Overcapacity looms for China industry

Is China’s Titanic economy finally running into the iceberg of overcapacity?

Problems at China Cosco Holdings suggest trouble ahead.

Cosco, a giant state-owned shipping company, is locked into long-term contracts for chartering vessels that haul iron ore, coal and grain around the world.

Many of those contracts were signed in the commodities boom, when the price for chartering a giant Capesize vessel peaked at around $US200000.00 a day. The price is now $US10000.00 a day. The consequences of that collapse are showing up in Cosco’s bottom line; the firm posted a loss of $US420 million in the first half of the year.

The irony is that the painful collapse in shipping rates is partly of China’s own making.

From 2003 to 2008, growth in China’s import volumes for iron ore averaged 26 per cent a year. Jason Leung, an expert on shipping at Jefferies, says that a total of 550 Capesize ships, with around 50 added each year, was inadequate to cope with the demand.

As a result, charter rates rose sharply. The Baltic Dry Index, which tracks worldwide shipping costs, rose to a peak of 11600 in June 2008.

Shipping companies, assuming the upward trend would remain unbroken, placed orders for new vessels or signed long-term contracts to charter ships at high prices. They were wrong. China’s iron ore import volumes actually shrank last year, and this year’s growth is languishing at 8 per cent year to year.

The number of Capesize vessels, meanwhile, rose to 1150 by the end of last year, with 200 more coming online each year, according to Leung.

A huge increase in shipping capacity and a marked slowdown in demand growth have resulted in a collapse in prices.

The Baltic Dry Index is now around 1500. Shipping companies that assumed an unbroken upward trajectory for demand have a taste of what excess capacity looks like. Shipping isn’t the only sector that placed too aggressive bets on growth and has been caught out by overcapacity. Take Aluminium.

China’s production capacity runs at 23 million tonnes per year, compared with around 16 million tonnes of demand. Graeme Traine, a metals analyst, says 3-4 million tonnes in capacity are set to come on line this year. The biggest loser Chinalco, the state-owned giant that finds its own margins squeezed by excess supply pushing down prices.

The situation in China overall is more nuanced than some bears suggest. Overcapacity is a problem in some parts of the economy and not in others. And where there are problems, rapid growth in some cases can help solve them.

Concern about excess production in the car sector, for example; proved ill-founded as domestic as domestic demand accelerated. But in shipping, aluminium and renewable energy, the iceberg of overcapacity is already breaching the hull. Investors should prepare to man the life boats.

Source: The Weekend Australian, September 3-4, 2011.