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Friday, February 26, 2016
The march of the zombies: Industry in China
OVERSUPPLY is a global problem and a global problem requires collaborative efforts by all countries.” Those defiant words were uttered by Gao Hucheng, China’s minister of commerce, at a press conference held on February 23rd in Beijing. Mr Gao was responding to the worldwide backlash against the rising tide of Chinese industrial exports, by suggesting that everyone is to blame.
Oversupply is indeed a global problem, but not quite in the way Mr Gao implies. China’s huge exports of industrial goods are flooding markets everywhere, contributing to deflationary pressures and threatening producers worldwide. If this oversupply were broadly the result of capacity gluts in many countries, then Mr Gao would be right that China should not be singled out. But this is not the case.
China’s surplus capacity in steelmaking, for example, is bigger than the entire steel production of Japan, America and Germany combined. Rhodium Group, a consulting firm, calculates that global steel production rose by 57% in the decade to 2014, with Chinese mills making up 91% of this increase. In industry after industry, from paper to ships to glass, the picture is the same: China now has far too much supply in the face of shrinking internal demand. Yet still the expansion continues: China’s aluminium-smelting capacity is set to rise by another tenth this year. According to Ying Wang of Fitch, a credit-rating agency, around two billion tonnes of gross new capacity in coal mining will open in China in the next two years.
A detailed report released this week by the European Union Chamber of Commerce in China reveals that industrial overcapacity has surged since 2008 (see charts). China’s central bank recently surveyed 696 industrial firms in Jiangsu, a coastal province full of factories, and found that capacity utilisation had “decreased remarkably”. Louis Kuijs of Oxford Economics, a research outfit, calculates that the “output gap”—between production and capacity—for Chinese industry as a whole was zero in 2007; by 2015, it was 13.1% for industry overall, and much higher for heavy industry.
Scarier than ghosts
Much has been made of China’s property bubble in recent years, with shrill exposés of “ghost cities”. There has been excessive investment in property in places, but many of the supposedly empty cities do eventually fill up. China’s grotesque overinvestment in industrial goods is a far bigger problem. Analysis by Janet Hao of the Conference Board, a research group, shows that investment growth in the manufacture of mining equipment and other industrial kit far outpaced that in property from 2000 to 2014. This binge has left many state-owned firms vulnerable to slowdown, turning them into profitless zombies.
Chinese industrial firms last year posted their first annual decline in aggregate profits since 2000. Deutsche Bank estimates that a third of the companies that are taking on more debt to cover existing loan repayments are in industries with overcapacity. Returns on assets of state firms, which dominate heavy industry, are a third those seen at private firms, and half those of foreign-owned firms in China.
The roots of this mess lie in China’s response to the financial crisis in 2008. Officials shovelled money indiscriminately at state firms in infrastructure and heavy industry. The resulting overcapacity creates even bigger headaches for China than for the rest of the world. The overhang is helping to push producer prices remorselessly downward: January saw their 47th consecutive month of declines. Falling output prices add to the pressure on debt-laden state firms.
The good news is that the Chinese have publicly recognised there is a problem. The ruling State Council recently declared dealing with overcapacity to be a national priority. On February 25th the State-Owned Assets Supervision and Administration Commission, which oversees big firms owned by the central government, and several other official bodies said they would soon push ahead with various trial reforms of state enterprises. The bad news is that three of the tacks they are trying only make things worse.
One option is for China’s zombies to export their overcapacity. But even if the Chinese keep their promises not to devalue the yuan further, the flood of cheap goods onto foreign markets has already exacerbated trade frictions. The American government has imposed countervailing duties and tariffs on a variety of Chinese imports. India is alarmed at its rising trade gap with China (see article). Protesters against Chinese imports clogged the streets of Brussels in February. There is also pressure for the European Union to deny China the status of “market economy”, which its government says it is entitled to after 15 years as a World Trade Organisation member, and which would make it harder to pursue claims of Chinese dumping.
Another approach is to keep stimulating domestic demand with credit. In January the government’s broadest measure of credit grew at its fastest rate in nearly a year: Chinese banks extended $385 billion of new loans, a record. But borrowing more as profits dive will only worsen the eventual reckoning for zombie firms.
A third policy is to encourage consolidation among state firms. Some mergers have happened—in areas such as shipping and rail equipment. But there is little evidence of capacity being taken out as a result. Chinese leaders are dancing around the obvious solutions—stopping the flow of cheap credit and subsidised water and energy to state firms; making them pay proper dividends rather than using any spare cash to expand further; and, above all, closing down unviable firms.
That outcome is opposed by provincial officials, who control most of the country’s 150,000 or so publicly owned firms. Local governments are funded in part by company taxes, so party officials are reluctant to shut down local firms no matter how inefficient or unprofitable. They are also afraid of the risk of social unrest arising from mass sackings.
China’s 33 province-level administrations are at least as fractious as the European Union’s 28 member states, jokes Jörg Wuttke, head of the EU Chamber: “On this issue, increasingly Beijing feels like it’s Brussels.” So Mr Gao’s claim that the problem is not entirely his government’s fault may be true in a sense. But in the 1990s China’s leaders did manage bold state-enterprise reforms involving bankruptcies and capacity cuts, that overcame such vested interests. To meet today’s concerns, the central government could provide more generous funding to local governments to offset the loss of tax revenues arising from bankruptcies, and also strengthen unemployment benefits for affected workers.
If China’s current leaders have the courage to implement such policies, there may even be a silver lining. Stephen Shih of Bain, another consulting firm, argues that much quiet modernisation “has been masked in many industries by overcapacity”. For example, little of the fertiliser industry’s capacity used advanced technologies in 2011; most of the new capacity added since then has been the modern sort that is 40% cheaper to operate.
Baosteel Group, a giant state-owned firm, has been forced by Shanghai’s local authorities to shut down dirty old mills in the gleaming city. So its bosses have built a gargantuan new complex in Guangdong province with nearly 9m tonnes of capacity. This highly efficient facility has cutting-edge green technologies that greatly reduce emissions of sulphur dioxide and nitrogen oxides, recycle waste gas from blast furnaces and reuse almost all wastewater. “When the older capacity in China is shut down, we’ll have a much more modern industrial sector,” Mr Shih says. “The question is, how long will this take?”