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Cablegate: China/Overcapacity: Overweight or Healthy Baby Fat?

DE RUEHBJ #3349/01 3490920
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E.O. 12958: N/A

Refs: A. Beijing 2952; B. Hong Kong 2124; C. Shanghai 0273.

1. (SBU) SUMMARY: China's industrial structure is extremely
overcapacity and the recent massive government stimulus packages and
credit expansion exacerbated the problems, according to a November
26, 2009 EU Chamber of Commerce report. The report stirred
controversy in China's blogosphere and media with its claim that
excess capacity fueled trade protectionism, and was soon followed by
a Chinese government press conference outlining the government's
measures to combat overcapacity. Economists, academics, and
policymakers agreed industrial overcapacity was a serious and
pervasive problem in China, although difficult to evaluate on an
industry-level basis. While the recent fiscal and monetary stimulus
plans increased investment, there was little consensus on whether
the majority of funding went to fuel infrastructure projects or
further industrial overcapacity. Chinese observers hoped
overcapacity would not lead to trade disputes, but the EU Chamber of
Commerce's president noted a series of trade remedy cases currently
making their way through the European system. END SUMMARY.

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EU Chamber Report: Overcapacity a "blight"

2. (SBU) The Beijing-based European Union Chamber of Commerce on
November 26, 2009 released a report, "Overcapacity in China,"
charging that Chinese industrial overcapacity was a "blight on
China's industrial landscape... wrecking far-reaching damage on the
global economy in general and economic growth in particular." The
report stated that Chinese industrial overcapacity would lead to
trade disputes as other economies sought to protect their markets.
It investigated six industries that the Chinese government had
identified as suffering from over-capacity: steel, aluminum, cement,
chemicals, refining, and wind power equipment.

3. (SBU) The authors attributed overcapacity to several "key
recurring factors," namely:
-- high retained earnings (i.e. excess profits) by State-Owned
Enterprises (SOEs)
-- collapse of export-market demand
-- low domestic consumption due to low incomes
-- weak enforcement of regulations and health/safety standards
-- artificially low input prices
-- artificially low capital costs
-- artificially low technology costs
-- incentives to local governments to attract investment
-- local protectionism and regionalism
-- an over-emphasis on market share over profitability.

Report Provokes a Harsh Reaction

4. (SBU) EU Chamber President Joerg Wuttke admitted to Econoff that
the report was timed for release just before the EU-China Summit,
and had provoked an unexpectedly strong reaction from both the
foreign and domestic media. Chinese state media and netizens lashed
out at the concept that such excess production could result in trade
protectionism. The Global Times warned flatly: "Do not blame trade
protectionism on China's excessive productivity." Blogs such as
EEO, Huachen, Wang Yi, and Jin Rong Jie acknowledged that
overcapacity has been a problem for years, especially in the six
industries Chen Bin, Director of the Department of Industry at
China's National Development & Reform Commission (NDRC) committed to
curbing in October: steel, cement, plate glass, coal-chemicals,
polycrystalline silicon, and windpower equipment. Bloggers,
however, called the EU Chamber's assertion that overcapacity would
lead to global trade disputes "inaccurate" and "absurd." And the
Chinese government reacted quickly: the NDRC and Ministry of
Industry and Information Technology (MIIT) held a press conference
in Beijing on December 3, 2009, announcing new, stricter guidelines
to control overcapacity in steel, cement and flat glass.

But Is Overcapacity Really a Problem?

5. (SBU) Within a specific industry, and even with excellent data
sets, measuring overcapacity was challenging, analysts told EconOff.
Steven Watson, Chairman of Capital Research and Management's China
Business Group, explained to Econoff that his staff had been looking
at the Chinese steel sector in great detail, but had been unable to
determine whether China's current excess capacity is a long-term
systemic problem, or a cyclical downturn resulting in a dip in
demand, implying that China will grow into its current capacity.
Similarly, Dragonomics Research Managing Director Arthur Kroeber
noted that it was possible many companies were "just a little bit

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ahead of growing demand." Kroeber cited the auto industry as a case
where many analysts thought the major players were producing at too
high volumes, but later revised their opinion when new cars were
still rolling off the lots. China Academy of Social Sciences (CASS)
Researcher Liu Feng opined that traditional industries, such as
iron, steel and cement suffered from overcapacity, but commented
that new industries, such as wind and solar power, may not be over
capacity. Moreover, Chinese industrial overcapacity was temporary,
he said, and just an issue during this period of rapid development:
"People should see the problem from a developing country

6. (SBU) Taking a more macroeconomic, economy-wide view, however,
most economists agreed that excess investment had led to excess
capacity. World Bank Economist Louis Kuijs told Econoff that
government policies led to increased capacity, such as direct
stimulus money, subsidies to energy, lax environmental regulation,
and over-accommodating local officials. Stephen Green, an analyst
with Standard Chartered, agreed that the stimulus package had
encouraged new capacity, especially in the cement industry where new
facilities are easily constructed. Green echoed Kuijs' main reasons
for overcapacity: "artificially low energy and land prices, local
protectionism, and the lack of a proper framework for mergers and
acquisitions do indeed facilitate the building of more and more
heavy industrial capacity." UBS Economist Wang Tao added another
factor, noting that local officials were evaluated by their
locality's GDP growth rates, and capital-intensive growth tended to
be faster, creating an incentive for lowering the costs of such

Does the Stimulus Investment Exacerbate It?

7. (SBU) CASS's Liu noted that much of the stimulus was aimed at
earthquake reconstruction and infrastructure projects like light
rail, subways and roadways. Additionally, infrastructure
investments in Western provinces such as Gansu and Qinghai may be
underused at present, but it was widely believed they would be
utilized in the future. UBS's Wang Tao agreed that China could
still utilize large amounts of infrastructure investment. She
asserted that, given China's size, population, and rapid growth,
China did not have too much infrastructure. She went on to compare
China's transportation infrastructure with the United States at
similar stages in development, arguing that China could still make
productive use of large infrastructure investments. Dragonomics'
Kroeber agreed China had huge infrastructure needs and this spending
had not been wasted. As hundreds of millions of people moved to the
cities, they would require much more infrastructure. Some funded
projects were anticipatory, but at worst China had "borrowed" some
future growth by front-loading infrastructure spending.

8. (SBU) The World Bank's Kuijs, on the other hand, argued that much
of the Chinese stimulus program was not simply infrastructure
investment but rather a more accommodative lending environment. He
saw the recent global economic crisis policy environment as
exacerbating overcapacity because it led to very easy access to
credit in China. Extremely fluid capital led to "worrisome"
increases in investment even in industries where domestic demand had
not increased. IMF's Vivek Arora also worried that credit was
flowing to certain industries already burdened with overcapacity.
While unconcerned about loans extended to households and
infrastructure projects, he was unable to determine the destination
for almost two-thirds of the stimulus-fueled credit expansion.
(Note: in a recent meeting with U.S. visitors, a Chinese banker
admitted that that new bank lending often flowed to industries with
overcapacity, despite careful guidance from Beijing on the types of
business allowed to receive loans. End note.)

Stimulus Indirectly "Fuels the Trade War Fire"

9. (SBU) Kroeber asserted that it may have been true in the late
1990s that excess consumer goods and textiles were dumped on the
international market. However, not all current overcapacity led to
trade disputes, he cautioned. Instead, the problem was one of
scale. For example, even if only 10 percent of steel produced in
China was for export, that approximately 60 million tons was still
"an astonishing figure that influences global prices and markets."
Kroeber added that Chinese policymakers were not used to thinking
about their policy impacts on global markets. They were, however,
used to the reverse, playing victim to international influences.

10. (SBU) CASS researchers Lu Tie and Li Xiaohua disagreed with the
claim that excessive Chinese productivity directly led to global

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trade disputes: "It is hard to say how much the stimulus packages
fan the trade war fire. This is another excuse for trade
protectionism." However, CASS researchers agreed that excessive
productivity in certain industries pressured exports. Economic
recovery would alleviate the situation, even though official data
showed Chinese industry has about a 60 percent reliance on exports.

11. (SBU) EU Chamber President Wuttke disagreed strongly, suggesting
that the world would see many anti-dumping cases against China
coming from the European Union. "Eleven are in the works," Wuttke


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