The continuous decrease of China’s industrial indexes in recent months has made China’s economic slowdown increasingly obvious. This decrease results from a declining share of investments in GDP, the will of government to shift its economic model toward more domestic consumption, services and higher value added industries, but also the massive over-capacities plaguing various industrial sectors and tremendous inefficiencies. As of today, Chinese over-capacities in steel production are estimated to twice the European demand

The graph below illustrates the declining growth of industry while services, such as finance, are fast growing. However, it should be noted that wholesale and retail sales also declined and that the growth of tertiary sector is driven by the very rapid increase in financial growth partly coming from the massive equity bubble and bust through H1 2015.

China GDP Growth Sectors Sept 2015

The slowdown of China’s industrial and construction sectors has severely hit heavy industries such as mining and metals (M&Ms). Indeed, China represents around 50% of the world’s steel and aluminum production and consumption and is by far the world largest consumer of minerals. As a result, even a slight decrease in demand creates large pressures on hard commodities prices.

A question worth asking is thus: who pays for Chinese over-capacities?

In the mining sector, China should have closed some iron ore mines to face with the declining demand and falling price of this mineral, especially as China runs iron ore mines with the highest production costs among the world largest producers, making them unprofitable at current prices (see figure below). In the steel and aluminum sector, China should also have decreased its production capacities to reduce oversupply and maintain sustainable prices for the industry, especially as China has some of the highest production costs of aluminum, which are now 14% above market prices, making many businesses running at a loss.

2015 Global Iron Ore Production Costs

Iron Ore Prices 2000-2015 Sept

But while these policies may not make sense from an economic point of view, China decided to implement a different strategy, leading to massive over-capacities and a fall of prices in worldwide markets:

  • In upstream markets (mining), even if the smallest and most unprofitable iron ore mines closed, leading to a decline China’s iron ore output (down 10% H1 2015), a lot of unprofitable mines keep running. In global commodities market, an insufficient reduction of domestic production combined with a declining demand led to a collapse of raw material prices in international markets (-50% between February 2014 and February 2015 for iron ore, similar trend for other raw materials).
  • In the steel and aluminum industry, while China closed some old plants it started new and more efficient production factories, preventing the reduction of over-capacities.
  • The main consequences of these developments occurred in sales: as domestic production remains at a high level while demand is declining (-4% in 2015 for steel), China increased its exports in order to find new end markets. Between 2013 and 2015, Chinese steel exports doubled, leading to a global collapse in prices, probably even below Chinese production costs. The graph below highlights the evolution of export price of Chinese Hot Rolled Coil (used in automotive and packaging industries for instance); the trend is the same for other steel materials such as slabs.

Commodities Metals Index 2015

China Export Hot Rolled Coil Prices 2015

China made this choice for 2 main reasons:

  • Preserve a certain level of autonomy and independence, especially in regard to raw materials supply;
  • Maintain the government’s credibility as well as domestic stability by leading an economic policy enabling a growth of real income and avoiding a large increases of unemployment.

To reach these goals, the Chinese government is willing to subsidize unprofitable companies and businesses during the time needed to operate a change of business model. Unlike Western countries and companies, profitably is not the major concern. Indeed, Chinese politics always give strategic priority to their country‘s stability and harmony. Consequently, China has to pay the price of this choice by supporting domestic companies’ losses, but because China is the ‘key’ producer and consumer in these industries, this strategy has major consequences for the rest of the world, companies and countries alike.

Foreign companies specialized in mining benefited from China’s exceptional demand growth for all kind of raw materials over the last decade, but they now suffer from the Chinese economic slowdown (and correlated over-capacities).

When China’s demand for raw material such as iron ore, bauxite, zinc and copper started to slowdown, main mining companies (i.e.: BHP Billiton, Rio Tinto, Vale, Glencore Xstrata, Anglo American…) decided not to reduce their production output. They let prices fall in order to “force” China to close its unprofitable mines and rebalance global demand and supply. Prices fell accordingly, but capacities did not decline as China kept running most of its mines, leading to further prices declines.

Then, it seems that mining companies accepted these low prices and entered a power struggle with China. The “fight” continued until several companies, seeing their share price collapsing and threats building on their balance sheet as China was maintaining its capacities, decided to close some mines. For instance, Glencore announced the closure of copper mines in Africa and cut zinc production in Australia and South America to reduce their output by 20% for copper and 33% for zinc, while Anglo American decided to reduce iron ore production in Brazil.

The graphs below shows selected mining and integrated metal companies’ share price since January 2010.

M&Ms Share prices

Integrated companies have some mining activities but their core business is the transformation of raw materials. They have been hurt on their entire value chain by China’s slowdown and strategy.

In upstream production, Alcoa reduced its bauxite production, ArcelorMittal slowed down the development of iron ore mines in Africa and Tata steel is reconsidering investments in iron ore mines in Canada.

In finished or semi-finished products, foreign companies also suffer from booming Chinese booming Chinese cheap exports. Due to this competition, Alcoa closed several refining and smelting plants around the world and the group announced its split into two parts to better deal with the massive expansion of Chinese supply. In the UK, Sahaviriya Steel and Tata Steel halted operations of 4 steel plants to reduce losses due to the competition and low prices of Chinese steel. After few month of discussion, Tata Steel also failed to sell its long products division, the potential buyer, Klesch Group, explaining that Chinese exports make the production unprofitable. ArcelorMittal closed a plant in the US and thinks about the future of some other factories in the country; in South Africa the group is asking the government to increase imports tariffs to prevent from Chinese exports.

In light of these developments, it appears that, to stop the fall of prices and profitability, M&Ms markets need to re-balance by reducing supply. However, China is not willing to decrease its production capacities and entered a power struggle with the aim to “force” foreign competitors to shut down their unprofitable plants. For China, subsidies are an immediate cost but this strategy shows signs of progress, even though this translates into the destruction of thousands of jobs in developed countries as well as in developing countries producing raw materials.

Countries usually fight against Chinese subsidized exports with anti-dumping cases and trade tariffs. Some have already been implemented on few metal products and additional are under investigation in the US and the European Union. Nevertheless, this process takes time and does not offer an immediate answer to the threat of Chinese flooding international markets with cheaper (and sometimes below production costs) products.

Moreover, 15 years after joining the World Trade Organization, China could be granted the Market Economic Status (MES) by the end of 2016. This recognition is discussed in the US and the EU and China has begun to push hard to access the MES. If it is granted, it could have major implication for the world trade as it will be difficult to impose tariffs against a country recognized as a “market economy”. A preliminary study ordered by a group of European industries organizations estimates between 1.7 and 3.5 million the number of jobs at risk if China is granted the MES next year.

To conclude, Chinese economic slowdown has already dramatically impacted  the world’s mining and metal industries. The country’s policy to support unprofitable businesses and export oversupply destabilizes the global markets, leading to a trade war with losses for all players: China subsidizes inefficient domestic companies, foreign companies and countries reduce production, cut jobs and see their revenue declining due to low prices and decreasing demand. Nevertheless, it should be noted that Chinese strategy can only be transitory because, in the long-run, subsidies and loans to unprofitable businesses will lead to a surge of debt, creating imbalances in domestic banking and debt markets.

It is too early to say if China will be granted the MES but, even if China is in the process of reforming itself and changing its economic model, it will not change the fact that China is not likely to become a full market economy according to a Western definition. The trade war described above is mainly due to differences of economic model and political priorities between China and other market economies, a confrontation between administrated economy and market economy. Western market economies give priority to profitability and private financial interests while China politics focuses on sovereignty and domestic stability. These cultural and conceptual gaps are not likely to change and are keys to understand the international current situation.

China may well implement some free markets elements that are useful for its development, but market economy remains only a tool besides central planning, interventionism and a strong regulation to manage domestic challenges, a mixture of economic development, sovereignty preservation, and political and social stability. In October 2014, President Xi claimed “to solve China’s problems, we can only search in the land of China for the ways and means that suit it”, confirming that China will build its own model, fitting with its national interests, even if this creates international imbalances and requires to partly let the rest of the world pay for it.

About Nicolas Houilliez

Luxemburg based with strong analytical skills, I worked as market and strategy analyst in large multinational companies. Passionate about China, economics, geopolitics and finance.