The rebound in China’s industrial sectors in recent months has really created a stir.
After years of weakness, plagued by acute overcapacity and heavy levels of indebtedness, suddenly these sectors have sprung back to life, underpinned by a surge in infrastructure investment, primarily from state-backed groups rather than the private sector.
It’s been a remarkable turnaround, delivered in a manner only China could deliver.
To those who witnessed China’s unprecedented stimulus splurge between 2008 to 2011 — unleashed to mitigate the effects of the global financial crisis at the time — it all seems eerily familiar, harping back to the old China growth model of big investment and big credit growth all pushed out in record-breaking time.
For a government pushing the need for economic rebalancing and reform, this distinctive shift to the past has certainly raised some eyebrows.
Just how serious are authorities about reforming the industrial sector when they’ve just provided it with the largest stimulus boost seen in years? It’s a question than many investors are asking themselves, and understandably so.
Gerard Burg, NAB’s senior Asia economist, is one analyst who isn’t overly enthused by recent developments in the world’s second largest economy, describing the recent construction-led, credit-fueled rebound in the nation’s steel industry as “unsustainable”, suggesting it threatens to derail necessary reforms to the sector.
“The sudden improvement in conditions in China’s steel sector – with profitability back to multi-year highs – could draw idle capacity back into production,” says Burg.
Part of the reason why Burg is unenthusiastic about the recovery in China’s steel sector is that it has been assisted by a sharp recovery in construction activity in smaller Chinese cities, already plagued by a years of existing unsold housing inventory.
“At a fundamental level, little has changed in China’s property markets – with excess supply persisting in many locations,” says Burg, acknowledging the exception to this view is in the nation’s largest cities such as Shanghai, Beijing and Shenzhen.
Instead he suggests that “policy changes that have relaxed purchase requirements, looser credit and the poor performance of alternative investment options have started to re-inflate the property bubble that had somewhat deflated across 2014 and 2015”.
The recovery in construction activity, along with significant elements of speculative activity in Chinese futures markets, has underpinned stronger demand for steel, and as a consequence the main ingredients required to produce it, iron ore and coking coal.
The chart below, supplied by the NAB, tracks MySteel’s East China Steel price index, looking at the evolution in steel prices going back to 1997. After falling below RMB 2,000 a tonne in late 2015, the index has subsequently surged by more than 50%.
As a result of the recent surge in steel prices, Burg notes that profitability at Chinese steel mills is now at the highest level seen since 2009, right when the government was rolling out its enormous infrastructure stimulus package.
“Falling steel stocks have supported prices that have increased more rapidly than raw material costs. The result has been that while steel prices are around the highest levels since September 2014, steel profitability in late April was at its highest level since mid-2009,”says Burg.
That’s quite a turnaround, particularly given just a few months ago China’s state council announced plans to cut crude steel capacity in the nation by between 100 and 150 million tonnes over the next five years.
The chart below, again supplied by the NAB, looks at the relationship between Chinese hot-rolled steel prices and the profitability of Chinese producer.
Even with the improvement in profitability for the sector, Burg believes that there are significant long term challenges that need to be addressed, noting that China’s annual production capacity is currently 1.13 billion tonnes, over 300 million tonnes more than its total output in 2015.
From a demand perspective, recent commentary from the China Steel and Iron Association (CISA), the nation’s peak steel body, suggests that Chinese steel demand has already peaked, adding to supply-demand imbalances if its view turns out to be correct.
Though in the short-term Chinese mills could export excess supply into foreign markets, Burg suggests that “Chinese producers [are] already stretching the limit as trade tensions rise”, noting China exported nearly 100 million tonnes of steel last year, a figure akin to Japan’s total annual output.
Of course, should the dumping of cheap excess supply onto global markets be met by greater hostility from other steel producing nations, something that other analysts have already cited as having increased, it could further exacerbate overcapacity and solvency concerns in the sector.
You can see why Burg, and others, are cautious on the outlook for the sector, even with the recent improvement seen.
There are more questions than answers, with most fundamental factors suggesting the government is merely exacerbating problems for the sector, creating an even larger task down the line to restructure this and other industries.
Instead of encouraging idle production to come back online, Berg believes that policymakers need to play a long game, dealing with the problems now before they get worse in the future.
“(Encouraging idle capacity back into the market) could impact both the short term – through worsening trade relationships and further pollution – and the longer term, if it is allowed to derail much needed reform to the sector,” says Burg.
“Chinese authorities need to remain focused on the long term strategic benefits of reform.”
It’s certain many share this view in light of recent developments. The only question now is which path policymakers will take — reform or reversion to the previous norm.
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