Thursday, Nov 27, 2014, 5:55 AM CST – China

Economy

Industrial Overcapacity

BLACK LISTS, RED TAPE

Does overcapacity get a bad rap in China? Are the government’s continuous crackdowns on this opaque issue actually a symptom of the broader dichotomy of private versus public commerce?

A Chinese worker stands on rolls of coiled steel rods at a processing plant in Huaibei, Anhui Province, July 30, 2013 Photo by IC

Piles of coal at the port of Qinhuangdao, Hebei Province, July 6, 2009 Photo by IC

Fashions change fast. Sometimes so fast that ordinary consumers are struck with déjà vu as often as inspiration. Economics too has a cyclical feel to it. Over the past decade, China’s economy succumbed to a trend towards overcapacity in a vast range of industries, with output often exceeding demand by multiple percentage points.

Although policymakers and analysts have done their best to derail the fad for prioritizing production targets over efficiency and marketization, China’s overcapacity problem has got worse as economic growth has slowed.

On July 19, 2013, the Ministry of Industry and Information Technology (MIIT), China’s primary industrial agency, waged another attack. Hundreds of enterprises operating at overcapacity were given 4 months to shut selected projects down permanently. The 19 industries hit included iron and steel, cement, electrolytic aluminum, coke, paper, lead batteries and, unusually, flavor enhancers.

Most of these sectors had already been named and shamed for overcapacity problems since the government began to take the problem seriously in 2001. However, as MIIT minister Miao Wei acknowledged in a recent interview with the Economic Daily, newly installed capacity in these sectors has “far exceeded what has been eliminated” in over a decade of crackdowns. Miao added that more lists would follow, raising hopes that, unlike during previous crackdowns, the name and shame strategy might actually pay off.

However, others have called into question the government’s official perspective on overcapacity. Some have even questioned whether the government and State-owned enterprises, themselves the inadvertent architects of China’s overcapacity problem, are the best people to be assessing and attempting to rectify it.

Popsicles and Pig Iron

In the late 1990s, Chinese people, most of whom had grown up accepting scarcity and want as a part of life, suddenly discovered surpluses of almost everything. Particularly plentiful were the products of State manufacturing – first textiles, then iron, with other products to follow. The government responded with sporadic cutbacks, censuring industries operating at overcapacity and waiting until equilibrium returned before removing restrictions.

However, China’s official protocols to determine the existence and extent of overcapacity have been somewhat ad hoc. Typically, investigators first try to establish the capacity utilization rate – the ratio of real output to installed capacity – a figure notoriously difficult to verify without multi-layered parallel investigations. In China’s case, analysts typically cite poorly sourced and defined “international standards” or “the US experience” to declare a utilization rate below 75 or 80 percent “unacceptable.”

The second principle determining factor for overcapacity is summed up as “poor profit margins,” a nebulous term which means completely different things depending on the industry under investigation.

Even the IMF, in a report published last year, claimed that the bulk of industries in China were operating at overcapacity, but provided no detailed data on how they reached this conclusion.

The manifold flaws in reasoning are exemplified by the way the State has treated its iron and steel industry. In a recent interview with State broadcaster China Central Television (CCTV), Executive Deputy Secretary-general of the China Iron and Steel Association (Chinaisa) Li Xinchuang admitted that his industry’s utilization rate was currently well below the 75 percent red line.

Li’s interviewer cited industrial data to prove that for some time in the first half of 2013, the profit made on one ton of iron was not enough even to buy a cheap popsicle. A few years ago, the profit on one ton of iron was enough to buy, according to the same interviewer, “a US$200 cell phone.”

While China’s iron and steel industry has been blasted for its inefficiency for over a decade, senior executives with Chinaisa, including Li himself, claim that there “was no such thing” as overcapacity in the sector between 2001 and 2011, when China’s iron and steel concerns were operating at an average 80 percent capacity. This was thanks largely to the central government’s massive expansion of infrastructure, particularly railroads, and a booming property market, which also allowed the cement, timber and glass industries to all enjoy similar prosperity.

However, in an economy as fast-changing as China’s, the business cycle is very difficult to predict. Coal, for example, has been on the government’s overcapacity hit list for years, even during the coal rush of the early 2000s. This has led to a number of shortages, most recently in 2010 when local governments in some coal-rich areas restricted transportation to secure a local supply. The National Development and Reform Commission (NDRC), China’s most powerful macroeconomic planning agency, ultimately had to intervene to prevent an embarrassing shortfall in the national fuel supply.

In 1999, the central government, worried about overcapacity in the power industry, declared a three-year moratorium on “big power projects” policy. In 2003 power shortages that had begun in 2001 led to rolling blackouts across the country, again, to the embarrassment of the central authorities.

Misguided

From a broader perspective, the government’s persistent and prevailing aversion to excess capacity in China is confusing. The US Federal Reserve’s own monthly data on the industrial utilization rate shows that at most times since 2000 the industrial portion of the US economy has operated well below 80 percent of full capacity, even falling below 75 percent in sectors like chemicals, computers and transportation equipment.

Even when it comes to profit margins, overcapacity is often wrongly pilloried ahead of more important problems. China’s integration into the world economy has naturally led to squeezes in sectors which previously had little or no domestic competition. China is heavily reliant on imported iron ore, which has retained a consistently high price tag which has prevented manufacturers from cutting costs. China’s iron and steel products are also now subject to anti-dumping investigations and tariffs in the EU and the US, further depressing growth in the sector.

Domestic coal prices, too, have been hit hard by falling international demand for coal in the wake of the shale gas revolution beginning in 2012, as well as the EU shift towards renewables. Domestic coal producers had to reduce their prices to compete with cheaper imports. As a result their returns could hardly cover their costs.

Statistics released at the end of 2012 by the Organization of Economic Cooperation and Development (OECD) estimated that China’s iron and steel making capacity utilization rate stood at 78 percent, one of the highest rates in the world, putting China ahead of the EU and Japan. Despite this, neither the EU nor Japan has ever launched countermeasures in response to industrial overcapacity, instead trusting the market to absorb excess and supplement shortage. Officials in these countries might well wonder why overcapacity is such a sensitive issue in a country with a growth rate like China’s.

While the US also red-flagged overcapacity in some industries from the 1960s onwards, blaming the problem on rising overseas economies undercutting American manufacturing – first Germany, then Japan – little was made of the overcapacity problem outside of government committees. China’s somewhat overzealous persecution of industries at overcapacity has confused analysts and, seemingly, policymakers, in its severity.

Selective Targeting

Others have questioned why other sectors, many of them notorious for their overcapacity problems, have not made the list even as minor offenders have had their names dragged through the mud.

Before China ascended to the WTO in 2001, countless surplus made-in-China consumer products, particularly apparel, shoes, refrigerators and TVs simply piled up in domestic warehouses, yet manufacturing barely faltered. While China had a decade in which to flood the international market with cut-price consumer products, these industries never saw capacity as a concern.

Even as the world economy has contracted and demand for these goods has fallen even further, no apparel or electronics companies made the government’s overcapacity hit-list. Indeed, it is hard to find sectors that are not operating below capacity, and yet the State seems concerned with only a handful of industries. Why?

Perhaps it is to do with State interests. Nearly all the sectors on the Chinese government’s overcapacity blacklist are those in which investment decisions are subject to the approval of various central government agencies, in particular the NDRC.

Agencies with approval power don’t want to lose this lucrative and influential status. Because a lot of capacity in China is installed without approval, enterprises, particularly small, private concerns tempted by favorable land and tax policies, were accused of conspiracy with GDP growth-hungry local governments.

He Keng, vice chairman of the Finance and Economic Committee of the National People’s Congress, said in an interview with CCTV on August 6 that it is time to let the market, not the government, determine the direction of capital in China’s vast industrial network. While some continue to justify government meddling in China’s marketplace on the basis that the economy is still not fully developed, this mindset, according to Professor Lu Feng, Director of the China Macroeconomic Research Center at Peking University, is “based on the assumption that the government is smarter than the market, something which may not necessarily be true.”

At a June forum sponsored by the NDRC, honorary chairman of the China Chamber of Commerce for Metallurgical Enterprises Zhao Xizi complained that the most serious surpluses in China’s iron and steel sector capacity were in the production of steel sheeting, the only product which can be produced in the massive blast furnaces mandated in all State steel plants by the NDRC. This is one isolated example of the State attempting to direct the market – and misjudging demand at a cost to both the government and enterprise.

While academics like Lu agree that governments can and should use their considerable resources to take the lead in areas such as data collection, this data should only be used to inform and assist – not to govern and control – investment.

Professor Lu’s research has proven that the sectors targeted in crackdowns on overcapacity are mostly areas in which SOEs compete directly with private concerns. In the iron and steel industry, for example, private manufacturers account for a full 50 percent of total output. Once a sector is labeled as at overcapacity by the government, private investors are normally the first to suffer.

In 2002, Dai Guofang, an ambitious private investor in Jiangsu Province, launched an iron and steel project which continuously expanded with the full support and encouragement of the local government. Two years later, the project was suddenly defined as illegal by the central government. The local officials involved in the project were dismissed or penalized by the central government, and Dai was stripped of his assets and jailed for five years.

With smaller projects easier to liquidate, SMEs and their non-Party personnel are easily pillaged or forcibly assimilated into SOEs in the name of environmental protection, employee safety or industrial restructuring. In short, the government can, when suitable, deploy a “crackdown on overcapacity” to swiftly appropriate huge volumes of private assets.

Professor Lu is particularly opposed to overcapacity being equated with problems relating to environmental protection and health and safety. While overcapacity is a logistical issue and should be dealt with according to market principles, Lu argues, environmental protection and health and safety issues should be dealt with according to the law. This simplistic, scattershot approach to economic regulation only serves to exacerbate China’s already massive industrial inefficiencies, and is often little more than a smoke-screen for seizures of private assets by a rapacious and underperforming State sector.

In 2008 and 2009, several provinces nationalized coal mines entirely at the expense of their former investors. In 2009, a profitable private steel maker in Shandong Province was forcibly sold to the loss-making State-owned Shandong Iron and Steel Group. Not only do such actions as these do nothing for the efficiency of the seized enterprises – indeed, they often make them less efficient – they undermine competition and often further exacerbate existing problems in the vast State sector.

Analysts like Lu believe that only the efficiencies of marketization can eliminate the overcapacity problem as well as force the far more important reform of the inefficient State sector.

However, for the government’s overcapacity watchdog, for now, it is business as usual.

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