In a precarious state

Earlier this year Warner Brothers released the film Man of Steel. It featured Henry Cavill as Superman, and proved popular with Chinese audiences (see WiC199) in spite of fairly mixed reviews. It did well elsewhere too, earning $658 million worldwide on a budgeted cost of $225 million.

You may be surprised to learn that makes Man of Steel more profitable than China’s steel industry. According to statistics from the China Iron and Steel Association, the country’s 86 largest steel firms made the equivalent of $359.5 million in combined profit in the first half of this year. Zack Snyder’s Superman flick, by comparison, made $433 million.

Of course, as WiC is the first to admit, Hollywood arithmetic is never quite that simple. Nevertheless, we think it’s telling that a film franchise looks to be a better commercial proposition than an entire steel sector, particularly one with production capacity accounting for roughly 66% of global steel output.

Of course, it’s not the first time we’ve told you that Chinese steelmaking isn’t very profitable (see issue 206 for the announcement that it was ‘officially’ China’s least profitable industry, having made a loss of Rmb699 million in June).

But it’s also a subject earning more local media attention in recent weeks. That’s because there are new fears that the industry could well become the biggest systemic risk facing the Chinese financial system.

A problem for the banks?

There has been much speculation on where the next round of bad debt might originate for the Chinese banks. Among the favourite candidates: overstretched property developers and highly-leveraged local government financing vehicles. But the Chinese press is starting to suspect that the first wave of loan defaults may come from the steel sector instead. Those very same poorly performing steel firms have run up Rmb3 trillion – yes, $490 billion – of debt. The Economic Observer – citing official data – notes that Rmb1.3 trillion of that is owed to banks.

Among those 86 debtors, 35 are losing money…

This has sounded alarms. Li Xinchuang, President of the China Metallurgical Industry Planning and Research Institute, believes that one or more of these steelmakers will default within the next year because they will not be able to refinance.

National Business Daily adds that more than 70% of the bank loans in the sector are short and medium-term. That means a large chunk of loans are set to expire within a year or less.

Given their losses, many of the steelmakers can only hope to repay outstanding loans by borrowing more money. But the Economic Observer says this is getting difficult because the State Council is telling banks to cut lending to industries facing overcapacity (of which steel is the worst, with Southern Weekend estimating there are 200 million tonnes of excess supply annually). Even without this guidance, the banks are waking up to the mess that the industry is in, as well as their growing exposure to its bad debts.

“Some mills have already failed to get new loans, and others are finding credit more difficult to get,” reports the Economic Observer, adding: “The financial data of the country’s key steel enterprises in the first half of this year show that in accordance with current operating conditions, when bank loans mature the likelihood of the steel mills repaying them is almost zero.”

So steel firms will default?

21CN Business Herald says that we have already seen a wave of defaults in a related business area: steel trading. The worst hit area is Jiangsu province, which now has the highest level of non-performing loans (NPLs) in the country owing to defaults by steel traders. The newspaper adds that the branch presidents of 10 banks in the province have already been dismissed for reckless lending to the sector.

Local governments are also getting much of the blame. During the boom times following the 2008 stimulus package they encouraged mills to build new plants or expand existing ones (to create jobs and tax revenue). According to National Business Daily, 400 million tonnes (i.e. 55% of China’s steel producing capacity) was covertly ushered through by local officials without central government approval.

The Economic Observer says many firms are still expanding too. A worrying example is Shougang which is said to make a loss of Rmb66 on each tonne of steel it sells (Shougang lost Rmb1 billion in the first half). However, it still needs to finance Rmb60 billion worth of new plant that it committed to build by 2015. Those mills will add millions more unwanted tonnes to the steel surplus.

More debt, more capacity, more losses. Little wonder that Southern Weekend concludes: “Right now it’s hard to find companies in worse shape than those in China’s steel industry.”

In the first half, the 86 biggest firms made Rmb2.2 billion. But their bank interest payments amounted to Rmb40.6 billion. Having borrowed too much, and built too much capacity, the steel industry now finds itself in an unsustainable position.

What to do next?

A series of steel industry defaults would see non-performing loans (NPLs) soar. The situation would be dangerous, given the likelihood that bankrupt mills will drag down other parts of the economy (for example, they’d default on monies owed to their suppliers).

That puts bankers in an awkward bind. Such then is the logic of Zhang Zheyi, deputy general manager of Hebei Baoxin Steel: “Now banks have begun to shrink loans, but they cannot directly stop lending, for if they stop lending, steel mills will go bankrupt and the banks’ losses will be greater.”

Hubristic local governments may be responsible for much of the industry’s overcapacity. But it is likely to be the central government in Beijing that will have to come up with a solution to the problem.

What needs to be done? For a start the industry needs to be returned to some sort of operational equilibrium, so as to return to greater profitability (average profit margins for the first half were 0.13%). This requires the shuttering of at least 200 million tonnes of steel capacity, targeting the oldest and most environmentally unfriendly mills.

It also means dealing with the debts on the books at many of these firms, especially in figuring out an orderly workout solution. In other words, entities will have to be created to warehouse the problem of the steelmakers and their unsustainable borrowings.

Fortunately for the Chinese authorities, they’ve done something like this before. Back in the late nineties four asset management companies were created to hive off the weakest assets from the balance sheets of the big four banks. Cleaned up, these banks were later listed on stock exchanges and recapitalised.

Those asset management companies are now back in the news. In fact, the boss at Huarong (which took much of the bad loans off ICBC, China’s biggest bank) gave an interview to Talents Magazine last week. Lai Xiaomin noted that Huarong had disposed of Rmb680 billion of non-performing assets over the last decade, but that business has now run its course. Instead, he suggested in the article that Huarong is searching for new fields of toxic waste to plough. Lai – who spent 18 years at the central bank and six with the bank regulator – says he is hopeful that Huarong will be permitted to buy the bad assets of non-financial institutions, both state-owned and private sector.

While Lai doesn’t specifically mention the steel industry, it could be a logical fit.

Last time around Huarong and its three peers got their capital from a 10-year low-interest loan from the central bank. This financed the purchase of the bad assets and offered the breathing space to sell them off.

How would a similar approach work this time around? With another injection of cheap capital from the state, firms like Huarong could acquire and shut excess steel capacity. Should conditions change, some of the plant could be upgraded or sold should demand for steel again exceed supply. In other cases, if the plant is on valuable land, a quicker return might be realised by selling plots to property firms.

And the banks? It wouldn’t be a perfect solution, but it would beat a wave of defaults. Indeed, by reducing capacity and putting the remaining steelmakers on a sounder financial footing, the bulk of their loans to the steel sector would become viable again.

As to the mechanics of the process, banks might be repaid a portion of the loans owed by the shuttered mills; but made to swap the rest into equity alongside the likes of Huarong.

Who might object? WiC guesses that local bureaucrats would be a key obstacle. A lot of the targeted steelmaking capacity is state-controlled and in many cases owned by local governments. City officials won’t be keen on having their mills mothballed or closed down entirely because of the subsequent hit to local GDP, jobs and tax receipts.

In fact, the industry regulators in Beijing have been trying to cut capacity for years, often with little discernible impact. There’s no reason to believe that resistance to a new plan to reduce supply would not be similarly fierce at the local level.

But there might not be any choice. Li Keqiang, China’s prime minister, seems to be upping the ante on initiatives in other areas of the economy, particularly the financial sector, with a warning this week that reforms were entering a “deep-water zone, or the most difficult phase”.

“I want to tell everybody that the Chinese economy is at a critical moment of transformation and upgrade, but the fundamentals of current economic growth are good and the economy operates with stability,” Li said.

Perhaps that’s just rhetoric designed to impress local leaders with the need for change.

But if newspapers like the Economic Observer are right, the clock is ticking on the steelmakers. And if nothing is done, the banks’ balance sheets could soon start to look a lot uglier because of their exposure to the precarious sector.

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