When a public sector mining/trading company’s profit margins are nearly five times that of a manufacturing navratna, what does it say about the economy and the matrix of policy priorities?
National Mineral Development Corp. (NMDC), a mining company, has an enviable margin of 92%. In the same sector, Steel Authority of India (SAIL), the largest steel manufacturer in the country, earns a margin of around 20%. Both are public sector enterprises.
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These numbers become anomalous the moment you consider that NMDC mines and sells coal and iron ore, which are raw materials for companies such as SAIL, which supposedly “add value” to these minerals and manufacture steel. Given the process and product hierarchy, steel is supposed to be a high value-added product compared with iron ore and coal.
Instead, in the current situation, the raw material or input is more highly “valued” than the final “value-added” product. This explains why NMDC’s margins are over 90% while those of SAIL are about 20%. So instead of selling steel, SAIL can, and perhaps should, earn more profits by selling the iron ore that it uses to make steel.
Given the certain level of efficiency required in converting raw materials into final products, the profitability of manufacturing enterprises such as SAIL today is nothing but an arbitrage on the prices of raw materials.
In such a situation, the best investment for these companies would be to invest in raw material source acquisition rather than capacity creation. Contrary to this simple—perhaps simplistic—logic, SAIL plans to invest about Rs 80,000 crore in creating capacity.
The larger point here is that manufacturing activity in some basic and intermediate goods is in the throes of a crisis. Most companies in the business have been reduced to being mere converters. The macroeconomic implication of this trend is rather scary. In such cases, the value addition-to-output ratio is next to nothing. And since a large part of the value addition in manufacturing consists of wages and salaries, income generated in the process of manufacturing is no more than 2-3% of the total cost of producing. Almost 75-80% of the total cost of production is accounted for by raw materials. Till five years back, raw materials accounted for no more than 20-25% of total costs.
This is true not only of Indian companies manufacturing basic goods such as steel. It is a global phenomenon. The current phase of skyrocketing prices and growing shortage of raw materials on the world market is a much bigger threat to economic recovery than the Euro debt crisis. The only difference is that the former is a silent killer and doesn’t attract screaming headlines.
There are, of course, many factors responsible for the flare up in raw material prices. One of these relates to the increasing incidence of oligopolies and cartels in raw materials. Just three international players—Vale, Rio Tinto and BHP—control the global iron ore market. They not only set prices as they deem appropriate, but even enforce changes in the system of pricing for iron ore.
As if price hikes weren’t enough, these three companies have moved to a quarterly price negotiation system since early last year, replacing the practice of annual bargaining over prices. This has resulted in price increases of up to 90%, reducing the profit margins of global steel producers, be it Arcelor Mittal or ThyssenKrupp Steel, the largest German steel group.
The current situation in commodity markets the world over is worrisome, as it is now beginning to taking geopolitical overtones. There have been lobbying efforts for a pan-European strategy for raw materials under the aegis of the European Union (EU) to counter the Chinese, and attempts are under way to get exclusive access to African markets.
In these days of post-meltdown nervousness, when protectionist murmurs haven’t quite died down, this situation can quickly get out of hand. For not so long ago, it was the formation of cartels and monopolies aimed at the procurement of raw materials that was a key feature of the imperialist stage of capitalism, resulting in two world wars.
It is out of fashion to quote Lenin. But he did point out in 1916 that “monopolies have stimulated the seizure of the most important sources of raw materials, especially for the basic and most highly cartelised industries in capitalist society: the coal and iron industries. The monopoly of the most important sources of raw materials has enormously increased the power of big capital, and has sharpened the antagonism between cartelised and non-cartelised industry.” (Imperialism, the Highest Stage of Capitalism.)
Ninety-five years later, raw material imperialists seem to be becoming powerful again. They may not be a threat to political superstructures of nations this time around, but they are certainly a serious threat to the very survival of manufacturing. This is especially so in countries like India, where intermediate, basic and capital goods form the backbone of the manufacturing sector.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comment firstname.lastname@example.org