China looks to steel megamerger to ease industry ills

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They have grown flabby, complacent and overbuilt. They have clung to work forces the size of cities, even as revenues shrivelled and, for many, losses mounted.

They are the giants of China's state-owned sector, some 150,000 companies in all that employ 30 million people, and they are ailing. In the first five months of this year, their profits fell 9.6 per cent. Coal, steel and non-ferrous metal companies are bleeding.

China's solution: supersize the giants, in hopes bigger companies will prove better able to defy the downward pull of heavy debt loads and overcapacity.

On Sunday, two steel companies, Baosteel Iron & Steel Co. Ltd. and Wuhan Iron and Steel (Group) Corp. – China's second-biggest producer and its first supergiant, respectively – halted share trading, citing restructuring plans. They are widely expected to merge into a single company that will produce 7.6 per cent of China's crude steel and large majorities of its high-end automotive and electrical steel.

Local planners, driven in part by political pressure, believe "competitiveness can come from scale," Chen Xingdong, chief China economist at BNP Paribas.

Outside China, "SOE [state-owned enterprise] reform is widely understood by the markets and those with Western ideologies to mean privatization," he said.

Not under president Xi Jinping.

"They believe SOEs are the economic base of Communist Party rule, " Mr. Chen said. "They want SOEs to improve, to play a more important role rather than a less important role in key sectors."

What China's leaders want is "simply strength."

With a steel megamerger, they will certainly get it – at least in raw size.

Last year, Baosteel and Wuhan produced 60 million tons of steel, not far off the 87 million produced by the entire U.S. industry. Chinese analysts said together they would form the second-largest steel maker on earth. after ArcelorMittal SA.

On their own, the two companies have suffered mightily. Baosteel profits shrank 82.5 per cent last year, while Wuhan lost $1.5-billion (Canadian), and has publicly discussed plans to cut 50,000 workers.

As one firm, though, they would be big enough to fulfill the mandate set out by Baosteel's general manager in May, when he said the country was building "aircraft carrier"-scale enterprises.

"Together, they have far greater bargaining power when it comes to raw materials and downstream pricing," said Zhu Ning, a professor at Shanghai Advanced Institute of Finance and author of China's Guaranteed Bubble, which discusses the mounting risks in the country's economy.

But practice hasn't shown it to be a good idea. Not only are large firms far more difficult to manage efficiently, but Prof. Zhu's study of companies on the Shanghai composite index showed clear disadvantages with unwieldy conglomerates.

Firms with more than "five lines of business have the worst financial performance and operating performance," he said. "It's not the bigger the firm the better."

He hopes the national strategy is to first create healthy corporate gains and then allow smaller players to fail.

But so far, China has only shown an appetite for the former.

Last year, planners approved megamergers in rail, nuclear and mining, followed by a major shipping combination this year.

Some of the resulting firms are staggering in scale. Joining China Power Investment Corp. and State Nuclear Power Technology Corp. resulted in a company with 140,000 employees and annual sales of $40-billion. The combination of China Metallurgical Group Corp. and China Minmetals Corp. created a single miner with some $96-billion (U.S.) in sales – roughly 50 per cent more than BHP Billiton Ltd.

The rise of mega-mergers under Mr. Xi is so striking it has drawn rare dissent from inside the system. "I think someone must have changed the concept of the reforms," Shao Ning, the former vice-chairman of SASAC – the Chinese commission that oversees state-owned firms – said last week in an interview with Nikkei Asian Review.

But China shows no sign of halting the trend. More consolidation seems likely in "nuclear power, defence, airlines, shipping and railways," said Wendy Leutert, a PhD student writing her dissertation on SOE reform.

Such moves have potential economic benefits – although they are outweighed by political gains, she said. "Mergers avoid dismissing employees or selling off state assets, while offering the prospect of building larger, more globally competitive national champions."

It's a strategy predicated in part on hope.

"What they're really hoping to do is just grow their way out of their problems," said Christopher Balding, an associate professor with the HSBC School of Business at Peking University.

The idea is, "let's make everything bigger and let's continue to bulk up on debt and investments and keep unnecessary employees in the belief that at some point in the future everything will be okay."

He added: "I just don't see that as a viable option."

Much about the Chinese strategy defies Western expectations. In market economies, corporate combinations create value by shedding employees or trimming unneeded output. In China, some megamerger bosses have explicitly promised to keep payrolls intact.

Meanwhile, instead of cutting capacity, as Chinese leaders have demanded, local steel mills set daily output records in April. Outside the capital, calls to reduce overcapacity have perversely led to more steel production – a major issue for countries such as Canada, the U.S. and the U.K., which accuse Chinese firms of dumping steel exports.

"Those local bosses aren't dumb. If they can show Beijing, look we're operating at 85-per-cent capacity, they have a better case to stay in business. So that's what they're doing Prof. Balding said.

At the same time, China has found ways to intertwine even independent companies, orchestrating cross-shareholding arrangements between the steel industry and firms in shipping and oil. It's another type of corporate expansion, a kind of vertical integration that places the interests of steel maker and steel buyer in common.

"It will be very helpful for reshaping and building production chains," said Wang Guoqing, director of the Lange Iron and Steel Research Institute.

More is coming, she added.

"Mergers and reorganizations will help China reach three to five super-giant iron and steel groups," she said.

With reporting by Yu Mei