China's State Council announced long-awaited guidance Oct. 15 for weeding out overcapacity in key industrial sectors, namely steel, cement, shipbuilding, aluminum and glass. These sectors have boomed on the back of construction and exports, which have driven much of China's growth in the past two decades, but they stand to decline as the country's economic model shifts. The "Guidelines for Tackling Serious Production Overcapacity" set out to resolve ambiguities in previous guidance and outline the policy of President Xi Jinping and Premier Li Keqiang's administration on overcapacity, a critical symptom of imbalance in the economic system. The guidance will set the benchmark on which central ministries and local governments craft specific policies for dealing with overcapacity going forward, and its impact will be felt internationally.
Written in general terms, the guidelines envision an environment in which the entire central regulatory apparatus will scrutinize development more closely. Certain projects to expand capacity in these sectors will be prohibited. Regulators claim they will make marginal cuts to capacity in several sectors. These include removing 15 million metric tons of both iron and steel capacity (about 1 percent of total capacity), 100 million metric tons of cement clinker and grinding capacity (about 3 percent), and 20 million metric tons of flat glass (about 2 percent), as well as unspecified amounts from other industries.
Firms that expand without authorization, fail to comply with higher regulatory standards or operate illegally will supposedly face much stricter punishment, either monetary or administrative. The policy extends beyond cuts to give preferential treatment to firms that make productivity gains rather than production gains. Also, the government will subsidize firms to relocate or invest in different areas, whether at home or abroad, or to exit their sectors altogether.
The guidelines promise targeted public investment to lift demand and pick up some slack in these core sectors — a signal that China will tread cautiously. But above all, they claim that credit and tax policies and environmental regulations will seek to reward those firms that seek technological and efficiency upgrades in keeping with Beijing's long-run vision of improving the quality of Chinese growth. Under this vision, while Beijing consolidates these five industries, it will seek capacity growth in other sectors — most notably in the production of certain petrochemicals such as ethylene and propylene and other petrochemicals, pharmaceuticals, and of course, energy.
Beijing's Overcapacity Problem
Overcapacity is an outgrowth of China's economic model, which has prioritized production over consumption in a rapid, three-decade attempt to industrialize and raise China's economic power and status among nations. This effort has supported the regime in the post-Mao era, led to massive growth, urbanization and modernization, and created higher incomes for the majority of China's population.
Under this model, the central and local governments control the allocation of financing, land and raw materials, and subsidize the price and availability of these inputs to benefit the corporate sector. Enterprises in turn expand rapidly, generating higher tax revenue and wages. The system pays off in the form of social stability and regime security.
While this model has enabled Chinese industry to grab global market share and expand its national economy, it has led to dramatic imbalances. Resources channeled toward business often wind up going into new production or staying bottled up in corporate savings. They often do not go to households in the form of wages, thus forcing families to save a larger share of their income for health, education and potential hard times.
Certain sectors, notably the four targeted in the new overcapacity guidelines, produce more goods than the world can consume and yet continue to expand. Thousands of factories compete by making more goods at ever lower costs and thinner profit margins in attempts to swamp their rivals by sheer volume; they do not invest sufficient profits in product innovation, management or branding. Much of the built capacity remains unused. The State Council's guidelines claim that the iron and steel sector uses 72 percent of capacity, cement 74 percent, electrolytic aluminum 72 percent, glass 73 percent and shipbuilding 75 percent — and notes that these rates are much lower than international rivals at normal operating levels. Anecdotal reports point to even worse conditions.
With a quarter or more of facilities out of use, overhead costs and capital depreciation rise relative to shrinking revenues from sales, especially when prices are falling due to oversupply. In many cases, all that stands between bloated or inefficient firms and bankruptcy are local governments and state banks offering loans and other support. But massive debt is not the only negative consequence. There is also the resulting persistence of outdated, low-tech industrial firms — usually energy-intensive and highly polluting — that drive up China's dependence on foreign resources even as they delay the country's shift to more advanced production.
Enforcement poses the critical challenge for this consolidation effort. Previous administrations have recognized the need to attack overcapacity and consolidate industries to increase economic efficiency and political control. But firms' and local governments' interest in maintaining growth has generally outweighed the central planners' visions of a more efficient national economy. When former President Jiang Zemin attempted to tighten coal production, companies disguised their real production levels, and when his successor Hu Jintao tried to consolidate steelmakers that produced under a certain threshold, they simply increased production over the threshold.
The main reason recent consolidation efforts have failed is the financial crisis in 2008. In response to the global slump, the Chinese government launched an aggressive, loan-driven stimulus policy that involved relaxing regulations and the approval process for new projects. Stimulus gave a huge boost to thousands of companies that might otherwise have failed. In many cases, such as in the steel sector, industry concentration decreased as small- and medium-sized firms thrived despite the government's ostensible adherence to consolidation policy.
The difference now is that the major stimulus is over. The Xi administration's consolidation will occur amid an unavoidable trend of slower growth that encourages restructuring –- a context more like Jiang's reforms in the late 1990s, but without the cushion China had then. Today the domestic workforce is nearing a peak and China's production costs are rising while foreign demand remains weak. These trends are inescapable, meaning consolidation will be driven not just by central government edicts, but by market pressures on small and/or inefficient players.
The Threat to Stability
The consolidation drive conflicts with what has always been a core imperative for the regime: maintaining employment. In the 1990s, 30 million workers lost jobs at state enterprises and 11 million at urban collectives as the state sector was privatized amid an economic slowdown. Unemployment rose to an estimated 48 million. (While an enormous figure in absolute terms, it was only about 6 percent of the workforce at the time.) This posed a serious political risk, but the opening up of the private real estate sector at home and entry into the World Trade Organization initiated a new boom. Still, the negative consequences lingered long after in the form of the northeast rust belt and occasional protests by former state employees.
Today, such relatively easy sources of growth are nearly exhausted. New growth must come from new services and technologies and will require sweeping changes in education, research, management and social conventions. So while the layoffs may not be as big this time, they may ultimately be substantial. The China Academy of Personnel Science already estimates that for every 2 applicants, there is only one position open.
Certain provinces will take a particularly hard hit if the guidelines are enforced. The consolidation drive focuses on Beijing, Tianjin and the Yangtze and Pearl River areas. This is the wealthy industrialized coast, where the negative effects of industry on quality of life already have created the fiercest public backlash. And while the actual elimination of capacity will be kept to relatively small proportions of overall capacity, it will have a powerful impact locally.
Over the past decade, it has become more common for companies to relocate workers than to fire them. But relocation assumes that the work itself is not redundant — relocation can resolve regional disparities, but it is no solution for true overcapacity. For the steel sector, some Chinese reports suggest that wealthy, competitive provinces like Jiangsu will see companies moving from rural to urban areas, while poor provinces like Jiangxi with small firms scattered across the landscape are more likely to face shutdowns. Hebei faces perhaps the harshest social impact, since the government aims to cut 80 million metric tons of capacity (an amount larger than total U.S. steel output). Shandong aims for 20 million metric tons in steel cuts. The State Council also pointed to Liaoning, Shanxi and Guangdong as needing consolidation in steel and glass. The slowdown has battered Jiangsu, something symbolized by the near collapse of shipbuilder Rongsheng earlier this year. That company's president described the status of his industry as gray in 2011, black in 2012, and "bloody red" in 2013. So far this year, 70-80 percent of China's shipbuilders have received no new orders.
The State Council guidelines insist that governments at all levels must prepare support systems for laid off workers, ensuring, for instance, that they retain social security insurance and receive vocational training or other support. They suggest that tax relief, loans and consulting could be made available for laid off workers who become self-employed entrepreneurs, part of the broader vision of economic advancement. In reality, however, layoffs will not fold seamlessly into new employment in innovative, information technology and services jobs.
Thus, in order for Beijing's policies to be effective, local governments and targeted steel mills, glass makers, shipbuilders and others will have to determine that the cost of flouting new regulations — whether financial or procedural — outweighs the cost of adhering to them and suffering the political repercussions of layoffs, closures and lost tax revenues. This determination will depend not only on enforcing consolidation per se, but also on how tightly Beijing moves to contain the real estate bubble, since steel, cement and glass are major precursors to property construction, and it will be hard to rein in the former without reining in the latter.
Consolidation as a Test of Reform
The question for the new leadership is how to smooth out the effects of destructive market forces, and when and where to use government power to shield industries from them. Beijing is essentially preparing to disengage from actively supporting some parts of the economy, shifting back to the role of arbiter between stability and the need for change. It will do so primarily through an extension of regulation, which serves to enforce the new rules and to persuade the public that the government is addressing grievances over pollution and safety that have resulted from industrial overgrowth.
The consolidation raises obvious questions about the regime's willingness to tolerate higher unemployment. It will therefore become a crucial bellwether of the reform process. If the regime enforces it effectively, this might indicate that it feels secure enough to take long-term strategic moves and face down the consequences with propaganda and security tools. At the moment, the Xi administration seems capable of doing so. It has shown muscle in its party rectification campaign, targeting the major energy champion China National Petroleum Corp., and it is pressing forward with partial liberalization schemes in the financial sector and new free trade zones. In the upcoming Third Plenum, a meeting of Communist Party leadership, the Party will redouble its commitment to fiscal, financial, social and industrial reforms.
But if the economy slows too much, or worker issues begin posing more of a challenge, then the need to revive growth will likely water down enforcement. In the past, attempts at culling overcapacity have ultimately been overwhelmed by production capacity increases spurred by local interests and central laxity. If this happens again, it will reinforce the perception that has grown over the past 10 years of creeping paralysis in Communist Party leadership as economic efficiency and political stability clash. That is why the consolidation process will be critical to watch not only for the immediate impact on stability but also to gauge the regime's resolve in executing tough but necessary structural changes.
