Money-losing steelmakers in China, which produces nearly half the world's steel, are mired in debt, and a breakdown in the funding chain could quickly result in a wave of bankruptcies in the sector, reports Beijing's Economic Observer.

Li Xinchuang, head of the China Metallurgical Industry Planning and Research Institute, warned that steel companies may run into a liquidity squeeze in less than a year, which could have a domino effect and knock down the entire sector. More importantly, the steel industry is linked to many other sectors of the economy, and if steel goes under, it will most certainly pull others down.

Steel companies in China enjoy huge subsidies from local governments, whose main focus is to meet job and growth targets. Encouraged by easy financing and cheap energy supplies, the country has steadily built more steel mills than needed.

Currently, the world’s second-largest economy has about 300 million metric tons of excess steel capacity, equivalent to nearly twice the steel output of the whole European Union last year.

The latest figures from the China Iron and Steel Association reveal that 86 of China’s large and medium-sized steel companies accumulated more than 3 trillion yuan ($486.4 billion) in debt by the end of June. This puts the debt-to-asset ratio of these firms at close to 70 percent – a big red (pardon the expression) flag. Of this debt, 1.3 trillion yuan is in outstanding bank loans.

The steel industry, compared with other industries, tend to have a higher leverage ratio, CISA Deputy Secretary General Qu Xiuli told the Economic Observer. While a leverage ratio of 60 percent to 70 percent is normal, anything above 80 percent spells trouble.

During the first half of this year, 39 steel companies across China reported debt-to-asset ratios exceeding 80 percent, with 15 above 90 percent. The government's latest push to reduce overcapacity could break some companies' capital chains, the Economic Observer said. Banks are already starting to tighten their lending requirements and are refusing to extend new credit lines to some steel companies.

Meanwhile, the industry's profits for the first six months of the year totaled only 2.2 billion yuan ($356.7 million), with 35 steel enterprises, or about 40 percent of the total, reporting losses, according to the Economic Observer. The total debt represents 1.67 times the total sales reported by the 86 firms and 1,327 times their total profits, the paper said.

Decreasing profit margins in the sector due to sluggish demand and overcapacity have been eating into most companies’ bottom line. Their average sales profit margin was just 0.13 percent in the first half, the lowest level in China's industrial sector, the state-run China Daily reports, citing CISA data.

The price of imported iron ore has increased by about 30 percent since the end of May, while prices at the end of the manufacturing chain rose less than 10 percent

Baoshan Iron & Steel Co. Ltd. (SHA: 600019), the country's biggest listed steelmaker by market value, said Chinese steel prices are likely to weaken in the second half of this year as supply continues to outstrip demand amid an economic slowdown. Baoshan reported a 61 percent drop in first-half earnings.

Of the 3 trillion yuan of debt Chinese steel companies carry on their balance sheets, 1.3 trillion are bank loans. And given the grim outlook for the sector, analysts are concerned that many of these companies will not be able to pay back their bank loans on time. Add this to the fact that banks in China are already sitting on a huge pile of bad debt that they’ve been rolling over indefinitely to avoid booking a loss. One can’t help but wonder: How much longer can China keep kicking the can down this road?