The Steel Sector and Why Supply Side Measures Haven't Worked

After 55 months in negative territory,the producer price index,or PPI - which measures prices at the factory gate -- finally showed a year-on-year rise in September. That was hailed as an indication that China's economy was turning the corner. Coupled with an improvement in the purchasing managers' index,or PMI - a measure of business activity -- the conclusion has been that perhaps it was time to discard the prevailing pessimism about overcapacity in key industrial sectors. However,a careful observation of the industries with excess production capacity shows that there are many factors at work. At the end of last year,the prices of coal,iron and steel were all at record lows,which made it difficult for enterprises in the sector to generate profits. This year,especially in recent months,prices for these same commodities have shot up. And in some sectors high prices have been the result of government efforts to cut production capacity.

This is partly because government policies have been inconsistent. At times,authorities have slapped limits on working hours while at others they have curbed prices or removed all restrictions on supplies of materials. Such contradictory policy directives have ignored normal pricing factors. They have also confused entrepreneurs and distorted market expectations. More importantly,these measures have undermined confidence in the ability of the market to make a sustained recovery. What forces are the real cause of this strange situation and how do we address this problem?

The 'Visible Hand' and the 'Invisible Hand'

A careful observation of the improvement in the PPI and the PMI,however,reveals that the upturns coincided with the rebound in the prices of iron,steel and coal. A look at the sub-indexes of the PPI shows that the PPI rebound came mainly from the production side and that was largely from heavy industry rather than light industry. Coal,iron and steel are all important upstream and-midstream products. They drove the rise of the PPI and in turn the PMI.

The iron and steel industry,which is intricately linked to coal,electricity,property development,infrastructure and automobiles,is the key link in the whole macroeconomic industrial chain and it is critical to understanding the economy's direction. And in order to do that we need to examine supply and demand as they relate to the "visible hand" of the state and the "invisible hand" of the market.

Even before the government rolled out its policies aimed at cutting production capacity,the market had already made its own adjustments in the rundown of inventories. According to data released by the China Logistics and Procurement Association Consultancy,since the beginning of 2014,ferrous metal smelting and the rolled steel processing industry has entered into a destocking period and the process gathered pace in the second half of 2015. Data from the China Iron and Steel Association have confirmed this. And since 2011,steel prices have undergone a lengthy decline and that has signaled to traders that the destocking process was well under way. In particular,since the beginning of 2014,some small steel plants have shut down production and the trend continued until the end of 2015.

After the government put its policies on cutting capacity in place,the decline in the recovering production and the policy expectations exacerbated the contraction of the supply side. The cuts had little immediate effect on iron and steel production and prices,but it had a big impact on the expectations from producers and investors.

Even if it has achieved the policy goals of cutting production capacity,the actual effect on production of crude steel has been negligible. According to the China Iron and Steel Association,the nation's average monthly crude steel output was 100 million tons at the beginning of the year. According to the policy targets,yearly production capacity would be cut by 45 million tons,or 3.75 million tons a month. Given the monthly base,the cuts are a drop in the bucket,leaving capacity at 96.25 million tons. China's average monthly crude steel production is still around 70 million tons,with the potential to climb 37.5%.

Modest Goal

Even though the actual result is a tiny cut in output,the modest goal has still been difficult to achieve. Some local governments are not fully implementing planned cutbacks,stopping only some parts of production lines instead