China’s collapsing stock market underlines need for New Normal reforms
on July 28, 2015

My latest post for the Financial Times, published on the BeyondBrics blog is below  | Jul 27 15:08 |

China stocks Jul15Red is a lucky colour in China, which is why share price displays go red when prices are rising. A green display means prices are falling, the opposite to stock markets elsewhere.

There is a similar discontinuity between the short-term impact of China’s recent 30 per cent stock market collapse and the concern of some western analysts that the government may see this as a reason for reversing President Xi’s New Normal programme of economic reform.

We do not expect this to happen. Rather, we see the aftermath of the collapse as a further playing out of the on-going factional struggle between the Princelings represented by President Xi and the Populists represented by Premier Li. If anything, it will strengthen Xi’s hand over the medium term, as the stimulus policy of the Populists is further discredited.

The key issue is that although China’s Communist Party presents itself to the outside world as one unified whole, the Princeling and Populist factions are constantly battling each other for influence, power and supremacy:

  • The Princelings are descendants of the revolutionary Party leaders
  • The leaders of the Populists are closely tied to the Communist Youth League

Both factions had until recently shared power in the Party’s supreme policy-making body, the Politburo Standing Committee. But today, President Xi’s Princeling faction holds six of the seven positions, with Premier Li the only Populist representative. And it is well known that there are continued policy tensions between the President and the Premier, based on their differing approaches to the economy as well as their factional backgrounds.

We suspect historians will conclude it was Premier Li’s idea to encourage the stock market rally over the past year, partly as a mechanism for replacing the stimulus effect provided by the property market bubble initiated under Populist former President Hu. This was in marked contrast to President Xi’s focus on the need for long-term structural reform as part of his New Normal initiative.

The problem now for the Populists is that the stock market bubble clearly failed to revive economic growth. The official estimate of GDP growth in Q2 2015 – at the bubble’s height – was just 7 per cent. And many believe the real number was even lower: Sir John Sawers, former head of the UK’s MI6 secret service, suggested recently that growth was probably “nearer 3 per cent and falling”.

It therefore seems unlikely that we will see fundamental change in the policies launched by Xi nearly two years ago, when he opened the 3rd Plenum by warning: “The good meat is all gone; all that is left are hard bones to chew.” Abandoning the reform programme would clearly undermine the Party’s own credibility, which is now tied to the success of the New Normal policies. It would also undermine the anti-graft campaign, which commands broad popular support. Any sign of this being weakened would quickly reignite public cynicism over the corruption of government officials.

It is certainly possible that reforms related to the financial sector and capital markets will face short-term delays, to ensure that markets have entered calmer waters. But beyond this, the bubble’s collapse and the muddle of its aftermath has only reinforced the need for the New Normal reforms. The episode has in effect reconfirmed that the use of debt-fuelled stimulus programmes to boost the economy is doomed to failure.

One important lesson from the episode, however, is that reform on the scale being attempted in China does not proceed in straight lines. For westerners, the best analogy may be the well-known phrase that all change is a process of “two steps forward, one step back”. This is well understood within China, where it is clear that Xi is mirroring the approach of Deng Xiaoping in “crossing the river by feeling the stones”.

Companies and investors should therefore take heart from the stock market collapse, and not be panicked by it. Even if only half of the New Normal policies were to be implemented, China would still become a much more interesting place for foreign investment. And our view is that a lot more than half will be implemented during Xi’s presidency.

 

The pH Report is a UK-based strategy consultancy serving investors and companies.

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