UPDATE 1-China to reject Japan deal for 33 pct iron ore cut

(Refiles to fix typo in paragraph 17)

* China's CISA poised to reject 33 pct iron ore price cut

* Mills seeking 40 pct or more, statement may come later Weds

* Analysts divided: does benchmark system bend or break? (Adds detail, background)

By Alfred Cang and Tom Miles

SHANGHAI, May 27 (Reuters) - Chinese steelmakers, led by national champion Baosteel, will reject a 33 percent cut in iron ore prices agreed by mining company Rio Tinto (RIO.AX)(RIO.L) and Nippon Steel (5401.T), an industry source said on Wednesday.

The China Iron and Steel Association (CISA), the industry group that represents the country's major steel mills, will soon issue a statement on the rejection, the source said. The rejection is widely expected as Chinese mills have stood firm on demands for a 40 percent or more price cut, reversing last year's doubling in rates that came just before a collapse in demand.

"In the statement, China will refuse to follow the same price terms and will say it plans to continue negotiating," the source said, adding that the statement may be released on Wednesday.

China is rushing to circle the wagons after Rio Tinto (RIO.AX) (RIO.L) said on Tuesday it had agreed to cut key iron ore prices to Japanese steelmakers by one-third in this year's first contract. [ID:nSP498033]

South Korea's POSCO (005490.KS) will accept the same deal, sources said on Wednesday, following its Japanese peers as is the usual practice but undercutting Chinese steelmakers who are looking for allies to hold out for cheaper rates. [ID:nSEO273431]

Chinese executives had thought there was an understanding that the Asian mills would maintain a united front, sources said, so the Rio price deal caught them off guard and CISA convened an emergency meeting on Tuesday to discuss their next move.

"Now we have to see whether the Chinese Iron & Steel Association can hold the fort or not," said a senior official at a mid-sized state steelmaker.

In the past, Chinese steelmakers usually followed Japanese companies' first contract prices. The current situation has pushed Chinese steel makers into a very passive corner. The chances of a 40 percent cut seem very slight."

ALARM AND DISARRAY

Despite Chinese mills' initial alarm and the growing list of rivals who have conceded to Rio's price, analysts expect them to continue seeking an even bigger cut because they are not under great pressure, since China is awash with iron ore stockpiles after importing record amounts of ore for three months running.

Despite a sharp drop in high-cost domestic ore production, Chinese mills can buy on the spot market for less than the prices agreed by Rio Tinto, whereas the Japanese mills were keen to fix prices due to the nature of their steel price contracts.

One Chinese steel executive said the Chinese mill that was most keen on benchmark pricing was national champion Baosteel (600019.SS), which this year has yielded to CISA its traditional role of leading the talks with miners Rio, its Anglo-Australian rival BHP Billiton (BHP.AX) and Vale (VALE5.SA) of Brazil.

Analysts agreed that many other mills in China were open-minded about pricing.

"Among the larger mills, you'd be surprised about how progressive they are in terms of their attitude towards flexible pricing approaches," said Graeme Train of Steel Business Briefing. "It's certainly a possibility that they might abandon the benchmark."

BREAKDOWN OR COMPROMISE

China's insistence on a big cut has thrown the annual pricing negotiations into disarray, with widespread speculation that the system could break down and give the spot market a bigger role.

China has by far the world's biggest steel sector and consumes more than half the world's freely traded iron ore, so even if Asian mills stick to the traditional benchmark, its absence could seriously weaken the system. [ID:nSP279084]

The cloudy outlook for China's economy has worsened the deadlock with iron ore mines, since both sides can call on data which shows either a massive oversupply of iron ore or a healthy market which is recovering well from a dip a few months ago.

"There is actually nothing wrong with Chinese steel mills not signing long-term contracts this year," said Zhang Changan, consultant with World Steel Dynamics in Beijing, who expects China to hold to its original demands.

"For this year and next, supply of iron ore will outstrip demand and nothing bad will happen if the Chinese side doesn't sign anything," he said. "Even if the miners agree a 50 percent cut I think the spot market price will still be lower this year."

But Macquarie analyst Jim Lennon sounded a note of caution, saying China's growing reliance on imports could leave its mills struggling to compete for spot ore if demand picked up elsewhere.

"The Chinese buyers run the risk in this scenario of losing tonnage and also ending up paying a higher price," Lennon said in a note to clients.

"They will also have to gamble that Vale and other suppliers will ramp up production to meet incremental demand growth. For these reasons, we think the Chinese steel mills will eventually settle at the new prices for some of their tonnage." (Reporting by Alfred Cang and Edmund Klamann; Editing by Jonathan Leff)