Scrap equipment at the Baijiazhuang Mine of Shanxi Coking Coal Group Co. Ltd. With a history spanning over 80 years, the mine suspended its production in 2016 after exhausting its resources (XINHUA)

Cutting excessive industrial capacity has been a hot topic in recent years, but many discussions around it assume that existing industrial capacity has to be digested in a closed market. A number of analysts confine their focus to the immediate problem, which inevitably affects the feasibility of the solutions they offer.

In fact, people in China must regard the problem and its solutions through the lens of an open economic environment and with a long-term view, mindful of the goal to improve China's position in the global economy, and maintain the foundation for its sustainable development. Therefore, the primary commodity sector should be the target of capacity cutting measures. As for excess capacity in the manufacturing sector, as long as their products meet environmental protection standards and are competitive in the international market, the government should allow them to tap into their export potential, rather than shutting them down.

A rational choice

Shutting down factories out of overcapacity concerns causes three major problems—unemployment, tax losses and non-performing bank loans.

As Stewart C. Myers, a professor of finance at Massachusetts Institute of Technology, has said, in bankruptcy the value of tangible assets is higher than that of intangible assets; therefore firms with tangible assets tend to borrow more. In China, most of the industries afflicted with overcapacity are capital-intensive industries with high debt ratios. Since the turn of the century, the upgrading of China's industrial structure has been composed of interactions between capital-intensive industries and the bank-based financial system. This has resulted in numerous industries with overcapacity being saddled with a higher debt-to-asset ratio than the average level.

The government should therefore focus on cutting overcapacity in the primary commodity sector instead of the manufacturing sector. Despite the excessive production capacity present in most of manufacturing industries, they are still very competitive in the international market, whereas the primary commodity sector has witnessed decreasing global competitiveness.

For example, many mineral enterprises produce low-quality products at high costs. Therefore, when the primary commodity market is booming, they can gain some profit, albeit at a lower rate than their foreign counterparts. But when the market is in a depression, they are unprofitable. To make downstream manufacturing industries competitive in the international market, China should no longer protect those upstream resource exploitation companies. Purchasing low-cost, high-quality raw materials from foreign markets is more beneficial to manufacturing industries than using domestic raw materials which are low-quality and expensive.

As for bulk farm products and the related processing industry, due to the decline of per-capita farmland and rising labor costs, land-intensive farm products such as cane sugar have lost their competitiveness in the international market.

According to figures from the National Bureau of Statistics, in the first quarter of 2015, only 54.1 percent of the processed sugar produced in China was sold. Although the rate was 12 percentage points higher than the first quarter of 2014, the increase came at such a price that sugar inventories soared by 118 percent compared with the beginning of 2015. A major reason behind this is that domestic sugar refineries' production costs are much higher than their foreign counterparts, as they have to use domestically produced sugar cane. These crops are planted by individual farmers and cost much more than those from foreign large-scale plantations.

In the past China had to depend on domestically produced commodities because it was unable to ensure the safety of imported products. Now, as China's national strength and the diversity of its import sources have improved, lowering the self-sufficiency rate of the agriculture industry won't harm China's economic security.

Manufacturing still strong

Compared to the decreasing international competitiveness of the primary commodity sector, some Chinese manufacturers, which are shouldering overcapacity, have shown strong global competitiveness and their exports have increased dramatically.

For instance, although the coke and semi-coke, refined oil, plate glass and steel industries represent the most serious cases of overcapacity in China, they have registered rapid growth in exports—many even with double-digit growth—since 2013.

Exports in such industries have not reached their full potential. Take the oil refining industry for example. In 2013, only 67 percent of its production capacity was utilized. Industry insiders have estimated that in 2020 China's oil refining capacity would reach 910 million tons. China's shutdown of low-level and high-polluting oil refineries is an adequate policy, but it is wrong to blindly encourage the building of subsidiary refineries in foreign countries. The amount of investment required to construct oil refineries is very large, leading to astonishingly high sunk costs, as well as business and political risks. Such refineries also require high-quality employees and they have to deal with competition in open markets. In these circumstances, China should negotiate with oil-producing countries in the Middle East to increase the amount of oil refined in China and increase their oil processing trade. In recent years, China's imports of crude oil and exports of refined oil have been growing, indicating that China's oil refining industry has followed this mutually beneficial path. Similar problems also exist in China's steel industry.

Many latecomer developing countries hope to attract investments from Chinese manufacturing industries to improve their industrial structures. The Chinese Government has also made great efforts in this regard, such as establishing several trade cooperation zones in Africa, and in its most recent efforts, calling on G20 leaders to support industrialization in Africa and less developed countries.

But we have to realize that not all desires come true. The development of manufacturing industries requires the support of environmental factors, security, infrastructure, industrial facilities, human resources, public services and the stability of the macro economy. Only countries which foster the right conditions can succeed in their aims.

In fact, leaders of many developing countries have realized that manufacturing industries are unlikely to develop quickly, and that they might as well respect free trade principles. In 2013, Lamido Sanusi, the then governor of the central bank of Nigeria, wrote an article for the Financial Times titled Africa Must Get Real About Chinese Ties, asserting that China and Africa are rivals and have contradictory interests in terms of economic and trade relations. He complained that the Chinese buy Nigeria's primary commodities and sell the processed products back to them. When he later assumed office as a local government leader, Sanusi quickly changed his views and denounced the trade protectionism actions of local textile companies against Chinese firms. This change of heart merits closer scrutiny.

Even from the perspective of protecting bank loans, it is better for the government to shut down primary commodity companies afflicted with overcapacity than to shut down their manufacturing counterparts. This is because the mortgaged assets of the former are mainly resources derived from the ground, whose value will not be affected by capacity reduction measures. The value may even increase when a bullish primary commodity market appears in the future. But manufacturing industries which craft rapidly evolving products and technologies may see their equipment—their main mortgaged assets—depreciate quickly once the company is shut down.

Cutting overcapacity in the primary commodity industry rather than the manufacturing industry also serves the purpose of protecting human capital and minimizing their losses in that respect. When laid-off workers seek new jobs in other industries, the professional knowledge, skills and connections that they have accumulated in previous industries is wasted. Compared with mining enterprises, the employees of downstream manufacturing industries must be equipped with more professional knowledge and skills, therefore incurring higher value.

For this reason, I oppose Chinese iron ore enterprises' launch of anti-dumping actions against imported iron ore. Between the options of protecting domestic iron ore enterprises, which results in steel companies losing out, and not protecting iron ore enterprises, I think the latter better suits the country's overall interests.

The author is an op-ed contributor to Beijing Review and a researcher with the Chinese Academy of International Trade and Economic Cooperation

Copyedited by Bryan Michael Galvan

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