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The much-heralded yuan revaluation would not have brought much cheer to the boardroom of the First Automobile Works (FAW) in Changchun  in the heart of China's rustbelt.

Profits for the country's second-largest vehicle maker fell from several hundred million yuan in the first half last year to 18 million in the same period this year.

The same picture is repeated across the country with a raft of big firms  ranging from power generators and petrochemical producers to airlines and telecommunications equipment makers reporting similar profit plunges.

The question is why an economy that apparently grew 9.5 per cent in the first half has so many large corporations issuing profit warnings.

'One answer is that official  [gross domestic product] figures in China are meaningless,'  says UBS economist Jonathan Anderson.

He reckons   the economy is  seeing a dramatic slowdown driven by a collapse in investment, after a period when actual growth possibly exceeded 10 per cent a year.

And it is this silent slide toward potential recession that is the real reason behind Thursday's revaluation,  several economists say.

'China needs to relieve pressure from trade partners so exports can continue to take up the slack in GDP growth caused by a slowdown in investment,'  said Tim Condon, chief Asian economist at ING.

The main reasons for falling corporate profitability in previously overheated sectors are higher raw materials costs and falling end-product prices due to overcapacity and vicious competition. The  boom of the past two years has produced an oversupply of everything from cement to  cars and led to government  controls, including restrictions on bank lending, to overheated sectors.

As oversupply increases and corporate profits fall, so does the amount of money companies can invest in new projects.

More than 50 per cent of China's economic growth comes from fixed-asset investment  and the proportion is rising. This compares with the pre-Asian crisis peak for the region of just over 40 per cent and is regarded as unsustainable on any historical comparison of developing economies.

'After all, somebody has to buy all the stuff [cars, cement, steel and luxury apartments] being built with today's investments,' says Morgan Stanley economist Andy Xie.

The government's stated target is 16 per cent growth in fixed-asset investment. As corporate profits slump, private-sector investment in fixed assets  falls  off.

'[But] public spending on rail networks and energy bottlenecks was a large element  [that kept] first-half  [fixed-asset investment] growing 25.4 per cent,' says James McCormack, head of sovereign ratings at Fitch Ratings.

As investment in fixed assets declines, there is a corresponding drop in  economic growth.  Beijing has often said  7 per cent is the annual minimum the economy needs to grow  to replace lost jobs in the public sector and maintain social stability.

The overused metaphor is of a bicycle that has to keep moving forward to avoid falling over. The government hopes private consumption, which grew 13.2 per cent in the first half, can take up some of the slack as investment slows.

The other substitute for fixed-asset investment in the GDP mix is to  keep exports growing fast enough to mop up  excess capacity.

China's exports increased 32.7 per cent in the first half, but imports rose just 14 per cent. The largest components of imports in the past have been raw materials and capital equipment (such as factory machinery) but with falling corporate investment and more machinery produced locally, these imports have dropped off.

In fact, a large and growing  proportion of China's exports in the first half  consisted of machinery and transport equipment -  items used in fixed asset investment.  The country's trade balance has gone from a US$7 billion deficit this time last year to a US$40 billion surplus.  This has increased friction with trade partners  flooded with cheap Chinese shoes, toasters and machines.

Before Thursday's revaluation, the United States Congress was considering a bill to introduce a 27.5 per cent across-the-board tariff on all Chinese imports because of 'currency manipulation'.

'The currency change is a political move, in our view, aimed at cooling international criticism,' said Credit Suisse First Boston economist Dong Tao.

To ensure access for Chinese products, the government had to be seen by its trade partners to be doing something about the currency imbalance.

Although the currency move could make Chinese exports marginally more expensive, it is a very small price to pay for respite from angry trade partners. Without being able to export its excess capacity, the mainland would have no hope of retaining high growth rates as investment in fixed assets slows.

The squeeze on corporate profits is expected to  worsen over the next two years, as even more capacity comes online. The spectre of deflation, Chinese economists' biggest worry for the five years  to 2002, is stalking the halls once more and, for the executives in the FAW  boardroom in Changchun, things are likely to get worse.



Fixed-asset investment slowdown tells China's real story