CLSA sees spectre of inflation emerging from China

For years, inflation has been plugged up in China, but CLSAÆs Jim Walker warns the honeymoon could be over.
Caught between spiralling commodity prices and collapsing profit margins, China will likely become an exporter of inflation, indicated CLSAÆs top-rated China economist Dr Jim Walker on Monday.

As US consumers experience prices rises in Chinese imports for the first time in their lives, US bond market would be spooked, and the result could be a crash in first US and then global equity markets, he told the CLSA China conference in Shanghai.

Walker said that the situation in current global financial markets is "the most dangerous period I have seen in my 25-year working life".

ôBased on company visits, we are hearing that exporters are raising prices. Given the margin compressions that manufacturing companies have been experiencing, itÆs not surprising,ö he said.

Walker pointed to the recent huge spikes in industrial metals, oil and gold as evidence of the problems that Chinese companies are facing.

The blame for these rising prices is not demand out of China, he says, but the easy money policy from the US Federal Reserve. This has created the liquidity which has fuelled asset inflation.

Walker says that margin compression in China means that companies are no longer able to absorb inflation as they have done previously. CLSA estimates that industrial enterprise profits were up just 6% year-on-year in the first quarter of 2005, compared to 37% in 2004. In addition, the brokerage estimates that 17 out of the 23 industrial sectors on the domestic stock marker saw declining net profit growth in the final quarter of last year.

ChinaÆs sensitivity to commodity prices is due to the high contribution of manufacturing to the economy, which at 42% Walker says is the highest in the world.

Contrary to previous downturns, the Chinese government will be reluctant to allow the state banks to funnel working capital towards Chinese companies to help them ride out the downturn. Walker estimates that reluctance has signalled by the recent interest rate rise in China earlier this year.
Although the rise was just 27 basis points, Walker estimates that it was a signal from the government to banks to reverse the sharp acceleration that lending activity has recently shown.

ôTightening the economy now will be very different to the tightening in 2004,ö he pointed out, ôbecause in the previous period they had very healthy margins.ö

Walker believes the Chinese government is concerned that unless it nips loan growth in the bud now, it will be faced with another colossal bad loan bill û just after it has poured billions of dollars into the banking sector to prepare them for international listings.

The banks may in any case not have much liquidity to play with, since rises in US bond prices will cause the hot money counting on a yuan appreciation to pour out of China and back to its home markets.
Walker added that it didnÆt make sense to expect consumption to pick up the slack when industry was in dire straits, since people are worried about their jobs and unwilling to spend.

If there is a downturn in China, the government will rue the day it listed its banks abroad, he said, since using the banks to pump prime the economy would cause a collapse in their share price, and endanger the whole financial sector reform effort.

Walker concluded that ChinaÆs GDP growth will drop to 5% in 2007 from 9.9% in 2005, but insisted he saw this as a normal part of the economic cycle and that long term, the effect on China would be healthy.

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