As an important task of supply-side reform, the government has continued to promote capacity and production in the overcapacity industry in the past two years. These measures have supported the improvement in PPI and corporate profits, boosting the good performance of the stock market. Recently, the government has increasingly reduced production capacity by tightening environmental standards, including the start of heating seasons in the major northern cities (November 15 - March 15) to control air pollution. How is China's capacity to go, and how will it evolve? How will this affect industrial production, employment, debt problems and economic growth? How is the capacity going? Significant progress has been made in the steel and coal industry's de-capacity since 2016. The government proposed a capacity reduction target at the end of 2015. It plans to reduce its steel production capacity by 140 million tons and coal production capacity by 800 million tons within 3-5 years (adjusted target, equivalent to 10-15% of total capacity). In 2016, China actually reduced its steel production capacity by 65 million tons and coal production capacity by 290 million tons. The actual steel and coal de-capacity in 2017 is also expected to exceed its official target of 50 million tons and 150 million tons. Limiting production and strengthening environmental protection also help control supply. In addition to capacity, direct production is also a key measure. In 2016, the National Development and Reform Commission reduced the production days of coal enterprises from May to November from the usual 330 days to 276 days, which directly led to a 9% reduction in annual coal production, while domestic coal consumption remained stable at only 1%. Although the 276-day limit on production was lifted in 2017, the safety and environmental policies have tightened, and coal companies are reluctant to increase their supply significantly. Coal production since the beginning of the year has only increased by 6% year-on-year. In addition, the government's continued tightening of environmental policies has also restricted the production activities of high-pollution, low-energy, small-scale enterprises in the mining and raw materials industries. The steel industry shut down production of strip steel. We estimate that China has cut about 125 million tons of floor steel capacity by shutting down intermediate frequency furnaces and electric arc furnaces, and the strip steel may not be included in the statistics of steel production capacity and production. As a result, the actual reduction in steel production capacity may far exceed the official results. In 2017, the actual comparable crude steel output growth rate should be much lower than the officially released data (up 5.6% year-on-year since the beginning of the year), which may be roughly equivalent to the growth rate of steel production (up 0.5% year-on-year since the beginning of the year). Capacity utilization has improved significantly. Driven by de-capacity and improved demand, the 5% of the 5,000 companies surveyed by the central bank have rebounded sharply. This year, the Bureau of Statistics also began to release capacity utilization data for the industrial sector, which rose from 72.9% at the beginning of 2016 to 76.8% in the third quarter of 2017, the highest level since records began in 2013. Among them, the coal industry capacity utilization rate increased by 10.6 percentage points year-on-year to 69%, and the steel capacity utilization rate increased by 4.4 percentage points to 76.7%, which is basically consistent with our forecast. The prices of products in the upstream industry have risen sharply. Benefiting from strong real estate activities, steady growth in infrastructure investment and rebound in external demand, overall economic activity remained stable in 2016-17. Therefore, domestic coal consumption decreased by only 1% in 2016. In the second half of 2016, steel consumption increased by 3% year-on-year, and annual consumption increased by 1%. Coupled with the promotion of capacity and production restrictions, the prices of products in the upstream industry rebounded sharply, and the performance in recent months was stronger than market expectations. The PPI fell sharply from 5.2% in 2015 and 3.9% in the first half of 2016. It rose to 1.3% in the second half of 2016 and 6.5% year-on-year since the beginning of the year. Among them, the price of mining industry has increased significantly by 23.2% year-to-date, and the price of raw materials has increased by 12.1%, which will bring certain upward pressure on the prices of processed products and consumer goods in the future. Corporate profits have also improved significantly. Driven by improved supply and demand fundamentals and strong PPI growth, industrial profits have increased by 23% year-on-year (8.5% for the full year of 2016), with 51% of growth coming from the mining and raw materials industries (16% from coal, 14 % comes from steel, 5% comes from non-ferrous metals, 16% comes from other mining and raw materials industries, and 21% comes from the chemical industry. Both corporate income growth and rising profit margins have supported a jump in profit growth, with the effect of rising margins on the upstream industry being more important. The financial indicators of the company improved significantly, and the signs of de-leverage began to appear. This was mainly due to the continuous advancement of capacity, limited capital expenditure, and a sharp rebound in PPI and corporate profit growth. The growth rate of fixed asset investment in the coal and steel industries continued the downward trend since 2013. The proportion of the two fixed assets investment in 2017 was only 1%, much lower than the 4.6% in 2010 and 1.5 in 2015. %. In addition, the leverage ratio (asset-liability ratio) of coal and steel companies has also fallen from the high point of 2015-16. At the same time, the overall leverage ratio of state-owned industrial enterprises has also declined. As the nominal value-added growth rate accelerates and the debt expansion rate slows down, the macro leverage ratio of industrial enterprises (approximate calculation: the proportion of total industrial enterprises' total liabilities to industrial nominal added value) has also declined since the beginning of 2017. Related stocks have risen, and market concerns about the quality of bank assets have eased. Driven by a sharp rebound in upstream prices and corporate profits, mining and raw materials stocks have risen markedly in the past two years. At the same time, as the bank's non-performing loan formation rate stabilized, the market's concerns about the quality of bank assets also eased slightly. How will the production capacity evolve? De-capacity will continue to advance, and environmental requirements will be tightened. At the recent closing of the 19th National Congress, de-capacity and corporate (especially state-owned enterprises) deleveraging and environmental protection were listed as important tasks to further promote supply-side reform. We expect the government to basically complete the current steel de-capacity target in 2018 (UBS expects to go to capacity of 25 million tons in 2018) and reduce the average annual production capacity of 120 million tons in 2018-2020 while continuing to limit thermal power plants. Capacity expansion. Tightening environmental protection policies may become the new normal in the next few years, which will continue to limit production in the upstream industry, especially in high-pollution production and heating seasons. In addition, the environmental tax will be levied from January 1, 2018, which should help to improve the incentive mechanism for pollution reduction, which will affect the production decisions of enterprises in the mining and raw materials industries. Domestic demand may fall slightly in 2018. In China's macroeconomic outlook for 2018-19, we expect China's GDP growth rate to slow from 6.8% this year to 6.4% in 2018, and further slow down to 6.3% in 2019. This is mainly because the tightening of real estate regulation and the peak of market sentiment will lead to a slowdown in real estate activities, and regulation of local government financing will drag down infrastructure investment. This means that demand for commodities and raw materials may weaken. UBS estimates that both crude steel consumption will decrease by 1% in 2018 and 2019, and coal consumption will shift from a low single digit growth in 2017 to a 1% and 2% decline. Production limits and production reduction measures are implemented during the heating season. In the next two quarters, one of the most important policies on the supply side is the autumn and winter air pollution control work in several northern provinces and cities. Although the official heating season is from November 15, 2017 to March 15, 2018 (four months), some policies have been implemented ahead of schedule in October (before the 19th National Congress). The main targets of air pollution are Beijing and Tianjin, and 26 prefecture-level cities in Hebei, Henan, Shandong and Shanxi (the “2+26†cities), and these provinces may extend the scope of governance to other cities ( That is, "2+4" provinces and cities). The government plans to "2+26 cities": 1) reduce coal consumption; 2) in Shijiazhuang, Tangshan and other key steel production cities, steel production capacity is limited to 50%; 3) increase the peak productivity of building materials industry, cement, ceramics, etc. The building materials industry stopped production; 4) electrolytic aluminum plants limited production of more than 30%; 5) bulk materials for peak transportation; 6) further reduction of coal and steel production capacity. At the same time, some local governments (such as Beijing and Tianjin) have also announced plans to suspend construction activities during this period. In the first two weeks of air pollution control work (from November 15 to the heating season on March 15), the operating rate of blast furnaces in Tangshan has dropped from 75% in October to 43%, further pushing up steel. price. Impact of air pollution control in autumn and winter The air pollution control coverage in this autumn and winter accounted for one-sixth of China's GDP and one-third of some metal production. “2+26†cities account for 16-18% of China's GDP and secondary industry added value, about one-third of steel and electrolytic aluminum production, and 13% of cement production. If the governance of the above four provinces is expanded to all cities, the importance of the “2+4†provinces and cities will be further increased, equivalent to 26% of GDP, 30% of industrial added value, and 43% of crude steel production. 38% of electrolytic aluminum production and 19% of cement production. Our baseline estimate is: steel production during the heating season is reduced by 10%, cement by 13%, and electrolytic aluminum by 6%. Our baseline scenario is that the government strictly implements atmospheric management programs in “2+26†cities. In this case, we estimate that steel production will decrease by about 10% (26 million tons) during the heating season, and electrolytic aluminum production will decrease by 6%. (700,000 tons), cement production decreased by 13% (83 million tons). Taking into account the seasonal characteristics of raw material production, we estimate annual production by 3%, 3% and 2%, respectively, relative to steel, cement and electrolytic aluminum. It is worth noting that: 1) The goal of air pollution control is to reduce the capacity utilization rate to a certain level, which is not for production; 2) Our baseline estimate assumes that steel production is limited to only nine of the plans that have officially introduced a 50% reduction plan. A major steel producing city. If all steel production capacity in the 2+26 city is limited, the decline in steel production may expand to 31 million tons. The impact on overall GDP and industrial production may be less than the proportion of “2+26†cities. First, production in other unrestricted areas may rise, partially offsetting the impact of “2+26†cities' production cuts. Second, the suppressed industrial production and construction needs of the “2+26†city may be released after the heating season. Third, given that we expect real estate activity and infrastructure investment to slow down, the demand for raw materials (and production) will naturally weaken, and this has been taken into account in our 2018-19 economic outlook. In the baseline scenario, we estimate that air pollution control in autumn and winter will lower the GDP growth rate by 0.1 and 0.2 percentage points in the fourth quarter of 2017 and the first quarter of 2018, respectively. Affected by the suspension of production in the heating season, there may be 2 million employees in the raw materials industry facing temporary vacations or pay cuts, including steel, building materials and non-ferrous metals. In addition, employment in the construction industry may also be affected, but given that the winter itself is the off-season of the construction industry, a large number of employees may have left the site. Upstream prices may remain high throughout the heating season, but may fall after the first quarter. Although we expect steel, electrolytic aluminum and cement production to fall sharply, construction activities are constrained at the same time, real estate and infrastructure investment slowdown, which will partially offset the effect of limited production on prices. We expect raw material prices to remain high during the heating season, but there is limited room for further significant upside. After the first quarter, as GDP growth slows and the disturbance of supply to major conferences in 2018 decreases, raw material prices may fall back. UBS expects the average annual price of thermal coal in 2018 will be 14% lower than 2017 to 550 yuan / ton, and rebar prices will fall 11% to 3126 yuan / ton. Our baseline scenario is expected to face both upside and downside risks. Scenario 1: The implementation of production restriction measures is more relaxed. If the local level is relaxed in the actual implementation of steel, cement and electrolytic aluminum production limits (such as 40%, 80% and 24% respectively) and the restrictions on construction activities are loose, the decline in the output of related products may be less than It is expected that the overall impact on GDP growth will be more moderate (which drags GDP growth by 0.08 percentage points in the fourth quarter of 2017 and GDP by 0.14 percentage points in the first quarter of 2018). Scenario 2: The scope of implementation of the production restriction measures is expanded. If the production limit is extended to all cities in the “2+4†provinces and cities, the total output decline will be greater than expected, and the overall impact on economic growth will exceed the estimates in the baseline scenario. The impact of further de-capacity on employment is basically controllable, but tightening environmental protection policies may bring certain downward pressure. We estimate that the total employment of the coal and steel industry in 2016 is about 12 million. Last year, the coal and steel industry's de-capacity directly caused a decrease of 710,000 jobs, which is basically consistent with the official data. We expect steel and coal de-capacity in 2017 and 2018 to further reduce employment by 450,000 and 280,000. The total number of jobs directly affected by capacity in 2016-20 may exceed 1.7 million. However, thanks to government compensation and subsidies in place (partly through special adjustment funds) and corporate profits have risen sharply, workers who have been laid off due to de-capacity seem to have been properly compensated or resettled. However, with the tightening of environmental protection policies, some small private enterprises in the capacity-consuming industry may temporarily or even permanently close, which may bring certain downward pressure on the job market. Investment in fixed assets in the upstream industry is still weak, but the impact on GDP growth is relatively limited. Since the beginning of 2017, fixed assets investment in the coal and steel industry has decreased by 9% year-on-year (13% in both 2015 and 2016). Although corporate profits have risen sharply in the near term, we expect fixed asset investment in these two industries to remain weak, but the decline may narrow in 2018-20. In addition, based on the China Input-Output Table, we estimate that further de-capacity in the coal and steel industry in 2018 (reducing capacity by 2-3%, respectively) will drag the overall GDP growth by 0.05 percentage points, which includes direct impact and input and output through various industries. The indirect effects of relationships. In addition, recent government tightening of environmental protection policies (such as air pollution control) may further reduce overall GDP growth (to drag the GDP growth of 0.2% in the first quarter of 2018 or 0.04% of GDP in 2018). The growth rate of PPI and corporate profits declined, but the industry differentiation was obvious. As overall demand weakens and supply normalizes next year, we expect upstream industry prices to fall slightly from current highs. However, the government will continue to push for capacity and tighten environmental protection policies, which should curb the rebound in supply or capacity of upstream industries, thus limiting the downward adjustment of prices. We expect the overall PPI growth rate to slow down to less than 2% in 2018, in which the price of mining and raw materials will fall in single digits, but with the gradual transmission of price pressures, coupled with a slight slowdown in economic growth, the midstream and The prices of downstream industry products will continue to rise. The profit of enterprises in various industries may be differentiated next year. The profit growth rate of upstream industries will face obvious downward pressure, but still maintain a good absolute level of profit; the profits of manufacturing and consumer goods industries may be further improved, especially for large leading enterprises. UBS expects the MSCI China Index and the Shanghai and Shenzhen 300 Index's profit growth to slow down in 2018, but still remain relatively stable, at 12% and 8% respectively. Signs of corporate de-leverage have begun to show, and the pressure on bad debts has eased. Thanks to significant progress in capacity reduction, limited capital expenditure in some industries, and overall credit growth slowdown, the total liabilities of the domestic coal and steel industry (above scale) remained stable at around 8 trillion yuan in 2016-17. The asset-liability ratios of these two industries peaked in 2015-16 and fell back in 2017 (Figure 21), and their profit margins and interest coverage ratios also improved significantly. The overall potential non-performing loan ratio (ie, the proportion of ABIT non-financial corporate liabilities with total EBITDA/financial costs less than 1 in total liabilities) fell from 16% in 2015 to 13% in 2016, and further decreased to 11 in the first half of 2017. %. We expect the above improvement trend to continue for some time, although the improvement may be slowed down. Industry perspective coal industry. We expect that the price of 5,500-car thermal coal in Qinhuangdao will reach the highest point of 640 yuan/ton in 2017 and fall back to 550/520 yuan per ton in 2018/19. After entering 2018, we expect coal supply to continue to rise as coal production at the national level is less affected than in 2017. Given that we expect demand to fall back but remain strong, we believe that supply and demand in 2018/19 will not be as tight as in 2016/17. In the next six months, we expect coal spot prices to fall only slightly, as stocks are at their lowest point in recent years. Demand for replenishment of downstream users may support coal prices in the winter, unless demand is much lower than expected. For 2018, we believe that the annual coal contract benchmark price should be at least 535 yuan / ton (same as 2017), thus supporting the overall coal price in 2018. We expect domestic commercial coal supply to increase by 2% in 2018, flat year-on-year in 2019, and total demand in 2018/19 will fall by 1%/2%, indicating that market supply will be more abundant (especially in the spot market). steel industry. We expect the average price of steel products to fall in 2018/19 due to lower demand, restart of idle capacity and near completion of capacity planning. However, we also expect that the price of raw materials, coking coal and iron ore, will fall by about 15% in 2018. This should help cushion the decline in steel prices and maintain profit margins, especially in the current market where supply and demand are tight. We believe that the tension between steel supply and demand may ease, but the slowdown is slow. Steel demand will peak in 2017, and we believe steel demand will fall by about 1% in 2018 and 2019, respectively, due to the reduction in new construction area and slowdown in infrastructure spending. However, we believe that the new construction area of ​​real estate is still at a healthy level, and land transactions are also very active. The resulting lag material demand may mean that steel demand will only decline slightly. On the supply side, the capacity-removal plan for 2018 will come to an end, and the elimination of polluting facilities in North China may once again constrain supply, thus making the industry capacity utilization rate at a high level in the next three years. Therefore, we believe that the profit margin of the steel industry can be maintained for a long time. (The author of this article: China Chief Economist, UBS Securities.)
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