The Great British Bailout

The British government is closing in on a bailout of the Chinese owned British Steel in which taxpayers would inject £600 million pounds into the group.

British Steel is one of only two manufacturers of “virgin steel” in the UK alongside Tata Steel at Port Talbot in Wales which some industry experts claim is strategically important. Tata is in more advanced talks of its own with the government over a similar bailout.

The British government wants the steel mills to switch from using blast furnaces to more environmentally friendly electric arc furnaces at a cost of £1.25 billion to help achieve Britain's net zero goals.

Unions warn that even if the deal is approved, 2,300 jobs would be lost, because EAF is far less labor-intensive than traditional production methods.

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Transcript

The British government is on the verge of agreeing to an almost 800-million-dollar bailout for Jingye Group - the Chinese owners of British Steel. Rishi Sunak’s government already agreed to an almost 700-million-dollar subsidy for Indian owned Tata Steel - if they replace their two remaining UK based blast furnaces with more environmentally friendly electric arc furnaces. These are two of the largest state support packages in British history. The outgoing conservative government didn’t sign the Tata deal before the recent election, and the new Labor government has now since said that they will make “job guarantees” a requirement of any state support package offered to Tata Steel.

Last year the British government offered 700 million dollars in subsidies to the Tata the owner of Jaguar Land Rover to persuade them to build a new battery plant in the UK. They agreed to 100 million dollars in subsidies for German owned BMW to continue building the electric Mini in the UK and 100 million dollars to Nissan to safeguard the Japanese owned companies’ future in the UK. 

Do these bailouts and subsidies to foreign owned companies make any sense for British taxpayers, and if they are paid, can taxpayers expect these companies to stop coming back for more government handouts by threatening layoffs again in the future?

Many foreign owned companies do ask for – and get - subsidies, but the steel industry is possibly the most interesting of this group, because governments around the world worry about losing their steel industries both for fear of losing manufacturing jobs and for strategic military reasons. The American Iron and Steel Institute (for example) highlights on its website that all segments of the American steel industry contribute to the defense industrial base.

The British steel making industry has unfortunately been in decline for quite some time, which is a sad thing to say for the country that invented modern steel manufacturing.

Before 1860, steel was a very expensive product, that was made in small quantities and used to manufacture precision tools and cutlery. The Bessemer Process, developed in England made steel easier, quicker and cheaper to manufacture. In 1875, Britain led the world, accounting for 40% of global steel production, the majority of which was exported.  Twenty-five years later, the United States had become the market leader and Germany was catching up quickly.

The British iron and steel industry first came under government control during the Second World War as part of the war effort.  After the war the Labor party won a landslide victory and established an Iron and Steel Board, to control the price of raw materials, finished products and the development of new plant and equipment. A few years later they nationalized the steel industry with the passage of the Iron and Steel Act. This was reversed by the Conservative government who were elected in 1951, but the industry was nationalized once again in 1967 under a Labor government as British Steel.

Under nationalization in the 60’s and 70’s, the government's goal was to keep employment as high as possible, especially in industrial regions. Many of the Steel plants at this time were overstaffed, pay was higher than average and British Steel was unprofitable, it was only able to stay in business because of government subsidies.

In the early 1970s the British Steel industry employed around 320 thousand people, by 1991 that figure had fallen to just 44 thousand workers and today it employs around thirty thousand people. The British Steel industry is today ranked 26th globally and comprises of six steel mills, four of which are blast furnaces.

According to government documents the decline in steel industry employment can be explained by increased productivity (as fewer workers are needed in modern factories), but the job losses are mostly explained by foreign competition, (particularly from China) where manufacturing costs are significantly lower.

Britain’s new net zero laws mean that the four remaining blast furnaces, two of which are operated by Tata, and the other two by British Steel have to be replaced with electric arc furnaces to reduce their carbon output.

When the subsidy deal for Tata was announced, the government said the new electric furnaces would cut the country's total carbon emissions by around 1.5%.

There has been some concern in the UK that as global tensions have been rising and other countries have focused on supply chain resilience that these new greener furnaces can’t make virgin steel, and instead just recycle steel, which some industry experts say can’t be used for military purposes. To be clear – virgin steel has nothing to do with Richard Branson – its just primary steel made from iron ore.  While the newer technology is cleaner, more efficient and requires fewer workers. Britain, which was once the world’s largest steel producer, may soon become the first major economy with no capacity to make steel from scratch.

One of the biggest arguments in favor of subsidizing Tata and Jingye group (the owners of British Steel) is that if they were allowed to go bankrupt, Britain would have no remaining steel industry. Tata and Jingye manufacture almost 6 million tons of the 7.2 million tons of steel produced in the UK each year.

Under the current plans, all four of the remaining blast furnaces will be shut down anyhow while the new electric arc furnaces are being built, which will take a minimum of three years (assuming no time overruns) and in the meantime, Britain will be importing almost all of its steel. So, one way or another, Britain will be importing almost all of its steel over the next few years.

A big part of the pro subsidy argument is that if these furnaces were permanently shut down, the UK might be dangerously exposed – particularly in the case of war.  There has even been some press about how with the upgraded furnaces – Britain could still find itself in a strategically weak position, as once the blast furnaces go away, the country will no longer be producing Virgin Steel – meaning steel made from the primary raw materials.

To explain the difference, 70% of the world’s steel is today made using basic oxygen furnaces – like the ones being shut down, which burn coal to melt iron-ore to extract the iron. This iron can then be turned into steel. Most of the inputs to this process are mined raw materials - and the carbon footprint of virgin steel can be up to five times greater than the carbon footprint of recycled steel – when you take the carbon intensive nature of mining into account. 

The electric arc furnaces, on the other hand, take scrap steel and use a massive electrical current to melt it down, and with some processing, the end product is recycled steel which has a much lower carbon footprint.

According to a blog post by Ed Conway – the author of the book Material World (I’ll put a link to the book – and his blog - in the description) Electric arc furnaces – historically produced significantly worse steel than the “virgin steel” that comes from primary steelworks. In the past this recycled steel was good enough for making things like rebar which is used in construction but was not good enough for advanced uses.

Conway explains that this is no longer the case. He points out that the steel that goes into aircraft landing gear – which is apparently one of the finest grades in the world - is made today in the electric arc furnaces at Rotherham. The steel used to make nuclear submarines and parts for nuclear power stations is made by Sheffield Forgemasters – once again in electric arc furnaces.  Conway argues that recycled steel quality is not a big issue and that the real issue the manufacturers are struggling with is whether they will be able to churn out enough of the relatively cheap rolled steel that they currently make, which is used for packaging products like cans.

In terms of Britain giving up its self-sufficiency, Conway points out that virgin steelmaking in the UK is already hugely dependent on imports - as Britain stopped mining iron ore decades ago and already relies on imports from Sweden, Brazil and Australia. Additionally, most of the coal used in British steel mills is imported from Europe and further afield.  He points out that even in the run up to the second world war, the UK was heavily reliant on iron ore imports from Sweden (as was Germany) to manufacture ships and other weapons.

The idea that holding on to blast furnaces for the purposes of self-sufficiency doesn’t asse to hold much water.

According to the Financial Times, The UK produces ten to eleven million tons of scrap steel each year, the majority of which is exported, with more than half of it being shipped to Turkey, Egypt and India for processing. This is considerably more – in exports - than the six million tons of virgin steel produced in the UK every year. Based on these figures, it can be argued that moving from virgin steel production to steel recycling – in fact, decreases the UK’s reliance on imports.

In terms of the military need for steel, I have no real expertise on that front and was unable to find figures for the UK, but, in the United States only around 3% of steel demand comes from defense and military end users, with the main uses of steel being construction and automotive manufacturing.

From a strategic perspective, western economies should possibly worry more about critical minerals which are used in manufacturing semiconductors and in military and communications equipment, as China produces 98 percent of the world’s gallium and 60 percent of the world’s germanium, according to the US Geological Survey. China began imposing export restrictions on these critical minerals last year in response to US controls on sales of chips and chipmaking equipment, saying the export restrictions were needed to safeguard Chinas “national security and interests.” 

If steel is easily procured but the entire planet relies on China for critical minerals, it might be more worthwhile to focus on that supply chain.

With regard to protecting steelworker jobs, the transition to more modern electric arc furnaces is likely to involve layoffs as these new furnaces require far fewer workers than the existing blast furnaces do, so about 5,600 jobs are expected to be lost in the UK, just because of the upgrades, and I’m not sure how many steel workers will keep their jobs over the three or more year period when the plants are being upgraded. For this reason, British steel workers have been threatening to strike saying that they are "not just fighting for their jobs – but fighting for the future of their communities and the future of steel.”  The threatened strikes were suspended when Tata warned that it would bring forward the planned furnace closures if walkouts went ahead.

So, should governments be subsidizing businesses at all, and in particular, should they subsidize foreign owned firms?

When governments subsidize specific companies with billions of dollars of taxpayer money and put restrictions in place on foreign competition, the policies can definitely be expected to have an effect in the real economy, but what does the taxpayer get in return? If the trade interventions generate huge private investment where factories are built and workers are employed - boosting the national economy and generating a return on investment, then the government’s gamble will have paid off. If on the other hand you end up with weak companies and weak industries that can only get by under continued protection or support, the taxpayer loses out, and either the owners of the subsidized businesses or the workers in the chosen industries win out at the expense of society as a whole.

AstraZeneca, the British/Swedish pharmaceutical company recently warned that it might move its vaccine manufacturing site abroad because of recent government negotiations to reduce state aid promised for the project. According to the Guardian, at least 97% of the funding for the development of the vaccine came from taxpayers or charitable trusts.  According to the FT, AstraZeneca told UK government officials that they are considering moving the facility to the United States, where generous government financial support is offered.

Reuters reports that company bosses in the UK have warned that Britain is falling behind the United States, which has benefited from the huge subsidies of Biden’s Inflation Reduction Act, and the European Union, which also has incentive schemes in place.

What is today known as British Steel, already went bankrupt in 2019.  It had been bought from Tata Steel in 2016 as a loss-making business by a private equity firm, who paid one pound for the business, promising to invest more.  Over the next two years, it flipped to profitability, paying three million pounds per year to its parent company along with 17 million pounds in interest on a loan. 

The government gave British Steel a $152 million dollar loan in 2019 so that it could pay CO2 emissions fees to the EU as it had been excluded from the EU’s carbon emissions trading scheme due to a no-deal Brexit. The company collapsed into bankruptcy just three weeks later when the British government refused to advance it an additional $38 million dollars to cover short-term financing needs.

It was bought – out of bankruptcy by Jingye Group, (its current Chinese owners for £70 million pounds, which is around 92 million dollars. Jingye agreed to invest $1.6 billion dollars into the business at the time, but only invested 200 million dollars – according to the telegraph. They are now asking for an 800-million-dollar subsidy – which is a bit over two and a half times the money they themselves put into the business.

Earlier this year, Jingye’s auditors - Moore Kingston Smith unexpectedly resigned just days after the company released its financial filings for 2021 – more than a year after they were due. This auditor had only been appointed one year earlier after its predecessor, Mazars, quit. Moore Kingston Smith cited problems with the audit of inventory, such as raw materials and equipment, stating that they had been unable to ‘satisfy themselves over the existence of £45.8 million pounds worth of inventory, despite trying to verify it through “alternative means.” They issued a qualified audit opinion.

You really have to question if a government should provide a huge subsidy – far in excess of the value of the business – or what it’s owners paid for it, to a company who seems unable to prove the existence of inventory they are carrying on their books.  

According to Wikipedia there are 3200 British employees at British Steel.  With an $800 million dollar subsidy it would cost the British taxpayer 250 thousand dollars per person to save each job – assuming that Jingye don’t come back looking for further subsidies.

According to UK Steel – The UK’s electricity wholesale price is more than double the cost of French and Spanish electricity. The British steel industry is already heavily reliant on electricity, and this demand will only grow as new Electric Arc Furnaces come online. UK Steel say that with the change, it’s expected that the sector’s electricity consumption will roughly double.

Last year, the British government announced measures to support employers in sectors including steel, metals, paper and chemicals that are among those most exposed to the high cost of electricity.

Based on these facts, we have to question if the UK is even a good place to manufacture steel at all?  If some onshore manufacturing is needed for military purposes, should the cost of an appropriately sized steel mill come out of the military budget, rather than the government subsidizing foreign firms to manufacture steel uneconomically in the UK?

In the British governments own report, they describe how more steel is being produced globally than there is demand for and that a glut of steel has pushed prices down.  It is difficult to justify spending so much taxpayer money subsidizing an industry that has such a poor outlook. If there is more supply than demand – and you are competing with subsidized steel from China, at what point can you reasonably expect to ever see a return on this investment?

To highlight how bad the situation in the steel industry is, Brazil recently announced quotas and tariffs on cheap imported Chinese steel. Now, while China does mine some iron ore, it buys the majority of its iron ore from Australia and Brazil. The fact that Brazilian steel mills (where wages are probably not too high) are struggling to compete on price with competitors who buy their iron ore in Brazil, ship it eleven thousand miles to China, convert it into steel and ship the finished eleven thousand miles back to Brazil tells you that this is not a great business to be in.

It would be easy for me to oversimplify and claim that there is an obvious solution to these trade problems that we see today, but very smart people are working on these problems, and likely considering everything I have brought up in this video and much more.  

Milton Friedman argued that exports are the cost of trade and imports the return from trade – the only reason to export is to have money to pay for imports. He argued that there’s no reason for a country to want to export more than they are importing, and I think he is right about that. 

Unfortunately, this sort of balanced free trade that is based on the law of comparative advantage is not something that we have seen in recent decades, as many emerging markets pursue a strategy of keeping wages low and subsidizing industries so that they can export far more than they import, sacrificing profitability for growth. This strategy doesn’t make much sense – it eventually leads to all of the problems that Japan is dealing with today.  Hugh Hendry has joked that countries pursuing this strategy are great at generating GDP but not profits – and there’s not much point in that.

Michael Pettis recently wrote in the FT that the global trading system has long diverged from one in which countries specialize and benefit from the comparative advantage-based trade that economists talk about. 

The theory of comparative advantage says that the global economy benefits when different countries specialize in the products they can produce comparatively more efficiently, exchanging them for products that other countries can produce comparatively more efficiently.

Pettis points out that it is a lot trickier to trade with countries who are willing to dump goods abroad below their cost of manufacture, as while you are getting cheap goods – which is a win - if they persist long enough your industry can be wiped out.

This isn’t a smart strategy from the exporting country’s perspective either, as eventually they may end up with the biggest factories in the world, but if their trade policies caused unemployment abroad, they find themselves having sold goods on credit to customers who can’t pay them and who are no longer buying more goods. Everyone loses in such a situation.

Almost all economists support free trade based on comparative advantage as this maximizes the value of goods and services produced by the global economy, but Pettis argues that the excess savings and persistent trade surpluses that we see today are not signs of comparative advantage-based trade or signs of a healthy system of international trade.

He argues that the current global trade regime subjects deficit economies like the US to an industrial policy, but not one of their choosing, instead, they end up with the obverse of the industrial and trade policies of their most aggressive trade partners.

Over the last few decades, globalization has brought down the price of goods.  For example, fifty years ago you couldn’t buy a t-shirt for a dollar the way you can today – and have it shipped to your house for free.  I don’t agree with subsidizing manufacturing – especially in industries like steel where the UK has no competitive advantage today, and it’s not clear that one will appear in the near future – especially when the cost of electricity and raw materials is so much higher in the UK than it is abroad.

The recent slowdown in China has meant even lower Chinese consumption, and because the same amount of goods are being produced, the surplus is just being exported. The recent increase in exports, from a country that was already a huge exporter has led politicians around the world to implement protectionist measures to defend local industry.  We are seeing this with Electric vehicles where The United States, Canada and the EU have all increased tariffs on Chinese EV’s. Britain has not done this yet, likely because in the post Brexit environment they don’t want China imposing tariffs on British goods – Britain already has enough trade problems to deal with.

The long downturn in the British steel industry is part of a broader decline in industry and manufacturing that many argue played a big role in reshaping politics, leading to the UK’s vote to leave the EU in 2016.

A British Government research report describes steel as being an intensively traded product where a glut of steel on global markets has depressed its value. It says that governments participating in the OECD Steel Committee “consider excess capacity as being one of the main challenges facing the global steel sector today.” It goes on to say that steel industries are often heavily subsidized by national governments resulting in production levels far exceeding what the market needs would otherwise dictate.

In such a situation – and in such a competitive environment - would it be better for the British government to allow the steel mills to just fall into bankruptcy, with their foreign owners taking the loss? If it makes economic sense to build new electric arc furnaces, a new company could step in to do this – I’m not sure that the existing management are needed. It doesn’t sound like a great business opportunity to me at present, so there is a good chance that – left alone - the steel mills would just shut down, but at least it wouldn’t involve taxpayers providing a subsidy to foreign firms greater than the foreign firms own investment in their own businesses.

I will of course be interested to hear my viewers’ thoughts in the comments section, international trade is a very complex topic – and a topic that affects the lives and livelihoods of many people – and we do have to keep that in mind.

Thanks for tuning in to this week’s podcast.  A special thanks to my supporters on Patreon whose contributions make this podcast possible.  Have a great week, and talk to you again soon, bye.