Mao’s “steel furnaces in every commune” created inefficient producers that China needs to shut down as part of its transition to a global economic power. Despite commitments to do this, China is now desperately trying to hold on to 6.5% pa growth rate and lending money to these same inefficient producers to keep investing. If the gamble fails, it increases the likelihood of a China hard landing
China has invested massively in industrial capacity in the past few years. Much of this was fuelled by corporate debt, sponsored by local governments and often through “shadow banking” channels that don’t show up in official government debt ratios. China accounts for 65% of all corporate debt raised globally since 2008, resulting in a larger build up of debt than that seen in pre-GFC United States.
This debt fuelled investment was initially welcomed by a global economy desperate for growth. But each new dollar invested in steel making or other industrial capacity increased global overcapacity. That resulted in dropping prices, which has led to an unprecedented fall in global manufacturers’ export prices.
In this article we drill down a bit further on the steel industry in China. The story is analogous with the coal, cement and residential property sectors. Overcapacity was the problem for all of these; but now worse as local governments throw fuel on the overcapacity fire, at best making the flames burn longer, but at worst, further damaging the sectors.
Mao’s dream needs to be unwound, not geared up
China’s overcapacity and unprofitable steel industry issues are Mao’s fault. When the Communist Party seized control of China in 1949, they chose to use steel as a tool to industrialise the economy in a single generation. But Mao Zedong feared that large steel plants would be vulnerable to US or Soviet attacks as was the case in Germany in WWII, so he encouraged the development of small, state owned steel mills. China’s steel production rose rapidly, but inefficiency quickly bankrupted the economy.
Following Mao’s death, some State owned enterprise steel producers were chosen for expansion through consolidation. In the years that followed, massive efficiency gains saw China rise rapidly to become the world’s low cost producer of everything, including steel. China grew its total production of steel from 24.9% of global supply in 2004 to 48.9% in 2015.
But this success hides an ugly truth; much of the production is loss making. Total losses in 2015 were A$19.2 billion across the steel industry, from an industry profit of A$3.9 billion in 2014. The lowest 60% of producers lost A$15 billion between them.
The impact of inefficiency and the long journey ahead is best illustrated by comparing China’s industry to Australia’s largest producer, BlueScope Steel. BlueScope increased its profit by 119% over the past year by focussing on cost efficiency, competing with Chinese production despite the massive 420% labour cost disadvantage, and despite the lowest industry margins in more than 15 years. If a western producer can compete despite such massive labour cost disadvantages, China’s small steel producers have nowhere to move, and adding further debt for them to fund investment in more capacity cannot be the answer.
So why is China risking a debt bubble by lending these producers more money?
The Chinese government needs to see the economy transition to a domestic consumption driven economy, and not be reliant on fixed asset investment. But domestic consumption isn’t growing fast enough to make up for the rapid fall in investment, so the Chinese government, desperate to maintain GDP growth of 6.5%pa, is lending more and more capital to these producers in the hope that consumption picks up before the debt bubble gets too big.
This might be proven to be genius; China might achieve what no economy has managed to achieve before, but history is working against them. Japan, South Korea and the US have all failed at attempts to use debt to fuel investment cycles beyond their natural conclusions.
They might manage the perfect landing; but why would we risk our money on it?
If you believe that China can make this work, resource equities will offer good value. If not, it’s time to rotate into much more defensive positions.
Steel is used in this article as an example only. Industrial capacity in China is far in excess of global demand levels across many sectors, particularly steel, coal, cement and other heavy industrial products. China has similarly aggressive targets for reducing coal production, for example, with 83% of coal related companies in Chongjing municipality, alone facing forced closure.
For Australian investors there are two relevant issues at play:
- A bursting of the debt bubble will likely result in a hard landing, devastating for the Australian economy
- If China doesn’t reduce capacity and instead chooses to encourage more investment in its industrial sector to maintain GDP growth, excess capacity globally will get worse, lowering global inflation and forcing interest rates even lower for longer.
- Resource company bonds – Regardless of the outcome on the capacity issues in China, low cost commodity producers such as Fortescue, Newcrest or BHP should be able to maintain strong free cashflow, ensuring payments are made on bonds. This is because even in the worst case scenarios where a debt crisis results in the bankruptcy of many of the smaller producers, China’s large producers, the ones that are efficient and profitable already, effectively underwrite their cashflows for decades to come.
- Short AUD – In the hard landing scenario, an increasing possibility, with growing debt used to fund inefficient industries, the best place for Australian investors to be is outside Australia. The US economy remains the strongest global performer and certainly has the best outlook. With the AUD stubbornly remaining above 75c against the USD, now is a good time to be looking at USD denominated lower risk investments such as corporate bonds.
This is Part Three of a four part series on the big picture facing Australia’s most important trade and investment partner.