China's steelmakers are facing low demand and potentially disastrous oversupply, supporting their insistence on a 40 percent cut in benchmark iron ore prices, an industry group executive said on Tuesday.

China's steel industry, the world's biggest, traditionally sets a global benchmark each year after lengthy talks with three miners that dominate the iron ore trade: Vale, Rio Tinto and BHP Billiton.

Shan Shanghua, secretary general of the China Iron and Steel Association (CISA), said the buyers had more power this year because of too much supply and too little demand.

I have not seen any fundamentals to support a sustainable steel price recovery. Major steel mills have cut their production of steel coil remarkably in China and steel mills have already seen their exports falling sharply, he said in a telephone interview on Tuesday.

China produced 127 million tonnes of crude steel in the first quarter, commensurate with an annual output of 508 million tonnes, despite a target to reduce production by nearly 10 percent from 2008, to 460 million tonnes this year.

Shan said output levels were being driven by a blind rush back to production by small mills and would not continue for the rest of the year as the weak market would force more cutbacks.

We are still aiming at a yearly production of 460 million tonnes. Whether we can make it or not depends on exports and domestic demand. But I am sure that if we remain at that high production rate and do not cut output, it will be a disaster.

China is trying to squeeze the lowest price out of miners by a principle that CISA calls settling volume according to price, so any miner willing to set 2009/2010 prices at around the 2007/2008 level -- which would imply a price cut of around 40 percent -- will be sure of a big export market.

Shan said the Chinese, led in the negotiations by Baosteel, should be able to get a price below the spot market, which would mean a cut of more than 30 percent.

There is a common sense that wholesale prices should always be lower than those for retail, he said.

Low spot prices for imported iron ore have been pushing Chinese mines out of business, resulting in heavy inventories at Chinese ports and an increasing reliance on overseas ore miners, as their production costs are far below those of Chinese mines.

Some Chinese regions have cut taxes and the fees they charge miners in order to lighten the burden and support sales of domestic ore, Shan said.

But China is unlikely to reduce a 17 percent value-added tax on domestic iron ore in an attempt to undercut imports, he said.

I've never heard of such plans and I think it sounds unlikely to me as changing VAT policy is a big move that the government is always extremely cautious about, he said.

Shan said CISA was still opposed to the idea of switching to an index system for iron ore prices, as only long-term agreements could foster development in both the steel and mining sectors. (Editing by Keiron Henderson)