HANCHENG, China (Reuters) - In a ramshackle township in northwest China's Shaanxi province, red Communist Party banners call on a nearby steel mill's workers to seek "progress" and avoid making "backward steps".
The slogans demonstrate the hybrid nature of China's floundering steel sector, which as it tries to serve the twin masters of the state and the market has seen margins plummet and racked up a mountain of debt.
Beijing's attempts to tackle the problems by forcing lumbering state-owned mills to consolidate or push up the value chain look likely to aggravate rather than solve the problems of a sector that accounts for 3-4 percent of China's GDP.
An obvious solution - to allow the worst performers to go out of business - seems unlikely in an industry identified by Chairman Mao Zedong nearly half a decade ago as a key symbol of the country's economic and political prowess.
"The big state-owned steel mills are motivated not so much to seek profits but to seek government support," said Jiang Feitao, a steel policy researcher at the China Academy of Social Sciences.
"There is actually no mechanism to put them out of business, no sense of the survival of the fittest, and that is probably the biggest problem facing the sector."
China's steel mills have expanded ferociously since market reforms began in 1978 and have already passed Mao's once unthinkable 1958 ambition to bring output close to 771.6 million metric tonnes (700 million tons) a year. China now produces 45 percent of the world's steel and hosts six of the world's ten biggest producers.
But an obsession with size and technological advance has saddled them with a profit-sapping surfeit of high-end capacity and $400 billion in debt.
China's annual crude steel output rose 9 percent to a record 683 million tons last year and most acknowledge that while growth could slow, demand is still nowhere near its peak.
At the Shaanxi plant - a 7-million ton joint venture set up by state-owned Longman Iron and Steel Group and U.S.-listed General Steel GSI.N - there is little sign of slowdown.
"Demand has never been the problem," said Zhang Jia, a sales manager at the mill. "The problem has always been costs."
While still robust, China's total consumption growth of 8 percent to 650 million tons last year was nearly halved from 15 percent average annual growth of the previous decade.
Excess capacity is seen at 110 million tons this year, around 14 percent of the total. This will mean margins, an already thin 3 percent in 2011 and only half of the 6 percent average for other industrial sectors, will continue to be squeezed.
Overall the sector made a loss in the first quarter of 2012, according to the China Iron and Steel Association (CISA), which expects demand growth to slow to just 4 percent this year.
"The money earned by steel mills from the steel business every year isn't even as much as depositing money in the bank," said Zhou Jicai, head of the state-owned Jiyuan Iron and Steel in central China's Henan province.
Last year, a standard deposit in a Chinese bank would have earned 3.5 percent in interest. Average returns on equity from the steel sector were 3.51 percent, but were as low as negative 7.98 percent at Anshan Steel.
Encouraging the giants to move up the value chain to compete with foreign rivals has also created a glut in supplies of high-end products that has eroded profits further.
The big producers have borrowed heavily to pay for new equipment. In contrast, small privately-owned mills have commandeered multitudes of ramshackle smelters across the country to fill the low-end niche.
Attempts to bring 60 percent of total capacity under the control of the top 10 mills also served to strengthen the hand of the minnows, with a crackdown on small suppliers creating a shortage of low-end material and more profits for the survivors.
Data for small mills are hard to find, but analysts estimate their profits are healthy. Last year, rebar was selling at the same price as hot-rolled coil, which is far costlier to produce.
While Beijing has blamed the private sector for "blindly expanding", they are partly doing so because of government policy.
Analysts say the focus on consolidation has created a vicious circle in which the smaller private mills expand as rapidly as possible in order to avoid becoming a merger target, often with the support of local governments.
A case in point was Rizhao Steel in Shandong province, which embarked on an expansion drive that saw capacity rise more than tenfold to over 12 million tons from 2003 to 2010, mainly to protect itself against a government-led consolidation plan.
China's big mills have been urged to buy overseas mining projects to bring down costs of their raw materials, but they have been reluctant because prices are high. Some are also looking to build steel plants in emerging markets.
But mills admit that foreign opportunities are limited.
"Chinese steelmakers face much higher investment and operation costs such as the environment, employees, and infrastructure, so there won't be a massive foreign expansion drive," said a mill source who has studied emerging regions.
Exports, a small fraction of total business, have not recovered to pre-2008 levels, with CISA routinely lamenting the rise in protectionism that has seen the United States, Brazil and Europe slap anti-dumping taxes on Chinese products.
The domestic market will remain the major focus, especially in underdeveloped regions.
"China is still in the middle of a construction period and demand for steel will at least remain strong," said Henry Yu, the founder and chairman of General Steel.
Yu said the company is confident about growing demand from China's west, which needs new roads and factories.
Only one major enterprise - the Baosteel-owned Bayi Iron and Steel - covers Xinjiang, a region in the far northwest of the country the size of Iran. Baosteel plans to move two advanced but loss-making ironmaking furnaces to Xinjiang and aims to double Bayi's capacity to 15 million tonnes by 2015.
Also in Xinjiang, Shandong Iron & Steel (600022.SS) has nearly completed a 2.5-million-tonne steel project and Xinxing Ductile Iron Pipes (000778.SZ) will build a special steel plant with 3 million tonnes of annual capacity.
Consultancy Mysteel said 91 billion yuan ($14.42 billion)will be spent in Xinjiang over 2011-2015 to boost annual steel capacity to 32 million tonnes, but demand from China's west may not prop up the sector for very long.
"The supply tightness is expected to ease by 2013 and the region could also face a glut given the current investment frenzy," said Hu Yanping, analyst with the Custeel consultancy.
"It will also be hard to ship out the surplus steel products due to limited transportation capacity," she added.
Despite the losses, bankruptcies will not be widespread, with neither Beijing nor local governments willing to risk such a blow to their prestige, employment levels and tax receipts.
Small, regional state-owned firms like Jiyuan Steel and Valin could be vulnerable to takeovers, but debt-ridden industry giants are not likely to volunteer for more punishing restructuring programs. Angang's protracted merger with Benxi Iron and Steel is still mired in red tape five years after it was first proposed.
Experts say problems will not be solved until Beijing ends its obsession with creating huge and inflexible state-owned Goliaths and instead addresses the underlying politics of the sector.
Nourished by cheap loans and granted easy access to key contracts, steel giants have served as arms of the local government, hiring hundreds of thousands of workers and providing cradle-to-grave welfare services.
Jiang of the China Academy of Social Sciences said mills could still thrive if they are allowed to do so.
"The steel sector could develop very steadily as long as there is no great policy interference, but there has been a lot of policy interference."
($1 = 6.3102 Chinese yuan)
Additional reporting by Hyunjoo Jin in Seoul; Editing by Jason Subler and Michael Urquhart