China spreads steel fever

As China goes back to work after the Chinese New Year holiday, steel traders the world over are holding their breath. 2003 was a volatile year for world steel markets, due largely to enormous demand from China, and with prices for some steel products reaching their highest level in living memory before the holiday, the future for the steel markets in China is far from certain. The risks to the Chinese steel markets are threefold. Firstly, there is a short-term risk that a price bubble has formed. Second, there is a medium-term risk that changes in trade flows in the international steel market may disrupt the domestic Chinese market. Finally, but most importantly, there is the long term risk that recent over-investment in the Chinese steel industry could lead to over-supply of steel and serious global price deflation, as has been seen in so many industries in China in recent years.

But before looking ahead, it is first necessary to take a look back at the past few years and see how China came to dominate the pricing of the world steel markets. The global steel markets are generally split into three categories. First, there is crude steel – the steel that is actually melted down or produced from raw materials such as iron ore, coal and scrap. China's output of crude steel surged by 22% in 2003 to over 220 million tons, out of a global total of 950 million tons. Over the last five years, China's share of global crude steel production has nearly doubled.

Next, there are two classifications for 'downstream' steel products – the kinds that are actually used in industry. The first type is referred to as 'long products.' This kind of steel can be very thin, like wire, or thicker, such as the beams that are used to reinforce the concrete foundations of the skyscrapers springing up all over China. For this kind of steel China is self-sufficient, as domestic production is near enough to domestic consumption that imports are not an important pricing influence. Chinese consumption of long products accounts for roughly a quarter of total world consumption.

The second type of steel is the one that has been the cause of all the instability and trade friction in the global steel markets in recent years. This is referred to as 'flat' steel, because it is produced in flat sheets or coils. This kind of steel is used in shipbuilding, car bodywork, appliances, or anywhere you see a large surface area of steel.

In the 'flat product' market, Chinese demand has been growing at an astonishing pace in recent years. In 1998, Chinese consumption of flat steel was roughly 10% of the world total of nearly 300 million tons. But early estimates for 2003 suggest that Chinese consumption totaled 45-50 million tons, while global consumption rose to a little over 300 million tons for the year.

While China's consumption of flat steel has risen by over 50% during the last five years, domestic output of this steel has not increased to match such strong demand. China's output of flat steel in 2003 is estimated to be around 30 million tons. Consequently, China's steel markets have been forced to import more and more material to meet domestic demand, and this shift in global dynamics is what caused such disruption in the world's steel markets in 2003.

China's imports of flat steel have almost doubled over the past five years. In late 2002 and early 2003, the global flat steel market was suffering from weak demand throughout the world, except for China. The Chinese were the only consumers who were buying steel, and as they frantically brought it in from any available source, the producers around the world kept asking for higher and higher prices. In addition to real buyers, many speculators also moved into the Chinese steel market, as they saw a good opportunity to make money as prices rose on a weekly basis. But when the Chinese markets re-opened after the Chinese New Year break in February 2003, the buying slowed as people realized that a price bubble had formed. World prices for flat steel then plunged by up to 30% between March and May 2003.

Since the middle of last year global demand for steel products has been improving as the global economic recovery has accelerated. Chinese imports have also continued at a brisk pace. One major change in the market dynamics since September 2003 has been the surge in raw material and freight costs. This increase in costs has partly been due to a lack of availability of some raw materials due to higher demand throughout the world. Without sufficient supply of raw materials, output of finished steel has not increased in line with demand and prices have increased due to this structural shift in the demand/supply balance.

In China, the accelerating demand for imports has led to buyers offering increasingly higher amounts of money just to secure cargoes. As a result, prices have gone even higher than at the peak of the previous price cycle back in February 2003, and are now up to 50% above the low point seen back in May 2003.

With such a sharp increase in prices in late 2003, many people in the steel market have voiced concerns that another bubble has already developed. But whereas the previous bubble was largely a result of speculative buying in China, the recent price rises have considerable fundamental support. Firstly, it is not only China that is buying material – the whole world is now consuming more steel as the global economy improves. Chinese buying is less important to producers around the world who are also easily able to sell their material into other markets, particularly Europe and the Middle East. In addition, producers are suffering from sharp increases in raw materials costs, which make the price rises for flat products seem justifiable as producers' profit margins have not increased substantially, and in many cases have actually decreased. Finally, buying in China today seems to be driven more by real consumers of steel, as opposed to the speculators who were importing vast quantities last year in order to make a quick profit.

Looking further ahead, there are other risks to the Chinese steel markets. One of the most important risks comes from changes in the global trade flows for steel. On December 26, 2003, the Chinese government announced that they would remove their safeguard measures against imports of steel with immediate effect. These measures consisted of tariff-free quotas and various tariff levels for different steel products, and had aimed to prevent cheap steel imports from flooding the Chinese markets. However, even though these measures had been in place since May 2002, China's imports of steel continued to grow at a rapid pace. The government decided to remove the safeguards as the USA and Europe had removed similar measures in their markets, and global demand is currently very strong so there is no longer a surplus of steel that may flood any one market. Nonetheless, if global demand were to weaken, China could see a further increase in import volumes, which may result in lower prices on the domestic market.

The most important risk to the Chinese steel markets are that they may become oversupplied within the next decade. This could happen as a result of two factors – either demand fails to grow as strongly as expected, or domestic output increases too fast. Looking at demand first, the outlook for the foreseeable future is very positive. Growth in demand for steel will be driven by the continued economic expansion and an expected strong performance from steel intensive industries such as automotives, construction and appliance manufacturing. According to forecasts by the China Iron & Steel Association, China's growth in steel consumption will continue at a strong pace in coming years. They forecast that consumption of all steel in China will increase by 10% in 2004 to 270-275 million tons, accounting for one third of the global total. This compares with consumption of 211 million tons only two years ago.

However, on the supply side, there may be problems. As China's consumption of flat steel has increased, many domestic producers and investors have poured billions of dollars into projects to build new steel plants and processing mills. If all the investments go ahead as scheduled, China's production capacity for hot-rolled steel (the first stage in downstream production) would increase from 33 million tons per year (tpy) at present, to as much as 80 million tpy in 2006. There is a strong prospect that China could switch from being a large net importer of steel to becoming a net exporter in five years time.

This would of course have a catastrophic effect on not only the Chinese steel market, but also the global steel markets, as such a structural shift in the supply/demand balance would likely result in sharp falls in steel prices. The only winners in this scenario would be the main raw materials providers such as Australia and Brazil. Indeed, China's lack of raw materials, such as iron ore, is one significant constraint on the country's production capabilities and this may eventually be the factor that prevents domestic output from rising too far.