Beijing steels itself for a battle over capacity

9 February 2016

One of the hottest new buzzwords in Chinese debates about the economy at the moment is ‘supply side reform’. There is considerable confusion around what it actually means and some pundits are comparing it to Ronald Reagan’s supply side reforms in the 1980s.

Leaving aside the irony of drawing on Reagan to talk about Chinese economic reform, one thing we can be sure of is that so-called supply side reform will need to tackle the country’s awful problems of excess capacity.

Many industries in China suffer from this ill, including steel, coal, cement and glass. One of the worst performers is the steel sector, which has enormous influence over the price of iron ore, Australia’s largest export earner.

Despite tumbling iron ore prices, the profits of the Chinese steel sector dropped 92.2 per cent during the fourth quarter of 2015. Industry experts are predicting an even worse year in 2016. It is quite a scary thought considering 21 of 29 of listed steel producers are in the red. Many will falter without government subsidies and loans.

The Chinese government has announced a goal of reducing the country’s steel production between 100 and 150 million tons within the next three to five years. To put that into perspective, the combined steel production of Germany and Japan in 2015 was around 150 million tons.

The human toll of this planned industrial policy is about half a million jobs. A Chinese worker on the average produces about 300 tons of steel a year; the planned reduction will translate into 300,000 to 500,000 jobs.

For years Beijing has talked about the need to reduce the excess capacity and not much has been done due to local bureaucratic resistance. The sector is crucial for tax revenue and job creation, two important considerations for local cadres. In the tug of war with Beijing, local officials seem to have had the upper hand.

Will Beijing overcome the local protectionism this time and achieve its avowed goal of cutting 150 million tons of steel production before 2018?

This question will weigh heavily on the mind of BHP Billiton and Rio Tinto executives.

There are several indications that suggest Beijing’s efforts are more likely to succeed this time around.

The first is the Chinese people’s increasing frustration with ever-worsening pollution.

A retired senior official from the Communist Party’s Committee of Political and Legislative affairs, Chen Jiping, noted last year that public discontent about pollution had replaced land disputes to become the main source of social unrest.

The Chinese central government will use new environmental law as a key policy lever to shut down inefficient and polluting steel mills.

According to official statistics, about 20 per cent of the country’s steel producers don’t meet the new standards. Out of that 20 per cent, about two-fifths have neither the resources nor the ability to meet the new standards.

This means about one in ten Chinese steel mills could be closed down for environmental reasons. This would translate into about 80 million tons of steel production capacity, or twice Germany’s annual production.

The new State Council directive on reducing excess capacity specifically calls for vigorous implementation of guidelines on curbing steel production. Li Xinchuang, the head of Beijing’s Metallurgical Industry Planning and Research Institute, says the new guideline’s emphasis on effective enforcement is a powerful weapon.

Beijing is prepared to offer crucial support to unemployed workers once it starts to close down steel mills. One of the key reasons, the Chinese government has not been successful in curbing excess capacity in the past is due to the reluctance of local governments to cut jobs.

For example, some large state-owned enterprises like Hebei Steel and Iron Group employs 140,000 people and Wuhan Iron and Steel employs more than 200,000. They are pillars of the local economy; it is almost impossible to implement large-scale redundancies without causing social unrest.

The central government has created a dedicated industry assistance fund by introducing a special levy to help affected workers. The fund is believed to hold around 40 billion yuan. Experts are not sure about whether this amount will be enough to assist the predicted mass lay-off of workers, but it will go some way to address the impasse.

There are also strong indications that the Chinese government is thinking seriously about reducing subsidies to the embattled steel sector. Many mills, including listed producers, receive substantial subsidies from local governments just to stay afloat. Baotou Steel received 1.8bn yuan in subsidies in six months last year.

On January 4, People’s Daily, the government’s principal propaganda paper, called for the end of providing a lifeline to zombie firms. According to an “unnamed authority” -- party-speak for the senior leadership — there is an urgent need to get rid of the country’s zombie firms that survive on government loans and subsides.

Many industry leaders believe the new round of Beijing’s policy aiming at reducing excess steel capacity is more likely to be more effective and determined than before. If the Chinese government is successful in its endeavour, it will have serious implication for share prices of BHP and Rio as well as the Australian government’s budgets for years to come.