- Despite modest gains in coal prices in recent months, the majority of China's coal businesses will remain unprofitable in the second half of 2016.
- Weak demand, low prices and high levels of debt will contribute to rising rates of coal enterprise bankruptcy and closure.
- Market headwinds will contribute to Beijing's latest coal consolidation effort — a newly created coal asset management company that pools resources from China's two largest coal enterprises.
- Local political imperatives will ensure that coal consolidation remains a work in progress throughout 2016 and into 2017.
China's Sichuan Coal Group, a provincial state-owned enterprise, is just one in a sea of small to middling Chinese coal businesses on the perpetual verge of bankruptcy. The company announced July 27 that it had completed a nearly 1.06 billion-yuan ($159.5 million) bond payment that it had missed in June, a rare piece of positive news from an industry battered by sluggish demand, low coal prices and the central government's increasingly stringent attempts to cut excess capacity. But Sichuan Coal's payment, which averted a bond default, hardly augurs an upswing for the industry that has powered China for a century and that still supplies 64 percent of the country's energy mix today.
Sichuan Coal alone has six other outstanding bonds set to mature by 2018, worth a total of 3.35 billion yuan — obligations that the company will no doubt struggle to meet. Furthermore, Bloomberg Intelligence estimates that as of May, 70 percent of China's coal mining businesses were unprofitable. Prices of thermal coal have fallen by 56 percent since 2011, leading miners increasingly to formal and informal debt to cover their operating expenses. By the end of 2017, some 460 billion yuan in coal-related corporate bonds are due to mature, and many of them are likely to be nonperforming. That amount comes to roughly 35 percent of the gross regional product of Shanxi province, long one of China's leading coal producers and home to the majority of its unprofitable mining operations.
On the surface, China's coal industry in some ways appears to be doing better this year than last, when 80 percent of coal mines were unprofitable. Coal prices, though nowhere near their 2010-11 peaks, have climbed by 7 percent so far in 2016. But profitability and prices are rising not because demand is strong but because supply is tight. In June, Chinese raw coal output was down by 15 percent, measured year-on-year. Meanwhile, investment in coal assets has plunged by 34.1 percent in the first half of the year. During the same period, power demand from heavy industry, which accounts for the vast majority of nationwide power use and coal demand, rose by just 0.5 percent year-on-year. China's coal sector is contracting, and supply is tight because miners have stopped mining.
A Double-Edged Sword
For China's leaders, these developments are at once fortuitous and ominous. For well over a decade, the central government has struggled with increasing vigor but no more success to consolidate the notoriously fragmented coal industry. Now, the growing threat of bond defaults and restricted supply suggest that market forces are starting to do what government initiatives largely could not. The longer prices remain low compared with earlier years, and the better Beijing gets at cracking down on shadow lending, the greater the consolidation in the industry will be. Ultimately, Chinese authorities hope to achieve a happy medium in the industry between extreme consolidation (of the sort accomplished, for instance, in the Chinese energy sector) and the kind of extreme fragmentation that prevailed throughout the 1980s and 1990s. Weak prices will help, as will the steady migration of China's key coal production bases from the eastern seaboard, where small-scale mines predominate, to western China, where giant strip mining operations and long supply lines necessitate larger-scale enterprises.
At the same time, these developments also portend higher rates of joblessness in the months ahead. The central government in recent years has grown more tolerant of unemployment for the sake of accelerating economic reforms. But local governments, which must deal with the social, political and economic fallout from job loss, rarely share that tolerance. For most local officials, preventing unrest is the single most important task since failure to do so almost automatically bars officials from advancing professionally. And as Chinese authorities have learned, stable employment is the best means to avoid unrest. Going forward, the likelihood of cross-provincial or even provincewide unrest in places like Shanxi remains low; Beijing is remarkably adept at keeping local discontent local. Even so, the social disturbance caused by business closures and job losses in coal-dominated regions is politically and economically costly. Beijing understandably fears that local problems in struggling regions such as Hebei — which surrounds the capital — could spread quickly if not closely monitored and properly managed.
Whatever their local social and political costs, low coal prices, falling profit and declining output would seem ideal for catalyzing Beijing's industrial consolidation plan. It is somewhat surprising, then, that the pace of coal business mergers and acquisitions appears to be slowing. In 2015, there were just five mergers in the sector, down from nine in 2014. In part, this reflects the growing prevalence of alternative financing avenues for coal companies beyond bank loans, bonds and equity markets, which have all faced tighter government controls in recent years. The practice of peer-to-peer and parent-to-subsidiary lending among coal enterprises is catching on rapidly: Peer-to-peer lending had surged by 332 percent year-on-year as of March 2016, reaching a total value of 504 billion yuan. These and other forms of informal emergency financing, most of which fly under central and provincial governments' radar, have helped keep otherwise failing mines afloat — if not enough to produce, then at least enough to provide employees some form of stipend.
Two Companies to Carry the Load
The slowdown in mergers and acquisitions also reflects reduced access to funding and generally weaker finances for the conglomerates that Beijing counts on to do most of the merging and acquiring. China's two largest coal conglomerates, Shenhua and ChinaCoal, have each seen declines in output, coal-related revenue and market share in the past two years. In 2015, ChinaCoal sold 12.6 percent less coal than it did the year before, and its market share fell from 4.1 percent to 3.7 percent. Shenhua missed its sales target by 8 percent last year — its first miss since 2005 — and its overall revenue dropped by 30 percent, a decline it expects to extend by another 18 percent in 2016. Though Shenhua and ChinaCoal handily outperform virtually all of their domestic competitors and face little risk of bankruptcy (they are far too politically important), their performance is nonetheless striking. Just a few years ago, Beijing lauded these enterprises as the centerpieces of an ambitious plan to consolidate most domestic coal output in the hands of eight coal-rail-power conglomerates. That Shenhua and ChinaCoal have ceded market share is testament to the difficulty of realizing such plans.
Against this backdrop, Chinese authorities recently announced the formation of a coal asset management company. The company will pool the influence and financial resources of Shenhua, ChinaCoal and two existing asset management companies to buy out struggling small-scale coal businesses and buy up poor quality coal assets from state-owned enterprises outside the sector. So far, few details are available regarding how the asset management company will operate, which regions it will focus on, or how it will be financed. But Beijing hopes that creating a single entity to oversee coal consolidation will add momentum to the effort while helping to stave off defaults. Assuming that the new asset management company is ably financed, and given Shenhua and ChinaCoal's influence throughout Chinese coal country, the new company should have more success than its constituent parts have had on their own.
But even if the asset management company meets Beijing's expectations, China will struggle to reach the central government's target of cutting 500 million tons of excess production capacity and to consolidate another 500 million tons under state-run coal conglomerates. China is by far the world's largest coal producer, and most of that coal is still mined by small and medium-sized companies. Most of those companies are tightly bound to the local governments that rely on them to provide employment and will bend central rules — and mobilize local financial institutions — to that end. Though macroeconomic conditions finally favor Beijing's vision of a consolidated coal sector, local politics in many places do not. In China, where political imperatives often overpower market dictates, resolving that discrepancy will take more than pronouncements from the central government. It will require reworking the incentive structure for local governments and dealing with the results.