Chinese steel companies, the world’s largest, helped drive a regional industry benchmark index to a seven-month low as concern builds that some mills face financial difficulty amid a government credit squeeze.

“They are having trouble accessing finance,” Yunde Li, chairman of Ishine, a unit of China Zhongsheng Resources Holdings Ltd., which processes iron ore in Shandong, said today in an interview in Perth. Some of Ishine’s steel mill customers cannot make their payments to his company, Li said through a translator, declining to name the companies.

Closely-held steel mills in China are struggling to get funding at the moment and that’s led to panic selling of iron ore, according to Morgan Stanley. The nation’s top banking regulator said yesterday strict credit guidelines will be imposed on mills that were big polluters and users of energy.

“The capital squeeze on steel traders has started to affect mills,” said Henry Liu, Hong Kong-based executive director of China Merchants Capital and head of its commodities research department. “It looks like the credit crunch is worsening.”

Iron ore this week had its biggest drop in more than four years, spooked by the credit squeeze and a surge in stockpiles. The Bloomberg Asia Pacific Iron/Steel Index, which includes China’s Baoshan Iron & Steel Co. and Angang Steel Co. and Japan’s Nippon Steel & Sumitomo Metal Corp., dropped for a third day today, to the lowest since July 31.

“There’re talks some mills are facing tightening credits, as they may be charged with higher interest rates on loans,” said Hu Shunliang, investor affair representative with Maanshan Iron & Steel Co. It hasn’t affected Maanshan, Hong Kong’s second-largest listed steelmaker, he said.

Government Strategy

Premier Li Keqiang’s strategy of driving up interest rates to reduce leverage is exposing a shadow banking network in the world’s second-largest economy as companies struggle to repay loans from trusts, asset managers and commodity-funding businesses. About 40 percent of the iron ore at China’s ports are part of finance deals, Mysteel Research estimates.

Aggregate financing in China decreased to 938.7 billion yuan ($153 billion) last month, from January’s record 2.58 trillion yuan, amid a crackdown on shadow lending, a government report this week showed.

“China is moving to trim small steel companies to eliminate over capacity,” Shang Fulin, chairman of the China Banking Regulatory Commission, told a briefing in Beijing yesterday. Secondly, “if highly polluting and highly energy-consuming companies don’t meet environmental evaluation requirements, banks won’t issue loans to them,” he said.

Artificial Prices

The loan practices have artificially inflated the iron ore price as demand for collateral boosted imports, which lead to average prices of $130 to $135 a metric ton at the end of 2013, IG Markets Ltd. said yesterday in a note. It’s believed most of the inventory purchases are unhedged so margin calls are rising and losses are mounting, IG Markets’ strategist Evan Lucas said in the note.

While this could see inventory-dumping as losses become unsustainable, Lucas said it’s more likely as traders default the inventories will be taken control of by banks who are unlikely to dump the cargoes until the market recovers.

China had its first onshore bond default after Shanghai Chaori Solar Energy Science & Technology Co., a solar-panel maker, last week failed to pay interest on notes due March 2017. That’s stoking speculation more companies in overcapacity industries in China may miss debt payments.

Price Volatility

Rio Tinto Group, the world’s second-biggest iron ore shipper, said yesterday short-term price fluctuations will continue as sentiment caused a rapid change in the market.

“There will be short-term volatility, proof of which you are seeing this week,” said Andrew Harding, who heads up the London-based Rio’s most profitable unit, said yesterday in Perth. “We continue to see an attractive longer term demand for iron ore, driven particularly by China.”

Closely-held steel mills in China are “struggling to get funding at the moment,” said Joel Crane, a Melbourne-based commodity analyst with Morgan Stanley Australia Ltd. “So they’ll be refusing both contracted and spot iron ore, and that’s led to the panic selling.”