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Takeaway: The Chinese demand curve looks to continue undergoing a structural shift. We do not think long-term investors are broadly prepared for this.

SUMMARY BULLETS:

  • There are four major themes to the Chinese Communist Party’s (CCP) long-term objectives as outlined at the start of China’s 18th National Party Congress.
  • The first of which is an increased focus on moving away from resource and capital-intensive industries and investment as drivers of economic growth towards expanding the role of the Chinese consumer via specific income growth targets, human capital development objectives, as well as a renewed focus on expanding the social safety net.
  • Secondly, there is a noticeable undertone of expanding the role of the markets and the private sector – a area where some would argue the Hu-Wen administration failed to live up to expectations due to their heavy reliance on SOEs and financial repression to achieve GROWTH targets. Any meaningful acceleration on this front would tend to be sustainably negative for the earnings growth of publically-traded SOEs.
  • Thirdly, quashing corruption among government officials and combating socioeconomic inequality was a major focus General Secretary Hu Jintao’s remarks. His willingness to be so open and outspoken on these topics suggests the broader social agenda – specifically the maintenance of social stability – has been promoted within the hierarchy of CCP objectives.
  • Lastly, there was an overt focus on China being China – specifically in that the People’s Republic of China is not going to give in to outside pressures to transform its government to a democracy, nor will it adhere to outside wishes that it pacify its foreign policy. In fact, it appears the CCP is focused on doing exactly the opposite. Additionally, Hu implicitly told the US/UN to “back off” and let China and other countries (Iran? Syria?) pursue their own political fates without interference from other world powers.
  • Combined, these four pillars hold the keys to understanding the direction of the Chinese economy as well as any future manifestations of Chinese public policy. Gone are the days of persistent double-digit real GDP growth (+10.6% per annum during the Hu-Wen administration) driven by heavy industry and infrastructure/fixed capital investment. Sure, China will certainly continue to build stuff (factories, dwellings, railroads, highways, etc.) en masse, but we anticipate the slope of growth in Chinese demand for both raw materials and capital goods to remain flat-to-negative for a long, long time.

NOTES FROM THE COMMENCEMENT OF THE 18TH PARTY CONGRESS

Today officially marked the start of China’s 18th National Party Congress, where it is widely anticipated that the Politburo Standing Committee (PSC), the top decision-making body in the Chinese State, is expected to have a dramatic turnover in leadership, as well as a reduction of the current 9-seat board to its original seven-seat setup (expanded in 2002).

To a small degree, we speculate that the number of seats may have been trimmed to allow for greater cohesion in the decision-making process, which requires a focus on long-term planning with the board having to achieve consensus on any major decision through careful deliberation. Moreover, the recent ouster of Bo Xilai from the Politburo may have ruffled some feathers throughout the party due to his close ties to senior military officials; having less “cooks in the kitchen” should aid the Chinese Communist Party (CCP) in forging ahead with its strategic initiatives.

That being said, we see little-to-no evidence that the CCP is crumbling from within amid internal power struggles, as some sources would have you believe. In his prepared remarks, however, incumbent Party General Secretary Hu Jintao did stress the need for the Party to appropriately respond the #1 threat to the power and legitimacy of the CCP as a whole – social discontent. This focus becomes very clear when interpreting his outline of the reforms China will undertake over the next 5-10 years, which we detail below.

While the composition of the new Politburo Standing Committee will not be unveiled until the congress concludes on NOV 14, it’s a near certainty that Xi Jinping and Li Keqiang will be promoted from their #6 and #7 rankings on the PSC to the #1 and #3 rankings of their respective mentors, Hu Jintao and Wen Jiabao. Xi’s likely #1 ranking will assign him the post of Party General Secretary, giving him ownership of the some of the most important portfolios, including military and foreign affairs. Keqiang’s likely #3 ranking will assign him the post of Party Secretary of the State Council (China’ s cabinet) – effectively making him the next Premier of China.

In some respects, Li is more important to Xi as it relates to the Chinese economy. While the Chinese Communist Party remains the ultimate source of power and key architect behind any economic, political and social reforms, the Chinese State – via the State Council, various ministries and institutions (Including the PBOC), the National People’s Congress (and its own Standing Committee), provincial/local level governments and State-Owned Enterprises (SOEs) – is often tasked with the design and execution of said initiatives. While China’s complex dual government has been set up in various ways to allow the Party to exert its influence at the top of every State organization, it is ultimately up to these committees to implement public policy in China.

As it relates to what reforms and strategic initiatives Party General Secretary Hu Jintao is promising below, we’ll have to wait to the 12th National People’s Congress convenes in MAR ’13 to receive any clues as to what these objectives will look like in action. For now, take his word(s) for it. If there’s one thing we’ve learned throughout our years of covering China, it’s that Chinese officials almost always do exactly what they tell you they are going to do. We caution against reading between the lines or anchoring only on reforms that support your current positioning; rather, we think it’s best to interpret these objectives holistically, as they are likely to shape the next 10 years of Chinese POLICY:

General Objectives:

  • "In building socialism with Chinese characteristics, we base ourselves on the basic reality that China is in the primary stage of socialism. Our overall approach is to promote economic, political, cultural, social, and ecological progress, and our general task is to achieve socialist modernization and the great renewal of the Chinese nation."
  • “The Party must be soberly aware that China is still in the primary stage of socialism and will long remain so. This basic condition of China has not changed; nor has the principal problem in the society; nor has China's international position as the largest developing country in the world… Only by promoting sustained and sound economic development can China lay a solid material foundation for enhancing the country's prosperity and strength, improving the people's wellbeing and ensuring social harmony and stability.”
  • “The country should institute a complete, multi-tiered and sustainable system to provide basic social security for both the urban and rural population.”
  • “Keeping to the goal of improving people' s health, China should improve the medical insurance system that covers the whole population, establish a mechanism to provide insurance and aid in treating major and very serious diseases, and improve mechanisms for handling public health emergencies and for preventing and controlling major diseases.”
  • “We should keep making progress in ensuring that all the people enjoy their rights to education, employment, medical and old-age care, and housing so that they will lead a better life.”

Economic Objectives:

  • “The country should fire all types of market participants with new vigor for development, increase motivation for pursuing innovation-driven development, establish a new system for developing modern industries, and create new favorable conditions for developing the open economy.”
  • “This will make economic development driven more by domestic demand, especially consumer demand, by a modern service industry and strategic emerging industries, by scientific and technological progress, by a workforce of higher quality and innovation in management, by resource conservation and a circular economy, and by coordinated and mutually reinforcing urban-rural development and development between regions.”
  • “Deepening reform is crucial for accelerating the change of the growth model.”
  • “While unwaveringly consolidate[ing] and develop[ing] the public sector of the economy, the country must also encourage, support and guide the development of the non-public sector.”
  • “On the basis of making China's development much more balanced, coordinated and sustainable, we should double [our] 2010 GDP and per capita income for both urban and rural residents.” (NOTE: This is the first time that per capita income has been included in the economic growth target set for 2020. Previous targets set at the 16th and 17th CPC National Congress merely called for the growth of GDP, not of per capita income.)
  • “The underlying issue we face in economic structural reform is how to strike a balance between the role of the government and that of the market, and we should follow more closely the rules of the market and better play the role of the government.”
  • “We should firmly maintain the strategic focus of boosting domestic demand, speed up the establishment of a long-term mechanism for increasing consumer demand, unleash the potential of individual consumption, increase investment at a proper pace, and expand the domestic market.”
  • “We should give high priority to rural areas in developing infrastructure and social programs in the country.”
  • “ China should continue to encourage industry to support agriculture in return for agriculture's earlier contribution to its development and encourage cities to support rural areas.”
  • "We should reform the land expropriation system and increase the share of gain in land value to farmers."
  • “The country should increase job opportunities for young people, especially university graduates, the rural migrant labor force, urban residents who have difficulty finding jobs, and ex-servicepersons.”
  • “The country should also strengthen vocational skill training, improve the human resources market and employment services, strengthen supervision of labor protection and labor dispute mediation and arbitration, and build harmonious labor relations.”
  • “The country should improve the way in which income is distributed, protect lawful income, increase the income of low-income groups, adjust excessively high income, and prohibit illicit income.”
  • “Major progress should be made in building a resource-conserving and environmentally friendly society. The establishment of functional zones should be basically completed, and a system for recycling resources should begin to take shape. Energy consumption and carbon dioxide emissions per unit of GDP as well as the discharge of major pollutants should decrease sharply.”

Political Objectives:

  • “We should place high importance on systemic building, give full play to the strength of the socialist political system and draw on the political achievements of other societies. However, we will never copy a Western political system.”
  • “Combating corruption and promoting political integrity, which is a major political issue of great concern to the people, is a clear-cut and long-term political commitment of the Party. If we fail to handle this issue well, it could prove fatal to the Party, and even cause the collapse of the Party and the fall of the state.”
  • “Leading officials at all levels, especially high-ranking officials, must readily observe the code of conduct on clean governance and report all important matters. They should both exercise strict self-discipline and strengthen education and supervision over their families and their staff; and they should never seek any privilege.”

Foreign Policy Objectives:

  • “We are firm in our resolve to uphold China's sovereignty, security and development interests and will never yield to any outside pressure.”
  • “China is committed to peaceful settlement of international disputes and hotspot issues, opposes the wanton use of force or threat to use it, opposes any foreign attempt to subvert the legitimate government of any other countries, and opposes terrorism in all its manifestations.”
  • “China opposes hegemonism and power politics in all their forms and will never seek hegemony or engage in expansion.”

SUMMARY IMPLICATIONS

There are four major themes to Hu’s remarks (and, by proxy, the CCP’s public policy objectives). The first of which is an increased focus on moving away from resource and capital-intensive industries and investment as drivers of economic growth towards expanding the role of the Chinese consumer via specific income growth targets, human capital development objectives, as well as a renewed focus on expanding the social safety net.

Secondly, there is a noticeable undertone of expanding the role of the markets and the private sector – a area where some would argue the Hu-Wen administration failed to live up to expectations due to their heavy reliance on SOEs and financial repression to achieve GROWTH targets. Any meaningful acceleration on this front would tend to be sustainably negative for the earnings growth of publically-traded SOEs (which happen to dominate from a market cap perspective). Perhaps that’s what the Shanghai Composite has been signaling to us all along:

HU SPEAKS; IS ANYONE LISTENING?: NOTES FROM CHINA’S 18TH PARTY CONGRESS - 1

Thirdly, quashing corruption among government officials and combating socioeconomic inequality was a major focus Hu’s remarks. His willingness to be so open and outspoken on these topics suggests the broader social agenda – specifically the maintenance of social stability – has been promoted within the hierarchy of CCP objectives.

Lastly, there was an overt focus on China being China – specifically in that the People’s Republic of China is not going to give in to outside pressures to transform its government to a democracy, nor will it adhere to outside wishes that it pacify its foreign policy. In fact, it appears the CCP is focused on doing exactly the opposite. Additionally, Hu implicitly told the US/UN to “back off” and let China and other countries (Iran? Syria?) pursue their own political fates without interference from other world powers. We interpret Hu’s statement that China “opposes terrorism in all its manifestations” as a direct shot across the bow of the interventionist US foreign policy experiment.

Combined, these four pillars hold the keys to understanding the direction of the Chinese economy as well as any future manifestations of Chinese public policy. Gone are the days of persistent double-digit real GDP growth (+10.6% per annum during the Hu-Wen administration) driven by heavy industry and infrastructure/fixed capital investment. Sure, China will certainly continue to build stuff (factories, dwellings, railroads, highways, etc.) en masse, but we anticipate the slope of growth in Chinese demand for both raw materials and capital goods to remain flat-to-negative for a long, long time.

In a world where price is set on the margin and first movers lock in the best returns, we can’t stress enough that it likely won’t pay to be long the go-to plays of raw industrial commodities, basic materials and energy stocks and/or commodity currencies on the expectation that China has bottomed and is poised to reflate its economy. We continue to see Chinese GROWTH in the late stages of a bottoming process and, thus, averting the risk of a “hard landing”.

That said, however, our expectation for Chinese real GDP growth to average +6-8% over the long-term TAIL is far shy of the expectations of some international investors and corporations. We are comfortable with this continuation of our contrarian stance because we remain willing to take Hu’s word for it – at least for now.

Darius Dale

Senior Analyst