Something is up with China’s steel production. It reached record levels in March, driving up expectations of rising coking coal and iron ore prices. As the FT and Reuters have reported, there are accounts of both thermal coal and iron ore shipments being deferred or even defaulted on, and prices of both commodities have fallen 12 per cent since the beginning of April. To an extent, China’s steel production growth has also slowed: April’s production only increased 1.9 per cent compared to a year earlier, versus March’s rate of 2.5 per cent compared to a year previous.

So why is China still producing steel at relatively high rates? There are a few theories. Wood Mackenzie says that even very thin margins are enough to keep privately-owned steel mills operating, while the state-owned operators had no incentives to stop production. The research house also says about 58 per cent of Chinese steel is typically used for construction.

Nomura’s China metals and minerals analysts Matthew Cross and Ivan Lee say there’s evidence that property sales and starts are a leading indicator for steel production. But what about those months of falling property prices in most major Chinese cities, which are supposedly the carefully-engineered result of policy to cool speculation? Well, it doesn’t seem to have sunk in, yet:

Cross and Lee (who are also the authors of the very interesting note we wrote about recently which rejects the popular China commodities demand growth narrative based on per capita consumption) believe that government stimulation of construction has contributed to the continuing steel output growth. But the excess inventories that are resulting — all those empty apartments we hear about — might be about to take a toll, they write:

Lead indicators from the property sector suggest that current levels of steel production have moved ahead of end-demand and may unwind in coming months Of particular concern to us is the continued deterioration in property sales and starts data exhibited in the April 2012 NBS data release, which has occurred in an environment of falling home prices, rising steel production and rapidly increasing property completions. We believe a “negative feedback loop” has now started where growing property inventories will put further downward pressure on house prices and reduce the incentive for re-investing in new construction projects, which could be very negative for China’s industrial commodity demand growth (ie, steel, copper and aluminium).

Some of this has only become apparent quite recently:

Commodity property sales are down 13.4% y-y for January-April and were down 23.2% m-m vs. March 2012. Starts which were up 5.1% y-y for January-February are now down 4.2% y-y January-April. The most concerning part of the data was the collapse in starts in the month of April, which were down 27% in m-m terms (vs. March 2012) and down 14.6% y-y from April 2011. Commodity property starts are now down 4.2% y-y for January-April, which is only the second time in the past 12 years that this data has been negative (the other time was January-September 2009).

But why, ask Cross and Lee, has real estate investment has remained so strong up until now, despite property prices falling? The reason might be that developers are willing to finish developments, but less keen to start on new ones:

We believe this is explained by the significant surge in completions. The obvious outlier when looking at falling sales and starts data is that real estate investment has held up very well, up 18.7% year to April 2012 vs. 2011. We believe the strength in real estate investment can be explained by the increase in completions, which are up 30.2% year to April 2012 vs. 2011 levels.

The above charts and data refer to commodity housing; which includes both private and low-income or “social” housing. There’s been hope in some quarters that the government’s expansion of its social housing programme in 2012 would be a big support for growth. For example, Jing Ulrich at JP Morgan wrote this a week ago:

The central and local government budgets approved during the National People’s Congress in March featured total social housing expenditure of RMB440 billion, with the central government targeting a 23% increase in expenditure. The China Land Surveying and Planning Institute recently disclosed that social housing accounted for 43.6% of residential land use in the first quarter of the year. With 7 million units slated to start construction in 2012, we expect social housing investment to play in important role in offsetting this year’s likely downtrend in private real estate investment growth.

However, that doesn’t seem to be happening either. Like overall housing, a lot of social housing projects are actually getting finished, but new starts are down and investment is thinning out quickly, as the chart below from ChinaScope Financial shows:

The high growth in newly started low-income housing last year will inevitably increase funding pressure this year. However, investment in low income housing in the first four months of 2012 is subdued.

Cross and Lee write that an outright collapse in China’s real estate markets is not a prerequisite for some nasty spillover effects on commodities markets and producers. It could be those rising inventories of unsold apartments alone that creates a problem:

A collapse in China’s real estate market is not needed for a fall in China’s industrial commodity demand The prospect of rising unsold property inventories is much more concerning for companies exposed to the capex cycle (eg, steel and mining) than it is for Chinese property developers. With a sound balance sheet a property developer can work through rising inventories; but their ability/desire to start new/complete existing construction projects if their unsold inventories are rising must come into question. In our view, for China’s steel demand to fall in 2012 a collapse in property construction is not needed, a scenario where property developers build slightly less than last year will suffice.

And how about these reports of new stimulus to help boost investment? That won’t help either, they argue: in fact it will make things worse:

With China macro data now so bad and likely to get worse in our view, the risk of a fiscal policy response from Beijing has increased substantially and cannot be ignored. While we believe Beijing is capable of providing sufficient stimulus to prevent a collapse in metal demand, we don’t think stimulus will be sufficient to create a material uplift in demand growth in y-y terms (something discussed in significant detail in our 19 April 2012 ANCHOR REPORT: China will continue to use a lot of metal, just not as much as the market expects).But we believe our view on the effectiveness of new stimulus remains at odds with the consensus that likely has higher expectations of eventual success.

The argument goes into reasons that will be familiar to many FT Alphaville readers:

We believe announcements of fiscal stimulus (if any) may be met with unrealistic expectations about the ability of this stimulus to create incremental demand growth for industrial metals. We would advise readers to use this as an opportunity to sell down existing positions in steel / mining equities, or to engage in new short positions from higher levels as we expect the actual impact of stimulus. Inventory de-stocking remains the key risk for commodities markets and commodity equities, particularly in iron ore, copper and thermal coal Reports that Chinese companies have requested deferral of iron ore and thermal coal contracts add further cause for concern about the potential for an inventory destocking cycle from China, potentially similar to the iron ore destock we saw in October 2011. This news is compounded by recent evidence that the copper financing trade that was a source of strength in the copper price in recent months is now unwinding with reports than physical copper is now being sent from China back to LME warehouses. .