China Isn't Really Reducing Capacity
Since December 2015, China's government has been talking up what it calls supply-side reform. State media says the goal is "stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity." That sounds reasonable. In reality, though, supply-side reform is doing almost nothing to reduce capacity, and may well be worsening the inefficiencies that are holding back China's economy.
Judging by the headlines, the reforms are working fine. State media routinely reports on factories shutting and industries meeting their mandated goals for capacity reduction. But if outdated or failing plants are simply being replaced by newer ones, the net impact will be a continued increase in total capacity. And the data suggests that's exactly what's happening.
For one thing, China has continued investing heavily in metals processing and coal, albeit on a somewhat smaller scale. Investment in ferrous metals processing last year was a paltry 2 percent less than in 2015 and down only 18 percent from the peak in 2013. Aluminum capacity is actually up 15 percent since December 2015, with major mill rebar capacity officially unchanged.
Data on steel-mill operation also suggests little progress. Blast furnace operating rates in June and July 2015 were at 82 percent. Over the same period this year, they had dropped only to 77 percent. Given that crude steel output increased by 11 percent in June and July over the same period in 2015, a decline in operating rates of 5 percentage points doesn't exactly suggest painful capacity cuts.
What's confusing is that prices of basic commodities, such as steel and coal, have been surging. Since Dec. 1, 2015, the futures-traded price of steam coal is up 113 percent, iron ore up 97 percent, and steel rebar up 149 percent. Those numbers would seem to tell the story of an industry suffering from harsh plant closures and tight supply.
But what really happened is that China's financial market swung into action. Financial firms increased the allocation of commodities in wealth-management products from an average of 0.9 percent from October through December 2015 to 2.1 percent for the last three months. This provided a large capital inflow that encouraged rampant speculation. The one-month average of daily trading turnover by value in rebar is up 295 percent from December 2015 and coking coal turnover is up 785 percent. By volume, the amount of iron ore traded each day now regularly exceeds the yearly output for all of China. Rising prices don't indicate tighter supply; they're the result of vast financial inflows into commodity trading.
Regulators show little inclination to stop this. China's National Development and Reform Commission has proposed an inventory-control rule that would prevent companies from stockpiling coal when prices are high or running down inventories when they're low. But relative to financial-market turnover, that won't have much impact. In fact, given that other regulators are prodding financial companies to plow yet more money into commodities, such measures seem beside the point.
Perhaps more importantly, the restructurings that would be needed to really reduce capacity don't seem imminent. Last week, the government approved a megamerger between the coal giant Shenhua Group Corp. and the power generator China Guodian Corp., which will result in a state-owned firm with assets worth $271 billion. Rather than forcing two firms in surplus-capacity industries to close plants, they're letting them scale up and obscure the problem. The combined company will have more market power and even less incentive to significantly restructure.
The stated goals of supply-side reform -- reducing capacity, writing off debt and boosting efficiency -- are clearly what China needs. But meeting those goals will require some hard choices. For starters, it's critical to reduce investment by WMPs in commodities, which drives up prices and encourages inefficient factories to ramp up production. While this may keep plants profitable in the short term, it will do nothing to reduce risk or surplus capacity. Worse, it will only delay the reckoning that China needs to move on.
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Timothy Lavin at email@example.com