"Taiyuan Steel and Zhongyu discussed merger details two weeks ago, led by Shanxi Province's Economic and Information Committee," said the source.

"Taiyuan Steel wants to conclude the deal in two months to allow time (to begin) operations before the peak season starts in October."

The deal will be the first acquisition by Taiyuan Steel as the State-owned mill has taken the lead in Shanxi province's 45 million tons of capacity consolidation, starting this summer.

Beijing-based Shougang Group will lead the province's capacity consolidation for the remaining 15 million tons.

Shougang paid 500 million yuan ($79 million) for a 90 percent stake in Shanxi's Changzhi Iron Steel last year and plans to invest 19 billion yuan over the next three years to boost its annual steel production capacity to six million tons.

"We are talking with Zhongyu about the merger, but (the details) have yet to be settled," said Guo Juncai, vice-director of the Development and Planning Department of Taiyuan Steel.

Taiyuan Steel had selected seven to eight steelmakers, with capacity of more than 1 million tons, for the first stage of consolidation. The companies include Meijin Steel, Zhongyu Iron and Steel, Zhongyang Iron and Steel, Antai Group and Luliang Iron and Steel Project, Shanxi Youth Newspaper said.

The new plan designates that Taiyuan Steel will regroup steel bases in Taiyuan, Luliang, Yuncheng and Linfen, where Zhongyu is based.

"Acquiring Zhongyu could enhance Taiyuan Steel's marketing in the Linfen area," said Zhang Lin, an analyst from Lange Steel Research Center.

"Taiyuan Steel produces high-value-added stainless steel while Zhongyu produces low-value-added products like construction steel. Zhongyu's products could also fill in the gaps for Taiyuan Steel."

Shanxi province has more than 200 steel mills. There are only five steel mills with a capacity over 2 million tons, and 13 steelmakers with 1 million ton's of capacity.

The central government is encouraging big mills to merge with rivals to create more cohesive steel groups.

The nation's top 10 steelmakers are expected to account for more than 60 percent of the country's total steel capacity by 2015.

The government will withhold approval for any new projects aiming to expand capacity by 2011, forcing steel mills to consolidate.