“Six bucks and my right nut says we’re not landing in Chicago”

John Candy to Steve Martin, Planes Trains & Automobiles

Conclusion
China's expansion of its ship building capacity is the obvious wing-clipper for a soaring Baltic Dry Index (BDI).

Veterans of the shipping industry often cite the collapse of freight rates in the 1970s as an example of the havoc chronic over capacity can wreak. But the capacity issues of the 1970s arose because of two shock events: the 1967 Six-Day War and the 1973 OPEC oil price shock. The war forced oil transport around the Cape of Good Hope (the Suez canal would be closed until 1975), drove up freight rates and encouraged construction (by a factor of three) of larger ships too big for Suez. When OPEC cut supplies in 1973 freight rates fell out of bed and a lot of large, empty tankers were left at anchor.

Are trends in Chinese shipbuilding a shock or potential shock of similar scale?

Probably not - but it is ironic that shipping, about as economically liberalised an industry as exists, is entirely at the mercy and influence of a centrally-planned economy. That alone makes significant the risk that accelerated shipyard creation by China doubles global shipping capacity much faster than free markets would thereby depressing freight rates.

And that is before any consideration of potential concurrent problems posed by generous global liquidity, the end of Olympic preparations, possible steel market gluts and a macro-economic slowdown.


Background & tour d'horizon
In the year to end March 2007 the Baltic Dry Index has more than doubled. The drivers:

Chinese steel exports

Despite the efforts of China’s National Development and Reform Commission (NDRC) steel production continues to expand. China has been a net exporter since 2005 and in 2006 increased them by 92%.

Where is all this metal going? The US is the number one global importer of steel but with housing starts off dramatically is clearly a softening market. Against this, however, Malaysia, the number two importer of steel (by some distance) embarked in 2006 on its "Ninth Malaysia Plan” (jargonified as 9MP over there). 9MP involves ambitious infrastructure works in support of its objectives and is a price support for steel and freight rates. Although a neat immeadiate offset to US developments it is not likely to be in the medium term enough to soak up the startling increases in China’s steel output.

Chinese iron ore imports
The thriving counter party to China’s steel exports.

Chinese cement exports
China exports 3 million tonnes a month.

China's coal consumption
Energy hungry China has steadily increased consumption of its own coal leaving less to export. This has compelled Japan and Korea to seek supplies from Australia - action that has caused in Q1 2007 the worst port congestion in 3 decades. Clarksons, the shipping broker, reports that up to 70 bulkers are waiting 3 weeks to load coal.

International & Chinese politics
China’s iron and steel industry employs 2 million people. Political pressure to maintain jobs is a formidable obstacle to the NDRC’s desire to reduce capacity. China does not want people in the streets and its obvious response to the threat – and US led WTO pressure – is to shift its export subsidies from low to high value-added steel products. The NDRC has itself revealed this intention to be enacted, ah, sometime soon.

An important indirect consequence of this policy shift may well be the increasing capacity of Chinese shipyards. High value-added steel products like hot rolled coil and sheet serve industries such as car and fridge manufacturers, construction and, crucially (see below), shipbuilding. Expanding its shipyard capacity offers China a neat solution to its excess steel production, potential social problems and perennial search for new markets to conquer.

Chinese shipbuilding & capacity trends
China is already the second largest ship builder in the world after South Korea. Since 2003 and the start of this latest BDI boom global ship orders have leaped ahead of deliveries. South Korea has taken the lion’s share of these but, with its low cost base, China has pushed to expand its capacity in response. It has 14 yards under construction and another 9 due for completion by 2010 which are already taking orders. Delivering all actual projects would mean China’s yards will double current world freight capacity. Clearly, the pace of completions is one of the keys to future freight rates. And with backlogs such that yards are able to turn down lower-margin builds swift output is of the essence in the race for market share.

Exhibit A: South Korean, Chinese and Japanese shipyard deliveries and orders, 1996-2006


Sources: Clarksons plc; Lloyds List; Iron & Steel Statistics Bureau; Malaysian Industrial Development Authority (MIDA)

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