Dark winter awaits China's steel industry

Defaults are on the cards as razor-thin margins strike China's most heavily leveraged companies.

Graph for Dark winter awaits China's steel industry

Australia’s largest iron ore miners are still upbeat about Chinese demand for the steelmaking material, despite iron ore prices falling to their lowest level in 18 months in March. The price of iron ore may have jumped overnight, but there’s no denying the Chinese steel industry -- the largest buyer of Australian ore -- is fighting for its survival.

In the first two months of 2014, members of China’s Iron and Steel Association made a collective loss of 2.8 billion yuan, or $490 million. “The first quarter of this year is likely to be the worst performing quarter in the new century,” said Liu Zhenjiang, deputy director of the China Iron and Steel Association.

The steel industry’s profitability also sunk to a nadir in 2013 when it barely managed to stay in the black, with a razor-thin margin of 0.48 per cent. The owner of China’s largest privately controlled steel mill, Shen Wenrong, illustrated it more graphically last year.

He said the profit for a tonne of steel was about 2,000 yuan 20 years ago and about 1,000 yuan a decade ago. And now it was less than the margins on a simple dish of stir fried meat, he complained bitterly last year.

Apart from sharply declining profitability, the prospect of default is looming over China’s heavily indebted steel mills. The debt ratio for many of the largest steel mills in China is about 70 per cent, which banks regard as the red line for listed steel companies.

In fact, China’s largest privately controlled steel mill has a debt ratio of 83.03 per cent. And the seven largest steel mills in China have a collective debt obligation of 1.3 trillion yuan ($226 billion), which is much larger than the market capitalisation of BHP Billiton.

The prospect of default in the world’s largest steel industry is only a matter of time  -- especially after Beijing allowed its first corporate debt default this year since 1990s. Haixin, the largest private steel mill in the coal-rich Shanxi province needs to pay back 15-20 billion yuan worth of its bank loans.

The local government is unlikely to come to its rescue as it struggles to keep coal companies -- the most important industry for the province -- afloat after significant fall in coal prices recently.

China’s banking regulator and banks are coming down hard on indebted steel mills and especially private ones without the backing of local governments. China Banking Regulatory Commission chairman Shang Fulin told officials to pay particular attention to industries that suffer from problems of excess capacity and the steel industry is one of the worst offenders in this category.

Chinese lenders like the Construction Bank of China, Minsheng Banking Corp and Pudong Development Bank are all reportedly avoiding issuing new loans to steel mills. A banker from Minsheng told Caixin, “regarding steel industry, we will try our best to avoid it.” 

It looks like Beijing is using this opportunity to consolidate the fragmented steel industry through forced mergers and closures of steel mills. The Chinese government has been long unhappy about the fragmented nature of the industry.

In China, the top ten producers only account for 40 per cent of the total steel production. In contrast, the top producers in Japan and Korea usually account for 20 per cent of the total production on their own.

We can probably expect more defaults in China’s steel industry this year as economic headwinds remain strong. In addition, Premier Li Keqiang also made clear the government’s goal to reduce 27 million tonnes of excess capacity this year.

China Metallurgical Industry Planning and Research Institute head Li Xinchuang said recently that the most important trend for the steel industry in the coming decade was consolidation and reorganisation.

China’s steel industry will face twin headwinds of high leverage and razor-thin profitability this year. It is inevitable that Beijing will have to let go many smaller mills this year as they struggle to meet their debt obligations as well new tougher environmental standards.