Two years ago China suspended a range of business contacts after French President Nicolas Sarkozy met the Dalai Lama. That was supposedly patched up last November when the Chinese leader Hu Jintao visited France, shortly after France decided it would not ruffle Beijing's sensitivities by attending the Nobel Peace Prize ceremony for Chinese dissident Liu Xiaobo.

But then came the curious electric car secrets affair when Renault suspended three senior executives over allegations of industrial espionage amid waves of media speculation about China's commercial spies. Renault and the French government have pointedly refused to name any specific country and at least one of the men in the $4 billion Nissan-Renault research project is suing to restore his good name. China denies involvement but it soured the courtship.

But now comes the warning from one of France's top banks, in a report titled "The Dragon Which Played With Fire," which says bluntly "Policymakers have not done enough and an inflation break out is now inevitable."

SocGen argues that China's massive injection of more than $2 trillion in bank lending in the economy over the past two years may have helped the country navigate the global recession. But China will pay the price with a nasty wave of inflation that will force the country to slam on the brakes and bring growth down to about 5 percent, which in China would count as a screeching halt.

Along the way, SocGen suggests, China's inflation wave will send global commodity prices into a boom and bust and that the bust will affect the rest of the global economy.

"The skew of risks is very much for an extended period of overheating and therefore uncontained inflation," it said. "This would cause tremendous pain and fuel widespread social discontent," and brings the risks of what SocGen calls "a pernicious wage-price spiral."

Apart from the somewhat excitable phrasing, this forecast isn't far out of the mainstream. Indeed, China's central bank implicitly shares this fear, which is why they have kept raising the capital rations of the country's top banks to a chilling 19 percent. In the last two months, China's authorities have raised interest rates twice and raised reserve ratios four times, a reaction that verges on panic.

Inflation is officially less than 5 percent but much higher in foodstuffs and the quasi-official Producer Price Index says that the price of fuel and raw materials has risen almost 10 percent over the year. Few observers believe the official figures. Why should they, when the M2 measure of money supply is up 53 percent in the last two years.

Chinese investors are worried; the China Consumer Sentiment Index dropped by 5.1 points in December to 88.8 for the third month in a row. This level was just above the all-time low of 88.6 posted in November 2008 at the height of the global financial crisis. December's drop follows the record drop of 6.5 points in November and a decline of 2.6 points in October.

The worry is that China could be facing another banking crisis, with a surge of bad debts. And we know how China worked its way out of the last wave of bad debts, by forcing down the share of consumption in the economy from 45 percent of gross domestic product in 2000 to 36 percent last year. They achieved this by holding down the interest rates paid by banks to Chinese savers, in effect allowing the banks to recapitalize and keeping loans cheap for industrial borrowers by putting a tax on savers.

"This is how China's last banking crisis was resolved," says Professor Michael Pettis of Peking University's business school, one of the most respected experts on China's economy. "It did not result in a collapse in the banking system but it nonetheless came with a heavy cost. The banking crisis in China resulted in a collapse (and there is no other word for it) in household consumption as a share of the economy."

Beijing could run the same tactic again but as the SocGen report notes, China's leadership is in the throes of a succession process and Hu won't want to go down in history either as the man who ran the economy into a crisis nor as the man who ground down consumption yet again.

In fact, policy for the past year has been directed at stimulating private consumption because the state council has been warning for months of the dangers of over-investment and excess capacity in industry. Adding to all this is the surging rate of wage wises in key industrial areas like Guangdong, where the minimum wage in the export industry has just been raised 18.6 percent from March after jumping by 20 percent last May.

China's economy faces some sharp challenges in the short-term, and as this column has repeatedly noted, faces an even greater demographic challenge in the longer term, after 30 years of the one-child policy is starting to cut into the labor force and raising the that that China's population will grow old before they get rich.

So maybe this time France's exporters won't have to pay the price for SocGen's gloomy assessments since it seems fairly based in reality. But it is always dangerous to shout out publicly that the emperor's clothes are starting to look distinctly threadbare.

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