Thomas Brizendine and Charles Oliver
Cover by Benjamin Hurd
Thomas Brizendine is a partner with GCiS China Services in Beijing.
Charles Oliver is a partner with GCiS China Services in Shanghai.
GCiS is a private consulting company that specializes in business-to-business research and consulting.
Despite the risks, foreign steel-makers would do well to start looking at China
Foreign investors can supply China's domestic demand with a wide range of finished products that the domestic industry cannot.
Bearing steels and other steel products in which China is strong are already being incorporated into global product and distribution systems.
Investors should examine medium- and smaller-sized key enterprises for possible partners, preferably ones with recoverable assets.
With World Trade Organization (WTO) entry for China now a certainty, the time for stepped-up foreign involvement in China's steel sector is approaching rapidly. To attract foreign interest, however, the industry will have to overcome its pervasive and high-profile troubles, from backward management practices and poor product quality to government interference of all kinds at all levels. No industrial sector in China is more representative of the condition of state-owned enterprises (SOEs) today than China's steel industry, with its problems of over-employment, poor management, low efficiency, and social cost burdens.
Partly in preparation for WTO entry, SOE reforms have been intensifying. The short-term impact of WTO on the steel sector will be mixed, however. On one hand, PRC importers will be free to supply their clients in a more open and transparent environment. On the other hand, WTO membership will enable China to seek redress for antidumping and other unfair trade practices through formal WTO mechanisms.
An industry in disarray
China, which produced 123 million tons of steel in 1999, is already the world's largest producer of steel by a rapidly growing margin. By the end of 2000, this margin was roughly 20-30 million tons per year. At the same time, PRC steel producers are enormously inefficient: they waste and abuse resources, maintain redundant employees, and serve as increasingly reluctant employers to entire cities. Without government protection, only a handful of these companies could compete regionally, and none globally.
The numbers tell a grim story. China's finished steel productivity per employee is approximately 37 tons per year. In developed nations this figure is closer to 400 tons. The modern steel industry is capital- and knowledge-intensive, but China's comparative advantage lies largely in its low labor costs. Per-person productivity indicates not only the bloated nature of enterprise payrolls, but more significantly, provides a direct measure of management effectiveness.
Domestic consumers are demanding higher quality steel in ever-larger quantities, and China's domestic industry has great difficulty meeting their requirements. Though it is the world's largest steel producer, China consistently imports higher grades of steel and specialized steel products.
Steel enterprises, like other SOEs, face rising taxes and social burdens even as their financial results deteriorate. And yet China's steel authorities still retain central-planning habits and controls. They appoint managers based on political rather than performance criteria, approve and fund investments, arrange shotgun-marriage mergers, set production levels and prices, and promote import-substitution policies.
One reason for government involvement is that the steel sector's performance directly influences China's unemployment rate and social stability. The World Bank estimates that Chin a has between 16 and 18 million unemployed urban workers, a figure many analysts view as conservative. China's steel industry employs 3 million, mainly urban, workers, and several times that number depend on China's steel enterprises for their pensions, health care, and housing.
One example is the city of Handan, Hebei Province, where city and health officials' estimates of urban labor force unemployment range from 30 to 70 percent. Handan is also the home of Handan Steel Co., one of China's more efficient producers, at 103.5 tons per employee per year, according to government figures. Handan Steel employs 28,176 people directly. Were the company to raise its productivity to 250 tons per employee per year without raising output, it would have to lay off 16,510 people-over half of its workforce-in a city that already has 50 percent unemployment. Clearly Handan's corporate decisionmaking is an issue for provincial and local officials, who also depend on Handan for tax revenue, no matter what policies emerge from Beijing.
The recent rebound in overall economic growth and the likely development of a domestic housing market will relieve some steel enterprises, but most are doomed, and increasingly desperate. Baoshan Corp. (Baosteel) and other large enterprises (see Box) will probably survive because of the government's strong support for these "key" employers and producers. Among smaller key enterprises and non-key enterprises, the winners will be those that successfully discover actual costs; reform marketing, sales, and distribution; and focus on a limited number of products-while disentangling themselves from the SOE mentality. The changing environment presents the astute foreign investor with a series of opportunities-and corresponding risks.
Reasons to invest
Careful examination of product requirement trends and the capacity of the domestic steel industry reveals a series of product demand and supply mismatches. Foreign investors can thus supply China's domestic demand with a wide range of finished products that the domestic industry cannot. These mismatches also make potentially fertile hunting ground for strategic, limited investments in the sector. The joint venture remains the primary investment vehicle, as wholly foreign-owned enterprises are forbidden in the steel industry and will remain so after WTO entry.
One example of the opportunities that can be found in such mismatches is the joint venture approved in 1997 between Germany's Krupp Thyssen Nirosta and a subsidiary of Baosteel. By far the largest steel foreign investment project in China, it is also the only one to be approved at the national level. Total investment exceeds $300 million for the construction of a factory to produce integrated stainless steel, which is in short supply in China's d omestic market.
Another example is the PRC antidumping case against importers of sheet steel for the appliance market. Chinese market participants estimate that the gap between domestic production and demand in these product lines is now about one million tons annually, and is growing in the low- to mid-double digits. Domestic producers not only produce insufficient quantities of the steel, but also produce steel of inadequate quality in the areas of thickness, surface consistency, and treatment. To make matters worse, domestic suppliers typically do not meet endusers' size demands. For example, the minimum sheet steel width from Baosteel in 1999 was 900mm, while endusers require widths of 750mm, 785mm, and 810mm. The result is an alarming level of waste in highly competitive PRC industries, particularly the home-appliance market. This market demand is currently being satisfied by imports.
China's new antidumping procedures against foreign competitors (see The CBR, May-June 2000) enable Chinese steel enterprises to force their enduser industries to accept higher costs and lower standards. In the short term these antidumping efforts give the steel companies a little more time to reform. But in the long term the Chinese trade authorities will not be able to protect the steel industry to such an extent. This is because many of the injured endusers, such as appliance makers, are among China's most competitive companies. It makes li ttle sense for China's authorities to weaken other industries' international competitive advantage to protect the steel industry. The more likely long-term solution will be an easing up on imports and an increase in investment by the larger key enterprises in specific remedies. For example, Baosteel is already establishing a sheet-cutting center that will address the sheet-width issue. For the time being, however, direct investment is the only realistic way to avoid this kind of administrative protectionism.
Acquisitions ahead
In addition to product supply and demand mismatches, opportunities for foreign investors exist in the industry's high level of wasting assets-fixed assets that hold the potential for positive economic returns, but earn negative returns as a result of poor management or other factors. China began steel industry reforms in earnest in the early 1990s, intending to build a number of world-class steel manufacturing and processing enterprises. Government investment in the sector has been heavy throughout the decade but the allocation of investment has been spread far wider than was originally intended. A typical government-funded upgrade provides a top-grade foreign factory, integrated with domestic equipment as feasible. Because of poor management, among other reasons, these investments have not produced anything close to acceptable economic yields. Many of the investments have b ecome trapped, and are just wasting assets employed in economic loss-making.
Some of these facilities will soon go on the block-perhaps as early as this year. At this time valuations are still unreasonable and government-forced mergers are the primary resolution. But over 60 steel enterprises are currently on the waiting list for debt-equity swaps with the new asset management companies (see The CBR, July-August 2000). In the next couple of years, through direct negotiation and investment as well as deals with asset management companies, many of these assets will become available for foreign participation, if not outright purchase.
Another source of opportunity is the "white knight" phenomenon. As endangered enterprises run out of options, whether they are non-key enterprises facing unbearable pressure or key enterprises facing unwanted mergers, companies are increasingly desperate to find strong partners to bail them out. Imminent WTO accession may assure foreign investors-potential white knights-that, given time, successful enterprises in China will be able to export. This will create opportunities mainly in niche or regional markets. But in China, a regional market is typically larger by population than a medium-sized country. Examples of niche and regional markets in China include tool and bearing steels, large sectio ns for shipbuilding, sheet steel in the Shanghai region, and construction rebar in Sichuan Province. The Krupp Thyssen investment, an integrated stainless steel facility, is an example of this strategy.
In addition to these areas of opportunity, other trends make investing in China's steel sector strategically important for foreign steel-makers.
- Product substitution The mature steel industries of developed nations rely on efficiency improvements and technical product innovations to bring better returns. As a material, steel has held its ground far better than anyone might have predicted 15 years ago, but creeping substitution by plastics, composites, aluminum, magnesium, and related alloys is held at bay only by advancing product and manufacturing technologies and systems. The only realistic way to drive significant growth is in new markets-among which China stands out.
- Global integration Globalization is forcing multinationals to integrate China into their supply chains. Bearing steels and other steel products in which China is strong are already being incorporated into global product and distribution systems. As heavy steel users progress down this path, the impact on foreign steel producers will become ever more apparent. Also, Chinese enterprises are exporting increasing amounts of steel in finished-product form. Foreign producers and distributors that do not participate in China's market will gradually lose control over progressively larger portions of their traditional customers' steel consumption.
- Market size A comparison with the United States illustrates how large China's steel industry could become. Average US per capita steel consumption is approximately 0.35 tons per person per year. In China, assuming a population of 1.3 billion people, this number is currently only 0.1 tons. China's housing and automobile industries, two primary steel consumers, are in their early stages of development. Add to this machinery, appliances, and the export of components of the housing and automobile industries, and it seems likely that domestic demand alone could propel China's steel production to 160 million tons per year and beyond by the end of the decade. And with domestic demand of this scale, export competitiveness is a given.
The reasons and the strategic imperatives for action are clear, but the fact remains that such investments will require a long-term perspective and will involve almost unprecedented risks. The steel sector at this time represents the worst of China's investment climate. Below are some of the more troublesome risks of investing in China's steel industry:
- Economic risks
Major projects in the steel industry require a great deal of capital. Though the participation of industry champion Baosteel and the presence of various soft-financing supports reduces the risk of the Krupp Thyssen/Baosteel project, industry observers are skeptical of success for a variety of reasons. Schedule and budget overruns can quickly become problems with a project of this size. The bulk of the economic risk of a large steel projec t lies in the project's execution stage. So when choosing to invest this level of capital, investors are right to be cautious and conservative. Proper homework on all aspects of the deal is a prerequisite-one that far too many foreign investors in China have ignored, usually to their own detriment.
The valuation of assets and liabilities is a clear economic risk. In some cases, as mentioned above, wasting assets can be rescued at a discount and made productive. The Chinese government must approve all asset valuations. However, like much in China, this process is frequently manipulated for various purposes-almost always to the disadvantage of the foreign investor. In addition, huge liabilities hang over many of these enterprises, ranging from pension, health, and social service liabilities to problems of triangular debt. Despite practices recently established in other PRC industries, where foreign investors have been able to avoid taking on SOEs' historical liabilities, the steel industry's so-called "old guard" is likely to resist adopting similar practices, at least at first. - Personnel risks
The second risk in working with domestic companies is the role of the old guard. These steel industry managers are 50- and 60-year-olds who were trained in the former Soviet Union or Eastern Bloc countries. They spent their careers in the politically intense but economically crippled SOE s ystem. In many ways these managers are as unfamiliar with the needs of foreign investors today as they were at the start of the reform era. This not only causes all kinds of relationship and communication problems, but exacerbates all of the common problems-from foreign currency issues to finding competent management and staff-that foreign investors encounter in China (see The CBR, November-December 2000). - Government risks
Another major area of risk for foreign investors is government, at all levels. Globally, the steel industry has always had a close relationship with governments, and this relationship will probably remain close in China in the future. Because of the strength of the relationship between the government and the steel industry in China, Baosteel and other large key enterprises will have an advantage in any potential conflicts with their foreign partners. Indeed, domestic competitors, no matter their size, enjoy a wide variety of benefits, and key enterprises have explicit government support. Nearly all steel enterprises enjoy local and provincial support, which may include preferential concessions on utilities, resources, and land. In addition, domestic producers' abilities are improving, and they will eventually be able to fill any supply gaps. Inevitably, foreign investors and domestic producers will collide in the market. Chinese enterprises use their strong relationships at all levels of government to negotiate deals to their advantage and to their foreign counterparts' disadvantage.
Interestingly, the collusion of regional and local governments with their enterprises to obscure national policy intent only hastens the impact of marketization. In effect, the governments enable the discontinuity in planning through which market forces gain control.
China's steel industry is also one of the last strongholds of China's central planners. Though central planners are not likely to relinquish power easily or quickly, market forces cannot be held off indefinitely. Central planners can dictate certain terms, but they cannot force an enterprise to make a saleable product, and they cannot force customers to buy.
Not to be overlooked is the interference of international governments and their agents outside of China. International organizations are already playing a role in China's steel industry. The German Development Agency's involvement in the Krupp Thyssen/Baosteel joint venture illustrates the European Union's longstanding pattern of assisting its own companies abroad by providing concessionary financing. Of course, the European Union is not alone in this regard, and US trade practices can be criticized as well. These kinds of activities on the part of foreign governments and international institutions only distort the market-thus arbitrarily increasing risks for all investments in the industry, especially existing investments.
If foreign steel-makers are able to import successfully into China's market after its entry into the WTO, then trade is a natural and low-risk path to take. Foreign firms are likely to face protectionism, however. Tools such as antidumping legislation and import-substitution tax breaks are used the world over to protect domestic steel industries, and China will be no different.
Companies thus must consider investment in China not just to overcome tariff and non-tariff trade barriers but for strategic reasons, particularly the need to stay ahead of China in the areas of product quality and efficiency. In 10 years, China's steel industry may be producing in the neighborhood of 200 million tons per year and supporting more sophisticated enduser industries such as appliances, machinery, automobiles, and eventually even construction.
If foreign steel-makers come to China, they must decide what form their investment will take and with whom to work. One choice is to work on major projects with key enterprises, as Krupp Thyssen did. The other choice is to work with smaller partners in specific product lines for regional or niche markets, as several other companies have done. The second choice offers a number of adv antages. Smaller projects allow for more clearly defined partnerships, better overall leverage, and better chances for success. All forms of risk mitigation are easier to undertake. Political interference is less likely than in large projects in this industry, which are by nature political. Also, making small investments today does not preclude expan ding projects or making larger investments at a later date. The Chinese market is changing rapidly; there is no assurance that any of the major producers, other than the four large key enterprises, will be viable enterprises a decade from now.
Investors should look at markets in which both the quality and quantity of domestic supply is insufficient. With this knowledge, they should examine medium- and smaller-sized key enterprises for possible partners, preferably ones with recoverable assets. Aggressive investors might even examine some of the larger or more competent non-key enterprises in upstream industries such as infrastructure and construction. Investors should also define the project in the tightest terms possible, negotiate management control, and avoid assigned employee transfers from the Chinese partner.
The first deals will be slow to materialize, but for many foreign investors now is the time to begin the process. The fact remains that China's steel sector will develop into a global force of unprecedented size. Foreign steel companies ignore this fact only at their own long-term risk.
| China's Key Steel Enterprises | |
China's government, in an attempt to rein in the steel industr y and coordinate the allocation of government resources, established a list of key steel enterprises (guojia zhongdian gangtie qiye). In 1998, China officially counted 1,078 steel and iron manufacturing enterprises, of which 75 were designated as key enterprises. Non-key enterprises are ineligible for government support. China's steel industry can be divided into four categories (data for 1998 unless otherwise noted): The Big Four
Medium-Sized Companies
Small Companies
Non-Key Enterprises
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