As its manufacturing engine sputters, the world's second largest economy is increasingly relying on infrastructure spending to boost growth, spurring demand for construction steel products and lifting producer profit margins to near record levels.

Combined with recent cuts to low-quality steel capacity amid a war on pollution, this infrastructure drive looks set to brighten the outlook for construction-grade steelmakers just as their more sophisticated peers wrestle with sluggish demand from manufacturers and automakers.

"Because of capacity cuts and expected stronger infrastructure spending by China, there's a strong upside for long products consumption which can boost rebar makers' profits in the years ahead," said Richard Lu, analyst at CRU consultancy in Beijing.

The profit margin on construction steel product rebar, also known as long steel, has surged more than 800 percent this year to around 1,100 yuan ($162) per tonne in early June, according to data tracked by brokerage CLSA.

The margin for cold rolled coil, or CRC - otherwise referred to as flat steel - used in cars and home appliances, has dropped 47 percent to around 437 yuan over the same period.

Margins for high-end products like CRC have usually been higher than for rebar. Between 2012 and 2016, the average margin for CRC was 341 yuan per tonne compared to 107 yuan for rebar, CLSA data showed.

That has spurred mills in the world's top steel producer to reopen once-shut rebar production lines to cash-in on soaring prices.

The strong demand has also cut traders' inventories of rebar by more than half in less than four months.

"Our boss saw good profit on rebar, so he decided to resume the lines which had been shut for two years," said a sales manager at Rizhao Steel Holding Group, a midsize steel producer in China's eastern Shandong Province.

"The lines are expected to keep operating as the outlook for construction steel is good."

'NO CHOICE'

Improving infrastructure is high on Chinese President Xi Jinping's agenda as he promotes his ambitious Belt and Road initiative - building road and rail connections with Central Asia and beyond.

Meantime, manufacturing has struggled, with China's car sales falling for a second straight month in May for the first time since 2015, limiting demand for high-value flat products like CRC.

The reversal of fortune between Chinese producers of cheap, low-grade construction steel and makers of high-value steel was also triggered by Beijing's crackdown on industrial pollution.

As it battles smog, China has vowed to eliminate induction furnaces - a highly polluting type of plant that produces mostly rebar - by the end of this month.

Analysts estimate induction furnaces produced about 50 million tonnes of rebar last year - about a quarter of China's total rebar output.

So far this year, average margins for rebar were 572 yuan per tonne compared with 91 yuan in all of 2016, CLSA data showed.

The unexpected resurgence among producers of lower grade, cheaper steel is a setback for China's efforts to modernise its massive steel sector, mainly by pushing the big, sophisticated steelmakers to swallow smaller rivals and shut inefficient ones.

Last year, China's most technologically advanced steelmaker Baosteel (>> Baoshan Iron & Steel Co Ltd) acquired rival Wuhan Iron and Steel, creating the world's second-largest steelmaker behind ArcelorMittal .

Some Chinese mills that produce both long and flat steel products are making more of the former because of the robust margins, said Daniel Meng, a Hong Kong-based analyst at CLSA.

"It is quite a general phenomenon," said Meng. "You should see such switching across many mills rather than just a small number of mills."

But some mills that make only flat steel products could not shut their plants.

"Although flat producers realize the margin is narrowing, they have no choice but to continue producing since it would cost more money to stop the equipment and turn it on again when profit goes better," said a manager of a unit of state-owned Shandong Iron and Steel Group (>> Shandong Iron and Steel Co Ltd).

At around 437 yuan a tonne in early June, the margin on flat steel CRC was less than half of where it was in late January, CLSA data showed.

While Chinese traders' stockpiles of both rebar and CRC have fallen from this year's peaks, rebar inventory has dropped 56 percent while CRC stocks have fallen only 13 percent, data compiled by SteelHome consultancy showed.

HIGHER EXPORTS?

As domestic appetite slows, more flat steel products from China are being sold overseas. They totalled 14.85 million tonnes during January-April, or 55 percent of total steel exports.

In 2016, flat steel shipments were 48.03 million tonnes and made up 44 percent of total exports. The increased proportion of high-end steel shipments this year could raise fresh concerns that China may be open to renewed accusations of steel dumping on international markets.

Chinese steelmakers "have previously been accused of selling material at below cost, in order to offload their excess supply," said Jeremy Platt from UK steel consultancy MEPS.

"Amid a weak domestic trading environment, Chinese suppliers could be encouraged, in the coming months, to increase their export volumes."

(Reporting by Manolo Serapio Jr. in MANILA and Muyu Xu in BEIJING; Editing by Simon Cameron-Moore)

By Manolo Serapio Jr and Muyu Xu