Source: NTC Economics

Latest survey data, published in Hong Kong on Tuesday, highlighted a robust and accelerated rate of improvement in the health of the Chinese manufacturing sector in September.

The headline CLSA China Purchasing Managers’ Index (PMI) – a composite indicator designed to provide a single-figure snap-shot of manufacturing operating conditions – recorded a three-month high of 55.0, up from 53.4 in August and well above the survey average of 52.6.

CLSA is the Asian investment banking arm of French banking giant Crédit Agricole and in September, its Chief Economist Dr. Jim Walker raised the spectre of a sharp slowdown in China's economy by the end of 2008.

Commenting on the PMI survey, Eric Fishwick, Deputy Chief Economist at CLSA said: "Aside from the dip in July, recent PMIs have painted a consistent picture. Rapid manufacturing growth is becoming even more rapid. This is repeated in September but despite the big jump in new orders, thanks to the pace of capacity growth pricing power remains moderate. Cost inflation is running well ahead of output price rises."

The rise in the PMI reflected faster expansions of output and new orders during the latest period. Manufacturing production increased for a twenty-second successive month, with the rate of growth accelerating markedly to its sharpest since April 2004. Higher output was underpinned by a further rise in volumes of incoming new orders, with September’s expansion the strongest for two-and-a-half years. Data suggested that the domestic market was the main engine of growth, as new export orders increased at a far slower rate than total new work.

Part of the increase in sales during September was met through the depletion of warehouse stocks of finished goods, which fell for a sixth straight month. Although lower inventories were mainly attributed to stronger-than-expected sales, there were also some reports of efforts to streamline stocks.

Higher workloads underpinned a further round of hiring at Chinese manufacturers in September, with staffing levels rising for an eighteenth consecutive month. However, the rate of workforce expansion eased from August’s joint series high to a relatively modest pace, and the increase in employment was insufficient to prevent backlogs of work rising for an eleventh successive month.

In order to satisfy strongly rising production requirements, Chinese manufacturing firms stepped up their purchasing activity again in September. Furthermore, the rate of growth of input buying accelerated to a forty-one month high. Despite the marked rise in purchasing, stocks of purchases continued to decline, and the latest drop was the sharpest since December 2004. Supplier delivery times were reported to have lengthened again, albeit only slightly.

A downturn post-Olympics?

CLSA's Jim Walker has a reputation for being bearish on China and is credited with predicting the Asian financial crisis in 1997. He now says that the problems caused by the US subprime mortgage crisis - “probably the biggest crisis the global financial market has seen since the Great Depression” - will now spread around the world and cause recession where capital “malinvestment” is pronounced, and may even lead to a global financial sector meltdown.

Last month Walker invoked the butterfly effect—inspired by legendary sci-fi writer Ray Bradbury back in 1952.

Walker said: In the well-known Chaos Theory metaphor a butterfly flaps its wings on a yak's ear in Tibet and sets in motion the climatic forces that result in a hurricane devastating Florida. In that analogy the disturbance to the initial conditions starts in the east and finishes in the west. The reverse reaction is in train in this crisis. Sub-prime is Chaos Theory's flapping butterfly. The beat of its wings disturbed the 'sensitive dependence' of the credit house of cards which is now falling around the global financial system. But the 'hurricane; in Florida will eventually manifest itself as a typhoon in China's capital goods industries! The first extended capital goods structure to collapse in this story was the US housing market. But China's industrial build-out has been no less dependent on easy global credit conditions than Florida and California's overbuilt condominiums. It may take a number of months or quarters but eventually the demand, credit and capital patterns will shift enough to expose China's productive capacity for what it is, a structure based on artificial global, not solid domestic, demand.

China's  National Bureau of Statistics  reported last month that investment in fixed assets in China's economy rose 26.7 percent year-on-year in the first eight months.

A total of 149,751 new projects were launched during the first eight months of 2007, 18,665 more than a year earlier.

The fixed-asset investment now accounts for about 45% of China's GDP. Its trade surplus has grown from almost nothing in the late 1990s to 9% of GDP and private consumption has fallen from half of total economic activity in the late 1990s to just 35% this year. By comparison, Japan's investment component averaged 30% of GDP during its peak growth years, its trade surplus peaked at 4.5% of GDP and its consumption levels never fell below 58% of GDP.

Walker predicts that growth may shrink from 12 to 5% by the end of next year, as a downturn in developed countries takes its toll on the Chinese rust belt.

Walker says that “no other country has benefited more from demand in the US and global central bank profligacy than China, and the problem is that we don’t know how distorted the industrial structure has become as a result.”

China’s growth and investment momentum - alongside its capital misallocation signals of negative real interest rates, undervalued currency and subsidised energy inputs - will ensure that additional capacity in all the wrong sectors will come on stream over the first half of 2008.

Following the Olympic consumption boost, the overcapacity in China will become evident. As capacity utilisation falls, corporate earnings will collapse, along with the stock market, says Walker.

“China not only has a malinvestment problem, but a stock market bubble as well,” says Walker. “The authorities in Beijing have done an awful job in controlling overheating in the economy or in containing market expectations.”

He adds, that this is “a recipe for a crash.” The scenario may not manifest itself for a year “but eventually it will be the stuff of legends, for the bears,” Walker says.