China’s Excess-Capacity Nightmare

By Mark A. DeWeaver

SHANGHAI ― Back in 1958, the year of China's ill-fated ``Great Leap Forward," Chairman Mao had big plans for the steel industry.

While production had been just over five million tons in 1957, he expected the country to catch up with or even surpass the United States by 1962, producing 80-100 million tons per year, and to reach 700 million tons per year by the mid-1970s, making China the undisputed world leader.

All this was to be accomplished using small ``backyard steel furnaces" operated by ordinary people with no particular technical expertise.

Today, Mao's dream of catching up with the rest of the world has been realized, albeit a bit behind schedule, not only in steel making, where annual capacity has reached 660 million tons, but in many other sectors as well.

In 2008, China ranked first in steel (about half of world production), cement (also about half), aluminum (about 40 percent), and glass (31 percent), to take just a few examples.

The country topped the U.S. in auto production in 2009, and remains second only to South Korea in shipbuilding, with 36 percent of global capacity.

For Beijing's central planners, however, the size of China's industrial base has become a cause for alarm rather than celebration.

In a document approved by the State Council on Sept. 26, the National Development and Reform Commission (NDRC) warned of serious excess capacity in a wide variety of sectors.

(The State Council, which includes the premier, vice premiers, and heads of ministries and commissions, is China's highest executive authority.)

Based on the NDRC's figures, 2008 capacity utilization rates were just 76 percent for steel, 75 percent for cement, 73 percent for aluminum, 88 percent for flat glass, 40 percent for methanol, and 20 percent for poly-crystalline silicon (a key raw material for solar cells).

The current project pipeline also implies less than 50 percent utilization for wind-power equipment manufacturers in 2010.

Excess capacity has been a priority for the State Council since 2005, when it issued industry-by-industry restrictions on new projects and targets for shutting down inefficient production. Since that time, however, the situation has in many cases only gotten worse.

The problem is that much of the so-called ``blind" and ``redundant" investment that Beijing would like to eliminate has the strong support of local governments, whose primary concern is with generating GDP growth in their jurisdictions, regardless of whether the means of achieving it make any economic sense.

Consider cement production, where, according to the China Cement Association, 38 percent of capacity consists of ``shaft" kilns.

These have been obsolete in most of the rest of the world for over a century, and accounted for less than 3 percent of production even in 1957, when most of China's cement plants were imports from Eastern Europe.

Nowadays, however, shaft kilns are a favorite of local governments because they can be built cheaply and quickly and generate growth and employment. Achieving economies of scale and lessening environmental impacts simply are not priorities.

A similar situation exists in the steel industry, where the central government has made repeated unsuccessful attempts to close small furnaces.

In 2006, for example, the NDRC produced a list of plants that were required to cease operations by the end of the following year.

As the deadline approached in December 2007, a correspondent from Mysteel, a leading local source of information on the sector, visited a number of these mills to see first-hand how they were progressing with the government-mandated dismantling of their equipment.

What he found was a great example of how any such program is likely to work in practice. One site was still operating 24 hours a day; in others production had been temporarily halted until the deadline passed. In only a very few cases had any machinery actually been removed.

Local officials and managers had a variety of reasons for not complying with the NDRC's order. Some expected to expand their plants so that they would no longer be counted as inefficient ― a stratagem explicitly prohibited by the regulations.

Where facilities were privately owned, it was felt, perhaps not unreasonably, that removing assets would violate China's property-rights law.

One formerly state-run enterprise was being operated under a 2001 lease specifying that no workers could be laid off for the next ten years.

And there were also jurisdictions that had canceled the licenses of the operators in question, so that, as one regulator put it, they simply ``didn't exist."

China's excess-capacity problem reveals a serious defect in its ``socialist market economy." In many industries, neither market forces nor central planning are strong enough to bring about the ``creative destruction" of inefficient producers.

As a result, the dream of catching up with the developed countries has to a surprising extent been realized much as Mao imagined ― by lower-level cadres using small-scale technology.

If simply leading the world in output is the goal, the Chairman's vision has been resoundingly vindicated. But if product quality, environmental protection, and economic efficiency are important as well, this state of affairs is little short of nightmarish.

Mark A. DeWeaver manages the hedge fund Quantrarian Asia Hedge. For more stories, visit Project Syndicate (www.project-syndicate.org). For a podcast of this commentary in English, please use this link:
http://media.blubrry.com/ps/media.libsyn.com/media/ps/deweaver2.mp3.

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