Stealing Steel: A Microcosm Of Macro-Forces

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Includes: FCA, FXE, FXI, KOL, SLX
by: Marc Chandler

Summary

EU will soon begin to investigate whether China is dumping steel.

China's excess capacity can aggravate Europe's in the steel industry.

The EU may change its mind about granting China market economy status at the WTO.

There are few industries that offer a picture glass window to see numerous macroeconomic forces as steel does. Excess capacity, trade policy, and the yuan all intersect when looking at the steel industry. Moreover, it also shed light on why the drop of energy and other commodity prices, such as iron ore, have not bolstered the steel industry, let alone the general economy, as many expected.

At the heart of the problem is that globally there is greater capacity to produce steel than demand. That excess capacity is not simply a function of the state planning effort of China. Rather Europe also suffered from excess capacity. It lost a quarter of its steel workforce since 2009. The slow growth in Europe sapped demand while exports from China are boosting supply. Last year, China's steel exports rose by 50%, while prices for some steel products fell by 50%.

China joined the WTO in 2001. It has argued that after 15 years, it should automatically be given market economy status. This particular designation is important because it would make it more difficult to pursue anti-dumping charges. The US argues that this is not an automatic process and that China does not yet deserve that designation. The European Union, in contrast, appeared to be looking to curry favor with Beijing, signaled was leaning to granting market economy status to China. The US argued this was similar to unilateral disarmament. Europe countered that it had other trade defenses.

In the past when countries want to challenge Chinese trade practices by filing charges at the WTO. Now China is encouraging the EU not to retaliate but to go to the WTO. It is not clear the logic, but when George W. Bush imposed steel tariffs in 2002, part of the logic was that, even if they violated the WTO (which they did), it would take a couple of years to sort it out. It might be the same logic for Beijing.

China has large excess capacity in numerous industries, and Beijing recognizes it. This is one of the things that scare governments and industries around the world. What is China going to do with its excess capacity? Some of the excess capacity will be shuttered. China reports that around 90 mln tonnes of steel capacity have been shut in recent years. It plans on cutting another 100-150 mln tonnes in the coming years. It is reportedly strictly controlling the building of new steelmaking capacity. Beijing says it is also beginning large-scale cuts in coal output, and halting new coal mine approvals.

However, the old problem of the divergence between China's declaratory policy (what it says) and operational policy (what it does) resurfaces. China has made similar pledges in the past. Premier Li may be more committed. He is announced that the government will set up a fund to help steelmakers and coal miners to reduce their workforce and dispose bad assets, on the condition that capacity is reduced.

Some of the excess capacity will be used to meet foreign demand. A significant depreciation of the yuan threatens it will export more of the surplus. That would exacerbate the excess capacity in other countries. Economics is called the dismal science because it is about the distribution of scarcity. That was then. This is now. It is the distribution of surplus capacity that is increasingly the issue.

This kind of surplus is different from Summer's argument of secular stagnation. The surplus capital he discussed was that new businesses required less capital than previously and that without creating asset bubbles, capital and labor could not be fully employed. His preferred solution seems to be a large infrastructure spending program that would absorb the surplus capital.

The surplus in the steel industry is partly an issue of redundant investment. It grows out of the competitive drive that is at the core of market economies. A profit opportunity is seized by many, each thinking that they have the better proverbial mousetrap. As numerous capitalist engage the market, the competition squeezes the profit margins over time. Mergers and acquisitions are the industry's way of rationalizing and getting rid of excess capacity. Failures are another way to eliminate high-cost excess capacity. Lower prices may work at first to boost demand and replace alternatives, but demand elasticity is not infinite.

Summers sees the surplus as a relatively new phenomenon that can be corrected with a government response. The view here is that it grows out of the normal functioning of the market and planned economies. While public spending can absorb some for the surplus, it can only do so if the funds are borrowed not raised through taxation, and as we have seen there are political and economic limits on government borrowing.

The excess capacity in the steel industry discussed here is also different from the surplus savings hypothesis proposed by Bernanke to address the Greenspan Conundrum. The Greenspan Conundrum was that long-term US rates were falling even as the Fed hiked short-term rates. Bernanke suggested that the answer was to be found in Asia and OPEC countries that were running large current account surpluses but did not have the capacity to absorb their own savings. They exported it. The surplus capacity in the steel industry and other industries cannot simply be attributed to Asia and OPEC current account surpluses.

A couple of months ago, it appeared that Europe would not renew sanctions against Russia when the current set expire near mid-year. However, Russia's action Ukraine (and Syria) have antagonized European officials. It is not so clear here in mid-February that sanctions against Russia will be lifted. Similarly, the EU's leaning toward granting China market economy status may also be reversed, and its experience with the steel sector could provide the catalyst.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.