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


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INTRODUCTION/SUMMARY
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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

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LAIWU STILL EYING MERGER WITH ARCELOR-MITTAL
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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.

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BEIJING EXPERTS QUESTION BID'S PROSPECTS
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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.)

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LAIWU WANTS NEW PROVINCIAL STEEL GROUP COMPANY

BEIJING 00003765 002 OF 004


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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.)

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SHANDONG OFFICIALS OFFER MIXED VIEWS ON POSSIBLE PROVINCIAL STEEL
GROUP COMPANY
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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.

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BEIJING EXPERTS SEE OTHER MOTIVATIONS...
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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.

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...LIKE HOLDING ONTO TAX REVENUE
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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.

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BEIJING 00003765 003 OF 004


EXPERTS, MILLS PROMOTE COASTAL PRODUCTION BASES
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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.

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SECTOR NEEDS IMPROVED EFFICIENCY, BETTER PRODUCT MIX
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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.

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COMMENT: PROTECTIONISM ALL AROUND...
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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.

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... BUT COMPETITIVENESS COULD RISE IF OVERCOME

BEIJING 00003765 004 OF 004


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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