China just gave the game away

Chinese leaders expressed deep concern for their country's economy at a meeting of G-20 nations in Ankara last weekend.

That is weird for two reasons.

First, China's leaders are normally incredibly confident about their economy.

Second, because despite all of the worry - despite the Chinese economy's visible slow down and dramatic action over the last month - officials maintained the the country would continue to grow at 7% annually.

Basically, that means Chinese officials just gave the game away: They expect us to believe that the country's economy will close this year growing the same way it did last year. 7% - always 7%.

Something here doesn't fit.

Here's what they said

The reports started leaking out on Friday, when Japan's finance minister Taro Aso revealed that Zhou Xiaochuan, governor of China's central bank, had repeated several times in a meeting that the Chinese stock market bubble had "burst."

This is the same stock market that the government helped inflate and has since been trying to prop up. Goldman Sachs strategists estimate that China's 'national team' of state-backed brokerages and funds has pumped around $240 billion into the stock market since June.

It is also the same stock market China has been trying to "purify", and that has been falling because foreign investors don't understand China's growth model, according to Chinese media.

Admitting that the market was a bubble, and that it has now popped, is a big step.

Of course, that's just the stock market - a stock market in which only 5% of Chinese people are invested. What's far worse is what was reportedly said about the country's real economy.

According to Japan's Nikkei news service, Chinese Finance Minister Lou Jiwei told a group of delegates that China would face up to 10 years of tough economic conditions. The next five years, he said, would most definitely be painful.

That doesn't tally with the 7% growth target China keeps repeating, a target that China's richest man has dubbed a fantasy.

Contrast what was said this weekend with what you read in China's state media and you get a picture of policy going forward. It's not pretty at all. It is the picture of the government whose carefully laid plans have gone awry.

The plan goes awry

Right now, China is trying to move its economy from one based on foreign investment to one based on domestic consumption. Leaders knew that as this happened, the economy would slow down.

President Xi Jinping called this "The New Normal" and prepped his people for change, and the country's heavily indebted state-owned enterprises (SOE) for reform and restructuring.

Here's where Zhou's comments about the stock market bubble come in. To keep fresh cash flowing to SOEs and other corporates, the government encouraged people to invest in the stock market in Shenzen and Shanghai.

That's why, until June, both indices had seen a glorious year and a half plus rally of around 150%.

Then in June both indices crashed. Then they crashed again in August. The Shanghai Composite, which had gained 60% for the year until the first crash, is now down 2% for 2015.

So that's one thing to freak out about. The corporate capitalization plan didn't work.

Meanwhile, in the real economy, the "New Normal" has started slowing China down faster than officials expected. Export and manufacturing data for July came in much weaker than expected falling 9% from the same time the year before.

At the same time the services sector (the growth driver leaders are dreaming of) and property market ( China's traditional growth driver) aren't growing fast enough to make up for losses elsewhere in the economy.

That, in part, is why on August 11th, China devalued the yuan. Exports recovered a bit in August, falling only 6%, but that isn't comforting anyone in Beijing.

7%?!

"Another month of shrinking exports adds to the gloom on China's growth outlook," wrote Bloomberg economist Tom Orlik. "With new real estate construction also contracting, the main external and domestic sources of demand are both down. The scene is set for further easing. The key question is whether that will include a further weakening of the yuan."

China has been walking a tightrope with the yuan - it is willing to allow the currency to fall a little to help spur exports, but not so much that it leads to capital flight. And right now it is spending a lot of money keeping the yuan steady at about 6.37 per US dollar.

The People's Bank of China (PBOC) has had to expend its big pile of foreign exchange reserves selling dollars and buying yuan to create demand for the currency. The weaker the demand for yuan in the market, the more buying the Chinese have to do.

And we know demand is weak, because the PBOC burned through between $94 and $110 billion in foreign reserves in August. That's the largest drop in reserves in the country's history.

In other words, the PBOC can't do this forever. There needs to be more easing, but the government has already cut rates and enacted looser policies to spur growth in the property market (among other things). It's unclear what they can do next that will really make an impact.

And there's another reason why this can't last forever. Already there are rumblings within the Chinese Communist Party that some loyal to former President Jiang Zemin want Xi to end the "New Normal." Xi's made it clear through the Chinese media that "retired" leaders should stay retired.

So we may have some serious infighting on our hands if this situation gets worse.