* China spot prices down 8 pct, futures continue their slide
* Shanghai rebar futures open interest doubles in Aug
* Strong output growth raises oversupply concerns
SEOUL, Aug 20 (Reuters) - As debate grows over the possible deflation, or not, of a China asset price bubble, the commodity right at the core of the world's third-largest economy has this week succumbed to its sharpest correction this year -- steel.
After a months-long rally to a 10-month high last week, the price of benchmark hot-rolled coil in China -- which makes half the world's steel -- plunged 7.6 percent to around 3,987.5 yuan a tonne this week, data from Metal Bulletin showed.
That in turn has dragged iron ore prices off their peaks as well, with Indian spot market exporters reporting virtually no deals this week, adding further complexity to price negotiations.
The question, of course, is why: Has the outlook for Chinese demand changed that dramatically? Has the risk of tighter policy from Beijing spooked speculators? Or was this simply a long overdue correction after a nearly 30 percent rally since late April that most analysts had said ran far ahead of fundamentals?
The answer may be a bit of everything.
Fundamentals, to be sure, are tenuous: amid the promise of a steadily improving demand outlook driven by China's nearly $600-billion infrastructure-focused stimulus plan, China's steel mills pushed production to record 50.68 million tonnes in July.
At 600 million tonnes on an annualised basis -- a 20 percent surge from last year's 500 million tonnes -- output appeared out of step with end-user demand which lagged far behind.
That heavy production had also pumped up demand for iron ore, the main ingredient, but that too now appears to have evaporated.
"The market is not good. Liquidity in China is bad. I have heard of iron ore deals being done at $105 a tonne" versus $110-$112 last week, said an iron ore trader in New Delhi.
"China is very speculative in nature. When they start buying, they keep on buying and suddenly they stop ... We could see it coming. We could see that the Chinese are not very aggressive."
But steel, like other industrial metals, has over the past month become an increasingly popular speculative play, with China's easy credit policy driving funds toward any liquid markets with a bright outlook.
Shanghai rebar futureslanguished with minimal trade after its March debut, but broke onto the main stage this month, with trading volume surging seven-fold from end-July and open interest nearly doubling in just over two weeks. Meanwhile, prices have collapsed 14 percent from their record high on Aug 4.
"Everybody was buying a lot in July and now people are realising that demand is getting better but steel prices are already far ahead of the fundamental demand recovery," said Julian Zhu, a Deutsche Bank analyst.
"So prices are falling and open interest is rising because people now have a lot of short positions."
The liquidity-driven futures market is increasingly dragging the more fundamental physical market with it -- as Shanghai surged, mills rushed to raise prices even during the dull summer season.
The sell-off has coincided with China's stock market's collapse of 20 percent in just two weeks, sparking worries that it may signal underlying economic weakness in China, and evidence of sharply reduced new bank lending in China could extend it.
"The liquidity-driven element of Chinese steel prices appears to have been reversed over the past week and we expect steel prices to continue to moderate in the face of very high rates of production," Macquarie analysts said in a note this week.
New loans in July sharply shrank to 355.9 billion yuan from 1.53 trillion in June, as banks reined in credit after a record surge in the first half, the central bank said. [ID:nBJB000646]
The threat of destocking by speculative investors or traders, uncertainty over end-user demand and continued full-steam production by mills all loom large over the market.
Even positive macro data -- such as the annual 11.6 percent rise in housing investment in the first seven months -- failed to counter widespread expectations of a pull-back that has just begun.
"Traders, who have restocked, feel that they do not need to make fresh purchases at current levels, especially as they expect prices to fall. This could lead to a further price correction," Goldman Sachs analyst Rajeev Das said.
"We still remain hopeful that 2010 demand will be strong and will cause a more sustainable recovery in steel prices then. In the interim, however, the end of restocking may cause prices to soften...hence, the cycle's recovery may be W-shaped." (Additional reporting by Ruchira Singh in MUMBAI, Alfred Cang in SHANGHAI; Editing by Jonathan Leff)
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