Behind Steel Bars

China's unlicensed steel plants reflect rapid economic growth but may also signify an investment bubble.

Dressed in a shabby Mao suit covered with singe marks from flying sparks, the security guard insisted that the steel plant had been shut down. But after a little cajoling, he allowed some visitors in for a quick look around and approaching the furnace, he put his hands up close.

"See, it is still hot," he said, flashing a toothless smile. "We are supposed to be closed but we work at night instead of during the day."

On the outskirts ofTangshan, east ofBeijing, the small plant is a primitive operation that takes cheap steel slabs and turns them into H-bars long, thin rods used in construction. Belching out smoke and spilling untreated waste water, it is just the sort of placeBeijingsays it wants to shut. But with local officials turning a blind eye, business is going on as usual once the sun has gone down.

Steel is the backbone ofChina's booming economy. It produces three times as much asJapan, the second-placed country, and output has doubled over the last five years. Working out just how much steel there is inChinais a constant headache for industry executives.

YetChina's semi-legal plants also have much broader implications for the economy. They raise the question of whetherChinais overinvesting. They also challenge the idea that bureaucrats inBeijingstill have the ability to direct the economy as it becomes ever more complex and privately owned.

A few years ago, thatTangshanstreet boasted not much more than a scrapyard for old machines. But now there is an endless line of small chimneys that indicate new steel facilities most of them private which have helped turn the city into the biggest steel producer in the country. Some plants process steel for use in construction and manufacturing, while others turn any iron ore they can get hold of into rudimentary forms of steel bars.

During Mao's Great Leap Forward in the 1950s, millions of individuals set up basic furnaces in their backyards to forge steel. Now thousands of small entrepreneurs, with an eye on profits rather than politics, are building facilities that are not much more sophisticated. The private sector accounts for one-third of the industry's output.

Last year the industry association conducted a survey of production capacity that included these new small producers. It concluded that there was actually 50 million tonnes more steel capacity than most analysts had predicted equivalent to more than half the annual production of theUS, the third biggest steel producer.

Unlicensed plants such as this have led some analysts to concludeChinais creating an unsustainable investment bubble. This perception has been amplified by recent government figures showing that fixed-asset investment has been increasing by an astonishing 30 per cent a year. From these numbers, it would seem that steel is not alone in witnessing an investment binge.

According to Stephen Roach, chief economist at Morgan Stanley: "InChinatoday rapid economic growth seems in danger of veering out of control." Even Wen Jiabao, prime minister, admitted last week that the economy was in danger of "overheating".

Yet not everyone is convinced. Some economists point out that the way the fixed-asset investment data are calculated means they are exaggerated. Moreover,Chinais witnessing modest inflation not the rampant deflation that would result from overcapacity.

The steel industry numbers are equally inconclusive. Prices and profits slid in the second half of last year, suggesting that overcapacity was hitting hard. But in the first half of this year they recovered strongly, only to drop back in recent weeks.

Trade might provide the answer to why the suffering has not been greater.Chinamoved last year from being a massive importer of steel to being a modest net exporter providing a temporary escape valve for domestic producers.

Peter Marcus, an industry consultant at World Steel Dynamics, reckons that by 2010 steel production inChinawill outstrip demand by 63 million tonnes.

TheTangshansteel plant raises the further issue of how the government manages the economy. In most countries, if a central bank were worried about overcapacity, it would use monetary policy to try to slow investment.Chinahas made a start, raising rates once, with another increase widely predicted.

But inChina, the formal financial sector provides only 20 per cent of investment funds, so a sharp boost in interest rates might not have much impact. Instead,Beijingstill has an army of bureaucrats who want to use "administrative measures" new rules, approvals, warnings to mould economic behaviour. Yet with the private sector growing and the economy becoming more diverse, it becomes harder to make these planning tools work.

In 2004, the government introduced a raft of measures to slow the economy and paid special attention to the steel sector. Managers at one unapproved steel plant nearShanghaiwere arrested. But over the next year, the industry expanded output by 69 million tonnes equivalent to the entire industries ofSouth KoreaandIndia, says CLSA, an investment bank.

Over the last year, the government has announced a series of initiatives to close small steel mills, in an effort to streamline capacity and limit environmental damage.

In theTangshanarea, the authorities have indeed forced some small plants to shut. But many have continued. The provincial government ordered that the night-shift plant be closed but the district government has not enforced the order.

Local officials across the country are judged almost entirely on the economic growth they produce, making jobs more important than clean air.Chinais governed by a form of authoritarianism but it is a decentralised one.Beijing's writ has its limits.