The issues facing China’s steel industry at home continue to send shockwaves around the world. Finbarr Bermingham reports.
In Asia, it has been clear that all is not well for a long time. Based on conversations with commodity traders and bankers around the region, the deal flow in the iron ore and steel sectors has been running dry for the past couple of years. Notable heads have fallen; notable names have disappeared from deal tickets.
In Hong Kong in June, two commodity trade finance lawyers told GTR that there have been virtually no cross-border metals financings into China this year. In Jakarta, an experienced metals trader spoke of his decision to jump ship from an iron ore house to a trade consultancy. “I’m getting out while I can,” he said, predicting an imminent crash for Indonesia’s metals-heavy and China-dependent economy.
On Australia’s east coast last April, a group of lawyers discussed the rot that was setting in across the state, with small iron ore miners going out of business, but still being forced to pay for the upkeep of their dormant mines and the infrastructure that the government built to access them. They can still sell their ore if they wish, but it sometimes comes at a loss.
Arguably though, it wasn’t until the proverbial hit the fan in Western Europe this year that the wider consciousness was awakened to the extent to which China dominates world steel markets. When Tata Steel announced plans to close its UK steel operations, risking thousands of job losses, the finger of blame wasn’t long in being pointed eastward.
In the past few years, China’s economy has slowed from the double-digit growth levels of the past 20 years to around 7% (that’s the official figure; the experts’ consensus is that the actual figure is a couple of digits shy of that). Partly, this was due to the government’s move away from investment-led to consumption led-growth.
This rebalancing meant a tapering in the decades-long investment splurges that defined China’s meteoric rise. The property and construction industries have been major casualties, with demand for primary construction materials such as iron ore, nickel and copper suffering as a result. China consumes almost two-thirds of the world’s iron ore, in turn producing more than half of its steel supply. Now though, the markets are awash with supply. The gravitational pull on prices was inevitable.
At the beginning of 2015, a spokesperson from BHP Billiton refuted claims published by GTR that China would reach peak steel in the same year. Now, it seems that the prediction was accurate. “I think consumption in China has peaked. I’d be less confident about saying production has peaked,” says Caroline Bain, metals analyst at Capital Economics, reflecting a widely held view in the industry.
The repercussions of this have been felt in iron ore-producing countries around the world. Australia, which for years poured billions of dollars into cultivating its mining sector, leaving it with one of the world’s most unbalanced economies, was one of the most vulnerable to the Chinese slowdown, which has threatened to push it into recession. Westpac senior economist Justin Smirk tells GTR that while the volume of Australian ore being exported to China has stayed consistent, the amount of money made from this has declined substantially.
“Australian ore, on average, is still one of the cheapest sources of iron in China. So the slowdown in growth in China has not really changed the demand for imported Australian ore but rather the price for it,” he says. With a shrinking domestic steel market, China’s producers had to look outward and – allegedly aided by government subsidies that run counter to WTO regulations – started flooding the international markets with cheap steel.
Tata Steel UK is a relatively late casualty. For a number of years prior to this, steel mills across Asia were faced with a choice of death or slashing production, with large Indian conglomerate Essar Group, for instance, being forced to seek buyers for its steel asset at the behest of its creditors.
This is a mere snapshot of the full picture, but suffice to say China has been met with widespread opposition on the world stage, as successive governments call foul over its steel export policy. At the same time though, efforts to control the amount of steel China produces have failed: China’s relationship with steel is an extremely complex political and social issue.
Winding the mills
Nobody knows for sure how much iron ore and steel China has lying in reserve, but few are predicting a dramatic recovery in the market anytime soon. “This has a long history,” says Casper Burgering, senior analyst in ABN Amro’s metals teams in exasperated tones. Burgering has for some years been discussing China’s consolidation plans. The pace of change is perhaps a source of frustration.
He explains: “In response to worsening steel market conditions during 2015, the Chinese government announced restructuring measures and aimed to cut and close domestic capacity. The plans were a welcome initiative for the global steel market, but similar plans from 2013 have still not been executed.”
China announced in 2013 ambitious plans to tackle the oversupply issue, including closing small inefficient mills and requiring the top 10 producers to have a market share of 60% by 2015. That did not happen.
Burgering continues: “The 2015 goals aim to cut capacity by 10% by 2018, gain more control over emissions and encourage M&A activity. Very ambitious also, but up till now we have not seen significant measures. Unless and until the Chinese initiatives show some real results, we think oversupply in the ferrous market will continue to dominate market direction.”
In February, the Chinese government announced that it would cut 500,000 jobs in the steel industry, in addition to 1.3 million job losses in the coal sector. This was part of an overall plan to cut 150 million tonnes of steel production per year to 2020. The announcement was met with widespread protests.
The central government’s plans have been opposed by many regional authorities, for which the steel industry provides huge levels of employment. This in turn affords stability and acquiescence among the public towards governments which are unelected. Some local authorities have taken matters into their own hands.
Hebei is the largest steel-producing province in China and accounts for one-quarter of the nation’s steel capacity. In the fourth quarter of last year, many steel plants in Hebei were operating below costs and therefore were facing pressure to shut down or suspend production.
Laura Zhai, director for Asia Pacific Kong, tells GTR: “Some tried to shut down, take Songting for example, but re-started again in March/April this year due to protest by workers.
“A number of banks and financial companies affiliated with state-owned enterprises (SOEs) actually came to the rescue, carrying over debt and injecting capital into a number of steel plants like this to allow them to stay afloat. So indirect government and SOE support is still there, it’s just not in such direct forms as before and it is definitely not openly stated in the market.”
So not only have various levels of government been encouraging the steel industry to keep producing, they’ve been actively providing the finance to keep the mills fired up. For years, it has been perceived as Chinese policy to cover up corporate and financial defaults. There have been notable cases in the property sector, however, that this trend is on the wane, and in the metals sector there are small signs that government might be beginning to step back and let things run their course.
Inarguably, to continue bailing out unsuccessful enterprises is unsustainable. When debt levels reach the point they’re at in China’s steel sector, it’s borderline impossible. The sector is among China’s most highly levered. Average debt-to-asset ratio is higher than 70%, with the total industry debt estimated to be around US$600bn, not including upstream funding through payables
and unpaid wages.
“One-third of these debts are in the form of bank loans, therefore, say, shutting down 100 million tonnes of capacity, approximately 10% of total capacity, would significantly hurt lenders,” says Zhai.
Earlier this year, Bohai Steel, a steelmaking enterprise owned by the Tianjin government, defaulted on its debt of more than US$29bn – a staggering figure. The government didn’t take the usual measure of paying off creditors, but moved to restructure the debt, with a debt-equity swap and a direct cash repayment mooted as possible outcomes.
Zhai says: “Large-scale defaults or defaults involving SOEs would be more eye-catching and would receive more attention, such as Dongbei Steel’s default in January 2016 or SinoSteel’s default in October 2015. Smaller producers are less likely to be reported. Nonetheless, the whole industry relies on short-term financing such as commercial paper and super/short-term commercial paper to refinance debt every year, and this could raise the liquidity risks of the sector if there is a sharp and sustained deterioration in the domestic bond market.”
The state of these markets helps explain why international banks are doing so little cross-border metals trade into China from Hong Kong. Risk appetites are diminishing while risk perception increases.
Domestically, there are no official data on the extent of non-performing loans (NPLs) in the steel sector, but it is almost certainly higher than the government’s 1.04% figure for domestic mining defaults in 2014. The lack of transparency makes it difficult to assess, but the amount of bad debt tied up in the industry is bound to be to the detriment of the wider economy.
“When distressed assets are not being recognised as NPLs, loan provisions are understated and bank capital is locked up in rolling over bad debts. This capital could otherwise be redeployed to support the real economy, so the consequence is less capital being made available to support GDP growth. This partially explains why there is a diminishing return on credit towards GDP creation post-2008,” says Zhai.
In short, Chinese metals debt is viewed as toxic in the mainstream banking sector. Those that still trade there are often – with the exception of blue-chip multinationals – using non-bank finance, with new fly-by-night hedge funds said to be popping up in the sector at a rapid rate. There’s a quick buck to be made, but few are willing to take a long-term bet.
For the banking sector, this may be bad news. But for the wider global steel market, normalisation would surely be positive. With steel mills around the world winding down or consolidating rapidly, a move by China to stop propping up failing SOEs would lead to a decrease in production and exports. It’s a trend that is unlikely to come soon enough to stop the demise of Tata UK, but perhaps some light at the end of the tunnel for the industry at large.