Despite the slowdown in the Chinese economy, iron ore imports to the country have been rising since the start of this year. The increase in imports was partly due to the fact that steel mills were using iron ore as collateral to obtain financing as credit dried up. According to some reports this week, China has finally decided to crack down on iron ore import loans. Not surprisingly, iron ore prices have come under pressure and could fall even further if China imposes strict measures to curb the activity. For the likes of BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Vale (NYSE:VALE), this is not good news.

Chinese financing deals
In order to rebalance its economy and cool down the country's property sector, Chinese policymakers have implemented several measures. One of the measures was to tighten credit to sectors that are related to the property market. The measures made it difficult for steel mills to obtain financing from conventional sources. However, China's shadow banking system meant that steel mills had other options.

As I have noted in several articles, Chinese steel mill have been using iron ore as collateral to obtain financing from state-owned companies, which can still obtain loans from banks. The state-owned companies obtain the loan and then lend it to steel mills at a higher interest rate. The imported iron ore is used as collateral. Iron ore is also used in other types of financing deals as well.

The financing deals explain the surge in Chinese iron ore imports this year despite a slowdown in the economy. However, this type of financing activity carries a significant risk. If cash-strapped steel mills fail to repay their loans then the iron ore kept as collateral could be dumped into the market by lenders. This could push iron ore prices lower, triggering margin calls. The end result could be an even bigger drop in iron ore prices than we have seen so far this year. Not surprisingly, Chinese regulators have finally decided to act.

Crackdown on financing deal
According to a report by Reuters earlier this week, China Banking Regulatory Commission (CBRC) has urged local authorities and banks to look into iron ore financing deals in order to minimize default risks. The CBRC, which is China's banking regulator, issued a document on April 18 in which it asked local regulators and banks to investigate iron ore financing and submit detailed reports by April 30.

Shortly after the news of the probe was released, iron ore futures on the Dalian Commodity Exchange dropped nearly 5%. Spot iron ore prices are currently hovering around $108.50 per ton.

Prices could come under further pressure
The crackdown on iron ore import loans comes at a time when iron ore supplies have been rising. As I noted in an article here last week, miners have continued to increase their production despite a slowdown in China, which consumes around two-thirds of global seaborne iron ore. BHP Billiton recently said that its iron ore production in the March quarter totaled 49.6 million tons, up 23% on a year-over-year basis. The miner even lifted its iron ore production outlook for the fiscal year ending on June 30, 2014. Rival Rio Tinto also reported robust production for the first quarter. Rio Tinto's March quarter iron ore production was a record 52.3 million tons. Vale, which reports its first-quarter results today, is targeting annual production of more than 360 million tons. Overall, seaborne iron ore supply is expected to exceed demand by 79 million tons in 2014, according to Morgan Stanley.

In such an environment, Chinese regulators have decided to crack down on an important source of iron ore demand this year. According to some estimates, of the nearly 110 million tons of iron ore stockpiles at China's ports, around 40% is tied up as collateral in short-term financing deals. A clearer picture will only emerge if the CBRC releases the reports it has asked from local authorities and banks on iron ore financing. If the number is anywhere near what is estimated, there could be a significant drop in iron ore demand from China. While Chinese regulators are right to crack down on this form of financing activity, for miners an important source of demand is likely to be taken away from an oversupplied iron ore market.