China's overcapacity problem in several industries including iron and steel, aluminum, and cement may have several roots. This has appeared due to a stage in its development; the Chinese economy has reached a moderate growth period after its high speed growth era, and supply has surpassed demand. Another source that causes overcapacity is institutional defect. A type of iron and steel companies have found it difficult to exit due to subsidies from the government, and can only maintain their production by running operational deficits and engaging in exporting.
This paper tested the causality between subsidy/non-operational revenue and operation profits, and quantified "overproduction of iron" by the groups that are operating in deficit. Difference-in-differences estimation finds that (1) state-owned enterprises (SOEs) which recorded operational deficits will receive a larger non-operational revenue in the next period, and (2) these SOEs, which received non-operational revenue larger than their operational profits, ended up with an overall profit, but maintained their operational deficits into the following year.
The result implies that subsidies soften the budget constraint of certain iron and steel SOEs. This conduct might cause a vicious cycle of competition with deficit to occur.