A Comparison of the United States and Chinese Steel Industries

Qingfeng ZHANG

Perspectives, Vol. 3, No. 6

In order to provide some temporary relief to the United States steel industry, the Bush administration has recently imposed tariffs of up to thirty per cent on steel imports. This article examines the reasons why a tariff-centered strategy will not resolve the fundamental problems of the American steel industry. It will also analyze the underlying weaknesses of the American steel industry and will suggest some possible solutions. Finally, it will review China's steel industry.

1. Section 201 of the United States Trade Act of 1974

Section 201 of United States Trade Act of 1974 (Global Safeguard Investigations) offers import relief for domestic industries. Under section 201, domestic industries which have been seriously injured or are threatened with serious injury by increased imports may petition the United States International Trade Commission (USITC) for import relief. Section 201 does not require a finding of an unfair trade practice, as do the antidumping and countervailing duty laws and section 337 of the Tariff Act of 1930, but Section 201 does include the presumption that the protected domestic industry will go through restructuring to regain competency.

On March 5, 2002, President Bush announced that the United States would introduce up to thirty per cent tariffs on most imported steel products. The safeguard measures came into effect as of March 20, 2002 and are to remain in place for three years. The president, however, will review his decision in September 2003.

Table 1. Steel Tariff schedule

Commodity name Tariff and/or quota
Flat products 30%
Tin mill products 30%
Bar 30%
Rebar 15%
Certain tubular products 15%
Fittings & Flanges 13%
Stainless steel bar 15%
Stainless steel rod 15%
Stainless steel wire 8%
Slabs 30% on out-quota; Tariff-rate-quota = 5.4m short tons

President Bush has determined that Free Trade Agreement (FTA) partners, such as NAFTA partners, Mexico and Canada, should be excluded from this tariff scheme on all steel products. Developing countries, including South Africa, which export less than three per cent of their steel to the United States and which are World Trade Organization (WTO) member states are also excluded from the tariff. The countries hardest hit appear to be the European Union (EU) countries, Russia, Ukraine, Taiwan, Japan and South Korea.

President Bush retains the discretion to consider requests for product exclusions within one hundred and twenty days of the date of the March declaration and will consider requests for product exclusions each year thereafter.

2. Background

The United States produces approximately eighty per cent of its domestic steel demand and utilizes installed production capacity at around eighty per cent. In 2001, the United States produced ninety million tons of crude steel and imported twenty-seven million tons (Note: the measurement "ton" in the article refers only to "metric ton"; one metric ton equals to approximately 1.1 short ton) in steel products. Steel imports into the United States peaked in 1998 at 38 million tons and have since decreased by thirty per cent. Industrial globalization has made the steel market so international that around forty per cent of global steel production is shipped across borders each year. The United States is now the second largest net steel importer, after China.

It is expected that Section 201 will not heavily influence imports of semi-finished products. The import quota for semi-finished products is 4.9 million tons in addition to the material imported from Canada and Mexico. In effect, the major existing slab-exporters (Brazil and Russia) can even expect to increase the level of exports over the levels they achieved in 2001.

Section 201 is targeting finished steel products. The United States imports finished steel products from a large number of countries. The EU has been the biggest exporter to the United States, as it shipped about five million tons to the United States in 2001. Canada is the second largest exporter shipping four million tons, followed by South Korea (two million tons), Japan (1.8 million tons) and Mexico (1.5 million tons). Turkey, Brazil and China exported approximately seven hundred to eight hundred thousand tons each in 2001. Russia and Taiwan exported approximately five hundred thousand tons each. (Source: Financial Times, 2002)

As a result of the March declaration, annual imports of finished steel products into the United States are estimated to decrease from 17m tons to 11m tons or even more in 2002.

The world steel market may feel the chill from the United States as the diversion of steel products may pull down prices worldwide. However, the negative effects of the tariff imposition might not be as bad as feared.

The demand for steel products is projected to grow at CAGR (Cumulative Average Growth Rate) 1.4% in the next ten years as long as the growth rate of demand is as high as four per cent provided the economies in the United States and other major developed countries will be improving. In other words, global apparent crude steel consumption is estimated to increase from 820m tons in 2001 to 852m in 2002.

On the other hand, worldwide crude steel production in 2002 is projected to be 818m tons versus 845m tons in 2001. The recent high-level Organisation for Economic Co-operation and Development (OECD) steel meeting reported the prospect of a capacity reduction of nearly one hundred and twenty million tons being affected by 2005. The exception is China which will see a large increase in steel production as well as steel consumption.

The eight million tons of diverted steel products from the United States to the international market may be not that significant in the dynamics of the demand and supply described above. Additionally, strong cycles occur in steel prices and the prices are now on an upward curve. In the three months since the imposition of the United States' tariff, prices in the United States and in the international market had both gone up.

3. Effects on the United States Steel Industry

What will the controversial tariffs bring to the United States steel industry? This topic is divided into two parts. The first section will examine effects on the United States integrated steel mills which have been aggressively looking for help from the government. The second section will look at effects on mini-mills in the United States which have consistently grabbed domestic market share from the integrated mills and have also been quite competitive by global standards.

"Integrated steel mills" are comprehensive steel works that convert iron ore, coke and other raw materials to steel products and "mini-mills" are nimble steel mills that melt scraps to produce steel products. The capital expenditure of the integrated steel mills, which have existed for more than one hundred years, is much greater than that of the young mini-mills.

3.1 Integrated Steel Mills

The United States integrated steel mills now make up fifty-five per cent of all domestic production and have been troubled for the last two decades. Since the early 1980's the integrated steel mills have sought Chapter 11 protection. After emerging from bankruptcy in the early 1990's, these mills rushed into bankruptcy courts again in late 1990's. There are about thirty integrated steel mills now in Chapter 11. LTV, one of the top steel mills, has been liquidated.

3.1.1 Tariffs

The immediate effects of tariffs are reflected in decreases in imports and increases in prices. The integrated steel companies might start to see their profits return, but they will not have enough cash flow from operations to modernize plants and to sort out liabilities to the retirees, which is known as the "legacy cost". The companies might have better short-term financing for the use of working capital; nevertheless the capital market will remain unfriendly to them because of the short-term nature of tariff protection, the issue of the legacy cost and the uncertainties of the political environment.

Most bankrupt steel companies will prefer to stay in Chapter 11 for a while for two reasons. One reason is to avoid spending newly improved cash flow on interest expense payments and the other is to prove to the government that further help is still needed.

Tariffs do not change the fundamentals of the integrated steel companies and they will essentially remain the same after the termination of tariffs. The presumption underlying the exercise of section 201 is that the protected industry is to go through restructuring. However, the United States steel industry as a whole does not have the ability to restructure itself.

The steel mills have known this fact from the very beginning. Their initial request for government help was forty per cent tariffs and twelve billion dollars of financial assistance on legacy costs. The request was too high for the Bush government which could then be faced with similar requests from other industries such as timber and clothing.

Even so, these tariffs have attracted huge domestic and international criticisms and the WTO verdict is due next March. The Bush administration has been under tremendous pressure to remove the tariffs and it excluded one hundred and seventy-nine imported steel products on August 22, 2002. Meanwhile, the USITC ruled against domestic steel mills on the cold rolled steel anti-dumping case which has left the mills wondering how much they can count on Washington in the future.

3.1.2 Root Problems

1) Fragmentation

The United States steel industry is extremely fragmented. There are more than a dozen integrated steel mills, the biggest of which is US Steel (NYSE: X) with annual production of 13m tons. The rest are all in the class of millions of tons per year. However, 160m tons of total European production are shared by several major steel groups. Acelor, the world's biggest steel company in Luxembourg, contributes 55m tons per year while Anglo-Dutch Corus Group makes 20m tons per year. German Thyssen Krupp and Italian Riva are dominant steel players in their own countries with production of 17m tpy and 16m tpy respectively.

Compared with most of the other downstream and upstream industries, the global steel industry is also fragmented indeed. The top four steel companies on the earth grab only fifteen per cent of the global market whilst the percentage for the nickel industry, one of the upstream industries, is sixty per cent. The top six in the downstream auto industry have global market share of eighty-five per cent.

The bargaining power of United States steel companies is generally weak because of industry fragmentation, which leads to the steel companies' inability to capture value. The value that could have been retained by steel companies has been diverted to both downstream and upstream industries.

The perception that integrated steel companies are unable to capture value or to add value to shareholders scares away many investors. Many integrated steel companies have not raised funds by issuing equity for many years. Meanwhile the risk premium for integrated steel companies in the corporate bond market is huge, especially given the fact that more than 30 companies are now in Chapter 11.

Without the funds to modernize the old equipment, United States integrated steel mills have lagged in technology. With other burdens such as high labor costs and legacy costs, most of these companies cannot compete in the growing international market at all. The only market left for them is the domestic market, which has a negative cumulative average growth.

2) Labor Costs

On the one hand, the wages of steelworkers in the integrated steel mills are quite high, as most of the workers are unionized. On the other hand, the costs of benefits for retirees and their dependents are more than these companies can afford. One hundred fifty thousand steelworkers have to take care of seven hundred fifty thousand people.

The legacy cost issue is the greatest headache for the United States steel industry. It requested twelve billion dollars in federal subsidy for this expense, which was later declined. Any prospective investors or acquirors will hesitate to consolidate the steel industry if they are obligated to cover these huge legacy costs.

3) Globalization

The United States integrated steel companies have been quite resistant to the wave of globalization. They do not leverage cheap resources abroad, explore international markets or follow key customers' footprints around the world.

The United States steel companies do not have any overseas productions except US Steel, which has a subsidiary in Czech. Their rivals in Europe, however, have established production sites in Asia and South America. Corus, for example, just acquired $1.8 billion Brazilian CSN to leverage cheap iron ore sources. Thyssen Krupp set up joint ventures in China to benefit from the cheap labor costs and huge market.

The focus of the United States integrated steel companies has been only on their domestic market and they do not have independent sales and marketing capacity in the international market. Although the United States market is very lucrative, demand has been decreasing and this trend will continue. These companies will have to develop appropriate globalization strategies to address these issues sooner or later.

The inability to serve global customers across borders costs United States steel companies millions of dollars. Many of their customers in the United States, such as auto companies, are global. The steel companies could have secured business abroad from their customers' overseas subsidiaries by appropriately managing customer relationships.

3.1.3. Solutions

1) Industry Consolidation

It is very difficult for United States integrated steel mills to compete on the global platform without further consolidations. Legacy costs are a great hurdle. The United States government cannot be expected to step in and save the steel companies because there are too many political and economic issues.

Liquidating and reemerging as new companies may be the only effective method left for United States steel integrated steel mills. The new companies owned either by specialized distressed asset management companies or by other steel companies will have no legacy costs when the social security system takes over benefit payments to their original workers.

Russ & Associates, a bankruptcy management company, acquired LTV's assets and created a new competitive steel company - International Steel Group (ISG). The new company will start production in late 2002 and hire twenty per cent less people. ISG is projected to be a quite competitive steel company and will put great pressure on existing integrated steel mills.

The approach will be opposed by workers, who have a strong political voice in Congress. However, the government is not in the position to use taxpayers' money to help some entities meet their obligations. Although workers and creditors may suffer, social resources can be allocated efficiently. It is the essence of a "market economy".

Some shareholders might also be against the "liquidating and reemerging" approach since they do not want to see the shares in their hands become worthless. However, a key question to ask is "how much is the equity of those companies worth?" Before the debut of tariff protection in March, the market capitalization of the top six integrated steel mills was less than that of one mini-mill, Nucor, although the steel production of Nucor is about one-third of theirs. The share prices are now higher as a result of tariffs, which, however, are not sustainable at all. The nightmare will come sooner or later. After all, destroying the value of a company is worse than liquidating the company.

2) Globalization

The United States steel mills can reduce costs through globalization. It might be a good idea to move some production outside of the United States to leverage cheap labor and low environmental costs. Mexico should be the top choice on the list as it is a member of NAFTA and geographically close to the United States.

Foreign markets can also be attractive to some integrated steel mills, especially the high-end products for global customers. The steel mills might need some marketing savvy to establish key customer management programs and to follow the footprints of their key customers. In the long run, foreign markets are the place where United States steel mills will have to be because domestic demand for steel has been decreasing for many years.

The United States steel companies can also connect with some global steel alliances to start co-operation in research and development, operations, purchasing and other areas. There are already two key global alliances, one of which is Acelor-Nippon Steel-POSCO-Baosteel with production of 120 metric tons per year (mtpy) and the other is ThyssenKrupp-Kawasaki-NKK with 45 mtpy production. United States steel mills can chose to join existing alliances or to initiate their own global alliances.

3.2 Mini-Mills

United States mini-mills are the real winners. They already compete with global players without protection from the government. They are nimble, entrepreneurial, and less burdened. Some mini-mills, such as Nucor, are considered among the best steel works in the world.

Tariffs make them even better. Sales revenue is increasing as well as profit margin. The P/E ratio of Nucor in March was 40 (March 15, 2002), higher than that of GE (20) and most other manufacturing companies at the same time.

The United States mini-mills will keep grabbing market shares from imports under the tariff protection and from the integrated mills although integrated steel mills cannot be replaced by mini-mills entirely. Some steel products cannot be made through mini-mills because of quality issues. The limited availability of scraps and the slow growth of demand will also limit the consumption of steel from mini-mills.

4. Review of China's Steel Industry

China is now the number one steel producing country with an output of 149m tons in 2001 versus 128m tons in 2000. Most Chinese steel mills are integrated as the development of mini-mills is constrained by the availability of scraps. The biggest mini-mill in China, Pearl River Steel, has to import some scraps to feed its electric arc furnaces.

A booming economy makes China a behemoth in consumption of steel products. Demand in 2001 reached 160m tons and the growth rate is projected to be five per cent for the next several years. Many foreign steel companies put their hopes on huge consumption from China, which is supposed to stabilize and even lift international prices when economies in the rest of the world are declining. China imported 25m tons net in 2001 and became the biggest steel net importing country, followed by the United States (23m tons).

China exported 700k tons of steel to the United States in 2001 and the effects of the tariffs have been limited. Although diverted steel from the United States to the international market can be a negative factor on steel prices in China, China's strong economy and recovering economies in other regions can easily digest the extra production.

The history and the status quo of the United States steel industry are good lessons for China's steel industry.

4.1 China's Fragmented Steel Industry

There were one thousand and forty-five steel companies in China in 2000, thirty-four of which had production of more than one million tons. The top four companies (Baosteel, Anshan, Capital and Wuhan) represent only thirty per cent of all of China's production. (Source: China Steel Yearbook, 2001)

In the United States, the top six companies produce around fifty per cent of all domestic production. The percentage for the top five in Japan is seventy-five per cent and for the top three in Russia it is fifty per cent. POSCO alone produces sixty-five per cent of Korean steel while one major steel mill represents almost all the production of a whole country in France, UK and Italy.

Chinese steel companies have been trying to consolidate the industry. However, most attempts have been fruitless. The root of the problem is multi-level government ownership. For example, Anshan belonging to the central government tried to acquire Fushun Steel held by the local municipal government. The local government was unwilling to sell Fushun Steel as local officials were reluctant to see decreases in their authority and local tax revenues. Handan Steel and Wuhan Steel met similar problems and integration challenges later when acquiring Wuyang and Daye respectively. The smooth acquisition of Shanghai Steel and Meishan Steel by Baosteel are probably the only exceptions.

Multi-level government ownership and administration structure will have to be modified to address the agency problem of those officials. The tax revenue sharing scheme between the central and local governments will also have to be restructured to take away the barriers of acquiring state-owned companies. Meanwhile the equity market should be strengthened so that the private sector can also actively be involved in the consolidation of state-owned companies.

4.2 Labor Productivity and Efficiency

Labor productivity is quite low in China's steel industry, which hired two million people to produce 140m tons of steel in 2001. The industry would require only 300,000 employees to match the average global standard of five hundred and forty tons per employee and one hundred and forty thousand employees to match the advanced international standard of one thousand tons per employee. This comparison implies massive layoffs ahead through modernizing China's steel industry.

For example, Wuhan Steel, one of China's top four steel giants, makes 6.6m tons through the efforts of one hundred thousand persons (66t/person.year) while China Steel in Taiwan produces 9m tons per year with nine thousand employees (1,000t/person.year). Wuhan Steel will have to let go of ninety per cent of its workforce if it wants to match China Steel's standard.

Despite the gap, state-owned steel companies in China have tremendous difficulties in dismissing employees as the government is concerned about social stability and therefore enforces strict restrictions on layoffs. But any world-class steel companies must strategize to improve labor productivity and efficiency. China's steel companies can cooperate with local governments to establish long-term mutual-beneficial de-manning schemes, for example, offering career-training opportunities and raising severance packages. Meanwhile, steel companies should not promise more future benefits to employees and ex-employees than it can afford. Otherwise they will later be troubled by the similar legacy costs that United States steel companies are currently facing.

4.3 Regulations

The Bush administration has been friendly to the United States steel industry, but not yet as friendly as the Chinese government to China's steel industry. Up to thirty per cent tariffs and frequent anti-dumping cases make the environment for Chinese steel companies quite comfortable.

Besides, the Chinese government even forces output reductions by allocating quotas when prices are perceived to be low. Cheap financing, tax holidays and subsidies are also available to some major state-owned steel companies. Some western analysts call the Chinese government the friendliest government in the world to its domestic steel industry.

The problem is that the friendliness of the regulations in China is temporary. Along with the reform process of Chinese government, the role of regulation leans toward neutral rather than towards favoring producers. In the future, the Chinese government might not intervene to boost prices and cheap financing, tax holidays and subsidies might become scarcer and scarcer. Tariffs will also be decreased when China tries to meet its WTO promises and competition in the domestic market will become more intense.

Chinese steel companies should leverage the "last" vestiges of regulatory friendliness and secure cheap financing to lay the foundation for intense competition in the future.

4.4 Low Cost of Capital

All steel companies on earth except China's complain about difficulties in raising funds from capital markets. The steel industry has been infamous for its low returns on capital employed for many years. Krupp-Thyssen Stahl, the top German steel company, had to withdraw its initial public offering in 2001 because of low valuation and the Anglo-Dutch Corus Group had to distribute a big chunk of retained earnings to shareholders as dividends rather than keeping it within the company as reinvested capital.

The situation is not much better in the corporate debt market. Most steel companies receive unfavorable ratings from credit agencies and pay high premiums for their debt.

On the contrary, Chinese steel companies have raised lots of money from the Chinese stock market and banks. The required return on equity is as low as around six per cent in China while in the United States it is eleven to twelve per cent on average. The cost of capital of some major Chinese steel companies might be in the range of four to five per cent, in light of cheap financing from Chinese banks as well.

It is a great time for Chinese steel companies to modernize plants, purchase new equipment and make overseas acquisitions. Chinese steel companies can take over foreign steel companies which are lacking financing to upgrade technology. As the sunk costs are quite high in the steel industry, the effect of the "late-mover-advantage" in the industry is obvious. Low costs of capital can place Chinese steel companies in the position to acquire overseas upstream ventures, such as iron ore, and steel productions.

Again, the strategy works only as long as capital is controlled within China. As soon as Chinese investors are allowed to invest in overseas capital markets including the Hong Kong market, the cost of capital will increase to an international level adjusted with risks.

4.5 Globalization

Chinese steel companies are lagging behind the United States steel companies in globalization.
It is justified for Chinese steel companies to focus on the domestic market though, which is the biggest steel market in the world with strong growth. But globalization can bring huge benefits to Chinese steel companies in the arenas of management, research and development, environmental protection, operations, supply chain and even finance and marketing skills.

On the one hand, Chinese companies can introduce foreign partners to leverage international know-how. Baosteel Group established a joint venture with German Thyssen Krupp Group to produce stainless steel in Shanghai. Taiyuan Steel outsources gas production from the BOC Group (formerly Brin's Oxygen Company Ltd).

On the other hand, Chinese companies can step out of their borders to acquire upstream ventures and steel production. It can be an advantage for steel companies to secure some good quality iron ore mines as the iron ore supplying industry is quite consolidated. The Corus group just paid $1.8B for Brazilian CSN (an all share deal) to get a hold on the mine under the name of CSN. The iron ore issue is imperative to China as it is set to import more and more iron ore given its limited resources and huge demand for steel. Capital Steel and Baosteel have gotten involved in mines in Brazil and Australia. Chinese steel companies can leverage their low costs of capital to grab an advantageous position in the international fight for raw materials.

In general, United States integrated steel mills cannot be restructured to be modern and competitive unless the issues of legacy cost and globalization are resolved. The new International Steel Group might indicate one of the possible solutions. Meanwhile on the other side of the globe, Chinese steel companies have their own unique problems as well as some issues their United States peers also face. With the right strategic moves, the Chinese steel industry can become the strongest in the world given the size, opportunities and resources available to it.

(The author is a global market analyst with the BOC group. The author's view does not reflect that of the BOC group.)