Why Is the Sun Setting on China’s Solar Power Industry?

Just two years ago, SuntechPower Holdings Ltd. wasan emblemof China’s meteoric rise in the global economy. From humble beginnings in 2001 as a startup founded in Wuxi by entrepreneur Shi Zhengrong, Suntech became the world’s biggest solar panel player within eight years. It was the most successful of some 100 Chinese companies that jumped into solar panel manufacturing after the government deemed the sector a priority.

But now, Suntech and China’s solar industry have taken a dramatic tumble. Fueled by Chinese production, which quadrupled between 2009 and 2011, world polysilicon solar panel capacity skyrocketed and prices plunged, only to be hit by a contraction in demand from major buyers in Europe in the wake of the global recession. Unable to pay back its debt, Suntech defaulted on a convertible bond in March; Wuxi Suntech, its primary unit, filed for bankruptcy, and the board ousted Shi as CEO and chairman. Meanwhile, the rest of the Chinese solar panel sector likewise is reeling, dogged by too much capacity, too little demand and punitive trade tariffs imposed by the U.S., perhaps soon to be followed by ones levied by the European Union.

China’s solar sector follows the pattern set by many of the country’s target industries, including steel and aluminum, historically. “This is just the latest example of a long list of industries that have run through those peaks and valleys,” says Louis Schwartz, president, China Strategies LLC, a Pittsburgh, Pa.-based China trade and investment consulting firm. “It starts with government incentives. In an incredibly short period, [the industry] develops enormous capacity, helped in large measure by the banking system, and the desire of towns, villages or provinces to foster a new industry for employment purposes. Once they get started, they have a hard time stopping.”

Wharton management professor Marshall Meyer, who is studying the phenomenon, underscores the role of local governments: “In China, you see not just growth-driven investment, but local government growth-driven investment, which creates redundancy and overcapacity,” he says. “At the end of the day, it’s a race to the bottom, because no one can make enough money to pay the cost of capital, much less retain earnings and create more capital. The question is how to get sustainable markets, not only in China, but globally, with this dynamic.” 

Time for a Change

Andrew Batson, research director at GK Dragonomics in Beijing,    says that despite the hand-wringing, excess capacity is plaguing primarily priority sectors targeted by the government. Overall industrial profit margins in China are about where they have been over the last 10 years, he notes. Nevertheless, “a weak economy gives the issue of excess capacity more urgency than in the boom years.” 

Indeed, in the past, healthy domestic and global demand could absorb much of China’s overcapacity. In its high-growth days, “China built ahead of itself, so that what looks like overcapacity today, in two years, looks like under capacity,” says Alistair Thornton, a Beijing-based senior China economist at IHS, a global business information and analytics firm. But with the domestic and global economic slowdown, that picture has changed, and China’s stimulus spending post-global financial crisis only exacerbates the situation. “The credit expansion at the end of 2008 fueled capacity building, and much of that capacity came on stream just as the domestic economy began to calm down to a lower growth path,” says Pieter Bottelier, senior adjunct professor of China Studies at the Johns Hopkins School of Advanced International Studies(SAIS) in Washington, D.C.“ The next 12 or 24 months will be very painful in many industries.” 

As China’s economy slows to an annual 7% to 7.5% growth rate from a 10% annual average over the last decade, it has to learn to rely more on smarts than on brute-force, credit-driven investment, say experts. The benefit of investment-focused industrial policy has been fast growth. In a short period of time, “you create an industry that employs a lot of people and gain technical and manufacturing expertise,” says Schwartz of China Strategies. “The negatives are wastefulness in the application of capital. That gets into a much larger issue about the extent to which China can make the transition to being a more innovative than imitative economy.”

Thorntonagrees: “This is the story of the next decade — how to create a more sustainable foundation for the next 30 years of growth,” he says. “The big question yet to be resolved in China is the role that the state plays in the economy. The credit allocation ability of central and local authorities is worse than the market, and you become increasingly inefficient. Growth has to suffer as consequence.” 

While the new administration of Chinese President Xi Jinping was quiet on questions of economic reform in its first three months, on May 24, China’s State Council announced a significant shift in direction with a slate of new market-oriented policies, including the introduction of a value-added tax, liberalization of bank interest rates, promotion of private capital, and continued reform of state-owned enterprises. 

But following a more market-oriented course may be more easily said than done. Though the central government may know consolidation is necessary, for instance, letting firms fail is difficult. “From an economic and political standpoint, [China] wants stability,” says Thornton. “The moment you let some of these companies go under, you just don’t know when the chain of interactions is going to end.”Add to that the tendency of local governments to protect their employment base, and the outlook for consolidation becomes more uncertain. “It’s a messy process with the intersection of so many interests inside China,” says Shyam Mehta, senior analyst in solar markets at GTM Research, a Boston-based clean energy market research firm. 

Experts debate the extent to which local governments will continue to rescue local champions. Certainly, local forces can be strong. “There are 120 central government state-owned enterprises, and thousands of local government state-owned enterprises, which are also recipients of favoritism,” notes Wharton’s Meyer. Yet, many local governments are constrained fiscally, and Beijing may not allow them to overextend themselves, notes Bottelier of SAIS. Indeed, the Chinese presshas reported many senior Chinese officials have said the government is not envisioning any more stimulus measures to counteract slowing growth this time. 

Domestic Demand to the Rescue?

In the Chinese solar panel industry, consolidation is inevitable, but how that process unfolds is uncertain, says Mehta. Unlike many Chinese sectors experiencing excess capacity, the solar panel industry made products primarily for export, not domestic use. Chinese overproduction has had a marked impact on the world market, and the global solar market is watching with interest whether and how the Chinese oversupply resolves itself, he notes.

Now that European subsidies for solar energy are ending, and demand from that primary market is drying up, China is ramping upits own demand.It is incentivizing utility-scale solar plants in theWest, building electrical transmission linesfrom Xinjiangto the East and Southwest, respectively, and encouraging rooftop installations in the East, according to Matthew Feinstein, a solar industry analyst at Lux Research, a Boston-based market research firm. But domestic demand still falls far short of manufacturing capacity, says GTM’s Mehta. With “razor-thin profit margins,”these projects “help keep companies afloat, but they are not a driver for prosperity,” he notes. Meanwhile, says Mehta, leading companies, such as Trina Solar Ltd., Jinko Solar Holdings Co., and Renesola Ltd., are doing what they can survive by moving downstream from low-margin module manufacturing into higher-margin solar systems and project development.

As companies fight for survival, the central government has signalled support for consolidation. The China Development Bank, the major lender for the sector, has reportedly pledged to support a dozen solar companies, including Trina, Yingli Green Energy Holding sand Shanghai Chaori Solar Energy Science & Technology Co., indicating it is “picking winners,” says Mehta. In addition, central authorities plan to issue industry standards to sift out the strongest players and to ensure higher-quality exports, notes Lux Research analyst Feinstein. In theory, only the largest and strongest will survive. Winners could include Yingli, Trina, Jinko, Renesola, and JA Solar Holdings Co. Ltd., predicts Mehta.

But at the same time, local governments are counteracting those moves. Wuxi city, which played a significant role in Suntech’s founding and development, for example, is taking over part of that company. Xinyu City, Jiangxi, which has repeatedly extended financial support to local company LDK Solar Co., Ltd., backs Heng Rui Xin Energy, which bought a 20% stake in the struggling solar outfit. Similarly, a company controlled by Donying in Shangdong purchased 50.38% of local CNPV Solar Power SA. “As more Chinese companies get near insolvency, you’ll see more local governments bail them out,” says Mehta. “How central lenders and authorities will interact with city and provincial governments is quite unclear.”

Turbine Makers: Blowing in the Wind 

Though the solar panel industry is the most extreme example of industrial overcapacity in China, other high priority sectors are likewise contending with the issue. Over the last decade, China’s promotion of wind turbine manufacturing, for example, attracted more than 100 companies to the industry. China’s Goldwind is now the world’s largest producer. Last year, China installed a third of the wind turbines in the world, and wind energy, accounting for more than 5% of the country’s generating capacity, comes in third after coal and hydro as the country’s top power source. “China successfully created a domestic wind power industry in a relatively short time,” says Joanna Lewis, assistant professor of science, technology and international affairs at Georgetown University in Washington, D.C., and author of the recent book Green Innovation in China: China’s Wind Power Industry and the Global Transition to a Low-Carbon Economy. 

Because wind power was less expensive than solar, Chinese planners intended wind turbines for domestic use, unlike solar panels envisioned for export. Thus, China has more control over demand for its wind turbines. But the uptake of wind power has been dogged by challenges connecting it to the grid. 

Now, the glut of turbine makers is driving smaller ones out of business, even as larger ones, such as Goldwind and Sinovel, saw profits drop last year, says China Strategies’ Schwartz. To encourage industry consolidation, the government is putting in place technology certification and testing requirements, notes Georgetown’s Lewis. “A top-down consolidation process doesn’t always end up choosing most innovative technology producers,” she says. But this process “can make some room for small manufacturers with good technology.” 

Revving up the Wrong Auto Companies?

Meanwhile, in autos, overcapacity of a different sort — in the form of industry fragmentation — coupled with local protectionism is hobbling the sector’s ability to innovate, says Seung-Youn Oh,a postdoctoral research fellowat the Center for the Study of Contemporary China at the University of Pennsylvania. With overall vehicle ownership rates still low in China, the market potential justifies robust production. Yet, the excessive number of automaker skeeps them from becoming world-class producers, contends Oh. 

The sector’s fragmentation stems historically from Mao’s mandate to local governments to develop their own auto plants in the spirit of self-reliance, says Oh. As a consequence, China’s auto assembly plants suffer from a lack of economies of scale. Korea, Japan and the U.S. have only a handful of auto assemblers, compared to about 120 in China, many owned by sub-national governments, Oh adds. 

To encourage consolidation, in the early 1980s, the central government invited foreign investors as joint venture partners with Chinese state-owned enterprises (SOEs)to create entities such as Shanghai GM and Beijing Hyundai. The hope: Big SOEs, allied with foreign auto makers, would acquire smaller companies. But closing auto factories is a challenge in any country, and consolidation efforts failed, says Oh. Meanwhile, content with profits from their joint ventures, the SOEs had little incentive to produce innovative models, while their foreign partners were reluctant to transfer technology, she says. By the late 1990s and early 2000s, independent auto companies, such as Chery Automobile Co., Ltd. and Great Wall Motor Company, Ltd., caught the industry by surprise when they introduced their own models. 

Even as the Chinese central government adopts policies to support the independent automakers, local protectionism continues to sustain SOE joint ventures, says Oh. The post-financial crisis stimulus package, for example, included reduced taxes for consumers to purchase new, smaller vehicles, such as those produced by the independents, and in 2012, government procurement rules required the purchase of smaller-engine cars, effectively excluding joint venture models, Oh notes. But foreign joint venture partners, such as GM and Hyundai, have become adept at teaming up with their local government champions to keep their operations going strong.

The Way Forward

If China is able to bite the bullet and allow more market discipline to determine winners and losers in industry, Chinese companies must raise their game, say experts. “The ones that adjust quickest live; the ones that don’t die,” says Derek Scissors, research fellow in the Asian Studies Center at the Heritage Foundation, a Washington, D.C. think tank. The alternative: “If your success depends on local government commitment, not your business strategy, you’re not going to get the better company, but the better-connected company,” he says.

Indeed, says Wharton’s Meyer, Chinese companies have to learn better to compete on management acumen, efficiency and technology. “You can put in place a very tough management system, and tell people you won’t survive in this company unless you personally are growing profit,” he says. “You have to be smarter, quicker, deliver a better product and find margin doing that.” 

Says Michael Tomczyk, Managing Director of the Wharton School’s Mack Center for Technological Innovation: “The big lesson from solar experience is that [companies] need to be very flexible and sensitive to shifts in the marketplace, which requires constant and detailed analysis of market size, trends, competitive factors and the risk of tariffs and trade wars. This is critical, because the lives of thousands of workers are going to be affected by these kinds of changes in any industry.”   

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