VZCZCXRO5456
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #3765/01 1560934
ZNR UUUUU ZZH
P 050934Z JUN 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 8618
RHMFIUU/DEPT OF ENERGY WASHINGTON DC
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS SECTION 01 OF 04 BEIJING 003765 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
STATE FOR EAP/CM PSECOR, GWARD AND EEB/ESC SIMONS, HAYMOND, WECKER 
DOE OEA FOR CUTLER, NAKANO 
TREASURY FOR OASIA DOHNER/HAARSAGER/CUSHMAN 
USDOC FOR 4420/ITA/MAC/CEA/MCQUEEN 
USTR FOR STRATFORD/WINTER/ALTBACH/MCCARTIN/KEMP 
 
E.O. 12958: N/A 
TAGS: ECON ENRG EINV EPET EFIN CH
SUBJECT: CHINA/STEEL: MERGER EFFORTS HIGHLIGHT PROTECTIONIST 
TENSIONS AND CHANGING SECTOR DYNAMICS 
 
 
-------------------- 
INTRODUCTION/SUMMARY 
-------------------- 
 
¶1. (SBU) Reflecting concerns about energy, environmental efficiency, 
and competitiveness in the steel industry, China's State Council 
recently adopted policies aimed at eliminating excess capacity, 
facilitating mergers, and reducing resource intensity.  Econoff's 
recent meetings with industry reps and watchers in Beijing and 
Shandong Province suggest that moving the industry in this direction 
will be a significant challenge given underlying protectionist 
sentiment towards foreign acquisition and provincial-level anxiety 
about consolidation that eliminates jobs or redirects tax flows. 
 
¶2. (SBU) Global giant Arcelor-Mittal, for example, aims to acquire 
38% of Shandong's Laiwu Steel (China's number eight producer), while 
Laiwu is at the same time looking at a merger with provincial 
competitor Jinan Iron and Steel (not to mention that Jinan is 
considering a tie-up with number one Baosteel).  Econoff's 
discussions about these proposed mergers drew out from contacts a 
variety of opinions relating to foreign investment in China's steel 
sector, highlighted the impact of China's stock market rise on 
valuations of domestic enterprises, and called into question the 
efficacy of local government intervention in the steel sector.  A 
closer look at Laiwu also underscored how the future of the industry 
may increasingly lie in new coastal production bases that will 
better position China's steel enterprises to access the overseas 
market with higher-end products. END INTRODUCTION/SUMMARY 
 
-------------------------------------------- 
LAIWU STILL EYING MERGER WITH ARCELOR-MITTAL 
-------------------------------------------- 
 
¶3. (SBU) Central Government concerns notwithstanding, Luxembourg's 
Arcelor-Mittal (AM) is still working with a willing Laiwu to acquire 
a 38% stake in the firm, according to Laiwu Vice President Wang 
Yaowei.   He told Econoff that negotiations are still ongoing, 
although Chinese media reports that the National Development and 
Reform Commission (NDRC) on March 13, 2007, refused to approve the 
bid.  The NDRC stated that the RMB 2 billion offer (or RMB 5.888 per 
share of Laiwu stock) significantly undervalues Laiwu, and Wang 
added that this is just one of seven problems the NDRC identified 
with the offer.  The two companies are working to address the NDRC's 
concerns.  As Wang sees it, Laiwu wants to cooperate with AM to gain 
access to more advanced technology, better management techniques, 
and new overseas markets.  Wang noted that the Shandong Provincial 
Government fully supports the bid and is lobbying Beijing on Laiwu's 
behalf. 
 
---------------------------------------- 
BEIJING EXPERTS QUESTION BID'S PROSPECTS 
---------------------------------------- 
 
¶4. (SBU) Conversations with steel industry experts in Beijing 
suggest the outlook for the merger may not be so rosy, but the two 
experts we spoke with differ on what stands in the way of the bid 
going through.  Zhou Weifu, a senior researcher at the Chinese 
Academy of Social Science (CASS), said that in addition to the 
NDRC's concerns about price, the commission's steel policy does not 
permit the 38.41% stake.  NDRC believes AM should have offered at 
least RMB 4 billion.  Zhou added that AM's bid was based upon 
Laiwu's domestic stock market value during 2005 and 2006.  The bid 
at the time of its issuance was a 15 percent premium on the 
company's listed stock price.  With Chinese equity markets in a 
rally -- maybe even a bubble -- Laiwu's stock price has more than 
doubled since the bid. 
 
¶5. (SBU) Zhou went so far as to question Laiwu's actual interest in 
a tie-up.  Meanwhile, Danny Chen, a steel sector analyst with Fitch 
Ratings, told us that the NDRC is blocking the bid because it wants 
to keep foreign steel enterprises, especially AM, out of the Chinese 
market.  AM itself is the product of its own recent merger, and the 
company's interest in expanding into China has rattled Beijing. 
Beijing is now taking more active measures to promote the growth of 
domestic steel majors to thwart foreign takeovers, said Chan. (Note: 
AM's bid may violate aspects of China's mergers and acquisitions 
regulations issued in September 2006, most notably Article 14 which 
calls for the proper valuation of acquired assets; however, the 
regulations so far have not been directly cited as a roadblock to 
the bid.  End Note.) 
 
--------------------------------------------- - 
LAIWU WANTS NEW PROVINCIAL STEEL GROUP COMPANY 
 
BEIJING 00003765  002 OF 004 
 
 
--------------------------------------------- - 
 
¶6. (SBU) Laiwu's Wang said the company is separately pursuing a 
merger with provincial rival Jinan Steel (Jigang), China's number 
six steel producer.  The result would be a large provincial steel 
company with some 20 million metric tons of production capacity 
under its control.  Wang stated that the merger would form a wholly, 
or largely provincial government-owned group company that would 
manage Jigang and Laiwu as separate listed companies.  Laiwu's 
merger with AM could still take place, but AM's proposed 38% 
acquisition of Laiwu would fall instead within the provincial steel 
group company.  The new company's headquarters would be along 
Shandong's coast and would include construction of new steel 
production capacity.  (Note: China's Economic Research News reports 
that the new provincial steel company would be headquartered in 
Rizhao, a port city south of Qingdao and just north of Shandong's 
border with Zhejiang Province. End Note.) 
 
--------------------------------------------- --- 
SHANDONG OFFICIALS OFFER MIXED VIEWS ON POSSIBLE PROVINCIAL STEEL 
GROUP COMPANY 
--------------------------------------------- --- 
 
¶7. (SBU) A senior Shandong Province NDRC Planning Division official 
confirmed to us that Shandong SASAC and NDRC are enthusiastically 
backing the creation of the provincial group steel company, which he 
believes is a mistake.  The merger would not be a "happy marriage," 
given Jigang's own interest in pursuing a cross-provincial boundary 
merger with Baosteel instead.  The NDRC official stated that forcing 
the merger also runs counter to market principles.  The government 
should play a role of providing services and support to provincial 
enterprises, rather than making decisions for them, according to the 
official. 
 
¶8. (SBU) Expresing a different view, Han Minqing, a Shandong 
Provincial CASS research fellow, enthusiastically supported creation 
of a new provincial steel company, citing potential improvements to 
overall competitiveness by creating opportunities to cooperate on 
product lines and sourcing of raw materials.  Han observed that 
Shandong Province is a large manufacturing base and needs access to 
large amounts of steel; a provincial-level group company would 
ensure the continued availability of steel to Shandong customers at 
a competitive price.  This may not be the case were Jigang and 
Baosteel to merge, according to Han. 
 
---------------------------------------- 
BEIJING EXPERTS SEE OTHER MOTIVATIONS... 
---------------------------------------- 
 
¶9. (SBU) CASS' Zhou disagreed with his provincial CASS counterpart 
on the potential efficiencies created by a merger between Laiwu and 
Jigang.  The two companies' product structure, management 
techniques, and labor costs are very different, said Zhou.  For 
example, Jigang's salaries are three times higher than Laiwu's 
because Laiwu is located in a remote area more than a three hour 
drive from the provincial capital of Jinan, where Jigang is located. 
 Zhou also dismissed fears that a Jigang-Baosteel merger would 
somehow impact the price or availability of steel in Shandong.  The 
Shandong Government's support for the merger is really about keeping 
Baosteel out of Shandong, according to Zhou and fellow CASS 
researcher Lu Tie. 
 
-------------------------------- 
...LIKE HOLDING ONTO TAX REVENUE 
-------------------------------- 
 
¶10. (SBU) CASS' Zhou and Lu stated that a possible merger between 
Baosteel and Jigang would probably take the form of Baosteel's 
acquisition of Jigang.  This means future tax revenue generated by 
the merged company would flow to Shanghai, leaving Jinan in the 
cold.  Lu said that similar tax issues are preventing other 
cross-provincial boundary steel mergers advocated by the NDRC. 
Local governments are blocking proposed mergers to prevent tax 
revenue loss.  Lu went on to observe that such tax issues are not 
limited to the steel industry.  For example, tax revenue generated 
by Three Gorges Dam work being done in Sichuan Province is paid to 
the Hubei Provincial Government since the project is headquartered 
there.  As a result of this type of problem, the NDRC has tasked 
CASS and other government research organizations to study local tax 
flow issues and make recommendations for possible policy or 
regulatory changes, said Lu. 
 
--------------------------------------------- -- 
 
BEIJING 00003765  003 OF 004 
 
 
EXPERTS, MILLS PROMOTE COASTAL PRODUCTION BASES 
--------------------------------------------- -- 
 
¶11. (SBU) CASS' Lu stated that working out tax flow issues is also 
important for Chinese steel sector development since most experts 
assume newly merged steel mills will want to build new production 
bases along the country's coast.  New coastal production bases would 
facilitate access to cheaper input materials, such as iron ore, 
which would reduce transportation costs.  A CASS study conducted 
several years ago indicated that Chinese steel companies transport 
four times the volume of raw materials as finished steel products. 
Lu noted that water transportation costs are significantly cheaper 
than overland costs, making it more cost effective to import raw 
materials from overseas and transport finished products overland. 
Most of China's steel demand is located near the coast, limiting the 
distance required to ship final products.  Lu stated that the 
development of new coastal steel production bases would also give 
China's large steel companies an opportunity to significantly 
improve their production technology levels.  This is a key component 
in China's future competitiveness in the international steel market, 
according to Lu. 
 
--------------------------------------------- ------- 
SECTOR NEEDS IMPROVED EFFICIENCY, BETTER PRODUCT MIX 
--------------------------------------------- ------- 
 
¶12. (SBU) CASS' Zhou said that better technology will be needed to 
improve the efficiency of China's steel mills.  To date, China's 
steel prices have been lower than international market prices 
because their production does not adequately factor in the true 
costs of land use, natural resource exploitation, or labor.  Zhou 
stated that this will change in the future.  Beijing is increasingly 
focused on the steel sector's environmental and labor costs, 
including those relating to worker safety and provision of an 
adequate worker social safety net.  CASS' Lu observed that a 
contradiction between inland and coastal provinces has emerged in 
this regard.  So far, provinces in China's central and western 
regions are more willing to tolerate polluting, inefficient steel 
mills than coastal provinces in order to preserve continued high GDP 
growth.  Lu said Beijing's challenge is to eliminate this 
difference. 
 
¶13. (SBU) CASS' Zhou stated that China's steel enterprises have made 
some recent gains in efficiency through production scale increases, 
changes in product mix, management reform, and reduction of 
production costs.  This has helped them maintain or improve profit 
levels in the face of rising input costs.  Laiwu appears to be a 
good example of this type of efficiency gain.  The company claims to 
have cut its water usage per ton of steel produced from more than 8 
tons of water to 3.5 tons during the last several years.  The 
company also claims to have improved its product mix by becoming 
China's largest H-beam producer. 
 
¶14. (SBU) Not everyone in Chinese Government research circles is 
buying this argument.  Some are openly questioning why profits of 
China's steel and other industrial enterprises are rising so fast 
given rising input costs, explained Zhou.  Wang Jian, a 
well-regarded government researcher at the NDRC's Macroeconomic 
Research Institute is studying this issue right now, according to 
Zhou. 
 
------------------------------------ 
COMMENT: PROTECTIONISM ALL AROUND... 
------------------------------------ 
 
¶15. (SBU) Not only does there appear to be protectionist sentiment 
against the foreign acquisition by AM of a stake in Laiwu, but also 
similar (and possibly stronger) views in play among the provinces 
themselves.  The Vice President of China's steel industry 
association stated in late-2006 that more stringent foreign 
investment restrictions are needed to protect China's steel mills 
from AM and others.  The recent and dramatic rise in China's stock 
market, which has at minimum doubled the market cap for firms like 
Laiwu, appears to be serving as a useful foil against foreign 
acquisition making the firms less attractive as value buys and 
giving government officials a basis for alleging low-ball bids. 
Chinese steel experts and government officials may acquiesce in the 
trying to keep the foreigners out, but they are likely at some point 
to take on the provincial protectionism since it directly challenges 
their efforts to streamline the energy-hungry steel sector. 
 
--------------------------------------------- - 
... BUT COMPETITIVENESS COULD RISE IF OVERCOME 
 
BEIJING 00003765  004 OF 004 
 
 
--------------------------------------------- - 
 
¶16. (SBU) Foreign stakes in Chinese steel companies can bring needed 
management skills and technologies to the sector.  More importantly, 
if and when domestic merger and acquisition gains steam, Chinese 
steel enterprises movement to the coast will most likely accelerate. 
 As a result, Chinese steel companies would be much better 
positioned to access the international market with higher value 
products resulting from the construction of new, more efficient 
production bases.  In the end, this may prove a bigger impact on the 
international steel market than present concerns in developed 
markets of China dumping low-value steel products. 
 
PICCUTA