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Tackling China’s Latest Steel Bubble: Implications For Petrochemicals

Business, China, Company Strategy, Economics, Environment, US
By John Richardson on 20-Feb-2017


Note: A technical fault meant I was unable to update the blog on Wednesday and Friday last week. Business as usual returns this week.

By John Richardson

THE stop, start nature of economic reforms in China, which is the result of the battle between the reforming “princeling” politicians and the “populists” who want to maintain the status quo, is perfectly illustrated by what happened in China’s steel industry last year:

  • China announced in late 2016 that it had achieved its ambitious targets for cutting steel capacity.
  • But it is instead the case that most of the plants that were closed down were already idled.
  • Meanwhile, the restart of old plants and new builds resulted in a net increase in operating capacity of 36.5m tonnes.

The longstanding problem is that economic reforms in the short term cost jobs and growth whenever China makes serious efforts to escape its middle-income trap, deal with its bad debts and tackle its environmental crisis.

Provincial governments thus battled hard in 2016 to keep plants running and add new capacity for the sake of local employment. And central government politicians, perhaps supported by Prime Minister Li Keqiang, may well have had a hand in allowing this re-inflation of the steel capacity bubble for the sake of shoring-up last year’s GDP growth. Li falls into the populist political faction.

There is a positive aspect to all of this in that some of this excess steel was used for infrastructure projects in inland, or western, less-developed China. Better roads and bridges etc. do fit with the long-term aim of using the One Belt, One Road initiative as route for escaping the middle-income trap.

But I would argue that, on balance, the negatives of more pollution, and bad debts etc. of higher steel capacity outweighed the positives.

What Happens Next?

Li is widely expected to step down as Prime Minister in March 2018, a move that will be confirmed at this autumn’s 19th National Party Congress. The congress is also likely to see President Xi Jinping, the leader of the princeling faction, increase his influence over the politburo – China’s top governing council.

Ahead of the autumn meeting it thus seems quite possible that Xi will once again push the foot down on the accelerator pedal of economic reforms of old, heavy industries in general. This would mean real, effective closure of steel capacity rather than last year’s on-paper shutdowns.

Why? Because Xi seems to know to that China is facing a race against time. The longer that China delays reforms, the greater the risk of long-term economic stagnation because of a rapidly ageing population, unsustainable debts and levels of pollution that no country has ever experienced before. So he may decide to waste no more time by biting the bullet now of painful, but necessary, capacity rationalisation.

There is another risk if Xi wastes more time, and that is anger in the US and Europe over low-priced Chinese steel exports. With Donald Trump already in the White House – and Marine Le Pen with an outside but not-to-be-underestimated chance of winning the French presidency in May – the West is moving towards greater protectionism. Further aggressive, low cost Chinese steel exports could be one of the catalysts that drags the world into a global trade war. The lost growth that China would suffer from such a trade war would make its essential economic reforms even harder.

Events could of course go the other way. Up until the all-important 19th National Party Congress, Xi may lack the authority to accelerate reforms. Without his key people in place, he could find it politically impossible to shutter steel and other oversupplied industrial capacities.

Xi may also calculate that he needs to steady the economy until the congress. He may decide that the short term pain resulting from closing steel and other oversupplied industrial capacity would be too politically risky – i.e. it would jeopardise his chances of getting the key people in place that he needs to achieve his long-term reform objectives.

Want my opinion? I think Xi cannot afford to waste any more time on reforms, and so will press ahead with steel and other capacity closures in 2017. Even just a few more months of kicking the can down the road is too risky.  Bad debts have already reached levels that risk an economic crisis – and the net loss of political capital from not doing enough to deal with the environmental crisis would be just too great. The rise in steel output is said to be a major reason behind worsening air quality in Beijing.

The biggest single reason not to delay any further is the trade factor. Even if China can demonstrate that its increased steel output in 2016 didn’t add to oversupply in global markets, perceptions matter. In today’s febrile political climate in the West, in today’s post-fact world, even the impression that China is flooding global markets with even more “state-subsidised” steel could be enough to tip the balance towards a global trade war.

What does this mean for petrochemicals?

There is a connection here with China’s polyethylene (PE) operating rates which I shall discuss in detail on Wednesday. This relates to the surge in coal prices in 2016 that was partly due to the resurgence in steel prices. This led to lower-than-expected operating rates at China’s coal-to-PE plants, and thus supported PE imports. One scenario that I will discuss on Wednesday is that reduced steel capacity might help drive coal lower prices and China’s PE operating rates higher.

But more broadly here, all of the above shows how following government policy is critically important for understanding petrochemicals in China. Standard, Western cost curve analysis by itself simply doesn’t work in tracking growth in the country’s petrochemicals supply and demand. What you also need to do is get the right people in place to interpret government policy.

Again using steel as an example, if you had the right people in place you would have predicted lower coal-to-PE operating rates in 2016. You would have also foreseen the boost to short term economic growth – and so, of course, petrochemicals demand – that resulted from the rise in steel capacity.

There are two more key messages or petrochemicals – probably the most important messages. Firstly, steel and other capacity closures would of course lower petrochemicals demand growth as the economy decelerated. And secondly, iron ore prices would be the first to fall – as of course they would be most immediately affected by lower steel production – followed by oil price.