China's Overcapacity Problem

China's economic slowdown has been at the front of the business news for several months and has largely been blamed for the collapse in commodity prices and the concerns about future economic growth.  A recent examination of China's economic issues by the European Union Chamber of Commerce in China looks at one of the nation's key economic problems; overcapacity.

Overcapacity is defined as the difference between production capacity and actual production.  China has had an overcapacity problem for some time largely as a result of the lingering negative impacts of the Great Recession.  At the same time as stimulus investment was growing in China, leading to the building of new manufacturing facilities, the demand for Chinese exports was dropping.  Some of this over-investment is due to the significant surge in lending that was encouraged by the government during and after 2009 as shown on this graphic:

While credit growth fell significantly after 2011, you can see that it is total credit is still growing at between 15 and 20 percent plus on a year-over-year basis.

While China's overcapacity problem has grown worse since the Great Recession, it was a problem well before that.  In the late 1990s, then Premier Zhu Rongji shut down state-owned enterprises which resulted in the sudden unemployment of nearly 40 million industrial workers.  This move was made to combat China's significant over-investment problem, a problem that was not noticed globally because China was not integrated into the global economy so its overcapacity problems did not result in a large trade surplus.  After 2002, (i.e. after China joined the World Trade Organization), China's heavy industry expanded exponentially with the size of heavy industry production growing threefold in five years.  This expansion started another round of overcapacity.  Prior to the 2008 global economic retrenchment, China's excess production over domestic needs was absorbed by the global economy with exports acting like a pressure release valve on China's economy.  Once the global economy slowed in 2008, that pressure release valve disappeared and, what made the situation even worse for China, was that its production capacity continued to grow.  To respond to the Great Recession, the Chinese government created a massive fiscal stimulus package that targeted infrastructure investment, mainly in the expansions of Chinese state-owned enterprises.  This created a situation where manufacturing company's fixed asset investments by an average of 18.8 percent on a year-over-year basis between 2009 and 2014.  This massive over-expansion into questionable projects has led to significant market distortions and problems for China's banking sector which is facing major growth in their portfolios of bad loans.  In fact, the size of non-performing loans grew by $76 billion (USD) during the first ten months of 2015 to $291 billion (USD) and the average ratio of commercial banks' average non-performing loans grew from 1.6 percent at the beginning of 2015 to 2.07 percent ten months later.

With that background, let's look at China's overcapacity/underutilization problem.  There are eight industries that have been severely impacted by overcapacity:

1.) crude steel

2.) electrolytic aluminum

3.) cement

4.) chemicals

5.) refining

6.) flat glass

7.) shipbuilding

8.) paper and paperboard

Here is a graphic that shows the dropping utilization rate (inverse of the overcapacity rate) for six key Chinese industries:

Overcapacity is a bigger problem in economic sectors that are either low-tech or where technology is cheap such as the steel and cement sectors since it is easy and relatively inexpensive to set up new production facilities.

Let's look at one of these sectors; steel, an industrial product that was very important to the economies of the United States, the United Kingdom and Canada in the past.  Despite the fact that China has very little of the key inputs for steel manufacturing (i.e iron ore, coal and scrap), it is the world's largest producer of steel with China's steel production growing by 52 percent between 2004 and 2014.  China now produces over half of the world's steel or more than twice the output of the next four steel producing nations combined as shown on this graphic:

Interestingly, steel exports from China to both Korea and Japan rose sharply between 2009 and 2012 while Korea and Japan remained major exporters of steel to the United States.

This growth in Chinese steel production took place for two reasons:

1.) government support for what was deemed a "strategic" industry.

2.) rapid growth in infrastructure spending including real estate, machinery and the automotive industry.

This resulted in capacity growing by 496 million tonnes between 2008 and 2014 with production reaching 1.14 billion tonnes annually.  Unfortunately, between 2008 and 2014, utilization dropped from 80 percent to 71 percent and overcapacity grew from 132 million tonnes to 327 million tonnes.  To put these numbers into perspective, in 2015, the United States produced 88.2 million tonnes of steel and Canada produced 12.7 million tonnes.  

While the Chinese government has taken tentative steps to curb overcapacity in the steel industry, its moves have been less than effective at cutting steel production.  Rather than reducing capacity after the Great Depression cut the global demand for steel, the Chinese government's massive economic stimulation package has actually contributed to the overcapacity problem.  A study by HSBC in late 2015 suggested that even though 50 million tonnes of capacity was either eliminated or suspended during the first eleven months of 2015, a further 120 million tonnes would have to be cut during 2016 to bring the steel industry back up to a utilization level of 80 percent.  As I noted above, this is 150 percent of the amount of steel produced in the United States in 2015.  This would certainly result in the permanent layoffs of tens of thousands of labourers and would likely create social unrest.  Oddly enough, one of the reasons why it is so difficult to cut steel production is that many mills find it cheaper to maintain high production levels because they are saddled with very high levels of debt that need to be serviced.

One of the areas of growing global concern are China's mounting exports of steel.  Between January and October 2015, China's exports of steel to the European Union grew by 41 percent over the same period in 2014 following growth of 49 percent between 2013 and 2014.  China's steel exports to the United States grew 20 percent on a year-over-year basis from 2014 levels, hitting 112.4 million tonnes in 2015.  The fact that the United States is currently the only growth economy in the globe is proving to be a tempting export target for China's steel inventory, creating a situation where illegal dumping of low-cost Chinese steel is displacing more expensive American-produced steel.  While the report is a bit dated, a mid-2014 study by the Economic Policy Institute suggested that imports have caused a significant decline in steel employment as shown on this graphic:

   

This allegedly dumping has recently led the U.S. Department of Commerce to impose a duty of 227.29 percent on imports of cold-rolled steel and 225.8 percent on imports of corrosion resistant steel from China.  The EU has imposed tariffs of up to 25.2 percent on cold-rolled stainless steel sheets from China.  These countervailing duties will certainly create additional trade strains between China and its trading partners and, in addition, will cost America's consumers in the long run as prices for everything that contains steel will rise. 

As we can see from this posting, China's overcapacity problems are creating a global pandemic of dropping prices (i.e. the central banker's most dreaded issue - deflation) for primary manufactured products.  The global trade agreements, particularly the 2001 agreement that saw China join the World Trade Organization, have resulted in a series of unintended consequences, not the least of which is massive overcapacity in China's manufacturing sector, an issue that is now inflicting additional pain on the global economy.