JPRI Critique Vol. XVII, No. 2 (August 2011)
Rare Earths Controversy: Confusing Numbers, Consistent Strategies
by George K. Whitney
Reporting about rare earth elements (REE) was rare indeed until September 2010 when The New York Times and other major newspapers reported that China was suspending REE exports to Japan because of a flare up in a long-simmering dispute over the Senkaku/Diaoyu Islands. Since last fall there has been a steady stream of related media stories on Chinese government announcements of REE export quotas, dramatic price increases for these vital materials, and Western challenges in the World Trade Organization to China's export policies. The recent WTO ruling against China's export restrictions on bauxite, magnesium, and other materials - and the looming legal challenge over rare earth elements - suggests that the REE story is far from over. At this juncture, a close look at the REE trade drama nonetheless reveals a number of important insights about Chinese and Japanese economic strategies.
OPEC Meets METI - How to Leverage a 97% Market Share
The perception fostered by much of the mainstream reporting has been of a rising and assertive China unveiling a new economic weapon of profound political force; a weapon tested on Japan that would inevitably be employed against the United States. Actually, a careful reading of the recent history and available data on China's REE industry presents a slightly different picture. Beyond the hazy outlines of a monolithic state wielding an economic tool for diplomatic leverage are clearer images of an ongoing and not always successful effort by the Chinese central government to secure economic advantages through Japanese-style industrial policy and OPEC-like price maximization policy.
China's control of perhaps as much as 97% of the global supply of REE is a relatively recent development, which followed the 2002 closure of Molycorp's Mountain Pass Mine in California. As recently as 1995 the United States accounted for more than 40% of the world's REE oxide supply. China's current dominance of the industry has been driven by its dramatically lower cost structure, which in turn is enabled by lax environmental controls. The severe pollution potential from both the mining and the processing of REE has long deterred other countries from entering this industry.
During the past decade China's production of REE is estimated by the U.S. Geological Survey (USGS) to have grown by as much as 64%, while its domestic consumption of these materials has increased by a whopping 305%. The potential advantages are quite obvious for any nation whose industries can maintain access to adequate supplies of these vital materials, especially if all others are bidding for access to a reduced supply. China's increased export taxes also add directly to the higher prices all other nations now have to pay for REE supplies.
As early as 2005 the Chinese government announced restrictions on REE exports - signaling the first step in a concerted effort to maximize advantages from its virtual control of these materials. Yet, this and subsequent announcements of reduced export quotas went largely unreported in the U.S. mainstream media, with the exception of the specialized trade and mining publications.
Interestingly, while quotas were reduced each year starting in 2006, China's REE exports continued to rise, peaking in 2009 with reported shipments of over 43,000 metric tons. Although reported exports for 2010 dipped to approximately 39,800 metric tons, figures for the first half of the year actually exceeded that for the first six months of 2009. It was not until the September 2010 diplomatic row between China and Japan that actual trade figures began to move in the direction of announced quotas.
One analogy that comes to mind is the Arab-Israel War and ensuring Arab Oil Embargo of 1973-74, which allowed OPEC to finally succeed in operating as a price-setting cartel after gradual efforts over the preceding years to drive prices up by setting production quotas among its members. The War galvanized Arab opinion and catalyzed a sustained embargo by Arab members of OPEC - which demonstrated to all members of the cartel the potential gains from cooperation.
REE prices began climbing steeply in fall of 2010 and have dramatically accelerated their ascent throughout the first half of 2011, driven by declining exports and further announcements of tightened market controls. Year-to-date data as of the end of May 2011 show that China has succeeded in leveraging its REE market dominance into a strong price and income advantage. Through May, reported exports had declined by 8.8% versus 2010, while export earnings had actually tripled to $1.6 billion. By pursuing the central goal of any natural resource cartel or monopolist, which is to be able to exercise sufficient market control so that lower production can actually yield higher earnings, China has entered a period where it will enjoy the types of gains in REE trade that OPEC nations experienced on a much larger scale during the 1970s.
By combining REE export reductions with preferential supplies for domestic industries, China has enhanced the potential effectiveness of its Japanese-inspired industrial policy, which seeks to move Chinese manufacturers up-market for finished goods and downstream in the value-added chain. From a consumption share of about one-fifth of the world total in 2000, China now accounts for more than half of REE consumption, the majority of which ends up in products for export.
Beijing in Control? - Strong Pronouncements, Often Weak Impacts
Americans tend to view China as monolithic - as tightly controlled from Beijing by a Communist Party that firmly sets, promulgates, and enforces policies. Yet anyone who has followed economic and environmental issues in China during the past decade can point to examples that challenge and at times starkly contradict this model. Whether one examines bank lending, export tax rebates, or labor market policies, there are often significant gaps between central policy pronouncements and verifiable actions at the local or provincial levels. While some of these gaps (especially in the area of environmental protection) might be dismissed as evidence of disingenuousness or lack of commitment on the part of top Chinese officials, their frequent occurrences also indicate a weaker level of central control than many outside observers assume.
The long time lag between the central government's initial announcements (2005-06) of a reduction in REE export quotas and actual reductions in shipments (from 2010) highlights the inherent conflict between Beijing's objectives and the often contrary financial and development incentives that operate at the local and provincial levels. Moreover, the greatest threat to China's long-term control of the REE market may be neither market nor government induced responses in Western countries and Japan, but rather the huge incentives inherent in any cartel system for individual members to skirt supply restrictions so as to gain an additional share of the available monopoly profits. The degree to which recent REE export directives are being skirted is strongly hinted at by USGS statistics for 2009 that indicate a gap of 20,000-40,000 metric tons between world REE consumption versus reported supplies, where the majority of this gap is assumed to be unreported exports from China. 
Japan and REE - New Challenge, Same Game Plan?
The Japanese government and industrial enterprises are also pushing back. Prompted by increasingly uncertain availability and pricing for REE, in January of this year Toyota Motor Corporation - whose phenomenally successful Prius hybrids each requires more than 20 pounds of Lanthanum and various quantities of other rare earth elements - announced a long-term initiative to eventually eliminate all REE usage in its cars. Then on February 25th Japan's Ministry of Economy, Trade and Industry (METI) announced a ¥15.2 billion program of subsidies aimed at reducing the nation's overall use of REE, and specifically its dependence on Chinese supplies by one-third. The METI program will function in tandem with expected investments by Japanese firms of an additional ¥36.0 billion to support improvements in recycling technologies, research on substitute materials, and development of supplies from nations other than China.
Notwithstanding the WTO claims against Chinese export practices lodged by the United States, the European Union, and Mexico, there has been a lack of policy initiatives by Western REE-consuming nations that might serve to protect their economies from the potential damage of restricted REE supplies. In the United States, Congressional hearings have been held, industry testimony has been heard and speeches have been made, but the prospects for concrete action appear dim at this time.
The aggressive actions on the part of Japan's METI and its industry partners stand in stark contrast with this level of inaction. While "Japan Inc." has struggled to overcome the Japanese economy's two-decade-long malaise, the challenge posed by today's volatile REE market seems to be providing advocates of administrative guidance a new mandate for action.
Prognostication about the REE drama is complicated by fragmentary trade figures that often raise as many questions as they answer. Indeed, despite an announced REE export quota for the first quarter of 2011 that represented a 35% reduction from reported exports for the first quarter of the previous year, data from the Hong Kong-based Economic Information & Agency Holdings, as analyzed by the Wall Street Journal , indicate that actual Chinese REE exports for the first four months of 2011 were pacing a 33% gain versus the same period in 2010. It was only from May and June of this year that the central government clearly succeeded in suppressing REE exports again. Beijing may have the upper hand in this struggle at present, but the interests of the local and provincial players will likely be heard from again.
All of the factors above add up to a picture of Chinese actions and Japanese/Western responses that is highly unsettled and confusing, marked by shifting official statements, incomplete trade data, and often opaque firm-level behavior. It is inevitable that trade in REE will continue to experience significant price volatility and inspire trade conflicts. The current REE market structure of a 97% share resting in China's hands has created a situation where METI-meets-OPEC policies can be both highly effective and quite disruptive. How China plays its hand will go a long way towards demonstrating what type of power it aspires to be.
George K. Whitney is JPRI Research Associate in Asia Pacific Business and Economics. He has over thirty years of experience overseeing international merchandise trade and is currently a mid-career degree candidate in the Master of Asia Pacific Studies (MAPS) program at the University of San Francisco Center for the Pacific Rim.
1. On September 7, 2010, a Chinese fishing boat collided with two Japanese Coast Guard vessels near the disputed Senkaku/Diaoyu Islands, which led to the detention of the fishing boat captain and weeks of diplomatic wrangling.
2. In 2009 the European Union, Mexico, and the United States each brought complaints to the World Trade Organization concerning Chinese export duties and quotas for bauxite, coke, fluorspar, magnesium, manganese, silicon carbide, silicon metal, yellow phosphorous, and zinc. On July 5, 2011, a WTO panel finally issued a ruling that China is in breach of WTO rules - rejecting the Chinese government's claims that export controls are primarily motivated by conservation and environmental protection policies.
3. Pui-Kwan Tse, "China's Rare-Earth Industry: U.S. Geological Survey Open-File Report 2011-1042" (U.S. Geological Survey, 2011) . http://files.eesi.org/usgs_china_030011.pdf
4. Consider also the case of bank credit extension for real estate investment. Maintaining price stability and avoiding property value bubbles are important objectives for the central government. At the same time, continuing the rapid pace of construction fueled-growth is very much in the interests of the provincial and local government officials, where career advancement and reputations are greatly based on the pace of economic growth. This tendency is exacerbated by the high levels of insider dealing and outright corruption within the construction and real estate sectors.
5. It is possible that Japanese utilization of reserve stocks of REE may also be contributing to this gap.