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Is the Party Over in China?

July 25, 2008

Unsold inventories are climbing, the consumers aren't biting
Sam Baker
Asia Sentinel
July 21, 2008

China's National Development and Reform Commission (NDRC) reported
today that unsold inventories of cars rose 50 percent from the
beginning of the year to a four-year high; this suggests that macro
challenges in China have finally reached a crisis point. The future
may have finally caught up with China.

Sharply rising inventories in such a strategically important industry
as autos suggest that the slowdown in the economy is biting domestic
demand such that corporate investment is likely to slow. If inflation
weren't already such a problem, the People's Bank of China, the
nation's central bank, could ease monetary policy to boost domestic
demand. But with inflation recently spiking and real interest rates
already quite negative, the central bank is in no position to ease.

Rising inventories, slowing growth and rising inflation suggests a
self-reinforcing cycle of gloom for the economy and financial sector,
especially when the banking sector inevitably begins to feel the pain
of rising NPLs into a slowing economy.

The last time Chinese policymakers faced such a daunting challenge in
charting the domestic economy through such treacherous waters was
during the Asian financial crisis of 1997-1998 when capital flight
was of paramount concern. his time the stakes are much higher and the
risks of a crisis are much greater. During the crisis, policymakers
could count on capital flight reversing if temporary measures would
just provide a bridge through turbulent external conditions. Asia
recovered, China hung on and the world exhaled.

This time around, however, China is, ironically facing the opposite
problem where so called hot money inflows are the problem. Unlike
with the capital flight problem during the Asian crisis, just hanging
on won't solve the current hot money crisis as nothing short of a
domestic economic crisis seems likely to slow or reverse hot money
inflows into China. The growth rate of foreign exchange accumulation
has gone parabolic, with reserve growth doubling in 2006, 2007 and
set to double again in 2008 judged by inflows in the first half of
2008 already matching total inflows for 2007. Parabolic growth is a
classic symptom of an unsustainable trend in markets.

In the fall of 2003, I advocated a maxi-revaluation of the Chinese
yuan. At that time I even argued naively that Chinese policymakers
might even consider such an option because they would eventually come
to the logical conclusion that if they didn't do it now, it would
only get harder and more painful to do it later as foreign capital
continued to pile into the economy in a classic boom­bust cycle.

By June of 2004, I finally gave up on the idea that policymakers
might seriously consider a maxi revaluation. All of the rhetoric
coming out of Beijing rationalizing the current account surplus as
temporary, combined with a number of administrative measures aimed at
neutralizing the macro impact of foreign capital inflows, including
the beginning of an aggressive sterilization program finally
convinced me to give up my "radical" notion that Chinese leaders
might actually consider a large adjustment of the yuan.

Since June 2004, my theme on China has continued to be that nothing
the authorities did would slow (let alone derail) a booming economy
thus as the debate has raged about whether there might be a soft
landing or hard landing for China's economy, my mantra has been: "no
landing". As long as capital inflows continued to surge into the
economy ­ which I didn't see any reason why they would slow let along
reverse—my view for China's economy was full speed ahead. After our
latest research trip to China, I came back with the same bottom line
view on China: inevitable crash, but not yet, and meantime, continued boom.

The report on rising car inventories, however, has changed my view.
One of the keys to our positive short-term view on China was that as
long as inflation remained relatively contained and inventories
weren't building up, there was no reason to think the
self-reinforcing cycle of capital inflows, higher investment and
growth wouldn't continue ­ short of a trade war or protectionist
backlash. Rising inventories for cars, however, is a huge red flag,
especially with inflation rising into slowing growth.

For the last several years, I've talked about Chinese policymakers
systematically eliminating the usual canaries in the coal mine that
indicate macro stresses, and thus reducing the usual triggers that
derail economic booms in other countries, such as rising inflation,
rising interest rates, an appreciating currency, bankruptcy or a bank
run. Through various administrative measures Chinese leaders have
been able to keep such usual canaries in check. Until recently. With
hot money flows rising and inflation finally breaking the canaries
are finally starting to break their silence.

Rising inventories has always been a potential canary that we've kept
an eye on because it is something the government can't really control
directly. Until recently, however, rising inventories haven't been a
problem. As long as that remained the case, it was hard to see any
serious trigger for a financial and/or economic crunch in China.
Rising inventories are potentially the proverbial straw that breaks
the camel's back because they indicate falling corporate profits,
slowing investment, and slowing growth, in a self-reinforcing cycle
in a downward spiral that is the opposite of the positive cycle in
the boom phase of an investment boom/bust cycle.

Sam Baker is director of Asia research for Trans National Research
Corporation, a US-based political and economic consultancy
specializing in global emerging market research.
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