On May 26, the Singapore-based financial company OCBC Investment Research initiated coverage of FerroChina, a small Chinese steelmaker listed on the city’s main stock exchange. OCBC’s inaugural report hailed the Jiangsu-based smelter for “sterling” 2007 performance, characterized it as smartly positioned to answer an “urgent need” for infrastructure steel in its home market following a devastating earthquake in Sichuan earlier this year, and cited FerroChina’s overseas expansion into Vietnam to justify a “buy” rating on the company. On Friday, Oct. 10, OCBC suspended coverage of the steelmaker after it revealed that it couldn’t repay $104 million in bank loans that had come due. “FerroChina is technically insolvent,” OCBC analysts Kelly Chia wrote in what will likely be her final report on the company.
In a week when panic gripped global stock markets, the FerroChina implosions made barely a ripple. But it might, in time, prove to be a symbolically important inflection point for Chinese industry. The core issue: are the factors that led to its apparent demise exceptional among the tens of thousands of companies that drive the world’s fastest-growing major economy today, or commonplace?If FerroChina is no aberration, watch out.
For starters, the steelmaker – like most companies in China – had stellar performance numbers until very recently. According to Bloomberg, it reported in August that net profits for the April-June quarter tripled from the second quarter of 2007 to $35 million; the first indirect hint of liquidity problems came when it announced last month that it was looking for a strategic investor. Yet in a statement issued on Thursday, it cited “the current economic crisis” for its inability to honor “working capital loans” now due and said that it had begun negotiations with lenders and would seek “new equity and loan funding.” The company reportedly shut down its main production facility, which makes corrugated metal sheets, last week, triggering demonstrations among its workforce.
Due to the lack of transparency that typifies China Inc., it is hard to determine if FerroChina’s problems arose due to reckless expansion, a sudden evaporation of new business or cash-strapped clients that can’t pay their bills. The safe guess is that each factor contributed to the fall (though an outside observer would be forgiven for thinking that the company looked great right up until it the moment it revealed that a crisis was at hand).
Experts have long-realized that China’s steel industry is particularly risk-fraught. Overcapacity is a chronic problem, yet investment in additional mills is forecast to rise more than 20 percent in 2008. Most analysts believe a painful consolidation is looming, and demand – linked as it is to the production of everything from white goods to cars and skyscrapers – is highly dependent on China’s ability to clock double-digit growth rates. Of course, that’s getting harder for the world’s largest exporter as the global economy lurches toward recession. In a report on Asia’s steel sector issued three weeks ago, the Hong Kong-based brokerage CLSA wrote that a “death spiral” for the industry in late 2008 “has to be the base case for China.” Indeed, it may have begun.
But is steel the exception, or the rule? Construction, autos, and other sectors have also experienced explosive growth in China since 2000 but now are visibly sluggish. And like steel, they too are thick with small-time players like FerroChina that may also be undercapitalized and operating on thin margins. With growth slowing and stock prices in China down almost 70 percent from their peak a year ago, the risk is that a large number of small and medium-sided companies in key industries could now be falling into stealth distress. For China’s rising middle class, that would spell greater job insecurity and a further stock portfolio battering. Systemically, the biggest danger is that non-performing loan rates will soar, hobbling China’s financial system.
According to Kelly Chia’s final FerroChina report, Chinese lenders hold most of the steel-maker’s problem loans, making it Exhibit A for how firms struck down by the global economic slump will pass on the pain to the major source of investment capital in China: state banks. And because so much of China’s manufacturing capacity now targets export markets, faltering demand in the U.S. and Europe “cannot help but slow China’s export economy,” wrote Peking University finance professor Michael Pettis on his blog last week, adding that an export slowdown “is one of the most likely channels by which global financial difficulties will become Chinese financial difficulties.”
It’s important to watch Beijing’s policy response should failures like FerroChina’s multiply. Speculation is rife that an economic stimulus package is in the works, yet the details aren’t yet known. If it aims primarily to boost domestic consumption, thereby weakening the national economy’s dependence on export markets for growth, great. But if Beijing props up the export sector by, say, halting renminbi appreciation, reducing taxes on exports or otherwise intervening against market forces, the outcome will be sustained over-production. And that will only make today’s problems worse.
