An example of overcapacity in China

It is the same story elsewhere in Fengrun, a gritty steel town where the red flag of the People's Republic flies from giant-like loading derricks. After shutting briefly when steel prices dipped last fall, most of Fengrun's more than 100 mills have come back to life to exploit a price uptick this winter, churning out countless tonnes of pipe, girders, rolled steel and heavy cable.

And that, Mr. Yu says, is the problem: Not that so many mills are going out of business, but that so many are still going.

China simply makes too much steel. The government estimates that China's annual production is about 100 million tonnes more than it should be, a figure equal to the whole annual output of the industry in the United States.

Worse, China has far too many steel companies, more than 700 at last count. Add in iron companies and companies that roll or otherwise shape steel, and the total comes to more than 7,000. Despite repeated government attempts to force them to consolidate into fewer, bigger companies, most of them are still small and inefficient.

By rights, many companies should have closed. Instead, they march on like zombies, China's industrial undead.

(source: China's runaway steel train, by Marcus Gee and Andy Hoffman. The Globe and Mail, April 11, 2009)


The above quote comes from a good Globe & Mail article on the potential steel overcapacity problem in China. If anyone wants to get a sense of why I always keep saying that there may be overcapacity in many industries in China, do read the article. No one can say for certain whether China will face severe overcapacity problems and we likely won't know, except in hindsight. Similar to the argument of 'good deflation' versus 'bad deflation', it's very difficult to know for sure what is going on. To complicate matters, the Chinese government owns or controls key industries, and hence they can keep industries afloat for a long time by absorbing losses.

Even if one didn't believe the argument presented in the article, it presents the nature of business in China. For instance, one gets the feeling that many businesses are not capitalist entities (i.e. profit maximizers.) Many simply seem to operate without taking the cost of capital into account. That is, as long as operating costs break even, they will keep going. I also get the feeling that this may be occuring because China's banks are government-owned (for the most part) and hence loan out money to anyone without considering business viability or potential losses.

If China does end up having sizeable overcapacity, it will unleash massive deflationary forces. In the last decade or two, we have seen deflationary currents from "excess" foreign labour--not just from China but also India, Brazil, Vietnam, and so on. But the deflation from "excess" manufacturing has been muted for the most part. This, I believe, is mainly because China was mostly consuming most of its own production. As this article points out, China used to be a net importer of steel a few years ago but isn't any more. There are many other areas where China has switched from an importer to an exporter. Throw in slowing world demand and you can see how excess production will deflate everything it touches.