UPDATE 3-Steel merger puts second Chinese firm in top 5

(Recasts, adds comment, background)

By Alfred Cang and Fang Yan

SHANGHAI, Dec 30 (Reuters) - Three Chinese steel mills agreed on Tuesday to merge into the country's biggest listed steelmaker, creating a second Chinese industry champion in the world's top five steel producers.

The three-way merger could bulk up China's bargaining power in negotiations with mining giants Vale (VALE5.SA), BHP Billiton (BHP.AX) and Rio Tinto (RIO.L), which normally set benchmark annual iron ore prices with Baosteel Group, the current leader of China's fragmented steel industry.

China's policymakers have long wanted to crunch the sprawling sector into a few big players, hoping to have 10 steelmakers account for half the country's production instead of 20.

The plan, which aims to improve efficiency and cut pollution as well as adding to China's bargaining power, has gained traction as the economic crisis forces once swaggering steelmakers to look for a way to survive the economic bloodbath.

The new firm will unify Tangshan Iron and Steel Co (000709.SZ), the listed unit of China's third-largest steel mill, with smaller rival Handan Iron and Steel Co (600001.SS) and ferroalloy producer Chengde Xinxin Vanadium and Titanium Co (600357.SS), with an aggregate market value of about $4 billion.

"The consolidation will definitely boost the efficiency of the merged entity," said CITIC Securities analyst Zhou Xizeng.

All three are based in the province of Hebei, which encircles Beijing and is home to one-fifth of China's steel production capacity, facts that prompted officials to crack down on the province's polluting heavy industry during the Olympic Games.

The three are all part of the state-owned Hebei Iron and Steel Group, and merging them would be a first step towards listing all of the group's major steel assets, Tangshan said.

BIGGER, QUICKER, BUT STRONGER?

The merger follows the creation of Shandong Iron and Steel Group in March from the state-owned parents of Laiwu Steel Corp (600102.SS) and Jinan Iron and Steel Co (600022.SS) and the formation of Anben Iron and Steel Group in northeastern Liaoning province three years ago.

Anben, half of which is owned by the central government, was only a partial merger, with no equity or cash changing hands and no pooling of steelmaking capacity. The Hebei case, as in Shandong, is likely to forge stronger bonds.

"Both cases in Hebei and Shandong were handled by the provincial governments, as all the mills involved in the cases are under local state asset management. Therefore, such consolidations move faster," said analyst Henry Liu at investment bank Macquarie in Shanghai.

The companies will merge via a share swap, which Zhou at CITIC Securities said would inhibit the parent firm from injecting assets into the mix, a common method for fostering a favoured company's growth and often a boon to its share price.