The Chinese State Council in mid October instructed local governments to stop approving new production facilities, suspend the construction of unauthorized projects and order the closure of inefficient capacity in the steel industry.

The government’s goal is to eliminate more than 80 million tonnes per annum in steel production capacity. We estimate, using World Steel Association data that represents about 11% of 2012 domestic production.

This effort is credit positive for most large steelmakers in Asia because it should reduce the lingering supply glut in China, which is the dominant driver of the region’s weak industry fundamentals. That said, uncertainties remain as to the timing and scale of capacity reductions.

Baosteel Group Corp and other large Chinese steel companies such as Wuhan Iron and Steel Corp will benefit most, because they can leverage their competitiveness to take over market share from those that exit the market.

While other companies must close capacity to comply with the government’s instructions, Baosteel and WISCO will increase their market share further as they have received government approval to build new steel facilities in southern China. Baosteel is constructing a nearly nine million tonnes per annum steel plant in Zhanjiang, Guangdong Province, which it expects to complete in 2016. WICSCO is constructing a 10 million tonnes per annum new steel plant in Fangchenggang, Guangxi Province.

Increased market share and scale will strengthen the two companies’ bargaining power with suppliers and customers and boost efficiencies, all of which will bolster their profitability.

Concentration of the Chinese steel industry will increase after the removal of inefficient facilities. This will improve capacity utilization and profitability at the remaining Chinese steel companies, including China Oriental Group Co.

Compared to advanced economies such as South Korea and Japan, the Chinese steel industry is highly fragmented. The three largest Chinese steel companies accounted for only 17% of the nation’s steel output in 2012, versus 82% by the top two steel manufacturers in South Korea and 73% by the top two in Japan, according to the World Steel Association.

Fragmentation in the Chinese steel industry worsened in 2012. The 10 largest steel companies accounted for 45.9% of the nation’s steel output in 2012, down from 49.2% in 2011, according to the China Iron and Steel Association.

While small steel companies in China expanded their capacity in an effort to increase their scale and bargaining power amid fierce competition, large steel companies refrained from capital investment given their already leveraged capital structure and weak profits. Oversupply and industry fragmentation have resulted in weakening profitability for Chinese steel mills.