Commodities

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Powering Down
World crude steel capacity utilization ratio for the 66 countries reporting to the World Steel Association
Source: World Steel Association

Why does China need more steel? To make another steel plant. And why does China need another steel plant? To make more steel.

That's just the kind of joke that a glut-addled global metals industry doesn't find funny any more. In the first 11 months of 2015, the People's Republic produced 736 million metric tons of steel, of which it exported more than 100 million tons. As Bloomberg Intelligence notes, that's more steel exported by China than made in the U.S. The oversupply has caused prices, and profitability, to nosedive everywhere for producers.

Now authorities are taking pity on the hapless steelmakers by pledging to cut domestic capacity by 100 to 150 million tons. Anything that removes excess production is good news and the target appears bold, considering about 68 million tons of China's overcapacity was shuttered last year, according to Morgan Stanley.

China's Steel Glut
The People's Republic exports more steel now than the U.S. produces in a year
Source: Bloomberg Intelligence
* Year-to-date figures

There's no doubt that 100 million tons of capacity reduction will make a difference. Even assuming the most inefficient of Chinese steelmakers are operating well below the world average of about 67 percent capacity utilization, 100 million tons of nominal closures, if carried out swiftly, should still put 50 to 60 million tons of annual production out of circulation. That's significant. 

However, whether those shutdowns will actually happen, and if they'll happen soon enough to bring investors relief, will depend on Beijing's willingness to go slow on its strategic priority to industrialize landlocked western China.  

To see why, consider a state-owned behemoth like Baosteel Group, which controls Baoshan Iron & Steel, one of the country's largest publicly traded producers. Baoshan's shares jumped more than 5 percent in intraday trade Monday on news China would be closing superfluous capacity. But there wasn't much cheer in those plans for shareholders of another Baosteel subsidiary, Xinjiang Ba Yi, which made a net loss of 2.5 billion yuan ($380 million) last year and is now at risk of getting delisted by the Shanghai Stock Exchange.

According to Moody's, a delisting could limit the unit's likelihood of raising equity, and would put Baosteel on the hook for its losses and capital calls. Those could be substantial considering Ba Yi's operations in western China make it reliant on captive iron ore, denying it the benefit of falling imported mineral prices. Meanwhile, the ratings company estimates that investments in Baoshan's soon-to-be-ready plant in the Pearl River Delta has pushed its parent's gross debt up to 5.5 times Ebitda from 4.6 times in 2014. Add the support needed for Ba Yi, and the group's credit quality may well weaken further.

A Tale of Two Baosteel Subsidiaries
Return on invested capital is deeply negative for western China-based Ba Yi
Source: Bloomberg
Faltering Steel Demand
Floor space under construction in China was rising, but has now plateaued
Source: National Bureau of Statistics of China

The failing health of western Chinese mills, which are important to the nation's proposed ``one belt, one road'' trade and investment network in Eurasia, are only one risk for investors. The other issue is demand.

Construction activity on the mainland flattened in 2015 and there's a danger 2016 might see a decline. And while car sales are expanding in China, orders in other emerging markets, such as Brazil, Russia, India, Indonesia and Thailand, are either sluggish or falling. Slumping oil prices could also impede a recovery in metals, considering the energy industry generates about 8 percent of U.S. steel demand.

Overall, China's decision to mothball capacity is a welcome step. But just how effective it proves to be in reviving the steel industry's fortunes will hinge on demand not dropping any faster than supply being cut. Given that's also in the lap of Chinese authorities and their propensity or otherwise to put strategic considerations on the back burner, for now, it's safe to assume investors' relief might be less than enduring.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net