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The slump in demand for steel has caused great turmoil in global steel markets, resulting in the need for risk management strategies to deal with it.

Risk Management Strategies - Turmoil In Global Steel Markets As China Slows And Demand SlumpsARTICLE

By Frances Coppola

The global steel market is in turmoil. As global demand falters, prices are collapsing. Banks and investors are withdrawing loans and selling shares: share prices of major steel producers have tanked and bond yields have spiked.1 Prices for iron ore – from which steel is created – are also falling, causing share price falls in mining industries.

The demand slump is largely due to the slowing Chinese economy.2 China’s need for steel is falling dramatically as construction declines. But instead of cutting production, China’s steel mills are exporting their surpluses at ever-lower prices.

Risk Management Strategies

Both the US and the EU have alleged that China, by far the largest steel producer in the world, is dumping steel on the world market at below-cost prices – a charge that has been denied by the Chinese authorities.3 Introduction of effective Risk management strategies have become a necessity for steel markets across the globe. The US has increased tariffs on Chinese steel imports by 522 percent,4 and the EU is under pressure to follow suit.5 Meanwhile, China has instituted a 46 percent tariff on UK imports to protect its own steel producers.6

It is hard to conclude that a 23 percent increase in Chinese steel exports between February and March 2016 is driven solely by market forces.7 But if China is propping up its steel production, it is in good company. The UK has now part-nationalized its steel producer, Tata Steel, and is offering further inducements to potential buyers, in the hopes of avoiding the political disaster of thousands of job losses in an area with few other sources of employment.8

But the troubles of steel producers don’t deter speculators. Over the last few months, money has poured into steel and iron ore futures on China’s Shanghai Futures Exchange and Dalian Commodity Exchange. Despite widespread expectations of a glut in iron ore and steel production in 2016, prices have soared.9 It’s like a re-run of the credit derivatives bubble of 2007-8, which built up to extraordinary proportions even while the price of the underlying assets – American residential property – was falling. Or the oil price bubble of the first half of 2008, which as Bloomberg’s Ed Wallace reported at the time, was caused by intense speculation in oil futures despite an oil oversupply.10

All three of these speculative bubbles share the same characteristic: a huge short-term price rise followed by an abrupt collapse. All have essentially the same cause: speculators, who know perfectly well that demand for the underlying asset is falling, driving up the price in order to cash in before the inevitable crash. In the case of the current bubble, the Wall Street Journal observes that “speculative trading was facilitated by easier credit flows that were intended to prop up China’s slowing economy”.11

Since bubbles are known to have devastating effects when they burst, China encouraging banks to lend to speculative investors to create a market bubble seems rather unlikely. But as the Wall Street Journal points out, China has done this before.12 In 2015, a credit-funded stock market bubble grew from measures to stimulate the Chinese economy. The fallout when that bubble burst disrupted global transaction services as investors fled to safe havens. But the Chinese authorities successfully supported the market, forcing banks to lend and traders to buy,13 and imposing harsh penalties for “market manipulation” – which meant anything that would cause the market to fall.14 Now, they know how to use effective risk management strategies to deal with bubbles.

On April 22nd, 2016, the Dalian exchange announced increases in margin requirements and transaction fees on iron ore and steel futures trades. The Shanghai exchange followed suit.

The prices of steel and iron ore futures crashed, falling by 20 percent as speculators cashed out. To support the unwind, the two exchanges indicated that further tightening of requirements was likely.15 Daily trading volumes more than halved.

The Takeaway

Global supply of steel and iron ore now significantly exceeds demand. Unless construction can be revitalized through large-scale infrastructure investment programs, supply may have to adjust downwards – and that means possible permanent capacity reduction in steel producers worldwide.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. http://articles.economictimes.indiatimes.com/2016-03-09/news/71346277_1_loan-repayment-jindal-steel-national-australia-bank
2. http://www.bloomberg.com/news/articles/2016-05-08/steel-exports-from-china-drop-after-rally-in-local-price-demand
3. http://www.ft.com/cms/s/0/4bd8c6ec-16c5-11e6-b8d5-4c1fcdbe169f.html#axzz48F05bmhf
4. http://news.sky.com/story/1697986/us-raises-tax-on-chinese-steel-imports-by-522-percent
5. https://www.theguardian.com/business/2016/may/18/uk-and-eu-urged-to-act-on-chinese-steel-dumping-after-us-hikes-duty-on-imports
6. https://www.theguardian.com/business/2016/apr/01/chinese-imposes-tariff-on-eu-steel-imports-tata
7. http://www.reuters.com/article/china-economy-trade-steel-idUSL3N17F2P6
8. https://www.theguardian.com/business/2016/apr/21/government-take-stake-tata-steel-british-plants
9. http://www.wsj.com/articles/in-china-the-new-casino-is-iron-ore-1462112857
10. http://www.bloomberg.com/news/articles/2008-05-13/the-reason-for-high-oil-pricesbusinessweek-business-news-stock-market-and-financial-advice
11. http://www.wsj.com/articles/chinas-steel-iron-ore-futures-plummet-obliterating-recent-gains-1462880500
12. Op.cit., note 10.
13. http://www.theguardian.com/world/2015/jul/09/china-bans-major-shareholders-from-selling-their-stakes-for-next-six-months
14. http://www.wsj.com/articles/china-fines-star-fund-manager-3-million-for-stock-market-manipulation-1442899181
15. http://www.wsj.com/articles/china-metals-prices-dented-by-expectations-of-new-trading-curbs-1462794383

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