China’s 2008 economic stimulus programs may have been necessary for stabilisation, but they appear to have been too large, too intensively focused on fixed assets and too heavily concentrated on construction. All this stimulus led to massive increases in domestic capacity for steel, cement and aluminium – while demand from export markets fell and property deflated amid financial tightening. As a result, these industries experienced massive excess capacity (see figure 1, which shows domestic capacity and average utilisation rates for steel in China).
In short, we believe that China’s steel demand has reached a near-term peak. As the country’s fiscal focus shifts from public investment to tax cuts and consumption subsidies, and property policies remain restrictive, we expect China’s ability to consume incremental steel over the secular horizon to be negatively impacted.
Figure 2: Annual steel consumption (million tons per annum): US., China and Japan
China’s over-investment in steel
The Chinese steel industry today shows many signs of serious economic difficulties brought about by the unprecedented size and speed of industry expansion. The unique structure of the Chinese economy makes government policy the key driver. The state is heavily involved in all major industries, including the steel industry, and has significant control over industrial output. This distinguishes China from other economies and has fuelled rapid uneconomic investments in China’s steel industry.
The industry has benefited from the CNY4 trillion ($US600 billion) stimulus program for infrastructure construction that was used to avoid recession in 2008. At the same time, local governments in China set up their own stimulus plans, with an estimated total investment of about CNY13 trillion ($US1.8 trillion), three times more than the central government’s plan.
These stimulus plans have affected capacity, consumption and return on assets.
We currently estimate China’s current steel industry capacity (its total ability to produce steel) at 850 million metric tons. However, in 2011 it only produced roughly 683 million tons.
Of those 683 million tons of production in 2011, China consumed only 631 million tons (see Figure 2), leaving excess production of 52 million tons, which was carried over as surplus inventory in 2012. Even if consumption remained flat in 2012, there should only be "true” expected demand for new production of roughly 580 million tons for 2012 (631 million tons minus 52 million tons). Demand is not likely to rise, in our view, because stimulus plans have resulted in an estimated consumption of an additional 120 to 140 million tons of infrastructure-related steel from 2008 to 2012 – and we do not expect new stimulus programs to be announced in the coming years.
Return on assets
Additionally, the massive investments made since 2008 combined with the weak global economy have contributed to a material reduction in steel sector return on assets since 2008, remaining under 6 per cent (see figure 3). We estimate total assets employed in the sector increased by CNY 2.8 trillion ($US450 billion) since 2002 for additional annual profits of around CNY 70 billion ($US11 billion), an average annual ROA of around 4 per cent on assets employed.
Projecting steel consumption in China
We study two contrasting approaches to gauging China’s steel consumption prospects – a per capita assessment and a cumulative approach.
A per capita analysis focuses on the potential to consume steel. Using this approach, the consensus view for peak steel consumption in China of one billion tons per year (46 per cent growth from 2011) within the next five to seven years, in our view, is highly unlikely. Moreover, even this approach has a high risk of overestimating China’s steel requirement, as population size does not always equate to steel consumption, given steel’s linkage to the economic cycle.
Used correctly, per capita analysis can provide a guide for predicting China’s steel consumption potential, assuming a whole range of other things also happens. Simply having a large population and a willing government did not spur the type of economic growth, urbanisation and steel consumption that China has experienced in the past decade. The catalyst, in our view, was foreign capital investment in the manufacturing sector that was motivated by China’s low-cost labour advantage. An export-based investment model drove economic growth, which led to capital formation, which facilitated urbanisation and steel consumption. If this model is in the process of changing, we should expect a negative impact on China’s ability to consume more steel.
In contrast to the per capita framework, Pimco’s preferred methodology frames China’s likely ability to consume steel as a function of its cumulative steel consumption to date. This recognises the reality that steel is effectively "consumed” over many years, unlike industrial outputs like electricity, which are consumed all at once and need to be replaced each year. For example, if China’s economy grows at 7 per cent each year, China must regenerate all of last year’s electricity plus a little bit more. But once last year’s building is completed, steel production capacity is freed up to build new and different buildings. Because China can create incremental demand growth (more buildings, roads, etc.) with the same amount of steel production, the annual consumption of steel as a percentage of cumulative steel consumption tends to exhibit a declining path over time, as it has for other economies like Japan and the US (see figure 4). This process was interrupted thanks to the investment boom in the first decade of this century, but we expect the downward trend to resume in the upcoming years.
We acknowledge that rapid urbanisation of China has accelerated steel consumption during the past decade. However, the economic prospects of East China, Central China and West China are very different. Data show quite clearly that China’s economic growth and steel consumption has not been evenly distributed throughout the country. China’s fundamental demand for steel is likely to slow as its urbanisation process (currently more than 50 per cent of the population lives in cities) moves west. Central and West China are on a lower growth path than East China and thus are likely to require less steel.
Implications for future demand and investments
What are the implications for future steel demand in China? The natural rate of steel consumption appears set to slow and even fall from 2012 in the absence of incremental, steel-intensive stimulus. Housing, construction and heavy machinery represent approximately 70 per cent of steel demand, so a housing slowdown is likely to be negative for steel consumption. Social housing, while a top priority for the government, will not be a major source of new steel demand because many of these projects will have difficulty in securing local government funding. As the Chinese economy matures, this problem is likely to worsen, particularly if new steel capacity investment continues, as the amount of steel required declines as a proportion of GDP and the type of steel demand also shifts from construction to consumer-related industries, which are less steel intensive.
How could our analysis be wrong?
Probably the greatest risk to our forecast for Chinese steel consumption is that a faster-than-expected slowdown in China prompts another round of investment-intensive fiscal stimulus by Chinese policymakers. This may not be the baseline path, but it is a possible scenario. Second, a major new commitment to social housing could potentially be a larger demand source for steel vs. our internal estimates, should the authorities make such a social-oriented program a higher government priority.
For investors, we believe the biggest risk is that iron ore prices may falter (since iron ore is one of the main ingredients in steel production) as new iron ore supply ramps up by 2014 and Chinese steel demand weakens. The Australian dollar could be vulnerable, since it has traditionally been closely aligned to the price of iron ore, one of Australia’s main export commodities. Along with other natural resources, iron ore is a major driver of Australia’s trade with China.
Finally, high-cost steel producers globally are at risk, as excess capacity in China potentially translates to weaker global steel prices. China consumed roughly half of all global steel produced in 2011.
Raja Mukherji is an executive vice president of Pimco's Hong Kong office and head of Asian credit research.
© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.