Backdoor financing deals and debt disputes in China's steel industry are challenging the government's plans to fight pollution and promote sustainable growth.
In September, China's government pledged to cut excess steel production capacity as part of a five-year anti-smog plan, attacking a major source of emissions in the industrial northeast.
Under the plan, steelmakers were ordered to close 80 million metric tons of production capacity by 2017 with the bulk of the shutdowns in the manufacturing heartland of northern Hebei province.
But producers have responded by opening new plants and pursuing dodgy financing schemes to keep older operations afloat, according to industry reports.
In late February, a top official of the China Iron and Steel Association (CISA) called the capacity problem "beyond imagination," the website of Beijing-based Caijing Magazine reported.
Li Xinchuang, CISA executive vice-secretary general, estimated China's surplus steel capacity at 300 million tons, nearly double the amount of European output in 2013.
CISA estimates that production this year will outpace demand by 95 million tons, despite slumping prices, a sluggish economy, and overcapacity problems that have dragged on for years.
On April 28, CISA said the industry's first-quarter losses reached 2.33 billion yuan (U.S. $372 million), compared with earnings of nearly 8 billion yuan (U.S. $1.27 billion) in the year-earlier period, the official Xinhua news agency reported.
Despite an 11-percent drop in prices, crude steel output rose 5.6 percent, the National Bureau of Statistics (NBS) said.
But Hebei is still increasing capacity twice as fast as it is closing older inefficient mills, an industry official told The Wall Street Journal.
The province is adding about 30 million tons of capacity a year while it is supposed to be cutting 15 million tons annually, said Wang Jiguang, marketing director of Hebei Iron and Steel Sales Corp.
Most of the announced reductions are at outmoded lines that are already idled, Wang said.
Last week, the Ministry of Industry and Information Technology (MIIT) posted a statement on its website, reminding local officials that excess capacity must be shut down. MIIT boosted this year's reduction target from 27 million to 28.7 million tons.
The resistance to the government's plan reflects the persistence of development interests and local pressure to protect business and jobs, despite consequences for the industry as a whole.
"With the industry in such a state, how can new capacity still be built?" asked CISA vice-chairman Zhang Changfu, as cited by the Financial Times.
Peter Ogden, director of international energy and climate policy at the Center for American Progress in Washington, said the industry resistance may raise doubts about enforcement of the anti-smog plan.
"That was always going to be the inherent challenge here," said Ogden in an interview.
"I don't know whether it's a case of being a relatively new policy or whether they're facing an unexpected degree of noncompliance and they're going to have to ramp up their efforts," Ogden said.
Last year, China produced 779 million tons of crude steel, accounting for 48.5 percent of global output, the World Steel Association said. CISA's comments suggest that China's capacity now exceeds 1 billion tons.
Aside from effects on the industry and the environment, there are concerns for the impact on the economy and the financial system.
The steel industry's predicament has spawned a series of problems for China's banks, regulatory agencies, and courts.
As the government has clamped down on bank lending, indebted steelmakers have turned to riskier financing to stave off shutdowns.
On April 18, the China Banking Regulatory Commission (CBRC) ordered local officials and banks to investigate financing schemes that use iron ore imports as collateral for new credits, Reuters reported.
"Local offices must step up measures to manage risks arising from commodities trade financing and to assess the risks presented by iron ore financing," said the agency, warning that the practice could lead to defaults.
Some companies have been using letters of credit for iron ore imports as a funding source, allowing them to bypass loan restrictions and speculate in higher-paying investments on the "shadow banking" market.
"Because of the difficulty getting funding, steel mills need to think of all types of methods including letters of credit," another CISA official told the Financial Times. "We do not think this is against any regulations. They need to do what they need to do."
But the practice, combined with China growth slowdown, led to a record buildup of nearly 109.5 million tons of iron ore at China's ports. When news of the CBRC probe broke on April 28, iron ore prices plunged nearly 5 percent.
The prospect of sudden selloffs and a crackdown on credit have raised concerns about a new wave of defaults.
Last month, 10 major Chinese banks filed a class action suit against steel traders over loan disputes, according to wantchinatimes.com, citing China Business News.
Slumping prices have swamped the Shanghai Pudong Area People's Court with some 3,700 lawsuits involving 23 billion yuan (U.S. $3.6 billion) worth of steel trades, the website said.
The implications for banks, the industry, and investors may test the government's resolve to implement the anti-smog plan and expose bloated sectors to market forces.
"In setting those standards, I think they were well aware of what the costs would be, and they felt, at least at the national level, that whatever near-term costs were associated were worth the environmental payoff," said Ogden.
"But as is often the case, the challenge is going to be whether they can get compliance at the local level," he said. "It sounds like they're still trying to work that out."