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For now, it’s nothing more than an expanse of muddy land lying just off the southern Chinese province of Guangdong. But Baosteel Group’s planned $11 billion steelworks will eventually transform the sleepy island of Donghai. Land is being reclaimed from the sea for a plant that by 2015 will produce 10 million metric tons of high-grade steel annually.

The 12-square-mile site will include a new port with an iron-ore terminal, an export terminal capable of handling 500,000-ton ships, and its own power plant. The new complex is expected to create tens of thousands of jobs and contribute to the city’s tax coffers. Wang Zhongbing, the town’s mayor, was pictured in a newspaper in May kissing the project’s approval documents.

Even as local officials relish their good fortune, it is unclear that China needs another steel plant. The country is already the world’s largest steel producer, accounting for 45 percent of global output, and is home to six of the world’s 10 largest steelmakers, including Baosteel, which had revenue of 223 billion yuan ($35 billion) last year. The mainland’s total capacity, which is set to hit 940 million tons this year, already outstrips demand by 220 million tons, according to Shanghai-based research and consulting firm Mysteel. “The situation is dire. We have never seen overcapacity on such a scale,” says Michael Komesaroff, a principal at commodity consultants Urandaline Investments in Queensland, Australia.

The excess supply, coming at a time when iron-ore prices remain high, is hitting profitability. China’s steel industry lost 1 billion yuan in the first quarter, compared with a profit of 25.8 billion yuan last year. “The winter for the steel industry has come. We will have to control output and watch for high inventory,” warned Zhang Changfu, general secretary of the China Iron and Steel Association, in April. “Major steel users such as property, auto, shipbuilding, and infrastructure have all slowed their growth or even declined.” Baosteel announced on June 12 that it plans to cut prices for some products by 4 percent in July, the first reduction so far this year.

Since the Mao era, China’s steel industry has been a symbol of national strength. Its development has often been spurred by political goals rather than economic realities. In the aftermath of the global financial crisis, China embarked on an infrastructure binge, building bridges, buildings, and high-speed rail. But loose credit policies at the banks, plus rapid approval for most industrial projects, meant the country was adding new steel capacity even faster than demand. Growth in steel consumption will fall from the high single digits to around 3 percent this year, estimates macroeconomic consultant GK Dragonomics in Beijing.

All told, China’s National Development and Reform Commission has recently approved a total of $23 billion in new steel projects, Bank of America Merrill Lynch (BAC) noted in a May 30 report. China is loath to see economic growth dip too far, especially in the run-up to this fall’s 18th Party Congress, at which the new leadership of the People’s Republic will be anointed. “They are not building infrastructure now because they need it, they are building now because they want to hit GDP targets,” says Patrick Chovanec, a business professor at Tsinghua University in Beijing.

China now has an estimated 2,700 steel mills, many of them small and inefficient and producing lower-value products such as rebar, the ribbed steel bars used to reinforce concrete. And while the industry’s biggest players have moved up the technology ladder to produce more sophisticated products, even those are now in oversupply. “The question is: How many highways and how many high-speed trains can you build? The demand side probably is not going to be there,” says Peter Markey, who leads Ernst & Young’s China Mining & Metals practice.

Policy makers in Beijing want to force smaller mills to close or be swallowed up by the big guys. Beijing’s ultimate goal: consolidate enough so the country’s top 10 steelmakers produce 60 percent of output by 2015, up from around 50 percent now. Even that will be far from easy. “The central and local governments have different priorities,” with provincial officials unwilling to shut factories that provide jobs and pay taxes, says Wang Jianhua, editor-in-chief at Mysteel. “And China has to fix the profit problem. Most steel companies lack the money to finance the mergers and acquisitions Beijing would like to see.”

The bottom line: China now has 2,700 steel mills and will soon have 940 million tons of capacity, a glut that could take years to work off.