WHEN SMALL IS NOT BEAUTIFUL
China wants its thousands of small steel enterprises to consolidate, but the divergent interests of various players and the central government’s heavy-handed administrative approach are hampering progress.
By Zhou Xiaojie

He declines to give his full name, and it soon becomes clear why. “We would rather be acquired by a foreign-invested enterprise,” murmurs Mr Wang, who occupies a post in the board of directors’ office at smallish Guangzhou Steel. With annual production of only 3m tons, below the threshold of 5m tons that would have entitled it to support from Beijing, the state-owned company is under pressure to consolidate with bigger rivals. But Guangzhou Steel, like many of China’s 4,000 small- and medium-scale steel companies, is balking. “We are not guaranteed any benefits under [central government-mandated] M&A,” complains Mr Wang. “This is one reason why SMEs have not warmed up to big groups like Baosteel, which are having such a difficult time doing acquisitions in China.”

And so Guangzhou Steel is waging a quiet rebellion. It has welcomed a scouting visit by Mittal Steel, which recently merged with Arcelor to become Arcelor Mittal, the world’s biggest steel group. It is also exploring the possibility of its Japanese joint-venture partner taking a controlling stake, although it is not clear whether the central government will give its permission. Local governments are also wading in. Earlier this year, Shanghai-headquartered Baosteel built up a 3.5% stake in Jinan Steel in Shandong province. But Baosteel’s M&A plan was stymied when the provincial-level Shandong State Administration of State-Owned Assets announced the merger of Jinan Steel and Laiwu Steel to form Shandong Steel Group, a union that Jinan Steel says it prefers because both companies are in the same province.

Despite a constant stream of edicts from Beijing, it seems that the long desired consolidation of China’s highly fragmented steel sector will take far longer to achieve than the country’s central planners envision. This is welcome news for the world’s steelmakers, which have been quaking in their boots at the prospect of high-quality, low-cost steel from China flooding their home and export markets. Years of blandishments and threats have so far resulted in China’s top eight steel mills producing only a combined total of 105.2m tons of steel in 2005 (see table, below right), smaller than Arcelor Mittal’s production capacity of 130m tons. The nine second-tier players smelted 61.9m tons. The SMEs, defined as mills with annual capacity of less than 5m tons, accounted for 229.8m tons, 58% of total national production.

But while foreign players may be feeling relieved now, in the long term it is in everyone’s interest for Chinese steelmakers to get their act together. In just ten years, China’s steel consumption has risen 211% to 272m tons in 2005, making it the world’s biggest user of finished steel. Chinese consumption in 1995 was a mere 87.4m tons, far behind the rest of Asia’s 194.7m tons, the 146.3m tons of the European Union’s 25 members, and the 118.7m tons of NAFTA countries the US, Canada, and Mexico. China has also become the world’s third-biggest importer of steel, after Europe and the US, and the fourth-largest exporter after Europe, Japan, and Russia.

It is disruptive for the global steel industry to have the steel sector of its most influential market in turmoil and unable to tackle overcapacity. The lack of clarity makes it difficult not only to discern the future direction of prices, demand, and supply, but also to plan international M&A. After Mittal Steel acquired 36.7% of Valin Steel in Hunan province in 2005, for example, Beijing halted all M&As involving foreign equity while it decides how to handle the issue. Equally important is the impact of an unruly steel industry on China’s economy. Overinvestment in the sector – steel production has jumped 153% between 2001 and 2005 – is contributing to economic overheating. Unchecked, such overspending can lead to a hard landing that will have serious consequences for China and the global economy.

Champs or Chumps?

Steel has a storied history in China. During the Great Leap Forward campaign in the 1960s, it was seen as emblematic of progress and of communism’s superiority over capitalism. Mao Zedong exhorted the country to produce as much of the metal as it could to overtake Britain and the US as steel producers, resulting in peasants making pig iron in backyard furnaces and neglecting agriculture and other pursuits. The result was a vast mountain of virtually unusable iron, and pollution and famine as food production was sacrificed for the vainglory of communism.

Fast forward 40 years. China has finally overtaken Britain, the US, and every other country in steel production. According to the World Coal Institute, which monitors global steel production because the process uses coal as input, China produced 349m tons of steel in 2005, two times that of number-two producer Japan’s 113m tons and nearly three times America’s 94m tons (see table, below). China now accounts for 31% of total global steel production of 1.1 bn tons. The quality and variety of its steel products have improved immeasurably from the 1960s, but China still needs to import certain high-value special steel products.

The problem is that the modern-day equivalents of Mao’s backyard furnaces still produce the bulk of China’s steel. These SMEs are bigger and souped up, of course, but compared with the Arcelor Mittals of the world, they are just village shops. The central government has long realized that fragmentation is not in the national interest, especially after the country became a member of the World Trade Organization in 2001. China can hold the line only for so long against global competitors seeking to flood the country with their products and demanding to set up shop there. When the inevitable happens, the large but fragmented local steel sector could wither away, or worse, require financial life support from the state.

Beijing’s solution has all the hallmarks of communist simplicity: Designate national champions in the steel sector and direct the rest of the industry to consolidate with them. The resulting juggernauts will not only preserve the domestic market for locals, the theory goes; the Chinese champs will also challenge foreign players in global markets and become global leaders in steel themselves. The sense of urgency in Beijing was recently reinforced by the merger of Arcelor and Mittal Steel. “To cope with the pressure arising from international consolidation,” says Zhang Guobao, vice director of the National Development and Reform Commission (NDRC), “we should create large steelmakers with annual output of 50m to 100m tons as soon as possible.”

But the central government is so keen on rapid consolidation that it is riding roughshod over the multiplicity of interests in the steel industry. “There have been not only obstacles in cross-regional alliances and slow progress in restructuring, but also difficulties in alliances among steelmakers within the same province,” says Yang Dayi, head of the reform and investigation team at the China Iron and Steel Association (CISA), a Beijing-backed industry group. Indeed, the Big Four steel firms under the direct administration of the central government – Baosteel, An-Ben Steel, Wuhan Steel, and New Tangshan Steel – remain minnows in the global scheme of all things steel, with their combined output of 70m tons in 2005 equal to just 62% of Arcelor Mittal’s.

Revolt of the Locals

On paper, the consolidation appears to be gaining steam. In August 2005, Anshan Steel in northeast China merged with nearby Benxi Steel to create An-Ben Steel. In the same year, Wuhan Steel in the central province of Hubei acquired Echeng Steel and Liuzhou Steel in Guangxi province, creating the biggest steel manufacturer in south-central China. In February this year, Tangshan Steel, Xuanhua Steel, and Chengde Steel, all in Hebei province, announced a three-way alliance to create New Tang Steel Group. CISA vice chairman and secretary general Luo Bingsheng articulates Beijing’s grand plan in these terms: “Baosteel can become a 100m-ton producer, while An-Ben Steel, Wuhan Steel, and New Tangshan Steel can aim for 50m tons.”

But the decision of Shandong province to merge Jinan Steel and Laiwu Steel put in stark relief the strong feelings in the regions against the central government’s consolidation approach. Had Baosteel succeeded in acquiring Jinan Steel, it would have expanded its annual capacity to over 32m tons. Instead, the emergence of Shandong Steel Group created a fifth heavyweight with a combined output of 20.7m tons in 2005, just slightly lower than what Baosteel produced that year. “The Shandong government wants to overtake Baosteel as the market leader in China,” says Guangzhou Steel’s Wang.

Baosteel’s M&A strategy is to purchase a stake in target companies, and then open negotiations for a full-scale acquisition. In addition to Jinan Steel, it has bought shares in Maanshan Steel, Handan Steel, Anyang Steel, Guangzhou Steel, and four other companies (see table, above). Handan Steel in Shanxi province, which produced 7.3m tons of steel last year, is fighting back. Its major shareholders have proposed measures to strengthen their control over the group, including enlarging the number of shares in order to dilute Baosteel’s stake, estimated at 4.9% of total shareholding and 9.7% of tradable shares.

It’s not difficult to see why local governments want to keep their steelmakers in local hands. They are big taxpayers. If they fall under the control of the central government, as the Big Four are now, the finances of some provincial and municipal governments will be hit hard. “There are differences in contributions to local government finance and tax revenues, as well as to the political equation,” explains Liu Er, secretary to the board of directors at Shaoshan Steel. “Local governments naturally don’t want to lose control of local steelmakers. They would rather create market leaders on their own turf.”

Except for a few privately owned steel makers like Sha Steel and Fosun Group, steelmakers in China are all state-owned, but they are administered at different levels. The Big Four plus Panzhihua Steel (2005 output: 6.2m tons) are overseen by the State Administration of State-Owned Assets, a central government agency. This means that they pay corporate income taxes to the central government first, with local governments getting only a cut based on the income of the subsidiary in their jurisdiction, the staff numbers of those subsidiaries and the proportion of local assets to total group assets. The bulk of value-added taxes also goes straight to Beijing’s coffers. In contrast, steelmakers directly controlled by local governments pay taxes to local authorities, which then remit a portion of it to Beijing based on a set formula.

Shotgun Weddings

Does it matter whether China’s champions are controlled by the central government or a local government, so long as they can compete directly with the globals? Perhaps not, but ownership is not the only issue. The problem is that most of the unions look like paper weddings, not genuine marriages that leverage on the strengths of both parties and take full advantage of synergies. For example, it has been more than a year since the An-Ben Group was created via administrative arrangement, but their finance, procurement, sales, planning, and tax-paying functions are still managed separately. The State Council, China’s cabinet, had dispatched a team to push integration, to little effect. The only discernible union is in monthly sales – the respective figures are combined and presented as the results of China’s second-largest steel group.

Analysts expect to see the same sham situation in the newly formed Shandong Steel. The outlines of the mock union are already discernible. Both Jinan Steel and Laiwu Steel will be treated as fully-owned subsidiaries of the holding firm, and they will therefore keep their separate legal-person status. On paper, Shandong Steel will have a board of directors and a supervisory board. But the authority to call and conduct shareholder meetings will be assumed by ultimate owner Shandong State Administration of State-Owned Assets, not the directors of the holding firm. Needless to say, a leadership reshuffle in either Jinan or Laiwu is highly unlikely.

“It’s all only on paper,” reckons Du Lihong, a researcher with Southern China Financial Research Institute. “The alliances are pretty loose.” The experience of the US steel industry at the end of the nineteenth century, he adds, suggests that such relationships will not be long-lasting. Says Du: “Only strategic M&As involving real money in the marketplace can pull off the task of asset consolidation.”

Some big steelmakers agree. Maanshan Steel in Anhui province, which produced 9.6m tons of steel in 2005, prefers market solutions over administrative directives. “Restructuring is only one model of growth, and it has to align with overall corporate strategy,” says an executive at the chairman’s office, who requested to be referred to only as Mr Hu. “Maanshan Steel doesn’t have an M&A plan. We are taking another path to build up scale, such as restructuring and optimizing our product mix, and expanding capacity (through organic growth).”

Maanshan Steel is spending more than 20 bn renminbi on a new integrated complex that will have smeltering and rolling capabilities. When it opens in June next year, Maanshan will increase production capacity of high value-added steel plates from 3m tons currently to 5m tons, or 60% of total production. The company’s various steel-plate products are used in shipbuilding, factory boilers, and other applications that require top-grade steel. Maanshan aims to make steel plates as its core competency, and also to expand annual capacity to 14m tons. “We will consider M&As only then,” says Hu. The company has a relationship with Baosteel, but Hu describes it as just a “strategic agreement,” nothing approaching a merger.

To its credit, Baosteel appears to realize that there is more to growing big than simply adding up turnover figures. “To overcome obstacles in cross-regional M&As, the most important thing is to deal well with taxes and people issues, build and refine the management incentive mechanism, and raise management enthusiasm about restructuring,” says Chen Ying, who is CFO of Baosteel but is not directly responsible for M&A activities. “At the same time, it is necessary to change the old management performance review system and replace it with a more active, market-oriented system. Only by doing this can the interests of local governments, enterprises, management, and employees be weighed together and considered.”

Baosteel had shotgun weddings in 1998 when Beijing arranged for it to acquire Shanghai Metallurgical and Meishan Group through a share reallocation scheme at no cost to all the parties, the same arrangement used in the Wuhan Steel-Echeng Steel-Liuzhou Steel union last year. Neither Baosteel nor Wuhan is willing to discuss the success (or failure) of the resulting restructuring, but the fact that Baosteel is now pushing a market approach via stake-buying is suggestive. Even so, the central government does not seem to have given up on administrative means to force consolidation. CISA’s Yang asserts that progress is being made at An-Ben Group. “Although there has been resistance and difficulties, the parties have reached some consensus and there are now some detailed implementation plans,” he says.

Foreigners at the Gate

All of this means bad news for SMEs like Guangzhou Steel, which oppose consolidation by administrative means, whether arranged by the central government or by local officials. “SMEs are hard-pressed to explore the way forward,” complains Wang. “Unfortunately, neither CISA nor the NDRC care about our interests.” Guangzhou Steel may be a small producer, he says, but it is in a niche market that is very promising. “We have a joint venture with a Japanese company to produce premium automobile panels, and our major customers include Toyota and Honda,” Wang says. “We wanted to expand cooperation and might even allow our Japanese partner to take a controlling stake. Due to policy restrictions however, we are still state-owned today.”

And Mittal Steel? “They had come to Guangzhou Steel to check us out,” says Wang. “We have not started with detailed work yet, which needs long-term planning.” Earlier this year, the newly merged Arcelor Mittal won preliminary approval to buy 38.4% of Laiwu Steel for US$260m, but the status of that deal is now uncertain after the Shandong local government’s move to merge Laiwu with Jinan Steel. Arcelor Mittal’s negotiations with Baotou Steel, Kunming Steel, and Bayi Steel are also in limbo as the central government grapples with the issue of whether to allow foreigners to control Chinese mills.

The China Iron and Steel Association has made its position clear. “CISA opposes foreign capital acquiring and owning strategic domestic steelmakers,” says secretary general Luo. “We also oppose a single foreign company acquiring stakes in multiple Chinese enterprises to create a monopolistic position.” What about the newly issued National Steel Industry Policy, which calls for steel enterprises to consolidate and restructure? “CISA supports super-sized enterprises playing a dominant role in the process,” says Luo. “But with regard to foreign capital, especially M&As by large international enterprises, this should be dealt with on a case-by-case basis. In principle, foreign capital should not be allowed to control large Chinese steelmakers before the state has developed specific policies regarding foreign acquisitions.”

But Arcelor Mittal is confident that Beijing will eventually side with foreign capital. “It is a process with the government,” CFO Aditya Mittal told CFO Asia in September. “We have to demonstrate that we bring value to Valin Steel and to the Chinese steel industry. If they can see that over the next three or four years, I do believe they will allow us to take full control over the company.” Other foreigners are betting on the same outcome. “Talks between South Korea’s Posco and Taiyuan Steel are also in an advanced stage,” says Shi Qirong, a consultant with the NDRC.

The central planners in Beijing need to weigh China’s options in the post Arcelor Mittal era. Other behemoths are already in the making. In October, Posco and Japan’s New Nippon Steel, the world’s largest steelmaker before the Arcelor-Mittal merger, announced a plan to build up stakes in each other, a cross-holding that could eventually lead to a full merger. The Japanese government is revising its anti-trust law to allow the formation of 100m ton domestic steel enterprises. Russia, too, is planning to consolidate resources to create a new steel giant. And some large Brazilian steelmakers are accelerating alliances and restructuring.

“Domestic companies should consider how to build up scale, enhance competitiveness, and take the lead in domestic consolidation before foreign capital’s entry,” says Baosteel’s Chen. At the same time, she adds, “we should consider ways to better utilize foreign capital and enhance cooperation with foreign enterprises.” It’s a conundrum that the central and local governments, not to say the steel industry, need to resolve sooner rather than later. The clock is ticking.