MT Arcelor Mittal New

BEIJING—China's leaders are forging what may soon be the world's largest steelmaker, sticking to their conviction that big is good and gigantic is better for state-owned firms.

The merger is the latest Chinese effort to create "national champions" that can compete globally and trim excess production capacity to adapt to falling demand. It comes as Beijing faces growing international complaints over cheap steel exports.

But such efforts haven't aided efficiency in the past. And the consolidation has entrenched​state-owned enterprises in their strategic positions of power in the economy, despite Beijing's vows to develop a greater role for the private sector.

Through cheap loans and state support, Beijing has tried for two decades to nurture industrial giants, creating the world's largest rail-car maker and other behemoths. Yet, social and political factors, such as keeping people employed to avoid social unrest, have often trumped commercial ones such as shutting down production to stem losses.

Meanwhile, the efficiency of China's heavy industry continues to fall. In the oil-processing and steel sectors, ​for instance, one-third of capacity remained unused by the start of this year.

In the latest effort, China's two largest steelmakers, Baosteel Group Corp. and Wuhan Iron and Steel Group Co., or Wisco, confirmed on Tuesday their plans to merge. Baosteel's 130,000 workers are nearly as many as in the entire U.S. steel industry.

If China adds one or two more mills into the mix, as officials and analysts expect, the merged company's output would eclipse the world's top producer, Luxembourg-based ArcelorMittal SA.

"This is the inevitable way to deal with falling demand, and it will help the stable development of the global steel industry," said Dai Zhihao, president of Baosteel's listed subsidiary.

The companies declined to respond to requests for comment, citing stock-exchange rules. Ma Guoqiang, a Baosteel veteran now chairman of the heavily-indebted Wisco, told the official Xinhua News Agency in July that "true restructuring" was needed to reduce overcapacity.

"Megamergers don't necessarily lead to good restructuring," he said.

Chinese mills, including Baosteel and Wisco, have committed to cut 45 million metric tons of capacity this year and 150 million tons over the next five years. But past attempts failed when mothballed mills were reactivated as steel prices rose.

Instead, as China's economy slows and global demand for its products shrinks, the government is again using consolidation to assert control over unruly industries that haven't responded to market forces.

Despite a global freight glut since 2011, two state-owned shipping companies commissioned ever-larger ships, losing money even as its global peers boast a 3.3% profit margin, according to HSBC. The solution? Beijing merged them this year to create the world's fourth-largest such company.

The government whittled its heavy-industry companies from 196 in 2003 to 112 last year. It aims for less than 100 by year-end.

The steel merger approach extends policies in place since 2004 and mirrors the last big round of megamergers at the height of the financial crisis in 2009. To widen the reform process, Beijing has recently also tried selling more of its noncore oil assets. Yet, the twin goals of trimming excess and creating more competitive global companies never came to pass.

Over the past decade, for example, China's largest steel mills have become steadily less efficient than their peers in the U.S., Japan and South Korea. Return on assets fell to -3.6% in 2015 from 16% in 2004 at Wisco's listed subsidiary and only somewhat better at Baosteel's listed arm. Nucor Corp., the largest U.S. mill, showed return-on-assets of 4.7% last year.

China also lags behind in productivity. A worker at Baosteel makes about 269 metric tons of steel a year, company data show. Its largest global peers produce about 440 tons.

Global steel giants have laid off thousands of workers to cope with recent downturns. Beijing says it prefers consolidation to avoid mass retrenchments.

China struggles to close even the most obvious target in its campaign—smaller and heavily polluting mills, leaving the sector fragmented. China's top 10 steelmakers accounted for 34% of total output in 2015, down from 53% in 2011 and well short of the official target of 60%.

Turning these companies around would make a showpiece for Beijing as it tries to rebut allegations from the U.S. and Europe that it is overproducing and dumping cheap steel on world markets, driving down prices. The trade brawl is clouding China's bid for global stature and access to overseas markets.

Chinese officials say the country's steel is competitively produced. They have also made a show of dismantling mothballed furnaces, including one mammoth mill in Inner Mongolia last month.

But gains in efficiency ultimately appear not to be a priority. "State companies must be big, strong and good enough not to be shaken" by global competition, President Xi Jinping said last year.

Above the rutted roads of Muchangkou, a soot-blackened hamlet in China's northern steel belt, smoke has begun wafting anew from the red-and-white chimneys of the area's dozens of privately held mills after more than a year of state-imposed suspension.

Local officials depend on these mills, usually the largest employers, for revenue and kickbacks, workers and analysts say. Local officials close the mills under pressure from Beijing but often later let the factories reignite output.

"Lots of smaller mills in the area have revived production," said Liu Haibo, a 47-year-old steelworker who was laid off from one Muchangkou mill early last year and re-employed by another this month. "The local government won't let them fail."

Liyan Qi contributed to this article.

Write to Chuin-Wei Yap at chuin-wei.yap@wsj.com

(END) Dow Jones Newswires

September 20, 2016 23:05 ET (03:05 GMT)

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