Gary Jefferson on the Chinese steel industry

Gary Jefferson writes about institutions, technology, economic growth, and China’s economic transformation. At Brandeis, Jefferson has joint appointments in the Department of Economics and the International Business School, where he teaches undergraduate and graduate courses in the economics of innovation, development economics, and China.

Jefferson’s publications include, Enterprise Reform in China: Ownership, Transition, and Performance, Oxford University Press, 2000, "Enterprise Reform in Chinese Industry,” Journal of Economic Perspectives, 1994. “What is Driving China’s Decline in Energy Intensity?” Resource and Energy Economics, 2004. “R&D and Technology Transfer: Firm-Level Evidence from Chinese Industry,” Review of Economics and Statistics, 2005 “The Sources and Sustainability of China’s Economic Growth,” Brookings Papers on Economic Activity 2006, “A Great Wall of Patents: What is Behind China’s Recent Patent Explosion?” Journal of Development Economics, 2009; and “The Future Trajectory of China’s Political Reform: A Property Rights Interpretation,” Unfinished Reforms in the Chinese Economy, 2014, edited by Jun Zhang, and “Restructuring China’s Research Institutes: Impact on China’s Research Orientation and Productivity,” Economics of Transition, 2015. Jefferson’s research has been supported by various agencies and foundations, including the World Bank, National Science Foundation, and the Department of Energy. 

A graduate of Dartmouth College (A.B.) and Yale University (Ph.D.), Jefferson has lived and taught at the Chinese University of Hong Kong, Wuhan University, and Fudan University and frequently travels to China for his research and speaking engagements. His research has involved extended collaborations with the Chinese Academy of Social Sciences, the National Bureau of Statistics, and the Ministry of Science and Technology. On October 5, 2016, he spoke with Yujia Yao CMC '19.

Photograph and bio courtesy of Professor Jefferson

Steel producers across the world accused China for severe over-production and dumping its steel to the international market. What have caused the steel overcapacity in the global market? Or is overcapacity in this industry a purely Chinese phenomenon? 

I don’t consider myself to be an expert on China steel industry. I studied it in depth 25 years ago and followed it somewhat but it is not my primary area of research. But I would be happy to discuss what I know with you.

Regarding the nature of the overcapacity, my understanding is that it is a global phenomenon. It represents the economic weakness in not only China but also in the U.S. and the E.U. All of these economies are operating either below capacity or well below capacity. Because of the cyclical nature of construction and the demand for steel, it is not at all surprising that the steel industry should be in even more severe state of overcapacity relative to the overall economy. Particularly for the U.S. and the E.U., it is the investment part of national income that most substantially hurts the construction industry and the steel industry. Also, as the excess of China’s huge capacity represents approximately 50 percent of the world steel production capacity, it has been emphasizing an increase in export. Over the last few years, export has grown quite substantially for China. As export increased, flooding the global market, it is not surprising again that the world price of steel has fallen quite significantly, which in turn compounds the problem. The industry is in a challenging condition globally as well as in China. 

Regarding to the cause of the overcapacity, one is the cyclical demand. The other is a circular longer term trend. During China’s transition from a lower-income country to a middle-income country, much of that transition was achieved through extensive investment in public infrastructure and housing. There is now excessive capacity in housing in some areas. Returns on public infrastructure investment is much lower than what it has been five or ten years ago. Arguably there is not only a short-run decrease in demand associated with the business cycle, but there is also a longer term decline in the structural demand for steel as China becomes built up. If the U.S. can mobilize more investment in the infrastructure in the next administration, and if infrastructure investment banks in Asia expand its projects to the West, it would give a jump in demand. However, if you take all of the capacity that exists presently in China and other countries, in the perceivable future demand is more than likely not going to be able to absorb all of that capacity. 

What steps has the Chinese government taken in cutting steel production? How would you assess the effectiveness of these measures?

You would like to think that in a perfect market-based world, this imbalance of supply and demand will -- in the not too distant future and with lots of economic changes -- shake itself out, as companies restructure and some close-down. But the situation in China is a lot more complicated. Because most of the steel plants are locally owned by provincial governments, only three of the largest -- of a large number of steel plants -- are controlled by the central government. So there is a lot of resistance. Particularly as the overall economy has been struggling and unemployment has risen, there is a great deal of resistance in the state-owned industrial sector to accommodate the potential lay-offs of workers. The central government has given its instruction to a certain amount of lay-offs but they only control a portion of the country’s capacity. It really depends on local governments’ compliance with the central government’s directives. There is a lot of push-back from local governments, making it more difficult to restructure. Clearly in China the market is having a limited capability to curtail the excessive capacity, and therefore active government intervention with specific measures involving arranging mergers, shut-downs, and lay-offs seems necessary. 

There is a lot of discussions concerning the merger of Baosteel and WISCO (two of the largest steel plants in China). WISCO seems to be not as technologically advanced as Baosteel and in more of a financial difficulty than Baosteel. So there is concern that the merger will weaken Baosteel. I guess the issue is whether or not the merger will result in some substantial restructuring and capacity reduction. I imagine that is part of the objective, but with the new state-owned enterprise they form, you don’t believe them until evidence illustrates that it happens. The policy’s initiative of encouraging mergers is certainly an important one and when that happens usually one of the two or three merging companies is notably weaker along some dimensions than the lead company, Baosteel in this case. I think there does have to be a restructuring and that WISCO has already laid off a large number of workers. It seems that the state is taking it seriously. However, one can’t access the outcome until a year or so when it is probably transpired.

The steel industry has long been one of the most important industries in China. How will the current restructuring of the industry affect its long-term prospects?

There will be a navigational capacity in that the central government and the banking system are able to control subsidized lending to the steel sector. Other areas of problematic subsidies should also be addressed, including subsidized energy prices, subsidized land as well as subsidies of capital. To the extent that these various aspects of input prices can be marketized, it will enable the market itself to be a more effective instrument of restructuring. At the same time concerns of the U.S. and the E.U. regarding Chinese dumping and charges and retaliation will also be addressed. Those are things that need to happen if the central government succeeded in setting production quota across the industry. The key is to track the production capacity in the steel industry. But at the same time some of these problems are cyclical. China’s growth rate, which has been nine to ten percent, is six or possibly seven percent now, and is probably never going to return to the ten percent level again, at least not in a sustainable way. As its economy is more closely approaching international technology frontier, the pace of productivity growth is necessarily going to slow down. This could be a good thing. It’s the measure of success that China is moving up the technology ladder. It is more and more difficult to raise productivity as it moves up a round of a ladder to a different one. When we get out of this economic cycle, I’m not sure that the demand will be sufficient to absorb the capacity as now it is. Chinese government realized that one reason capacity has spiked in the industry was that over the past fifteen years or so it has been responding to an investment bloom in China that was unsustainable, and that it has to have a fundamental restructuring going forward. 

China’s overcapacity in the steel industry has raised tensions with the EU and the United States because Chinese exports have depressed prices and threatened the vitality of European and American producers. What are different measures the E.U. and the U.S. producers has undertaken to face this challenge. 

Some of those companies had to drop output considerably and they are reducing capacity particularly as prices fall, but it’s more true to market pressures rather than formal government intervention. Governments of the U.S. and the E.U. tend to act on behalf of the complaints from the steel industry regarding the trade and dumping violations, and then represent the case to World Trade Organization. In that sense there is arguably some dumping in the E.U. and the U.S. steel industry. But these companies are largely market driven and they are responding to the excess world capacity and decrease in prices. 

I suspect what you are going to see in China, U.S. and the E.U. is further technology upgrade and specialization. There is whole range of various steel products. Over the last fifty years, the U.S. steel industry has been systematically upgrading and retreating from flat raw steel production to a highly specialized form of production. Chinese companies will also turn to specialization, and hopefully also move out of their ancillary activities like real estate and try to move those resources into technology upgrading and specializing rather than being distracted by those activities that are not their core. This restructuring seems to be a global phenomenon. One thing that will be interesting to see is the extent to which there may be cross investment. Many people probably are not aware of the U.S. and the E.U. companies’ investment in Chinese firms, particularly since the government is seemingly opening and welcoming private investment in state-owned enterprises. At the same time, Chinese steel companies are trying to invest in or acquire U.S. and E.U. steel firms or assets for the purposes of technology upgrading and extending their markets. 

Would you say that dealing with the overcapacity in steel industry is a litmus test of the current Chinese government’s commitment to painful economic reform? Could the solution of this challenge help provide insights into Beijing’s strategy on restructuring other Chinese industries?

I think the Chinese government realized that this has implications for and is a part of a new initiative to restructure the state-owned enterprise sector, not only the steel industry but also automotive, chemicals, and other construction industries such as cement. These industries also depend extensively on energy. The government has issued various initiative and directions regarding the state-owned enterprises in the last year and half. The goal was to redouble their profits; to reform economic management and fair wages-setting process; and to promote conversations between companies and outside private investment. I think these initiatives in the steel industry serve as a test to that. It’s an interesting test because the steel industry is one of the most stressed industries with dominance of state ownership. Most of these state-owned enterprises has subsidiaries or initial public offerings that are publicly traded. What they often do is that they separate the most profitable segment of their companies into their subsidiaries which they have been able to successfully arrange IPOs in various markets and retain the weaker part of the company. A lot of these publicly traded subsidiaries are still state-owned, and these are the “state-controlled shareholding” companies. “Shareholding” is the part where they have non-state capital in them. They might try to expand the shareholding and make these firms more transparent and subject them to more market exposure than the more traditional state-owned portion of the firm. 

What would be the economic consequences if China fails to reduce its overcapacity in the steel industry, both for China and the world?

I think if it’s not successful it’s probably going to be associated with their greater emphasis on exporting, the “One Belt One Road” initiative, and other domestic initiatives . The problem is that all of those have downsides too. Exports tend to result in a series of anti-dumping restrictions, international criticism and retaliatory measures. As a result, there is not much cushion for expanding exports of their traditional steel products. And the “One Belt One Road” and other initiatives require more debt. The Chinese government is issuing bonds for these indirectly. China’s debt will build up and leverage could become a drain. One implication if this excess capacity persists is that the Chinese government is stuck in a relative low equilibrium in terms of a growth rate at four to six percent rather than six to eight percent. So I think the implication is that the problem will extend well beyond the steel industry and require something more radical, for example of a mix of central government administrative initiative and political initiative. 

The global market is going to be challenged as well. Part of the problem is that there is a growing trend of sentiment against globalization. Overall I suspect that China, apart from attitude overseas, is pretty much near capacity in terms of its ability to expand its presence in the foreign market, at least measured by its market share. The composition may be changing but a huge driver of China’s growth in the last twenty years has been the surge in exports and trade. China is approaching the limit of that growth path, and must focus on technology upgrade and quality of exports rather than the sheer volume of it. The key for China is being able to acquire and utilize the technologies to increase the marginal product of investment in order to move up the technology ladder. They certainly put some of the pieces in place with regard to their surge in research and development spending so that R&D as a share of GDP is about 2.2 percent. It is a lot more like the OECD countries than the developing countries. There is no other middle income economy that is operating at that range of R&D intensity. The challenge then would be utilizing that R&D spending effectively to develop and acquire the technology and to absorb it effectively. Perhaps a decade will help to improve the capacity to do that. But in addition to maintaining and expanding their own momentum, these are the prerequisites to get the new technology in place. Technology is the key to elevate the marginal productivity of the return on investments, so that they can get out of this slumber-hole they are in right now.

Yujia Yao CMC '19Student Journalist
Featured Image Source: "Shanghai Baosteel Group Corporation" by Zlatko Unger — Own work. Licensed under CC BY-NC-ND 2.0 via Flickr Creative Commons —
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