The new year has started with something familiar from the last - a bubble in Chinese iron ore and steel prices.

The most-traded iron ore contract on the Dalian Commodity Exchange leapt by as much as 8 per cent on Monday, in the process reaching a three-year high of 657.5 yuan ($95.29) a tonne.

Its gain so far this year is about 18 per cent and the contract is around four times higher than the low reached in July 2015.

It’s much the same story with Shanghai steel rebar, the benchmark construction grade, which gained 5.2 per cent on Monday and is up about 16 per cent since the start of the year.

The strong rallies so far this year appear to owe more to sentiment than actual demand and supply fundamentals, which raises the possibility of a repeat of last year’s medicine, tighter controls on commodity trading.

The main driver for steel’s surge is the Chinese government’s intention to keep closing excess capacity in polluting heavy industries, such as steel, iron ore and coal.

China wants major state-owned businesses to cut 6 million tonnes of steel production and 24.7 million tonnes of coal capacity this year, official media reported on Jan. 12.

This is a slight change of emphasis on the steel front from last year when the government wanted capacity cuts as opposed to output cuts.

Full-year figures are not yet available, but China’s steel output rose 1.1 per cent to 738.94 million tonnes in the first 11 months of the year compared to the same period a year earlier.

The rate of growth has also been accelerating recently, with November’s production jumping 5 per cent year-on-year, the fastest monthly pace in two years.

What was achieved in 2016 was about 45 million tonnes in steel capacity cuts, even as output was rising.

Given China’s steel production capacity is still above 1 billion tonnes per annum, it is clear there is still plenty of scope for further capacity cuts, something the government aims to achieve.

Output of low-grade steel in small, polluting furnaces is to be eliminated by the end of June, a move that could cut as much as 4 per cent of China’s steel output, according to a Jan. 11 report in state media.

What is currently happening is that steel makers are still making profits and are thus incentivized to continue producing, and the output that is being closed is less profitable, low-technology and polluting.

The question is whether China’s economic growth will be strong enough, and in the right sectors, to use up all the steel being produced.

This is especially the case given that exports are unlikely to grow strongly, given that protectionist measures against China’s products continue to mount.

China’s steel exports dropped by 4.4 per cent in 2016 to 95.22 million tonnes, still a significant amount and about 8 per cent of the country’s total production.

IRON ORE SUPPLY

The fortunes of steel are inextricably linked with its main ingredient, iron ore.

The strong rally in iron ore is perhaps harder to justify, given the market remains well supplied, and if anything will see more cargoes available in 2017.

China’s iron ore imports reached a record above 1 billion tonnes in 2016, jumping 7.5 per cent from the prior year, according to customs data.

This was because of the stronger-than-expected steel production as well as lower domestic iron ore output, which was down 3.6 per cent in the year to November, according to official data.

It is likely that iron ore supply will grow this year, as the higher prices prompt more production from existing mines and top producer Brazil’s Vale ramps up is massive S11D project.

Number two miner Rio Tinto said on Tuesday it expects to ship between 330 and 340 million tonnes in 2017, up from the 327.6 million it did in 2016.

Its Australian rivals, BHP Billion and Fortescue Metals Group are also expected to continue to produce at elevated levels to take advantage of the higher price.

Australia and Brazil supply about 83 per cent of China’s imports, but the smaller producing countries, such as South Africa, India and Iran, will no doubt be looking at grabbing some additional market share.

Even if China’s steel output remains steady in 2017, there would appear to be scope for increased supply to lower iron ore prices, with the SGX futures curve pointing that way.

The December 2017 contract was last at $67.70 a tonne, a discount of 16.5 per cent to January’s $81.03.

However, the main risk to both steel and iron ore comes from policy decisions and the likelihood that if prices continue to have volatile spikes, the authorities will take further steps to cool the market.