China: Buy on Weakness Once the Storm Settles

Includes: EWH, FXI, FXY, PGJ, SDS
by: Enzio von Pfeil

Readers know of our apprehensions about global stock markets in 10-07: the month and the year have not treated punters well in the past. Indeed, Friday’s market wobbles support our view that the investor should beware: Friday was the beginning of the end.

So we have a little time to withdraw from the investment pits and step back. We wanted to put the frenetic press reports of China’s National Party Congress into perspective, by putting this week’s events into a strategic investment perspective.

Crucially, the leadership decisions already were concluded on Friday, October 12, when the incumbent leadership had its last plenary session at the Jingxi Hotel in Beijing in the form of the Communist Party’s 16th Central Committee. The results will be announced in Beijing today at the end of the 17th National Party Congress.

1. No more “follow the leader”

Too much is being made of “who” (pardon the pun) will “lead” China as of 2012? The question is: who will lead China’s most powerful political club, the Standing Committee of the Politburo?

Two popular names are

  • Pres. Hu’s ally, Li Keqiang, the Party Secretary of Liaoning Province. He is embedded in Hu’s power-base, the China Youth League, and
  • Jiang Zemn’s ally, Xi Jinping, the Party Secretary of Shanghai, who Pres. Hu got to replace Shanghai’s former party secretary, Chen Liangyu, on account of corruption.

Here are some reasons why ONE individual’s name is less relevant – if relevant at all - these days.

Anachronistic mindset. First, this “who will lead” is an anachronistic framework: people of Mao’s and Deng’s stature simply do not exist, nor can they: China is far too developed to follow a “strong man” any longer. Indeed, even those successors appointed by musclemen Mao and Deng did not have a free lunch: consensus politics now reigns.

  • One of Mao’s successors, Lin Bao, died in a plane crash after allegedly plotting a coup and then trying;
  • The other Mao successor, Huao Guofeng, was kicked - out by Deng Xiaoping;
  • Meanwhile, Deng’s protege, Hu Yaobang, was forced to abdicate by a group of hard liners;
  • Another Deng favorite, Zhao Ziyang, was purged after sympathizing with Tian Men students in 1989. He died under house arrest, and
  • Deng chose Jiang Zemin and Hu – but now these two are fighting about their successor in 2012! Unity thus does not rule.

Totem pole. Second, the real game is who is will be on the nine-person Standing Committee of the Politburo? It is widely assumed that the two gentlemen mentioned will get into this Standing Committee – and then will have five years to prove who will be the next leader.

Forced team spirit. Finally, within the nine-strong Standing Committee, journalists suggest that Hu’s faction - so richly rooted in the Communist Youth League and in inland provinces - lacks hands-on experience in economic and financial matters. Indeed, this is where Jiang’s “Shanghai Faction”, rooted in successful, capitalistic coastal provinces, comes into its own.

So, what we end up with is an “and -and”, not an “either - or”, situation. “And – and” implies that in the Politburo Standing Committee, Jiang’s “Shanghai faction” sometimes will cooperate, and sometimes will fight with Hu’s faction. Here is the dynamic:

  • Ex-party secretary general and President Jiang’s factions emphasizes capitalism and thus urbanization of China’s eastern seaboard continue, AND
  • Current party secretary and President Hu’s emphasizes harmonious society as well as “scientific (i.e. sustainable) development”. He has sought to embed these concepts in China’s constitution. Within “sustainable development”, two crucial issues are the environment and land protection.

Thus, both want capitalism: Jiang’s group is more avaricious, whilst Hu's group wants more sustainable development. Hence, Hu recently has been fighting harder for proper treatment of the environment – in passing, something that is totally lost on Hong Kong’s “leaders” either in Government or indeed in our “elected” Legislative Council. Hu also has been fighting for more social spending.

2. What is “inter-party democracy”?

Pres. Hu Jintao has championed this since he took the helm in 2002. This refers to shared decision-making, but firmly within the boundaries set by the Party: when emphasizing such “democratic centralism”, Hu is rejecting any notion whatsoever of Western-style democracy.

According to the FT of 13th-14th October 2007, it is being promoted by Pres. Hu in order to

  • “…lift the professional standards of officials,
  • limit opportunities for corruption, and
  • make the government more responsive to public opinion.”

According to the South China Morning Post [SCMP] of October 12, 2007, inter-party democracy’s efforts are directed at promoting

  • internal transparency
  • consultation in policy-making
  • stronger internal supervision, and
  • more competition within the ruling hierarchy.

Hu’s key thrust is to promote sufficient internal checks and balances that corruption at least is brought under control.

So: this form of democracy consists of tighter internal checks and balances with which to solidify the grip of the Communist Party. Fair enough: why should the Party wish to abdicate?

3. Governing China

And this solidification of power has to have been the key to last week's meetings. Readers know our view: "the sky is high and the emperor is far away." This goes to say that "Beijing" cannot be in charge: China's land mass is four percent larger than that of the United States, but China only has four percent of America's per capita income! How can "Beijing" rule? China has yet to go federalist, as America and indeed Western Europe have...

Inter-party democracy is a smart way for Beijing to rein in the provincial and local leaderships - by putting checks and balances in at the local level.

This will be seen as Hu's legacy, namely strengthening the hand of the Center. And, given the "and - and" dynamic we sketched above, this strengthening means plenty of profitable opportunities for the strategic investor.

4. How to Make Money Off This Idea

  • For now, short the S&P. We have just done so by buying the S&P 500 Short ETF.
  • Go long the yen: carry trades are going to get unwound fast, now that punters have moved from oblivion, skipped denial and are heading straight for the exits.
  • Once you climb back in (we will keep you posted), follow the "and - and" dynamic outlined in point one's "forced team spirit":
    o Jiang plays: keep going with the industrialization/urbanization themes that you know about, and
    o Hu plays: get your broker to tell you of plays on China's environmental protection. Hunt globally for specialist, quoted firms that are making a fortune of selling their eco-cleanup tech to China.