Chinese steel industry 2008 and beyond

Analysis of Chinese steel industry is critical to understand the macro-economic trend in the steel industry particularly east Asia market, as China accounts for the most of demand and supply increase. The competitive advantage of Chinese steel makers is cost. They have access to cheaper coal, labor and mostly importantly cheap capital. Coking coal still trades $100 per ton cheaper than global market recently. While labor is still cheaper in China, it is a much smaller percentage after recent rise in raw material price. The ion ore deposit in China is lower quality and difficult to mine, hence the majority is still being imported, which mean Chinese steel makers pay the same rate as their global competitors. In sum, Chinese steel makers still have lower cost structure than its competitors but it is much smaller now. The biggest driver of the growth in Chinese steel industry is actually cheap capital. In China, local governors are usually evaluated by local GDP growth and employment rate. Hence they have the incentive to subsidize new steel mill by selling land cheaper than the market rates or/and making loans available at local bank. Chinese banks have been hungry for growth in their loan portfolio due to the high saving rate in China. As a result, steel mills at various scales are burgeoning during and supply soon outstripped fast growing demand. Due to their low cost capital, the steel mills are willing to make modest profit on their products. The small mills often make as little as $10 EBITA/ton.

Chinese steel industry is hitting a tipping point now. The small steel mills in China which accounts for a significant share of Chinese steel production are facing tough headwinds. The critical cheap capital is gone. To fight inflation, Chinese central bank has raised reserve rate to 17.5%., up from 7.5% in 2004. The rising price of raw material effectively raised the requirement for working capital, which caused a capital shortage in smaller mills, which are not able to easily obtain loans from banks now. There is also a biased industry structure working against smaller mills. The small mills can not directly negotiate with foreign raw material supplier and have purchase from the state owned steel maker at a much higher price. As a result their already paper thin margin is now zero to negative. The central government also vowed to improve environment by shutting down high pollution small mills by 2010. There is a nation wide consolidation going on. The state owner integrated steel makers are acquiring the suffering small makers and then shun down the low efficient plants. The new build capacity in 2008 will be around 5100M ton, while at the same time 2400M ton capacity will be shut down (1100M ton was shut down in 2007). So the net capacity increase is 2700M ton, which represent a 5.3% increase. The demand for steel in China is projected to be inline with 10% GDP growth, although certain housing related area is likely to slow. The supply/demand of steel in Chinese local market will move toward balance from overcapacity in 2008

Meanwhile Chinese have raised export tax on steel products. The following chart shows Chinese export raise from less than 10M ton in 2004 to close to70M ton in 2007, while the export tax was reduced from 15% to 0-5% depending on specific products. The export volume reached a tipping point in 2007 when the export tax was raised to 5-10%, which coincide with Chinese government’s move to shut down smaller steel mills. This further puts pressure on Chinese steel export.