Originally published by Gordon Orr on LinkedIn: How Much Control Does the Central Government Really Have in China?

China’s steel industry is proving to be a case example of how difficult it still can be, even in the more centralized regime of Xi Jinping, to get instructions executed in the provinces with the scale, and at the pace requested, if local politicians and business folk don’t see the benefit to themselves.

Direction, exhortation and even financial transfers (USD$12 billion allocated) have not been sufficient to get local government to implement capacity shut downs of the scale requested. Through July, claimed capacity reductions were less than half the target for the year (and less than 40% of the target for coal capacity reduction). Some provinces were reported by the NDRC to have achieved only 10% of their annual targeted cuts.

Claimed reductions should not be equated with actual permanent capacity reductions - some plants have restarted as prices rose in the last few months. And don’t forget the target for capacity reductions of 45m tons was pretty modest, less than 5% of total capacity and not much more than 10% of actual overcapacity.

This resistance has led to more and more shrill directions from Beijing to act on instructions. Now Beijing is sending out 10 inspection teams across the country to check on claimed capacity removal and to require follow through on additional closures. I have one suggestion for them: The only way to ensure a closed plant remains closed is to physically destroy or remove key pieces of equipment. Otherwise don’t be surprised when it starts back up again.

Why is capacity reduction proving so hard when excess supply is clearly massive?

• Exports: China’s steel exports in the first half of 2016 were a record 57 million tons, up from only 5 million tons in first half 2009, with forecasts for further growth in the second half of 2016. Sales were particularly strong to South East Asia. There are clearly export markets with growing demand for steel that lack a strong domestic steel industry, and that simply want to buy the most price competitive steel. With Chinese mills willing to price towards marginal cost and the depreciation of the RMB, it’s not surprising that demand for Chinese steel in such markets is strong.

• Domestic Demand: An uptick in housing prices led to a recovery in housing starts in many parts of China in 2016. Domestic inventories of steel were low. Consequently, prices for steel started to rise, making it possible for more steel mills to produce at least on a marginal cost basis. This allowed their lenders to continue to roll over their loans to local mills, and allowed mills to continue to pay something to their workforce. Moreover, the steel market is multi-local, with local government encouraging local construction companies to buy steel from local producers. A mill need only be locally, not nationally, cost competitive in order to produce.

• Cross Provincial Consolidation: Consolidation talks between some of China’s largest steel producers are underway. But, unsurprisingly, progress is slow. Local governments want to ensure the plant in their region remains to support employment and tax generation. Top management wants to ensure they come out on top as positions get reduced. If and when they do merge, the economic logic of these industry leaders reducing capacity is pretty poor. They have larger scale production facilities, greater depth of operating skills, secure access to finance and higher quality output. Market forces would make these industry leaders the long term winners. Capacity reduction should rationally be concentrated in the smaller, marginal, lower quality producers.

• One Industry Towns: Many steel mills are the key employer and tax payer in their city. In boom times, they might have provided as much as 30% of the tax revenue for local government. Workers from the steel mill were at the forefront of buying property in the town, creating a positive cycle of additional demand for housing and steel. If these workers are now laid off, even with one-time transfers from the center, local government faces an enormous challenge in trying to find new jobs for people who have been in a steel mill all their life. They can’t all become part-time Uber/Didi drivers. Many government officials see delay as the most logical course of action.

• Cascade effect of recognizing bad debt: And beyond workers, there is the cascading impact on other parts of the local economy. Local banks may have lent heavily to steel mills and related local construction companies, issuing long-term loans funded by short-term high interest paying wealth management products. If the steel mill is permanently closed, then the banks have no choice but to write off the loan. For the big four Chinese banks this is quite manageable, but for smaller banks it could be fatal. Already we are seeing some of the larger banks declining to support smaller banks in their financing operations. Cities could see their local banks come under severe pressure. And then maybe also their local construction companies as their land banks decline in value, their inventory of housing remains unsold, and they need to lay off workers themselves. The fear of a steel mill closure triggering broader difficulties in other sectors is very real.

• Local government mindset: Much of the time local government officials in China are playing defense, trying to avoid criticism more than trying to garner praise, seeking to be in the middle or the back of the pack rather than out front (just in case a policy changes mid course). Often they are seeking out what is the least worse option for themselves. In this instance they would much rather be criticized for not shutting a plant as quickly as Beijing likes than for allowing social unrest in their city as laid off workers who see no future for themselves demonstrate.