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Meet the New Boss

Confluence Investment Management
By Bill O’Grady
December 3, 2012


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On November 14th, the new Politburo Standing Committee (PSC) was unveiled.  The composition of this new group had been anxiously awaited for months.  Although most of the members (all men, by the way) had been anticipated, there were some surprises.  This committee is the most powerful group in China; it is essentially the legislative and executive branch of the country.  And, given that the judiciary is not really independent, the PSC effectively rules China.

Gone are the days when China could select new rulers in peace.  Now that China is the world’s second largest economy and a significant regional power, what happens in China matters to everyone.  The Communist Party of China’s (CPC) method of picking leaders is both opaque and transparent.  China watchers can generally see who is in ascendency and who is falling back by watching the grooming of new leaders.  Unfortunately, the process has now gone on long enough that candidates for power realize the best way to ascend is to reveal as little as possible about one’s true intent.  Showing oneself as a conservative or a reformer will tend to bring opposition.  Being all things to all people seems to be the key to becoming powerful.  Interestingly enough, this isn’t wildly different from what occurs in many democracies (including ours!). 

In this report, we will introduce the new members of the PSC with a short description of each.  We will analyze the new group, focusing on the signals being sent by who was selected and excluded.  We will also examine the “long shadows” being left by former leaders.  From there, we will discuss the challenges Xi Jinping will face over the next decade.  Finally, we will offer a few observations about the new General Secretary and conclude with the impact on financial markets. 

The New Standing Committee

The new members of the PSC are:

Xi Jinping (General Secretary):  Xi was one of the two new members who were known well in advance.  Xi is the second youngest of the new PSC at 59 years old.  CPC rules exclude anyone from the PSC who is older than 67 at the beginning of the five-year term.  Xi is a “princeling,” the offspring of a former important CPC leader.  Xi’s father was Xi Zhongxun, one of the founders of the Communist guerrilla movement and a former Vice Premier.  However, being the son of a major leader did not mean a privileged life, as Xi’s father was purged during the Cultural Revolution.  Young Xi was sent into the countryside as a teenager to work among the peasants.  After the revolution ended, Xi began college in 1975 and completed coursework in chemical engineering.  He eventually graduated in 1979 with a degree in Marxist Theory and education.  From 1979-82, he was an aide to Geng Biao, a subordinate of his father; Geng was the Secretary General for the military.  In this role, Xi gained exposure to the armed forces.


During the mid-1980s, he also spent time in the U.S. studying agriculture in Iowa. 

During the 1990s, Xi steadily advanced through various positions, mostly at the provincial level.  His record suggests he is an able administrator; it is also clear he has studiously avoided controversy.  He was appointed to the PSC in 2007 and it became apparent soon after that he was being groomed for the General Secretary position.

Xi is considered a close ally to former General Secretary Jiang Zemin.  As we will see below, Jiang’s stamp on the new PSC is surprisingly wide and deep. 

Li Keqiang (Premier):  At age 57, Li is the youngest member of the PSC.  As is customary, the PSC’s Premier (second in command) is given the economy mandate.  His role will be to guide the economy over the next decade.  Li is a member of the Communist Youth League (CYL) faction; the leadership of the CPC tends to break into two broad factions, the princelings and the CYL group.  The former are best described as CPC “royalty” with blood connection to the “founding fathers” of Communist China.  The latter are “commoners” who rise through their membership in the Communist Youth League.  They tend to come from the countryside while the princelings have tended to congregate in the coastal region. 

Li has a law degree and is an economist.   Like other CYL members, he tends to avoid flashy behavior and is considered a solid administrator.  He was successful in boosting the economic status of Henan, one of the inland provinces.  However, he was faulted for not dealing well with an AIDS/HIV problem in Henan. 

Li is an ally of Hu Jintao, the only member of the PSC considered a protégé of the former General Secretary.

Zhang Dejiang:  The 65-year old Zhang is considered an ally of Jiang.  He spent his university years in North Korea and has assisted the regime in its dealings with the Kims.  Zhang is considered a conservative; he ran Guangdong province and generally gave business a free hand in expanding.  However, he suppressed the media and forcibly ended protests.  During Jiang’s tenure, this behavior was prevalent. 

Yu Zhengsheng:  The 67-year old Yu is the oldest of the new PSC (in fact, he is in the last year of eligibility).  A princeling, he was very close with Deng Xiaoping; in fact, after Deng stepped down, Yu represented his interests in government.  He is also close to Jiang.  Yu is very well connected and was the Party Chief of Shanghai, replacing Xi.  The only real blot on his career was the 1985 defection of his brother, Yu Qiangsheng.  He is generally thought of as a competent administrator and is not known to have any obvious ideological leanings. 

Liu Yunshan:  Liu is the only other representative from the CYL but is considered more of an independent.  His background is in propaganda and, as is common with those from this part of the party, he is a hardliner on social unrest.   Lui, 65, has spent much of his career in Inner Mongolia.

Wang Qishan:  Wang is a princeling who has made a name for himself in economic management.  He was the primary deputy to the former premier, Wen Jiabao, and was in charge of economic affairs.  Wang was active in the breakup of many of the state owned enterprises (SOE) in the late 1990s.  He is credited with preventing a banking crisis after the failure of Guangdong International Trust Corporation, which owed money to over 130 banks worldwide.  Interestingly enough, Wang was given the mandate to address corruption; reports suggest that the CPC leadership was worried that keeping him as the economics deputy would overshadow Premier Li.  Wang, perhaps the strongest manager of this group, is 64.

Zhang Gaoli:  Zhang has no real affiliations other than close ties to Jiang.  He has spent most of his career at the Ministry of Petroleum and is considered part of the “oil clique.”  He has ties to many of the princelings and is considered a competent manager. 

Observations

The PSC membership was reduced to seven from nine; it had expanded in 2002 during the transition from Jiang to Hu.  Most analysts believe that the larger number made governing more difficult as it was harder to develop a consensus among the PSC.  In another important development, Hu completely ceded power to Xi; Jiang had kept the military portfolio for two years after his term ended.  This move by Jiang was considered to be bad form and Hu has gained respect for making a clean break. 

The new PSC is a transitional body.  All five of the new members will not be allowed to sit for a second five-year term, as they will be over the age of 67 in 2017.  Thus, Xi will most likely be able to dominate the PSC in the second term. 

The new PSC appears to be a very conservative group.  Wang Yang and Li Yuanchao, two Politburo members who were thought to have a chance of being selected to the PSC, did not make it in the end.  Both are considered reformers, open to greater social opposition.  It is highly likely that both will be appointed in 2017.   The new group shows the long reach of Jiang, who is influential to Xi and has close ties to several of the new members. 

The Challenge

When Deng gave up power to Jiang in the 1990s, the goal was to allow rapid economic development on the coasts to build enough investment capital for future development of the interior.  Deng and Jiang both realized that uneven development was a risk but also knew that the costs of building transportation infrastructure into the interior was not feasible without a strong base of growth.  When Jiang gave way to Hu and Wen in 2002, it was widely considered that their task was to balance growth by using the economic development on the coasts as a base for interior progress. 

Unfortunately, Hu and Wen were never able to complete the task.  As often happens, a constituency develops around certain policies and those on the coasts did not want to give up capital to the interior.  Instead, they wanted to maintain the status quo, which included a steady flow of migrants from the interior.  Due to Chinese residency laws, those migrants had few rights and were exploitable by the coastal firms. 

Xi inherits the same unbalanced economic situation from Hu but on a much riskier scale.  Not only does the economy’s geographic skew remain, but the internal balance in GDP has become dangerous.  The Chinese economy is heavily overweighted toward exports and investment and underweighted toward consumption.  Thus, Xi not only must boost growth in the interior at the expense of the coasts, he must also change the economy’s balance toward consumption.

Like dieting, such actions are intellectually simple but difficult in practice.  The problem for Xi is that many high ranking members of the CPC have benefited greatly from the status quo.  Reports in the NYT have indicated that Wen Jiabao’s family wealth may approach $3.0 bn.  Well-connected Chinese use their power to gain control of companies and capture cash flows from various SOEs.  Over the past nine years, the assets of the SOEs have risen nearly fourfold to CNY 28 trillion ($4.5 trillion).  Some of this growth in assets has found its way into the pockets of Chinese officials. 

The reforms China needs to make are fairly straight forward.  Consumption needs to rise relative to investment and exports.  To boost consumption, a social safety net is necessary to give citizens confidence that they won’t be destitute when they are old or sick.  This change won’t be enough, however.  In addition, China will need to restructure its financial system to end the financial repression of the household sector.  This action will require two major changes.  First, real deposit rates will need to rise into positive territory, and second, the Chinese yuan will need to appreciate to reduce import costs.  The investment and export model of development employs financial repression of the household sector to keep interest rates low and import prices high.  The low rates allow for investment and the low exchange rate supports exports. 

Unfortunately, these changes will be detrimental to the business sector, especially the SOE whose business model is predicated on low borrowing costs.  Giving households a higher deposit rate will require higher borrowing costs as well.  For Xi to make this change will require him to undermine the economic structure that has made his colleagues (and perhaps himself) wealthy.  In other words, the economic structure that has enriched the upper echelons of the CPC will need to change and it is difficult to see how Xi can do this easily. 

If China is unable to make these changes, it runs the risk of repeating Japan’s experience.  Japan has been struggling for the past two decades to change from export promotion and investment to a consumption model.  The failure to make this adjustment has led to stagnant growth.  If this is the outcome in China, it will likely result in widespread civil unrest; we doubt the Chinese citizenry will tolerate what Japan has suffered through since 1990.

Perhaps this is why capital flight has accelerated (see WGR, 7/16/2012, The Mystery of Chinese Capital Flight).  Chinese entrepreneurs who have benefited from the structure since 1990 appear to be establishing an exit strategy likely to continue if restructuring undermines the status quo.

Ramifications

So, what will Xi do?  So far, Xi hasn’t tipped his hand on his plans but a couple of signals have emerged.  There have been a number of reports indicating that Xi is somewhat enamored with Singapore.  Lee Kuan Yew generally ran Singapore as an authoritarian regime even though it has the trappings of democracy.  Yew’s method has been based on a social contract; the leadership is given free rein to run the city-state and the government religiously avoids corruption.

It is worth noting that Wang Qishan, who has a reputation of dealing with difficult problems, has been put in charge of dealing with corruption.  In Xi’s acceptance speech, he discussed the need to address corruption.  Although it is too early to tell definitively, it would appear that Xi intends to keep the current economic system in place but will rigorously deal with corruption so as to boost the CPC’s legitimacy.  In other words, if we are right, Xi does not believe that a major restructuring in the economy is immediately necessary, but raising the legitimacy of the party is.

If this analysis is correct, we can expect China to continue to grow via investment and exports.  In the short run, this is good news for commodities and global growth.  However, in the long run, this model is not sustainable.  If the export and investment model is maintained, over time, the economy will likely suffer through a debt deflation similar to Japan.

It is quite possible that Xi intends to make the structural shift in the second term.  The new PSC is bereft of reformers; in fact, Jiang’s stamp is so pervasive that it may be impossible to make serious changes in the next five years.  To make the change to consumption would repudiate Jiang’s economic model.  Thus, for now, we expect the status quo to be maintained with a highly visible attack on corruption.

The key unknown is whether China can maintain the current model for another five years.  If not, China could suffer a major economic breakdown.  However, it is quite possible China can maintain the status quo for a while longer.  Given the makeup of the PSC, Xi will have the chance to pick five new members in 2017.  We suspect that any major changes in policy will probably be delayed until then.

 

Bill O’Grady

December 3, 2012


 

 

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinions of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

 


Confluence Investment Management LLC

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri.  The firm provides professional portfolio management and advisory services to institutional and individual clients.  Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach.  The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives.  The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication. 

 

 


 

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www.confluenceinvestment.com

 

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