at a compound annual rateof 14% from 1997 to 2000,comparedto a world average (excluding China)of 3.9% for the same period. Theincreased consumption has beendriven mainly by the growth of Chinas construction, transporta-tion and power industries, as wellas by growth in the domestic pro-duction of consumer products.

Chinas estimated primary alu-minum consumption in 2001 was3.6 million tonnes. If secondary aluminum is included, estimatedtotal consumption reached 5.2 mil-lion tonnes during the same period.In 2001, the main end-use marketswere building and construction(32%), transportation (12%),electrical conductors (12%) anddurable goods (10%). Extrusionsrepresented almost 30% of totalconsumption, followed by castings(20%) and sheet & plate (19%).

In recent years, annual aluminumdemand growth has been parti-cularly robust for the followingproducts: new homes (31%), airconditioning units (30%), cars andlight vehicles (12%), transmissionlines (10%) and refrigerators (5%).

To satisfy overall demand, Chinaimports aluminum in the formof remelt ingot, scrap and semi-fabricated products. The latter arethe largest of the three forms andChina purchases around 350 kt each year. The poor quality of domesticmetal makes it quite often unsuitablefor further processing in modernhigh-speed rolling mills. This isparticularly true for the thin-gauge,can-making equipment China hasimported from Europe and North

America. Confronted with this prob-lem, Chinese can makers have littlealternative but to import the metal.This explains why sheet and platemake up the majority of importedsemi-fabricated aluminum products.

29.5%

10.1% 18.2%

6.2%

8.6%

9.2%

18.2%

34.0%

32.0%

10.0%

12.0%12.0%

Building & construction

Consumer durables

Electrical products

Machinery & equipement

Cans and other packaging

Transportation

Other

Western World 26,859 kt China 5,200 kt

ALUMINUM TOTAL CONSUMPTION BY END-USE MARKETS (2001)

Domestic production of manufac-tured and semi-manufacturedproducts also benefits from importtariffs, as follows. However, thesetariffs are being reduced to comply with WTO requirements:

IMPORT TARIFFS FABRICATED PRODUCTS

2001 2002 2003 2004Flat rolled products:

0.2-0.36 mm 12% 6%can stock 12%

Aluminum cans 34% 30%

Aluminum containers 14-15% 12%

Foil (less than 0.22 mm) 18% 10.8% 8.4% 6%

Aluminum windows/doors 30% 25%

Aluminum fabricated(structural) 15% 9.6% 7.8% 6%

Aluminum products(general purpose) 18% 14% 12% 10%

Various sources.

Aluminum Consumption Summary:

Chinas aluminum consumption has been growing at an annual rate of about14% since 1997. The higher consumption has been driven mainly bygrowth in the construction (32% of total aluminum use), transportation(12%) and power (12%) sectors. Imports of remelt ingot, scrap and semi-fabricated products fill the gap between Chinas surging demand and itsdomestic supply of aluminum.

TOTAL ALUMINUM CONSUMPTION BY END-USE MARKETS (2001)

Various sources.


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f) Filling the Gap BetweenDemand and Domestic Supply:Imports of AluminumMonthly data on Chinas net importsof unwrought aluminum (unalloyedprimary plus alloyed metal) and alu-minum semis have been publishedsince 1995. The country has been anet importer of unwrought aluminumevery single year except 1998 (-20 kt).Net unwrought imports were slightly

below 200 kt in 1995, reached a highof 705 kt in 2000 and declined last year to 120 kt. During the first eightmonths of 2002, China registered

net exports of unwrought metal of 146 kt. If one looks to net importsof semis, the flow has remained posi-tive throughout the period. They increased continuously between 1995and 1999-2000, when they stabilizedat around 330 kt before decliningsomewhat last year to 269 kt, becauseof the economic slowdown. Importsand exports of aluminum scrap havealso been monitored, but only overthe past two years. Total net importsof scrap reached almost 800 kt in 2000,before declining last year to 360 kt.About one-third of those importswere comprised of automotive parts.

16

-60

-40

-20

0

20

40

60

80

100

1996

256.7 40.4 (19.9) 327.4 705.0 120.6 (19.5) YTD

1997 1998 1999 2000 2001 2002

Total imports / (exports) (kt)

China unwrought aluminum net imports

Alumina prices

C h i n a n e t u n w r o u g

h t a l u m

i n u m

i m p o r t s

( k t )

A l u m

i n a p r

i c e s

( $ / t o n n e )

100

150

200

250

300

350

400

450

CHINA UNWROUGHT ALUMINUM NET IMPORTS

Source: Reuters, CRU International Ltd.


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How do we account for last yearsdecrease in net imports of unwroughtmetal? The drop may be explainedby the following reasons:

- First of all, 2000 was not a typical year, since net imports of unwroughtmetal surged during that period forreasons related to:- the very high price of alumina

(which stimulated imports, as illus-trated in the graph on page 16);

- a reduction of the aluminumimport tariff from 12% to 6%in order to promote broader tradebetween Russia and China (thistriggered the importation of about 600 kt of metal throughthe Russian/Chinese borderin Northeast China).

- Consequently, unwrought importswent from 530 to 910 kt, whileexports remained more or lessunchanged at around 205 kt.

- Second, exports of unwroughtmetal almost doubled in 2001 (from205 kt to about 400 kt) because alu-minum production capacity surgedby about 600 kt during the courseof the year. Also, Chinese smelterswere actively tolling alumina foraluminum, because the domesticalumina price was much higherthan that for imported alumina.On the other hand, imports of unwrought metal dropped from910 kt in 2000 to 520 kt the follow-ing year because of a decline inmetal consumption related tothe global economic slowdown.Aluminum demand increased by 17% in 2000 as compared to 1999,to reach 3,400 kt. In 2001, how-ever, demand increased only 7%over the previous year, to 3,640 kt.Consequently, net imports droppedfrom 705 kt to about 120 kt.

Imports/Exports Summary:

China has been a net importer of unwrought aluminum every single yearexcept 1998. Over the past seven years, Chinas net imports of unwroughtmetal averaged 230 kt. Imports dropped to 120 kt last year, reflecting asurge in aluminum production capacity, increased tolling activity by Chinesesmelters and a slowdown in metal consumption. For the first eight monthsof this year, however, China has been a net exporter of unwrought metal,with net exports amounting to 146 kt.

CHINAS UNWROUGHT ALUMINUM SUPPLY/DEMAND BALANCE*

Year Demand Production Imports Exports Net Imports

1999 2,900 kt 2,620 kt 530 kt 210 kt 320 kt

2000 3,400 kt 2,830 kt 910 kt 205 kt 705 kt

2001 3,640 kt 3,420 kt 520 kt 400 kt 120 kt

* Excluding stock variations.


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18

a) On the demand side, given thecurrent social/political stability in China, the growing purchasingpower of its emerging middle classand an expected increase in foreigndirect investment in manufacturing

facilities (tailored for domestic as wellas foreign markets), we assume thecountry will continue with its histori-cal pattern of robust economic growthin the years ahead. More explicitly:

Utilizing a given set of explicit assumptions about the future, Chinas aluminum production is forecast

to exceed demand for the next two to three years, as new capacity is expected to increase at a faster rate

than consumption. By the middle of the decade, however, consumption is expected to exceed production,

turning China once again into a net importer of unwrought metal. What are the assumptions about demand

and supply underlying such a scenario? And under what other set of assumptions might China become a

net exporter of aluminum?

THAT WAS THE PAST.WHAT ABOUT THE FUTUR

3

AVERAGE ANNUAL GROWTH

2002 2003 2004 2005 2006-2020

Real GDP 6.7% 7.4% 7.6% 7.6% 6.7%

Industrial production 8.1% 9.2% 9.0% 8.1% 8.0%

Source: DRI-WEFA, First-Quarter 2002.

2,000

1,000

3,000

4,000

5,000

6,000

7,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006('000

tonnes)

DemandSupply

HISTORIC, CURRENT AND PROJECTED PRODUCTIONAND DEMAND CHINA

ALUMINUM PRODUCTION/DEMAND


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As well, we continue to assume thatthe government will invest significantly in developing a west-to-east electricity transmission network. The construc-tion of new high-voltage power trans-mission lines will intertwine the sixregional power grids mentioned above.This should help generate higherdemand for aluminum in the yearsto come. Demand from the transportand construction and building sec-tors is also expected to continue grow-ing strongly.In the former case, Chinas automo-tive industry is theoretically capableof producing some 2.5 million cars,trucks and buses each year. But plantutilization is very low and there areonly a few large-scale producers. Chinalists some 120 enterprises capable of producing complete motor vehicles.However, many of those have annualoutputs of less than 1,000 units andonly seven are capable of producing

more than 100,000 units per year.The same drivers that are shifting theChinese economy away from heavy industry are likely to promote therationalization of fragmented indus-tries such as car production. Output

is likely to grow at the same timeas small, inefficient producers closeor merge with bigger players. Withimproved economies of scale andstronger demand from increasingly affluent consumers, more efficientprocesses will be adopted. This islikely to lead to an increase indemand for aluminum because of more intensive use of the metal ineach vehicle, reinforced by strongerdemand for automobiles.

In the case of the construction sector,rising incomes, combined with agrowing population will put pressureon housing both in terms of thesize of individual units and the num-ber of new houses. During the pasttwo decades, the living space of the average Chinese household hasincreased by a factor of 2.5. Sustainedincome growth and increased urban-ization should support a continuationof this trend, so the construction

of houses and apartments alongwith the demand for aluminum should continue to grow.

Chinas aluminum consumption hasincreased over the past four years atan annual rate of 14%.However, giventhat its per-capita consumption of alu-minum slightly exceeds 2 kg (as com-pared to 35 kg in the U.S.A.), thereis still ample room for further growth.Looked at from another perspective,Chinas aluminum consumption hasbeen increasing over the past 10 yearsat a rate about 1.5-1.6 times fasterthan real GDP. Such income-elasticityis not unlike that experienced by otherless-developed countries at similarstages in their development.Per-capitaconsumption may slightly declineover time as the economic infrastruc-ture gets built and the basic needs of Chinas consumers are satisfied. Butthe annual growth rate should remainin the 10-11% range well into thefuture. At that rate, Chinas annualaluminum consumption, estimatedat 3,640 kt for 2001, should exceed5,800 kt by 2006.


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The large number of small-scalesmelters operating under local-government jurisdiction. Due toa lack of competitive advantage,these smelters are constrained toproducing low-value, commodity grade aluminum ingots while facingnew international competitionresulting from Chinas entry intothe WTO. This should limit theirpotential for growth.

Because of rich coal deposits andsuperior power-generating capaci-ties, there is a concentration of alu-minum smelters in Henan (20%of all smelters), Shandong (7%),Shanxi (6%),and in Northwest (30%)and Southwest (20%) provinces(see table). As well, a majority of the planned smelter expansions thathave been announced are slated totake place in more or less the sameprovinces. The government of Chinahas the obligation to guarantee long-term supplies of electricity to prop-erly approved projects. However,neither the National Power Networknor government-owned power plantswill guarantee normal supplies of electricity to those smelters that donot have central government approval even those situated in energy-richareas should their existing supply sources be unexpectedly interrupted.This could be the case, for instance,if the government decided, for envi-ronmental or economic reasons, toimplement its stated policy of closingall power plants with a capacity of less than 50 MW. So the long-term

20

b) On the supply side, domesticaluminum production increasedby more than 600 kt/y (or 24%) in2001 for the reasons outlined above.It should go up by another 24%, or820 kt/y, in 2002, to exceed 4.3 milliontonnes. And we expect productionwill continue to rise after that, butat a slower pace of 8-9%. The assump-tions behind such a scenario arethe following:

SMELTER LOCATIONS IN CHINA (AT THE END OF 2001)

Ranking Region Province Smelters Capacity (kmt) Percentage

1 Central China Henan 27 791.00 20.17%

2 Northwest Gansu 8 404.00 10.30%

3 Northwest Qinghai 10 310.00 7.90%

4 Southwest Guizhou 4 271.00 6.91%

5 Northwest Ning Xia 2 250.00 6.37%

6 North China Shanxi 11 220.50 5.62%

7 Eastern China Shandong 7 278.20 7.09%

8 Southwest Guangxi 5 202.50 5.16%

9 South China Hubei 9 176.00 4.49%

10 Southwest Yun Nan 6 165.00 4.21%11 Northwest Neimengguo 2 138.00 3.52%

12 Northeast Liaoning 3 130.00 3.31%

13 Southwest Chongqing 4 94.00 2.40%

14 Northeast Jilin 3 103.00 2.63%

15 Southwest Sichun 4 66.00 1.68%

16 Northwest Shaanxi 4 61.00 1.56%

17 South China Hunan 7 50.50 1.29%

18 North China Hebei 4 51.50 1.31%

19 Eastern China Zhejiang 2 37.50 0.96%

20 South China Fujian 1 32.00 0.82%

21 Eastern China Anhui 2 21.00 0.54%

22 South China Jiangxi 2 16.50 0.42%

23 Eastern China Jiangsu 2 12.00 0.31%

24 Northeast Heilongjiang 1 10.00 0.25%

25 Northwest Xin J iang 3 31.40 0.80%

Total 133.00 3923 100%

Various sources.


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serve to further increase the overalloperating costs of small-scale Chinesesmelters that have no access to inter-national markets.

Moreover, the expansion of Chinesesmelter capacity may well triggera global alumina shortage, or at leastgreatly contribute to a reduction of the current market surplus, thereby pushing up the market or importprice of alumina, which would serve

to accelerate smelter closures in China. The final argument supporting our

hypothesis of a lower growth rate forChinese smelting capacity relativeto aluminum consumption is morepolitical. The State Council has beenwarned about the problems andconsequences that may result fromthe current expansion of aluminumcapacity. Potential problems includeenvironmental pollution resultingfrom smelters operating with 60 KAcells or lower; the misallocation of Chinas limited energy and capitalresources; lower long-term domesticprices for aluminum which, justas is the case with other industries,may force many small-scale opera-tors to phase out or cease their oper-ations. Consequently, at the urgingof Chalco, Minmetals and other

concerned parties, Premier ZhuRongji has issued a directive tothe Ministers responsible for theState Development and PlanningCommission, the State Economicand Trade Commission, the Ministry of Environmental Protection andthe Peoples Bank of China, demand-ing immediate actions to correctthe ongoing expansion situation.

The following actions were included

in his directives:- Enforcing the closure of smelters

that do not meet environmentalprotection regulatory requirements(emission and effluent targets)and/or are operating with unac-ceptable economies of scale;

availability of power for many of those announced expansions is farfrom guaranteed.

The availability of alumina may alsolimit the continued expansion of smelting capacity in China. Currently,China has sufficient alumina capac-ity to meet about 70% of total domes-tic demand, relying for the rest onimports from international markets.But surplus alumina capacity on these

markets is not unlimited. Moreover,it is subject to unpredictable priceswings, as was experienced in 2000,when alumina prices reached $450/t.Based on Chalcos development plan,domestic production of aluminashould increase by less than 3 milliontonnes between now and 2006. Theincrease may be even lower, consid-ering Chinas high production costsrelative to international aluminaproducers. There is even a possibil-ity that Chinas existing, higher-cost

refineries may be forced to ceaseoperation if the current low globalmarket prices for alumina persist.The resulting rise in the price of domestic alumina supplies would


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22

The State Economic and TradeCommission has issued an orderto suspend financing for all ongo-ing and planned smelter projectsexcept for the following, which wereapproved by the Central government:

Fushun Smelter 120 k t Start up in 2002

Liacheng Smelter 120 kt Start up in 2003

Boatou Smelter 100 k t Start up in 2002

Qingtongxia Phase 2 100 kt Feasibility Study

Yunnan Smelter 130 kt Completed

Guan Smelter 80 kt Completed

Also, the order clearly stated thatapprovals for planned expansion proj-ects involving the Lanzhou Smelter(150 kt) and the Yunnan Smelter(150 kt) have been cancelled. Bothprojects now must undergo reassess-ment by the Central governmentbefore proceeding any further.Finally, the State Council is consid-ering options for the closure of

all Soderberg smelters. This wouldaffect about 1,000 kt of capacity if all such facilities were to be closed.

It should be noted that about 1,100 ktof locally approved expansion planshave been classified as unacceptable,and that the Central government istaking action to reassess and halt thoseprojects that do not measure up.Also,

there has been a tightening of thecentral governments alumina-importregistration policy since May. Themore restrictive policy means thatonly eight companies (Minmetals,Chalco and six smelters) are qualifiedto import alumina in the conven-tional sense (as against tolling).Smelters that are not allowed toimport alumina directly can stillpurchase from Minmetals. However,under the new legislation, thosesmelters must now pay Minmetalsin advance rather than on delivery,which has an adverse impact ontheir working-capital requirements.Thus, it seems that, through thecontrol of imported alumina, thecentral government now has a pow-erful tool to achieve its goals vis--visthe aluminum industry.

-Restricting and returning tothe central government the rightto approve all smelter expan-sion projects;

- Holding leaders of state financialinstitutions (particularly commer-cial banks) liable for providingfinancial support to unapprovedsmelter projects;

- Introducing a tax-sharing schemedesigned to dampen local govern-ments enthusiasm for supportingill-advised expansion projects; and

- Finally, reviewing and possibly halting previously approved expan-sion projects if they do not meetthe following assessment criteria:capacity must be over 100 kt/y;and the projects must have securedreliable and committed (stable)supplies of power and alumina suf-ficient to support planned produc-tion capacity.

Chinas Demand/Production (2002-2006) Summary:

Chinas aluminum consumption should continue to grow during the years ahead at a rate in the 10-11% range. At thatpace, consumption should exceed 5,800 kt by 2006. On the supply side, after increasing by 24% in 2001 and another24% in 2002, Chinas aluminum production should continue to increase but at a slower pace, in the range of 8-9%/y,given the economic (cost structure, availability of alumina and power) and political factors mentioned above.Consequently, even should its production exceed demand for the next two or three years, by the middle of thedecade China should once again become a net importer of unwrought metal.


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Chinese domestic aluminum production were to increase by 15-20%

per year. This could occur only if there was unlimited cash for smelter

expansion projects, as well as reliable and unconstrained supplies of

alumina and power neither of which is likely;

Or if China were to experience a drastic reduction in domestic

consumption due to social instability or public policy restricting the use

of aluminum. To date though, Chinas socialist capitalism model has

been able to substantially improve per-capita income, thereforelessening economic discontent;

Or, finally, if the LME price climbed high enough to cover domestic

production costs or, even better, exceeded the domestic price. Such a

scenario could result from a devaluation of Chinas currency coupled

with a monetary policy designed to limit the ensuing inflation. Again,

the odds against seeing such a policy implemented seem very long,

given that it would set off a series of other devaluations in the region.

Given the above assumptions, the possibility of China becoming a long-term net exporter of unwrought

aluminum seems remote.

Nevertheless, one cannot totally rule out the possibility of such a scenario developing under a different set

of assumptions. China could conceivably develop a surplus of metal and thus become a net exporter of

unwrought aluminum in the years ahead if, for instance:

CONCLUDINGREMARKS

4


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On balance, this different set of assumptions simply does not jibe with

the facts presented earlier.

Assuming annual growth in aluminum consumption at a rate of 11%,

China would need to develop 450 kt/y of new smelter output just to keep

pace with the expected demand. Much higher output would be needed

to overflow the international aluminum market with its exports and

depress aluminum market prices. China may well increase its production

capacity to keep output in line with forecast consumption, but not

exceed it. China has no economic interests in exporting its scarce

resources (energy, alumina, and capital), or in depressing domestic metal

prices by creating a situation of excess production.

On the other hand, Chinas provinces and cities do have a political

interest in tussling with the central government over the right to

continue operating their small-scale, polluting smelters. The latter may

be uneconomic from a profit-maximization point of view, but the

provinces and cities are certainly making money out of them

particularly if some costs can be shifted to the central authorities or

public utilities. The same caveat applies to WTO implementation. Here it

would also be unwise to assume rapid or uniform implementation.

Nevertheless, in the medium term, economic rationale should prevail.

Thus, we believe that China will not be a major destabilizing factor in

the years ahead.

Industry Analysis Department

Alcan Inc.

October 2002

24


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This document represents Alcans views as prepared by the Industry Analysis Department of Alcan Inc. and is being distributed for information purposes only.It incorporates facts, views and opinions deemed relevant, which were obtained from various sources.


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Alcan Inc.1188 Sherbrooke Street WestMontreal, Quebec H3A 3G2Canada

Mailing Address:P.O. Box 6090Montreal, Quebec H3C 3A7Canada

china’s impact on the global aluminum industry

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