COLUMN-Alcoa shines a light on China's "fake semis" trade: Andy Home

(Repeats July 13 column with no changes. The opinions expressed here are those of the author, a columnist for Reuters)

By Andy Home

LONDON, July 13 (Reuters) - China exported 2.5 million tonnes of unwrought aluminium and aluminium products in the first half of this year.

That was 35 percent, or 650,000 tonnes, higher than the same period of 2014.

Most of what leaves China is in the form of semi-manufactured products. The rest is largely aluminium alloy with a very small amount in the form of primary metal, the stuff that's traded on the London Metal Exchange.

China has long penalised exports of primary metal with a 15 percent export duty. Exports of "semis" are not only exempt from the tax but qualify for a refund of value added tax (VAT). The policy is intended both to reward producers for investing in value-add product capacity and to prevent the export of an energy-intensive commodity from a country short of energy.

Well, that's the theory at least.

Because hidden somewhere in that flow of products out of China is a stream of "fake semis", metal that has been minimally transformed with the sole purpose of gaming the export tax differentials.

Awareness that all is not as it should be with China's exports has been growing over the last year or so.

But with aluminium prices once again pressuring producer margins, U.S producer Alcoa (NYSE: AA - news) has decided to speak out publicly about the "fake semis" trade.

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Graphic on China's official exports of aluminium semis:

http://link.reuters.com/san25w

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GLOBAL SURPLUS MADE IN CHINA

China's exports of "fake semis" are "the major driver" of lower aluminium prices, according to Klaus Kleinfeld, Alcoa chairman and CEO, talking to analysts on the company's Q2 financials conference call.

What irks Alcoa and other non-Chinese producers is the fact that they have been steadily shuttering capacity only to see the resulting supply-demand deficit filled by Chinese exports.

The company has revised upwards its estimate of global surplus this year by 400,000 tonnes to 760,000 tonnes.

But the headline figure masks two very different market dynamics. In the world outside China Alcoa forecasts a deficit of 1.465 million tonnes. In China itself, though, the outlook is for a surplus of 2.227 million tonnes.

China is exporting that surplus in the form of semi-manufactured products.

If they were all genuine products, Alcoa would be less concerned.

Kleinfeld once famously described China and the non-China aluminium world as parallel universes, each doing its own thing with the 15-percent export duty acting as a natural barrier.

Now (Other OTC: NWPN - news) , however, "these two planetary systems" are colliding with "fake semis" the problematic conduit, a leakage of Chinese surplus in a form that directly competes with primary metal in the rest of the world.

THE FAKE TRADE

Just how big is the "fake semis" trade?

A ball-park figure might be around half a million tonnes a year out of a total semis flow of 3.7 million tonnes last year.

But in truth it's almost impossible to know given it must by definition operate below the radar of China's customs department.

It is, after all, an illegal trade, "stealing money away from the Chinese people," as Kleinfeld bluntly expressed it.

The basics of the trade lie in that differential between the tax treatment of primary metal and products, which qualify for an effective 13 percent VAT rebate.

The economics of passing primary metal off as semi-manufactured product can be enhanced by false invoicing. The VAT rebate is based on the sales price of the "product", meaning the higher the price, the higher the rebate.

The key distribution channels appear to be other Asian countries such as Vietnam and Malaysia with analysts poring over import and export data for evidence that in part they are no more than transhipment points for remelted Chinese metal that will ultimately enter the primary supply chain elsewhere.

And it's an easy metallurgical process. At the end of the day it's all aluminium with minor technical modifications.

Paul Adkins, analyst at AZ China, explained to the Reuters Base Metals Forum how it worked for foil products.

These are made from 1000-series alloy. "That's pretty much the same alloy that some export plate is made from. Once that plate is remelted, all you need to do is add some grain refiner and you have the same raw material that foil is made from," Adkins said.

WHO WILL STOP IT?

So, how is this illegal flow of "fake semis" going to be stopped?

Alcoa's Kleinfeld said it was his "strong assumption" that the Chinese authorities would themselves try to close it down.

"I've last been in China four weeks ago or so, and had a lot of conversations also with high level folks. They are very clear that this is not in line with their policy, and that they are deeply looking into this."

Which makes sense because the whole point of the export duty on primary metal is precisely to stop China exporting a commodity that uses so much power to produce it is often called solid energy.

The only problem is just how much control Beijing has over its own system.

It has been trying to micro-manage its aluminium smelter sector for years but has been repeatedly stymied by local governments keeping alive non-competitive capacity through a range of subsidies.

Others argue that the market itself will ultimately kill off the trade with the all-in aluminium price collapsing to levels that choke off the arbitrage profits.

Except that what works for legitimate semis might not work for the potentially more profitable "fake semis" trade, which itself bends the principles of free market competition.

There is even talk of a potential trade case against China.

Alcoa, according to Kleinfeld, is "considering all options".

STILL PARALLEL UNIVERSES

There is also the not so small problem of the broader flow of semi-manufactured products out of China.

This is an entirely legitimate export trade but one that, even excluding "fake semis", is growing all the time.

That's because Chinese aluminium production continues to surge. It grew at a rate of 13.5 percent in the first five months of this year, compared with growth of just 2.3 percent in the rest of the world.

China's share of global production continues to increase. It currently stands at around 54.5 percent. A year ago it was under 50 percent. Two years ago it was just 42 percent.

These trends look unstoppable.

More Chinese capacity is being built and coming on stream in the country's northwestern provinces. It should be displacing older, higher-cost capacity but with local governments loathe to lose their smelters, it's not doing so in sufficient quantities to rebalance the domestic market.

Outside of China, meanwhile, many producers will have to look again at closing plants in the face of falling prices. Alcoa itself has just announced the permanent closure of one of its Brazilian smelters and is running the ruler over another 400,000 tonnes or so of smelter capacity.

The real problem for Alcoa and others is that Kleinfeld was right when he described the two parts of the global supply chain as parallel universes.

They are but not in the way he probably meant it.

One obeys the laws of supply and demand and the other one does only partly, if at all.

Unless that changes, what leaves China is going to be a growing problem for every other producer.

"Fake semis" may be a particularly egregious development but they are only the illegal tip of a bigger problem for the rest of the world.

(Editing by David Evans)