CHINA METALS-Steel industry seen more merger friendly

BEIJING Dec 6 (Reuters) - Beijing could sweeten incentives for local governments to support mergers in China's fragmented steel industry on fears that BHP Billiton's bid for Rio Tinto will leave it less bargaining power over raw materials supplies.

China has made little progress constraining investment in steel as booming demand underpinned profits. Indeed, many mills have expanded further, aggravating the country's pollution woes and exacerbating the tight competition for resources such as iron ore.

"The possible merger of BHP and Rio Tinto have pressured domestic steel mills to consolidate in order to have more say in iron ore price talks," said Feng Fei, a researcher with the Development Research Center of the State Council.

China, the world's largest iron ore importer, is worried that BHP Billiton Ltd (BHP.AX)(BLT.L) will have too much power in deciding iron ore prices if it acquires Rio Tinto Ltd/Plc (RIO.L)(RIO.AX) in its $125 billion hostile bid.

China relies on the two Australian companies for about 40 percent of its imported iron ore and negotations for the new contractual year are just getting under way.

Chinese steel mills are studying countermeasures to deal with the possible merger. Priorities will be to establish a state iron ore reserve and to consolidate to make its mills competitive.

"To consolidate the industry is one of our priorities next year," Luo Bingsheng, general secretary of the China Iron & Steel Association, told a conference over the weekend.

"We need to establish steel giants which can compete against AcerlorMittal in the international market."

China cannot produce enough raw material to feed its steel mills, and has to import about half of what it needs each year.

CONSOLIDATION PUSH

The association is urging the central government to provide financial support also to get the big steel mills, such as Baosteel Group, Wuhan Iron and Steel Co. (600005.SS), to take over small and medium-sized rivals.

The push for consolidation is in line with Beijing's policy to promote a economy that is less destructive to the environment by eliminating smaller, polluting and energy-intensive plants. Local governments often fear takeovers will result in their plants being shut.

The subsidies would make up for local governments' lost tax revenues and help them cope with job losses that may arise from the restructuring.

CISA's call also follows an announcement by AcerlorMittal, the world's largest steel maker, that it would raise its stake in China Oriental Group (0581.HK) to 73 percent from 28 percent.

If successful, it would become the first foreigner to control a domestic steelmaker.

Despite rules in China forbidding foreigners from taking control of major steel makers, analysts doubted Beijing could prevent the takeover of a private steel mill.

"Excess influence of foreign companies over the domestic market via joint ventures, cooperatives and takeovers, poses a great threat to China's steel industry," said Zhao Kun, deputy general manager with Baosteel Group.

Arcelor's plan to take a controlling stake in state-owned Laiwu Iron and Steel Co 600102.SS has been put on hold by Beijing. It already owns a substantial minority stake in Hunan Valin Steel Tube and Wire Co Ltd 000932.SZ.

The share in production by 10 top steel mills accounted for 35 percent of China's total crude steel output of about 420 million tonnes in 2006, compared with 46 percent in 2001.

This is a far cry from Beijing's plan to to have its top 10 mills account for half of the steel output by 2010 and more than 70 percent by the year 2020.

According to CISA's data, China still contains a staggering 487 crude steel mills, 985 pig iron makers and 2,476 steel products manufacturers.

"The plan for consolidation could be an empty call. The industry has been very profitable," said Ma Haitian at state-owned metals consultancy Antaike.

"When you are poor, you will think of changes, but that is not the case for steel mills," said Ma, citing a Chinese proverb.

But industry analysts said rising costs of raw materials, particularly iron ore and coking coal, enforcement of stricter environmental standards and lower profits on exports might be more effective in accelerating the long-awaited changes.

Beijing could raise taxes on steel exports again next year to shrink profits of rapidly expanding mills, government officials said at the weekend conference in Shanghai. (Additional reporting by Alfred Cang in Shanghai, editing by Lucy Hornby)