Credit FAQ:

Chinese Steelmaker's Default Highlights Troubles In Sector, Could Benefit Larger Players
Primary Credit Analysts: Sangyun Han, Hong Kong (852) 2533-3526; sangyun.han@standardandpoors.com Huma Shi, Hong Kong (852) 2533-3527; huma.shi@standardandpoors.com

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Credit FAQ:

Chinese Steelmaker's Default Highlights Troubles In Sector, Could Benefit Larger Players
Shanxi Haixin Iron and Steel Group Co. Ltd., a private steelmaker in China's Shanxi province, recently defaulted on Chinese renminbi 3 billion in debt. The company, which has an annual capacity of 6 million tons, is now likely to face bankruptcy. Standard & Poor's Ratings Services believes the default and the recent sharp fall in iron ore prices highlight troubles for uncompetitive private steelmakers in China. On the other hand, the market share and profitability of large state-owned steelmakers are likely to improve with the phasing out of smaller players. However, significant benefits from such consolidation would take a few years to materialize, and would be limited to only a few state-owned steelmakers with better product mixes. Also, the potential phasing out of troubled private steelmakers, though gradual, is likely to benefit regional steelmakers. Overcapacity in the Chinese steel industry is likely to fall, in our view, resulting in reduced Chinese steel exports and lower and more stable prices for raw materials. This article addresses some common questions regarding the Shanxi Haixin default and its impact on the Chinese steel industry.

Frequently Asked Questions

Is the Shanxi default likely to be a one-off event?
No. We expect more such defaults in China's steel sector because domestic steel prices are at their lowest in more than eight years and the industry faces chronic overcapacity. The prospects for steel prices to recover are limited, in our view. Concerns over overcapacity in many industries and pollution have been increasing in China. The government has long sought to tackle these problems, but with limited success. The current leadership is committed to making the economy more market driven, and has stepped up efforts to reduce pollution as it has reached a critical level. Tighter regulation has been put in place to consolidate industries with severe overcapacity; as they are also key polluters. Consequently, we believe uncompetitive and loss-making steelmakers will be phased out, as they have old plants that focus on low-end products. Slower economic growth in China and weak demand for steel--especially long steel, which is used in construction and infrastructurewill exacerbate the situation for private steelmakers. About two-thirds of China's steel production is long steel, reflecting the low-end product mix for most steelmakers. The recent fall in iron ore prices to about US$100 per ton from US$130 a ton a year ago captures the downside risk for demand. Private steel producers accounted for 76% of China's steel capacity in 2013. Potential new defaults are likely to

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Credit FAQ: Chinese Steelmaker's Default Highlights Troubles In Sector, Could Benefit Larger Players

accelerate the phasing out of weaker steelmakers, in our view.

Do we expect defaults to occur with state-owned steelmakers too?

No. State-owned steelmakers have far greater access to China's state banks and domestic capital markets because of government support. Many of these companies are highly leveraged and have been making losses for the past two to three years. However, we believe the government will support these companies to repay their debt through policies such as allowing them to sell their land or to make the land available for commercial development. It could also provide government funds to help these companies to finance employee compensation and redeploy workers.

How will the potential phasing out of Chinese private steelmakers impact large state-owned steelmakers?
We expect that large state-owned steelmakers would gain market share and improve profitability as smaller and less efficient private firms are pushed out. Overcapacity has been the most negative factor for large state-owned operators such as Baosteel Group Corp., Wuhan Iron and Steel, and Angang Steel Co. Ltd. Intense competition and fragmentation in the industry has kept market prices low and constrained profitability. However, large players have had good operating efficiency because of economies of scale. Also, they have had access to capital to upgrade their technology and develop higher value-added products, such as flat plating for shipbuilding and auto manufacturing. Regulations also favor the large steelmakers. The government will grant additional steelmaking capacity only to larger players that meet more stringent environmental standards. A good example is Baosteel's Zhanjiang steel mill project, which is expected to commence production next year. In our view, the government's measures will gradually balance demand and supply for steel, supporting prices and profit margins.

Will the benefits be uniform for all large producers?

No, we see limited benefits for steel companies with large exposure to long steel. We expect demand for long steel to remain weak as China's economy cools, with domestic consumption, rather than exports and investment, driving growth. With severe overcapacity, even if steel demand picks up, we see the chances for a recovery in long steel as limited, given that much of the demand will be for auto-related flat steel. According to the China Iron And Steel Association, growth in steel demand in China will slow significantly to 3.5% year on year in 2014, from 7.5% in 2013, signaling more controls will be in place to curb the industry's focus on expansion. We believe Baosteel has a better product mix than other large Chinese steel producers and will continue to generate higher profitability. Baosteel has a good product mix, reflecting its dominant market share in supplying auto steel, which supports its profitability. In our view, steel demand prospects are brightest in the auto sector; we expect auto sales in China to grow at more than 10% in 2014.

How will the potential phasing out of private steelmakers in China affect the regional steel industry?
We believe the trend will benefit regional steelmakers such as POSCO and Nippon Steel & Sumitomo Metal Corp. over the next 24 months. Chinese steel exports grew by more than 20% last year, pushing down regional steel prices and intensifying competition. We expect Chinese steel exports to decline because a large portion of the exports are from private steelmakers.

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Credit FAQ: Chinese Steelmaker's Default Highlights Troubles In Sector, Could Benefit Larger Players

Slowing growth in steel production in China is likely to lower prices of raw materials such as iron ore and coking coal. Lower participation of private steelmakers in the spot market for raw materials is also likely to reduce volatility in prices because these companies have irregular purchasing patterns. However, beyond the next 24 months, China's large state-owned steel giants could become stronger as steel industry consolidation accelerates. These companies are likely to increase investment in R&D, improve product quality, and narrow the gap with their regional peers. As a result, we expect Chinese steelmakers to increase penetration into some of the more profitable segments, such as high-strength automotive sheet and energy related steel products.

Related Criteria And Research

Related Criteria
Key Credit Factors For The Metals And Mining Downstream Industry, Dec. 20, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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