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(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, March 7 (Reuters) - No sector of the Chinese economy better mirrors the policy dilemmas facing the country's rulers than steel.
A growth model based on infrastructure spend and property boom has created a bloated leviathan, burdened by massive overcapacity, razor-thin profit margins, even for the best performing operators, and a mountain of bad debt.
The steel sector is also one of the single biggest contributors to the thick smog that now regularly envelops Beijing and other Chinese cities.
It therefore represents a prime battleground both in Beijing's new "war on pollution" and the long-running war on "blind" investment.
While other markets pore over the implications of premier Li Keqiang's "State of the Union" address to the National People's Congress, steel has already reacted.
The price of rebar futures <0#SRB:> traded on the Shanghai Metals Exchange touched a contract low earlier on Friday. So too did the price of iron ore on the Dalian Exchange <0#DCIO:> in what is a well-practiced two-step between the price of the steel sector's key input and one of its key outputs.
There is, however, a contradiction here and one that cuts to the heart of the balancing act that is Chinese industrial policy.
At one level the steel market's weakness is completely logical.
When Beijing says it is targeting fixed asset investment growth of 17.5 percent this year, the slowest rate in 12 years, it cuts to the very heart of what has been the core driver of China's steel expansion story.
Witness the collective gloom among the country's top steel producers, who have very publicly started to talk about "peak" production in the world's largest producer and consumer of the metal.
"You can basically say that Chinese steel output has reached a peak," said Zhang Wuzong, delegate at the National People's Congress (NPC) and chairman of private steelmaker Shandong Shiheng Special Steel.
Which is a bit melodramatic.
The official forecast is for the country's steel production still to grow this year, albeit at a slower rate of around 3 percent compared with 7.5 percent in 2013.
But even industry body CISA is now starting to warn that national output will peak around 850 million tonnes.
Given that output last year was 779 million tonnes and likely to rise to around 810 million tonnes this year, based on that 3 percent forecast, that doesn't leave a lot of upside room.
It also represents a challenge to the accepted wisdom outside China, namely that the country's steel demand is a long, long way from peaking any time soon.
This domestic gloom about slowing growth is inextricably intertwined with the problem of overcapacity.
The country is estimated to have some 300 million tonnes of surplus capacity, almost twice the output of the European Union last year.
Even that figure may be an underestimate. No-one knows for sure. But it is big, "probably beyond our imagination", to quote Li Xinchuang, Executive Vice Secretary-General of CISA.
Which is why Beijing's new "war on pollution" should be a good thing, both for steel-producing margins and prices.
Zhang Qingwei, governor of Hebei province, home to 250 million tonnes of Chinese steel capacity and seven of the 10 most polluted cities in China, has threatened to sack any official responsible for even a tonne of extra steel capacity this year.
Hebei has agreed to cut production capacity by 15 million tonnes this year and by 86 million tonnes by 2020 in what represents a tangible ratcheting-up of the official pressure for the industry to be culled.
The war will only intensify after Li Kequiang's warning that the smog in Beijing is "nature's red-light warning against inefficient and blind development".
So, as Beijing finally takes the gloves off in dealing with the legacy of past excess, why are local steel executives still so gloom-laden and why is the price still steadily grinding out fresh all-time lows?
Because they know that Beijing is still chasing shadows, or more precisely, chasing zombies.
These are the mills that have already been shuttered due to heavy losses but which remain nominally active to avoid defaulting on loans.
Hebei province is full of them and they are easy targets for local officials eager to show they are doing their part in the "war on pollution".
But "they are only closing steel mills that are already dead," according to Xu Zhongbu, chief of Beijing Metal Consulting and a veteran industry advisor who works with steel firms in Hebei.
Too many living mills are still producing too much steel and too many outside of targeted provinces such as Hebei are still bringing on new capacity. Some 69 million tonnes of it last year alone, according to consultancy CUSteel.
In other words, despite all the tough-sounding rhetoric, the wars against pollution and blind investment have only just started and the measures enacted so far are merely removing production capacity that is already economically obsolete.
Beijing's dilemma is that to do more now risks causing a disorderly collapse of what is one of the pillars of the Chinese economy, albeit one that is already crumbling at the edges.
That brings with it the dual dangers of mass lay-offs, a complete no-no given the prime importance of job creation, and a potential debt crisis, as banks would have to take the writedowns.
Moreover, the only viable policy tool to prevent general economic slowdown becoming something worse is to pump up the infrastructure spend again, reigniting the original cause of the steel sector's problems.
About an hour into Li's address to Congress, as the Financial Times noted, was the promise that "we will take investment as the key to maintaining stable economic growth."
Such are the contradictions at the heart of Chinese industrial policy.
What they mean is that there is going to be no quick fix for sectors such as steel, just a long, protracted war of attrition with producers continuing to live on the knife-edge of profitability.
Nor is there going to be much relief for residents of cities like Beijing. The smog is not going to disperse any time soon.
The only good news is for the world's iron ore producers. Chinese steel production is not going to peak this year. And it's probably not going to peak next year either. Or the year after that.
The real danger for China's steel production is not government policy but the intrinsic instability of a sector that has been allowed to grow too big too fast. (Editing by David Evans)