China’s quest for balance: the states aim to reduce excess capacity

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As China’s supply-side reform turns five years old, has the state succeeded in trimming excess capacity in core oil and steel industries? Jing Zhang and Oceana Zhou assess the results of the policy

China’s supply-side reform agenda was launched by President Xi Jinping in late 2015 with a view to stripping out excess capacity that had built up in key industries during China’s emergence as an economic power.

Industries targeted in a five-year plan presented in 2016 by the country’s top economic planner, the National Development and Reform Commission, included steel, coal, cement and aluminum. These sectors were deemed to have become too big, too polluting, and in some cases too dependent on export markets.

Beijing wanted to lift the quality of China’s industrial production, improve the environment and lower dependence on external markets. Supply-side reform was a key plank in China’s ambition to transition to a sustainable, consumption-driven economy – rather than one that relied on investment in heavy industry.

To a large extent, the policy has been successful. Chinese companies became more profitable, helped by industry consolidation, capacity reduction initiatives and healthy domestic demand. But success has been a double-edged sword. Stronger margins and profits incentivized companies to lift production and build new capacity.

Leaner, greener steel mills

At the start of the millennium, China produced 129 million metric tons (mt) of crude steel but last year this rose to more than 900 million mt. China now produces 50% of the world’s crude steel.

Supply-side reform initiatives in this sector appeared to be making great progress. The country achieved its target of stripping out 150 million mt/year of capacity over 2016-2020, some two years ahead of schedule. China removed an additional 140 million mt/year of “unlicensed” induction furnace capacity – small, low quality producers of construction steel – in 2017. On top of this, steel mills have been ordered to upgrade their environmental protection facilities to meet “ultra-low” emissions targets. This is another way of weeding out inefficient (read: polluting) steelmakers as installing facilities to lower emissions is extremely expensive.

Before China embarked on its supply-side reform agenda, the country’s steel industry was in very bad shape. In 2015, more than half of the China Iron & Steel Association’s 94 member mills were lossmaking, posting a combined loss of yuan 64.53 billion ($9.33 billion) that year. Their debt-to-asset ratio was around 71%, which improved to just below 70% as the reforms took effect.

To protect market share and generate liquidity, in order to roll over mounting debts and avert insolvency, steel mills had to maintain high production levels. This caused a price war as they elbowed out competitors, and huge losses. For mills with high debt-to-asset ratios, any signs of slowing or suspending production could result in lenders withdrawing credit and precipitating bankruptcy.

Meanwhile, domestic demand for steel had slumped. This scenario resulted in China significantly lifting its finished steel exports, causing tremendous grief to international competitors who were unable to compete with lower-priced Chinese material. China’s steel market started to improve from early 2016 as the supply-side reforms began to take effect, reducing the need to export and helping global prices to recover.

Chinese mills enjoyed bumper profits in 2017 and 2018 as good times returned to the steel industry. With improved profitability and sufficient liquidity, Chinese mills carried out M&As, replaced existing facilities with newer, more efficient ones, and improved their environmental protection performance.

Capacity creep

The net result is that production capacity has begun creeping up again this year. S&P Global Platts estimates there will be 142 million mt/year of new crude steel capacity commissioned in China over 2019- 2020. China can only build new capacity if it closes old facilities with similar capacity. But as replacement facilities are bigger and better than the old ones, a net increase is likely.

China’s crude steel output reached 87.53 million mt in June, taking the total output in the first six months of 2019 to 492.17 million mt, up 9.9% on year, according to the National Bureau of Statistics. China’s crude steel capacity will reach 1.17-1.2 billion mt/year by the end of 2019, Platts estimates.

Higher steel production this year has coincided with high iron ore prices and a relaxation of curtailments on production for environmental reasons. Ongoing tensions with the US, and Beijing’s deleveraging program, have contributed to softer demand from key consumer-driven segments, such as auto and white goods. Steel profit margins have been hit hard, but as in years gone by no one wants to be the first to cut production.

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