Very much like the self-imposed output cut by OPEC and non-OPEC members which successfully boosted the price of crude over $50 even if global crude inventories "inexplicably" continue to hit new all time highs, one of the main reasons why commodity metal prices have seen a dramatic increase in prices over the past year has been China's solemn vow to cut back on overcapacity and excess production. In 2016, China’s state council set out plans to eliminate 100 -150 million tonnes of steel capacity in a bid to restructure the economy from one driven by government-led infrastructure investment and exports to a more consumption and services-oriented model. Last January, the hub of China's steel production - the northern province of Hebei - announced it would cut output to ease pollution and help curb oversupply. Hebei said it planned to reduce steel output by 8 million metric tons in 2016, its Governor Zhang told local lawmakers, while Iron ore production would be cut by 10 million tons.

More than one year later, it appears that Governor Zhang lied about Hebei's intentions, and according to a provincial notice by the Chinese province, it has emerged that China's compliance with its own mandatory production cuts has been "problematic."

A steel factory in Wu'an, Hebei province

According to Reuters, the same Hebei province, China's biggest steel-producing area, launched a probe into steel overproduction in the city of Tangshan "amid concerns that firms have continued to raise output despite mandatory capacity cuts."

Tangshan is the heartland of Chinese steel production. The city is home to the headquarters of the state-owned Tangsteel Group, which in 2006 merged with other companies to form Hebei Steel Group, the second-largest steel producer in the world. Located around 100 miles east of the capital Beijing, Tangshan is on the frontline of the country's "war on pollution", and was seventh on the list of China's ten smoggiest cities in the first two months of this year.

Hebei was ordered by China's central government to investigate firms in Tangshan that have "restricted but not cut production, restricted production but not actually cut emissions, and cut capacity but actually increased output," the provincial dated March 25 said, and circulated by traders on Monday.

Cited by Reuters, an industry source based in Tangshan confirmed the veracity of the document, but said it was unclear whether the new round of inspections would have any immediate impact on production or prices. The document was issued by a special provincial policy team responsible for restructuring the steel industry. It said Hebei has already established an inspection team and Tangshan must begin its own investigations immediately.

The FT adds, that the notice, sent on Saturday, cites orders from President Xi Jinping and Zhang Gaoli, the vice-premier, for Tangshan to investigate the problem of falsely reported plant closures and rising steel output.

Tangshan produces around 90 million tonnes of steel a year, more than the whole of the United States. While China has pledged to slash steel capacity by between 100 million and 150 million tonnes over the 2016-2020 period to shore up prices and ease sector debts, there have been lingering suspicions that this may have been a ruse to push commodity prices higher, boosting cash flows of overindebted domestic producers, who employs millions of low-skilled workers and whose mass defaults could result in widespread social unrest.

The FT confirms as much:

local authorities have dragged their feet on implementing orders to shut down steel mills because doing so would potentially eliminate hundreds of thousands of jobs. “The local government will always want to protect its own industries because company officials get promotions based on growth,” says Scott Laprise, the founder of steel research firm LTH Consulting. “No one gets a promotion because they lost jobs and their local economy did poorly.”

In addition to the cuts noted above, at the start of the year, Tangshan promised to shut a further 8.6 million tonnes of annual crude steel capacity in 2017. It pledged to make cuts of 40 million tonnes over the 2013-2017 period and had already shut 31.9 million tonnes by the end of last year. Hebei promised to cut crude steel capacity to less than 200 million tonnes a year in the province by the end of 2020, down from 286 million tonnes in 2013. It aims to shut 15.6 million tonnes in 2017.

However, in light of the recent revelation, it appears that local producers did not take the directives too seriously, and may have simply been stockpiling the excess production.

As Reuters adds, the Ministry of Environmental Protection has routinely named and shamed municipal governments in Hebei for failing to implement pollution rules; so far it has failed to achieve the desired result.

Of course, if one province is reneging on its production cut agreement, why not more?

That may indeed be the case: one month ago, Greenpeace said that China's active steel capacity actually rose by 35 million tonnes in 2016 after the high-profile closure program focused mainly on shutting plants that had already been idled. Additionally, production of crude steel in 2016 actually rose about 1% from the year before, to 808m tonnes, according to preliminary data from the National Bureau of Statistics.

"The steel industry's capacity reduction targets need to be upgraded to reductions in actual production - only then will we see real improvements in air quality," said Lauri Myllyvirta, senior global campaigner at Greenpeace East Asia.

The problem is that just like with OPEC, there is no credible way of enforcing capacity cuts.

"Local governments will report back and simply say certain companies eliminated capacity or were closed or went bankrupt,” said LTH Consulting's Laprise. “No one is checking what is supposedly already closed and what is actually closed.”

Excess production notwithstanding, China's jawboning alone, and stated commitment to removing overcapacity, has managed to send prices of core commodities such as iron ore soaring as shown in the chart below.

Should it be confirmed that China was merely jawboning about removing excess supply then the appreciating commodity complex, a core driver of the global reflation trade which in recent months appears to have plateaued may soon see prices tumbling, in the process launching the latest deflationary wave to emerge out of China, and putting an end to the "global coordinated recovery" as so many analysts have called it in recent months.

It may already be happening: prices of iron ore, the key material used in steel production, tumbled fell 6.7% on Monday as inventories of the commodity at China’s ports rose. The fall brings the price to its lowest since January 10, down nearly 18% from its peak in March.



