China plans to put a broom through its coal and steel sectors

Photo by China Photos/Getty Images

Chinese Premier Li Keqiang has pledged “firmer resolve and greater efforts” to tackle overcapacity in the nation’s manufacturing sector.

According to the state-run People’s Daily newspaper, Li told told a seminar on the country’s economy in Beijing this week that the nation “should strive to upgrade traditional industries” in 2016, adding that the government was “determined to cut back on overcapacity in traditional industries as well as a large number of zombie enterprises”.

Li singled out the nation’s struggling steel and coal sectors, which face severe overcapacity, heavy levels of indebtedness and mounting losses, as areas of particular concern.

According to the report, China is currently producing 800 million tonnes of steel a year, four times greater than the annual output any nation has produced, of which around half is deemed to be excess capacity at present.

It has led to large and medium-sized Chinese steel companies – supposedly in the strongest position to cope with deteriorating operating conditions – record losses of 18 billion yuan in the first eight months of 2015, a sharp divergence from a year earlier when firms made 14 billion yuan over the same time period according to the China Iron and Steel Association.

In late October Xu Lejiang, chairman of China’s second largest steel producer, Shanghai Baosteel Group, suggested that the whole steel sector in China was struggling, every producer feeling pain.

Xu suggested that Chinese steel production may decline by as much as 20% due to chronic sector oversupply.

As the chart from Macquarie research below reveals, the interest bill on debts carried by most Chinese steelmakers are equal to or greater than total profits made at present, a clearly unsustainable situation that will only be resolved by a decline in steel making capacity or an unlikely pickup in demand.

Further emphasising how bad operating conditions are across the sector, China’s steel industry PMI gauge collapsed in November, plummeting 5.2 points to 37.0. Like all PMI reports, it is a diffusion index measuring monthly changes in activity levels across the sector. A reading below 50 suggests activity levels are contracting, so 37.0 is dire. They’re not just declining, they’re collapsing at present.

Weaker steel demand – both from China and abroad – has also impacted producers of the raw materials supplying China’s steel industry. Iron ore and coking coal prices have remained under pressure this year, hindering profitability at mining firms globally and contributing to overcapacity in China’s steel sector, which remained in production as the input price fell.

As the chart below reveals, it’s been an ugly year for the benchmark spot iron ore price.

While Li stressed that restructuring reforms covering both supply and demand should be carried out next year, indicating that more targeted stimulus may be on the way to boost demand, it’s clear that the government intends to clean up sectors suffering from large-scale excess capacity at present.

This may help to boost steel prices as a result, but it’s unlikely to boost demand for raw steel making ingredients.

Iron ore and coal producers – both within China and abroad – continue to pump out supply at rates that far exceed demand at present, leading to massive price declines seen over the past year.

With China looking to curb overcapacity in the steel sector, the question now is when will the miners supplying it follow suit?

There’s no indication at all that this is taking place, ensuring the outlook for iron ore and coal prices remains as bleak as one can remember.

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