China is in the throes of its most important leadership change since Deng Xiaoping came to power over 30 years ago. Before taking office, Deng was reported to have told a Chinese Communist Party (CCP) conference: “I don’t care if it’s a black cat, or a white cat, so long as it’s a cat that catches mice.” His point was that to escape poverty and build a new economy, China had to change, and embrace “the market.” China’s new leaders will make choices about political and economic reform that are no less important. Their decisions will impact the chances of avoiding a sharp slowdown in the next two years, but more importantly, they will determine China’s economic and political path for at least a decade.
This is all manna from heaven for political and economic analysts. Investors also have strong reasons to monitor these developments closely, because the implications will affect both Chinese and global asset prices. For investors and analysts alike, it is of the utmost importance that they understand the significance of the changing of the guard in Beijing.
First, factional rumblings erupted in March with the sacking of Bo Xilai, the CCP chief of Chongqing province, who was considered a shoo-in for the Politburo standing committee, China’s most powerful decision-making body. These rumblings intensified in April, when Bo was publicly accused of having violated Party discipline and law, and his wife, Gu Kailai, was arrested in the course of an investigation into the murder of the British businessman, Neil Heywood. This remarkable turn of events surrounding such a senior official, his family and implicitly, his supporters in politics and in the military, is of huge importance. But the way the authorities have responded suggests that the significance lies more in the re-assertion of party rules and discipline, than in any root-and-branch reform of Chinese politics or liberalisation.
Yet political reform generally has become a major issue in China: Wen Jiabao, the outgoing Premier, insisted in March at his last big press conference that without successful political reform, economic restructuring could not happen.
Second, economic reform is essential because China’s economic and social model has developed serious flaws, imbalances and distortions, including severe income inequality. Changes are needed to avert the risk of a sudden, sharp slowdown in 2013-2014. They are also crucial if China is to avoid the so-called “middle income trap” over the next decade, a condition where the absence of robust institutions causes income per head to stall around the $10,000 level. China’s state capitalism has proven remarkably successful, bringing hundreds of millions of people out of poverty, raising educational attainment and living standards, building world class infrastructure, and creating national corporate champions that are formidable competitors.
But this model, as suggested, is also driving imbalances, inequalities and a growing number of incidents of social unrest. If this is not addressed, the current economic slowdown, marked by a faltering property market and weakening exports related to the contraction in Europe, could become more serious. For the moment, the economy looks set to carry on growing at about 7-8 per cent per annum. Underlying growth remains robust and an ambitious programme to provide subsidised housing should help. But if world oil prices and Chinese inflation rise, growth would suffer still further.
Perhaps even more importantly, the structure of the economy would not be able to deliver sustainable high growth, development, and social stability. The way round this has been captured in a comprehensive study, “China 2030,” recently published by the World Bank in conjunction with Beijing’s Development Research Centre. Among many recommendations, the report urged steady progress towards the completion of a market economy (based on stronger competition and entrepreneurship), new initiatives to foster broad-based innovation including a better quality of tertiary education, and “green” growth. It advocated health and social insurance policies to strengthen household income formation and security, and better access to high quality jobs, which is becoming a problem because of China’s annual production of 7m college graduates. It recommended a sequenced liberalisation of the financial system, designed to remove interest rate controls, and so establish a true cost of borrowing and investing. It recommended urgent changes to the migrant registration system, or hukou, which deprives urban migrants of access to many social benefits and hence exacerbates income and social inequalities. And it argued for a stronger system to protect farmers’ land rights which have been at the centre of several high profile incidents of social unrest.
This amounts to a more liberal market capitalism that would divert the flow of financial and other benefits from state-owned enterprises, state banks, and regional party elites to households and private sector small and medium-sized enterprises. Such a system would emphasise income equality and social equity and the substitution of transparency, accountability, and a rules-based system for the decision-making authority that resides in the CCP.
Is this a realistic course for China? In theory yes, but it is unlikely that this is what China’s leaders are actually proposing. Political reform is almost certainly about making the CCP more efficient, accountable and responsive in administration—but not at the expense of diluting its control and authority.
Xi Jinping, heir apparent to President Hu Jintao, recently told a Party School (a higher education institution which trains new officials for the CCP) conference, in true Leninist fashion, about the need for purity in the party’s ideology, organisation and conduct. His remarks, clearly aimed at Bo Xilai and his supporters, were to remind cadres that public trust in the CCP had been undermined by inappropriate conduct, lack of principles and corrupt leadership among many party members. Xi also appealed to party cadres to listen more to the people, and be more accountable in a wide range of activities, including official appointments, lending and spending by regional governments and state companies and banks, and land usage and allocation, which has been at the heart of a growing number of incidents of social unrest. The most widely reported was the stand-off, ostensibly about land seizures, between villagers and officials in Wukan in southern Guangdong in late 2011. But Wang Yang, a top official in Guangdong province and a liberal rival to the more boldly egalitarian Bo, perceptively attributed the cause to long-standing tensions arising from rapid economic and social development.
Who is a reformer anyway?
Does this make Wang a reformer and Bo and his supporters reactionaries? Were it so simple. Bo’s methods and use of the party for his own ends may have fallen foul of the top leaders in Beijing, but he was hardly a slouch on reform. He was popular, took the credit for Chongqing’s fast growth, attracted companies away from the prosperous coastal regions, and pioneered a bold reform of the hukou migrant registration system, allowing more farmers to leave the countryside and take up residence in subsidised urban accommodation.
Wang’s liberal reputation was evident in his handling of the Wukan dispute, and he has overseen the development of high-end manufacturing in Guangdong, while allowing loss-making textile and toy factories to close. He has presided over the development of national champions in the private sector, such as the telecommunications giants Huawei and ZTE. But Wang can’t be seen as a champion of liberal causes any more than Bo can be seen as their enemy. The two companies cited are among many that receive huge financial benefits and subsidies from state entities that have helped them to become formidable global competitors. And Wang’s public rhetoric continues to suggest he favours strong growth strategies more or less in keeping with the current statist model.
One of the earliest tests of the new leadership’s appetite for reform may revolve around the immediate problem of the faltering property market. At 13 per cent of total national output, property investment matters, and the last year has brought a combination of failed land auctions, falling property prices in most major cities, and the revelation of a vigorous build-up in the debt of local governments and a deterioration in quality of loans made by banks.
The government has engineered this outcome to help lessen the likelihood that the property bubble will burst—but the endgame is as yet unclear. Reform could mean gradually relaxing the monetary and housing sector constraints that have been in place since 2010. This could help to re-energise the sector, the economy, and the Chinese stock market, but it also risks inflating the price bubble in the process. Reform might also mean “hanging in there,” sustaining tough policies for another two to three years, while real estate prices cool down and the economy starts to rebalance.
The China story has become a big and popular investment theme, but the uncertainties associated with Chinese politics and reform are now making it hard to follow. After all, investing in Chinese equities, for example, hasn’t exactly been a gold mine. The Shanghai Composite Index is only barely above what it was in the first half of the 2000s, though if you’d bought the index in those years and sold again at the end of 2007, you would have trebled your money. Timing is everything. Equity prices have picked up again this year, but by no more than other major stock markets.
But if your strategy was to own say, commodities in some form, or the shares of global companies that make a lot of money by selling to China and other countries in China’s supply chains, you’ve done better, and probably with fewer worries. Under most, if not all circumstances, this still seems an appropriate investment strategy.
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Whether or not China becomes a high income country in the long term, it will surely become richer and more modern, regardless. By 2030, nearly 300m more people will live in towns and cities, raising the urban share of the population from 47 per cent to 62 per cent. More Chinese companies will become global entities traded on US or European stock exchanges. And China will exploit its strengths in, for example, infrastructure, clean energy and carbon capture, and telecommunications. If successful rebalancing happens, the Chinese consumer will become steadily more important.
Because China is expanding rapidly and still uses relatively large amounts of energy to produce each yuan of national economic output, and because the country has a large, wealthy population to feed, the effects of Chinese growth on energy, food and raw material prices can be expected to remain robust. Water will become increasingly significant, because China is already classified as “water-scarce” by the World Bank, with future demands that outstrip its domestic supply capacity.
But over the next two to three years, investors need to be even more careful. A soft landing, where growth settles somewhere in the 6-8 per cent range, won’t exhilarate investors—at the outset, at least. But if the new leadership manages the economy well through the current slowdown, defuses the property and bad loan problems, and allows a wider rebalancing to evolve, the outlook for steady and sustainable growth will be more promising.
A hard landing, however, meaning a sharp drop in growth to below 5 per cent for a sustained period, would spell rising unemployment and political instability. Profits in China would suffer, as would demand for iron ore, oil and other raw materials, and the effects of a weak Chinese economy would be felt not only in Asia but in Western economies too. All the more reason not to put all your eggs in the Chinese basket, unless your investment professionals know a lot about Chinese companies and banks.
More sensible would be to stick with China-focused global companies and resource providers that have diversified businesses, lots of liquidity, transparency and good corporate governance. You’ll do fine in a soft landing, and be better protected if it’s a hard one. While everyone wants a soft landing, a lot of things have to go right. They might, but the chances are tilted to a sharper and sudden economic slowdown in 2013-14.
