A massive Chinese industry is flashing warnings signs the world cannot ignore

China’s steel industry, the biggest in the entire world, is in crisis.

The disaster has come due to a combination of factors, including a slowing Chinese economy, falling commodity prices and an industry loaded with debt.

Earlier this month, state-owned enterprise Sinosteel defaulted on a debt interest payment of $US315 million on bond notes maturing in 2017.

It’s a sign that, despite China’s best efforts at fiscal policy easing and pledges to reform “zombie” SOEs, the worst may be coming faster than policymakers expected.

The pride of old China

China’s economy is trying to make the difficult transition from one based on investment to one based on domestic consumption, so it’s useful to think of its economy in two parts — new China and old China.

New China includes businesses in the services sector, like technology, retail and banking.

Old China includes the country’s once-booming property and construction sectors, manufacturing and Chinese exports.

It’s important to note that old China — which includes a bunch of SOEs — is carrying a ton of debt. This has made companies less profitable as they spend significant sums of money making payments on that debt.

As new China rises, old China is fading. But the rising is happening slowly, and the fading is happening faster than anyone thought. The Chinese government faces the colossal challenge of managing this transition without a string of credit events crippling the economy.

That’s where the danger in China’s steel industry comes in.

Asking for help

As Bloomberg reports, Zhu Jimin, the deputy head of the China Iron & Steel Association (CISA), said on Wednesday that collapsing demand is putting the entire industry at risk.

From Bloomberg:

“Production cuts are slower than the contraction in demand, therefore oversupply is worsening,” said Zhu at a quarterly briefing in Beijing by the main producers’ group. “Although China has cut interest rates many times recently, steel mills said their funding costs have actually gone up.”

“China’s steel demand evaporated at unprecedented speed as the nation’s economic growth slowed,” Zhu said. “As demand quickly contracted, steel mills are lowering prices in competition to get contracts.”

Average steel prices hit an all time low on July 9. CISA notes that in September, steel demand contracted 8.9% from the same time a year before, and medium and large steel mills have lost $US4.4 billion in the first 9 months of 2015.

The restructure

That means China may need to both clarify and speed up its five-year plan to reform state-owned organisations. Sinosteel’s default indicates that it, and other SOEs carrying a ton of debt, may not be able to wait years for debt restructuring.

“I don’t know how the government can push ahead with the SOE reform, it will be extremely difficult,” one senior executive with China’s top aluminium producer Chinalco, told Reuters.

Winter is coming. That means construction will slow down and demand for steel will weaken even more.

And when that happens, China will have to make a choice. Prop up its steel industry, or make the rare decision to let companies collapse under the weight of their debt.

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