Things in China are about to get better, but for the worst possible reason

China man bike waterReutersYou have to keep your head above water somehow.

Chinese economic data continues to disappoint and the recent volatility in the country’s stock markets shows no sign of abating.

Wall Street’s reaction to this is pretty much unanimous: the government has to take action to stop the bleeding.

And that action, they believe, will help China’s economic performance turn around in the second half of 2015.

The problem is that the measures the politicians will likely implement will only exacerbate China’s deepest, structural economic problems.

That means any bubbles in its credit and property markets will only get bigger, and the reform required to tilt the economy towards domestic consumption will be put off until further into the future.

This is a giant can being kicked down the road.

Plans

The plan for China’s economy had been to start accepting lower growth in what President Xi Jinping called a “new normal” in order to reform sluggish economic sectors and normalize the system. The government was at the same time encouraging investment in the stock market.

“The ideal situation would be several years of a steady bull market to cover the restructuring phase,” Societe Generale’s Yao Wei wrote in a recent note.

“Conversely, the worst-case scenario would be a stock-market crash before restructuring has even begun.”

That is where we’ve ended up. Chinese markets have been flashing red for the past few months, and the restructuring hasn’t had chance to take effect.

The result is that Chinese authorities will likely move to stabilise the economy, and put those all important reform plans on hold.

Stay liquid

“We believe China’s top policymakers see more urgent needs to stabilise growth in the near term, as suggested by the statement released after the Politburo meeting to assess economic conditions on 30 July,” wrote analysts at Bank of America Merrill Lynch in a recent note.

“It called for close attention to downward pressures to economic growth, vowed to put a big emphasis on preventing systemic risks and to maintain growth within an appropriate range. In our view, in order to accelerate investment growth, the government will likely roll out more public and infrastructure projects and take multiple measures to improve project funding.”

We may also see more rate cuts. There have already been four since November of 2014 and none of them have been able to lift the economy out of the doldrums. The official July manufacturing PMI, which were released over the weekend, came in at its worst reading since February, scoring 50. Anything below 50 indicates a contraction of the economy. The June reading came in at 50.2.

Bloomberg analyst Tom Orlik wrote in a recent note that those manufacturing numbers, combined with an ailing stock market, means that the Chinese authorities have to do something.

“That reinforces our view that the extent of the slowdown in the first half was obscured by booming equity markets With equity markets now in a correction phase, and the factory sector faltering, our expectation is that the government will introduce more stimulus.”

What China’s working with

So what would that stimulus look like?

Chinese officials are trying to strike a delicate balance. They’re attempting to move the economy from one based on foreign investment to one based on domestic consumption. The problem is that Chinese demand isn’t yet where it needs to be to support the country’s massive economy.

What officials will likely do is target the engines of the economy that really need help, like the property market. Macquarie analysts said China’s current slow down in property investment was “the most important drag for the economy in 2Q15.”

The property market is also one of the Chinese economy’s bubblier spots. In fact, most of the areas analysts consider to be the most sluggish — like the corporate sector — are also the ones most in need of reform. They’re the ones that are most dangerous to target with stimulus.

“In our view, China is in the midst of a triple bubble, with the third-biggest credit bubble of all time, the largest investment bubble (proxied by the investment share of GDP) and the second-biggest real-estate bubble,” Credit Suisse analyst Andrew Garthwaite wrote in a recent note.

It looks like those bubbles are about to get bigger.

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