>EUROPEAN CHAMBER: Overcapacity in China

SUMMARY: Overcapacity is a blight on China’s industrial landscape, affecting dozens of industries and wreaking far-reaching damage on the global economy in general, and China’s economic growth in particular. Yet it is a strangely under-studied and seldom-examined phenomenon.

In the Summer and Autumn of 2009, the European Chamber and Roland Berger Strategy Consultants set out to examine to what extent overcapacity harms China’s economic development and contributes to rising trade tensions, and to provide suggestions on how this increasingly urgent problem could be addressed.

As will be outlined below, the overcapacity problem in China is by no means a new one. But its pervasive influence has become ever more prominent – and its effects on both the Chinese and international economies have become ever more destructive – in light of the global economic crisis that still grips world markets.

The crisis has throttled demand for exports from China at a time when even more investment, in the form of the Chinese government’s massive stimulus package, is being pumped into building new plants and adding unnecessary capacity. As a result, the problem is actually getting worse in many industries.

This in turn is having a severe effect on the Chinese economy. The extremely low utilisation rates in industries producing at overcapacity go hand-in-glove with resource waste. Companies are cutting corners, often disregarding environmental as well as health and safety standards and circumventing labour and social laws. Companies in overcapacity industries suffer from low profits and lack sufficient cash for R&D projects, leading to less innovation. Meanwhile, as banks bankroll the addition of unnecessary capacity in certain industries, the threat from non-performing loans (NPLs) is growing. At the same time, the global impact already can be felt in the form of growing trade tensions. Since trade frictions hamper supply chains, this is a major threat to globalisation’s positive effects.

The economic crisis has, then, given added impetus to the drive to find solutions to this key issue. It is precisely for this reason that the European Chamber, along with Roland Berger Strategy Consultants, produced this report.

The goal of the study is to discover why and how overcapacity has come to affect some of China’s key industries and, armed with this knowledge, to provide recommendations and suggestions on how the problem can be brought under control.

The study is divided into four sections. The first examines the emergence of China’s current overcapacity problem, the policies and politics that underpin it, and the reasons why the problem has worsened as a result of China’s stimulus package.

In the second section, the study will look at how this problem is affecting several key industries, and ask what are the specific drivers of overcapacity in these sectors. The industries examined in detail are:
• Steel
• Aluminium
• Cement
• Chemicals
• Refining
• Wind Power Equipment

Study findings show that overcapacity is driven by a small number of key recurring factors, among them:
1. High savings particularly driven by retained earnings from state-owned enterprises (SOEs)
2. Collapse of demand in export markets, primarily in the United States
3. Low domestic consumption
4. Weak enforcement of regulations
5. Low input prices due to government policies
6. Too low cost of capital in China
7. Fiscal system encourages local government to attract excessive investment
8. Local protectionism
9. Inexpensive and widespread availability of technology
10. Regionalism driving industrial fragmentation
11. Environmental, Health and Safety standards and laws not fully implemented
12. Philosophy of market share vs. profitability

The third section of the study then turns to the broader impact of China’s overcapacity – how it negatively affects the growth of China’s economy and how it also contributes directly to rising global trade frictions.

Finally, based on the findings of the first three sections the study offers a number of
recommendations on how overcapacity can be reduced by shifting policy priorities away
from investment- and export-oriented growth and focusing on more balanced patterns of
growth, driven by domestic consumption and a vibrant service sector. This policy shift is
the key to curbing industrial overcapacity.

REASONS FOR OVERCAPACITY

It is normal for developing economies to go through a period of rapid industrialisation. China’s economy today follows a pattern already traced by the economies of Japan, Korea and Taiwan in the late 20th century. China’s concentrated focus on developing its heavy industry has led to overcapacity in this sector. This overcapacity can mainly be attributed to three factors:

• Rapid urbanisation: 1% of China’s population moves each year from rural areas into urban ones. The major housing development that results from this migration creates massive domestic demand for construction machinery, building materials, steel, cement, and chemical products.

• High savings: The Chinese have a high savings rate, partly because of the lack of social security, but also because of the limited investment choices available to households, stringent capital controls, and policies that systematically transfer income from the household sector to producers, thus exacerbating the gap between production and consumption. This abundance of capital has led to abundant domestic funding and low interest rates.

• Low input prices: Input prices are low mostly because government policies stimulate the secondary sector, especially heavy industry.

See CAUSES, IMPACTS & RECOMMENDATIONS also