The dimensions of the problem are sketched in an analysis by funds manager Pimco, which calculates China's steel-making capacity last year reached 850 million tonnes.

However, its production was only 683 million tonnes while actual consumption was only 631 million tonnes. The balance of 52 million tonnes went into stocks.

Consumption is unlikely to show growth this year, because the stimulus programs rolled out during the global financial crisis, which consumed a total of about 140 million tonnes of steel on infrastructure, have largely concluded.

With flat growth in consumption and the overhang of stocks from 2011, the real demand for new production has probably dropped to about 580 million tonnes, says Pimco.

The imbalance between supply and demand is evident in the falling prices for steel products, which are down about 20 per cent in the last six months, with the pace of the decline picking up in August.

In the last four months of 2011, when demand started to weaken, the mills responded by sharply cutting their production by about 10 per cent. But there has been no matching move so far this year. World Steel Association figures out last week show all-time record monthly output of 61.7 million tonnes last month. Figures from the China Iron and Steel Association for the first 10 days of this month reveal a further rise in production. Some analysts have suggested these figures are not telling the full story: there are up-to-date figures on the largest state-owned steel mills, but output for the rest is a matter of conjecture.

The large state-owned companies, on which the production figures are based, are under pressure to keep output up to support the government's growth targets, even if it means they are producing for stocks rather than for customers. The smaller mills are thought to be cutting back aggressively. This helps to explain the build-up in iron ore stocks on China's ports, despite the apparently high level of steel output.

China's steel industry is highly fragmented. As a Reserve Bank paper last year explained, there are about 660 steel mills across the country -- nearly all of them blast furnaces -- of which the biggest 10 account for just under 50 per cent of output while the next 75 largest companies produce another 30 per cent. That leaves 575 companies producing a combined 20 per cent of China's production.

Throughout the 1980s and 1990s, the steel industry grew at a fairly steady pace of about 7.5 per cent a year adding between 6 and 9 million tonnes a year to world production. But in 2001, steel output leapt 23 million tonnes, the next year 30 million tonnes and the year after that 40 million tonnes until, in 2005, production jumped 75 million tonnes.

To put these numbers in perspective, China was adding the equivalent of the entire production of Japan or the US every two years. Over a decade, output rose fivefold to the point where China now accounts for half the world production.

The country developed factories capable of churning out new blast furnaces so that new steel mills could be erected close to the cities where they were needed in less than two years. It became a point of pride for local governments to have steelworks.

China's National Development and Reform Commission announced a campaign this year to curb what it termed the "reckless expansion" of the steel industry.

What happened in the steel sector is a microcosm of what has happened across the Chinese economy. Investment levels of more than 40 per cent of GDP have been achieved with easy bank finance and scant due diligence for the state-owned companies and the well-connected private entrepreneurs. It is a model that works well only for so long as everything is growing. After a decade, there is excess capacity to be found everywhere. China's banking system faces a torrid time once non-performing debts start to be recognised.

Pimco notes that steel is a long-lived commodity. Industrial inputs such as electricity are immediately consumed, so if China's economy grows at 7 per cent a year, it must generate the same amount of electricity as it produced last year plus another 7 per cent.

But once last year's building is completed, steel production capacity is freed up to build new buildings. China can supply additional demand growth (more buildings and roads) with the same quantity of steel production. The excess steel capacity of more than 200 million tonnes is likely to dog China for years.

As Pimco puts it, "The Chinese steel industry today shows many signs of serious economic difficulties brought about by the unprecedented size and speed of industry expansion". The large mills will soon be forced to cut production and work off their stocks. This will put far greater pressure on the iron ore price than has been seen to date.

Citigroup is predicting a 20 per cent fall in steel production. "We see excessive capacity becoming more excessive," it says. "Fire sales of traders' steel inventory should drive down steel prices further, as highly leveraged traders go bankrupt and banks become more prudent on steel trade financing."

The iron ore market has already suffered a stunning fall -- prices down 20 per cent in a month and a third from their peak in April -- and that is before the shake-out in the steel industry has really begun.

With iron ore trading on Friday below $US100 a tonne, the market is reminding those who believed that $US120 a tonne was an impenetrable floor price that commodity prices typically overshoot on the downside, as well as on the way up.

Australian policymakers have generally welcomed the slower growth in China in the first half of this year as marking a deliberate shift to a less inflationary path and have expressed confidence in the ability of China's authorities to keep annual growth rates of about 7.5 per cent into the indefinite future.

"Economic developments in China had been a little more positive, with tentative signs that growth was stabilising at a more sustainable pace," was the reassuring comment in the minutes of the Reserve Bank's August board meeting, released last week.

There's little sign of anything stabilising at a more sustainable pace in the iron and steel sector. On the contrary, it reveals many of the failings in the Chinese model of "socialism with market characteristics", with state-owned giants that are deaf to price signals. alongside tribes of insiders on the make.