Fuelling the reflation trade

Announced 20 months ago, the policy aims to remove outdated and inefficient production capacity across China's vast factory sector and thereby improve the profitability of the remaining industrial base.

To the surprise of many, it has been largely successful, fuelling the so-called "reflation trade" that has flowed onto Australian coal and iron ore miners, which have benefited from the shutting down of illegal mines and highly polluting factories using scrap steel instead of iron ore.

But with the economy forecast to slow after this year's Party Congress in Beijing, traders and economists are split over the sustainability of Xi's policy.

For Australia, it is more than an academic argument as the longer-term success of the policy will ultimately determine if commodity prices remain relatively high or plummet as they did during the most recent downturn in 2014.

A demolition in takes place in Wenzhou. Wenzhou Evening News

"Commodity prices have held up pretty well even though the economy is forecast to slow next year," says Julian Evans-Pritchard from Capital Economics in Singapore. "Some of this can be attributed to supply side reforms.

"But once we see the full effect of the drop off in demand, then commodity prices will likely follow."


The rebalancing market

One analyst at a major commodity house agrees prices are likely to fall, but he argues the pull-back will be far less severe than in 2014. He credits Xi's reform program.

"I don't think we will see iron ore return to $US30 [a tonne] ... maybe around the $US50 a tonne level," says the analyst who asked not to be named.

The Heng Du demolition site in the eastern Chinese city of Wenzhou. It took just 18 days to level this 16-hectare site, which was previously filled with low-rise apartments. Lisa Murray

"They have cleared out much of the [steel] inventory and so, if demand falls away, the market will rebalance quickly."

Iron ore is trading at about $US75 a tonne, down from nearly $US100 a tonne earlier in the year, but, due to demand out of China, the price is far higher than what many analysts were forecasting.

Supply cuts in China have also left aluminium trading near a six-year high, while zinc is close to its highest price in a decade.

The relatively high price of iron ore and other commodities has raised hopes that China's industrial base has been put on a firmer footing due to the reforms.


The 'new cycle' theory

This has given rise to the "new cycle" theory, which posits that the shutting down of illegal mines and factories will allow the heavy industrial sector to remain profitable even as the economy slows, which should prevent the precipitous fall in commodity prices seen three years ago.

That theory will be tested if the forecast slowdown takes hold next year, but, as the video from Yongkang shows, there's plenty of resolve on the government's part to shut down illegal factories.

This was not the case in previous years when officials spoke of the need to reduce over-capacity but did little about it.

According to government figures, authorities in Yongkang have demolished 80,000 square metres of factories, equivalent to 18 football fields, since the start of this year, although those on the ground believe the actual figure may be many times this.

They have done this mainly through stricter enforcement of building codes and environmental standards, demolishing factories that are not correctly licensed or built illegally.

One source says production equipment is destroyed so the factories cannot restart in another province or export the equipment to a country where environmental standards are more lax.

No more factories moving offshore


The source says the export of equipment happened when China shut down its highly polluting dye factories three or four years ago. "They simply sent the equipment to Africa and re-started," the source says.

"That meant, rather than raise standards for the industry globally, they created another low-cost competitor. They were not going to make that mistake again."

In other provinces across China, environmental regulations have been the main weapon for shutting down highly polluting furnaces that make steel from scrap metal, rather than iron ore.

The National Development and Reform Commission said in June that 600 of these illegal factories had been shut across the country, taking out 120 million tonnes of steel-making capacity. This has boosted the profitability of the remaining steel sector and increased demand for iron ore.

It's a similar story in the coal sector, where the closure of more than 400 million tonnes of low-grade capacity over the past 18 months has boosted the profitability of those still operating, including Australian companies exporting to China.

Factories return to profit

The inflection point for Xi's industrial policy was in October when 54 months of price deflation came to an end for China's factories.

The Producer Price Index (PPI), which measures prices received by China's factories, had been negative since April 2012, but, to the surprise of many, turned positive late last year.


It has remained in the black ever since, rising by 5.5 per cent in July, signalling a return to profitability for China's factories.

According to official figures released on Monday, profits among China's industrial companies rose by 21 per cent over the first seven months of the year.

Along with shutting down outdated factories, the other aspect to Xi's reform agenda is upgrading existing factories to make them more efficient and producing goods of a higher value.

Known as "Made in China 2025", the reform has resulted in the country overtaking Japan in the number of industrial robots used in factories.

At the same time, the policy has made it very clear China's long-term manufacturing future is not in cheap T-shirts and cigarette lighters.

Better quality in China

Rather, as wages rise, the focus is on higher-end products, ranging from electric cars to consumers goods.

Andreas Petersson, an Australian who designs and produces home furnishings from Shanghai through his company Nimble, says, despite wage rises over recent years, China still wins as Asia's top manufacturing destination.


He says the country has better transports links, manufacturing know-how – which means better quality output – and greater access to components than elsewhere in Asia.

"It's also easier to build a factory in China as most of the machines are made here," says Petersson, who supplies to the likes of Walmart, Carrefour, Costco and Target.

He also says China is a huge market in itself and therefore it makes sense to manufacture close to your customers.

"For a very simple product, it's better to do it in south-east Asia, but for higher-end products the quality is better in China," he says.

This partly explains why authorities are happy to demolish low-end factories in places such as Yongkang, confident the country's comparative manufacturing advantage remains in place.

This speaks against a dominant narrative five years ago that said China could never move up the value chain, and that rising wages would decimate its manufacturing sector and its industrial base would move offshore.

The opposite is true.

Rather than fight to retain low-end manufacturing, Beijing is actively and often violently forcing it down, as the video from Yongkang shows.