China Cuts Overproduction Dramatically

China’s government moved dramatically in 2016 to cut bloated overproduction that threatened global supply and prices, chopping 65 million tonnes of steel production and 290 million tonnes of coal capacity, according to a new report by the Swiss investment bank UBS, and is expected to meet or exceed similar targets by the time figures are totaled in 2017.

There had been concern on the part of western economists that China’s continued massive overproduction would result in the dumping of cheap steel, aluminum and other commodities on world markets, depressing prices and overwhelming producers.

In addition to abating those concerns somewhat, the massive cuts in production also indicate Beijing’s commitment to cleaning up its immense environmental problems, even at the result of causing economic pain both to the macro economy and individual workers.

In addition, the country’s intensive campaign to remedy its horrendous air quality is expected to slightly weaken gross domestic product growth in the fourth quarter of 2017 and the first quarter of 2018 as the government continues to seek to cut excess capacity. Coal-fired plant capacity is expected to fall inexorably. That is in sharp contrast to decades of economic growth at any cost that propelled China into the top ranks of the world’s economies and contributed to wrecking its environment.

While the US ignores problems

The government’s commitment to cut hundreds of millions of tonnes of coal production, at least partly to meet global greenhouse gas commitments and its own environmental commitments, also stands in marked contrast to the United States, where President Donald Trump ordered the United States out of the United Nations-sponsored Paris Climate Agreement dealing with greenhouse gas emissions mitigation, adaptation and finance starting in the year 2020, ordered the firing of US government climate-control officials, and ordered increases in coal production.

The 16-page report, titled China Economic Perspectives: Capacity Reduction and Air Quality Campaign, was written by economists Ning Zhang, Tao Wang and Benson Chen. It was published on Nov. 28 and said that coal production restrictions, illegal steel capacity closures and tighter environmental rules have all helped to restrain supply, although at a cost, with as many as 2 million workers in related sectors to be affected, either forced to take lower wages or to be furloughed, at least temporarily.

Making the cuts has been a gargantuan task. Since the Communists took over China in 1949, local and provincial cadres have seen that their path to success within the party lay with meeting or surpassing production targets. In addition, particularly in coal, the problem has been exacerbated by the fact that provincial government figures have been illicit owners of many mines and factories their profit has hinged directly on keeping illegal facilities open and producing.

“We estimate that the 2 + 26 cities (Beijing, Tianjin and 26 other cities in the smog-plagued provinces of Hebei, Shandong, Henan and Shanxi) air quality campaign will potentially cut 10 percent of China's steel, 13 percent of cement and 6 percent of aluminum production during the peak heating season” between Nov. 15, 2017 and March 15, 2018, the authors write.

Net drag on economy

“We see a net drag of around 0.1 percentage point on fourth-quarter 2017 GDP growth and 0.2 percentage points on first-quarter 2018,” the report notes although the negative impact may be somewhat less given slower-than-expected demand growth, higher production in unrestricted areas and the later release of pent-up demand after mid-March.

Further capacity reductions in 2018, expected to reach 50 million tonnes of steel and 150 million tonnes of coal in 2018, are expected to cut another 0.05 percentage points off GDP growth. Tighter environmental rules and other production restrictions may have an additional negative impact.

Total job losses directly from capacity cuts could exceed 1.7 million in the four years 2016-2020, though two thirds of the cuts have likely already occurred over the past two years. While capacity reduction will continue to support producer prices and profits, such support is likely to fade in the upstream sectors in 2018.

In late 2015, China announced its plan to cut excess capacity as a key theme of its supply-side reform, aiming to reduce 140 million tonnes of steel capacity and 800 million tonnes of coal capacity over the following three to five years. That is the equivalent of 10 to 15 percent of overall capacity.

Production restrictions continue

Production restrictions and tighter environmental rules have helped to manage supply, the authors write. Apart from capacity reduction, direct production restrictions have been a key measure. The imposition of a cap of 276 days (from a normal 330 days previously) between May and November 2016 helped to reduce coal production by 9 percent in 2016, compared to largely stable domestic coal consumption.

Although the 276-day cap was relaxed in 2017, coal production has only grown by 6 percent annually in the year to date due to tight safety and environment rules and coal producers’ reluctance to increase supply.

Meanwhile, China’s ongoing tightening of environmental rules has restricted mining and materials production of small firms with high pollution and low energy-efficiency. Illegal capacity and production of steel has also been tackled, with as much as 125 million tonnes of illegal steel capacity shut off. Actual steel capacity reduction so far may have been much greater than what officially was announced.

Capacity utilization rises

The cuts across sectors have significantly improved overall capacity utilization, the authors write, with a sharp rebound among the 5,000 medium - and large enterprises in the annual People’s Bank of China survey. The national statistics bureau, which published industrial capacity utilization for the first time, indicated a rise from 72.9 percent in early 2016 to 76.8 percent in the third quarter of this year, the highest available reading since 2013.

Coal capacity utilization rose by 10.6 percentage points annually to 69 percent, with the steel sector up by 4.4 ppts annually to 76..7 percent. Coal and steel fixed asset-investment have continued to decline since 2013, shrinking their share in total FAI to only 1 percent in 2017, from 1.5 percent in 2015 and 4.6 percent in 2010.

“Excess capacity reduction will continue, increasingly with tighter rules of environmental protection,” the authors write. “In the recently concluded 19th Party Congress, excess capacity reduction continued to be prioritized as a key pillar of ongoing supply side reform, along with corporate (SOE) de-leveraging and environmental protection.”

Local governments suspend construction

Local governments, particularly the hard-hit cities of Beijing and Tianjin have agreed to suspend construction activity during the peak heating season from Nov. 15 to Mar. 15, with Tangshan cutting steel furnace operations to 43 percent from 75 percent in October.

The air quality campaign affects the regions that account for a sixth of China’s domestic production and a third of its metal production. The “2+26 cities” account for 16-18 percent of GDP and secondary sector value added, roughly a third of steel and aluminum production and 13 percent of cement production.

“If the campaign is expanded to all cities of these four provinces, then the “2+4 provinces” would be a bit more important, accounting for 26 percent of GDP, 30 percent of industry value-added, 43 percent of crude steel production, 38 percent of aluminum production, and 19 percent of cement production.”

The net impact on GDP and industrial production, however, is likely to be more moderate than the headline share of 2+26 cities as production in unrestricted areas picks up and industrial production and construction activities in the 2+26 cities rebounds after the peak heating season.