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Economic Insights

The Chinese leader’s emphasis on quality-of-life issues is likely to slow the rate of economic growth to which the world has grown accustomed.

 

In Brief

  • The closing of the 19th Congress of the Communist party of China on October 25 makes it very clear: the party rules China, and Xi Jinping rules the party.
  • Xi’s Chinese Dream combines aspirations of global leadership and national pride with improvement in the quality of life for citizens, but may come at the expense of economic growth.
  • The party pays lip service to “market-oriented” reforms, but what it wants to do is improve the productivity of state-owned companies, thereby making the state stronger.
  • The private sector may face higher taxes to support social welfare programs, but services such as health care and companies benefiting from China’s push for electric cars may offer investment opportunity.
  • The 19th Congress is challenging the West’s assumption that a market economy can be more efficient in the allocation of scarce resources than a centrally planned economy.

 

With the closing of the 19th Congress of the Communist Party of China (CPC) on October 25, 2017—a political summit held every five years—investors are coming to terms with a new reality in the world’s second largest economy.

Five years after becoming China’s leader, Xi Jinping has been granted power and stature unmatched since the days of Chairman Mao Zedong. Confirming the “coronation,” the party added Xi’s political theories to China’s constitution—bearing his name, something also not done since Mao.

With the ruling Communist party thus emboldened, it is imperative that Western investors find their bearings in what likely will be a new investment environment. Following are some of our observations on the changes wrought by the 19th Congress.

Consolidation of Power
Xi has been consolidating the power of his position since he first became China’s leader in 2012. As such, he holds a unique position in post-Mao China in terms of the level of power held by a single person. Soon after becoming head of state, he assumed the lead positions in the CPC and the Central Military Commission, which essentially made him the head of the military.

Chinese leaders have always had a lot of discretion as to how they distribute power to others among the party ranks. Under the two prior administrations (the most recent one being under Hu Jintao), the nine members of the Politburo Standing Committee (PSC), the party’s top body, each had responsibility for a different function. Hu was considered the “first among equals” and had only one vote.

Xi reduced the PSC to seven members and shifted control to seven central leading groups and commissions that he heads personally. These are the National Security Commission, the Central Military Commission, the Leading Group for Military Reform, the Political and Legal Affairs Commission, the Leading Group for Financial and Economic Affairs, the Leading Group for Internet Security and Information, and the Leading Group for Comprehensively Deepening Reforms.

In short, prior to the 19th Congress, Xi already had taken power back from other members of the PSC. The 19th Congress confirmed the party’s support for these actions. Moreover, within the new PSC, there does not seem to be an apparent designated successor, suggesting that Xi may not retire in 2022, thus bending informal succession rules in place since 1992 that limited leaders to two successive five-year terms.

The Chinese Dream
In his keynote speech at the Congress, Xi said China’s primary task was now to satisfy the people’s increasing demands for a “wonderful” life in the face of incomplete and unbalanced development—a not so veiled reference to the growing income inequality and corruption that followed the nation’s market liberalization efforts since the 1990s. The market reforms and privatizations were themselves an attempt to address the social unrest manifested most publicly by the protests in Tiananmen Square in 1989. But accusations of political advantages abused and state enterprises sold at unfair prices to the well-connected became rampant over the next decade.

In his first five years as party leader, Xi confronted the issue of corruption head on in an anti-corruption campaign that reached to the highest levels of government as well as to private enterprises, and continues to this day.

Xi believes that his anti-corruption campaign is key to establishing his legitimacy as China’s leader, maintaining the support of the Chinese people, and implementing the kinds of public welfare programs that he feels are necessary for China, such as income generation for all, better health care, and environmental safeguards. Xi encapsulates these ideas in what he calls the “Chinese Dream,” a vision for the nation’s future that integrates national and personal aspirations, with the twin goals of reclaiming national pride and achieving personal well-being. The program requires sustained economic growth, expanded equality, and an infusion of cultural values to balance materialism.

The concept of a Chinese Dream is not a response to any pressure from abroad. China has always been a very inward-looking country. This is about China reaching its own perceived potential. It’s about realizing the things that China believes are important for its future welfare and position in the world. For party leaders, it is about reaching three important goals: doubling China’s 2010 income by 2021, the 100th anniversary of the founding Communist party; achieving what Xi calls “socialist modernization” by 2035; and making China a “great modern socialist county” and “global leader” by 2049, the centenary of the establishment of the People’s Republic of China.

Party Control Strengthened
Xi’s reading of history is that the collapse of the Soviet Union in 1991 was due to the fact that the Soviet leaders of the Communist Party had let diminish their control over culture, society, political life, the military, and economics under the influence of Western forces of economic liberalization. Xi is determined to prevent that from happening in China.

Accordingly, he wants to extend the party’s control over many aspects of Chinese life. As reported in The Wall Street Journal, the 19th Congress makes that clear: “The party leads on everything, be it party work, government, military, civilian, or academia, be it east, west, south, north, or middle,” the resolution said. Xi’s supporters say the president’s enhanced authority will enable him to overcome the vested interests that have prevented him from tackling such problems as pollution, the inefficiency of state companies, and mounting domestic debt.

Meanwhile, the CPC exercises its control in many different ways. In fact, the role of the party is institutionalized in law in ways that seem very oppressive to Western observers. For instance, unlike in Western law where the judiciary is independent from the legislative branch of government, Chinese courts do not have independence from the party. In addition, every state-owned enterprise (SOE), a category that includes some of the biggest companies in China, has a CPC committee, which must be consulted by the boards of directors before deciding on any material issues. The Party’s goals and objectives must be taken into account by companies in the private sector as well.

Accepting Slower Growth
In 2013, Xi set a floor for economic growth, at 6.5%, which he said was needed in order to achieve the goal of doubling China’s 2010 income by 2021. But GDP growth need only average 6.2% for the next three years to achieve the doubling targeted for that date. And given his broader quality-of-life objectives, he may be playing down the role that economic growth will play in his concept of “national rejuvenation.” Will a slower rate of growth be acceptable to the Chinese people?

It’s widely believed that the legitimacy of Chinese leaders depends on maintaining strong growth in the economy and delivering these benefits to the people, helping them move up the economic ladder. The assumption is that slower economic growth would lead to social unrest and a demand for more personal freedoms, creating an existential crisis for the party. Such was the thesis upon which market reforms were initiated following the murderous unrest in Tiananmen Square.

But that may not be true anymore. First of all, China’s underlying GDP growth rate has roughly halved since 2010, to just above 5%, and Xi’s leadership has not been challenged at all, even as this slowdown has been taking place. So, it seems clear that the Chinese people can tolerate some slowdown without having Xi’s (or the CPC’s) leadership called into question.

 

Chart 1: China’s Real GDP Growth Rate Has Been Falling Since 2010
TED™ five-year moving average, 1995–2015

Source: The Conference Board’s Total Economy Database™ (TED) and Lord Abbett. TED adjusted corrects for measurement problems stemming from biased investment price deflators and excessive estimated productivity growth in “non-material” services. Past performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

Productivity and the State
Most of the slowdown in GDP in recent years has been due to decelerating productivity growth, which must pick up to prevent GDP from slipping well below 5%. During the privatizations of the 1990s, productivity rose as private investors took over what formerly were SOEs. As is typical in socialist economies, the state-run companies were functioning more like broader social institutions than profit-creating entities—providing not only jobs but also housing and education for their workers. During the same period, productivity gains also were realized simply by the shifting of economic resources from subsistence agriculture into industry and services. The privatization process effectively ended when Xi came into power and he turned his focus on anti-corruption efforts, although the leadership continued paying lip service to “market-oriented” reforms.

 

Chart 2: Most of the Slowdown Has Been Due to Decelerating Productivity
Percent growth of various measures, 2002–2011 and 2012–2016

Source: The Conference Board’s Total Economy Database™ (TED) and Lord Abbett. Past performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment. 
Author’s note: Since growth in labor’s contribution will remain low and that of capital is likely to slow further, productivity growth must pick up to prevent GDP from slipping well below 5%.

 

Xi is not a “reformer” in the sense that Westerners understand and have come to expect from China over the last few decades. In our opinion, we won’t see Xi transferring assets from the state to private companies in order to make more room for the free market. That’s not the type of reformer he is. Even though we believe Xi sees a role for the market—and just that, subsumed to party dictates—a wholesale privatization of the economy and the implementation of liberal market reforms are not likely to take place anytime soon.

In fact, since Xi has come into power, the share of fixed investment undertaken by private companies as opposed to public companies has stopped increasing. And more recently, the fixed-asset share in the public sector has started to increase again.

 

Chart 3: The Government’s Share of Fixed-Asset Investment Has Increased Since 2015
Percent state share fixed-asset investment, February 2003–February 2017

Source: China National Bureau of Statistics, Bloomberg, and Lord Abbett. Past performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

This is telling us that Xi is looking at things in a different way, the essence of which is that he is going to reform the state companies. Instead of selling SOEs to private investors, he will attempt to make the SOEs more efficient while retaining full control of them.

So, for example, where there is excess capacity in the coal and steel industries, we may expect Xi to shut down the highest-cost plants, which is what a capitalist would do. He will want to make state companies run more efficiently by using technology. That’s what a private company would do. And there’s much room to improve performance in the state sector by doing such things. In short, what Xi wants to do is improve productivity in SOEs, making them stronger, thereby implicitly making the state stronger.

Xi’s plan is to grow the economy by having a more efficient state instead of using the market to organize the economy on a more efficient basis. That may be a kind of reform, but it’s not market reform.

Certainly, SOE reform will be essential for maintaining economic growth. But if the state is prioritized over private enterprise, then counting on SOE reform to achieve rapid productivity growth is probably unrealistic.

Financial Stability
One of the objectives of the Chinese Dream is to achieve financial stability—that is, to avert the kind of financial crisis that slowed economic growth in the Western economies in 2008–09. China stimulated growth in its own economy during that period through debt-financed capital spending and land development using SOEs as the vehicles for stimulus.

Although the debt accumulated is now a concern to policymakers, the fact that China’s investments have been financed internally (i.e., they don’t depend on borrowing from overseas), the national savings rate exceeds investment requirements, and that their capital markets are closed (i.e., you can’t take money in or out freely) means that this big debt buildup isn’t quite as threatening as it is for some other countries that over-borrowed and then collapsed.

But if financial stability and the lowering of debt is prioritized, along with an increased emphasis on SOE reforms instead of growth of private enterprise, that would be another clear signal that the party is willing to accept slower growth, and that could lead to more of an economic slowdown than anybody expects. And, at this point, that seems to be the case. An increased focus on quality-of-life issues may be important, but such a shift in emphasis won’t drive economic growth.

Investment Opportunities
So, where will one find potential investment opportunities under Xi’s regime?

Direct investment in listed SOE equity has not been a good way to take advantage of growth in China in recent years, and, in our opinion, that is not likely to change over the next five years, despite Xi’s pledge to make them more efficient. Certainly, existing shareholders face an ominous prospect. The balance sheets of many SOEs are loaded with debt. Most likely China will convert at least a portion of that debt to equity, diluting the equity value for owners of those stocks. In fact, the market is anticipating that eventuality, and many SOE stocks are trading at a discount. If you can find an SOE without a lot of leverage in its balance sheet, an investment there might at least avoid the risk of dilution. But that would be more of a niche strategy than a “buy China” strategy.

 

Chart 4: Investing in SOE Equity Has Not Been a Good Way to Take Advantage of Growth in China
Equity index* of SOEs relative to private companies, August 2015–November 2017 

Source: Bloomberg and Lord Abbett. Data as of November 1, 2017. Performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. *CSI Hong Kong State Owned Enterprises Index (CSISOE) divided by CSI Hong Kong Private Owned Mainland Enterprises Index (CSIPOE).

 

In 2017, Xi forced the closure of polluting factories, mostly privately owned, helping to push steel and aluminum prices sharply higher. That was another niche play.    

With Xi strongly reaffirming the role of SOEs atop the economy, private sector firms—including foreign enterprises—may be called upon to fund China’s increase in welfare spending, potentially through higher corporate taxes. That is not a positive prospect for the companies or their investors.

Nonetheless, foreign investors may find opportunities in service sectors, such as health care, that support the regime’s goal of a better quality of life. According to The Wall Street Journal, Xi specifically cited services as an area that should open up to foreign investors.

 

Chart 5: China Drives Demand and Production Growth for Many Key Global Commodities
Percent of global demand and production

Source: Australian Bureau of Agricultural and Resource Economics, Resource Bureau, China Resources Quarterly (December 31, 2016).
Past performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

Another investment opportunity may be discovered in the electric car industry; China is supporting a huge initiative to go all-electric by 2025. China also is a major global player in commodities (see Chart 5) and mining, in the tourism industry, in global real estate, and retail. Any one of the above examples could lead to investment opportunities outside of China that would benefit from China’s participation in global markets.

Finally, with China’s goal of being more assertive abroad, military spending is expected to increase in South Korea, Japan, and other wary neighbors, providing another opportunity for investors outside of China’s borders.

Challenging the West
As China strives to achieve the Chinese Dream, it’s likely that just by achieving its goals that it will be challenging the West. After three decades of double-digit economic growth, China now sees itself as deserving a return to its historical role as the core of the world economy. And the new constitution enshrines China’s economic strategy to dominate the world.

China’s currency, the yuan, is a key part of that strategy. Having achieved reserve status from the International Monetary Fund in 2015, the yuan joins an elite currency club that includes the U.S. dollar, the euro, and the yen. The yuan, however, is the only member of that club that isn’t freely convertible, with official trade limited to within China and the offshore trading hub of Hong Kong. In our opinion, China will likely retain its firm hold on the currency for the foreseeable future.

Elsewhere, China will work within existing institutions, such as the World Trade Organization, as effectively as the nation must. But China’s leaders also will be creating new institutions, as they already have done, to exercise their influence apart from that of the United States and other developed nations. In our opinion, the International Monetary Fund and the World Bank will decline in importance, while newer institutions, such as China’s new Asian Infrastructure Development Bank, will increase in influence, especially around China’s One Belt, One Road initiative, which is trying to create a new East–West transportation hub that stretches around the entire world.

Another way China is challenging the West is on the assumption that a market economy can be more efficient in the allocation of scarce resources than a centrally planned economy. Such an assumption has always been predicated on the difficulty and costliness of collecting data on the many millions of supply and demand changes occurring every day. But technology is changing that. The ubiquity of point of sale terminals, of inventory tracking, of GPS devices and other sources of information is making it easier for companies to run global companies, and China is convinced that, with the information systems in place, the data it collects will aid in the management of its huge economy.

One could say that this is communism with a lighter touch. The oppressive control, the knock on the door at night, the spies on every corner—long associated (in the minds of the West) with a strong communist party—such tactics are no longer needed to obtain information about people and their economic and personal inclinations when a point-of-sale terminal on every corner, a cellphone record, and cameras on every street will do the job just as well. Nearly everybody (the rural population is not as wired up) now leaves an electronic trail that didn’t exist before.

In addition to having the technological capability to collect data, we also are living in a time when more of us are willing to accept the intrusion of privacy to a greater degree than before—a combination of factors that supports the authoritarian impulse of the central planner.

A Key Trade-Off
Despite the lighter touch, and the seeming beneficence of Xi’s Chinese Dream, China’s system remains an authoritarian one, with all the implications that has for personal freedoms.

Are the Chinese people willing to accept the trade-off between personal freedoms and a “better quality of life” as defined by the party? Only time will tell. But many of the Chinese people who have been the beneficiaries of China’s growth over the past few decades are still alive today. They remember what it was like when they were much poorer. So their most likely inclination, along with their patriotism and support of China, is to support and trust the leadership until, and if, that trust in the party is broken.

Not the End
In his 1989 essay, “The End of History,” political scientist Francis Fukuyama posited that mankind had reached the pinnacle of its ideological evolution with its seeming rejection of communism and its acceptance of Western liberal democracy as its guiding principle for the future.

But China wants the world to see its form of governance as a reasonable alternative to the “free” market in the developed nations, offering a better quality of life through the promise of financial stability, moderate prosperity, better health care, and education.

Apparently, Xi wants a rewrite.

 

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