Agreat deal has been said about how Stern Hu and his colleagues at the Shanghai office of Rio Tinto are guilty of accepting bribes. But remarkably little has been said about who offered those bribes and why. Yet without some understanding of why anyone would want to lavish cardboard boxes full of cash on the representative of an iron ore mining company, it is pretty much impossible to make any sense at all of the whole affair. From the day in July last year that Hu and his chums were arrested on charges of stealing state secrets, it has been painfully obvious that there was more to their detention than the mainland authorities cared to admit. In the absence of any detailed information about the charges, commentators could only speculate about what was really going on behind the scenes. Their theories ranged from unlikely to outlandish. Some suggested Hu and his colleagues had been seized as hostages to give Chinese negotiators more leverage over mining companies in stalled iron ore pricing negotiations. Others argued that Hu had been arrested in revenge for the way Rio backed out of a proposed deal to sell an 18 per cent stake to Chinese aluminium giant Aluminum Corp of China (Chinalco). And at least one analyst suggested that Chinese officials had ordered Hu banged up in a fit of pique after Rio pipped a state-owned company to a valuable mining deal in Africa. But the few details that emerged from last week's trial appear to confirm what industry insiders had suspected all along: that Hu's arrest and subsequent conviction had more to do with political infighting within China's steel industry and the inadequacies of the prevailing iron ore pricing mechanism than any bizarre desire among officials to punish Rio for frustrating planned Chinese investments abroad. To understand what was really going on, we have to look at how the mainland steel industry has expanded over the past few years. With capital costs low and the political rewards for rapid development high, local governments across China have backed the construction of hundreds of new steel mills. The result is a deeply fragmented industry plagued by massive overcapacity. By the end of this year, China is expected to have the capacity to produce 760 million tonnes of steel, far more than the country needs, even given the elevated demand from government-backed infrastructure projects (see the first chart below). Naturally, all those new steel mills need a reliable supply of iron ore to operate. And for the most part, that ore must be imported. The quality of most Chinese-mined ores is too variable and their purity too low to feed into modern blast furnaces. The problem for most smaller steel mills is that obtaining good iron ore is not easy, especially at a price that allows them to compete with the big central government-controlled steel giants like Baosteel or Anshan Iron and Steel. The biggest state-owned companies get privileged access to iron ore supplies from overseas miners like Rio at annually agreed contract prices. Other steelmakers must buy much of their ore from the spot market, where the intense demand means they may have to pay several times as much as the contract price (see the second chart below). As a result, smaller steelmakers have a huge incentive to pay big bribes to obtain ore at contract, or near-contract, prices. They bribe the handful of licensed importers to get allocations of contract ore. They bribe the staff of large steelmakers to sell out the back door the contract ore that comes in through the main gate. And as the Hu case shows, they bribe the local representatives of foreign mining companies in order to secure steady supplies. In the words of one industry insider: 'They are all at it.' The whole industry is riddled with corruption. The problem for the central authorities is that this web of corruption is frustrating their attempts to force a consolidation among steelmakers. They had hoped to use control over access to ore at contract prices to compel steel companies to merge. But the prevalence of corruption within the industry has undermined that control and the industry remains fragmented despite years of official efforts to encourage mergers. As a result, industry insiders say the authorities decided to make an example of Hu and his colleagues, not to punish Rio but rather to serve notice to domestic steel companies that they must stop subverting official attempts to restructure the industry. The real problem, however, is the market distortion produced by the discrepancy between the contract and spot prices for ore. As long as that distortion remains in place, the Chinese steel industry will remain a deeply corrupt business.