Images of workers striking outside the factory of one of northeast China’s largest steel groups in late June could be taken as just the latest example of the ongoing woes of the industry. Overcapacity and wavering demand amid a prolonged cooling of the domestic economy have battered prices and pushed almost a quarter of medium and large steel mills deep into the red.
But Xilin Iron & Steel Group, the biggest steel producer in Heilongjiang province where the protests occurred, should not have witnessed such scenes. At least not according to a privatization program launched by the local government in 2005 that aimed to create a blueprint for the sale and restructuring of state industrial assets.
Instead, the firm was sitting on debts of RMB19 billion (US$3.07 billion) at the end of March and hadn’t paid employees wages of almost RMB2 million in the five months through the end of June, according to local media. Although operations were officially continuing as usual, the plant was no longer producing anything, a worker told local media during the unrest. Xilin Steel’s decline raises new questions over what has gone wrong with a grand scheme to revitalize the northeast and about whether current efforts to reform the steel industry can succeed.
Northeast China was the first region the Communists sought to industrialize in the 1950s and 1960s. It was chosen for this role because of large coal reserves, vital Soviet development aid and infrastructure built under the Japanese occupation. By the early 1980s, however, with reform and opening up on the agenda of leaders in Beijing, it was increasingly clear that the northeast’s heavy industries were unsuited to the new market-oriented environment taking hold across China.
By the early 1990s the region had come down with a bad case of the “northeast syndrome,” as it was dubbed. Without the government holding down prices of raw materials, industrial production floundered. Growth was almost non-existent. In 1990, when industrial production increased by 7% nationally, output in the northeast increased by only 0.6%. Experts say such capital-intensive industries were doomed to fail in a country which by that point was coming to rely on near-endless quantities of cheap labor as its main competitive advantage.
So as manufacturing and exports became the main economic growth drivers in the south and east of the country, the northeast fell behind. Huge shutdowns and layoffs ensued in the following years as the “iron rice bowl” system of cradle-to-grave support was decisively smashed.
China’s accession into the World Trade Organization in 2001 advanced manufacturing exports, further entrenching the problems of the industrial north. Embarrassed economic planners decided to do something, and in 2003 launched the Northeast Revitalization Plan, which called for a massive overhaul of state-owned enterprises, or SOEs.
It is perhaps fitting that this model of privatization started, and seemingly stalled, in the city of Yichun, lying just across the border from the former Soviet Union. Founded in 1966, Xilin Iron & Steel Group is one of only two major steel producers left in Heilongjiang today. It employs over 10,000 people in a city of 1.25 million residents.
In 2005 the company was earmarked for restructuring under the broader umbrella of revitalizing the northeast – a series of favorable policies from the central government including tax relief and experimenting with collectively owned enterprises. One element of that was to pull in private sector capital and management.
Xilin Steel was just one of hundreds of SOEs that were shaken up by the government, but central to its story is Wu Jinliang, the father of its privatization and one of the notorious shadowy characters who started scooping up failing state firms in the late 1990s.
Graduating with a PhD from Southwestern Finance University in Chengdu with a thesis titled “Research on Mergers and Acquisitions within China’s Economic Reforms,” Wu is an academic turned steel magnate. Early on he became convinced that the structure of asset ownership within SOEs was unclear, and that this ambiguity was hurting their profitability. To him, it was one of the best-kept secrets in the Chinese business world.
Upon graduating, Wu put his theories into practice by buying up SOEs under the banner of his company, Tongde Industrial. Restructuring drove up stock prices, and Wu would funnel the extra capital into the acquisition of new firms. Eventually, Wu bought and merged his company into a massive conglomerate called Tianxing Meter Group, in which he held a majority share.
As Wu pushed his aggressive buying spree accusations starting surfacing in the media and among industry insiders that he had won bids for companies fraudulently and that his restructurings of firms had resulted in massive losses of state capital. But the bad press didn’t stop Wu from riding the wave of privatization created by the Northeast Revitalization Plan.
With this momentum Wu made a bold play for Xilin Steel under the Tongde banner. In 2005, Wu acquired all rights to Xilin Steel, including land premiums, through a RMB370 million agreement with Heilongjiang province.
Critics, however, believe it was never Wu’s intention to restructure Xilin Steel’s assets, only to profit off them. He resorted to questionable methods, such as winning over management by promising them a 30% share in the company – a share that came out of money earmarked for workers’ resettlement. Xilin Steel wasn’t the last of his exploits, either. He used his stock rights in the company as collateral to buy yet another mining enterprise.
It was a model that Wu trademarked, but he wasn’t the only shady character in SOE reform. Zhang Zhixiang, the owner of Heilongjiang’s other major steel producer Jianlong, also had a penchant for M&As. His attempt to buy state-owned Tonghua Iron & Steel Group was halted by the local government after protests turned deadly. Employees had feared Jianlong was plotting to drain the SOE’s assets and introduce cost-cutting measures to exact bigger profits.
Private businessmen like Wu and Zhang were able to take advantage of the privatization process through connections to local officials, who were happy to sell off assets for greater financial returns. In a preliminary paper published in May, researchers from Tsinghua University in Beijing and Booth School of Business in Chicago dubbed this sort of agreement “crony capitalism.” “The privatization is a special deal between the local government (ruler) and the new private owner (crony), which brings to [the] ruler more economic benefits,” the paper says.
Wu was one of the most successful of these shady steel magnates – at first. Fast forward a few years and the picture had changed dramatically. New environmental regulations to curb pollution added costs to steel mills while lagging demand from the construction industry that had boomed in earlier years hurt earnings. Wu could no longer rely on his steel empire to turn a profit and funnel funds into his frenetic M&A dealmaking.
By 2011, profit margins in the Chinese steel industry had fallen from a peak of over US$50 per ton just three years earlier to below zero, according to data from Platts. Although they have now risen above those lows, steel prices remain volatile. Overcapacity also continues to plague the industry. Con
sumption of finished steel products collapsed in 2013, even as production totals spiked to an all-time high of over 800 million metric tons.
These troubles blew up on June 30 when Xilin Steel workers went on strike. The Yichun city government eventually stepped in to provide lifesaving loans to the firm to avoid mass layoffs and the risk of social unrest that can follow such incidents. But that runs counters to Beijing’s efforts to restructure steel mills to make them more efficient and less polluting, a process that will only see the further erosion of the northeast’s industrial base.
Late last year the State Council recommended cutting 80 million tons of excess steel capacity by 2017. Premier Li Keqiang has also said plants may have to be moved away from polluted areas. “China’s steel reform appears to be taking a three-pronged approach – cutting capacity, shutting down polluting plants, and upgrading the steel industry to be cleaner and more efficient,” Joseph Kim, executive director of metals products at CME Group, said in a report in early July. Kim noted that “this time, however, the political pressure exists to follow through” with restructuring, said Kim, referring to previous campaigns to curb steel production that failed to gain traction.
The Third Plenum has put privatization of state assets firmly back on the agenda and in recent weeks more plans have been publicized to bring private capital into SOEs. But Xilin Steel serves as a reminder that throwing state firms to the private sector isn’t a problem-free solution. China needs to stop thinking of its early investment in SOEs as interest-free loans that don’t need to be repaid and start thinking of them, finally, as debts that need to be settled.