Macquarie believes it’s the local governments and State Owned Enterprises (SOE) that aren’t committed to accepting short-term pain for the sake of long-term gain. 

“While the long-term goal of reforms to consolidate and rationalize capacity may be positive, in the short term it is hard for local provinces and government to overcome the pain imposed from layoffs and debt write-offs.”  

And who can blame them, as they are the first to feel the heat of workers dissent. During a recent strike at a coal mine in the northern province of Shanxi, police and strikers clashed. Several workers were beaten up or detained. 

“I think the main reason has to do with the recent economic situation, which has seen a fall in the fortunes of the coal industry,” activist Huang Qi told Radio Free Asia. “That’s why people are standing up and protesting for their rights and interests.” 

The Hong Kong-based China Labour Bulletin reports a total of 1,454 strikes and protests in the first six months of 2016, an increase of 18.6 percent compared to 2015.

According to Macquarie, as many as 2 million workers out of 11 million in the mining and smelting industries could lose their jobs if the reform targets are met. 

So local governments are trying to postpone real economic pain for as long as possible by making the debt of bankrupt companies evergreen and by spending on infrastructure investment themselves. In the first quarter of this year Local Government Finance Vehicles (LGFV) issued $115 billion worth of bonds, the highest quarterly figure on record.

According to Goldman Sachs, 11 out of 18 high-profile defaults have not been resolved since the first official default of a Chinese company by Chaori Solar in 2014. 

The best example of a local government trying everything to avoid a painful debt restructuring is Dongbei Steel, which defaulted on $6 billion of debt but is still in business. Bondholders pressured Liaoning Province to finally resolve the situation and demanded that the local government stop raising money to support Dongbei. 

The central planners aren’t happy with the progress and have issued a stern directive to use stricter environmental standards to close more of the inefficient businesses. The Ministry of Industry and Information stated in a draft document on its website it would “normalize the stricter implementation and enforcement of mandatory standards” and apply harsh measures if the standards aren’t met, according to Reuters. It threatens to cut off loans, power, and water supply and destroy company equipment.

There is another problem. Even if the central planners achieve their capacity reduction goals, production won’t go down.

“Our industry contacts continually tell us that they do not believe capacity closures under supply-side reforms will have any impact on output or prices. There is a clear belief among our contacts that there remains enough latent capacity in the system that no “effective operating capacity” will need to be closed to reach the target outlined by the government,” writes Macquarie. 

Let’s take steel as an example. China can produce 1250 million tonnes per year, but production is only 804 million tons. So even if China managed to close 450 million tonnes of capacity, it could still produce the same amount of steel. However, the plan until 2020 only looks for a reduction of 172 million tonnes until 2020. The situation in the coal and nickel markets is similar.  

As a result of the overcapacity and a slowing economy, the Shanghai Steel Rebar Future price collapsed from $780 in April of 2011 to $244 in late 2015 before rebounding a bit in early 2016, mostly because of government stimulus and not because of capacity reduction, says Macquarie.

Because Chinese steel makers are high-cost producers—especially the SOEs—many of them are teetering on the verge of bankruptcy, as they cannot cover interest rate payments at current prices.

So we are back to square one. Low-efficiency capacity needs to be reduced significantly to ensure a rebound in prices and a better future for economic producers. This process inevitably leads to workers unrest and has a negative effect on the banking system, where bad loans are skyrocketing.   

If China doesn’t close down inefficient production capacity, prices stay too low for efficient producers to make money and eventually they will run into trouble as well.

No short term pain, no long term gain. 

Twitter: @vxschmid