Provincial officials are driving the latest steel industry merger, involving the parent companies of Jinan Iron and Steel Co Ltd (SHA 600022) and Laiwu Steel Co Ltd (SHA 600102), with the economics of the deal likely to be overshadowed by more defensive motives, analysts said.

They said the proposed reorganization of the two Shandong-based groups under a new entity, Shandong Iron and Steel Group, bears the mark of local government agencies seeking to create a local champion, making it more difficult for outside parties to take control.

'The main reason for their merger is the same motivation behind the Angang-Bengang deal. The provinces want their steelmakers to have a unified voice,' according to Chen Dongming, associate director of Fitch's corporate ratings team in Beijing.

He said provincial governments – and in this particular case the Shandong branch of the State-owned Assets Supervision and Administration Commission – are hoping to resist future mergers or takeovers by encouraging steelmakers within their jurisdictions to enter into alliances.

'Many steelmakers are under the control of provincial governments, which in turn are not willing to relinquish power and lucrative local tax income. Therefore, cross-border acquisitions involving different Chinese regions will remain difficult in light of local protectionism,' he said.

The merged entity will have the two parents – Jinan Iron and Steel Group Corp and Laigang Group – continuing to operate independently under the holding company – an arrangement that calls into question how thoroughly they can integrate. Limited potential for integration in turn puts the logic behind the merger in doubt.

Chen also noted that one of the considerations of merging is synergies, and yet on this count Laiwu and Jinan are unlikely partners, as their product mixes are well distributed across long and flat products.

The merger of two companies within Shandong reflects previous problems in merging steel groups across provinces, the Fitch director said.

'M&A activity going forward will likely center around local consolidation rather than cross-border deals. We saw prospective inter-provincial mergers that simply didn't work. Baosteel tried to merge with Jinan, and failed. Cross-border mergers are very, very problematic.'

Another analyst said the proposed merger is likely a reaction to global developments in the steel industry.

'We suddenly find on the global steel stage that the two biggest players, Mittal and Arcelor, are now one. So this latest Chinese merger is likely a response to that, and is to an extent an attempt by Chinese steelmakers to compete with this new giant and other foreign rivals,' said Sun Jianliang, managing director of metals firm Shanghai J. Sun Trading Consultants Ltd.

'There are certainly geopolitical incentives driving this merger. Provincial governments also want to do something more to compete on the global stage,' Sun said.

But he added that the Angang-Bengang merger in Liaoning province carries a hint of two unwilling parties – the partners have not even tried to integrate fully. This lesson will not be lost on the two Shandong companies, for whom a similar organizational structure is being considered.

Angang and Bengang 'are still not really happy and prefer to operate as independent companies, despite the government's desire for them to work more closely together. They are still not even listed as a merged entity,' Sun said.

Whether the latest merger will allow the new entity to become a 'national champion' – part of the central government's plan to create two or three large-scale 30-mln ton global competitors – is still unclear.

'Baosteel said it plans to raise capacity to as high as 50 mln tons in less than a decade. Now with the Mittal-Arcelor marriage, they will certainly not stand still but will ramp up production too. So it is really hard to imagine what the global steel picture will look like – let alone the domestic – even a year or two down the road,' Sun said.

Jinan and Laiwu produced over 10 mln tons of crude steel in 2005. If output were combined the new entity would be in second place behind Baosteel, with current output of nearly 23 mln tons.

It is unclear how the merger would affect an Arcelor agreement to take a nearly 40 pct stake in Laiwu. That deal is pending central government approval.

Jinan Iron & Steel Co Ltd reported a 2005 net profit of 828.58 mln yuan, while Laiwu Steel Corp booked net profit of 415.48 mln.