Report for the Iron Ore Mining Investment in the Democratic Republic of Congo

To:

The Board of Directors of Rio Tinto

From:

Senior Analyst

Date:

05.05.2010

Content

1. Executive Summary 2. Introduction 3. Discussion 3.1. Economic Risk Assessment 3.2. Sources of Financing 3.3. Repatriation Issues 3.4. Strategies for Expropriation situations 4. Conclusion 5. Appendices 6. References

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1. Executive Summary Iron ore mining is a growing industry within the African region and when compared to the global leaders, the Chinese, Australian, and Brazilian mining industries the size of the African industry is very small. However countries like the Dominican Republic of Congo are rich with iron deposits and have the potential to be significant players within the market.

This report focuses on highlighting the key economic risk factors of the Democratic Republic of Congo considering the political variables, economic factors and the financial status of its economy, and to identify the impact it would have on a potential Iron ore mining investment by the International Mining Company Rio Tinto. The risks associated with shipping from the country are also identified due to its importance in the mining industry. Further the main sources of finance available for the investment are discussed in relation to the methods Rio Tinto normally uses to finance its foreign direct investments. Repatriation of funds being a key area of importance in investment decisions, the impact taxation, CSR and local environmental expenses may have on this is evaluated. Considering the political climate of the DRC, expropriation of assets and licences are a threat most investors may have to face. This report identifies strategies the company could adopt in such a situation.

2. Introduction

Rio Tinto is a British-Australian listed mining company that mine and produce mineral resources. The company is considered to be one of the largest mining companies in the world with numerous investments and subsidiaries around the globe. Its product portfolio includes aluminium, copper, diamonds, coal, iron ore, uranium, gold and industrial minerals. Iron ore mining is the companys most profitable sector.

The company is currently planning to make a foreign direct investment in the Democratic Republic of Congo to mine iron ore. The DRC is a country with an abundance of natural resources with the worlds largest deposit of copper and cobalt and also gold diamond and minerals. The country has a large population of approximately 68 million people. However the countrys political instability makes it one of the most difficult countries to invest in.

3.1. Economic Risk Assessment The Democratic Republic of Congo has an open to trading system which is advantageous for potential investors. However the countries progress is curtailed due to its political, economic and social challenges. The country has a high level of corruption, inadequate security, an underdeveloped infrastructure, short supply of skilled labour, lack of property rights protection with unreliable contract enforcement practices. The courts are highly corrupt and public administration is flawed. The DRC was ranked 181 out of 181 in the 2009 and 2008 World Banks Doing Business reports as one of the most challenging countries to do business. Further the process of granting permits and licences suffer from corruption and lack of transparency.

The inadequate physical infrastructure includes transportation, energy and social problems. However the loss making state owned energy sector is being open for private investment which would lead to a more reliable service in the future and the Chinese Chinese Ex-Im Bank is lending the DRC money that will be used to upgrade the road and railway network and upgrade water systems.

The country has a free floating exchange rate since 2001 and international funds can be transferred freely and the whole transfer process takes less than one week. After having somewhat stable exchange rates for sometime the Congolese Franc depreciated by 35% in the beginning of 2009 against the US dollar due to the tightening of monitory policy and the reserves hit an all time low of $30 million. Nevertheless there has been a slight improvement throughout the remainder of the year due to financial assistance from several donors. The mining sector was also affected during 2008/2009 as there was a significant decrease in demand due to falling international commodity prices and tightening of international credit.
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The pound value of the GDP (Appendix A) has increased over the last three years showing a 34% increase in 2008. However the GDP growth rate dropped to 4.6% in 2009, due to the global economic downturn. The Pound value of the profits generated by the DRC has increased over the last two years. There is an increase of 13% in 2008 and increase of 74% in 2009. The DRC also appears to be stable and profitable to cover its interest obligation as the interest coverage ratio, despite the fact that it dropped to 3.25 in 2008 from 3.88, has risen to 4.78 in 2009. The Financial leverage of the economy was at -27% in 2009. Despite the drop in 2009 overall the economy of DRC appears to be growing.

There are no specific requirements for foreign investors other than the investment conditions that must be agreed upon with the government.

Risk associated with Shipment of Iron Ore The Iron ore which is mined, crushed, and processed is then specifically stockpiled according to its composition. Once the ore is in stockpiles they are transported to ports from where it is shipped to the customers. There are some risks associated with the transportation of Iron ore that Rio Tinto needs to consider in their proposed investment to the DRC.

Transportation Firstly the main method of transporting iron ore to the ports is through rail services however, ground transportation within the DRC is very difficult due to its underdeveloped infrastructure. Since DRC is within the Congo Basin the terrain and climatic conditions make it difficult to

construct roads and railways. The rail transportation within the country is slow and unreliable. The roads of the country are deteriorated therefore road safety is a major concern. Since Iron Ore is delivered mainly through rail and trucks this is a serious problem for the company as it will be hard to ship the ore on time. Rio Tinto is a company that is known for its reliability but the unreliable transportation services may cause delays and harm the companys reputation.

Port Facilities

DRC has three main ports Matadi, Banana and Boma. However Banana and Boma are small ports and the Matadi port is not equipped for transporting Iron ore. Iron ore requires special ports with specialized docks to load the cargo. Iron ore is shipped through specialized ore carriers that transport nothing else. These ships are generally larger in size therefore the ports should be specifically in deeper water. There are only two such ports in Africa from which considerable amounts of iron ore are shipped. These two ports are the Port of Saldanha, in South Africa, and the Port of Nouadhibou,in Mauritania. Therefore the iron ore needs to be further transported to one of these ports. The process will be time consuming and more costly.

Congestion All large scale shipping activities in Africa are carried out through the above mentioned ports. There is a large levels of exports done at these ports therefore there is a high level of congestion. Both ports have very long waiting lists as they are the only ports that carry out iron ore shipping. Further the time taken to load and for ships to enter and leave the port is very long. In addition to that there is severe congestion at the Chinese ports as well. The shipping congestion at both ends is a huge hindrance for exporters. This will also cause delays in the process.

Security Risks Towards the eastern parts of the country there are several militias and foreign armed groups. There are infrequent attacks in North Kivu, South Kivu, and northern Katanga provinces and in Bas-Congo and Equateur provinces. These groups may cause a security risk as they can attack and highjack the ore when it is being transported. There are also Somali pirates who highjack cargo ships. This is also a security risk.

3.2. Sources of Financing There are different ways companies can finance its operations overseas. The main methods used include;

Internal Sources of Financing

Retained Earnings

A company could use its own retained profits to finance a project. The accumulated funds which are the undistributed profits of the company set aside for future financial needs can be used to finance investments. Rio Tinto can use its substantial retained profits to finance this investment. But in most situations they use retained funds to finance only part of the investment. The main advantage of using this method is that it is a readily available with no interest charges. However this may not be sufficient to finance large scale projects.

Borrowing from companys Subsidiaries

Large MNCs could also finance its project by borrowing from their own sister companies or subsidiaries. Rio Tinto plc borrows funds from financing company Rio Tinto Finance (USA) Limited which is a subsidiary of Rio Tinto Ltd. The company takes up Bonds from the subsidiary to invest in some of its large scale investments. Through this method the company can borrow at lower coupon rate and the company does not have to keep collateral. However there will be an exchange rate risk when transferring funds, but as Rio Tinto uses swaps to hedge its exchange rate exposure the company might be able to reduce the risk of exchange rate fluctuations.

Finance from sources within the Home country

Bank Loans

Rio Tintos portfolio has secured and unsecured loans. Secured loans are loans which are secured by an underlying asset or collateral. Unsecured loans do not require a collateral or asset as security. Since the Rio Tinto has the backing of a powerful balance sheet and a steady cash flow it has the ability to take up loans without a security and at low interest rates. The acquisition of Hamersley Iron ltd an Australian was funded using loans. Transferring funds will have above mentioned exchange rate risk.

Finance from sources outside the home country

International Bank Loans

Syndicated loans

Syndicated loans are loans offered by a group of lenders who collaborate to provide funds for a single borrower. These types of funds are available for large corporations and even governments. The loan interest rates can be fixed for the loan term or floating based on rates such as the London Interbank Offered Rate. This type of financing is very useful for large investments which are not available from single sources. Rio Tintos largest borrowing is a syndicated loan borrowed for the investment in acquiring Alcan Inc. an Aluminum smelting company in 2007.

European Medium Term Notes

These are similar to bonds where US dollars are borrowed outside the US for a medium term. Euro Medium Term Notes are mostly non underwritten. Rio Tinto has borrowed funds through EMTN for investment purposes.

Financing within the Host country

Joint Ventures

A Joint Ventures is where two or more parties come together to set up a new entity by contributing funds. Rio Tinto uses joint ventures to finance most of its investments. The investments in mining company Western Turner Syncline in Western Australia and Iron ore producer BHP Billiton in Australia were funded as joint ventures.

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With this method the company only has to contribute half of the investment and the risk will also be shared. Other than the reduced cost this method gives the company easy entrance to the foreign environment and it will give access to the other partners competencies. In the case of investing in the DRC, this method will give the company local support of the government and access to distribution channels etc. However there will be the risk of the partner gaining valuable knowledge from the company and competing separately.

Funding using local Investors or Banks

The company could fund its investments using local investors or banks within the host company. There will be no exchange rate risk if the funds are borrowed within the host country. This will also help gain local support.

3.3. Repatriation Issues

Rio Tintos mission like most companies is to maximise shareholder profits by operating responsibly and sustainably. To achieve their objective the company needs to repatriate its profits from its globally dispersed activities. Repatriating profits from foreign investments is very complicated process as this will expose the company to foreign exchange risk, political risk, and capital market risks.

The foreign exchange risks are caused by the changes in the foreign exchange rates. Rate changes will expose the company to economic or accounting losses this will have significant effect on the expected cash flows which are denominated in foreign currency. Foreign exchange

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rate fluctuations can affect the payments made for foreign goods or assets purchased and receipts from the companys exports. This will in turn affect the amount of funds that a company can repatriate.

Political risks include fiscal and monetary policy changes of the country. The DRC is a country with an unpredictable policy system therefore changes in these policies would affect the companys profitability thereby the fund available for repatriation. For example an increase in the taxation rates would affect the profits available for repatriation.

Further the companys corporate social responsibility, taxation issues and local environment issue can have an impact on the companies aim to repatriate profits.

Corporate social responsibility Corporate social responsibility is the continuous commitment of business to behave ethically and contribute to economic development while improving the quality of life of the work force as well as the local community (World Business council for Sustainable Development) There is a continues increase in companies adapting CSR strategies.

Under the mining code of 2002 mining companies are expected to support infrastructure projects in the host country such as building roads, hospitals, schools etc. and the labour laws of the country have specific clauses on employee working conditions, medical provisions, family allowances, daily transportation. Therefore the company is obliged to comply with such expectations. These projects would impact the profits available for the shareholders. However Rio Tinto is a company that has a reputation for its CSR strategy of paying attention to their host countrys economic prosperity, social well being, the companys environmental stewardship, and
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strategic governance and integrity system, and have taken up numerous CSR projects in their host countries to achieve this.

Despite the fact that the company would lose a proportion of their current profits the companys CSR strategy will help it retain its reputation as a responsible entity and in the long run the company will be able to increase its wealth.

Rio Tintos reputation for being socially responsible will help the companys ability to apply and gain the pro-business incentives given by the Congolese government such as tax breaks and duty exemptions granted for three to five years. This will reduce the impact the taxation will have on the profits available for shareholders.

Local Environment Mining of iron ore can have negative impact on the environment such as air pollution due to SO2 or NOx emissions, loss of land and soil and water contamination due to smelter waste, health and safety issues related to explosive handling, water clogging in adjacent land, release of toxins etc.

All mining companies are required to submit an environment impact statement under the mining code of 2002. Companies are expected to minimise the damages the projects will cause on the environment this includes finding ways to minimise the impact on the environment and trying to rectify the damage done to the environment. These projects will have reduced the funds available for repatriation. However undertaking such CSR practices will further establish the companys reputation as a socially responsible entity.

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Corporate Taxation Taxation is one of the main factors that affect the profits available for shareholders. Multinational companies such as Rio Tinto, being globally dispersed have to deal with different tax policies and government regulations. DRC taxes foreign investors at a rate of 30% for mining projects, 0.5 4% mining royalties, sales tax of 13% and withholding tax of 10% for dividends in the mining industry. However double taxation is avoided in the UK therefore the company would not have to pay tax twice and the tax paid in the host country as withholding tax would be reduced from its overall tax liability within the year. However taxation will reduce the profits available for repatriation and considering the DRCs unstable economic climate sudden changes in the tax amounts would affect the funds available for shareholders.

Since the products are sold to the companies JV in China Rio Tinto can use transfer pricing techniques to reduce the impact taxation and such issues would have on the companies retained profits.

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3.4. Strategies the company could adopt in the case of Expropriation The Democratic Republic of Congo is a very difficult to country to conduct business in. Despite the fact that the government encourages foreign investments to reduce the level of unemployment, the level of corruption and bureaucracy is very high.

The land laws of DRC allows the government to expropriate property on the grounds of public interest with claims of preserving community heritage sites, conserving precious minerals and other natural resources, and completing public work such as infrastructure projects.

There are strategies a company could adopt to protect itself from its exposure to such political risks. The company could negotiate with the government of DRC on the terms of the contract, specifying clearly the rights and the responsibilities of the company and the government.

Rio Tinto could involve the local interest in its business activities such as a local company and make the investment as a joint venture, using local labour or borrowing from local banks to finance the investment. The company would have the support of the locals in such a situation as they would also be affected if the government takes over the company.

Rio Tinto can also take out an insurance against such political risks. Many companies insure the investments they make in the African countries to overcome political risks as the expropriation of licences and assets.

The company can also retain the control of technology it uses in the production process, connections to the markets it sells to, and retain control of its patents. This will reduce the risk of expropriation as the government will not be able to operate the company without the Rio Tinto.

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These are strategies to avoid such situations, however despite the fact that companies take such measures to avoid expropriation, due to the unpredictable nature of the governments in the African region companies are put in such situation.

For example the recent expropriation of London listed, Canadian based resources group First Quantum Minerals Ltds mining project in Kolwezi, where the property and licences were expropriated on the ground of misconduct and handing over the permits to the state-owned mining company SODIMICO.

First Africa Diamonds ltd is another company where the licences and company was confiscated by the Congolese government. Therefore in the event of Rio Tintos licences are confiscated by the Congolese government the company could,

Rational Negotiations This is where the company could negotiate with the local government and try to convince them that the expropriation was a mistake. This would involve the top a management of Rio Tinto meeting with the authorities regularly to discuss about possible solutions that are beneficial for both parties and try to compromise. In this situation if the company maintained the earlier mentioned strategies, such as getting local parties involved in the process, and building good community relations, Rio Tinto can get their support to defend their claim.

Applying Power As mentioned above if the company retained control over key technologies, markets, and patents etc. The company will have power over the operations and no other party will be able to

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successfully conduct the business. Therefore Rio Tinto could exercise its power by cutting off their access to export markets. As the iron ore is to be exported to their JV in Japan the company could stop importing from the Congo. Also the company can retain its patent and technical knowledge so that the government will not be able to make use of the confiscated assets.

Legal Remedies

As in the case of First Quantum Minerals Ltd, the company could first try to resolve the problems within the country by taking the dispute to court. Even though foreign investors seek local court adjudication, the judicial system within the country is dysfunctional therefore if the company is not able to gain any relief from the local judicial system Rio Tinto can take legal action against the host country by approaching a legal system of a third country to resolve the issue. This option is currently adopted by First Quantum Minerals Ltd as they are approaching the Geneva legal system.

However approaching third country would have a few drawbacks as the Act of state doctrine states that the a nation is sovereign within its borders and that the domestic actions cannot be questioned by a third country courts, even if international laws are violated and to try a sovereign state in a third party court the country must first consent to it and it will not be easy to get the consent of the Congolese government for such a trial.

Arbitration Here the company could seek international arbitration to resolve the issue. The International Centre for Settlement of Investment Disputes which is under the World Bank can be approached

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to resolve the matter as the centre would provide conciliation or binding arbitration. However if both parties agree on arbitration neither party may unilaterally withdraw.

Management Surrender As the last resort if it appears that the licences and the property cannot be reclaimed the company could withdraw from the process. And the company can claim the insurance provision they made to cover the losses. Such as above mentioned Insurance claims. Bodies like the Overseas Private Investment Corporation (OPIC) in the US, Export Credit Guarantee Department (ECGD) in UK, African Trade Insurance Agency (ATIA) and Multilateral Investment Guarantee Agency (MIGA) of the World Bank offers insurance on new foreign investments.

Considering the countries high level of political risks it is of paramount importance that the company adopts strategies to protect the company from such situations so that if such a situation does arise the company would have some claims to support the company.

4. Conclusion

The decision to invest in the DRC is a risky decision when considering the political instability, lack of infrastructure and the risk of expropriation. However the country has great potential and the investment will help Rio Tinto increase its market share in the iron ore mining industry.

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References David Eitman,Arthur Stonehill & Micheal Moffet (2010) Multinational Business Finance 12th Edition

John Ogilivie Christine Parkinson (2006) Management Accounting Financial Strategy CIMA

Annual Report of Rio Tinto (2009)

Bureau of Economic, Energy And Business Affairs (2010) US Department of State http://www.state.gov/e/eeb/rls/othr/ics/2010/138056.htm (used for the economic assessment)

Data Bank (2009) The World Bank ttp://databank.worldbank.org/ddp/editReport?REQUEST_SOURCE=search&CNO=2&country= ZAR&series=&period= (used to obtain financial data)

Rio Tinto Official Web site http://www.riotinto.com/

Country Brief Democratic Republic of the Congo (2009) EStandardsForum Financial Standards Foundation

Stanford Graduate School Of Business (2007) Global Supply Chain Management Forum - Rio Tinto Iron Ore Challenges of globalization in the Mining Industry.

The African Economic Outlook (2009) http://www.africaneconomicoutlook.org/en/countries/central-africa/congo-democratic-republic/

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Scribid (2010) http://www.scribd.com/doc/31426960/Sources-of-finance

Investopedia http://www.investopedia.com/terms/s/syndicatedloan.asp

Expropriation News Editor (2010) FDI Uptick Highlights Expropriation Risk, says MIGAExpropriation News http://expropriationnews.com/

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