China's grand expansion

Obsession with steel size and global power may prove to be the Achilles Heel of the Chinese Communist Party's (CCP) vision of China becoming the factory of the world and the dominant global economic, industrial and military powerhouse.

The perception that China's export-reliant economy and insatiable demand for resources will provide the energy to drive the global economic recovery may be ill founded, especially for resource export reliant countries. The objective of the stimulus plan was to spend US$586 billion by the end of 2010 and raise China's GDP (gross domestic product) by 0.1 per cent.

While infrastructure spending exceeded the target and elevated GDP to double digit growth, it also exposed banks, local government and the state to unprecedented levels of questionable quality debt.

Debt bubbles

The emerging debt bubbles of the related steel, property, local government and state banks are shaping as the greatest challenge to China's economy and the CCP as government.

The CCP claims its economic management is responsible for "China the economic miracle", provider of employment, raising the rural and urban poor out of poverty, and elevating China to its rightful place as the major global power.

Scrutiny of China's export industries, state v private sector, and net contribution to GDP and taxation revenues, however, questions those claims. Two of Mao's three generals are under serious threat: General Steel and General Coal.

Steel

Before the global financial crisis, serious industrial overcapacity was an emerging problem in various sectors, especially steel.

Beijing's infrastructure-driven stimulus spending created unprecedented demand for steel, cement, copper, heavy equipment and motor vehicles and is planned to continue to the end of 2010.

The steel content in the stimulus spending was a major contributor to China recording recent double-digit GDP growth figures. Major steel state owned enterprises (SOEs) received a substantial share of the US$3 billion in discount loans and special funding for technology upgrades.

Four sectors of the ambitious infrastructure program have insatiable appetites for steel:

• railways;
• energy;
• urbanisation; and
• construction.

In 2009, China's steel production capacity rose 13.5 per cent, reaching 567.8 million tones. That 50 million tons in expansion produced an excess capacity of 20 million tons. By early 2010, China's total capacity rose to 660 million tons and January steel production reached 47 per cent of global production. Overcapacity could reach 20 million tonnes during 2010.

Pricing

Imported ore prices rose 38 per cent in 2009, with a further minimum 50 per cent increase likely for 2010-2011.

Sole responsibility for the 2009 price rise lay squarely with Beijing and CISA. Rejecting the contract price, agreed to by the global steel majors, China's mills had to buy on the higher price spot market.

The looming problem for China is Beijing's rigid command economy mentality that refuses to adapt to a free market global economy and attempts to impose its will on that market by direct involvement in negotiations. Beijing's frantic manoeuvring and posturing on iron ore pricing however, has far greater and urgent implications for the steel industry and the economy.

China failed to factor in rising iron ore prices, and because of the massive content of steel in the stimulus package, Beijing is facing a major blowout in stimulus spending, and the economy's rising debt load. The CCP cannot cut back without losing considerable face and has no option but to fund the program from all available sources.

Cutting back will hit the steel industry, steel producing provinces, and especially local and national GDP, and unemployment. Resolving the problem of serious civil unrest by redundant workers will come with a large price tag or increasing violence.

Cuts will create a ripple effect on the coal and energy producing industries and regional bases. But without cuts debt will continue to mount and property values will decline.

While there is growing debate as to China's overcapacity in 2010, the reality of that overcapacity will become apparent at the end of 2010 when the stimulus projects are completed. China will then need buyers for what will be a major steel capacity surplus and a sudden decline in the driver of its steel industry, China's own domestic demand.

Steel exports

It is not only spiralling domestic demand for steel that is driving iron ore imports. Official statistics report rising exports for China's steel despite tariffs from the US and Europe for products that included oil drilling pipe driven by rising exploration and development.

Scrutiny of those exports, however, reveals that they form a critical and valued component of China's aid programs in client states that range from neighbouring Asian countries in the South, to Russia and North Korea in the north; west to Central Asia and the Middle East; south into Africa and across the oceans to the south Americas.

Aid, grants and low interest loans fund the programs that include government buildings, airports, shipping facilities, customs security systems, railways, mining, highways, oil and gas development, as well as military hardware

Railways

In fulfilling Sun Yat-Sen's vision of "The International Development of China," the CCP created the most ambitious railway expansion program in history: it is a major consumer of China's steel.

In Tibet, the new railway is extending westwards, southwards and eastwards. And a major upgrade and expansion in Xinjiang is connecting China's vast rail network throughout central Asia and on into the Middle East and Western Europe.

Projected demand for steel has accelerated development and expansion of large-scale mechanised open cut coalmines in Mongolia, Inner Mongolia and Xinjiang. New parallel, dedicated tracks on mainline networks carry coal trains from far western Xinjiang to industrial and energy bases in the east.

New tracks in the northeast connect the Russian Far East and North Korea to China's vast network as part of China's trans-Asian network.

One system consuming record levels of steel is the hi-speed rail network and dedicated rolling stock. Beijing allocated US$50 billion for construction of the high-speed rail system in 2009. By 2012, this ambitious system will have 42 hi-speed railway lines totalling 13,000km. By 2020, that will total 18,000, and by 2023 it will total 120,000km.

Baotou Steel claimed a world record 1.3 million tones of steel rail in 2009 that included high-speed rails, standard rail for the upgrade and expansion of China's rail systems and standard rail for railways for foreign aid and loan projects.

But it is not just steel for the railway tracks. Substations, related infrastructure, and new railway lines connecting stockpiles to the nearest trunk line or dedicated coalmine requires more steel. Excluding the coal railways, China will require more than 800 complete new trains. Coal industry expansion and railways will increase demand for additional locos and rolling stock.

This huge railway expansion is mainly electrified, requiring considerable tonnages of steel just to carry and manage the 90 per cent coal fired power supply.

Energy

The existing coal fired energy expansion program continues to the end of 2020, commissioning one coal-fired power station with an average individual capacity of around 2gW, every 10 days.

China's nuclear expansion will consume a wide range of construction, as well as standard and speciality steels for buildings, reactors, generation, distribution and waste disposal components. China's continuing hydro expansion is also a major consumer of construction and speciality steels.

Stimulus spending is driving a major alternative energy expansion program supported by the CDM (Clean Development Mechanism) and reflected in the GPD (gross domestic product).

Rapid expansion of wind power increased the demand for steel for the towers and nacelles, as well as generators and turbines. Onsite demand also includes construction steel for the bases, as well as buildings, sub stations and security fencings. The biggest onsite demand for steel however, is the coal fired backup power stations and related infrastructure, dwarfing steel demand for wind power generation facilities.

Offsite, there is also considerable steel demand to rebuild and upgrade a grid system that is presently incapable of receiving fluctuating wind generation and managing demand. There is also construction of China's high and ultra high voltage transmissions systems to carry and control huge and increasing loads.

Solar power also has considerable demand for steel, and like wind generation, requires large scale on site coal fired power generation plants and related infrastructure for backup.

Urbanisation

By 2030, China will have a population of around 1.5 billion.

Beijing's ambitious urbanisation program for completion by 2030, envisages the relocation of more than 500 million from the rural regions to new and existing industrial cities to meet the expected demand of factory labour by 2030.

This rural to urban transition translates into demand for accommodation and services, the equivalent of about1.6 new cities the size of Beijing every year. And this does not take into account demand generated by normal urban population growth.

It not just a matter of accommodation; new factories are needed to provide employment. Sustaining increasing urban demand requires services including electricity, gas, telecommunications, water, sewage, municipal waste, public transport all of which consume steel.

Projected demand for water and electricity by the urbanisation program is not a simple exercise of transferring consumption from one area to another. The rural sector relies primarily on untreated water from storage tanks, wells, rivers and basic community supplies. Urbanisation on the other hand, demands potable water that has a higher per capita consumption, imposing disproportionate and escalating demands on water resources.

Official statistics report that the rural sector consumes 25 per cent of the electricity consumed by their urban counterparts. The majority of farmers however, rely on coal, gas, kerosene, batteries and crop stalks to provide energy for lighting, heating and cooking. These 500 million new urbanites will bring with them an additional 100 per cent per capita increase in electricity demand.

The state-owned enterprise factor

Steel remains China's major strategic pillar industry produced by iconic state owned enterprises (SOEs). That steel, in turn, is reliant on considerable coal, coke and energy resources produced by other major SOEs.

China's SOEs are there to produce for China at a controlled price, boost GDP by turnover, and act as the sponge for unemployment. Profits are a secondary consideration and are mostly minimal and annual losses are common. SOEs monopolise the heavy industry sector and are reliant on the generous government subsidies on coal, coke, ores, water, and electricity as well as rail and maritime transport provided by other SOEs to avoid insolvency.

All SOEs are dependent on state bank financing, even the oil companies which have received multi-billion bailouts for losses on fuel and oil refinery operations in 2009.

Except when Beijing approves the release of selected details of SOE "profits" the accounts and profits of SOEs fall under the catchall of "state secrets" making it impossible to verify accuracy and methodology of calculation.

Because of their immense combined capacity and workforces, the major SOEs are major and important contributors to China's GDP. The obvious question is, where is the money coming from?

Stock and property

Both stock and property benefitted from lax bank lending under the stimulus package.

The property and stock markets are driven by investors whose only experience is two decades of rising markets, little understanding of the differences between the two markets, and with virtually no comprehension of the impact of an economic bust.

With millions of domestic investors across the spectrum of China population, any hint of a problem will create panic on an unprecedented scale and the real potential for widespread civil unrest.

Inflation

Relying on different philosophies but lacking adequate oversight, unrestrained lending and poor credit management by China's banks to meet stimulus package targets, Beijing created its own problem for China similar to that by the financial institutions of the US.

Unlike the US and developed nations, China has failed to implement social reforms to develop the level of consumer demand that can assist in softening economic blows. With no option but to restrain inflation, Beijing still believes that a softer approach will work.

Bank lending restrictions will affect property market values. Because of the level of speculation and extent of unsold property, banks will face the real risk of carrying high risk loans. Banks will move quickly to recover what they can. That in turn will trigger a ripple through the financial institutions holding those securities.

Reliance of China's notorious "rubbery figures," has the potential to generate its own financial tsunami and civil unrest backlash.

What does it all mean?

The central government of China is:

• the major buyer of its own steel products;
• reliant on long term repayments and counter trade on much of its steel exports;
• missing out on revenues from taxation on SOE profits; and
• building infrastructure capability that exceeds domestic and global demand.

When completed, China's immense infrastructure, steel and energy programs will have created capacity on an unprecedented scale that has the capability to exceed combined domestic and global demand. Recovery of the huge debt that funded that construction will become a priority.

Factoring in the cost of amortising construction and ongoing maintenance of such colossal capacity, begs the question of the source of such massive demand. Well before the end of 2010 China must lock in that revenue. China also must find new markets for the immense capacity of its restructured steel industry, at the same time, reducing debt and find employment for redundant steel and coal workers.

Where is the money coming from?

Beijing appears to have conveniently overlooked critical economic inputs:

1. the huge SOE's that built this capacity that launched GDP back into double digit growth, are reliant on subsidies to survive and do not produce the tax revenues relative to turnover necessary to fill taxation coffers;
2. there is also the matter of continuing crucial subsidies for future survival;
3. finding the revenues to recover the outstanding debt, maintenance and operating costs of the huge infrastructure;
4. running parallel is China's property and stock market debt as well as state banks and local government exposure to both;
5. Beijing will be pressed to find solutions to the redundancies flowing from restructuring of the General Steel and General Coal; and
6. Hu Jintao may face serious and unprecedented criticism in the forthcoming NPC on two crucial issues:
   • the possibility that his anti-inflationary measures will undermines the property market and jeopardises some local government's solvency; and
   • the effects of unemployment in provinces where restructuring is decimating the local steel and coal mining operations will impact on regional economies and civil unrest.

China's relations with developing nations are reliant on China maintaining growth and global economic influence and credibility. Any question on that growth and credibility will have a resounding negative impact in confidence in China's future role as a global power and future political realignments.

There may be good reason for growing paranoia in the Zhongnanhai.