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May 1, 2007

TIDAL WAVE OF STEEL

What motivates the continued huge surge in Chinese steel production? Is it market ineptitude, policy paralysis or a determination to swamp the rest of the world with unneeded metal?

It’s difficult for the buttoned-down, market-oriented capitalist mind to comprehend just how illogical and crazy-eyed the Chinese steel behemoth has become in the last year.

China, the world’s third-largest exporter and fourth-largest economy, seems unable or unwilling to slow the momentum of its steel-production growth. Last year, the Chinese National Bureau of Statistics reports, steel production rose about 18% to 419 million tons, or as much as the next six largest producing nations combined (Japan, the United States, Russia, South Korea, Germany and India).

So far this year, Chinese production is up another 23%, a pace that if continued would result in 2007 production of a stupendous 516 million tons. The official government estimate for likely 2007 production is a more moderate 475 million tons, up about 13% from last year.

All that steel has to go someplace. China doesn’t need it all. Its exports last year totaled—dependent upon who does the counting—about 49 million tons, or about 90% higher than in 2005. The official export figure was 21 million tons, up 44%. For the first quarter, exports increased 118.4% to 14.1 million metric tons, the Chinese customs office says.

What’s more, the production juggernaut isn’t close to slowing anytime soon. The central and provincial governments continue to approve new steel plants. The official government policy, discussed publicly for the last several years, is to eliminate obsolete or inefficient steel mills and to sharply limit new construction in efforts to better manage energy and water supplies. So far, though, almost no capacity has been closed.

Is There an Explanation?

The threat, of course, is that the Chinese steel gusher will inevitably cause a glut of supply worldwide, substantially depressing prices for some time to come. For an industry that only recently began to earn its cost of capital across the full economic cycle, this constitutes a potentially mortal threat.

Why has this happened? How can China be so far out of sync with global supply and demand? Why do Chinese officials and industry spokespeople continue to downplay a threat that the rest of the industry sees as potentially catastrophic?

“[China’s] intent is to continue to invest in all the capacity in the world to try and drive many others out of business,” says David Sutherland, president and CEO of IPSCO Inc., the steel pipe, tube and plate manufacturer based in Lisle, Illinois (see “A Full Plate”). “They think they have a right to it. They pick certain markets, and they somehow think they have a right to those markets—whether they have an advantage or not. Well, they have no comparative advantage in steel.”

John P. Surma, chairman and chief executive officer of United States Steel Corp. and chairman of the International Iron & Steel Institute, says China’s production growth “does not make sense in terms of market signals and supply and demand fundamentals.

“China is not a market economy and retains many elements of government control over economic decisions,” he says. “This allows many other influences to enter the equation that have little to do with market incentives, including the desire to create employment, to aid local or regional industries, mercantilism, nationalism and so forth. What often results, as it has in this case, is a misallocation of capital to other than the highest and best use.”

This is far from just a North American concern. Hajime Bada, chairman of the Japan Iron & Steel Federation, said in a trade press interview last year that the industry is concerned that the U.S. might act to curb imports of surplus Chinese steel. “If Chinese exports are blocked, these could flow back to Asia and to Japan,” he said.

Locked-in Advantages

The reality of Chinese growth may be much more subtle than an overt plan to take over global steel, even if the impact of Chinese growth ultimately is the same. Business people and academics knowledgeable about China suggest a number of explanations for the steel deluge that are more about the narrower imperatives of China’s economy and inefficient regulatory mechanisms than anything else.

To begin with, nearly all Chinese steel companies—even those with stock traded on public exchanges—are majority owned by the government. This provides significant advantages—in the form of subsidies, cheap or inexpensive land, “free” money in terms of loans that don’t have to be repaid, subsidized water and power, free infrastructure costs, low-cost healthcare and benefits, the benefits of China’s significantly undervalued currency and more.

No one seems to be able to quantify and total the value of all these advantages, but they are considerable. They explain why China now holds a 33% or better share of markets for such products as DVDs, toys, bicycles, cameras, shoes, telephones, televisions, computer monitors, luggage and microwave ovens, to name just a few.

In fact, Peter Navarro, a professor in the Paul Merage School of Business at the University of California, Irvine, has identified eight factors that, together, contribute an estimated 82% of the value of the “China Price,” the term applied to pricing for Chinese goods that often arrive in North America for less than the cost of raw materials here. These mercantilist factors include subsidies and tax preferences (equal to a 17% share of China’s cost advantage); currency manipulation (11%); piracy and counterfeiting of intellectual property (9%); lax health and safety regulations, and poor enforcement (2.5%); advantages conferred by unrestrained foreign direct investment (3%); and low labor costs (39%).

How greatly these factors influence Chinese steel competitiveness is not specifically known, although Surma, among others, notes that China enjoys no advantage in raw material and production inputs.

“No private enterprise can be expected to compete with foreign treasuries and foreign producers propped up by their governments,” he says. “Between 2003 and 2006, China increased its steel production by an amount roughly equivalent to twice the total production of Japan or the U.S. Since 1996, China has built the equivalent of about 10 steel industries the size of Brazil’s. That is not the result of market forces, but instead has been accompanied by an enormous amount of evidence of subsidies and unfair trade.”

Government de Facto

With all those advantages and a domestic economy growing at double-digit rates, Chinese steelmakers have become generously profitable. Infrastructure investments for such steel-intensive projects as roads, railways, ports, airports, factories and other construction have been growing by 30% a year for the past four years. With every significant Chinese city seemingly booming, steel industry profits rose nearly 24% last year, to about $36 billion (U.S.) in total. With steel prices remaining higher in overseas markets than in China itself, Chinese producers have a continuing incentive to add to production for export.

Yet with government preferences come government-like responsibilities. How different Chinese steel companies are from their counterparts elsewhere is demonstrated by Kunming Iron and Steel Company, a medium-sized producer with capacity of 6 million tons a year. Kunming, or KISCO as it is often known, operates on a 9-square-kilometer campus in the southwestern province of Yunnan, which borders Myanmar (formerly known as Burma), Laos and Vietnam.

It is much more than just a steel company; it is a local government. The campus houses 100,000 people and has its own hospital, schools and university, sporting facilities, hotel, lakes and swimming pools. It plays a significant role in local employment. Majority owned by the government, KISCO is an important income generator for the local and provincial government.

What’s more, national policies can seem like quaint suggestions in a nation the size of China. “There’s an old saying in China: ‘The mountains are high, and the emperor is far away,’” says Joseph A. Massey, director of the Center for International Business at Dartmouth College’s Tuck School of Business. Provinces compete for investment with one another. Production over-capacity is estimated to be 90% for the manufactured goods that China exports. It’s often difficult for Beijing to secure compliance from provincial authorities, Massey says.

Other factors include the ongoing need to find jobs for China’s huge labor force, and demographic pressures that will make the nation top-heavy with aged and retired workers in the next 20 years. “There’s a sense that if they don’t build as much as they can now, they will be overtaken by younger populations, like India,” Massey says. “They will be really old before they can become really rich.”

China, as a Communist state that still relies on central controls and five-year plans, has announced specific strategies to restructure the steel industry. The intent is to phase out inefficient capacity and merge smaller companies—the country has more than 800 steel producers in all—with larger ones, including four companies that will be the largest producers. Restating this goal, Premier Wen Jiabao told the National People’s Congress in March that 35 million tons of capacity will be closed this year.

But will that happen? This is not the first time that such a plan has been announced, but so far, no one can identify any capacity that has been closed because of this national policy.

Instead, some smaller companies have expanded production to elude government strictures against little producers. These include, among others, Tangshan Guofeng, now with annual capacity of 5.2 million tons, and Jiangsu Yoggang, at 2.9 million tons. The goal of these smaller fry is to reach the 10-million-ton threshold, or perish—an attitude that does not auger well for reduced Chinese production.

Officials also have complained about new steel plants that have been built without the required approvals from provincial or national regulatory agencies. This was the case, for example, with Ningbo Jianlong Steel and Nanjing Steel. Despite the complaints, both now operate with all necessary government approvals.

Even the largest Chinese steel companies are racing to add capacity. Baosteel, historically the largest Chinese producer plans to more than double its production, exclusive of mergers, which continue apace, to more than 40 million tons a year, says Xu Lejiang, chairman of its Baoshan Iron and Steel Company Ltd., Shanghai Baosteel Group’s listed entity.

As for mergers that might potentially rationalize production, Xu says the process isn’t easy. “So far, there have been many difficulties in the merger and consolidation process,” he says. “There are many reasons: conflicts between local government and central government, and also the steel market is so good that every steel mill can survive. It is difficult to merge them now.”

A Taxing Situation

One approach that may have at least a minimal effect is a reduction in tax rebates that China traditionally has paid to its exporters. The tax rate was first cut to 13% of value from 15% in 2004. The rebate on plate, wire rod and bar products was reduced to 11% in May 2005, and to 8% on those products in September 2006.

China also removed the export rebate for pig iron, slabs, billets and other semi-finished products in 2005, and began to impose an export duty on those products last year. Further rebate cuts or duty impositions are expected as the central government tries to reduce exports, and the global backlash that goes with them on products that have a high-energy content. The growing momentum of steel exports may speed the introduction of new government measures to make exporting less attractive, says Luo Bingsheng, vice chairman and secretary-general of the China Iron and Steel Association (CISA), although Chinese steel executives have suggested their impact may be low.

Another factor that may slow the growth of production may be rising concern about pollution in China. China’s State Environmental Protection Agency (SEPA) early this year halted construction of 15 steel projects because they lacked proper environmental assessments. The affected projects include Ma’anshan Iron and Steel, Laiwu Iron and Steel, Shougang Group’s Qinghuangdao Shouqin Metal Materials, Haixin Iron and Steel, and Pingxiang Iron and Steel.

Taken together, do these steps mean China’s production growth rate will slow or even halt?

The simple answer is no. CISA hopefully suggests that China’s exports this year will actually fall by 10 million tons. But CISA made similar calming comments a year ago, when exports rose substantially, to new records.

“This statement is designed to placate foreign governments and reflects central government concerns over potential U.S. and European trade actions against Chinese imports,” says Jim Lennon, an analyst with Macquarie Bank, the Australian investment bank.

The problem is that Chinese mills are expected to add as much as 150 million tons of capacity per year, easily boosting total crude capacity to just under 600 million tons per year by the end of 2010, notes John Johnson, chief executive of the Beijing bureau of consultancy CRU.

Contributions by Stephen Wyatt in Shanghai, China, and Judith Crown in the U.S.