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All governments are masters of deception; they prey on our stupidity and nationalism. They are excellent at making us believe their “classic pearls of idiocy.” But when it comes to the economic realm, no one can hold an AK-47 to the ability of the Chi-Coms when it comes to fantasyland.

If you are the typically worry wart, you may be worried about Chinese inflation. In fact, China just hiked rates on the flimsy excuse inflation may be a problem. But, no need to worry because as you can see by the chart we pulled from our trusty Reuters systems, China inflation is receding period over period.

This of course doesn’t quite square with the reality we see in almost every other locale in the world. Emerging and developing markets are instituting a mix of rate hikes, capital controls, and price controls to try to quell rising food and energy cost. But those wiley Chinese leaders have it under control. Solution is to produce fake economic statistics. Nothing new there when it comes to House of Mirrors we refer to as China.

We noticed this little tidbit from the monthly newsletter of Absolute Return Partners, a money management firm based in London—we don’t know them, but their analysis always seems excellent and interesting. ARP discussed the fabrication of GDP numbers by China. During the good times they tend to understate GDP and during bad overstate it. Ditto on inflation we surmise. To evaluate real Chinese growth, the tried and true method outside analysts have focused upon for years, at least those analysts not selling emerging market mutual funds, is the electricity production in China. Here is what ARP provides us:

We draw your attention to 4Q 2010, which shows GDP growth near the vaunted 10%
number, but the power output number was only 5.5%. Could this be a reason why
German industrial production numbers were a bit lower than expected? China is the
key destination for German machine tools that will soon become Chinese machine tools
sold back to China’s new “partners” in the eurozone.

Just a couple other things to consider when you look at the power output numbers.

1. China’s money supply has soared something like 78% in the last three years.
2. Chinese benchmark 5-year note yields (see chart below) are sitting at around
3.75%; one might think that is a bit low given power output running in the high
teens…can you say credit spigot wide open?

3. Goss fixed investment has really been gross! In fact, one might say it looks parabolic. I remember when the Nasdaq looked parabolic during E-Greed era, as Woody Dorsey so aptly coined it.

Let’s add one more little item:

China has accumulated about $2.5 trillion in foreign exchange reserves in the process of manipulating its currency. That’s a lot of money.

Yet, remember, China officially doesn’t manipulate its currency value. And what is all this concern about the currency anyway. It has nothing to do with the rising trade surplus—the US is a bunch of slackers, everyone knows that.

From The Financial Times:

“The relationship with China is important but, from an industrial perspective, it is extremely negative,” said a statement from the San Paulo Industrial Federation known as Fiesp. While Brazil reported a trade surplus with China of $5.2 bn last year, this was du to commodity exports, Fiesp said. On the industrial front, imports of manufactured goods from China rose a ‘devastating’ 60 per cent last year. The deficit in manufactured goods was a record $23.5bn, up from only $600m seven years ago.”

Jeez Brazil! Get with the program. Suck it up and start becoming more efficient. (Is Germany paying attention to this?) Of course Tim Geithner is quite thrilled with Brazil’s new outlook.

To summarize why worry:

1. Despite official statistics, inflation is likely running at 10% or a lot more in China based on unofficial estimates.
2. There is a massive overhang of mispriced capital in China.
3. China’s real GDP growth is predicated on increasing supplies of liquidity because at this stage in the business cycle at the margin stimulative impact has fallen dramatically.
4. The cost of housing in China is far out of reach for the average worker.
5. China wants no change to its policy given that government transition to a new keeper of the mirrors is underway.

Either Mr. Market makes a big change to this situation:

CRB Index Daily: A nice little A-B-C correction carrying 50% is in place….

Or, China keeps fabricating those economic stats and keeps the credit bubble, capital dislocation bubble, and trade tension bubble brewing longer and adding to the inevitable day of reckoning.

With $2.5+ trillion in reserves, it pays for a lot of music and papers over a lot of problems. The only question in the minds of those who worry about this stuff is when, not if.