China: Surplus capacity is the challenge – BBH

Research Team at BBH, suggests that making room for China in the global economy was always going to be difficult, but it is taking place.  

Key Quotes

China is the host of the G20 this year, and in a few months, the yuan will formally join the SDR, even though its role in the world economy is considerably smaller than the other components by nearly every relevant metric.

It is not that China insists on closely managing its currency.   Rather, the larger and more profound challenge is the vast industrial capacity that China has built.   It aggravates the excess capacity that may already exist in some industries in the US, Europe, and Japan.  It may be another source of deflationary pressure on good prices.   It affects the international terms of trade (manufactured goods prices relative to raw material prices).  

It appears that there are a limited number of ways to address excess capacity.  First, mind new markets for the products that outstrip domestic demand (exports).  Second, close inefficient (high cost) producers (bankruptcies).  Third, encourage industry consolidation (horizontal merger and acquisitions.  

Each of these approaches is problematic for the Chinese steel industry.  It exports have begun triggering a protective response by those export markets.  

China's largest steel producers are state-owned.  It can force industrial consolidation relatively easier compared to the challenge of facilitating the industrial rationalization when the major agents are privately owned.

Despite a previous round of consolidation, China's steel industry remains fragmented, which presents all sorts of coordination challenges.  

Chinese Premier Li was quoted in the local press acknowledging that less than a third of the coal and steel reduction targets have been achieved.  Reports suggest that the pace of mine shutdowns is running ahead of government target, which may have helped support iron ore and coking coal prices.  

The US Commerce Department estimates that the US steel trade deficit widened by nearly 350% between 2009 and 2015.  The US is the largest steel importer in the world, and its imports have rebounded to pre-2008 levels while exports are flat.  Chinese figures indicate its steel exports rose nearly 380% in the same period, while its imports fell 40%.  

China's excess capacity in a large number of industries is a major strategic challenge.  The steel industry is a great case study.  A significant devaluation of the yuan would raise the prospects that China will try to export its surplus.  This would not only represent a challenge to foreign producers, fueling protectionism, like India's MIP (minimum import price regime), but it could be a new source of deflationary pressures.”