(The SEOUL/SINGAPORE/HONG KONG, May 23 (Fitch) This week Matt Jamieson spoke with Su Aik Lim, Fitch's Asia Pacific steel sector analyst based in Hong Kong, about China's steel industry and specifically the recent anomaly of record production levels following record losses. Mr Jamieson is Head of APAC Research in Fitch's Corporate Ratings Group. Su Aik explains that a combination of seasonal factors and slower economic growth negatively affected the steel makers' profitability in Q111, and he expects China's steel industry production growth to decelerate to below 5% in 2012 from 7% in 2011.

Matt: According to the latest release by China's National Bureau of Statistics, Chinese crude steel production again crossed the 60 million metric ton level (mt) to 60.6 million mt in April after March's monthly record high of 61.6 million mt. However, the China Iron and Steel Association noted that the steel industry reported record losses in Q112 due to low steel prices and weak steel demand. Do the high output levels reported in April have anything to do with central government control over the industry, particularly given that it owns nine of the top 10 largest steel groups which produce close to 50% of China's total crude steel production?

Su Aik: On the contrary, the central government of China is cognizant of the Chinese steel industry's over-capacity problem and has prohibited new capacity expansion. However, development of the steel sector is strongly supported by the local city or county governments since the sector is an important employer and tax revenue contributor.

Furthermore, while the central government sets the policy regulating and supporting the steel industry, it does not dictate the operation of the steel companies. For example, it is not uncommon to see state-owned steel companies producing the same products and competing intensely with each other for market share. Besides, the central government only directly owns three of these steel groups, which total 20% of China's crude steel production.

Matt: How then can we explain why the Chinese steel manufacturers were willing to continue with high production levels in April after reporting losses during Q1?

Su Aik: Firstly it is important to understand that the winter period is the seasonal low for steel production in China, as construction activity in the northern provinces halts due to the cold weather. Secondly, demand can be further dampened by adverse economic factors as per the cases of 2008 and 2011. Hence the combination of seasonality and slower economic growth led to weak capacity utilisation in Q112 and negatively affected their profitability.

Higher output levels in March (1.99 million mt crude steel production daily) and continued acceleration in April (2.02 million mt daily) can be explained by the increase in construction activity after the winter season as well as channel re-stocking by steel distributors and users in the lead-up to the busier summer season. Since 2007 Chinese steel sales have shown a consistent pattern of peaking in the summer months. Importantly, this predictable seasonal pattern has resulted in many of the smaller steel mills rapidly ramping-up production from the beginning of Q2 to capture the more profitable markets during the peak season, while minimising production during the winter months to save on operational costs.

Matt: But despite the seasonality, wouldn't you expect the widespread losses suffered by the steel mills to restrain their production levels in April?

Su Aik: Not necessarily. While the steel mills reported losses at the net level in Q1, they are still making money on a cash flow basis and hence covering most of their overheads. Also remember that the losses in Q1 largely focus on the larger steel mills, which have obligations towards their customers, whereas many of the small mills (with crude steel production capacity below 2 million mt per annum) produce generic products and have some flexibility to avoid losses. Examples include switching to steel products with better pricing, or reducing production costs by using cheaper lower-grade iron ore. In the worst case, these small mills are not averse to shutting down their plants for a few months and waiting for a better time to re-enter the market.

In the case of the large steel mills, so long as they are generating positive EBITDA it makes more sense for them to continue production through the quieter winter period rather than closing down. Economies of scale are critical in this highly competitive industry - to obtain a cost advantage a producer needs to maintain a high capacity utilisation rate to keep unit costs down. If they were to cut production, then they risk losing their cost advantage, as well as their market share.

In the case of the small steel mills, as they have credit facilities in place, they are able to continue operations on a flexible basis despite low operating margins and low economies of scale. While small, these steel mills still represent an integral part of the local economy, and hence local banks are under pressure to continue extending credit to them. In addition to their ability to adjust to the seasonality pattern, their ability to take a position in iron ore when prices are cheaper in the winter helps them survive.

Matt: Given the deteriorating demand/supply dynamics, why is the pace of consolidation moving so slowly?

Su Aik: From our perspective industry rationalisation is necessary to improve overall profitability but we do not expect any significant consolidation activity in the near future. This is firstly because operational integration from previous consolidation activity, by some of the large players in 2009 and 2010 including the Hebei Steel Group and the Shandong Steel Group, is likely to take a couple more years to complete. Secondly, cross provincial consolidation continues to face resistance from local authorities although each province is already driving intra-provincial consolidation. Finally, consolidation among the smaller players remains an uphill task considering the tight liquidity environment and the lack of incentives for the smaller steel mills to exit the industry.

Matt: Finally, how do you expect this summer to play out, given that demand for steel from China's construction and shipbuilding industries may not be as strong as previous years?

Su Aik: We expect growth in steel demand to decelerate, but not turn negative. Specifically we expect China's steel industry growth to fall below 5% p.a. in 2012 and 2013 compared with 7% and 11% in 2011 and 2010 respectively. Demand is likely to be supported by construction of low-cost housing and ongoing infrastructure projects and, potentially, from a recovery of Chinese auto production as we have seen some nascent improvement in Chinese auto sales in March and April this year.