The capacity cut in chinas steel industry and policy recommendations

DIPLOMATIC ACADEMY OF VIETNAM FACULTY OF INTERNATIONAL ECONOMICS THE CAPACITY CUT IN CHINA’S STEEL INDUSTRY AND POLICY RECOMMENDATIONS Hanoi, 2017 TABLE OF CONTENT 2I Definition of overcapacity and th[.]

DIPLOMATIC ACADEMY OF VIETNAM FACULTY OF INTERNATIONAL ECONOMICS

THE CAPACITY CUT IN

CHINA’S STEEL INDUSTRY AND POLICY RECOMMENDATIONS

Hanoi, 2017

TABLE OF CONTENT

I Definition of overcapacity and the overcapacity in the Chinese steel

industry: 2

1 Definition of overcapacity: 2

2 The overcapacity in the steel industry of China: 3

a Overall of the Chinese steel industry in the 2006 - 2016 period: 3

b The overcapacity in the Chinese steel industry: 6

c Causes of the overcapacity in the steel industry: 7

II Capacity cut measures of the Chinese government in the steel indsutry: 8 III Impacts of the capacity cut: 10

1 Positive impacts: 10

a Improving environmental conditions: 10

b Easing the real estate bubble: 12

2 Negative impacts: 13

a Unemployment: 13

b Unpaid debt: 15

c Security and defence: 16

IV Policy recommendations: 17

1 In the short run: 17

2 In the long run: 17

REFERENCES 18

I Definition of overcapacity and the overcapacity in the Chinese steel industry:

To quantify overcapacity, one needs measures of capacity and production.Capacity can be measured as nameplate capacity, which is the intended full-loadsustained output of a facility Alternatively, it can be measured as “effectivecapacity,” which is nameplate capacity minus some standard percentage allowed formaintenance and other scheduled downtimes The second part of the overcapacitycalculation is a production measure Capacity and production measures allow thecalculation of overcapacity, which is the difference between productive capacityand its utilization in current production

Overcapacity affects the profitability of companies in the sector because millscannot produce at economically sustainable levels This is caused by several factors,

in which the most common ones are economic situation and overinvestment

Cyclical overcapacity is caused by variability in demand When economicdownturns occur, factories have more productive capacity than existing demand for

a product can support

Structural overcapacity is caused by overinvestment in industrial facilities.The result of this overinvestment is a rightward shift in the supply curve, wherebymore units of a good are supplied than what the market alone would provide

2 The overcapacity in the steel industry of China:

a Overall of the Chinese steel industry in the 2006 - 2016 period:

From the map, it can be seen that most of the steel production is concentrated

in the Northest, including 5 cities and provinces: Liaoning, Beijing, Hebei,Shandong and Jiangsu

Distribution of steel production in China by province, 2015

In the last 25 years, China's steel output had increased more than 12 times.Meanwhile, European Union (EU) steel output fell by 12%, while that of the UnitedStates remained the same China's steel output from 1990 to the present is asfollows: 1990 - 66.4 million tons, 2000 - 128.5 million tons, 2010 - 638.7 milliontons, increased to 822.7 million tons in 2014 and reached 803.83 million tonnes in

2016 In 2017, the steel output is expected to continue to rise as the Government has

enhance the infrastructure buidling to prepare for the 19th National Congress of theCommunist Party of China.

Source: World Steel Association

However, the domestic demand has always been lower than the supply Asshown in the chart below, although the steel demand in China increased verysignificantly over years due to the rapid economic growth, it has never been equal tothe production output The gap between quantity demanded and quantity suppliedstood at around 85 million of metric tons, which is equal to the total productionoutput of Japan, the second-largest steel producer in the world China's expectedsteel demand in 2016 even dropped to only 672 million tonnes, much lower than thedomestic output

Steel demand in China, 2008 - 2015

Source: Marketrealist

For that reason, Chinese manufactures had to enhance the steel export andlower the price to deal with the large amount of products which can not be sold.46% of the world's 725 million tons of excess steel is located in China, according to

a report by the Alliance for American Manufacturing Association (AAM) Thecountry's steel exports have doubled since 2012 to 108 million tonnes, or 23% ofthe world's trade volume As a result, cheap Chinese steel has flooded the world,which put steel mills in other countries into a crisis caused by the inability tocompete with Chinese steel1

1AAM (2016), Steel and the US Economy,

http://aamweb.s3.amazonaws.com/uploads/resources/projectgreenwood_factsheet_steelfacts_11.2.pdf ;

Báo Giao thông (2016), Ngành thép Trung Quốc đang tự bắn vào chân mình,

http://www.baogiaothong.vn/nganh-thep-trung-quoc-dang-tu-ban-vao-chan-minh-d149845.html

According to World Steel Association (WSA), China's steel industry issurging in volume However, it comes with a large amount of redundant products2.This has been a result of overcapacity within the industry The excess capacity inthe steel sector have increased significantly over the years, leading to theremarkable drop in prices

b The overcapacity in the Chinese steel industry:

Chinese steel industry has been facing serious overcapacity situation, asshown in the chart below

Overcapacity in the steel industry of China, 2000 - 2015

Source: Center on Globalization, Governance & Competitiveness, Duke University

2 US Department of Commerce (2017), Steel export report: China,

https://www.trade.gov/steel/countries/pdfs/2016/annual/exports-china.pdf

The chart shows the overcapacity in the Chinese steel industry from 2000 to

2015 It can be seen that the excess capacity has risen sharply over the year andreached nearly 350 million metric tons in 2015 Meanwhile, the steel productionoutput of this country stood at lower than 800 million metric tons in the same year.Therefore, if Chinese steelmakers want to achieved their optimistic productioncosts, they have to increase the output by nearly a half in the coming years.However, given that the steel industry of China has already been saturated with a lot

of inventories and redundant products, raising the output will only exacerbate theproblem and put the Chinese economy into an overproduction (or capitalist) crisis.That is not to mention a lot of criticism that China has received from theinternational community and global manufactures due to the remarkable increase inoutput in recent years, as it led to the drop in Chinese steel prices and the inability

to fairly compete of other countries’ steelmakers Furthermore, Chinese steelproducers themselves, including many state-owned ones, have also suffer from thismatter, as cheap prices caused serious losses, but if they stop the production, theconsequences would be much more severe (losing market shares, higher opportunitycosts, )

Therefore, in that situation, cutting the steel capacity appeared as the bestchoice for the Chinese government, although it comes with a lot of socio-economicproblems From that, the output is also expected to reduce in order to deal with thecriticism from US and European governments and steel producers

c Causes of the overcapacity in the steel industry:

- Economic downturn: As the global and Chinese economy showed downward

trend in recent years, the demand for steel also decreased sharply As a result,factories cannot produce with their most effective capacity due to the fear ofredundant products and inventories, which led to the serious situation ofovercapacity

- Overinvestment: Overinvestment in the most recent era has been created by

China’s “state capitalism” model, which designates “pillar” and “strategic”industries for special growth targets and financial incentives that are received

largely independent of market conditions In particular, overcapacity in China’ssteel sector is caused by subsidized energy and other inputs, access to cheapfinance, and national versus subnational government dynamics, notably thefinancial and tax incentives of provincial and local government to increasesteelmaking capacity independent of market prices and the mandates of China’scentral government

II.Capacity cut measures of the Chinese government in the steel indsutry:

In February 2016, the Chinese government revealed its ambitious restructuringplans for the country’s steel industry, aimed at tackling overcapacity and boostingefficiency of the sector The government plans to remove 100-150 million tonnes ofsteel capacity and 800 million tonnes of outdated coal capacity by 2020 Therestructuring plan appears to have been well followed through so far as it wasannounced at the 12th National People’s Congress annual meeting that China, in

2016, successfully cut steel capacity by more than 65 million tonnes and coalproduction capacity by 290 million tonnes, surpassing the target of 45 milliontonnes and 250 million tonnes, respectively

13th Five-Year Plan targets of China’s steel sector

For the share of China’s 10 biggest steel producers to reach 60% of thecountry’s total (compared to 35% in 2015), a series of mergers and acquisitions(M&As) is expected in the steel industry For a start, Baoshan Iron & Steel hasmerged with Wuhan Iron & Steel, creating China’s largest and the world’s second-biggest steel mill in terms of combined crude steel production (61 million tonnes in2015) About 10 million tonnes of outdated steel capacity has been removed in theprocess and total of 15.4 million tonnes will be cut by 2017 The consolidation is

expected to increase competitiveness, especially in value-added sectors such as theautomobile market, and improve profitability through cost savings.

Despite the outstanding results, China’s crude steel output showed growth to808.3 million tonnes (equivalent to the 0.6% increase) in 2016 This is because alarge proportion of closed capacity had actually already been left idle for years In

2017, China plans to cut another 50 million tonnes of steel-making capacity, shutdown coal output by 150 million tonnes, and, at the same time, close or stopconstruction of coal-fired power plants with capacity of more than 50 millionkilowatts in 2017 Not included in this capacity-reduction target is the closure ofintermidiate frequency furnaces (IFFs) that produce substandard steel

In order to reduce the capacity, shutting down substandard factories isnecessary For that reason, in 2017, Chinese government has paid more attention inclosing IFFs

In January 2017, in an update to regulations governing entry into the iron andsteel scrap processing industry, MIIT started prohibiting the sale of scrap to IFFoperators, starving them of their main raw material In February 2017, the NationalDevelopment and Reform Commission and four other top government agenciesreiterated the importance of cracking down on excess capacity and IFFs churningout low-quality steel A reminder on the 30 June deadline was also served.Furthermore, banks are forbidden to lend to the targeted companies, and are toldinstead to support steelmakers that conform to capacity cuts and environmentalregulations

China’s central government has set 30 June as the date for the elimination ofIFF-based steel production, which would be the cornerstone of its supply-sidestructural reforms of the industry in 2017 Earlier measures for curbing inductionsteel output have failed to deliver results, but this time round, the government seems

to have set its mind on removing such steel-making capacity According to China’sMetallurgical Industry Planning & Research Institute (MPI), the capacity of IFFs isestimated at 80-120 million tonnes a year, with about 30-50 million tonnesproduced in 2016 We think that shutting down substandard steel players should be

a key step towards achieving an effective capacity cut IFFs are estimated toaccount for about 10% of China’s total steel-making capacity and its products,about 3.7% of total production.

To facilitate the country’s supply-side reform measures, Siyuanhe SteelIndustry Restructure Fund was established on 7 April 2017 in Shanghai Among thefour participants is China’s Baowu Steel, which will hold 25% (US-China Green25%, WL Ross & Co 26%, China Merchants Finance Holdings 24%) The US$5.9-billion fund is expected to launch in June 2017

In conclusion, since 2016, the Chinese government has strengthened thecapacity cut in the steel industry and achieved significant results However, thereare still a lot of limitations in the cut which will be discussed in the next part

III Impacts of the capacity cut:

1 Positive impacts:

a Improving environmental conditions:

Eliminating excess steel capacity and restructuring the industry has enormousenvironmental significance because steel industry is the second largest emitter of airpollution in China, as well as second largest coal consumer and emitter of CO2,after the power sector In the Beijing region (Beijing-Tianjin-Hebei), the share ofsteel industry in emissions even exceeds coal-fired power, due to the heavyconcentration of China's steel industry in the region

The chart shows the air pollutant emissions in Beijing region - the most concentrated place of steel production It can be seen that a very large portion of emissions come from iron and steel manufacturing activities.

The cut in steel capacity is expected to lead to the reduction of output as well,which could result in the improvement of environmental conditions in China.Besides, the shutting down of substandard factories and fernaces could alsocontribute to reaching environmental targets of the country If the output rises in thecoming years, this rise will also come from factories which fully meetenvironmental standards set by the government, thereby help resolving the seriouspollution which is currently a severe problem to China

In fact, the Chinese government had conducted the steel output cut from 2014.However, this did not last long, as Chinese steelmakers started to raise theproduction output again in 2016 The government has found another way to dealwith the root of the issue, meaning the overcapacity, which lead to the decision tocut the steel capacity in 2016

Source: Greenpeace East Asia PM2.5 pollution levels in the Beijing region were improving rapidly from the beginning of 2014, when national air pollution action plan measures started to bite and steel industry output was slowing; when steel output started to surge in early

2016, the improvements in air quality stalled and reversed.

Figures show that the capacity cut can actually help improve the air pollution

in China However, the shortcomings of the overcapacity reduction recently couldthreaten to undermine the effectiveness of the entire policy of cutting excessindustrial capacity, unless addressed soon Most of the capacity elimination targetset for the 2016-2020 period has, technically, already been achieved in 2016,meaning that capacity elimination in 2017-2020 will be much more modest unlesstargets are increased

b Easing the real estate bubble:

The prolonged reduction of steel capacity is likely to ease the housing bubblesituation, as the property sector accounts for the majority of steel consumption inChina The cut in steel capacity could lead to the higher steel prices and lower steel