The Great Chinese Political Rift

by: Adam Whitehead
Summary

The conflict between Xi Jinping and Li Keqiang is common public knowledge.

President Xi is focused on wealth distribution from the urban elite to the rural disenfranchised.

Premier Li is focused on economic reform and retraining.

A financial crisis is being stage managed by an "authoritative person" in order to win the conflict.

China's developed and emerging market economic characteristics undermine its trade partners.

The last report observed the deteriorating relations between President Xi Jinping and Premier Li Keqiang. This observation can be directly traced back to the report entitled, "Chinese Intelligence Question: What Is the Czar's 'Core' Strategy?" It would seem that the president is consolidating power over the media, the army and lately economic policy, in order to defeat his rival.

Premier Li's power base comes from the intelligentsia and technocracy. This cadre also seems to be heavily supported by the neoliberal globalist political and economic infrastructure and its cheerleaders. Premier Li is identified with economic reform and the opening of China's economy. The President is, however, antipathetic to this elitism and foreign influence. This ideological antipathy therefore spells class war. The economy's underperformance and need for reforms also adds an interesting dimension to the conflict.

(Source: Bloomberg)

Xi's policies threaten to turn the clock back on reforms and therefore weaken China's economic fundamentals. They also risk protectionism and trade wars by supporting the aging industries that are China's main employers. Evidence of Xi's invisible hand on the economic tiller was signaled recently by the PBoC.

Prior to Xi's heavy handed influence, the PBoC used to enforce strict control over the Policy Banks by making them apply directly to it for the Pledged Supplementary Lending Program (PSLP) which funds them. The PBoC was therefore able to keep a tighter control over the policy banks as part of Premier Li's attempts to avoid wastage and to apply economic reforms. Control over the Policy Banks has now been overturned, as the PBoC will allocate the PSLP support directly at the beginning of the month.

There is now no cap on lending or expiration date for the funding, thus clearing the way for increased credit allocation from the lenders: China Development Bank, the Agricultural Development Bank and Export-Import Bank. While this may appear to be a genuine economic stimulus, it should also be viewed as a return to the old economic model that Xi had initially pledged to reform at the last G20.

(Source: Business Insider)

One reason for this new hands-on stimulus can be found in the latest migration flow data. The great urbanization wave is over, as job prospects in the big cities decline and the cost of living rises. In addition, many migrants are returning home to take care of their elderly relatives and to tend to their farms. The Policy Banks are therefore being positioned to address this reflected wave.

It now remains to be seen if the Policy Banks will try and reverse the wave back towards the urban areas or just go with the flow and stimulate the hinterland where the migrants are returning to. The current wave of reverse migration has the potential to become a great destabilizing effect by creating pools of idle labor in places where there are no real jobs. Such locations then become breeding grounds for popular dissent.

It should be noted that President Xi is empathetic towards and directly identifies with these rural migrants, as opposed to the city dwellers and the urban elite. These are his foot-soldiers should he require them, as Chairman Mao once did. It looks as though they will be mobilized very shortly. Xi's position is that the urban beneficiaries of China's growth miracle should share their good fortune with their rural brothers and sisters.

The IMF has picked up on the rural-urban conflict on the ground and at the policymaker level. In a recent report, it highlighted the rapid urbanization of coastal city areas as creating this economic divergence. In addition, lower educational attainment and returns on education have exacerbated the problem in rural areas.

(Source: Nikkei Asian Review)

It has become clear that China is entering a period of domestic political friction. A classic proto-Soviet dialectic between the peasants and the bourgeoisie is being played out at a higher level. Thus far, it has not erupted onto the streets.

Both leaders of each faction are losing focus on the economy as they focus on each other. A leadership vacuum and internal political struggle will therefore undermine the economy and also perceptions of Chinese risk. China's debt mountain will then command a higher risk premium in recognition of the deteriorating political landscape.

(Source: The Guardian)

President Xi's enigmatic response to the palace coup rumors only served to confirm that there is indeed just that happening in real time. In his opinion, there are "cabals and cliques" inside the party that risk "compromising the political security of the party and the country." In a scene reminiscent of the Night of the Long Knives, he then went on to say that: "There are careerists and conspirators existing in our party and undermining the party's governance."

(Source: CRIEnglish)

Premier Li quickly tried to regain the initiative in the rural-urban conflict by reaching out to Xi's younger, rural battalions. In a carefully staged visit to the Ministry of Human Resources and Social Security, he promised that: "The employment opportunities should focus on key groups - college graduates and migrant workers. We should further develop the job promotion program for college graduates. Since there will be more college students graduating this year, we should also do more to support self-employment." He thus intends to deploy retraining and fiscal support for the younger and rural cohort. Allegedly they will become entrepreneurs.

Finance Minister Lou Jiwei is potentially a collateral casualty from the combat between Xi Jinping and Li Keqiang. At the Asian Development Bank meeting in Frankfurt, he tentatively took ownership of the structural reform issue. Using the analogy of Germany's "sick man of Europe" transformation into the powerhouse of today, Mr. Lou announced that successful economic reform has a precedent. What he failed to emphasize is that Germany got a massive leg-up in its alleged reform from the creation of the euro. Germany's eurozone industrial competitors were taken out of the game as their nations were denied the opportunity to play the weak currency export stimulus game. More recently, the ECB has obliged by weakening the euro as the going gets tough.

President Xi's position of control over the Finance Ministry has been bolstered by the latest reshuffling at the top. Vice Finance Minister Zhu Guangyao has been promoted to a senior position in the Communist Party's elite financial and economic panel led by President Xi Jinping himself.

In his new Party role, he will serve as a deputy director of the general office of the Central Leading Group for Financial and Economic Affairs. Since his ministerial role involves him interfacing and coordinating with G20, his new role allows the President to directly control this interface function through the Party.

Premier Li's attempts to finance training and entrepreneurship after the mass layoffs in his reforms will therefore be circumscribed by President Xi's effective control of the Finance Ministry and the Policy Banks. Once again it appears to a conflict between Li's economic reforms and Xi's redistribution of wealth. President Xi controls the finances and occupies the populist moral high ground. Premier Li is the bad guy following a foreign agenda.

(Source: Bloomberg)

The timing of this political fight could not be worse for what has become known as the Great Maturity Wall of Chinese debt that comes up for redemption and/or refinancing this year. The PBoC will be forced to step into the breach and engineer attractive refinancing terms in the domestic capital markets to ease the passage of this pig through the python. The banking sector is already trying to convert its bad debt to equity, so any attempt to also convert the Maturity Wall into equity will face a crowded and difficult market environment.

(Source: The Daily Shot)

The debate in the analyst community over whether China's economy has become like America's pre-Credit Crunch has continued to rage since George Soros made the comparison. The growth of debt and GDP in tandem is to be expected. The growth of debt in an economic slowdown, as a counter-cyclical stimulus, is also to be expected. The problem for the China watchers is that the size of the debt mountain has grown much larger than the GDP that it has stimulated. The situation therefore appears to be unsustainable.

(Source: Business Insider)

What is more, there is a growing suspicion that China's GDP is now an invoicing system purely created to sustain the debt creation industry rather than vice versa. Analysis by Deutsche Bank finds that the expansion of credit in the capital markets has not even been translated, let alone multiplied in the real economy.

Traditionally speaking, the "financialization" of an economy signals that it has reached the maturation phase, perhaps in secular as well as in cyclical terms. The financial services sector accounting for the most significant share of GDP and/or stock market capitalization is also an indicator of economic maturity. China thus evinces signs of cyclical and secular maturity. On the ground, however, the mass migration waves and current focus of the President on the disenfranchised suggests that there is still a significant early phase demographic in the economy who have been left behind.

The battle between Premier Li and President Xi therefore represents a battle over who should receive a bailout/stimulus from the rapidly dwindling economic resources, aka reserves. Premier Li believes that the maturing economy he perceives requires a bailout for the asset-owning middle classes combined with structural reform. President Xi believes that the resources should be focused on saving those who have fallen behind and remain in emerging nation stasis. It is not just an ideological battle, but also one based upon differing perceptions of China's economic and political situation. What is dangerously lacking is a holistic view that reconciles both combatants and unites the nation. What is currently on show is atavism and conflict.

Popular dissent is already breaking out in the regions. The immediate targets of this dissent are the non-bank money lenders and brokerage houses. This dissent plays into the hands and strategy of President Xi. In fact, it may be that his invisible hand is involved in this regional popular dissent since he controls the organs of the media that orchestrate it.

His firm visible hand is also very evident in the response. New licenses for financial services activity have been cancelled and existing operators are having their operations and rents squeezed. A rolling failure among this community is now in process, so that it is difficult to discern the real business failures from the enforced closures.

Simultaneously, there is a crackdown and a tightening of the rules governing the shadow banking community masquerading as asset managers. Pooled investment vehicles are increasingly viewed as and being treated like Ponzi schemes.

(Source: Bloomberg)

The government had been supporting these shadow lending activities over the last two years, as part of its general monetary stimulus to provide loans for struggling small businesses. It has created a monster of financial leverage and speculation that is having a diminishing impact on the economy while raising the level of risk of a crash to the whole financial system. When the people start to blame the government for creating this problem, heads will have to roll. President Xi's controlled media will then help them to decide. Finance Minister Lou Jiwei's neck must be feeling a little exposed at this point in time, as is no doubt Premier Li's as well.

(Source: People's Daily)

The tension heightened when the state-controlled press, which is now under direct control of the President, called time out on the monetary easing process. On pages one and two of the People's Daily, an eponymous "authoritative person" opined that leverage is "original sin" and that deleverage should take priority over the "fantasy" of pursuing short-term growth.

It would appear that the crash in equities and the political and economic reforms that this event will launch is being engineered by said "authoritative person." Presumably those who have prospered politically and financially from the "fantasy" will also be removed. It seems that President Xi is already picking the winners and losers.

The monetary stimulus at home has created an arbitrage opportunity for Chinese companies listed abroad. Listing at home in China and delisting or even buying back shares abroad offers a great arbitrage opportunity. This arbitrage also shows that domestic Chinese equity valuations are significantly over-valued. This arbitrage and the signal that its sends, is also putting Chinese equity valuations in general at risk. Ponzi schemes associated with enabling this arbitrage are hence another sign of the vulnerability of the whole system. Chinese companies that are listed abroad and trading at significant multiple discounts to their monetary-policy-inflated domestic listed peers have had their option to relist in China suddenly revoked.

The last report highlighted the growing body of evidence, supporting the view that China's export-driven policies had significantly weakened the economies of its trade partners. The risk of trade wars, especially in light of the trend towards populism in developed economies, has thus been raised as a consequence. The OECD became the latest body to add to this volume of evidence when it released its conclusions about the steel industry.

The "High Level Meeting on Excess Capacity and Structural Adjustment in the Steel Sector" recently held in Brussels made the following conclusions. Firstly, it opined that the "challenges facing the steel industry, have an important global dimension that needs to be addressed through ongoing international dialogue"; and then, secondly, that "while the challenges facing the industry arise from many factors, such as structural and cyclical economic developments, government support measures have contributed to significant excess capacity, unfair trade, and distortions in steel trade flows." The OECD has therefore politely informed China to address its creation of a global steel glut before this escalates into an official trade war.

This call was echoed by a global confederation of 10 steel associations, who collectively opined that: "While we were disappointed that the Chinese government was unwilling at this time to join with other governments in a program of actions to address the global steel overcapacity problem, we are encouraged by the support of the governments of eight major steelmaking countries and regions to recommend steps to address excess capacity in the steel sector and eliminate market-distorting government subsidies and other support that promotes and sustains excess capacity in the steel sector, distorting competition." This group cited that China's position had"prevented a broad agreement on these commitments."

The pressure is now on China to show good faith; however, its political leaders may be too busy watching each other to respond, while its steelmakers are making the most of the PBoC's bubble in steel prices by expanding output. A crash in steel prices, predicted by many observers, may then put the global steelmakers into bankruptcy, at which point they will blame the Chinese for deliberately taking them out. It is hard to see the political civil war in China or the trade wars in the steel industry being resolved with pain for all involved.

(Source: The Daily Shot)

The crash in iron ore and steel prices got under way as physical stockpiles that the real economy has no use for have grown with the large speculative open interest in the Chinese futures markets.

In the last report, the Chinese tactic of offshoring its industrial capacity to avoid trade sanctions was observed. This tactic has now been followed up with a new one. China is currently lobbying hard for recognition as a "market economy" in order to avoid punitive anti-dumping sanctions from America and the European Union.

As the previous analysis shows, China is both developed ("market economy status") and developing (planned economy) in nature based on the classification of the current conflict between the urbanized and rural demographic. When negotiating, China therefore emphasizes either of these two faces, in order to extract pecuniary advantage from its trade partners. The developed face should be associated with Premier Li and the developing face with President Xi.

Given that these two faces are currently in conflict with each other, it would be advisable for China's trade partners to see who wins, and therefore which smiling face to deal with in the future. Given that the election cycle is just beginning in the developed world, where populism and xenophobia are in fashion, it may also pay to put further negotiations with China about its real economic status on hold too.

Thus far, China has been able to scare western policy makers and central bankers into thinking that it will drag the global economy into recession if it is not given the concessions that it needs. Western policy makers may therefore need to think out of the box about China, just as they must think out of the box about their own domestic issues. President Obama waited until his lame duck phase to lambaste "free riders" in the Middle East. This would now be an opportune time for him to similarly reflect on his "pivot."

Disclosure: I/we 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.