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Herve van Caloen, a managing partner at Belpointe Asset Management, is an investor with more than 25 years of experience managing international equity portfolios for Scudder, Mitchell Hutchins, Provident Capital Management. He is currently a portfolio manager at Belpointe Asset Management in... More
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  • China: The End Of The Deng Era. 0 comments
    Nov 7, 2012 11:01 AM

    As I write, the Chinese political black box is preparing to spit out a new team of leaders. At their coming November Party Congress, the Chinese nomenklatura will designate the first generation of leaders not handpicked by the late Paramount Leader Deng Xiaoping.

    The Eighteenth Party Congress comes at a difficult time. The economy is in a relative slump. The country is trying to digest both a housing bubble and an excessive investment boom. Many government-favored industries are facing substantial overcapacity problems. Exports are under pressure and trade tensions are mounting. GDP growth is slowing. After three decades of breathtaking expansion, China has reached a new crossroad.

    The Chinese Economic Miracle.

    Chairman Mao left China in a shambles. The country had suffered massive famine during The Great Leap Forward. Then, Mao upped the ante with the Cultural Revolution, which added more hardship to an already devastated country.

    The Cultural Revolution was a purge like none other. Instead of targeting the incompetent leaders responsible for tens of millions of deaths, Mao Tsetung launched a vendetta against whoever questioned his judgment. Prominent among them was President Liu Shaoqi. His crime? Trying to reverse some of the catastrophic policies of the Great Leap Forward. Many others in Mao's entourage suffered the same fate. Anybody with a brain was considered a menace. Teachers and "intellectuals" were prime targets. Kids were forced to condemn their parents. Anybody that could perpetrate the idea of a calamity induced by Mao's absurd policies had to be silenced by death. Mao's Cultural Revolution was in fact the greatest exercise of forced amnesia in human history. Many in the West fell for it. That too was quickly forgotten.

    When Mao finally passed away in 1976, the Middle Kingdom was longing for stability and, above all, some sanity. Deng Xiaoping's steady hand would take them to a very different place.

    It took Deng a couple of years to push aside Hua Guofeng, Mao's designated heir. By then, Deng was already in his late 70's. He was in a hurry. He rapidly launched a number of reforms that eventually lead to the Chinese economic revival of the last 30 years.

    Deng first stabilized the country and then put it on a path to a free market economy. However, unlike his fellow reformist Gorbachev in Russia, the new Red Emperor believed in a carefully managed transformation. Too much freedom at once could lead to more chaos. More economic freedom did not have to go hand in hand with political freedom. The communist party's firm grasp on power was not to be challenged.

    Ever the pragmatic, Deng famously declared that the color of a cat does not matter, as long as he catches mice. Gone were Marx's teachings. It was all right to become rich again. But it was not alright to challenge the communist party's hold on power. That's where the old revolutionary drew the line. Gorbachev lost control of Perestroika. Deng was not inclined to make the same mistake.

    The Global Wind of Freedom Stopped in Tiananmen Square in 1989.

    Soon after returning to power, the aging Deng had put Hu Yaobang in charge of continuing China's economic transformation. Hu and his liberal policies were immensely popular. However, the Party took umbrage. Hu Yaobang's "bourgeois liberalization" was too much for the old guard to swallow so Deng pushed him aside. Still, Deng did not give up on economic reforms. He promoted another liberal, Zhao Ziyang, to the top job.

    Hu's death soon afterwards lead to the Tiananmen Square massacre. Young people gathered en masse to pay tribute after his funeral. The movement evolved rapidly from grief to demands for what Hu Yaobang had stood for: a more free society. Some in the communist party, including President Zhao, were sympathetic to the students' aspirations. Zhao even tried to negotiate with the students for several days. The world was mesmerized. Was communist China going to fall so soon after the Soviet Union?

    Eventually Deng lost patience. He was still pulling the strings and ordered Zhao to send the army to quell the movement. Zhao bravely refused, which led to his house arrest. Mao would have killed him.

    However, Deng Xiaoping did not give up. He was still intent on liberalizing the economy, if not the political system. He promoted Jiang Zemin to the presidency. Jiang, with the help of the very capable Prime Minister Zhu Rongji, continued the economic reforms during the 1990's. The Chinese economic miracle was born. However, it had a major flaw.

    Years later, Zhao Ziyang's illicit memoirs were smuggled out of the country. In them, Zhao warned of the incompatibility of a free economy with dictatorship, even one of the so-called proletariat. His contention is that entrepreneurship will be held back by monetary extortion from those with political power. An authoritarian regime leads to an unfair system that rewards the connected at the expense of the talented and/or hard working. Zhao writes that without political reforms, China will continue to suffer from "commercialization of power, rampant corruption and a society polarized between rich and poor."

    Hu Jintao and Wen Jiabao Proved Zhao Right.

    In 2002, power was peacefully transferred to the next generation in accordance with Deng's plans. Even though he had already passed away (in 1997), his orders to pass the torch to Hu and Wen were dutifully followed. This was a remarkable feat. How often do dictators give up power? Deng's instructions were still respected and implemented years after he had rejoined Mao and Karl Marx. In death, Deng had outdone Chairman Mao himself.

    Unfortunately, this time Deng may have overreached. He misjudged the next generation and overestimated their free market credentials. His chosen political grandchildren, Hu and Wen were no reformers.

    Using growing inequalities as an excuse, the new leadership reversed the policies put in place by their predecessors. Privatization was stopped and the public sector was again favored over the private sector. Today, for example, state-owned enterprises (SOEs) enjoy an effective tax rate two thirds less than the private sector's, as well as cheap capital from a state-controlled banking sector.

    Then, at the time of the global financial meltdown, Prime Minister Wen doubled down with a huge economic stimulus plan that favored mostly the SOEs. No longer a communist economy, China today has nonetheless moved back toward top-down decision making, focusing investments on "strategic industries". In the process, Wen and his family managed to accumulate an immense fortune. Many members of the nomenklatura are similarly wealthy today.

    For a decade, under President Hu, the Chinese people have watched bureaucrats distribute resources to state companies and their friends. Whereas the early reforms created explosive growth, new entrepreneurs and a trickle-down wealth effect, current neglect of free-market principles has led to corruption and profiteering by the well-connected. The stock market is a case in point. (In recent years it has been used mainly to list state owned companies at inflated prices, "raising money from outsiders (including foreigners) to redistribute to insiders", according to The Economist. Small investors did not fare as well. The Shanghai Composite Index, after peaking at 6,000 before the financial crisis, is now back to the 2,000 mark, about where it was twelve years ago.

    Wealth disparity, always a sensitive issue, becomes explosive when it is the result of a rigged system.

    A Middle-Income Trap.

    Without reforms, experts now fear China will slide into a "middle-income trap", i.e., rapid growth followed by stagnation. China is indeed at risk of duplicating what many Latin American economies have experienced. Corruption and a huge income gap will prevent the country from becoming the economic superpower many believe inevitable. Already capital is fleeing the country, a sure sign of how locals feel about the future. Real estate in Cyprus seems to be the fad among the wealthy Chinese.

    The irony is that China desperately needs to develop a "bourgeois class". Its growth depends on what is also known as a middle class.

    This is China's predicament on the eve of the 18th Congress of the Communist Party which is expected to elevate Xi Jinping to the top job. Li Keqiang will take Wen Jiabao's job. Astonishingly, no less than 70% of the aging leadership bodies-the Party, the army, and the government-- are also expected to be replaced.

    Can Xi get the country back on a free market track? Does he intend to? Will he have the authority to do it? Or is the old guard going to continue to pull the strings to keep the status quo? After all, if I were Mr. Wen I would worry about letting others decide if my accumulated wealth could stay in the family.

    Like Father Like Son?

    China's communist system is opaque and nobody seems to be able to assess where it is taking the country next. There is very little known about Xi's personality or his intentions. Neither have I read any story about how he got chosen to be the next head of the most populous state in the world. All we know is that he is a member of the new communist aristocracy, also known as princelings.

    Aristocrats, when they are not crashing their Ferraris, are usually inclined to paternalistic behavior. If so, is Xi going to implement a strong social agenda more in line with European socialist redistribution policies? Or does he feel he has to continue in the footsteps of his father, Vice Premier Xi Zhongxun, who was instrumental in setting up the first free economic zone of Shenzhen?

    Xi Senior was a true reformer and a bit of a trouble maker. Three times in his career he opposed the supreme leader. Mao sent him to internal exile in 1962. Deng brought him back. The elder Xi's rehabilitation under Deng, however, did not prevent him from speaking out publicly against the Tiananmen Square massacre.

    One can only hope Xi Liping is a more patient version of his father. But there is no way of knowing at this time.

    Time to Bottom Fish in China?

    Here is what investors need to see before committing money to the Chinese market. They should wait to see if President Xi will tackle fundamental problems currently impeding sustainable growth. In my opinion, investors should only re-enter the Chinese market if he goes that route. I do not agree with traders who want China to come up with yet another stimulus program. This would only aggravate long-term problems, including crony capitalism and further misallocation of capital and resources by the government.

    The reforms which should head Xi's agenda include: restarting privatizations; changing the one-child policy; abolition of the hukou system; and quickly addressing the looming nonperforming loan crisis.

    Xi should also phase out the remaining dominance in many key industries of state-owned enterprises. This would allow the private sector, the real driver of the economy, to boost growth.

    Unlike rapidly-aging Japan, China is getting old before it is getting rich. The one-child policy needs to be ended quickly if the Chinese do not want to be buried by the cost of an aging population.

    Using the hukou system to control migration is an anachronism. The rigid urban residency system was a logical part of a true communist system that controls every aspect of one's life. Today, in China's post-communist economy, it only creates more disruptions. Migrants have become the new underclass. When moving to where the jobs are, all migrant workers are denied health care, education and welfare benefits because of this outdated system. Being vulnerable, they have to settle for lower wages to boot.

    Finally, state-controlled have been told to lend money to SOEs without regard for profitability or viability. By consequence they are now sitting on an explosive number of non-performing loans. The sooner this is dealt with, the better for the overall economy. Pretending, as Japan did for years, that the problem is minimal will only prolong economic stagnation.

    And then there is the issue of escalating nationalism. Considering the many challenges the country is facing, one would think this is not a good time to look for trouble with neighboring countries. De-escalating the bellicose rhetoric would help. Nationalist anger directed at Japan, for example, is harmful in many ways, not least by severely discouraging foreign direct investment.

    Conclusion.

    More and more investment advisors seem to be attracted by the Chinese stock market. It has had a long correction and valuations may start to look attractive. However, China today is a good illustration of something most investors have forgotten about emerging markets: political risks justify lower valuations.

    Investors who are willing to put a toe in the water and wait for better times by buying an ETF or a dedicated mutual fund should do their homework. He or she should make sure the investment vehicle focuses on private companies and not poorly run state owned companies.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Themes: market-outlook
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