China’s Overcapacity Problem – 4/27/16

China has an overcapacity problem. Years of cheap credit and over-reliance on state-owned companies to support growth have resulted in industrial output so high and cheap that it threatens profits for producers across the globe.

Officials in Beijing seem to be only begrudgingly accepting that investment has diminishing returns as a driver of economic growth. Since infrastructure projects offering the best bang for each buck can only be built once, China’s shift towards consumer spending via unpopular restructuring of its bloated, state-dominated industrial sector was inevitable. Unfortunately, well-connected interest groups and a reluctance to do anything that could destabilize ruling Communist party for the sake of the economy could hinder reform efforts.

As China transforms its export-based economy into one of consumption and services, there are sure to be winners and losers. Regions of the country where businesses are well-suited to the transition to consumer goods and services are seeing growth rates above 6% even now, but areas heavily dependent on resources are struggling under declining demand and capital spending cuts. Provinces in the rust belt with little to offer besides coal and steel are likely to fight tooth and nail against the restructuring. And it is not hard to see why given that it threatens to displace an estimated 1.8 million workers in two of the country’s largest industries, as well as eating into tax revenues for local governments.

Although defaults are rising with defaults on publicly traded bonds in 2016 already equal to the total number in all of last year, many of the companies failing seem to be smaller ones without the clout to get government support. Smaller companies such as Dongbei Special Steel Group and iron-ore miner Zibo Hongda are basically left to rot while state-owned Sinosteel seen the redemption deadline on its bonds extended several times. Such favoritism suggests that companies are not being assessed on fundamentals so much as their influence in the government.

China ministries released new guidelines recently as a follow up to plans to restructure the coal and steel industries and care for displaced workers. The new measures focus on reducing unemployment, something seen as a threat to social stability.

In a similar restructuring two decades ago, Beijing cut tens of millions of jobs in what was seen a harsh, but effective overhaul of a bloated state sector. The government appears less open to such aggressive measures this time. Government data has shown economic growth slowing only slightly in the first quarter thanks to new loans, debt and investment in real estate and factories; however, such easing only sustains dependence on growth in sectors the government has called unsustainable. Plans calling for a 10% to 15% reduction of capacity in the steel and coal sectors over the next several years only appear significant until you realize that more than twice that amount of cuts are needed to bring supply in line with demand, while many other industries facing overcapacity have yet to be addressed at all.

To show commitment to reform, more of China’s state-owned enterprises will need to be shut down or restructured. Credit rating agency S&P made the decision this year to cut China’s sovereign rating outlook to negative from stable because of concerns about the speed of economic rebalancing. Moody’s Investors Service also downgraded the outlook to negative citing surging debt and weak reform efforts. Premier Li Keqiang pledged stop state support of the zombie firms dragging on economic growth, which is at the slowest in decades.

Chinese companies have never waited so long to get paid, according to data compiled by Bloomberg on non-financial corporations traded in Shanghai and Shenzhen.

cash conversion

“The longer the cash conversion cycle, the higher the risk of corporates not having enough cash to repay their debts,” said Iris Pang, senior economist for greater China at Natixis SA in Hong Kong. “That creates a chain reaction.”

“When the economy slows to a point, everyone drags their feet in repaying business partners,” said Xia Le, chief economist for Asia at Banco Bilbao Vizcaya Argentaria SA in Hong Kong. “We will see more defaults because longer time to collect cash means companies need more financing to keep their business going, which will increase their financing costs.”

China’s oil, gas and coal companies saw a particularly high jump of 68% in cash conversion days jump due to the commodity price decline.

cash convert sector

Coal use in declining as Chinese President Xi Jinping pushes for use of cleaner fuels and a shift away from heavy industry. His policies are being met with resistance and bargaining in the Shanxi Province, which relies heavily on coal. Provincial officials report that they are seeking to export excess supplies and have proposed the elimination of export quotas.

The nation’s coal exports increased to 1.27 million metric tons last month. China’s domestic demand for coal is forecast to fall for the third year in a row.

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