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SECTOR IN-DEPTH Steelmakers - China 27 March 2017 Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings

TABLE OF CONTENTS Chinese steel companies’ earnings will likely weaken in 2017 after substantial Chinese steel companies’ earnings improvement in 2016. The decline will result primarily from a slight weakening of domestic will likely weaken in 2017 after substantial improvement in 2016 2 demand amid continued excess capacity and a build-up of steel inventory in early 2017. Domestic steel demand will decline 4 These factors will depress steel prices, which have reached a four-year high. Elevated raw Declining steel exports will worsen material prices and reduced exports will also weigh on steel producers' earnings. domestic oversupply and weigh on prices 6 Domestic steel demand will decline. Property investment, the largest driver of Chinese Capacity reduction will continue but steel demand, will likely slow this year following the government's tightening of policy in encounter hurdles 7 an effort to curb property-price growth. Auto sales, and subsequently production, will also SOE reform and tight credit environment will continue to drive slow owing to a reduced tax break on small-vehicle sales. These pressures will be lessened by steel consolidation 8 government-led infrastructure investment, which will remain robust. Moody's Related Research 10 Declining steel exports will worsen oversupply and weigh on prices. We expect steel exports to decline by a high-single-digit percentage this year, following a 3.5% decrease in Contacts 2016. The decline will be driven by increased trade barriers outside China and a narrowing Jiming Zou 86-21-2057-4018 price gap between the domestic and international markets, which makes exports less Vice President - Senior attractive. Analyst [email protected] Capacity reduction will continue but encounter hurdles. The Chinese government's Danny Chan 86-21-2057-4033 target to reduce the country’s steel-production capacity by 50 million tonnes in 2017, if Associate Analyst achieved, should temper the downward pressure on steel prices and earnings. However, the [email protected] capacity-reduction effort will face hurdles that could slow the pace of reduction, such as the Chris Park 852-3758-1366 steel sector's improved profitability and the impact of the closures on the steel-producing Associate Managing Director regions' economies and employment. [email protected] SOE reform and tight credit environment will continue to drive steel consolidation. Gary Lau 852-3758-1377 The Chinese government's ongoing efforts to increase the efficiency and profitability of state- MD-Corporate Finance [email protected] owned enterprises (SOEs) will encourage large steel SOEs to merge with each other and acquire smaller competitors, and lead to the closure of weaker producers. We expect large steel SOEs to improve their reported financials by renegotiating terms and conditions of their existing liabilities or carrying out debt-to-equity swaps as a part of the SOE reforms. Stringent lending requirements will also make it difficult for struggling producers to continue operating. Consolidation will increase the large companies' market share. MOODY'S INVESTORS SERVICE CORPORATES

Chinese steel companies’ earnings will likely weaken in 2017 after substantial improvement in 2016 We expect Chinese steelmakers' earnings to be lower this year than in 2016 (Exhibit 1) because steel prices will decline due to a slight weakening of domestic demand amid continued excess capacity and increased steel inventory. Elevated raw material prices and reduced exports will also weigh on earnings. The potential for further cost reductions appears limited following substantial restructurings at many steel companies during 2014-16.

Exhibit 1 Chinese Steel Companies' Earnings Will Likely Decline in 2017 Following Strong Recovery in 2016 Aggregate pre-tax profit of large and mid-size steel producers in China

Sources: China Iron & Steel Association, Moody's Investors Service estimate for 2017

Chinese steelmakers' earnings increased significantly in 2016 owing to a jump in steel prices resulting from a slight increase in demand and substantial cut in production capacity during the year. Large and mid-size Chinese steel companies recorded a total RMB30 billion of pre-tax profit in 2016 versus RMB64.5 billion of losses in 2015, according to the China Iron & Steel Association. Those losses resulted from a sharp decline in steel prices amid weak demand and oversupply.

But it will be difficult for steel companies to sustain throughout 2017 the strong earnings they generated in 2016 and so far this year. This is because the recent increase in steel prices - prices nearly doubled during the past 14 months and reached a four-year high in early 2017 (Exhibit 2) - caused steelmakers to continue producing and distributors to build up inventory (Exhibit 3). Prices will decline from this high level as demand weakens and de-stocking takes place.

In addition, we believe the price increase has been driven partly by a significant amount of futures trading activity which, unlike demand, is volatile and often unsustainable. The anticipated moderation in domestic credit supply in 2017 will potentially tame speculative steel futures trading and drive prices back to the level reflecting the actual demand and supply balance.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.

2 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Exhibit 2 Steel Price Will Decline from Four-Year High Hit in Early 2017 China hot rolled steel sheet spot price

Sources: Bloomberg, Moody's Investors Service estimate for 2017

Exhibit 3 Steel Inventory Build-Up in Early 2017 Will Pressure Steel Prices LGMI Social Steel Stock Index

250

200

150

100

50

0 2012-03-01 2012-09-01 2013-03-01 2013-09-01 2014-03-01 2014-09-01 2015-03-01 2015-09-01 2016-03-01 2016-09-01 2017-03-01 Source: LangeSteel

Elevated raw material prices will also eat into steelmakers' earnings this year. Prices for major raw materials used in steel production, such as iron ore and foundry coke, increased by almost 90% and 130%, respectively, from 1 March 2016 to 1 March 2017 (Exhibit 4), although the foundry coke price has fallen since December 2016. Additionally, Chinese steel companies' bargaining power against major overseas iron-ore suppliers is weak. The fragmented nature of China's steel industry means no producer has meaningful bargaining power.

3 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Exhibit 4 Elevated Prices of Iron Ore and Coke Will Also Weigh on Steelmakers' Earnings

Source: Bloomberg

Domestic steel demand will decline We expect steel demand growth in China to turn negative in 2017 as the domestic property and automotive sectors begin to slow, and despite robust infrastructure investments.

Steel demand in China has generally been declining since 2014 as the government shifts economic growth drivers to domestic consumption and services from exports and government-led infrastructure investment.

But apparent steel demand (total output less net exports) rose 2.3% in 2016 after declining 5.8% in 2015, based on our calculations using data from China’s Iron & Steel Association and General Administration of Customs (Exhibit 5). Last year's growth came partly from policy support, including accommodative real estate policies during the first nine months of the year, tax incentives for light- vehicle purchases and ample credit supply. These supports are receding, however.

Exhibit 5 Steel Demand Will Decline Slightly in 2017 After Rising in 2016

Sources: China Iron & Steel Association, China's General Administration of Customs, Moody’s Investors Service estimate for 2017

Property development, which represents 30%-40% of Chinese steel demand, according to China's Iron & Steel Association, will likely slow in 2017 because the government has tightened policies in an effort to cool real estate prices and curb investments by speculative buyers. The government has introduced more restrictive policies since September and October 2016, such as higher down-payment requirements, additional purchase restrictions for home buyers and constraints on debt issuance by property developers. We forecast that nationwide contracted sales in 2017 will be largely flat or decline slightly following 36.2% growth in 2016 (Exhibit 6, also refer to China Property Focus). The weakness in contracted sales will slow property investment and reduce steel demand.

4 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Exhibit 6 Chinese Residential Property Sales Growth (3-Month Moving Average) Will Moderate Further in 2017

Source: National Bureau of Statistics of China

We expect auto-sales growth in 2017 to be lower than the 13.7% in 2016 (Exhibit 7, also refer to Global Automotive Outlook), because the government reduced a tax incentive. The tax rate on purchases of passenger vehicles with engines that are 1.6 liters and smaller climbed to 7.5% at the start of this year from 5% in 2016, but remains below the 10% normal rate. Sales growth slowed to 8.8% in the first two months of 2017, according to the China Association of Automobile Manufacturers. We estimate the automotive sector represents about 8% of Chinese steel demand.

Exhibit 7 Automotive Sales in China Will Slow in 2017 Due to Reduced Tax Break on Small-Car Purchases

35.00% 32.45% 30.00%

25.00%

20.00%

15.00% 13.94% 13.74%

10.00%

6.80% 5.00% 4.15% 4.57% 2.72% 0.00% 2010 2011 2012 2013 2014 2015 2016 2017e

Sources: China Association of Automobile Manufacturers, Moody's Investors Service estimate for 2017

China’s official Purchasing Managers' Index was 51.6 in February, indicating an increase in manufacturing. However, this robust figure was mainly driven by sectors that are not heavy steel consumers such as oil and gas, and mining.

Infrastructure investments, which account for about 20% of Chinese steel demand, according to China's Iron & Steel Association, will remain robust as many local governments have announced plans for transportation infrastructure and municipal projects to counterbalance the slowing property sector and private-sector investments (Exhibit 8). However, the expected moderation in credit supply resulting from the Chinese government's efforts to reduce corporate leverage, and the market-based assessment of return and credit risks for projects funded through public-private partnerships will potentially keep growth in check in 2017. Without additional government stimulus, infrastructure investments will not be sufficient to boost China's overall steel demand.

5 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Exhibit 8 Infrastructure Investments Will Remain Robust to Counterbalance the Slowing Property Sector and Private-Sector Investments

Source: National Bureau of Statistics of China

Declining steel exports will worsen domestic oversupply and weigh on prices Trade barriers against China's steel producers continue to emerge around the world, which will likely reduce Chinese steel exports by a high-single-digit percentage in 2017. The decline will exacerbate domestic oversupply, adding to the pressure on steel prices and producers' earnings.

China’s gross steel exports declined by 3.5% year on year to 108.4 million tonnes in 2016, according to China's General Administration of Customs (Exhibit 9). The exports accounted for about 13.5% of China's total steel production, based on data from China's Iron & Steel Association. The decline was particularly dramatic in the last quarter of 2016 and this declining trend extended into early 2017. The export decline also reflected Chinese producers choosing to sell their steel domestically instead of overseas as domestic steel prices climbed closer to international prices.

Exhibit 9 Chinese Steel Exports Have Been Declining Since August 2016

Sources: China's General Administration of Customs, Moody's Investors Service estimate for 2017

Many countries have introduced anti-dumping duties and safeguard taxes to protect their domestic steel industries and fend off Chinese imports. Twenty-one countries launched 49 trade remedy investigations against Chinese steel exports in 2016, according to China's Ministry of Commerce. The number of cases and dollar value increased by 32.4% and 63.1%, respectively, year on year. Steel- related investigations accounted for 41.2% of the cases and 55.1% of the value of all trade remedy investigations that China faced in 2016, according to the Ministry of Commerce.

6 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Additionally, the increasing threat of protectionism in many countries, including the US, will further hinder global steel trade and reduce the amount of steel China can sell to its trading partners and subsequently intensify domestic competition. Capacity reduction will continue but encounter hurdles China is pushing to reduce steel-production capacity, particularly inefficient capacity, in an effort to reduce oversupply and improve profitability and debt leverage in the steel sector. This effort is credit positive for leading Chinese steel producers such as China Baowu Steel Group Corporation Limited (Baa1 negative) because, if achieved, it should alleviate price competition and help producers increase their earnings prospects and market share.

But this year's capacity-reduction efforts will face hurdles such as the steel sector's improved profitability and the impact of closures on the steel-producing regions' economies and employment. These factors could slow the pace of reduction.

The Chinese government announced on 5 March its aim to cut steel-production capacity by 50 million tonnes this year. This goal is lower than the actual capacity reduction of 65 million tonnes in 2016, which was significantly higher than the 45-million-tonne target for the year (Exhibit 10).

According to the government, this year's reductions will target medium-frequency induction furnaces producing low-quality construction steel, and zombie steel companies (i.e., debt-laden, loss-making, non-operative companies), and strictly control capacity additions.

Exhibit 10 China's 2017 Steel-Capacity-Reduction Target Is Lower Than Actual 2016 Reduction

160 100 to 150 140

120

100

80 65

Million tonnesMillion 60 45 50 40

20

0 2016 target vs. achieved 2017 target 2016-2020 target Source: 2017 Chinese government working report from Prime Minister Li Keqiang

That said, the proposed capacity cuts will not materially reduce China's supply glut. China's steelmakers have the capacity to produce about 1.2 billion tonnes per annum and produced 808 million tonnes in 2016, according to China's Iron & Steel Association. Despite last year's significant capacity reduction, production rose 1.6% from 2015, driven partly by the resumption of idled mills, according to the association.

In addition, most producers are generating profits at current steel prices and will be reluctant to shut any additional production capacity. The improved earnings also bolstered weak producers’ financials and will allow them to continue operating.

Furthermore, the progress of additional capacity reductions will likely be uneven because closing production facilities leads to unemployment and unpaid bank debt and forces regions that rely on the steel industry to find new economic drivers. This year’s targeted capacity reductions will add to existing pressures from last year’s capacity cuts. Local governments are charged with reducing steel capacity, but at the same time have the responsibility to promote economic growth, and ensure employment and social stability.

7 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

SOE reform and tight credit environment will continue to drive steel consolidation The Chinese government's ongoing efforts to increase the efficiency and profitability of state-owned enterprises (SOEs) will encourage large steel SOEs to merge with each other and acquire smaller competitors, and lead to the closure of smaller and weaker producers. This industry consolidation will increase the market share and bargaining power of the large companies.

This was evidenced by the late 2016 merger of Baosteel Group and Wuhan Iron & Steel Group, which created Baowu. It became China’s largest steel company with a 7.9% market share and the second-largest steel company worldwide after ArcelorMittal (Ba1 stable) by production volume. Large steel SOEs (i.e., those with the individual capacity to produce more than 10 million tonnes per annum) are the most likely drivers of industry consolidation because they are leaders in their respective provinces and will receive government support to consolidate smaller steel companies (Exhibit 11). In addition, most of the capacity reductions that have occurred so far were at non-SOE companies, which has increased the market shares of large SOEs.

Exhibit 11 Large Steel SOEs Are the Most Likely Drivers of Industry Consolidation

2016 Steel production % of market Ranking Top 20 Chinese steel companies Ownership (million tonnes) share 1 China Baowu Steel Group Central Government 63.8 7.9% 2 Hebei Iron & Steel Group Hebei Provincial Government 44.9 5.6% 3 Jiangsu Shagang Group Private Sector 33.3 4.1% 4 Ansteel Group Central Government 33.2 4.1% 5 Shougang Group Beijing Municipal Government 26.8 3.3% 6 Shandong Iron & Steel Group Shandong Provincial Government 23.0 2.8% 7 Magang (Group) Holding Anhui Provincial Government 18.6 2.3% 8 Jianglong Group Private Sector 16.5 2.0% 9 Hunan Valin Group Hunan Provincial Government 15.5 1.9% 10 Benxi Steel Group Liaoning Provincial Government 14.4 1.8% 11 Rizhao Steel Holding Group Private Sector 13.9 1.7% 12 Jiangxi Fangda Steel Group Private Sector 13.7 1.7% 13 Hebei Xinwuan Steel Group Private Sector 13.7 1.7% 14 Baotou Iron and Steel Group Inner Mongolia Autonomous Regional Government 12.3 1.5% 15 Liuzhou Iron & Steel Guangxi Provincial Government 11.1 1.4% 16 Hebei Jinxi Iron & Steel Group Private Sector 11.1 1.4% 17 Hebei Jingye Group Private Sector 11.0 1.4% 18 Anyang Iron & Steel Group Henan Provincial Government 10.5 1.3% 19 Fujian Sangang Group Fujian Provincial Government 10.4 1.3% 20 Taiyuan Iron and Steel (Group) Shanxi Provincial Government 10.3 1.3% Total 407.7 50.5% -of which owned by the state 294.7 36.5% -of which non-SOE 113.0 14.0% Total Chinese steel production as of 2016 808.0

Sources: Company reports, China Iron & Steel Association, Moody's Investors Service

In contrast, smaller steel SOEs will see the likelihood of government support decreasing or disappearing over time as the government allows market forces to play a larger role in competitive industries such as steel. Dongbei Special Steel's (unrated) default in 2016 indicated the Chinese government's adoption of a market-oriented approach to deal with SOEs’ financial stress.

The tight credit environment in the steel industry will also help drive consolidation. Some smaller, weaker producers will find it difficult to refinance existing debt or take on incremental debt and will therefore close or be acquired by larger, stronger producers. The Chinese government is seeking to curtail credit growth in order to drive corporate deleveraging in 2017, as evidenced by the lowered growth targets for both M2 (broad measure of money supply) and total social financing growth (broad measure of credit) to 12% versus the 13% targets for 2016, according to Chinese government working reports. Banks have maintained stringent credit policies for steel companies, even as steel prices and profits improved, due to the companies' high debt leverage.

8 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

And since November 2016, stock exchanges in Shanghai and Shenzhen have stepped up their oversight of bond issuance by companies in the oversupplied sectors including steel, making debt financing more difficult.

As a part of the SOE reforms, we expect a number of large steel SOEs to improve their capital structures on a reported basis, liquidity and debt maturity profiles by renegotiating terms and conditions of their existing loans or carrying out debt-to-equity swaps with major banks, most of which are owned by the state. This is despite the fact that some swaps have debt-like features such as a repayment obligation if business performance is below expectation. Typically, large steel SOEs qualifying for those swaps have strong links to the government, large asset bases and high debt leverage but an ability to increase their earnings. Their financial improvement will give them a competitive advantage when consolidation opportunities arise. Since late 2016, seven steel companies, mostly SOEs, have renegotiated the terms of their existing liabilities or carried out debt-to-equity swaps. (Exhibit 12).

Exhibit 12 Seven Chinese Steel Companies, Almost All SOEs, Have Renegotiated Terms and Conditions of Their Existing Liabilities or Carried Out Debt-to-Equity Swaps with Banks

Total Amount of Negotiated Liabilities, Incl. Debt-to- Company Ownership Announcement Date Equity Swaps Major Creditors Wuhan Iron and Steel Corporation (before Central Government 10/11/2016 RMB 24 Billion China Construction Bank merging into China Baowu Steel Group)

Sinosteel Corporation Central Government 12/9/2016 RMB 60 billion Bank of China, Bank of Communications, China Development Bank, Agricultural Bank of China, Export-Import Bank of China, Shanghai Pudong Development Bank Taiyuan Iron & Steel (Group) Co., Ltd. Shanxi Provincial 12/26/2016 RMB 10 Billion Industrial and Commercial Bank of Government China

*Magang (Group) Holding Company, Anhui Provincial 12/28/2016 RMB 30 Billion China Construction Bank Huainan Coal Mining Group, Huaibei Coal Government Mining Group Anyang Iron and Steel Group Corporation Henan Provincial 1/11/2017 RMB 10 Billion China Construction Bank Government Nanjing Iron & Steel Group Corp. Private sector 2/23/2017 RMB 3.75 billion China Construction Bank Jiuquan Iron & Steel (Group) Co., Ltd. Gansu Provincial 3/10/2017 RMB 10 Billion China Construction Bank Government *Magang is a steel producer; the other two are unrelated coal mining companies also owned by the Anhui provincial government. The government announcement on the liability negotiations didn't specify the amount for each entity. Sources: Company and government announcements, news reports

9 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

Moody's Related Research Sector Comment

China Aims to Reduce Steel Production Capacity in 2017, a Credit Positive for Producers, 13 March 2017

Periodical

China Property Focus, 25 January 2017

Industry Outlook

Steel - China: 2017 Outlook - Weakening Production and Earnings Keep Outlook Negative, November 2016

Global Automotive Industry: Outlook Moves to Negative as US, China Demand Softens, 6 October 2016

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

10 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES

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11 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings