TAKING STOCK OF CHINA´S GROWTH OUTLOOK / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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MAY 18, 2011, 11:10 A.M. ET.

Taking Stock of China's Growth Outlook .
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By TOM ORLIK

Worried about a growth malfunction in China? Here's another reason—high inventory levels mean that if demand softens output could fall even more quickly.
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The inventory cycle amplifies the ups and downs of manufacturing output. When demand is strong, firms ramp up production and add to inventories—giving an additional boost to growth. When demand is weak, producers go slow on production and sell down their inventories, giving growth an extra kick in the teeth.
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In the global recession at the end of 2008, the collapse in demand caused firms to cease production and sell down their inventories, exacerbating the woes of the world economy. When growth started to get back on track in 2009, restocking gave it an extra boost.
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This process is the same in China. But it is even tougher to find good data on the inventory situation than in other countries. What information there is points to high levels of inventory that will damp output growth if final demand slows in the months ahead.
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Data from the China Federation of Logistics and Purchasing points to additions to manufacturers' stock of finished goods in March and April, unusual as the data normally points to falls in inventory. Calculations by Wang Tao, an expert on the Chinese economy at UBS, show that in key parts of the industrial sector the ratio of inventory to sales has returned close to pre-crisis levels.
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That restocking reflects ample liquidity and the manufacturing sector's confidence in the strength of the Chinese recovery. The trouble is if final demand now falls away, the response from producers will be to run down their inventories, resulting in a double blow to output.
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The outlook for demand is difficult to call. But there are reasons for concern. Growth in industrial value added—the most widely watched measure of industrial production in the Chinese economy—fell to 13.4% year on year in April, down from 14.8% in March. Production of automobiles, a key source of demand for steel, followed sales down with a drop to -1.6%. Real-estate investment remains robust, but a fall in construction because of government controls and oversupply is widely expected.
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The joker in the pack is inflation. If a moderating consumer price index allows the government to stop tightening monetary policy, growth should bounce back and concerns about the inventory cycle will recede. But if inflation remains high, and policy remains tilted toward tightening, high inventories look set to amplify any Chinese slowdown in the months ahead.
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