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Jun 19, 2005, 10:01
China: Too Many Factories?
If the economy slows, overcapacity could crunch profits in China

JUNE 27, 2005

Any day now, German chemical giant BASF (BF ) and its partner China Petroleum & Chemical Corp. (SNP ) -- better known as Sinopec -- will fire up a new, $2.9 billion petrochemical complex. The 220-hectare facility along a stretch of the Yangtze River outside Nanjing, built by 15,000-plus Chinese workers and contractors from 22 countries, can turn out 600,000 metric tons a year of ethylene, a base material used to make a variety of plastic products. By yearend two other plants -- one built in Shanghai by Sinopec and Britain's BP (BP ), the other in Guangdong Province, courtesy of CNOOC (CEO ) and Royal Dutch/Shell Group (RD ) -- will kick in an additional 1.7 million tons of capacity. All told, China's ethylene output could rise by 36% this year from 2004 levels.

Now consider this: Six additional ethylene crackers, as they're known in industry jargon, are expected to win government approval and come online by 2010. China's ethylene capacity is expected to grow by 22% annually through 2009, while domestic demand will climb by just under 13%, figures Qu Guangdong, a Beijing analyst with chemical industry researcher SRI Consulting. Already the excess capacity has helped whack global ethylene prices by 50%, to about $600 per ton, since September. Qu thinks that for emerging petromajors such as Sinopec and CNOOC, it's a matter of having too much cash. "They have the money, and they want to spend," he says, "and they don't really care about the international markets." A Sinopec spokesman says the company is not worried about overcapacity in ethylene.

That's because the petroleum companies think their domestic customers will soak up all the product they can make. China, after all, has grown at 9%-plus annually during the past two years and hit 9.4% in the first quarter of 2005. Until recently, domestic demand absorbed most of that fresh industrial capacity -- not to mention vast quantities of chips, chemicals, building materials, and machinery imported from abroad. As a result, corporate profits of both Chinese companies and mainland divisions of multinationals have swelled.

But what if China downshifts? Most economists foresee mainland growth slowing to a more sustainable 8.5% or so in the next couple of years. At the start of 2004, China appeared to be in real danger of overheating and contracting severely, which would have been a disaster, since the country needs to grow at least 7% annually to create enough jobs for new workers. President Hu Jintao's government has since raised interest rates slightly and forced state-owned banks to rein in lending in an effort to cool things down. So far the strategy appears to be working -- there are signs of a decline in industrial production -- and no crash seems likely.

But even as China's leadership breathes a sigh of relief, the outsize profits of recent years appear to be history, given all the new plants being built. Gluts are emerging in steel, cement, autos, chips, and petrochemicals, dimming the outlook for earnings. In the first four months of 2004, profits at China's industrial companies surged by 46%. During the same period this year, they grew by a more modest 15.6%, according to China's National Bureau of Statistics.

In the cutthroat auto sector it's even worse. Profit growth there slowed to 4% from January through the end of April, vs. 9% in the same period of the previous year, because of aggressive price-cutting, according to the China Association of Automobile Manufacturers. The industry is running at only about 70% capacity, according to Automotive Resources Asia Ltd., an auto consultancy. The biggest sign of a slowdown so far, says Automotive Resources President Michael J. Dunne, is that some joint-venture companies have started laying workers off. (He won't name them.) "We are entering a war of attrition, there will be continued overcapacity," he says. "Whoever has the deepest pockets will survive this battle of wills."

Yet capacity keeps growing. On May 28, General Motors Corp. (GM ) and its local partner, Shanghai Automotive Industry Corp., opened a plant near Shanghai that can make 170,000 Buick Excelle and Cadillac STS sedans a year. Honda Motor Co. (HMC ) is on track to nearly double its Chinese production capacity. By early 2006 the company expects to be able to make 530,000 Accord sedans, Fit compacts, and other models yearly via its tie-ups with Guangzhou Automobile Group and Dongfeng Motor Corp. Sho Minekawa, president of Guangzhou Honda Automobile Co., concedes that the price competition is ferocious, especially in the small-car segment. "We have lost some market share to the Hyundai Elantra and GM Excelle," he says. Honda in April started exporting China-made Fits to Europe from a new factory in Guangzhou.

Then there's steel. The government is forecasting that the country's steel production will soon exceed domestic demand: Total capacity is expected to surge 43% by 2010, according to government numbers. Inventories have stayed manageable so far, but only because Chinese steelmakers have turned to exporting. And prices are decreasing. Overall, hot-rolled and cold-rolled steel prices have declined 10% since early April. And the situation could get worse. "If you count imports and upcoming investments, we foresee overcapacity," says Wu Dongying, director of strategy and planning at Shanghai Baosteel Group Corp.

Semiconductors are likely to be hit, too. Just as the industry is showing signs of matching supply with demand after a nasty glut and plunging prices last year, China is heading for a massive buildup in chip-fabrication plants, albeit lower-end ones. The nation is already home to 35 silicon-wafer plants, and 22 new ones are expected to be in place by the end of 2008, according to the trade group Semiconductor Equipment & Materials International.

Of course, if you have the right product, there's still serious yuan to be made in China. Producers of semiconductor-manufacturing equipment, such as Applied Materials (AMAT ), Nikon, and Novellus Systems, are likely to see handsome profits selling gear to all those new chip plants. And wealthier Chinese are still willing to pay up to $7,000 for the latest in flat-screen television technology, says Piet Coelewij, a senior vice-president at Philips Electronics (Shanghai) Co. "That market segment is growing extremely fast," he adds. Unfortunately for companies in many other sectors, the fat margins of recent years look increasingly out of reach.