China's steel market - latest trends and implications

BOTH GOVERNMENT REGULATIONS AND MARKET FORCES ARE PUSHING THE WORLD'S LARGEST STEEL INDUSTRY TO CONSOLIDATE AND BOOST EFFICIENCY.

China's steel industry is young. Its success story began in the 1980s when the country started to use significant amounts of iron ore. Since then, the market has grown exponentially and become the world's largest in a breathtakingly short period of time. China not only accounts for one third of the world's steel production, but it is also the largest user of steel products, consuming a third of the global total. While these figures are remarkable, they become even more impressive when taking the consistently high growth rates into consideration: the Chinese steel market remains large and hungry.

Consolidating a fragmented market

According to China's Iron and Steel Association (CISA), major steelmakers are on track for another year of sizable profits in 2007. Market leader Baosteel Group reported a net profit of US$477 million in the first quarter of 2007, which is a 150% increase from the first quarter of the previous year. Most of the 4,500 companies registered in the Chinese steel market are made up of domestic corporations, as foreign investment is still restricted by the Chinese government and therefore comparatively low. Manufacturers come in all sizes, from small private companies to state-owned behemoths - a first indicator for the high level of market fragmentation. This impression is supported by the following facts: the top ten players in China's steel market have a combined market share of only 33% and only five players have a production capacity exceeding five million metric tons (mmt). In contrast, the top five players in Japan have a combined market share of more than 70%. In 2006, Baosteel Group created only one-fifth of the output of the globally leading producer ArcelorMittal. Consolidation in China's steel industry is imminent.

Although industry players have taken active steps in this direction, China's steel industry remains under Beijing's tight grip. Since the first state policy on China's iron and steel sector in 2005, the government has tried to shape the industry by elimination and consolidation. According to state regulations, smaller production facilities (blast furnaces of 300 cubic meters or less, basic oxygen converters of 20 tons and below and electric-arc furnaces of 20 tons and less) are to be eliminated. By July 2007, these regulations led to a closure of large capacities (8.1mmt) involving 62 enterprises across eight provinces and municipalities. The government is working on the creation of four steel production bases in Northeast China with Anshan Iron and Steel Group and Benxi Iron and Steel Group, North China with Shougang Group and Tanggang Group, East China with Baosteel Group and Magang Steel Group, Southwest China with Wuhan Iron and Steel and Panzhihua Iron and Steel Group.

Consolidation pressure in China is additionally increasing due to financing regulations. Even though big players finance more of their investment projects through the injection of funds or by investing in financial markets, bank loans are still the main source for project funding. Small and inefficient players face unprecedented challenges in getting financial support since the government has tightened bank loan regulations at their expense.

While the government is pushing hard to consolidate the steel industry through regulations, market forces are doing the same. An expected 25% rise in the cost of iron ore combined with an expected drop in steel prices at the beginning of 2008 may allow China's large steel companies to acquire their smaller rivals. This might not completely achieve Beijing's goal of removing 55 million tons of outdated steel capacity, but it will be a step in the desired direction, and it fits the expansion plans of key market players. Baosteel Group expects to expand its production capacity by 13% next year via acquisitions.

Sustainability in the face of scarce resources

Industry consolidation also facilitates technological development. Since the Chinese government has set long term goals of reducing energy and raw materials consumption in the interest of sustainable development, major steel companies are making efforts to launch a new industrial model with higher efficiency and less emission. Foreign investors play an important role in this regard - by forming partnerships and strategic alliances with local steel enterprises and by bringing in capital and technology. Wuhan Iron and Steel Group is planning to cooperate with General Electric to establish the largest blast furnace gas power plant in China, which may reduce emissions by two million tons of carbon dioxide and generate 2.4 billion kilowatt hours of electricity a year. First steps towards the ambitious goal of sustainability are underway.

The cost structure of steel industries is primarily comprised of iron ore, coal and shipping cost. Although China is self-sufficient in providing the amount of coal needed for the industry, local iron ore mines are still too scarce in quantity and too poor in quality to satisfy domestic demand. China has imported over 220 million tons of iron ore in the first half of 2007, which is more than 50% of the country's total consumption. This dependency on imports makes China's steel industry vulnerable to global price fluctuation. At the same time, rapidly rising shipping costs are putting pressure on Chinese steelmakers. As an example, the shipping rates for iron ore between Brazil and China have increased by more than 200% from January to October, 2007.

Confronted with these massive challenges, major steel players have made investments in order to secure iron ore supply and stabilize costs. Shougang Group has started the first phase construction of a 600,000-ton capacity project in a high-phosphorus iron ore mine in Hubei Province's Changyang county. Baosteel Group, while developing iron ore supplies from Australia, Brazil and Africa, is also planning to tap unexploited iron ore resources in northwest China's Xinjiang and bordering countries of Central Asia. Wuhan Iron and Steel Group is taking a different route: the corporation has signed a contract with China Shipping to guarantee shipment of its imported iron ore for the next 20 years.

Export controls

Apart from these structural problems, external pressure is forcing the government to control and regulate the industry. In the face of anti-dumping complaints from the United States and European Union, active measures have been taken to curb exports in 2007. For a total of 83 types of steel products, the Chinese government cancelled value-added tax rebates and levied a 5% to 10% export tax. These products include wire, hot-rolled plate and steel sections. In addition, each time they export, companies will have to apply for a license - which is only valid for three months after issuance. At first glance, government measures appear to be successful, showing a month-to-month decrease. Critics, however, do not expect the situation to improve significantly in the foreseeable future as long as international demand for steel remains high.

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