China's 'Made in China' Problem

Beijing - It's been a rough year for Inner Mongolia Baotou Steel. Revenues for the company, based on the windswept grasslands 350 miles northwest of Beijing, are off by 21%, and the steelmaker is likely to book its first loss since going public nearly a decade ago. Slowing exports have hurt, but the biggest problem has been surging output at home. Chinese steel production is up 10.5% this year, and capacity is on track to exceed 700 million metric tons annually—about 200 million more than China consumes. "[Overcapacity] is affecting every company in the industry," says Yu Chao, Baotou's investor relations chief. "We have no choice but to accept this."

Can this be the same China that's expected to grow by more than 8% this year? While Beijing's $586 billion stimulus package has helped the mainland navigate the global financial crisis, there's a downside. Fixed asset investment—money spent on factories, highways, and other big-ticket projects—soared 40% in the first half and accounted for nearly all of the country's growth.

The easy credit helped boost demand for commodities such as steel, chemicals, and glass. But it also led to a boom in new factories to make those goods. That may increase trade frictions if China starts exporting the excess at cut-rate prices—what trade experts call dumping. With the mainland's steel production capacity outstripping domestic demand by nearly 30%, "will they shut those plants down and lay those people off, or export their way out of it?" asks Daniel R. DiMicco, CEO of Charlotte-based steel producer Nucor (NUE). "Their tendency is to export."

China's state planning agency is warning of massive overcapacity in a half-dozen industrial sectors. Cement makers have added 600 million tons of annual production capacity this year to the 1.9 billion tons China already had. Aluminum smelters are running at only two-thirds capacity vs. nearly four-fifths last year. And over the past two years the number of Chinese companies making wind power equipment has quadrupled to more than 80.

RISK OF LOAN DEFAULTSWashington is starting to take action. China now faces duties that nearly double the price of tubular steel exports to the U.S. after the Commerce Dept. issued a preliminary ruling that Beijing is dumping the tubes, which are used in the oil industry. "China keeps adding capacity even though there's no need for it anywhere in the world," says Roger Schagrin, a Washington lawyer representing American steelmakers in the tube complaint. He says Chinese exports of tubular steel to the U.S. tripled over the last three years to 2.1 million tons annually, though the surge has slowed since the ruling. American manufacturers of coated paper have filed a similar complaint.

Beijing, too, is concerned about the industrial glut. If companies adding capacity can't sell their extra output, they risk defaulting on their loans. And plans to wean China off state spending, creating a more consumption-driven and innovative economy, could suffer if companies continue to overinvest in commodity production. "We need to think about what our economy should rely on," says Zha Daojiong, a professor at Peking University's School of International Studies. "Low prices and large quantity or higher value-added products?"

China has taken some steps to rein in the expansion. The state planning agency is limiting new projects in the cement, aluminum, and glass industries that don't meet strict standards for pollution control, energy efficiency, and size. It has ordered two top steel producers, Shanghai's Baosteel and Wuhan Iron & Steel, to stop building a pair of mills with annual capacity of 10 million tons each. And it has banned construction of smaller factories making polysilicone (used in solar cells) and silicone monomer (used for everything from skin lotions to electronics). "We like what the Chinese government is doing: They're focusing on who is using resources efficiently," says Tom Cook, Greater China chief at Dow Corning (DOW), which may see some smaller rivals shut down due to the rule changes.

That doesn't mean it will be easy to fix the problem. Most companies in the hardest-hit industries are big employers, state-owned, and a key source of revenues for regional governments. As such, they enjoy subsidized energy and land—not to mention close ties to local banks—so adding new capacity can be a breeze. When other countries could afford to buy the surplus, "China got away with it...but now it's a pressure cooker with steam coming out," says Joerg Wuttke, president of the European Union Chamber of Commerce in China. His group on Nov. 26 released a report on overcapacity that predicts growing trade frictions.

And China may not be willing to make the macroeconomic changes required to face up to the challenge. At Beijing's annual policy-setting conference on Dec. 7, the government hinted that its spending would continue to drive growth for at least a year. Officials have also shown little willingness to revalue the currency, the yuan, so China's surplus output will continue to be relatively inexpensive on the global market. "Some countries are calling for yuan appreciation while imposing trade protectionism on China, which is unfair and actually limits China's development," Premier Wen Jiabao told European officials at a Nov. 30 meeting in Nanjing.

Chinese economists, meanwhile, argue that growth eventually will eat up any excess production. "In a competitive environment, overcapacity is inevitable," says Lu Feng, a professor at Peking University's China Center for Economic Research. In normal times, that doesn't usually create the trade spats and other concerns now faced by China. But these are hardly normal times, says Xiong Bilin, an official from the state planning agency's Industry Dept. "The global financial crisis," Xiong says, "has made this problem even more pronounced."

With Nanette Byrnes, Steve LeVine, Charlotte Li, and Mark Drajem

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