CHINA/STEEL: MERGER EFFORTS HIGHLIGHT PROTECTIONIST

UNCLAS SECTION 01 OF 04 BEIJING 003765 SIPDIS SIPDIS SENSITIVE STATE FOR EAP/CM PSECOR, GWARD AND EEB/ESC SIMONS, HAYMOND, WECKER DOE OEA FOR CUTLER, NAKANO TREASURY FOR OASIA DOHNER/HAARSAGER/CUSHMAN USDOC FOR 4420/ITA/MAC/CEA/MCQUEEN USTR FOR STRATFORD/WINTER/ALTBACH/MCCARTIN/KEMP E.O. 12958: N/A TAGS: ECON ENRG EINV EPET EFIN CH SUBJECT: CHINA/STEEL: MERGER EFFORTS HIGHLIGHT PROTECTIONIST TENSIONS AND CHANGING SECTOR DYNAMICS -------------- INTRODUCTION/SUMMARY -------------- ¶1. (SBU) Reflecting concerns about energy, environmental efficiency, and competitiveness in the steel industry, China's State Council recently adopted policies aimed at eliminating excess capacity, facilitating mergers, and reducing resource intensity. Econoff's recent meetings with industry reps and watchers in Beijing and Shandong Province suggest that moving the industry in this direction will be a significant challenge given underlying protectionist sentiment towards foreign acquisition and provincial-level anxiety about consolidation that eliminates jobs or redirects tax flows. ¶2. (SBU) Global giant Arcelor-Mittal, for example, aims to acquire 38% of Shandong's Laiwu Steel (China's number eight producer),while Laiwu is at the same time looking at a merger with provincial competitor Jinan Iron and Steel (not to mention that Jinan is considering a tie-up with number one Baosteel). Econoff's discussions about these proposed mergers drew out from contacts a variety of opinions relating to foreign investment in China's steel sector, highlighted the impact of China's stock market rise on valuations of domestic enterprises, and called into question the efficacy of local government intervention in the steel sector. A closer look at Laiwu also underscored how the future of the industry may increasingly lie in new coastal production bases that will better position China's steel enterprises to access the overseas market with higher-end products. END INTRODUCTION/SUMMARY -------------- LAIWU STILL EYING MERGER WITH ARCELOR-MITTAL -------------- ¶3. (SBU) Central Government concerns notwithstanding, Luxembourg's Arcelor-Mittal (AM) is still working with a willing Laiwu to acquire a 38% stake in the firm, according to Laiwu Vice President Wang Yaowei. He told Econoff that negotiations are still ongoing, although Chinese media reports that the National Development and Reform Commission (NDRC) on March 13, 2007, refused to approve the bid. The NDRC stated that the RMB 2 billion offer (or RMB 5.888 per share of Laiwu stock) significantly undervalues Laiwu, and Wang added that this is just one of seven problems the NDRC identified with the offer. The two companies are working to address the NDRC's concerns. As Wang sees it, Laiwu wants to cooperate with AM to gain access to more advanced technology, better management techniques, and new overseas markets. Wang noted that the Shandong Provincial Government fully supports the bid and is lobbying Beijing on Laiwu's behalf. -------------- BEIJING EXPERTS QUESTION BID'S PROSPECTS -------------- ¶4. (SBU) Conversations with steel industry experts in Beijing suggest the outlook for the merger may not be so rosy, but the two experts we spoke with differ on what stands in the way of the bid going through. Zhou Weifu, a senior researcher at the Chinese Academy of Social Science (CASS),said that in addition to the NDRC's concerns about price, the commission's steel policy does not permit the 38.41% stake. NDRC believes AM should have offered at least RMB 4 billion. Zhou added that AM's bid was based upon Laiwu's domestic stock market value during 2005 and 2006. The bid at the time of its issuance was a 15 percent premium on the company's listed stock price. With Chinese equity markets in a rally -- maybe even a bubble -- Laiwu's stock price has more than doubled since the bid. ¶5. (SBU) Zhou went so far as to question Laiwu's actual interest in a tie-up. Meanwhile, Danny Chen, a steel sector analyst with Fitch Ratings, told us that the NDRC is blocking the bid because it wants to keep foreign steel enterprises, especially AM, out of the Chinese market. AM itself is the product of its own recent merger, and the company's interest in expanding into China has rattled Beijing. Beijing is now taking more active measures to promote the growth of domestic steel majors to thwart foreign takeovers, said Chan. (Note: AM's bid may violate aspects of China's mergers and acquisitions regulations issued in September 2006, most notably Article 14 which calls for the proper valuation of acquired assets; however, the regulations so far have not been directly cited as a roadblock to the bid. End Note.) -------------- - LAIWU WANTS NEW PROVINCIAL STEEL GROUP COMPANY BEIJING 00003765 002 OF 004 -------------- - ¶6. (SBU) Laiwu's Wang said the company is separately pursuing a merger with provincial rival Jinan Steel (Jigang),China's number six steel producer. The result would be a large provincial steel company with some 20 million metric tons of production capacity under its control. Wang stated that the merger would form a wholly, or largely provincial government-owned group company that would manage Jigang and Laiwu as separate listed companies. Laiwu's merger with AM could still take place, but AM's proposed 38% acquisition of Laiwu would fall instead within the provincial steel group company. The new company's headquarters would be along Shandong's coast and would include construction of new steel production capacity. (Note: China's Economic Research News reports that the new provincial steel company would be headquartered in Rizhao, a port city south of Qingdao and just north of Shandong's border with Zhejiang Province. End Note.) -------------- --- SHANDONG OFFICIALS OFFER MIXED VIEWS ON POSSIBLE PROVINCIAL STEEL GROUP COMPANY -------------- --- ¶7. (SBU) A senior Shandong Province NDRC Planning Division official confirmed to us that Shandong SASAC and NDRC are enthusiastically backing the creation of the provincial group steel company, which he believes is a mistake. The merger would not be a "happy marriage," given Jigang's own interest in pursuing a cross-provincial boundary merger with Baosteel instead. The NDRC official stated that forcing the merger also runs counter to market principles. The government should play a role of providing services and support to provincial enterprises, rather than making decisions for them, according to the official. ¶8. (SBU) Expresing a different view, Han Minqing, a Shandong Provincial CASS research fellow, enthusiastically supported creation of a new provincial steel company, citing potential improvements to overall competitiveness by creating opportunities to cooperate on product lines and sourcing of raw materials. Han observed that Shandong Province is a large manufacturing base and needs access to large amounts of steel; a provincial-level group company would ensure the continued availability of steel to Shandong customers at a competitive price. This may not be the case were Jigang and Baosteel to merge, according to Han. -------------- BEIJING EXPERTS SEE OTHER MOTIVATIONS... -------------- ¶9. (SBU) CASS' Zhou disagreed with his provincial CASS counterpart on the potential efficiencies created by a merger between Laiwu and Jigang. The two companies' product structure, management techniques, and labor costs are very different, said Zhou. For example, Jigang's salaries are three times higher than Laiwu's because Laiwu is located in a remote area more than a three hour drive from the provincial capital of Jinan, where Jigang is located. Zhou also dismissed fears that a Jigang-Baosteel merger would somehow impact the price or availability of steel in Shandong. The Shandong Government's support for the merger is really about keeping Baosteel out of Shandong, according to Zhou and fellow CASS researcher Lu Tie. -------------- ...LIKE HOLDING ONTO TAX REVENUE -------------- ¶10. (SBU) CASS' Zhou and Lu stated that a possible merger between Baosteel and Jigang would probably take the form of Baosteel's acquisition of Jigang. This means future tax revenue generated by the merged company would flow to Shanghai, leaving Jinan in the cold. Lu said that similar tax issues are preventing other cross-provincial boundary steel mergers advocated by the NDRC. Local governments are blocking proposed mergers to prevent tax revenue loss. Lu went on to observe that such tax issues are not limited to the steel industry. For example, tax revenue generated by Three Gorges Dam work being done in Sichuan Province is paid to the Hubei Provincial Government since the project is headquartered there. As a result of this type of problem, the NDRC has tasked CASS and other government research organizations to study local tax flow issues and make recommendations for possible policy or regulatory changes, said Lu. -------------- -- BEIJING 00003765 003 OF 004 EXPERTS, MILLS PROMOTE COASTAL PRODUCTION BASES -------------- -- ¶11. (SBU) CASS' Lu stated that working out tax flow issues is also important for Chinese steel sector development since most experts assume newly merged steel mills will want to build new production bases along the country's coast. New coastal production bases would facilitate access to cheaper input materials, such as iron ore, which would reduce transportation costs. A CASS study conducted several years ago indicated that Chinese steel companies transport four times the volume of raw materials as finished steel products. Lu noted that water transportation costs are significantly cheaper than overland costs, making it more cost effective to import raw materials from overseas and transport finished products overland. Most of China's steel demand is located near the coast, limiting the distance required to ship final products. Lu stated that the development of new coastal steel production bases would also give China's large steel companies an opportunity to significantly improve their production technology levels. This is a key component in China's future competitiveness in the international steel market, according to Lu. -------------- -------------- SECTOR NEEDS IMPROVED EFFICIENCY, BETTER PRODUCT MIX -------------- -------------- ¶12. (SBU) CASS' Zhou said that better technology will be needed to improve the efficiency of China's steel mills. To date, China's steel prices have been lower than international market prices because their production does not adequately factor in the true costs of land use, natural resource exploitation, or labor. Zhou stated that this will change in the future. Beijing is increasingly focused on the steel sector's environmental and labor costs, including those relating to worker safety and provision of an adequate worker social safety net. CASS' Lu observed that a contradiction between inland and coastal provinces has emerged in this regard. So far, provinces in China's central and western regions are more willing to tolerate polluting, inefficient steel mills than coastal provinces in order to preserve continued high GDP growth. Lu said Beijing's challenge is to eliminate this difference. ¶13. (SBU) CASS' Zhou stated that China's steel enterprises have made some recent gains in efficiency through production scale increases, changes in product mix, management reform, and reduction of production costs. This has helped them maintain or improve profit levels in the face of rising input costs. Laiwu appears to be a good example of this type of efficiency gain. The company claims to have cut its water usage per ton of steel produced from more than 8 tons of water to 3.5 tons during the last several years. The company also claims to have improved its product mix by becoming China's largest H-beam producer. ¶14. (SBU) Not everyone in Chinese Government research circles is buying this argument. Some are openly questioning why profits of China's steel and other industrial enterprises are rising so fast given rising input costs, explained Zhou. Wang Jian, a well-regarded government researcher at the NDRC's Macroeconomic Research Institute is studying this issue right now, according to Zhou. -------------- COMMENT: PROTECTIONISM ALL AROUND... -------------- ¶15. (SBU) Not only does there appear to be protectionist sentiment against the foreign acquisition by AM of a stake in Laiwu, but also similar (and possibly stronger) views in play among the provinces themselves. The Vice President of China's steel industry association stated in late-2006 that more stringent foreign investment restrictions are needed to protect China's steel mills from AM and others. The recent and dramatic rise in China's stock market, which has at minimum doubled the market cap for firms like Laiwu, appears to be serving as a useful foil against foreign acquisition making the firms less attractive as value buys and giving government officials a basis for alleging low-ball bids. Chinese steel experts and government officials may acquiesce in the trying to keep the foreigners out, but they are likely at some point to take on the provincial protectionism since it directly challenges their efforts to streamline the energy-hungry steel sector. -------------- - ... BUT COMPETITIVENESS COULD RISE IF OVERCOME BEIJING 00003765 004 OF 004 -------------- - ¶16. (SBU) Foreign stakes in Chinese steel companies can bring needed management skills and technologies to the sector. More importantly, if and when domestic merger and acquisition gains steam, Chinese steel enterprises movement to the coast will most likely accelerate. As a result, Chinese steel companies would be much better positioned to access the international market with higher value products resulting from the construction of new, more efficient production bases. In the end, this may prove a bigger impact on the international steel market than present concerns in developed markets of China dumping low-value steel products. PICCUTA