Iron ore red alert: China's steel output could shrink for the first time in 31 years

Official Chinese reporting on economic growth and other indicators that influences the business climate in the country and the confidence of foreign investors often tend to paint rosier pictures than the facts on the ground would suggest.

It is therefore a something of a big deal when a state-backed institution such as the China Iron and Steel Association (CISA) makes a bearish call, which is exactly what the organization did last week.

A report by Xue Heping, an analyst, published on CISA’s website argues that zero or negative growth in China's steel production for 2012 is "highly probable" because a significant decline in the second half of the year is a foregone conclusion.

Profits in the country's iron and steel industry fell more than 95% year-on-year over the first six months of 2012, but despite the weakening outlook mills continued to forge steel at a record-breaking rate of near 2 million tonnes per day.

Australia Financial Review says this is "partly due to the peculiarities of the local steel sector. [J Capital partner Tim] Murray said local governments force many steel mills to keep producing, even when it is uneconomic, to maintain tax revenue, jobs and to show Beijing they are delivering on economic growth targets."

The world's number one money manager Pimco has also released a bearish report on the Chinese steel industry. Raja Mukherji, Pimco's head of Asian credit research, writes:

In short, we believe that China’s steel demand has reached a near-term peak. As the country’s fiscal focus shifts from public investment to tax cuts and consumption subsidies, and property policies remain restrictive, we expect China’s ability to consume incremental steel over the secular horizon to be negatively impacted.

For investors, we believe the biggest risk is that iron ore prices may falter… as new iron ore supply ramps up by 2014 and Chinese steel demand weakens.

The globe's most active steel future – Shanghai rebar for January delivery – dropped to a record low of Rmb3,614 ($570) per tonne on Friday. If the contract does not improve over the remainder of August it will the fifth straight month of losses.

Iron ore prices dropped in tandem with the steel price to fresh multi-year lows with the benchmark import price of 62% iron ore fines at China's Tianjin port sliding 1.5% to $110.20 a tonne on Friday.

Iron ore has only enjoyed three up days over the last six weeks of trading according to data provided by Steelindex.