UPDATE 1-China iron ore falls more than 2 pct as physical appetite wanes

* Shanghai rebar also down more than 2 pct

* Chinese banks told to strictly control credit to steel firms

* China wants 23 northern cities put on red alert for smog (Recasts, adds comment, updates prices)

MANILA, Dec 16 (Reuters) - Chinese iron ore futures dropped more than 2 percent on Friday as steel prices lost ground in afternoon trading, with steel mills holding off on buying the raw material in the physical market after recent rapid gains.

But steel prices could bounce back as China sustains efforts to curb overcapacity in the sector by limiting credit and fighting pollution.

Iron ore on the Dalian Commodity Exchange closed down 2.4 percent at 591.50 yuan ($85) a tonne. It hit a nearly three-year high of 657 yuan on Monday.

“We’re just hearing on the physical side that buying appetite for iron ore has waned at the ports,” said Kelly Teoh, iron ore derivatives broker at Clarksons Platou Futures.

“I think the steel mills are just holding off on buying at the moment.”

The most-active rebar on the Shanghai Futures Exchange fell 2.2 percent to end at 3,293 yuan a tonne, after rising to 3,409 yuan in morning deals.

The construction steel product still gained about 1 percent for the week, having touched a 32-month peak on Monday.

China’s banking regulator said banks must strictly control credit to coal and steel firms that are violating capacity cuts, the latest in a series of regulations aimed at reducing loans to industries struggling with overcapacity.

Since November, China’s crackdown has focused on producers of low-quality steel that use induction furnaces which consume steel scrap as raw material.

“The total supply loss from induction furnaces may account for 5-6 percent of Chinese crude steel production, and this could create potential upside to steel prices into 2017 if implementation is comprehensive and sustained,” Goldman Sachs analysts said in a report.

China’s fight against smog has also forced mills to curb steel output. Environmental authorities have advised 23 northern cities to issue red alerts, the highest possible air pollution warning, on Friday evening, against the “worst” smog the country has experienced since autumn, state media said.

Both iron ore and steel prices “will remain resilient over 2017, following strong gains in 2016, as additional Chinese infrastructure spending will tighten the market,” according to BMI Research, a unit of Fitch Ratings.

That should support iron ore prices over the next six to nine months although BMI said it sees a “relapse later in 2017-2018 stemming from a slowdown of the country’s construction activity and the oversupplied seaborne iron ore market.”

Iron ore for delivery to China's Qingdao port .IO62-CNO=MB rose 2.9 percent to $81.50 a tonne on Thursday, according to Metal Bulletin. The spot benchmark was nearly flat so far this week after gaining 5 percent last week.

$1 = 6.9485 Chinese yuan Reporting by Manolo Serapio Jr.; Editing by Richard Pullin