China has warned its banks of rampant illicit borrowing by steel companies, a development that underscores the financial dangers for the country as the government mulls a new stimulus effort to support the slowing economy.

Some Chinese steel trading companies have borrowed excessively from banks and then used the funds to speculate on property and stocks, the bank regulator said in a directive that was seen by the Financial Times. The regulator added that banks must be more vigilant in lending to the companies.

The directive, which was issued on April 26 and never published, is an important reminder of the risks that could flare up if Chinese officials loosen the reins on the financial sector and approve another wave of investment projects.

Even without illicit borrowing, credit risks in the steel sector are on the rise, the regulator cautioned.

“Banks must accurately assess how slowing exports and falling domestic purchases of homes and cars will impact the demand for steel and the operations of steel trading companies,” it said.

Beijing used the country’s banks as the primary channel for pumping cash into the economy in 2008-9 when the global financial crisis erupted, and officials are still trying to get a grip on the bad debt that resulted from the lending spree.

However, with the economy slowing sharply over the past two months, pressure is once again mounting on the government to rev up growth. Premier Wen Jiabao said two weeks ago that it was time to kick-start more investment. Since his comments, bankers say that lending has picked up noticeably.

Analysts believe this push will make it easier for steel companies to obtain credit – contradicting the bank regulator’s warning that was seen by the FT.

Steel companies, from mills to traders, were among the biggest beneficiaries of the 2008 stimulus push, but a rush to expand has left them overleveraged and overexposed as the economy cools. Chinese steelmakers lost Rmb1bn in the first quarter, the first time that the entire industry recorded a loss since 2000, according to the China Iron and Steel Association.

Suffering from the downturn, they have sought profits in other ways. The China Banking Regulatory Commission said in its directive that steel trading companies had borrowed from banks for steel-related activities – sometimes then using the same collateral to get multiple loans from different financial institutions. Then, with little demand for steel, they had used the money for risky investments, such as stocks and property.

“This has led to a huge amount of financing in the steel market and, as risks emerge, it could cause a large amount of bad bank loans and major harm to financial safety,” the regulator said. It ordered banks to strengthen their risk management and do a better job of monitoring how loans were used.

A steel trader at a state-owned enterprise confirmed it was common to see companies buy steel with a loan, and then use that steel as collateral for further borrowing. These trades get riskier when steel prices are falling, he said.

“Recently the supervision has got stricter,” he said. “In the last few months the whole economy has been bad so all the [non-steel] investments have been bad, so it’s gotten a bit tighter.”

Chinese banks are state-owned and would normally be expected to fall into line with the regulator’s orders. But as the government shifts gear to prop up the economy, analysts say its most effective means will be to call on banks to issue more loans, undermining the restraint that had been demanded of them.

“The government has already started the loosening. That is very clear,” a top Chinese bank executive in Beijing said. “The supply of credit is already getting much easier.”

State-run media have denied that China will launch another stimulus programme. But analysts expect that an increase in bank lending at the end of May and this month will reveal that the government has quietly begun a stimulus, albeit on a smaller scale than in 2008.

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