China in Transition

What We Know, What We Don’t

The once in a decade leadership reshuffle in China opens new hopes for long-waited reforms and re-balancing. The current growth model that is constrained by weak external demand and lack of sustained project financing will likely decelerate steadily in the medium term. Since rural reform in early 1980’s, the demand for reforms and re-balancing to sustain growth has never been greater. Investment efficiency should be elevated, financial constraints are to be relaxed, and new growth engines need to be invented. All of this will require not only economic but political breakthroughs in order to release the growth potential in the economy. Optimists believe that the new leadership has no choice but reform.

The key message from the 18th Party Congress, however, is that policy will be more pro-stability than pro-reform. This is true in global politics as well. With no real crisis, there can be no real reform and even if there is a real crisis, like those experienced in some of the developed world economies, the re-balancing remains painfully slow. New leaders in China will be particularly stretched between reform and stability, and are more likely to put stability ahead of reform — at least for the near term. Here are key takeaways from the 18th Party Congress and leadership reshuffle:

On the political front, from the Arab Street to Main Street, public concerns about income inequality and elite corruption have risen to the top of the political agenda, threatening to topple leaders when they least expect it. Chinese leaders are not immune from these challenges, despite the fact that its citizens consistently rate their level of satisfaction with national conditions among the highest in the world. Although we think the risk of a “Jasmine Revolution” is limited, Chinese leaders will likely find themselves under heightened public scrutiny, particularly at the local level. In addition to managing domestic policy, China’s new leaders will take power during a period of changing regional political dynamics.

From an equity market perspective, all of the uncertainty has supplied plenty of fodder for both bulls and bears. But focusing on what we know, we find that what we have is a reasonably attractively priced equity market and liquidity which is tight but looks to be getting a little easier, which is a positive. Earnings revisions have been markedly negative but are now at levels which suggest a greater chance of a rebound than a further deterioration. The same is true for economic expectations versus actual data releases. So the omens for the market look better than they did 12 months ago but don’t necessarily bode for strong outperformance.

We think a more flexible market-determined appreciation of the Chinese currency will influence the movements of the more “managed” currencies in East Asia that have had a greater tendency to intervene (either directly or indirectly via various capital flow related policies) due to the desire to maintain external competitiveness with China. We think this is particularly relevant among East Asian countries that have significant trade shares with China, thus, more sensitive to seeing large deviations in their relative currency performance. Among the potential currency laggards to RMB appreciation, we find that India, Pakistan, Sri Lanka and Vietnam have relatively high net export similarity index with China and thus, are likely to gain relative competitiveness.