In Beijing's latest move to consolidate China's fragmented steel industry, the State Council agreed Aug. 26 to take further measures to curb the industry's overcapacity by restricting banks' loose lending, enforcing tighter environmental standards and prohibiting incremental capacity additions. When China's crude steel production first outstripped domestic consumption in 2006, the excess capacity did not constitute an immediate threat because China was able to export the extra steel. But with the onset of the global financial crisis and a precipitous decline in global growth, the shortcomings of China's steel policies have been placed in sharp relief as demand for Chinese steel has only been buoyed by China's economic stimulus plan and government-funded infrastructure projects. The new measures are aimed at addressing the shortcomings and unintended consequences of the National Development and Reform Commission's (NDRC) Steel Development Policy of 2005. However, since Beijing's latest efforts do nothing to address the need for comprehensive political reform, their ability to effectively consolidate China's steel industry will be greatly limited. Steel and cement are pillars of industrial development. Roads, bridges, dams, reservoirs, machines, buildings and ships all require steel, cement or both. China, which has been industrializing rapidly over the past decade, now produces about half of the world's steel and cement. Though China is the world's top producer of crude steel, with about 700 steel producers, the industry is incredibly fragmented. Whereas more developed countries' top five producers account for around 70 to 80 percent of their crude steel output, China's top five producers account for less than 30 percent of total output. Much of this fragmentation is a legacy of Mao Zedong's Great Leap Forward. Emphasizing self-sufficiency and economic development, Mao encouraged every commune to produce its own steel. And while widely dispersing production may have made China less vulnerable to supply disruptions in times of war, encouraging the creation of tens of thousands of so-called "backyard blast furnaces" has come back to haunt the current central government as it attempts to consolidate the industry. Unleashing China's full economic potential rests on Beijing's ability to effectively steer its growth- and employment-oriented economic model toward sustainable profitability. This means that unless China's industries consolidate and achieve economies of scale, they will never gain in efficiency what they lose in government support. Recognizing this, the NDRC in July 2005 approved China's Iron and Steel Industry Development Policy that sought to modernize, consolidate and recast the steel industry as a strategic sector. The policy called for the shuttering of inefficient, inland capacity by legislating minimum production requirements for mills, and for the scaling up of coastal production. The new policy aimed to increase coastal production because China's value-added steel industry, which Beijing is trying to expand, currently depends on imported iron ore. Highly concentrated ore is needed to produce the higher value-added products, but while China's domestic ore averages an iron content of about 30 percent, the iron content in Australian and Brazilian ores is above 65 percent. There are concentrators in northern China, but it is still cheaper to import premium ore than to concentrate and transport domestic ore to the coastal regions. Importing ore also takes business away from those mines supplying inland mills the central government wants closed. However, since it is the inland areas that really need new business and investment, this move has only exacerbated coastal-inland rivalries. Refusing to be sidelined, inland mines have continued to supply smaller mills — clandestinely or otherwise — in increasing amounts as the coastal demand for inland ore wanes, thereby undermining the NDRC's policy and allowing for inland mills' continued growth. Additionally, as most of China's steel production is made by small, inefficient mills, their inefficient production's voracious appetite for raw materials had bid up input prices for all of China. To control these rising prices
, Beijing has enacted an array of export quotas and taxes on the industry's vital inputs
, such as coking coal, to keep domestic prices low. These measures, however, have not only ensured ample domestic supply of cheap coal and other inputs for smaller mills, but also muted a natural pricing mechanism that would otherwise dampen the industry's growth. For these reasons, China's steel industry remains both internally and geographically fragmented. The steel policy also established minimum capacity requirements for mills with the aim of shuttering obsolete and inefficient production. However, much of this production capacity was located inland, where the provincial leaders' careers are based on metrics like production and employment. Understandably, those leaders are not keen on closing their mills and dealing with the fallout and attendant unrest. So to escape closure requirements, local and provincial leaders have attempted to protect their steel mills by adding capacity and increasing output – the exact opposite of the central government's intent. Thus the mills are producing even more excess steel and further entrenching their local mills' importance as drivers of growth, employment and tax receipts. The central government also introduced differentiated electricity costs to price steel mills out of production, but the initiative was poorly prosecuted if not completely ignored. Ningxia province, for example, bypassed the higher energy costs altogether by simply taking the Qingtongxia steel mill off the national grid and provided electricity directly to the mill through a local utility. Competition is usually healthy for any given industry, because the threat of losing market share to lower-cost producers motivates technological advancement and greater efficiency among participants. In China, however, intra-regional competition has had a deleterious effect, largely because China's steel industry does not lower costs through innovation. Local officials know that the local steelmaker wants to grow his business, and the local steelmaker knows the official wants to report good employment figures. Naturally, this mutual interest leads to an agreement — subsidies in return for redundant employment. But while such a plan is rational on the local level, collectively it is detrimental to the industry and to China as a whole. Rather than spurring innovation, the competition forces local and regional authorities to increasingly subsidize their respective steel mills in their bids for social stability. While direct, indirect and structural subsidies keep the industry's local unemployment low, as the overall growth of the steel industry is only limited by provincial leaders' respect for environmental regulations, workers' rights or Beijing's authority, it is no wonder production capacity has mushroomed. The subsidizing is also particularly harmful to privately owned steel mills. Unable to compete with the leaders' favored mills and without government recourse, private mills have been forced to downsize and lay off their workers. In July 2009, Jilin province reminded China of how unpleasant privatization can be when a proposed restructuring of the Tonghua Iron and Steel Works sparked riots that ended with a steel executive's death
— ironically, somewhat reaffirming the importance of government intervention and control. Reform in the steel sector is proving almost impossible for China because the industry has so much inertia. China must keep the industry stable and growing to maintain employment and adjust to changing demographic patterns, but since China imports 35 percent of its iron ore, it must also secure long-term iron ore contracts to minimize the risk of supply or price fluctuations that could stifle the industry's growth. But herein lies the problem: as stability allows the industry to grow, the bigger industry requires more imports, which ultimately requires more stability — a vicious circle whereby steelmakers' dependence on imports begets more and more dependence on imports. Even the Chinese central government knows that the steel industry cannot grow exponentially forever. The problem, however, is that no politician stands to gain from unilaterally initiating the reforms necessary to prevent the industry's eventual implosion. Without political reform, local and provincial authorities can only continue to serve their own self-interest at the expense of Beijing's national plans.