Consolidation Catching Up With Bloated Steel Sector
We believe the bloated steel sector in China will come under increasing pressure over the coming quarters. While concerns over maintaining employment has continued to prevent drastic cuts from taking place , a clearer-eyed analysis of recent events in China suggests to us that the government will eventually throw in the towel and allow market economics to work its way . Indeed, masked by the delivery of perpetual government's support, an overwhelming number of domestic steel mills would have batten down the hatches under current market conditions. Subsequently, they have failed to restructure themselves in a manner that will allow for more robust and sustainable growth.
W e are starting to see signs of a broader realisation on the part of Beijing that the previous government's state investment-led policies were inherently unsustainable . Following the splitting of the state behemoth Ministry of Railways (MoR) in March, Chinese solar panel maker Suntech Power Holdings recently announced it would be filing for insolvency after the default of US$541mn in outstanding bonds. The demise of Suntech is particularly surprising to us as it marked the first corporate bond default in Chinese history and , crucially , a default of the world's largest solar manufacturer. Sun tech's demise can be attributed to significant overcapacity, depressed margins, weak demand and persistent losses - traits , as we discuss , are very much visible in the steel sector.
Steel Sector Running Out Of Luck
With a string of precarious fundamentals weighing heavily on the industry, we believe that the decades of blind expansion and artificial government-led support are finally about to catch up with the Chinese steel sector. Firstly, significant overcapacity will almost certainly have to be addressed in the face of mounting debt levels for steelmakers and local governments (the primary purchases of domestic steel) . Compared with the global average of 78 %, t he debt-to-equity ratio of the ten larges t Chinese steel mills is currently at 137% , with gearing of companies such as Inner Mongolian Baotou reaching a staggering 216 %. Faced with sluggish demand and persistent overcapacity, many of the domestic steel mills will struggle to repay their obligations at a time when many of local governments , the principal buyers of steel for infrastructure projects, are grappling with swelling debt problems.
|Mounting Debt Stress|
|China - Select Steel Producers, Debt-To-Equity Ratios|
The International Monetary Fund (IMF), rating agencies and investment banks have all raised concerns on Chinese local government debt. P rovinces, cities, counties and villages across China are now estimated to owe between US$1.6-3.2trn, equivalent to 20-40% of the size of the Chinese economy. This notwithstanding, concerns about the overemphasis on fixed capital formation, coupled with a desire to boost private consumption will continue to encourage the Xi administration to loosen its grip on the steel sector. We expect cost rationalisation to gain grounds over the coming quarters and cases of better-performing firms being forced to acquire other loss-making state-owned steelmakers are likely to embark on a sustained downward trend. To highlight, Angang Iron & Steel was forced to take over unprofitable firms such as Panzhihua Steel despite posting losses of more than US$644mn in 2012.
|Steel Industry Margins At The Brink|
|Price Ratio: China Steel Rebar/Iron Ore Import Price|
Secondly, domestic steelmakers are currently suffering from razor thin margins . According to the Chinese Iron & Steel Association (CISA), high iron ore prices relative to steel prices have left the Chinese steel industry as the least profitable of the country's 39 industrial sectors. Profits for 80 major Chinese steel producers plunged by 98% y-o-y (year-on-year) to reach US$254mn in 2012, with total margins hitting a meager 0.04%.
|The Boom Years Are Over|
|China - Select Indicators (% Chg y-o-y)|
Thirdly, demand for steel products will further weaken with the slowing of the Chinese economy . W e forecast China's real GDP growth to reach 7.5% in 2013, which would not only imply a further deceleration from 2012's 7.7% print, but also sits some way off consensus projections of 8.1% . While our forecast may be a little on the bearish side, recent develop ments in China provide us with solace that the current economic rebound will prove fleeting. Specifically, China's real GDP growth came in at 7.7% y-o-y in Q113, versus consensus expectations of 8.0%. This is the fifth slowest quarterly growth outturn in over a decade, and is concerning given the ramp up in liquidity seen over recent quarters (see: 'Inflation On Its Way But Not Here To Stay', April 11). The gap between credit growth and real GDP growth appears to be heading in the wrong direction, which is a natural consequence of the poor quality of investment that has been undertaken over recent years.
|Less Bang for Their Buck|
|China - Real GDP Growth (% chg y-o-y) & Total Social Financing (CNYbn)|
Fourthly, Chinese steel mills have started to see their bottom line deteriorate rapidly. It was reported that 16 listed steelmakers, who reported their annual results for 2012 so far till April 2, choked up a combined loss of US$690mn last year. Of these, only four companies reported y-o-y profit growth. In contrast, only three listed steelmakers posted losses in 2011 and one in 2010.
|In Rough Waters|
|Select Chinese Steelmakers - Net Profit Margins (%)|
As a result, the Chinese government is explicitly pushing ahead with efforts to consolidate the industry. In a bid to bring 60% of total capacity under the control of its top 10 mills by 2015, China is set to close 7.8mnt (million tonnes) of outdated annual steelmaking capacity this year. While this constitutes only 1.1% of China's steel output in 2012, the fact that the new leadership under President Xi Jinping is willing to enact such reform during times of slowing economic growth marks a major step towards industry consolidation. It is also telling to note that a series of measures aimed at curtailing production and rectifying the stubborn overcapacity has been unveiled across the other metal and coal sectors.
Capacity Reduction Alone Will Not Suffice
While the government's waning support for domestic steel mills is key to tackling the crux of overca pa city, the restructuring of China's steel sector should not be confined to capacity reductions alone. In our view , an overhaul of the industry's distribution mechanism warrants significant attention. T he current model of using traders as the main source of distributing steel fails to pain t an accurate picture of the true levels of consumption in the country. With limited know ledge about the medium and long- term deman d trends of the companies that they service , production at domestic steel mills is often driven by speculation of stimulus measures or seasonality impact . Consequently, inventories through the supply chain can become excessiv e and led to extremely volatile prices. Nonetheless, we note that chan ges to the distribution system are unlikely to take place anytime soon. While the steel industry has been championing the need for more direct sales between steelmakers and the consumers, it will remain an arduous task to dislodge the strength of the prominent trader lobby in China .
While the deteriorating underlying fundamentals suggest that consolidation of the steel industry is almost inevitable, we are aware that this will not materialise into anything significant over the near-term. C oncerns over maintaining employment will continue to take precedence and constrict the ability of the Chinese leaders to deliver potentially painful economic and political reforms over the coming quarters.