It is again one of those times when medical analogies become appropriate for the Indian steel industry: like any serious disease, the longer one delays the recognition of a key symptom like non-performing loans, the bigger and broader the eventual bailout. We must also challenge the comforting assumption that “someone” is looking at the system rather than everyone following their own narrow interests.
Let’s begin at the beginning. Steel is an important part of our lives, and a good indicator of a country’s prosperity is how much steel is consumed per capita. Of its many benefits, one that stands out is its longevity. Skyscrapers, bridges, railway tracks and pipelines that use steel can last many decades, even a century. However, that also means that steel is prone to decades-long “super-cycles”: ten to fifteen years of accelerating demand, followed by a long period of stagnation or declines.
Over the past century we have seen three massive surges in global steel consumption: the first after the Second World War when most of the western world rebuilt their infrastructure, the second from the late-1960s driven mainly by Japan, and the third, more recently, when Chinese demand took off in the last decade-and-a-half. Between these surges, global steel demand stagnated for decades.
The cycles become worse when many decades of infrastructure construction are squeezed into one: recall the incredible statistic that China consumed as much cement in three years as the US did in the whole of the twentieth century. Even adjusting for different construction standards and a much larger population, it indicates an excessive pace. Not only does the pace of steel consumption in that decade far exceed the “normal” pace, necessitating the setting up of steel-making capacity that is far more than sustainable, the period of weak global steel demand could now last for decades as well.
This slowdown in demand is now clear, and seems to have started much earlier than anticipated by the steel industry and its raw material suppliers. As a result, steel prices have fallen to levels last seen in 2003. Indian companies, whose profits were protected so far by import duties as well as availability of iron ore at significantly cheaper than global prices, have seen rapid erosion in profitability. The precipitous decline in iron ore prices globally has eroded the cost advantage of Indian steel mills.
To be sure, while Indian steel demand growth may not accelerate like China’s did a decade back, it still has ample scope for growth. But local steel prices are set by global prices even if less than 10% of India’s demand is met by net steel imports. As they should: Steel is a basic raw material that feeds into everything from cars to ships to buildings. Making it much more expensive in India than it is globally would erode the competitiveness of downstream industries.
Since 2001, Indian steel capacity has tripled, and now significantly exceeds demand. That India is still a net importer is because some of these newly added capacities are still ramping up, and also as some inefficient plants have been forced to shut due to lack of competitiveness.
And now, we come to the debt. Companies should be able to ride out even prolonged downturns with prudent cost and capacity management. But if the capacity is largely debt-funded, as much of India’s capacity is, systemic risks emerge, particularly when banks keep supporting weak companies.
At the end of the last financial year, the total debt outstanding to Indian steel companies was nearly $50 billion. This was nearly ten times the industry’s ebitda (profits before interest, taxes and depreciation are deducted), a good proxy for cash profits. Ebitda per tonne was just $63. Since then, Chinese steel prices have fallen, and are already almost $160 per tonne lower than the last financial year’s average. Costs for Indian companies are unlikely to fall meaningfully. Even without including interest costs, no Indian steel mill would be profitable without duty protection.
This suggests pressure on debt-servicing. Even last year, when some interest costs on capacities under construction were not included, the average interest cost per tonne of production was nearly $50. This year it should be higher as those capacities get commissioned, and ebitda should be lower: The industry, as a whole, may not be able to pay interest on their debt.
As one can expect, averages understate the severity of the problem. There are companies with interest costs crossing $250 per tonne, when current Chinese steel prices are $330—it is hard to imagine a scenario where they become viable. Clearly, these companies are borrowing from banks to pay their interest—as underscored by the many “refinancing” deals recently for broke steel companies, where an additional R5,000-8,000 crore were lent by banks.
It would be in the banks’ best interest to call an end to this charade, but the unwillingness to book losses on their current loans is preventing that. Even if it means that losses eventually could be much larger.
This also increases systemic risk for the steel industry, as these unviable plants remaining operational hurts profits of slightly better-placed steel companies, and risks pushing them towards unviability as well. With significant production increases expected from newly commissioned plants, in excess of local demand growth, even raising import duties may not help for long.
As individual entities pursue their narrow self-interests, the problem is getting worse at an alarming pace. The outstanding debt is nearly four times the total market capitalisation of the sector, ruling out equity issuance as a solution. Worse, the economic value of these plants is now much below the cost of building them, even if those costs were not padded up. There needs to be intervention from the government and the banking regulator to bring the industry and the banks together and complete the much-needed surgery to keep this critical industry in better health.
The author is India Equity Strategist, Credit Suisse. Views are personal