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China’s President Xi Jinping commonly refers to “the Chinese Dream” as an attainable standard of living within that nation. In the case of steelmaking in China, it is hard to imagine anyone dreamed of output levels of 820 million tonnes, which the nation achieved in 2013 and again in 2014. Adjectives like amazing and staggering apply to production at this level, though more recently steelmakers in other nations use adjectives that are not so complimentary.

For some perspective on China’s rapid ascent, slightly more than three decades ago, in 1983, the USA produced 76 million tonnes of steel, while China produced about 40 million.

The amazing 800 million tonnes per year China reached seems to represent its peak. Steel output in China receded a bit in 2015 and is starting out on the same path in 2016.

Little indicates China can engage in the levels of infrastructure building and apartment tower construction it splurged on in the previous 25 years. Central planning documents and Communist Party signals alike point to a pivot toward a more services- and household-consumer-based economy.

It is the source of tremendous debate among economists of different schools of thought, and investors who follow them, as to how and whether China will accomplish this pivot. In any case, it seems China’s policymakers have accepted there really is no way for the country to consume 800 million tonnes of steel each year.

SIGNS OF TROUBLE

The signs pointing to this abundance of overcapacity have been visible for some time, and have been referred to not only by Western trade groups and media but by internal ones in China as well.

By July 2013, Chinese media reports were acknowledging the profitability difficulties facing Chinese steelmakers.

Even though the People’s Republic has one-party rule, the actions of its government or its steel industry are not monolithic. Power is centred in Beijing, but it also is dispersed through provincial and smaller subdivisions, and policies can be interpreted and implemented differently—sometimes intentionally.

Having said that, one-party rule and a centrally planned economy also can create conditions vastly different from what exist in more market-oriented economies.

The pattern steelmakers have experienced historically in the U.S., Europe and elsewhere when overcapacity exists and steel prices plummet consists of balance sheet problems followed by mill closures and even bankruptcies. Indeed, throughout 2015 many steel mills did idle their furnaces. However, not necessarily in China but rather in the United Kingdom, Spain, Australia, and the United States.

When one looks at how things unfolded in 2014 and 2015, it is understandable why the American Iron and Steel Institute (AISI), Washington, on its website calls China “a nonmarket economy” that “has disrupted world markets through state support of expanded production of steel and steel-containing products.”

Voices in China were foreseeing that very outcome. In 2012, Liu Haimin of the China Steel Industry Development Research Institute, in a presentation to the OECD (Organisation of Economic Cooperation and Development), noted that China already had experienced a wave of steelmaking overcapacity in 2006 and 2007, and that China’s 12th Five-year Plan further strives to “strictly control exports of goods with high energy use, high pollution and high resource consumption.”

Liu identified that overcapacity would lead to massive exports, which are not sustainable. So what happened?

AN UNPOPULAR ZOMBIE MOVIE

If the goal was to avoid overcapacity and massive exports, the target was badly missed. By 2013, China’s 700 million tonnes of steel consumption were outpaced by its 822 million tonnes of production. That more than 120 million tonnes of excess production is more than the entire output in the U.S., or about three times Germany’s annual production.

This is the point where the narrative switches to that of a zombie movie. Throughout the past three years, a term that grew in popularity was “zombie mills.” One hears this sometimes applied to copper, aluminium and newsprint facilities as well, but the zombies play a leading role in the steel sector.

When steel industry managers, analysts and journalists see mills that are allowed to keep churning out steel quarter after quarter while losing large sums of money, that leads to questions. The foremost question is: How has this situation been able to linger for this long? The answer comes in several parts.

Steelmaking is considered a strategic industry in many nations, and 20th and 21st century China has been no exception. Chairman Mao and the Communist Party identified it as a “pillar industry.” During the ill-fated Great Leap Forward of the late 1950s and early 1960s, Mao’s China invested to build blast furnaces in as many small towns and urban neighbourhoods as possible, apparently in a nod to Soviet-style industrialization and the belief that a nation that produces its own steel is making progress.

Although the low-grade pig iron that resulted in that era did not catapult China’s steel industry forward, steelmaking’s status as a pillar industry has been maintained. Currently, as much as two-thirds of the steel produced in China emanates from state-owned enterprise (SOE) facilities.

When organisations like the AISI complain about China not being a market economy, SOEs are a big reason. Their detractors say they are subsidised, immune from regulations, avoid taxes and receive loans (largely from SOE banks) that do not stand up to independent underwriting scrutiny.

While SOEs produce about 65 percent of the steel output in China, SOE banks may control as much as 75 percent of the banking and lending activity. It might be hard for a neutral party to fall in love with a zombie, but apparently an SOE bank can get along just fine with an SOE zombie mill operator.

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SOE Sinosteel, which equips and supplies steel mills and also has a presence in iron ore mining, has been facing bond payments it cannot make since the fall of 2015. Some combination of cash infusions and bondholders being instructed not to insist on collecting their debts, however, seems to have kept this zombie lurching forward. (In mid-April 2016, Sinosteel’s deadline to repay interest on its bonds was postponed for an eighth time.)

Another factor contributing to the prolonged existence of zombies ties into China’s Communist Party’s attempts to please multiple constituents.

Abundant policy objectives emanate from Beijing, but it is widely reported that lower level officials are truly judged by one yardstick: the gross domestic product (GDP) growth in their cities, counties or provinces.

A large steel mill not only acts as an important jobs provider, it also contributes to GDP. This is especially the case in China’s Northeast quadrant, the traditional home of China’s coal fields and its steel industry. That part of the country is near to Beijing and traditionally loyal to the party. Its welfare is important for political and public relations purposes.

That is one of many reasons why China’s leaders are extremely anxious about avoiding the creation a 1980s-era Rust Belt of its own. Downsizing and reforming China’s steel industry will be weighted heavily toward taking action in China’s Northeast.

Thus, the hands of party leaders really do seem tied to some extent. The northeast is where most of the inefficient, money-losing, high-emissions mills are located. While statements from public officials refer to retraining workers for the high tech or service sectors, those jobs are more widely present in Shanghai or Shenzhen and points in between—not in the Northeast.

Sticking to a plan like that would seem to involve additional reforms, this time pertaining to China’s hukuo registration system, which keeps many of its citizens tethered to the provinces or even the counties where they currently live.

A SLOW TURNAROUND PROCESS

Nonetheless, published statements in party-approved media outlets that refer to zombie mills and their ill effects have provided some encouragement.

As early as 2013 and then into 2014 and 2015, overcapacity was being referred to, but most often in a vague way that might include statements from government ministries that measures of some sort were pending. Often it was implied that mills that were heavy polluters would be subject to closure by the Ministry of the Environment (MOE). However, when GDP growth is the highest priority, the MOE may not genuinely have had the power to do much, especially when SOEs were involved.

The first quarter of 2016 is when a little more clarity became apparent in public statements. A Beijing Review article on the topic of zombie companies states in part, “The final sentence has been written for the shutdown of zombie companies. The Central Economic Work Conference held in December 2015 vowed to resolve industrial overcapacity, wherein a crucial aspect for its success will be the restructuring of zombie companies.” This makes it sound like progress is just around the corner.

In late February 2016, a Chinese government official placed a number on potential job cuts in the steel sector, using a figure of 500,000. That would certainly lead one to believe numbers are being crunched and programs are being created to actually phase out some of the massive excess steel capacity.

That is not to say progress moves in a straight line. Infighting continues to take place between the central and local governments, tying into the GDP growth “worship” that remains entrenched.

In early March, a small bump in the price of steel within China might have helped buy more time for some zombie mills, as might subsequent global steel price hikes.

Scaling back overcapacity already has been a long time coming, especially from the perspective of steelmakers in the rest of the world. And, despite the obstacles spelled out here, the government might have reasons or incentives to take action sooner rather than later.

One of these reasons is air pollution, to which older steel mills in particular contribute. Also among China’s policy aims is to have its currency gain global reserve status. That cannot be accomplished by China’s political will alone—it will take international cooperation. Currently, the AISI isn’t the only entity suspicious of China’s status as a market economy. Other holdouts include India and several European nations.

In March 2016, China’s premier pointed to lowering protections for SOEs as one of the steps it will take in its quest to pursue market economy status.

The statement might have been a little short on specifics, and it doesn’t mention steel specifically, but it does make a nod to the idea that the status enjoyed by SOEs is a problem to be addressed as far as the rest of the world is concerned.

The incentives are in place, but the scale of the challenge is considerable. Even in its biggest boom years, the United States never created the enormous overcapacity that now seems to be overhanging the Chinese steel sector.

For better or for worse, those within the steel industry and those who analyse it are observing what could be a critical juncture for China’s current leaders. Outsiders, including critics of central planning and also those who say they simply want China to play by the same rules as other World Trade Organisation (WTO) nations, have been calling for SOE reform for a long time.

Plenty of sentiment within China calls for SOE reform,too, including that of managers of private sector companies who compete with them. But resistance also is present, and how or if the current party leaders resolve these conflicting points of view on SOE reform is likely to get an early test in the steel sector.

The author is editor of Recycling Today Global Edition and can be contacted at btaylor@gie.net. This article is based on a presentation prepared for the Platts Steel Markets North America Conference that was given 14 March 2016 in Chicago.