Not What The Doctor Ordered: Pulling The Plug On Chinese Zombies

by: André Breedt


Chinese economic reform proposals are proving ineffective.

A merger and acquisition spurt is unlikely to fundamentally alter industrial output or solve the problem of overcapacity. Privatization, as alternative, could be made a priority.

Chinese (and other large steel producers) ought to focus on operational efficiency and cost cutting.

"Zombie" firms must be sought out and allowed to fail.

Investors should scrutinize opportunities in the environmental repudiation market.

Rumors about the health of the Chinese economy - typically of the worrisome variety - come a dime a dozen. Some, like Harvard professor Kenneth Rogoff, signpost China as the "greatest risk" facing the global economy. Others go even further: Andy Xie, a respected economist known for predicting China's 2007 market crash, recently quipped that China is running a "gigantic monetary bubble that has corrupted virtually every corner of the economy."

Not even at this year's G20 forum was China spared the rod, receiving almost universal critique from world leaders for its failure to curb industrial overcapacity -the most corroding effect of the country's economic slowdown. And while the policy planners in Beijing have been working overtime to devise the magic bullet that would solve their overcapacity worries, the future is bleak indeed.

A proposed merger between two of China's largest steelmakers, Baosteel Group and Wuhan Iron & Steel Co (Wisco), is a case in point. Party leaders see this type of mega merger - in keeping with the Ministry of Finance's announcement in May of adopting a "combination of tax, accounting, and land administration policies to support mergers and acquisitions" - as a crucial cog in the wheel of crafting 'national champions'; tackling overcapacity; profiting from economies of scale; and eliminating "malicious competition". Combined, the two will become the world's second largest producer behind ArcelorMittal (NYSE:MT), with a total worth of $16.3 billion and an annual production of some 60 million metric tons per year and would be able to stem excessive production.

Or so the planners would have you believe.

In fact, this odd union fails to address the key concerns of overcapacity: under the anticipated deal, Wisco, who chalked up a whopping 7.5 billion renminbi loss in 2015, will not be merged into Baosteel, a much more robust entity which posted a 710 million renminbi profit during the same year. It will instead become a separate subsidiary reserving self-governance at all levels. Instead of capitalizing on cost cutting measure and diversification, the deal is creating a more complex and indebted entity with little or no hope in curbing excess capacity.

For what it's worth, ArcelorMittal has taken a different approach. Instead of consolidating, the company implemented sweeping initiatives to lower costs and enhance operational efficiencies. These measures have allowed ArcelorMittal to benefit from not only improvements in market conditions, but also from the punitive import duties levied by the United States and Europe on Chinese producers. As such, the firm's EBITDA increased 41.6% during the last reported quarter. Chinese and other steel giants should instead take heed of ArcelorMittal's restructuring efforts in lieu of unrewarding and sloppy merger ambitions.

Living on an Unsustainable Diet

Indeed, a burgeoning mergers and acquisitions (M&As) market may not even be the panacea that many expect. While on paper M&As can be effective in reducing overcapacity by closing inefficient facilities and identifying synergistic alliances between firms, a 2014 BCG report struck a different note. The consultancy argued that "M&As that merely create a larger low-profit business could have a limited impact on profitability and overcapacity," a conclusion that shatters Beijing's promises of working towards reducing industrial capacity.

But as it often happens in China, economic facts and economic principles are expected to bend to reality and not the other way around. The state, weary of creating social unrest through unemployment, has been offering, amongst others, grants, cheap energy and raw materials, making sure these firms - employing millions of workers - survive even at the cost of wreaking havoc in the markets. As such, not only has China fallen prey to overcapacity but the industrial output of many firms is grossly inefficient.

The problem is endemic. Local governments, according to Li Wei, professor of economics at CKGSB, are skittish as they regard any closure as highly "destabilizing". While Premier Keqiang has called out zombie firms "with absolute overcapacity" as SOEs where "we must ruthlessly bring down the knife", his words ring hollow when looking on the local level. Eager to impress party bigwigs, provincial officials have been massaging statistics, watering down regulations, and taking bribes from industrial giants. As a Guandong official said to The Economist on the topic of pollution controls: "We don't think these decisions apply to us."

These zombie firms are moreover kept alive by irresponsible low-interest credit injections that have exacerbated the already unsustainable levels of debt: non-performing loans reached roughly $190 billion at the end of 2015, a ten-year high. These policies not only stall needed structural reform, but also impede the proper allocation of capital.

The latest estimates show that SOEs are responsible for 55% of corporate debt despite representing only 22% of economic output. Private firms are suffering by being crowded out and are forced, amongst others, to jettison crucial research and development spend. The Chinese government, which has had repeated calls for the country to improve existing production facilities - reliant on such research and development - are stymieing these efforts by their existing programs.

Let them die

Fighting overcapacity through industrial consolidation is a losing battle and will only prolong China's economic agony. But recent signs that the government is warming up to the idea of allowing firms to go bankrupt could be a deal-changer. In the first quarter of 2016, 1,027 cases were heard, an increase of 52.5% over 2015 figures. A decision on September 12 by a Chinese court to liquidate Guangxi Nonferrous Metals Group, a regional Chinese state-owned metal producer, has grabbed headlines and highlights this trend. The bankruptcy is historic since it is the country's first interbank bond issuer, and SOE, allowed to fail. A few days later, Dongbei Special Steel Group, a SOE that had gone through nine defaults this year, finally entered bankruptcy proceedings.

But bankruptcies don't address the social issue of mass unemployment for blue-collar workers. A better-suited policy, according to the Peterson Institute for International Economics, a think tank, is pursuing the gradual privatization of China's approximately 150,000 SOEs and creating a level playing field between these and domestic firms by reducing overcapacity when low-margin and low-profit firms are compelled to close or enter bankruptcy proceedings. When companies in a sector plagued by overcapacity are privatized, overcapacity is automatically (and habitually) lowered. With 90% of the $10 billion dollar losses registered in the Chinese steel industry in 2015 coming from SOEs, the Chinese government is risking a delay in curbing overcapacity by snubbing this strategy in favor of 'traditional' policies.

Chinese firms, operating under increasing pressure to squeeze profits from an overheated market, have been proven extremely cunning in finding ingenious, albeit illegal, schemes to skirt supply-side reform and circumventing increasing regulatory burdens.

Opportunities for Western companies

A delay in vital reforms; reshuffling of overcapacity that is likely to take years to yield positive results; and a less sympathetic policy on debt-ridden SOEs from Beijing may consequently prove favourable for non-Chinese producers. These factors may be instrumental in the rally observed in the Fidelity MSCI Industrials Index ETF (NYSEARCA:FIDU) which has shown a positive upward trend from its January 15th lows. One is inclined to believe that this momentum has the legs to sustain its upward trajectory.

Indeed, despite the cavalier display of thumbing their nose at regulatory policies, Chinese firms will be facing a government that has taken a steadier stance in tackling careless activities, including, amongst others, sanctioning the poor environmental metrics in the performance assessment of local government officials. According to a Goldman Sachs report, these measures "should promote effective enforcement and implementation of the new laws, regulations and initiatives." Combined with the State's ambitious pollution tackling initiatives as set out in its 13th Five-Year Plan, the policies set the stage for lucrative pollution remediation undertakings.

With Chinese companies lacking the advanced technologies for effective long-term remediation, European and American firms are well equipped - despite some lingering concerns about the risks associated with intellectual property theft - to satisfy this market gap. Suez Environnement Co SA (OTCPK:SZEVF), which boasts an established water-and-waste management operation in China, and Veolia Environnement (OTCPK:VEOEF), are primed to take advantage of this burgeoning industry. Investors wishing to capitalize on a remediation market estimated to be worth 8.2 trillion renminbi by 2020 should consider including these, and other related firms, on their watch lists.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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