Burnout!

China's economy has overheated. The March inflation report most likely will show higher inflation than growth. No one can deny that inflation is accelerating while growth is slowing. China has gained as much as their economy can from bringing ever more cheap labor to the local market. Now their wage inflation will force a dramatic transition in their economy. But this list is just the beginning of China's problems. The Szechuan earthquake will amplify near-term inflation pressures, just as Hurricane Katrina did in the US. In the meantime, the icing on the cake (or the haystack on the camel's back) is the inflow of speculative funds betting on the Yuan's appreciation. This foreign currency inflow is now so huge that it's making the export business look like small potatos.

Out of this big picture view comes news (from Michael Pettis on SeekingAlpha) that the government is attempting to manipulate the stock market.

According to Saturday’s South China Morning Post:

"For the second time in three weeks, the mainland's stock market regulator has told fund managers not to dump shares. And this time, it says they could be punished if they don't comply.

The China Securities Regulatory Commission said mutual funds should support falling stocks, even though other investors were selling their holdings amid the slump in the nation's equity markets. With concerns rising about the deteriorating economic conditions and with the authorities having so far failed to stem the slide through market-boosting measures, Beijing is now resorting to threats in an effort to maintain so-called market stability.

I believe that this is a desparate attempt to reverse what has become a self-reinforcing marging-call based avalanche. In my mind, this shows that the authorities have come close to losing control. Because this story has been widely circulated, it will make matters much worse. First of all, it gives non-mutual fund stock owners a strong incentive to beat the mutual funds out the door. Second, it will cause a panic among mutual fund holders to redeem their holdings. This will force the mutual funds to sell eventually anyway. As I predicted in Janruary, I expect a collapse in the Shanghai stock market before the Olympics.

Unfortunately, the Hong Kong listed shares have not followed suit downwards. If they don't, then I'll have to be content with moral victory. However, just as they lagged the "A" shares on the way up, it's still possible for them to fall even more.