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Jun 1, 2016 | 09:15 GMT

The Story of Steel in China

(Kevin Frayer/Getty Images)
Forecast Highlights

  • As EU and U.S. trade barriers grow, China will find it difficult to solve its overcapacity problem by exporting excess steel. 
  • With Beijing's support, China's large steel conglomerates will move production overseas to be closer to demand in India, Southeast Asia and Latin America.
  • Offshoring will fail to significantly reduce overcapacity problems in China's steel industry in the near future.

China's economy is changing. The country has relied on manufacturing, heavy industry and raw industrial development since it first kicked off a phase of explosive growth in the 1980s. But like Japan and South Korea before it, China has reached the limits of this export-led model and must now adjust to new conditions. Since the Mao era, steel production has driven economic growth in the country, feeding into other industries and, more recently, helping to undergird the real estate boom. In 2006, however, China's steel production began to outstrip domestic demand, forcing Beijing to look for new markets and for a way to align supply with demand. 

The structure of the steel industry has made this quite challenging. Thousands of tiny, local firms scattered across the country produce the majority — 66 percent — of China's steel. Local government policies protect the small producers from market forces, allowing them to survive despite their inefficiencies. This broad array of small producers has caused China's overcapacity problem, depressing global steel prices and capturing headlines. Beijing has tried several methods to rein in these tiny producers — denying credit, pressuring local governments and forcibly closing plants — to limited success.

Massive conglomerates, meanwhile, produce the rest of China's steel. Baosteel Group and Wuhan Steel Group, among other producers, are some of the largest in the world in terms of output. Beijing nearly always holds a controlling share in these companies and, in some circumstances, will intervene to help them. As a result, the central government has a much easier time getting these companies to follow orders and has enlisted their help to address overproduction.

As the economy slows in the wake of the real estate boom, China's steel conglomerates are looking to overseas markets with steadier prospects for growth. Recent U.S. and EU tariffs have demonstrated the risks of exporting steel. Consequently, several large steel companies have decided to instead build on their technical expertise to eventually become full-fledged multinational enterprises, albeit enterprises with the implicit financial backing of Beijing. But in the end, the offshoring will not significantly reduce steel overcapacity.

Socialist Steel

The story of steel is in many ways the story of the People's Republic of China. When the Communist Party seized control of the mainland in 1949, they singled out steel as a strategic sector for heavy investment, hoping to follow the Soviet example of industrializing within a single generation. 

But Chinese leader Mao Zedong also feared that this burgeoning industrial base would be vulnerable to attack by U.S. or Soviet forces. To make it more resilient, Mao encouraged a "cellular economy" that distributed industry across the country. Most of the industrial plants established were small, state-owned enterprises (SOEs) controlled by the local government to meet local demand. The development of "Third Front" industries in remote parts of inland China exemplified this approach. In 1966, Mao insisted that each province should have dozens of small iron and steel plants. The party's plan worked, and China developed a sizable industrial capacity spread over a wide geographic space.

As China moved away from the socialist system after Mao's death in 1976, the structure of the state-owned economy gradually adapted to market forces. The government selected some smaller local steel firms for growth and consolidation. Baosteel, now the fifth-largest steel producer in the world, began in 1977 as Baoshan, a small, local steel-producing SOE. In the 1990s, Beijing was pursuing a corporatization policy, divesting from small, inefficient firms and consolidating them into effective, market-driven operations, all while retaining an uncontestable controlling stake. Sweeping SOE reform brought enormous changes to Baoshan.

Baosteel became a holding company and acquired several smaller state-owned steelmakers. Today, it owns six large steel enterprises, including Baoshan. Other state-owned giants, including the central government-controlled Ansteel and Wuhan Steel and the provincially owned Hebei Iron and Steel — China's largest steelmaker and the world's second-largest steel company — followed similar paths to consolidation.

But Beijing was only partly successful in consolidating Mao's cellular economy. Large conglomerates like Baosteel did not cause the demise of the small local steel mill, and China's top 10 firms produce less than half of the country's steel. Though in 2013 the Chinese Ministry of Industry and Information Technology set an official goal that top conglomerates would control 60 percent of capacity by 2015, their share has fallen from around 45 percent in 2012 to 34 percent in 2015. This continued fragmentation makes it difficult for Beijing to exert full control over the steel industry or curb over-production. Unable to dictate policy, Beijing must instead fight with local governments before it can influence the regional mills it does not directly control. And local governments, intent on protecting tax revenue and employment opportunities, often side with firms.

Adjusting to New Conditions

Although Beijing has failed to fully overturn Mao's cellular steel industry, China's top 10 steelmakers at least have managed to progress beyond their local counterparts. The conglomerates are efficient, using advanced techniques to produce high-end steel products. Moreover, they are comparable in size to their potential competitors overseas, but enjoy the added advantage of massive state support.

The conglomerates are also more responsive to market forces than their local SOE counterparts are. China is no longer the booming, developing nation it once was. After the real estate bubble burst, double-digit growth in gross domestic product slowed to about 7 percent annually. High-level Communist Party leaders describe the country's economic trajectory as "L-shaped," admitting that growth rates will stagnate for several years as the economy readjusts from years of stimulus spending and easy credit. But China's steel companies did not plan for this decline. During the boom, they brought additional production capacity online, expecting that growth, fueled by real estate, would continue. Now they must reorient their enhanced capacity toward overseas markets. In many cases, this has meant exporting steel and absorbing the associated logistical costs.

Chinese steel exports rose 21 percent year-on-year in 2015, reaching 14 percent of the country's total steel production. China's 112 million metric tons in exported steel surpassed the entire steel production of Japan, the second-largest steel producer. But the arrival of so much steel on the world's markets depressed global prices, and, in response, the United States and European Union imposed tariffs on Chinese steel. The U.S. tariffs went into place May 18, at 522 percent for cold-rolled and 450 percent for corrosion-resistant steel. These protections will only increase, as the European Commission confirmed in statements ahead of the G-7 meeting.

To change tack, China's conglomerates will go abroad, following the example of Japan's Nippon Steel and South Korea's POSCO. Economic turns in Japan and South Korea prompted their steel industries — like China's — to move production closer to growing markets.

A May 17 article in state-run People's Daily announced China's plans to move 10 million metric tons of steel production to Brazil, involving facilities run by Baosteel, Ansteel, Wuhan Steel and numerous other large producers. And it appears that the central government is on board: State-owned China Development Bank will supply loans to bankroll the endeavor. Though the initial transfer is small in global terms, it is just the start of a broader trend. Now that Beijing approves, offshoring is likely to continue, expanding from Brazil to high-growth areas of Southeast Asia and India.

But this will not be an easy transition. China's steel companies are still relatively new to the game. Even POSCO, a more experienced company, ran into regulatory problems in India. The company suspended a $12 billion steel plant in 2015, 10 fruitless years after signing an agreement to build the plant with the government of Orissa state. Beijing, along with institutions such as the Asian Infrastructure Investment Bank and the Silk Road fund, may provide further support, allowing China's large steel firms greater leeway to accept potential regulatory risks. Even so, the push among Chinese steel firms to set up facilities overseas will do little to solve the overcapacity problem at home. The production moved overseas is simply too small and overlooks the real problem underlying overproduction: local producers.

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