Steeled for change: China's bloated industry to face market forces
* Top officials tending toward market reforms
* Direct state intervention in steel sector has failed
* Bankruptcies unpalatable, subsidies unsustainable
BEIJING, Aug 16 (Reuters) - Momentum is growing in China to allow market forces to end a titanic capacity glut in heavy industry that a decade of state interventions has failed to resolve, according to speeches made by high-ranking officials this month at a closed-door event.
The speeches indicate that China's reform-minded cabinet is considering a dose of deeper structural reform to remedy bloated, inefficient and debt-laden sectors such as steel.
China has around 300 million tonnes of surplus steel output capacity, equivalent to nearly twice the output of the European Union last year.
Encouraged by easy financing and cheap energy supplies, local governments looking to meet job and growth targets have steadily built many more steel mills than the country needs.
The steel sector is likely to be the first to feel the pain of a new approach based on tighter regulation and market economics. If it works, steel may become a model for how the government deals with other sectors such as aluminium, cement and shipbuilding.
Beijing has yet to make clear whether it would begin to allow loss-making firms to go bankrupt. Until local governments stop propping up firms, any reform will be slow and partial.
"The current methods of management do not suit the requirements of the industry," said Miao Zhimin, vice-head of the raw materials department at the Ministry of Industry and Information Technology (MIIT), responsible for the steel sector.
According to transcripts of speeches made to a China Iron and Steel Association (CISA) gathering last week, Miao said his ministry had already decided to stop micromanaging the sector and would instead try to ensure the market runs smoothly by establishing a level playing field and stronger rules.
It has started to implement a new registry to ensure steel mills operate under the same rules and standards, with the aim of making competition fairer across regions. It has also vowed to let the market rather than government pick which firms merge.
China's cabinet, the State Council, has identified overcapacity as one of its policy priorities this year, and it has been the driving force behind efforts to slash red tape and increase the role of the market in key industries.
Experts say a market-based approach would need a system that allows firms to exit. If Beijing is unwilling to countenance mass bankruptcies due to concerns about job losses, it should at least make it harder for new firms to enter by breaking up a support structure in which they are cosseted with subsidies and cheap credit, they say.
"We've got 21,000 steel companies and there are still more being created every year," said Scott Kennedy, director of the Research Center for Chinese Politics and Business at Indiana University, who has studied China's steel firms.
"Banks shouldn't be giving those start-ups money."
The 30 largest listed steel firms are estimated to have racked up nearly 760 billion yuan ($124 billion) in debt, largely as a result of rapid expansions and high costs.
A Reuters survey of 15 listed firms, including market leader Baoshan Iron and Steel (Baosteel), showed that despite receiving 3.49 billion yuan in subsidies in 2012, they still made losses of 5.29 billion yuan over the year.
With Beijing increasingly concerned about local government debt, there is a growing understanding that cash-strapped regions cannot bail the sector out indefinitely.
"Reform is going to hurt, but not reforming will hurt more," said Jiang Feitao, policy researcher with the China Academy of Social Sciences (CASS).
Beijing has sought to rein in the steel sector since 2003, but attempts to strong arm firms and local governments have failed. China's capacity surplus now stands at about two fifths of last year's output of 716.5 million tonnes. Utilisation rates last year fell to 72 percent.
The old approach was typified by a target, set in 2010, to put 60 percent of total steel capacity under the control of the 10 biggest firms by 2015. Despite heavy-handed efforts to force mergers, the market share of the top 10 fell from 49 percent in 2011 to 45.94 percent in 2012, official data showed.
"If you are just forcing the largest firms to be even bigger producers and have even larger shares of the market, you risk introducing inefficiencies into the industry," said Graeme Train, analyst with Macquarie in Shanghai. "That is a realisation that the government is coming to now."
The target ended up raising total capacity rather than cutting it, said Xu Lejiang, the chairman of the Baoshan Iron and Steel Group, parent of Shanghai-listed Baosteel and China's second-biggest steel producer, speaking at the CISA meeting.
Xu said "administrative factors" had turned steel firms into "huge monsters" lumbered with massive unprofitable investment. He urged China to "make market forces the guiding principle".
Miao of the industry ministry said China had failed to establish strong and universally enforced environmental rules, quality standards and even rates of taxation. The ministry says market signals have been distorted in all areas, including energy and land prices, leading to "blind investment."
SURVIVAL OF THE FITTEST
It remains to be seen whether Beijing or local governments will consider widespread closures a price worth paying. A small steel firm declared itself insolvent earlier this year, but bankruptcies remain rare despite mounting losses even at well-connected state-owned firms.
While many industry minnows voluntarily go out of business when times are hard, China lacks a bankruptcy mechanism to allow creditors to be compensated. Local governments have encouraged larger firms to acquire stricken assets and minimise job losses.
Mills receive hefty subsidies from local governments and also compensation for closing outdated plants and complying with state environmental rules. The 15 firms surveyed by Reuters received at least 127 million yuan in the first quarter of 2013.
Even if Beijing ordered subsidies to stop, state enterprises have access to cheap land and loans as well as low prices for energy and raw materials. They are even given stakes in projects such as coal mines to make them economically viable.
"They use land, government finance, direct subsidies, which are all major causes of overcapacity," said Jiang. "If local government income doesn't keep rising, these subsidies to local steel firms can't keep rising either and in the end they will be forced to restructure, whether the system is reformed or not."