Excess capacity in steel industry

Fri Mar 1 05:47:04 PST 2002

The Hindu Business Line

Saturday, Feb 23, 2002

Excess capacity in steel industry -- Easy money the main culprit

A. S. Firoz

EXCESS capacity is at the root of the steel industry's problems worldwide.
The recent OECD talks were more or less centred on this understanding, and
concrete action is being proposed to eliminate the estimated excess
capacity. While the identification of such capacities may prove difficult
for the OECD, the organisation's overall understanding of the malaise itself
seems faulty.
There is no clear estimate of the excess capacity, except that it is
substantial. One reads of numbers in excess of 150 million tonnes of crude
steel. However, many working on the subject have refused to go beyond 75
million tonnes. That is about 8.9 per cent of current production, and 9.1
per cent of consumption.
In any industry — automobiles, capital goods, shipbuilding or passenger
aeroplanes — the corresponding number is likely to be much higher. In the
worst-case scenario, assuming an excess capacity of about 150 million
tonnes, the numbers would double. In the last few years, capacity
utilisation in the industry hovered in the 91.1-94.9 per cent range, with
92.2 per cent being estimated for 2001. These could be dream numbers for
many other industries, but not for steel. By its very nature, the steel
industry needs to keep capacity use to the maximumWhile fuller capacity
utilisation may be ideal, newer technologies also offer substantial
flexibility. Over the years, the share of the mini-mills, known for their
flexibility in operation and the ability to break even at lower capacity
utilisation, has been on the rise. Statistics show that the steel industry
worldwide has always had significant surplus capacity. But the problem has
taken a slightly different form in recent years. According to the estimates
of the World Steel Dynamics, the world's leading steel information service,
the effective crude steel making capacity worldwide increased from about 841
million tonnes in 1997 to 907 million tonnes in 2001.
This involved an increase of effective excess capacity from 42 million
tonnes in 1997 to 66 million tonnes in 2001. More important, against this 66
million tonnes of effective capacity expansion, annual consumption grew only
33 million tonnes. This is the first major problem. There is an urge to keep
the operating rates high when the market is not as large.
The real problem in the industry comes after that. Despite the low growth in
consumption, the competitive forces in the market led to excess production.
The annual production increased from 799 million tonnes in 1997 to 840
million tonnes in 2001 — that is, by 41 million tonnes.
In the process, in 2000 and 2001, the industry globally produced 13 million
tonnes and 14 million tonnes of extra crude steel. All this was added to the
stock the market carried from earlier years. And this excess production was
responsible for the unprecedented turmoil in the market.
While there is no refuting the above, linking excess production to excess
capacity and trying to seek remedies for the industry's current problems
only through capacity cuts may not be the right step.
One has to go into the factors that create and recreate those conditions
that perpetually bring excess steel into the market. It is the soft budget
constraint that the industry has been faced with, at least till recently,
that has been largely responsible for perpetual excess production of steel
globally.
The soft budget constraint syndrome, manifest in the easy availability of
funds from banks or the equity market (for investment in projects as well as
for day-to-day operations) in total disregard of the profitability of the
operation, makes it possible for firms to slash prices in competition. In a
fixed price regime, as prevailed in the erstwhile socialist economy, the
problem is seen in the firm's lack of interest to reduce cost and achieve
higher levels of efficiency.
While the soft budget constraints are not specific to the steel industry
alone, the fact that the output in this industry has been maintained at high
levels despite falling and unprofitable prices shows that, like many other
industries, steel is also a victim of this malady. It is also important to
note that the massive capacity cuts and bankruptcies took place in the US
only after the lifeline funding for steel companies was cut.
It is the abundance of capital to invest that was at the root of the easy
availability of funds to the industry. For years, it looked more attractive
to invest in steel, despite the well-known fact that the industry had excess
capacity. Where else could the capital go? Even today, there are investors
eager to put their money in steel despite the current crisis. It is a fact,
however, that such ventures are fewer today.
Let us assume that certain capacities are closed. The question is: Where
will the equipment go? Will it be destroyed totally so that it cannot be
reused? If not, it may find its way to another country, or even to someone
else's premises to be reused once again by some enterprising person, who
might draw up a financial proposal for bank funding for the project!
If one goes by the efficiency criterion, again, the question is: Which of
these capacities could be termed inefficient? Can one ask a steel rolling
mill or an electric furnace in remote Africa to shut down because it cannot
match the operational or cost efficiency of a plant in, say, Japan or
Europe? This will not work.
Also, investment in steel is region-specific. For example, irrespective of
whatever happens in the rest of the world, any project in China may look
attractive. The project may not even be competitive but, just because there
is abundant capital, capacity addition may take place.
This may also happen in Russia, where global funds may head that way with
the impression that steel production is more competitive there than anywhere
else. Very little can be done about such investments until global capital
resources find more attractive destinations.
All talk of capacity cuts, therefore, will have to be seen alongside the
issues related to fresh investment and operating finance for steel
companies. It may be easier to operationalise remedial measures in the area
of finance than to resort to complicated exercises to identify surplus
capacities and have corporates close them down.

(The author is Chief Economist at the Economic Research Unit, Joint Plant
Committee. The views are personal)