Cutting overcapacity has been identified by the Chinese government as the top priority for the economy. Currently, the country's energy sector is also facing a large supply glut. In 2015, commodities and a host of energy-related industries such as electricity, coal, steel, cement and petrochemical processing suffered from oversupply ranging from 25 percent to 30 percent.
On the demand side, growth in China's demand for energy and major commodities reached a peak in 2011 before trending downward thereafter. As a rapidly growing developing country, the reason behind the overcapacity is easy to understand: The high growth around the year 2011 resulted in hefty investment, based on the assumption that the rapid growth of demand would simply continue. But when demand growth slows, it inevitably leads to oversupply. No-one had forecast in 2011 that coal demand would decline by 4 percent in 2015.
A direct outcome of the severe supply glut in the energy sector has been a plunge in energy product prices. For example, coal prices fell nearly 30 percent in 2015 after experiencing a rout the year before, which made the financial situation more difficult for many enterprises in the sector. Last year, more than 90 percent of China's coal firms posted losses, while around half of the country's large and medium-sized steel enterprises suffered large losses in their core businesses.
Now that energy product prices are still falling, there is a risk of further economic weakening. The producer price index (PPI) has continued falling over the past four years, with five major upstream and downstream sectors of the energy industry - coal, petroleum, petrochemicals, steel and iron ore - contributing to over 70 percent of the fall in the PPI.
Curbing overcapacity, however, has long seemed to be a difficult mission. A relatively old example is that the government has reiterated since the country's 11th Five-Year Plan period (2006-10) that overcapacity in certain industries needs to be addressed, but instead overcapacity has become an even bigger problem. A newer example is that coal capacity could be larger this year compared to three years ago, even though it is already well known that the only way for the coal sector to get out of its current difficulties is to reduce overcapacity.
Local protectionism and the problem of "zombie enterprises" - those that somehow remain open despite continuous poor performance - are apparently two important factors contributing to the difficulty in addressing the supply glut issue.
The country's overcapacity is mostly seen in high energy-consuming infrastructure industries that are considered capital-intensive but that are effective in spurring GDP growth. While these high energy-consuming sectors were on an upward trend, local governments offered various preferential policies to attract investment so as to achieve faster GDP growth and generate more tax revenues and jobs. However, even when the trend is reversed, local governments might still strive to keep the sectors alive by operating at a slightly lower capacity, in order to stabilize economic growth and maintain tax revenues and employment.
At a time in which demand has slowed and prices are lower, enterprises in sectors with oversupply still tend to maintain production rather than suspending it, as it allows them to avoid liquidation. These enterprises are likely to become zombie firms. But the elimination of these firms creates a variety of new problems such as finding new jobs for laid-off workers and handling nonperforming loans; these problems are difficult enough for local authorities to balk at forcing a shutdown.
Furthermore, cutting oversupply is a costly process, which will require a gigantic amount of spending on staff redistribution and occupational reeducation and training, among other things. Aside from government funds and policy support, businesses that are supposed to be curbing capacity need to keep their financial situation relatively healthy. And in order to be financially fit, prices have to be propped up, which could be enabled by narrowing the gap between supply and demand and also dampening expectations for continued imbalance between supply and demand. For that to happen, demand should be boosted. This is because expectations of weaker demand growth tend to weigh on prices and subsequently make it harder to cut overcapacity.
On the supply side, mergers and acquisitions should be favored over forced liquidation to conserve social resources and opportunities for relatively sound enterprises.
Also, overcapacity means that production capacity is not yet matched by an increase in demand, so increased demand could be more effective in reducing oversupply in the short term. In this regard, policy support is required to shore up infrastructure construction to help boost effective demand from upstream energy enterprises, or at least arrest further declines in demand.
To be more specific, the government should accelerate supply-side reforms of the energy sector that include an overhaul of the regime for setting energy prices and the framework that manages State-owned energy enterprises. Additionally, oversupply in an array of high energy-consuming industries such as thermal power, steel, petrochemicals and electrolytic aluminum could be addressed by exporting a certain amount of it to nations along the route of the "Belt and Road" initiative. This could bring a brighter outlook for these industries, albeit in the medium to long-term rather than in the near future.
The author is director of the Collaborative Innovation Center for Energy Economics at Xiamen University. bizopinion@globaltimes.com.cn