2010 was a magical year in China. Among the world records: 18 million new vehicles sold. Due to unprecedented stimulus, sales had skyrocketed 33% that year and 54% in 2009—mind-boggling growth rates which catapulted China to the number one new-vehicle market in the world, far ahead of the US which had never sold that many units in a single year, not even during the halcyon days before the financial crisis. In terms of passenger vehicles (excluding buses and trucks), 14.5 million units were sold in China that year, compared to 12 million in the US.

Exuberone, a hormone that governs industry thinking from time to time, had taken over. In January 2011 at the Automotive News World Congress in Detroit, Dazong Wang, president of Beijing Automotive, threw a number into a room: 40 million. That’s how many new vehicles would be sold in China by 2020, he said, roughly 30 million passenger vehicles and 10 million commercial vehicles.

People sucked in air. The number was beyond easy comprehension. But soon, it became a guidepost. Investment in manufacturing plants surged as foreign and Chinese automakers scrambled to get their share of that 40 million—and foreign automakers had to pay a steep price in terms of technology transfer, an inescapable feature of investing in China’s auto sector.

Alas, in 2011, sales inched up only 2.5% to 18.5 million vehicles—though foreign brands still did well. 2012 may turn out to be even tougher. And now, the problem is production.

Automakers have ramped up at a torrid pace. In May, wholesale deliveries to distributors jumped 23% from prior year to 1.28 million units, higher than analysts had expected. Toyota and Honda, recovering from last year’s supply problems following the earthquake and tsunami, nearly doubled their sales to distributors. Ford pushed 23% more units into the pipeline, GM 21%. BMW announced on Monday that it had achieved record global sales in May, despite very tough conditions in some teetering Eurozone countries. Reason: China, where sales jumped 32%. And those are the sales that make their way into automakers’ financial statements.

Stunning as they may be, they’re wholesales to distributors, not to consumers. At dealerships, however, the scenario is turning from less rosy to gruesome—final sales in May were not robust enough to digest the flood of production. Inventories on lots across the country ballooned from 45 days’ supply at the end of April to 60 days’ supply by the end of May—a dizzying 33% increase in just 30 days.

And the ballyhooed 23% increase in wholesale deliveries that got analysts drooling all over themselves? Unsold. Added to inventory. Channel stuffing. Testimony of rampant overproduction. And it has turned into an inventory glut. Yet, not a week goes by without a major automaker announcing starry-eyed plans of investing in new plants or expanding existing ones. As these plants come on line, their production washes over the market that is already saturated.

The auto industry—not just manufacturing vehicles and components but also building plants and the infrastructure to supply them—has been a driver of economic growth. And it’s still playing that part, just like building ghost cities is contributing to growth.

Perhaps the People’s Bank of China saw a truly scary thing or two beyond publicly known data when it announced a 25-basis point rate cut last week, the first since 2008, because so far, official economic data has been a mixed bag of decent numbers. Exports were strong, up 15.3% in May over prior year. Retail sales rose 13.8%, lower than expected, but still. And industrial production grew 9.6%, a healthy clip—but ominously, it included hundreds of thousands of new vehicles that have been overproduced and are now piling up on lots around the country.

And so there are divergent scenarios: automakers under the influence of exuberone are building plants, adding capacity, pumping out units, and stuffing channels with all their might—while dealers, who are forced to take their quotas, are unable to sell about a third of the new production. For them, it will turn into a nightmare as they drown in inventory, the costs of carrying it, and the losses inherent in selling vehicles that have been sitting on the lot too long.

Their only hope is that the government or automakers will introduce incentives to lure people into dealerships. Some are already underway, such as a subsidy for vehicles with engines of less than 1.6 liters. But vehicle sales to consumers would have to skyrocket to meet the phenomenal and still growing production. Unlikely. Next step will be production cuts and layoffs. When that proves insufficient, expansion plans will be trimmed. Another sharp hissing sound from the China bubble.

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