A crackdown in China on financingbacked by commodities risks unleashing a flood of iron ore sales from tens of millions of tonnes of the raw material sitting at Chinese ports, raising the prospect of a renewed price slump.

Investors who have raised funds against mostly unhedged iron ore could be at risk in the event of a price fall due to sluggish steel demand, leading to forced sales as banks wind back loans against the raw material, analysts and traders warned.

Beijing's moves to tighten access to credit have led to buyers defaulting on about $300 million of soybean imports in recent weeks, while fears of an unravelling of copper financing deals helped push the metal to a three-and-a-half year low in March.

Iron ore prices have recovered after slumping 8 percent in a single day to a 17-month trough last month as steel prices plunged, but a fragile outlook for steel consumption in China and towering port stocks mean the steelmaking raw material remains vulnerable to another rout.

Iron ore port stocks stood at a near record above 108 million tonnes last week, enough to build almost 1,200 New York Empire State buildings.

"A big crisis has passed, but with the high inventory, the risk is still there for iron ore prices," said Helen Lau, senior mining analyst at UOB-Kay Hian Securities in Hong Kong.

"It's all subject to how fast steel demand will recover going forward, and what I see is a mild recovery."

Commodities such as copper and rubber have been commonly used for financing, where traders or investors borrow against the commodity with the aim of investing the money in high-return areas such as real estate.

But Beijing's credit tightening has spurred investors desperate for cash to turn to iron ore. Industry sources familiar with the practice estimate some 30 million tonnes or $3.5 billion of stocks are now tied up by financing.

A surge in China's iron ore imports from late last year has been largely driven by these financing deals, traders and analysts say, but caution the raw material is an unlikely candidate for financing.

Unlike copper, most of the iron ore at the ports is not hedged, meaning those raising money against it are unable to lock in a price and remain exposed to any price fall, increasing the risk of a forced sale.

Hedging is little used by Chinese steel mills and iron ore traders, with the industry only shifting to spot pricing in recent years after 40 years of fixing iron ore prices annually.

The Dalian Commodity Exchange launched China's only futures market for iron ore just six months ago and foreign bourses have found it hard to convince the Chinese market to hedge via the more established iron ore swaps.

"I have not heard of too many Chinese traders hedging," said a foreign iron ore trader, one of a few who does hedge and did so recently on a 300,000-tonne cargo.

Chinese mills and traders also operate on narrow margins and are unused to paying to fully hedge their positions, added a Shanghai-based trader whose company has never hedged its port stocks.

"Since cash is tight, we don't have extra funds to hedge our position in the futures market," he said.

STORAGE, PRICE ISSUES

At the same time, the price of iron ore is particularly volatile.

Iron ore has recovered nearly 12 percent since its rout in March but remains down 13 percent for the year, compared with a more muted fall and recovery for copper.

"The person who ends up holding the cargo is making an all-in bet that the person on the other end is going to be able to pay for it and unload it," said Graeme Train, analyst at Macquarie Securities in Shanghai.

"With iron ore it is difficult to hedge and it can be very volatile, so that is the big risk."

Unlike copper, which has varied applications, iron ore is also solely used for steelmaking, and presents storage problems.

"You cannot stockpile iron ore too long, otherwise the iron will be oxidised and the quality will go down," said UOB-Kay Hian's Lau.

Iron ore also takes up a lot of space at ports, which can increase charges if they want to move the cargo or to free up space, said a trader who had a cargo stored at a port for up to a year.

Iron ore at around $116.90 a tonne is worth much less than copper at around $6,700 a tonne, so storage and logistics costs make up a bigger percentage of the overall price.

"It's not exactly a very profitable thing to be doing," said a source at a foreign lender with a presence in China.

China has up to $160 billion of outstanding loans using commodities as collateral, about 31 percent of the country's short-term foreign exchange loans, according to Goldman Sachs.

The steel sector is now taking a hit from China's crackdown on high-risk shadow banking activity as well as curbs on lending to shape up sectors plagued by excess capacity.

Many Chinese banks have slashed lending to these sectors by up to 20 percent, part of Beijing's efforts to reform an economy that in three decades relied on cheap debt to expand at a double-digit pace.

Some traders say credit conditions are tightening even further, with some banks refusing to open letters of credit (LCs) to industries such as iron ore and coal.

A Shanghai-based trader who sells Asian cargoes to Chinese mills said a buyer was recently refused a letter of credit by a major Chinese state lender, but was able to get credit at another bank.

"Our bank in Hong Kong has been warning us that the future might come when Chinese banks will refuse to open a letter of credit," he said.