Due to the decentralized nature of China’s economy and government, every industry in China is very fragmented. As soon as demand for a particular product begins to grow, development oriented government officials in every village, county and municipality across the country encourage the banks and entrepreneurs in their area to set up a new plant.

Why are China’s government officials so motivated to build new plants? New jobs created by new factories are one obvious reason, but not the only one. Also at stake is the 25 percent share of the 17 percent Value Added Tax (VAT) that the local governments are allocated from sales of products made by the factories in their areas. The VAT is the lifeblood of the government infrastructure in China. It pays the bills for the central, provincial and local governments, including the salaries of the government officials.

As a result of this phenomenon, industries in China can transition from a state of under-capacity to one of over-capacity virtually overnight. Whereas only a handful of companies are likely to manufacture a particular product in a developed country like the United States, hundreds of companies may make the same product in China.

China’s steel industry is a case in point. At the turn of this century, China had approximately 100 million tons of steelmaking capacity, putting its industry on a par with those in other large economies like the United States. But, as demand for steel rose due to rapidly increasing economic growth all over the world, but most notably in China itself, steel plants proliferated, with every local government in China having one built in its own backyard. China now has over 500 million tons of capacity, about one-third of the world’s total steelmaking capacity, and an estimated 100 million tons of over-capacity.

A Wall Street Journal article, China’s Steel Woes, which appeared on January 29, 2007 (only available through subscription), pointed out that there are somewhere between 300 and 1000 companies in China. No one really knows for sure. The article also said that Baosteel, the largest steel company in China, accounts for just 5 percent of the market.

With this as background, I was interested to read the article, China’s Steelmakers Gain Allure As Sector Mergers Gather Steam, which appeared in the Asian Wall Street Journal earlier this month. The article takes the view that China’s steel industry is ripe for consolidation (a view which I share), and quotes analyst predictions that by 2010, the industry will be restructured around five steel conglomerates with combined capacity of about 250 million metric tons (a prediction which I very much doubt). That would represent nearly 50 percent of the expected annual output for China’s entire steel sector, compared with 29 percent that now comes from the country’s 10 largest steelmakers. I question this prediction because the top five steel companies in China account for just 20 percent of the country’s total capacity today, and I am not aware of any industry in China that has consolidated to that extent in such a short period of time.

In fact, most industries in China are becoming more fragmented, not less so. In the early 1990s, there were over 120 vehicle assemblers in China. Everyone who studied the industry concluded that number was way too high, and that the industry would soon consolidate. Even the China government shared this view. Stated public automotive policy in the 1990s was that the industry would consolidate around “Three Big, Three Medium, and Three Small” vehicle assemblers.

That’s not what happened, though. Today, there are over 60 separate legal entities making passenger cars alone. When China’s truck and bus makers are added to the mix, the number of vehicle assemblers easily exceeds the number in existence in the early 1990s. Given the fast growth of China’s auto industry, new car and truck assemblers pop up all the time. There would be even more but for the minimum capital requirements imposed by China several years ago. Predictions for consolidation in autos, steel or any other industry in China tend to vastly underestimate the strong forces of decentralization at work in the country.

The other point of the article which I take some exception to is that the consolidation of China’s steel industry is necessary to deal with the consolidation that is occurring in the global iron ore industry. I fail to see how the consolidation of China’s steel industry, even if it were to occur, would help. Unlike ArcelorMittal and US Steel, two of the largest steel companies in the world, China’s steel industry is vulnerable because it is not vertically integrated and must depend upon imports of critical raw materials. If the BHP Billiton/RioTinto merger goes through, the combined company would control over 40 percent of global iron ore production. No amount of consolidation in China can produce a company strong enough to deal with such a stranglehold on the world’s iron ore supply by one company. Of all of the steel companies in the world, the China steel industry has the most to lose by the proposed merger. Consolidation is not the answer. Moreover, if other industries are any guide, China’s steel industry is likely to remain very fragmented for some time to come. That’s why I suggested not long ago that a Chinese entity buy Rio Tinto, rather than let BHP Billiton snap it up.