China is caught in a steel trap

Dealing with excess steel capacity seems straight-forward but the solution could mean dangerous social instability. How China solves the problem will be key to the future of iron ore mining in Australia.

China’s steel industry – the largest in the world –produced 300 million tonnes of excess steel last year which was twice that of total European production, according to Li Chuangxin, deputy secretary general of the China Iron and Steel Association.

Excess capacity is like the sword of Damocles hanging over the head of the Chinese steel industry, which is under siege on multiple fronts. Profit margins have been squeezed to razor-thin, from around 7.5 per cent before the global financial crisis to less than one per cent last year.

Some of the largest steel mills in China have turned to raising pigs and running plumbing services to stay in the black. Lately, they have also been under pressure to shut down their inefficient plants to combat the ever worsening pollution problem, which the industry is partly responsible for.

The mayor of Beijing even made an heroic promise to serve up his own head on a platter if the problem is not addressed. However, Li from the China Iron and Steel Association said the difficulty of tackling the problem of excess capacity was “extremely difficult” and “more complicated than previously thought.”

According to the association’s forecast, China’s steel production will increase another three per cent to 810 million tonne this year despite huge over capacity. Similarly, iron ore imports will increase another six per cent to 870 million tonnes this year.

Why is it so difficult to tackle excess capacity in China when the business case for reducing production is so compelling?

It’s all about employment and social stability. Steel mills are usually some of the largest employers in regional cities. They are not only providers of jobs, but also run social services like hospitals and schools.

If the government shuts down plants, it will cause severe disruption to the social fabric of regional cities where steel mills dominate economic life. For example, the city of Tangshan is one of the largest steel towns in China and it needs to shed 40 million tonnes of steel capacity in the next five years. If the plan is implemented, it means that hundreds of thousands of jobs will be lost.

In the absence of a comprehensive social security network, most local officials are not willing and prepared to take the risk of an army of unemployed steel mill workers taking to street. Maintaining social stability is still the number one concern for the party.

Remember that China spends more money on curbing domestic social unrest than its ever-increasing defence budget.

So in order to solve the problem of excess capacity, the government needs to develop a strategy to retrain and re-employ steel workers. This is a problem that is also confronting Industry Minister Ian MacFarlane at the moment, who is trying to protect livelihoods of laid off workers from Australia’s defunct car manufacturing industry.

A special taskforce from the Chinese Academy of Social Sciences (a top government think tank) that is dealing with the excess capacity issue recommends training laid off workers as the top policy priority. The taskforce says the government should not forcibly shut down plants and it should offer a rescue package that is designed to ensure workers are looked after once the mills are closed down.

Understanding how China will deal with the problem of excess capacity is the key to understanding the future of iron ore mining in Australia. China’s social security, environment as well as industry policy will have an important bearing on the demand dynamics of Australia’s most important customer.

Follow Peter Cai on Twitter: @peteryuancai
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