Asia’s chemical industry¹ is in deep trouble: the regional collapse in demand for its products is forcing more and more debt-burdened companies to the brink. But the crisis is hardly confined to Asia; it has deprived many US, European, and Middle Eastern chemical manufacturers of what used to be an important export market and undercut prices around the world for many of the industry’s products.

The continent’s chemical industry is highly fragmented, and its capacity is in many cases chronically excessive, particularly for commodity chemicals. A radical restructuring will be needed for prices to recover, and Asian companies must lead it. Asians, after all, control by far the largest part of installed capacity in this part of the world; Western players still have only a limited presence, and most would balk at the number of takeovers needed to consolidate the industry in a meaningful way—and at their cost. Moreover, uncertainty about the pace of economic recovery in Asia will probably deter all but the most risk-hungry outside investors.

Indeed, the task ahead for Asian chemical producers is enormous. Of all the world’s regions, this has the largest imbalance of capacity and demand for many products, as well as the largest number of subscale (and therefore uneconomic) facilities. Yet if the Asian chemical industry can reform itself, it will emerge strengthened in what remains the most promising of all growth markets.

Spectacular growth, negligible profits

During the past 20 years, the Asian chemical business has expanded phenomenally, so that it now accounts for a third of world capacity. Exhibit 1 shows the recent growth of Asia’s production resources for polypropylene, one of the most common kinds of plastics, used, for example, in the dashboards of automobiles. Nonetheless, profitability has been poor throughout the whole chemical industry.

Much of the problem stems from the exceptionally large number of companies that produce most chemicals in Asia. China, a market a third the size of Western Europe, has some 100 polypropylene manufacturers, compared with just 15 in Western Europe. The reason for this fragmentation varies from country to country. In South Korea, for example, it reflects rivalry among conglomerates whose primary goal has been to increase their share of as many markets as possible. In China, the cause is a political decision to support local industrial development. Throughout the continent, profits have been significantly less important. Indeed, the notion of maximizing shareholder value remains largely alien to corporate Asia.

Fragmentation and the desire to bid for market share have also generated substantial levels of overcapacity, particularly in such export-oriented countries as South Korea and Singapore. The problem is compounded by the fact that European and North American producers have off-loaded their excess capacity in Asia at knockdown prices. Overcapacity and inexpensive imports from other regions have often generated chronically low utilization rates, and this in turn has sparked recurrent, intense price wars. Over the past decade, prices for many commodity chemicals in Asia have therefore consistently lagged behind prices elsewhere.

Of course, national trade barriers and other protection mechanisms meant to ensure independence from foreign suppliers and low unemployment have done little to force chemical manufacturers to improve their performance. Most of the region’s countries still have tariffs of 20 to 40 percent for many chemical products—at least 10 percentage points higher than corresponding tariffs in Western Europe and North America. Even in the absence of specific measures of protection, local suppliers in some places still have a clear "relationship" advantage that effectively excludes foreigners.

Another reason for the poor performance of the Asian chemical industry is the low quality of many of its assets. With so few companies actually making money, most Asian producers have not been able to afford the investments needed to keep pace with world-class standards. As a result, many plants are too small, use outdated technology, and lack adequate supplies of feedstocks; the average size of polyethylene plants in Japan and China, for example, is about one-third that of their US counterparts. In an industry where economies of scale are vital, this has had a major adverse impact on productivity.

The collapse

Asia’s economic crisis exacerbated these problems, throwing the industry into a deep recession when demand for chemicals collapsed. Asian demand for polypropylene, to give just one example, fell by 20 percent in 1998, and this has cut the average Asian utilization rate to 82 percent, from 96 percent, and forced down prices by 34 percent. Worse still, substantial new capacity is expected to come on stream soon because canceling contracts would impose heavy financial penalties. In fact, installed capacity may increase by up to 30 percent from 1997 levels in the next few years.

For other products, such as polyvinylchloride (which suffered a 45 percent fall in demand in 1998), the situation is grimmer still. Overall, we estimate that $15 billion in shareholder value was destroyed during 1998 in the Asian chemical industry. In 1999, the total could rise to $25 billion.

Asian manufacturers of commodity chemicals are currently facing an exceptionally bleak picture

Asian manufacturers of commodity chemicals face a particularly bleak outlook. About one-third of the region’s polypropylene capacity—nearly three million tons, excluding India and Japan—is now owned by companies in financial distress. Many of the region’s chemical assets will probably be put up for sale, but not immediately, for the dominant forces now are pride and a business attitude that declines to focus on the bottom line. Many Japanese keiretsu and South Korean chaebol, for instance, may wish to cross-subsidize their loss-making chemical activities as long as they can. Moreover, local governments in China, fearing an increase in unemployment and dependence on foreign suppliers, are probably not yet prepared to close that country’s inefficient operations.

Such attitudes will have to change if the downturn is protracted—and the evidence suggests that it will be. A simulation of growth in demand and capacity for polypropylene shows that a healthy utilization rate will not be achieved for five to seven years. Recovery within three years is unlikely because for that, demand would have to grow by more than 7 percent a year starting in 1999. For recovery within five years, demand would have to grow by more than 4 percent a year (Exhibit 2). Asia’s producers simply will not be able to ride out this recession.

The way forward

The longer Asia’s chemical companies take to restructure the region’s industry, the more they will deplete their already thin financial resources. And the weaker they become, the lower their chances of taking an active part in the restructuring process that lies ahead. On the contrary, they will lose assets.

To forestall this fate, individual companies in Asia should at least try to improve their own operations aggressively by cutting costs and enhancing the product-customer mix (that is, focusing on customers that pay good money for higher-margin products). To date, many companies have focused instead on expansion, so they have a huge potential for increasing their efficiency. The most promising opportunities are likely to be in production, sales and marketing, and purchasing, which have an improvement potential of more than a 10 percent return on sales.

But these measures alone will not suffice at a time when prices are close to the variable costs of many producers. The most effective approach would certainly be to rebalance supply and demand across Asia by rapidly and fundamentally consolidating the industry at a regional level. Such a transformation would be achieved in the first place through mergers and acquisitions, alliances, and the swapping of assets among players and then through the capture of synergies—particularly by closing plants and mothballing capacity.

We estimate that $500 billion in net present value would be created if the whole Asian industry were restructured to remove excess capacity, leaving in place the most cost-efficient production facilities, with some laggards (companies with unfavorable cost positions) surviving to maintain a steep and thus healthy industry cost curve. This sum—more than the GDP of South Korea—would instantly restore the industry’s profitability. Performance improvements by individual companies, synergies achieved through consolidation, and price increases made possible by the elimination of excess capacity would each contribute about a third of that value.

Such a radical restructuring of the Asian asset base for polypropylene, for instance, would remove as much as a million tons of excess capacity, reducing total capacity to 10 million tons, from 11 million—mainly as a result of closing subscale Japanese and Chinese plants. Capacity utilization across the region would then rise to 90 percent, from 82 percent, and annual savings of $360 million would flow from lower fixed costs achieved by closing plants and making the survivors more efficient (Exhibit 3). Unfortunately, this kind of restructuring will not take place in the foreseeable future. Major impediments include political and trading barriers among Asian nations, the rather large number of companies involved, the high degree of integration of many chemical plants, and a shortage of capital. In addition, leading companies with the technological and managerial resources required to drive this kind of consolidation are clearly wanting.

A more pragmatic solution, involving consolidation at the national or subregional level, would have better prospects for several reasons. First, trade barriers protect countries (and potentially subregions) from regional competition. Second, the number of players would be smaller, so it would be easier to find solutions at the negotiating table. Finally, the political barriers may be diminished because the benefits would "stay at home" rather than go to foreign owners.

Each of the region’s countries has its own problems and solutions. Below we discuss four of these markets and suggest strategies appropriate for them.

Japan

Japanese chemical companies are among the region’s least cost competitive, in part because of the protection traditionally extended to them through tariffs, as well as the buy-Japanese habits of local customers. The country’s industry is highly fragmented, with a large number of subscale assets, even though Japan has less overcapacity than do other countries in the region. The great expense of labor, land, and energy, to say nothing of a high degree of regulation, weaken the position of Japanese producers still more.

Although by no means in good financial shape, some of these Japanese companies, unlike most of their Asian competitors, may still have access to money, which would permit them to consolidate the industry elsewhere in Asia by acquiring competitors. The best possible restructuring scenario for Japan would include closing laggard plants at home and taking over world-class plants in South Korea. Exhibit 4 shows how this might work in polypropylene. For its Japanese producers, the net present value of such a restructuring would be substantial—more than $1 billion—and the region would benefit from the elimination of almost a million tons of Japanese capacity. Asian capacity utilization would rise by 10 percent, which would dramatically improve prices.

China

In two respects, China’s chemical industry is unique in Asia. First, the country has tremendous potential for expansion. Second, China does not have sufficient domestic capacity for many chemicals, including all of the major plastics. Consequently, it has become a major importer, served primarily by such surrounding countries as Japan, Singapore, and South Korea.

A few Western companies, such as BASF and Shell, do plan to get involved in China in a major way. In the meantime, the country’s chemical industry—still largely state owned—suffers from a bloated labor force, subscale assets, and chronic managerial problems. All this explains why capacity utilization is low even for products like polystyrene, though demand far outweighs supply. In addition, each chemical plant is managed locally, almost as an independent enterprise, so the level of fragmentation is high.

The Chinese chemical industry is therefore vulnerable. Competitively priced imports, some of them smuggled, are flooding into the country to soak up unmet demand; rising losses burden highly leveraged state enterprises; and the government lacks the resources to subsidize them or to police illegal imports. The solution should be to close inefficient plants and to replace them with world-class plants. But fortunately for China, it has a huge reservoir of demand that will provide a large market for new facilities even if old ones survive. As a result, the country may be able to manage the transition to a modern chemical sector relatively painlessly by developing a few world-class production centers. Western financial, technological, and managerial support will probably be needed, and as it happens China is among the few Asian markets where foreign players should position themselves in the short term for longer-term growth (see boxed insert).

South Korea

In the chemical business, the South Korean players rank as relative novices. Their equipment and technology are quite new, and their plants are large enough to enjoy world-class economies of scale. In the past decade, however, the South Koreans have vastly outstripped local market demand, having added almost as much capacity as Western Europe has done. It was expected that the local market would grow and that South Korea would become a major (and profitable) exporter. In reality, the country’s manufacturers accumulated huge debts and have been exporting products at almost any price to keep plant utilization high. South Korea’s exports at any price are a major cause of slumping chemical prices throughout Asia.

Most of the South Korean producers—the petrochemical companies, in particular—have little choice but to solve their problems among themselves, either by forming joint ventures and thus sharing the pain of plant closures or by swapping assets; these companies cannot sell assets among themselves, since none of them has any money. Meanwhile, the degree of fragmentation in the South Korean market and the large debts that South Korean companies have accumulated make them unattractive takeover targets for the great majority of outside investors, although the Japanese may be an exception.

As a result of intense competition among South Korean producers, they are reluctant to contemplate cooperation of the sort that is needed, but unless they can bring it off they will not survive. Although the country’s modern chemical manufacturing plants will certainly form a major part of a consolidated Asian industry, they may not end up in South Korean hands.

ASEAN

Collapsing local demand has created dramatic overcapacity in the member states of the Association of South East Asian Nations (ASEAN), where more than half of installed chemical capacity stands idle. The problems are most extreme in Indonesia, which accounted, before the crisis, for one-third of ASEAN chemical consumption. Since the size of this market has shrunk by about two-thirds, some companies have been forced to close. Thailand and Malaysia have also been hit severely by the crisis, and a number of companies there are close to collapse as well.

Fragmented ASEAN manufacturers have tried to cope with overcapacity by competing on price. Like the South Koreans, they are attempting to alleviate their problems by exporting to China, but fierce competition there means that these sales barely cover variable costs.

For many ASEAN businesses, recovery might well start with efforts to negotiate a restructuring of debt. Large, diversified conglomerates should seize the opportunity to sell noncore chemical assets. Companies in Indonesia, Malaysia, Thailand, and other nations that have high tariffs should attempt to exploit them by closing or mothballing capacity and allowing more expensive imports to set domestic prices—a course that will offer relief at least until the year 2003, when the creation of a free-trade zone will likely cut intra-ASEAN duties.

By then, the association’s member countries may be ready for a broader restructuring, and demand will probably start to grow again, which would permit mothballed capacity to be reactivated gradually. In this respect, some ASEAN states, particularly Singapore, have an advantage because many of their assets approach world-class standards.

Whatever the pace of consolidation turns out to be, the Asian chemical industry will change drastically, and the probable outcome is clear. Many local players, above all in Japan and China, will go under because of their subscale, outdated assets. Companies—mostly in South Korea and the ASEAN nations—that hold world-class assets could survive by restructuring; otherwise, those assets will eventually pass to new owners.

If Asian companies succeed, they will help to support prices for chemicals around the world. But there will be a sting in the tail for Western European and North American companies: once demand recovers, the Asians will be far more efficient, and Western companies may lose many Asian export markets forever.