Globalisation is challenging the received economic wisdom in several ways. Consider the case of aluminium. Commodity prices have long been considered not only inherently volatile, but also fighting a losing terms-of-trade battle with manufactures. Thus, over the last 10 years, while aluminium prices rose sharply between 1994-96, the predominant trend was one of sharp fluctuations within the band of $1,200-1,500 per metric tonne. Prices rose little in real terms over the long run. Unsurprisingly, aluminium companies, like most commodity businesses, have traditionally been wary of aggressive leveraging, maintaining low debt-equity ratios. Big interest payments combined with periodic price shocks was too much of a worry. India?s biggest aluminium company, Hindalco, was symptomatic of this fiscal conservatism. Nalco, the PSU, funded much of its expansion through internal cash flows.
Of late, however, all hell seems to have broken loose in the metals commodity sector?first, in steel in the form of LN Mittal, and the Tatas, who uncharacteristically threw caution to the winds in their leveraged buyout of Corus Steel. This was closely followed by Hindalco?s leveraged buyout of the aluminium major Novelis, and Alcoa?s leveraged offer to buy out Alcan, quickly trumped by an even more aggressive bid by Rio Tinto.
What?s going on here? Has there been a structural shift in the fortunes of commodities in the structural metals sector, or will the predators burn their fingers in a predictable commodity boom-and-bust cycle?
The current phase of globalisation has raised world growth rates to unprecedented levels, facilitated by static and dynamic gains from trade. This has triggered a continuing consumption boom facilitated by falling real prices of manufactures, especially those produced by China. The Chinese boom has, in turn, fuelled a boom in commodity prices that is not fully reflected in the selling price of Chinese manufactures. Astonishingly, China seems to be able to both absorb the commodity price shock, as well as generate savings to bankroll the continuing consumption boom in other countries, particularly America. Despite fundamental global imbalances, inflation remains low the world over. Aluminium prices have been a major beneficiary of elevated and sustained global growth, rising steeply from 2003-04 to a level currently about twice as high as the average for the decade 1993-94 to 2003-04.
Although aluminium is the most abundant metal in the earth?s crust, the basic structural metal ever since the industrial revolution has been iron. Structural metals are different from other commodities because they are not easily substitutable, except amongst themselves. Unlike iron, aluminium is difficult to extract from its bauxite ore. The technology was discovered only in the 19th century, and its mass use only began in the second half of the 20th century. Being relatively young, the usage of this ?space age? metal is increasing fast, especially since aluminium alloys have clear advantages over steel in several respects, including strength. Indeed, aluminium has long been billed as the structural metal of the 21st century, once extraction costs become manageable. Electricity is a key input.
The aggressive leveraged buyouts being witnessed in structural metals such as aluminium are predicated on the view that prices have moved to a new plane and that the imbalance between supply and demand is likely to persist. Aluminium companies are sitting on piles of cash. The prevailing mood is that if this is not used to leverage larger borrowings to expand and integrate vertically to improve profit margins, competitors would move in for the kill. However, both stock markets and credit rating agencies have reacted swiftly and sharply to penalise the predators, predicated on the (contrarian) conventional wisdom that boom-and-bust cycles are a structural feature of commodity markets.
?The author is a civil servant. These are his personal views