NEW YORK (KWR) - October 27, 2007 -- August inflation numbers, reported by the National Bureau of Statistics of China, do not appear so grim, if compared to the 25%-plus inflation of the mid-90's. Year over year, the CPI rose 6.5% in August; the corresponding rate from July is 5.3%, and that from June is 4.4%. The urban rate for August, at 6.2%, is 100 basis points lower than the rural rate, which is 7.2%. Corresponding rates for July are 5.3% for urban areas, and 6.3% for rural areas. While the government has been raising reserve requirements for banks and increasing interest rates, reducing the taxes on interest, and raising stamp and other taxes on stock transactions -- these measured, gradual increases have yet had little, if any, effect on the inflation rate, which has risen dramatically since the 4th quarter of 2006. The government continues to soft-pedal the issue, expressing optimism that inflation will soon be under control. China continues to face a problem with inflation, as do other countries in Southeast Asia.

Core inflation, excluding food and energy, is growing at about 1.1% per year. But the real story is food prices, which are up 18.2% year over year in August, 15.4% in July, and 11.3% in June.

Category	August Percent	July Percent	June Percent
Foodstuff	18.2%	15.4%	11.3%
Non-foodstuff	0.9%	0.9%	1.0%
Consumable	8.0%	6.9%	5.2%
Services	1.8%	1.6%	1.7%

Breaking out food inflation shows where the problems are.

Category	August Percent	July Percent	June Percent
Grain	6.4%	6%	6.1%
Oils or Fats	34.6%	30.1%	27.6%
Meat (primarily Pork)	49%	45.2%	59.8%
Poultry and By-Products	23.6%	30.6%	35.7%
Fresh Eggs	6.2%	5.4%	37.9%
Aquatic Products	22.5%	18%	5.2%
Fresh Vegetables and Flavorings	4.4%	4.5%	4.8%¹
Fresh Fruits	-3.3%	-12.2%	-16.2%

Fish, pork, poultry, eggs, and oils or fats are the main drivers of recent inflation. Reports this summer indicate that blue ear disease, a viral infection, has decimated pig herds in China, and it is feared the disease may spread to Sichuan province, the center of China's pork industry. As pork is a staple of the Chinese diet, the government has not reported on the situation, and imports of pork are rising in the face of declining domestic supply. Anecdotal accounts indicate that floods and drought have also driven up prices. Prices of clothing have been flat for years, reflecting the oversupply of capacity in the country, which is driving down clothing prices worldwide. Rent is also increasing, as the largest mass migration in human history continues unabated. People in larger cities and towns are more able to offset increases in food prices than in rural areas, partly by urban consumers careful buying at wholesale markets, and purchasing fresh food at the end of the day, when it is cheaper. But competitive pressures and an oversupply of workers, especially from technical schools and colleges, mean that it is difficult for businesses to raise prices and thus wages, although wages have reportedly risen in both the rural and more developed coastal areas. However, wage reports from China may be misleading, as people obviously feel squeezed by the recent price increases.

What does this mean for China's stock market? Inflation is never good for stocks, but the market is, for now, ignoring the warning signs of increasing inflation and interest rates. The Shanghai and Shenzhen composite indexes (which include the A-shares that may only be purchased by Chinese citizens and a few qualified investors, and are denominated in renminbi, and B-shares listed in USD) are up this year 121% and 175%, respectively, in local currency terms, as of October 12th, 2007. Both markets are over-valued, as their P/E are 54 and 78, respectively. While just over 17 billion shares were traded in May 2007 alone, share volume has fallen off recently as prices continue to rise. Part of the reason for the increasing domestic interest in stocks is the low interest paid on deposits, which is regulated by the government. Investors have very few alternatives to invest outside China, and high savings are the norm as there are few pension and health benefits provided for older workers.

As inflation increases, there is increased pressure to earn higher returns. In a September 3rd report, Morgan Stanley analyst Jerry Lou reports that A-share companies' growth is exaggerated by non-operational income and investment income. Thus, P/E ratios are effectively much larger than reported. Anecdotal reports from China indicate that companies are able to borrow at cheap rates and invest in the stock market, which works just fine when the market continues to appreciate. According to media reports, including recent reports on Bloomberg TV, speculation by individuals is rampant, with many investors buying stocks based on numerology (Chinese and Hong Kong stock tickers are numbers, not letters).

Speculators in Shanghai gather outside brokerage firms on Saturdays to exchange rumors and stock tips, and to re-assure themselves that the market will continue to rise, telling themselves, among other rumors, that the government in Beijing will not let prices decline in the run-up to the 2008 Olympics. Share purchases are increasingly financed with bank borrowing. Speculative energy is also fueled by the Year of the Golden Pig, according to the Chinese zodiac calendar. With 362,719 brokerage accounts opened on May 24, 2007 alone, and over 300,000 accounts opened per day for five consecutive days, a new investor/speculator class has quickly risen in China.

The Chinese markets are caught up in a mania of speculation fueled by relatively low bank deposit interest rates, rumors, relatively good economic fundamentals, and corporate takeovers. At times, much of the speculative stock trading is concentrated in so-called "Special Treatment" shares, which are companies that have failed to earn profits for two years or are suspected of accounting problems. What will happen when the bubble bursts, as it must eventually? Will share prices begin to drop in the first half of 2008? Only time will tell. Factoring in the increase in property values over the past few years, the key point is that China has entered what is, for them, the uncharted territory of a historic asset price bubble in the face of rising inflation, and low interest rates and bank reserve requirements.

Dale Smith, Ph.D. is an analyst for a New York-based hedge fund

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KWR International Advisor

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Publisher: Keith W. Rabin, President

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