05 Feb 2020 | 04:00 UTC

Spotlight on China steel: Infrastructure construction to improve in 2020 but manufacturing to remain subdued

Highlights

Infrastructure will benefit from injection of special bonds but local governments need to manage debt

Auto demand unlikely to recover unless car making capacity removed

China's infrastructure construction is set to gain strong momentum in 2020 from new local government special bonds, but other financial factors will limit fixed asset investment growth in that sector, putting a cap on incremental steel demand.

China has issued a plethora of stimulus policies since late 2018 to revive its infrastructure sector, in a bid to cushion its slowing economic growth. As a result, steel consumption of new infrastructure projects approved in 2019 -- 39 million mt according to provincial government documents -- returned to a level slightly higher than in 2016 -- 34 million mt.

Infrastructure construction in 2016 gained most of its upward momentum from local government borrowing before it lost steam in the second half of 2017. This was due to the central government's deleveraging order and crackdown on shadow banking.

Now, mounting local government debts, together with a lack of alternative funding sources due to the probe into shadow banking, have become the biggest constraints on infrastructure investment.

The rise in local government special bond issuance, aimed at supporting infrastructure projects, has been unable to fully offset local governments' funding constraints.

The value of China's new local government special bonds issued in 2019 increased by 59% year on year to Yuan 2.15 trillion ($312 billion), according to government data. However, over 70% of these bonds found their way into the property sector through land reserve and shanty town renovation projects, leaving only around Yuan 0.54 trillion into real infrastructure projects, according to S&P Global Platts calculations.

At the same time, the value of entrusted loans, trust loans and undiscounted bankers' acceptances issued in 2019 decreased by Yuan 1.616 trillion on the year in January-November 2019. They were previously the major channels for shadow banking, but have been largely dented under the strict supervision of the central government since early 2018.

In 2020, infrastructure construction will gain strong momentum from new local government special bonds, which are expected to reach over Yuan 3 trillion ($429.5 billion) in 2020, according to market sources. The proportion of the total value of these bonds flowing into infrastructure projects is likely to reach up to 50%, according to Platts analysis.

However, local governments' ability to fund infrastructure projects will remain subdued in 2020 because they have lost most of their shadow banking channels. Further, tax cuts and fee reductions for enterprises and individuals, as well as slowing economic growth, have eroded local government revenues since 2019.

As a result, fixed asset investment growth in infrastructure in 2020 is likely to remain in single digits. Incremental steel demand generated from infrastructure construction, accounting for about 20% of China's total steel consumption, will remain mild in 2020.

CHINESE MANUFACTURING SECTOR STILL LOOKING FOR A BOTTOM

China's manufacturing sector was weak in 2019. The National Bureau of Statistics Purchasing Managers Index averaged 49.7 points -- out of 100 -- last year, meaning the sector was technically in contraction. The reluctance of Chinese enterprises to expand investment, and overcapacity, in passenger car manufacturing indicate the manufacturing sector will continue to underperform, and is therefore unlikely to contribute much incremental steel demand in 2020.

In addition, Chinese passenger car makers have been facing an even bigger problem -- overcapacity. Domestic demand for cars has reached a ceiling at current income levels.

Per capita income in the US is more than six times that of China, but the number of cars owned per 1,000 people is five times lower. This means that at current income levels, China has already consumed too many cars.

Given China's slowing economic growth, per capita income is unlikely to increase by a large extent in the short term. Eliminating passenger car overcapacity must be achieved before the industry is able to fully recover. Lowering interest rates or pumping more money into passenger car makers will only provide a short term solution.

Some steel mill sources said auto sheet demand -- an indicator of steel demand in the manufacturing sector -- was unlikely to see any significant improvement in 2020, and would probably be stable at best.

But average steel inventories at manufacturers are currently around one third of the level of 2018, according to market sources. In tandem with recovering demand due to seasonal factors or improving infrastructure construction in 2020, restocking at manufacturers will help boost demand for flat steel.

This is a five-part series discussing S&P Global Platts views on Chinese steel production, its capacity replacement mechanism, electric arc furnace development, scrap usage outlook, and the downstream demand drivers in 2020. We expect steel production growth to soften this year as net capacity increases slow. Demand should be stable, supported by robust property construction. More from this series: