FENGRUN, CHINA and TORONTO — Yu Jianshui fidgets in his big leather chair as he chain-smokes his way through an interview. Times are tough at the Tangshan Fengrun Zhengda Iron and Steel Co. Ltd.
With China suffering its sharpest economic slowdown in decades, Mr. Yu, the firm's general manager, complains that he is getting fewer and fewer orders for his main product, huge bars of raw steel known as billets. In his 23 years in steel, “this is the worst I've ever seen.”
Yet under the corrugated metal roofs of his steel mill, blast furnaces still blast and two assembly lines still roll out 3,000 tonnes of steel a day.
It is the same story elsewhere in Fengrun, a gritty steel town where the red flag of the People's Republic flies from giant-like loading derricks. After shutting briefly when steel prices dipped last fall, most of Fengrun's more than 100 mills have come back to life to exploit a price uptick this winter, churning out countless tonnes of pipe, girders, rolled steel and heavy cable.
And that, Mr. Yu says, is the problem: Not that so many mills are going out of business, but that so many are still going.
China simply makes too much steel. The government estimates that China's annual production is about 100 million tonnes more than it should be, a figure equal to the whole annual output of the industry in the United States.
Worse, China has far too many steel companies, more than 700 at last count. Add in iron companies and companies that roll or otherwise shape steel, and the total comes to more than 7,000. Despite repeated government attempts to force them to consolidate into fewer, bigger companies, most of them are still small and inefficient.
By rights, many companies should have closed. Instead, they march on like zombies, China's industrial undead.
That was not such a problem when China was growing at 10 per cent or more a year and demand was soaring for products made in the “workshop of the world.” No matter how much steel China made and how many companies were making it, there was always a market somewhere.
Now it's a problem, and not just for China and its steel makers. In China and around the world, demand for steel is plummeting. Producers are cutting back: Japan's output fell 39 per cent and Germany's 31 per cent in February from the same month last year.
But China's crude steel production in February actually grew 4.9 per cent, even as steel exports hit a 52-month low, falling 62 per cent on a yearly basis. Since last October, most steel makers have been losing money. Prices for Chinese hot-rolled steel fell to about $400 (U.S.) a tonne in March, less than half the peak of $980 a tonne hit last year. Even China's Iron and Steel Association has cautioned that overproduction has risked flooding the market with unwanted steel.
In its latest master plan for steel, drawn up this winter, Beijing says it will force the industry to slim down and consolidate. But such edicts have been issued many times before, and instead, production has continued to proliferate. Few believe this time is likely to be different.
The impact of China's overproduction is being felt around the world. As demand for steel products plunges, China's continued strong production is hurting producers in other countries. Just this week, a group of American makers of steel pipe used in oil drilling filed complaints with U.S. trade officials alleging unfair competition from Chinese imports they say have been dumped on the domestic market.
“That is the challenge of China,” says Michael Willemse, an analyst with CIBC World Markets in Toronto. “They can be very disruptive to the global market if their capacity-expansion plans are not consistent with consumption needs of the industrial economy.”
MINERS STILL HAPPYChina's romance with steel goes back a long way. Chinese in the Han Dynasty, 1,800 years ago, produced an early form of steel by combining wrought iron and cast iron.
In the disastrous Great Leap Forward of 1958 to 1961, Mao Zedong made grain and steel production the centrepiece of his plan to surpass the decadent West. The Great Helmsman encouraged the people to build backyard steel furnaces in every commune and neighbourhood. To meet wildly unrealistic production goals, they melted down pots and pans and burned furniture for fuel.
When Deng Xiaoping abandoned Maoist economics in 1978, China began building its steel industry in earnest. As foreign investment poured in and the economy took off, China ramped up production. In the present decade, it has grown at an average of more than 20 per cent a year. It now exceeds the combined production of Japan, the United States, Russia, India, South Korea, Germany, Ukraine and Brazil.
China became the world's biggest consumer and producer of steel, accounting for a third of the world's total output.
Like the auto industry in North America, steel in China came to be considered an essential industry, too big to fail. It directly employs 3.58 million people. Millions more live off it in support roles. As of 2007, it contributed 4 per cent of China's gross domestic product and 9 per cent of industrial profits.
For a long time, everyone seemed to benefit. Chinese steel makers were growing and making money. Foreign steel makers were selling lots of steel to China, which was a net importer of steel until 2006. Iron ore producers in resource-rich countries such as Canada made a fortune as the steel boom pushed up prices for ore.
Indeed, the relatively stable demand from China has helped coking coal and iron prices weather the global economic collapse better than most commodities – and if Chinese steel makers remain at their current production levels, that would not be unwelcome to the international iron ore and coking coal producers.
At a time when financing for most mining firms has all but disappeared, China has been a lone source of capital, playing sugar daddy abroad to shore up the future of the domestic steel industry. Last week, Wuhan Iron and Steel Group Corp., or WISCO, one of China's largest steel producers, agreed to invest a total of $240-million to acquire a 20-per-cent stake in Consolidated Thompson Iron Mines Ltd. and a 25-per-cent stake in the company's Bloom Lake iron ore development project in Quebec.
But for China, the continuing steel push, once a sign of strength, has become a sign of weakness.
The sector's prodigious growth made it a vivid symbol of China's rise. Now, it tells the story of chronic overinvestment and overcapacity, manipulated lending, political interference in markets and overreliance on heavy industry – faults that are being exposed by the crisis across many of the country's industries, and that could cost China dearly as the global recession grinds on.
Steel is not the only industry plagued by too much capacity and too many companies. China has 5,000 cement makers, 3,800 glass makers, 3,500 pulp and paper producers, and no less than 24,000 chemical companies.
“It's a kind of a perpetual theme here,” says Jack Perkowski, now a merchant banker in Beijing who came to China from the United States almost 20 years ago to start a car parts company – and was startled to find there were already 150 companies making piston rings.
“If you look at any product, there are usually only half a dozen or so companies making it in most countries. In China, there are hundreds or thousands making that same product.”
The reasons behind China's capacity issue say a lot about how China works – or doesn't – and points to a slew of other problems.
Outsiders tend to think of China as a centralized state with an all-powerful government that can order industries around at will. In fact, real power often lies with provincial and local officials, the powerful barons of the Chinese political system.
Like Canadian premiers, they fight among themselves to attract industry. And steel is a particular favourite, a “pillar industry” that produces a crucial raw material for many other prestige industries, like automobiles and appliances. In China, Mr. Perkowski says, “every town and every village has to have a steel mill.”
The result is a highly dispersed, even balkanized industry, with production spread around a half-dozen major steel-producing provinces and a dozen or more smaller rivals. Those provinces compete constantly to outdo each other at steel production.
The perennial winner is Hebei province, a traditional industrial powerhouse in northeastern China, surrounding Beijing and the port of Tianjin. According to the industry watcher mysteel.net, Hebei – where Mr. Yu's Fengrun mill is located – won the output “championship” for the seventh successive year in 2008, producing more than 100 million tonnes.
A value-added tax introduced in 1996 gives the provincial barons even more incentive to lure steel companies and win bragging rights. A quarter of the revenue from the VAT goes to local governments.
Balkanization makes for massive inefficiency. In a country like China that lacks high-grade iron ore, the ideal would be to produce steel in big, modern plants near coastal ports, making it cheaper to bring in ore and coking coal, and easier to export production. Instead Chinese mills often have to bring in their ore over hundreds of kilometres of rail track, pushing up their costs.
Pushing up pollution, too. A report last month from the Alliance for American Manufacturing claimed that China's steel industry, with its massive consumption of coal and electricity, produced half of the carbon dioxide from world steel production, making it a huge contributor to the greenhouse gases said to cause global warning. It also claimed that governments help the industry with more than $15-billion a year in energy subsidies, adding to pollution and overproduction.
China's government-directed banking system plays a part in runaway steel output, too. In China, the big banks are run by the state. Their local branches are often closely tied to local officials.
Eager to reap the taxes they get from steel companies, those officials arrange with banks to provide financing for new mills. In China, where labour and land is cheap, mills can be built in a fraction of the time it takes in the West for a fraction of the cost.
If steel prices are rising, they quickly generate handsome profits. But that adds to China's capacity and, in time, overcapacity. That, in turn, puts downward pressure on prices. In a normally functioning market, Mr. Perkowski says, that would lead to an industry shakeout. Weaker, smaller mills would close. Production would fall to meet demand.
Not in China. With “everyone incentivized to keep producing,” he writes in his 2008 book Managing the Dragon, “this capacity never closes. Instead, the plant churns out product at ever-diminishing prices. As long as it can sell at a price equal to the variable costs of production, it keeps producing.” Even if it can't cover those costs, friendly banks may step in to cover its losses.
“This is a topsy-turvy, helter-skelter model of economic growth where each province has its own plans and the central government just sits on top and screams,” says Hans Mueller, an independent consultant based in Tennessee who follows China's steel industry.
The screaming does not seem to do much good. Beijing's latest master plan would hold crude steel output to its current level of about 500 million tonnes. It would move more steel-making capacity to the coastal regions. And it would raise the minimum size of blast furnaces to 400 cubic metres, up from 300 at present, with the intention of forcing smaller, less-efficient mills to close.
The aim is to make its industry more like other countries', with a few big dominant players. China's top three companies account for only about a fifth of the country's total production, compared with well over half for the top three in the United States, Russia or South Korea. South Korea, in fact, gets 87 per cent of its production from just two giant mills.
To bang heads together, China's cabinet set a goal last month of raising the share of output from its top five steel companies to 45 per cent of the total from 28 per cent at present.
Canada's Teck Cominco Ltd., a major producer of coking coal used to make steel, is betting on the consolidation of the Chinese steel industry. Although it doesn't sell coal to China now, it hopes to in the future once more Chinese production moves to the coast, creating demand for seaborne coal.
Selling to China's coastal regions was a key driver behind the company's $14-billion (Canadian) takeover last year of Fording Canadian Coal Trust – a deal that has left Teck straining under more than $9-billion (U.S.) in debt. “It's one of the reasons that we believe in the coal assets,” said Teck spokesman Greg Waller. “There is going to be a fundamental change in the valuation of metallurgical coal in the future.”
If history is any guide, it could take a long time for Teck's coal to get to China's coast. The Chinese “have been talking about this as a matter of national state policy since 2001 and the number of steel firms went up and up and up,” says Daniel Rosen, principal of Rhodium Group, a New York consultancy. “The reality went in a totally different direction.”
In fact, Beijing's massive four-trillion-yuan economic stimulus program threatens to worsen steel's obesity issue. Much of the money will be used for steel-gobbling projects like railway expansion. To further cushion the industry from the global recession, Beijing is raising a rebate on steel exports.
Yet despite the likelihood of continued Chinese steel overproduction, the country's growth could very well serve as the cornerstone for a global economic recovery.
Na Liu, China strategist at Scotia Capital, says China's iron and copper imports hit record highs in February, and net imports of aluminum and zinc are at their highest in several years. China's recent willingness to pay $140 a tonne for coking coal helped support a 2009 benchmark coal contract of $129 a tonne that was much higher than many expected.
As for steel, low prices coupled with China's relatively high cost of production may have already tipped the trade balance in favour of imports. Russian steel producers “have been selling into the Chinese market at very competitive prices, and China might actually have become a net importer of steel in March,” Mr. Liu says.
While China's labour and regulatory costs give it a major advantage over other steel-producing nations, the bulk of those benefits will eventually disappear.
“Gradually, Chinese steel mills are going to lose their cost advantages, as environmental protection and other regulatory costs begin to go higher,” Mr. Liu says.
Back in Fengrun, Mr. Yu knows his industry may need to change.
“When I was a kid, the country's power was measured by how much steel it produced,” he says.
Now, he complains that the industry has too much capacity and too many players. “They can't all survive,” he says. “Some of these companies have to die off.”