China’s steel market has quickly become the world’s largest, and demand is set to soar during the next decade. Yet the country’s steel producers are in poor shape to take advantage of their homeland’s boom. Fragmented, uncompetitive, unprofitable, heavily in debt, and geared to the wrong products, they are losing out to imports.

But all is far from lost. Given steel’s strategic importance, the Chinese government is intent on remaking the industry to achieve international competitiveness. In addition to vigorously pushing for the industry restructuring that is needed to restore profitability to the main producers, which are still predominantly state owned, Beijing is forcing them to go to the private sector for the money they desperately need for growth.

Foreign and local private investors, as well as regional governments, have their eye on the booming demand, but many of them have decided to wait for additional restructuring before they act. To overcome the legacy of state planning, mills must shed their production quota mind-set and focus on what their customers want. Operational improvements to boost productivity and strategic alliances are required as well. Companies that move first have a chance to transform the industry and to become tomorrow’s leaders.

A growing appetite for steel

On the back of surging construction and infrastructure investments, demand for steel in China has more than quadrupled since 1980 while Japan, Western Europe, and the United States have experienced single-digit growth rates. China consumed more than 130 million tons¹ of steel in 2000, surpassing the United States to become the biggest market in the world. Chinese producers, generating 3 percent of the nation’s gross domestic product and employing more than three million people, supply 87 percent of the domestic market.

Yet China is still only in the early stages of burgeoning demand. There is a well-established relationship between a country’s GDP and steel consumption (Exhibit 1). China uses a mere 0.12 kilograms per dollar of GDP, or 92 kilograms per head, whereas Malaysia, for example, consumes 450 kilograms per head. Partly closing that gap in the coming decade could double demand even if new technologies allowed China to bypass some of the more steel-intensive phases of economic development.

Part of the demand for steel will involve relatively cheap long products used in construction. China’s steel industry concentrates on them, but stricter building codes will augment the growing demand for high-quality construction steel. Growth will be even faster in the market for higher-value-added flat products, above all for world-scale customers in the automotive, appliance, and assembly sectors. Markets for stainless, galvanized, coated, and other more complex processed steels are expected to grow faster still. Because China is short of the plants needed to make these products, it imports them from Europe, Japan, South Korea, and the United States.

Annual demand is set to increase by 50 million tons, to more than 182 million tons, by 2005, but no more than 27 million tons of net planned expansion capacity can be identified. This implies a gap, chiefly in flat products, of up to 44 million tons in the supply of finished steel by 2005—a gap that can be filled only by imports or higher productivity. The capacity shortfall is the unsurprising result of the downward spiral of profitability and investment since the early 1990s: some township and collective enterprises have built small plants with minimill technology, but only one large greenfield mill was built during the decade, and the level of investment dropped by 50 percent from 1995 to 1999.

If these trends continue, China’s steel industry will become increasingly incapable of serving the country’s needs. But steel is not a major investment area for the central government in the tenth Five Year Plan (2000), because Beijing is gambling that continued deregulation (see sidebar, "Rolling back central planning") and consolidation will be catalyst enough for improvement. And to be sure, if the industry is willing to restructure, private and foreign capital will arrive.

Consolidation: The first step

Many of the industry’s problems are rooted in its fragmentation, a result of China’s 1960s-era policy of regional self-sufficiency. Small loss-making companies abound, and even the industry’s biggest must grow to become competitive on a world scale (Exhibit 2). The very largest Chinese steel company—Shanghai Baosteel Group, at 18 million tons—is dwarfed by the more than 40-million-ton capacity of planned merger of Aceralia, Arbed, and Usinor, as well as the 25-million-ton capacity of South Korea’s POSCO and of Japan’s Nippon Steel.

Since 1997, Beijing has pushed to close obsolete and underperforming plants—part of its strategy to shift state industry to a more investment-friendly market footing. The consolidation program has been controversial, and the record is mixed at best. Managers of consolidated regional mills have been left with the unenviable choice of decommissioning or carrying excess capacity. In many of the merged entities, the burden of the loss makers has so far outweighed the promised benefits. The Shanghai Baosteel Group, for example, was formed in a 1997 merger of Shanghai Metallurgical, Meishan Iron & Steel, and Baoshan Iron & Steel (Baosteel). Since then, the company has absorbed seven other mills. Although it dominates demand in the greater Shanghai area, four years after its formation it still derives almost all of its profits from Baosteel.

By contrast, the Hualing Group, in Hunan, appears to have consolidated four smaller mills more successfully, thus raising profits and generating ongoing cost reductions. Encouraged by this and early relative success stories in other similarly fragmented industries, such as airlines, Beijing is persevering with its consolidation policy, as it must. Liaoning Province, in China’s northeast, is proposing to merge its mills at Anshan, Benxi, Dalian, and Fushun. Shougang Steel could acquire Tangshan Steel, in the north; Wuhan is slated to go on expanding along the Yangzi River.

Three winning strategies

Beijing’s policies and the strong demand for steel will provide an opportunity, while those mills that survive will have found a way to improve their performance dramatically—and thus to attract investment. Some investors, seeing the industry’s potential, are stepping in: ThyssenKrupp’s $1 billion stainless-steel venture with the Shanghai Baosteel Group, in 1999, was an extraordinary vote of confidence. International lenders, including the US firm McDonald Investments, are attempting to structure deals with local leaders such as Handan Iron & Steel.

Mills can tailor at least three winning strategies to their own needs, even as they push ahead with consolidation. These strategies may be familiar elsewhere, but they represent big steps for China, given the culture and capabilities of its steel enterprises.

Spurring productivity

What prevents the Chinese steel industry from beating the price-cost squeeze imposed by the country’s opening to world trade is low productivity. In the early 1990s, Japan and South Korea met China’s growing demand for high-value steel while cheap Russian steel flooded the low-value market. Before quotas were imposed, in 1996, imports peaked at 28 percent of consumption. Prices, which imports were setting by then, dropped 30 percent from 1996 to 2000.

Meanwhile, the price of raw materials, again set by international markets, was rising. Local iron-ore mines failed to meet the increasing demand, for they, like the mills to which they were attached, suffered from low productivity. Mills looking for higher-quality inputs had to import them, since the iron content of China’s ore is generally less than 40 percent. Imports now account for up to 30 percent of the iron ore consumed in China.

By 2000, the Chinese steel industry faced the same price-cost squeeze confronting the rest of the global steel industry. Its profitability had declined from 6.1 percent in 1990 to 0.7 percent in 1999, far below what is needed to attract reinvestment (Exhibit 3). As the industry’s share of national investment fell from 6 percent in 1996 to 2 percent in 2000, most mills had to borrow to finance expansion and even operating expenses. The industry’s debt-to-equity ratio rose from 1.26 in 1995 to 1.65 in 1999, compared with typical US ratios of 0.2 to 0.6 in 1999.

In this environment, any Chinese mill that wants to survive will have to make operational improvements. The opportunities are significant; even the top-ranked mills could reduce their costs by up to 9 percent to match international standards if they merely targeted nonlabor areas such as energy management, product yields, and maintenance (Exhibit 4).

Better performance, however, will also require layoffs, which are often impossible without government support. Shougang Steel, for instance, employs more than 100,000 people to make seven million tons of steel, though international standards suggest that the number of workers could be only 10,000 to 20,000. Shougang could in theory dismiss a majority of its employees immediately, but the local government, though supportive in principle, refuses to allow layoffs on this scale. Such enterprises have been employers of last resort, after all, and some other arrangements must be made for the full range of employee and family social services they provide.

Just as important, mills need the freedom to reward their people for individual performance. Although salaried employees—a majority of all workers—do receive a bonus, it is often the same for all of them, and when everybody gets the same bonus, it is just another part of fixed income. Meanwhile, the chairman of the largest steel company in China makes just 20 percent of the salary of a typical joint venture’s general manager.

Handan Iron & Steel is well-known as the first Chinese steel enterprise to put itself in order. Back in 1990, it produced 1.1 million tons of steel bars, wires, beams, plates, and other construction steels. Of the company’s 28 products, 26 were sold at a loss. Handan’s response was to make use of market prices for the internal transfer of raw materials, fuel, consumables, and refractory and semifinished goods. Previously, Handan had applied the government’s allocated prices, which were grossly below market levels; though the company sold its products at a loss, each of its operating units was miraculously profitable.

By knowing the market value of its end products, Handan could work backward to arrive at the cost reduction targets needed at all stages of production to ensure a profit. Handan included all of its employees in a program to identify and capture the potential cost savings at each stage. Finally, it developed a new performance-management program to sustain the improvements. In only eight months, the company turned itself around, achieving such great success that "learn from Handan" became a nationwide slogan. From 1991 through 1997, the company’s total costs fell by an average of 5 percent a year. Even with fierce price competition, Handan managed to increase its profits steadily until 1995. Since then, it has clearly outperformed the industry, maintaining profits while most of its peers sustained many years of losses.

The experience of leaders such as Handan shows how China’s mills should pursue operational excellence. They first need to find a determined group of people willing to drive efficiency on the shop floor. To set clear quantitative targets, they must then create what in many cases will be a mill’s first reliable fact base on costs. And to ensure a controlled environment, the effort should start with pilots rather than a plantwide push.

Dominating local markets with a new customer focus

Operational efficiency is a necessary first step, but it is far from enough. The industry is officially only four years removed from the days of central planning, when state enterprises lacked commercial connections to the markets they were created to serve. The needs of local governments tended to drive production planning, and executives typically had technical or administrative backgrounds and few market and business-development skills.

In the recent past, Chinese mills have fought hard to get closer to their customers. They have built direct-sales channels to skirt the slow delivery times and high inventory costs of layers of independent distributors. They have invested in new product and processing capabilities—in particular, hot and cold rolling, as well as galvanized and plating capacity—that their domestic end users needed. And they have explored e-commerce: 12 large mills just launched a World Wide Web marketplace.

Chinese galvanized steel sells at a 30 percent discount to imports, but Chinese customers have little interest in lower-quality goods

These approaches will help, but they are unlikely to yield a real breakthrough unless accompanied by a fundamental shift away from production quotas and toward efforts to find out what customers actually want. In chasing the large yet fragmented construction markets of China, its mills have consistently overestimated demand for new products and underestimated the quality and the marketing required. Chinese galvanized steel sells at a 30 percent discount to the imported equivalent, but customers just aren’t interested in lower-quality goods. Meanwhile, the Chinese subsidiary of Australia’s BHP Steel has shown how a well-researched, differentiated, and quality offer can secure both a premium and a dominant market share in China’s highly competitive construction sector.

Chinese mills, particularly in flat products, should concentrate on the handful of their customers—automobile, appliance, and container companies—that place large orders, for these customers will determine their profitability in years to come. Every mill should rigorously assess the needs of its customers and draw upon all of its cross-functional expertise to work with them to generate solutions. When a mill has unique product competencies developed with its customer base, it can then attack a broader market. Here the priorities are disciplined market research, a willingness to insist on quality, smart capital design to ensure a fair return, systems and structures to ensure consistency, and a realistic level of investment in the brand and product launch.

Forming alliances for an international market

Serving the new generation of demanding customers, both multinational and Chinese, will increasingly require these disciplines. Giants like General Motors, Toyota, and Volkswagen dominate the steel-reliant automotive industry, and a similar process of consolidation is occurring in packaging and other steel-intensive sectors. These customers have long sought to consolidate their suppliers across regions, and multinational steelmakers are now developing global networks to capture them.

China’s mills, however, lack the scale, relationships, and experience to serve the global giants. The international presence of Chinese mills is limited to information-gathering offices; overseas investments have been unsuccessful. One chance remains: Chinese steelmakers may have an opportunity to piggyback themselves on the global moves of Chinese appliance companies, such as Haier and Kelong, that are investing in assembly plants in the United States and Europe.

Otherwise, the threat to domestic producers is clear: join the international players or be relegated to the role of second-tier supplier. China isn’t new to alliances and joint ventures with foreign players. So far, the record in the steel industry is mixed, as the former partners of one of the larger investments in Shanxi would attest; a failure to assess the market, a lack of disciplined on-the-ground management, and a complete breakdown in trust between the partners contributed to the withdrawal of the foreign side.

To make joint ventures work in the long term, both sides must commit sufficient managerial and financial resources to create an independently viable business; Shanghai Automotive Industry Corporation’s joint venture with Volkswagen is a good example. Less formal links through the exchange of technology, coordination among suppliers, and comarketing to global customers may prove equally effective. Chinese mills, however, will have to become far more disciplined in developing skills than they have been to date.

What is possible for Chinese steel companies a decade from now? If they make the right moves, the industry could double its current output in a range of quality products and rival its European and Japanese counterparts in productivity. As a result of consolidation, 70 percent of production would take place in the hubs of Guangdong, Hebei, Liaoning, Shanghai, and Wuhan. And only two groups—which might align themselves with POSCO and Nippon Steel and with NKK and Kawasaki Steel to serve global automotive and appliance customers—would manage 60 percent of that business. If all went well, the companies, with a set of diversified, international, and well-rewarded investors, would be listed on the Chinese, London, and New York stock exchanges.

What will it take for this vision to come true? Regulators must continue to play the role of the catalyst. Developing talent will also be vital because, in an increasingly capital-intensive industry, China cannot rely solely on the competitive advantage of its low-cost labor. But the mills themselves now have, in their own hands, the responsibility for winning their share of the global steel market.