Amid overcapacity, falling prices and deep losses in infrastructure-heavy sectors such as steel, China has embarked on ambitious reforms to overhaul the supply side of its slowing economy.
Steel, the stuff industrial dreams are made off, has become something of a nightmare for China. Behind its bustling manufacturing hubs and cities bristling with skyscrapers connected by highspeed rail loom the structural challenges that have caused overcapacity and triggered falling prices and deep losses, as domestic growth slows and demand contracts.
Now, China is trying to retool its steel and other commodity-focused industries, as its economy transitions from infrastructure-led growth to a service and consumer-driven model. In its recent report “Turnaround in Steel Outlook”—the first in its new “China Supply Side Reforms” series—Morgan Stanley Research weighs whether reformers have sufficient mettle to overhaul steel and other supply-laden sectors, and finds that many of the reforms under way are in fact addressing the root causes of overcapacity, in particular, the “zombie” state-owned enterprises (SOEs) that are animated purely via subsidies and bank loans.
If those reforms prove effective, China’s steel sector could see a turnaround as early as this year, as supply-side cuts start to balance with moderating demand. The approach could also become a blueprint for China to work out issues in other sectors dealing with oversupply, such as machinery and construction. Over the long term, these types of supply-side reforms will be key to the health and growth of China’s economy.
Dealing With the Zombies
For the past several years, Chinese steel makers had focused solely on ramping up capacity and production. Amid government stimulus and generous inflow of foreign capital following the 2008 financial crisis, demand for everything from cement and copper to oil and steel grew rapidly amid large investments modernize infrastructure and speed urbanization. Even as spot prices began to fall in 2011, China continued to add to production, which totaled 730 million tons in 2012—eight times that of the US, or enough to build 10,000 Eiffel Towers. The next year, production grew 12% to 815 million tons.
As product flooded the market and domestic demand slowed, the once booming steel industry started to bust. According to data from the China Iron and Steel Association, an industry group, by November, 2015, some 48% of its member mills were loss-making. Yet to protect jobs, local governments often provide financing to prop up money-losing zombie companies.
Finally, after peaking in 2014 at 823 million tons, the industry began in earnest to cut capacity. That will entail putting the zombies out of their misery. To that end, Beijing last year set up a 100 billion yuan (roughly US$15.4 billion) fund to offer employee compensation, social security arrangements and plant closure incentives to a host of industries with overcapacity issues, steel included.
“China now has much lower tolerance regarding the survival of uncompetitive, low efficiency, and consistently loss-making SOEs," says Rachel Zhang, head of Morgan Stanley's China materials equity research. Because of rising pollution concerns (steel plants burn a lot of coal and iron ore), Zhang believes the sector could receive as much as half of those funds, or enough to pull up to 100 million tons of capacity out of the market. These national efforts are also getting local support, with some provincial governments promising to cut subsidies to companies too far gone to recover.
Sustainable Rebound?
While the government cleanup of state-sponsored zombies is key, private companies also play a significant role. “With profitability dropping to a historical low, we have seen an increasing number of players and capacity leaving the market voluntarily," Zhang says. Indeed, of the 68 million tons of steel capacity that was shut down in 2015, only 18 million was government ordered, according to the Morgan Stanley report.
The reform agenda seems to be working. Steel prices in China have begun to rebound for the first time in years. “We expect another 6%-9% capacity cut in 2016 from the supply side reform, which should bring industry utilization to close to 80% by the end of 2016, followed by further improvement in 2017, and largely resolve the overcapacity issue,” Zhang says.
A couple headwinds are worth noting. Local governments may fail to follow through on their promises amid fears of rising unemployment and bad debt. The overall slowdown in China’s economic growth also could further dampen demand for steel, calling for yet deeper capacity cuts that may be harder to implement without more serious political and social ramifications.
For the past several decades, export-driven manufacturing, construction spending and infrastructure investment have driven economic growth. As the economy matures, China is looking to its consumers to drive demand, much they do in developed markets such as Europe, Japan and the US. For that transition to go more smoothly, however, China has to rebalance its traditional sectors, such as steel. The current direction of reforms and industry resolve for supply-side solutions to overcapacity bodes well for long-term economic health.
This is adapted from “Turnaround in Steel Outlook” (Jan 16, 2016), the first in Morgan Stanley Research's new series on “China Supply Side Reforms.” Ask your Morgan Stanley representative or a Financial Advisor for the full report on steel reforms, as well as upcoming reports on other sectors. Plus, more Ideas.
