Steel for China's iron ore slowdown

China has overinvested in steel as it tries to stimulate its slowing economy. It is also going to need less steel as it develops west. Those factors and more mean less demand for Australia's ore.

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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

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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.

Capacity

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.

Consumption

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.

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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.

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