Steeling themselves

Why Chinese steel overcapacity will continue to test global steel producers’ patienceSince 2010, Chinese demand for steel has lagged far behind production and exports (Figure 1). In spite of this, production has remained strong with steel mills taking advantage of low iron ore prices at present. These sustained levels of production have been worrying producers of the metal around the globe as China ships its excess steel abroad. China is already the world’s largest steel manufacturer, in value terms they dwarf the whole of North America and are estimated to be responsible for around 50% of global overcapacity. Steel associations outside of China argue that China is flooding markets and hence driving steel prices down.  As a result of these concerns, eight representatives of steel organisations from around the globe (North America, Latin America and Europe) have lobbied China to alter its recent Steel Adjustment Policy 2015.

 

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Figure 1  | Chinese Steel Exports and Imports, demand and production compared, based 2010
Source | DeltaMetrics 2015

 

Chinese iron and steel trade is highly correlated with the value of the yuan (and with equity markets across the region). Further, its trade generally is also highly correlated with the Iron and Steel price. Through a state-controlled steel industry, China is able artificially to drive down steel prices and effectively circumvent the market forces which all other global steel industries are susceptible to. The eight steel association representatives therefore hope China will rethink its steel policy for the benefit of the free market and the future of steel trade.

Delta Economics, sees encouraging signs of China reining in its steel exports in future. Between 2010 and 2015 (to the current month), we saw a compound average growth rate (CAGR) in Chinese steel exports of 10.7%. This was compared with 5.3% growth from North America, 1.3% in Latin America and 1.5% in Europe over the same period. However, between 2015 and 2020 we are now forecasting significantly lower CAGR growth in Chinese steel exports of 6.8%. This is compared with growth in steel exports in Latin America (4.2% to 2020), North America (6.2% to 2020) and Europe (2.6% to 2020). It appears, therefore, that China may well be listening to global concerns over its steel overcapacity.

This will not be a quick or easy process, however. It will take years of adjustments to address the Chinese steel surplus. Smaller steel mills within China are most likely to bear the brunt of the readjustment policy with plant closures and redundancies. However, the larger steel mills will be slower to change. Therefore, although our forecasts are showing more encouraging signs for steel producers outside of China, the coming years are likely to severely test the industry.

 

 

Nerves of steel  |  Author  |  Jack Harding  |  Analyst and Publications Manager

China’s nerves of steel

Why January’s drop in exports may not be such bad news |  Chinese exports in January 2015 fell by 3.3% compared to a year earlier. Its imports fell by over 19%. Analysts had expected exports to grow by over 6% and the slowdown in imports to be less marked than it was. The Hang Seng Index (HSI), which has a high correlation with Chinese exports, dipped slightly on the news but had rallied by the end of the week.

Delta Economics views this rally as temporary: seasonal volatility in Chinese trade in January and February coupled with lower commodity prices means that we are likely to see a further drop in the value of China’s exports in February. Although the trend during the course of the year for the HSI is positive, lower trade could impact substantially on the value of the HSI until the end of Q1 2015 (Figure 1).

 

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Figure 1  |  Monthly value of Chinese exports (USDbn) vs Hang Seng Index, LPM, June 2001-Dec 2015 (forecast)
Source  |  Delta Economics, Bloomberg

 

Of particular concern to analysts was the drop in imports in January. China’s trade is 83% correlated with oil prices and therefore the recent drop in oil prices goes some way to explaining the fall. Further, a more general drop in commodity prices would also have impacted on China’s import trade values for January: China’s trade is 61% correlated with steel prices for example. Given that we expect an increase of 5.8% in iron and steel trade in 2015, compared to 2.4% in 2014, it would be reasonable to conclude that seasonal effects and falling commodity prices are more likely to be responsible for January’s, and potentially February’s, drop in trade values rather than a drop in demand.

Iron and Steel trade is a good proxy for infrastructure development and economic growth within China. China is a net importer of Iron and Steel, the largest products within which are flat rolled alloy steel and hot rolled steel products. China’s exports predominantly go to emerging markets in Asia while China’s imports come from South Korea, Japan, Europe and the United States. China has a net trade deficit in iron and steel, yet to its key export partners, its market penetration is above average for the world.

 

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Figure 2  |  Rebalancing of Iron and Steel trade
Source  |  Delta Economics, Bloomberg

 

The clearest indication of a reorientation of Chinese policy away from export and infrastructure-led growth in favour of demand-led growth can be found in its reimports of iron and steel. These are products that originate in China but are exported and then reimported from Chinese territories or Special Administrative Regions (such as Hong Kong, Macao or Taiwan). Over the past two years reimports have been slowing which suggests that China is utilising its internal resources less – arguably reducing its stockpiles.

Chinese trade, and particularly its iron and steel trade, matters for the rest of the world. But its importance is not as a proxy for the health of the Chinese economy. Instead, it matters because markets perceive it as a bellwether for the health of the Asian economy. For example, the HSI is 81% correlated with Chinese trade and 89% with the KOSPI. Similarly the Australian dollar’s correlation with Chinese iron and steel trade is 82%. While these do not reflect causality they do suggest that regional market sentiment and trade are strongly associated.

 

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Figure 3  |  Monthly value of iron and steel trade (USDm) versus USD-CNY spot, Last Price Monthly
Source  |  Delta Economics, Bloomberg

 

Weaker trade data in the first part of 2015 is likely to result in a depreciation of the yuan (Figure 3). In recent months there has been a slight revaluation of the yuan but we see it depreciating further over the next two quarters as trade growth remains sluggish after it spikes in March. The correlation is negative at -82%: in other words, a currency depreciation will have a positive impact on iron and steel trade, because the currency elasticity of commodities is high.

This will have broader consequences for the rest of the world, not least by potentially aggravating trade relations between the USA and China by making US imports into China more expensive. It would also make European imports into China more expensive and, at a time when the European economy is looking to re-establish its growth, the importance of the Chinese market cannot be understated.

Once again this demonstrates the power that China has to manipulate its own performance and therefore to impact the economies of the rest of the world. Emerging markets equities are likely to react negatively to slower Chinese trade in the short term while the Australian dollar may well become weaker against the US dollar because it is so influenced by the performance of the Chinese economy generally and trade in particular.

If the yuan devalues further, this also has the potential to threaten any export-led growth that may be developing in Europe and the export-fuelled growth that the US is enjoying. The broader geopolitical risks of embarking on a currency war to protect China’s domestic interests as it restructures would stall trade negotiations at the very least. The hope is there will be no devaluation as China seeks to restructure its economy. The outlook for trade towards the end of 2015 and into 2016 for China is certainly brighter, but to get through the first quarter at least of 2015 markets and analysts will need to have nerves of steel.