The After-Party

"China is likely to remain the only major economy engaged in serious easing, while much of the world is tightening." Andy Rothman, Investment Strategist

Now that the Party Congress is over, Xi Jinping has one big decision to make: return to the pragmatic policy path that made China rich and kept the Communist Party in power; or set a course for managing COVID and the economy that inhibits innovation and growth. A review of recent history and speeches by Xi, as well as considering what is in Xi’s own self-interest, leads us to expect him to be pragmatic.

A History of Pragmatism

It's worth remembering that the leadership of the Chinese Communist Party, including under Xi, has succeeded when it has been pragmatic.

When I first visited China as a student in 1980, its per capita GDP was less than that of Afghanistan, Haiti and Bangladesh, and 80% of China’s population was living below the World Bank’s poverty line. Today, Chinese consumers are estimated to account for 20% of global luxury sales.

When I returned to China in 1984 as a junior American diplomat, there were no private companies—everyone worked for the state. Today, almost 90% of urban employment is in small, privately owned, entrepreneurial firms. With the state-sector continuing to shrink, all of the net, new job creation comes from private companies.

That was the result of pragmatic policies that emphasized market-based reforms and de-emphasized the economic role of the state.

The last few quarters have been rough, but Xi’s 10-year track record as Party chief has been pretty good: China has seen average annual inflation-adjusted (real) income growth of 7% (vs. 2% in the U.S.); average annual real retail sales growth of 8% (vs. 3% in the U.S.); and China accounted for 36% of global economic growth during that period (vs. an 11% contribution from the U.S.).

Xi’s Mistakes

Xi has made plenty of mistakes over the last two years, including excessive regulatory intervention. But the chaos caused by his “common prosperity” policy did not come from his objectives—an effort to address the same socio-economic concerns that most democracies are wrestling with, everything from income inequality to unequal access to education, housing and health care. It was not an attempt to curb the private sector or roll back market-based reforms.

The problem was terrible implementation.

The Party leadership soon acknowledged its mistakes, with a blizzard of speeches conceding that “common prosperity” needs to be pursued in a more incremental way to reduce the risk of unintended consequences. Xi clarified that “common prosperity is a long-term goal . . . and cannot be achieved overnight.” He called for “substantive progress” by 2035.

Xi’s Speech

I’m aware that many commentators described Xi’s work report to the Party Congress as belligerent and focused solely on national security and political control. But, after reading the entire 64-page report, I’m puzzled by those assessments.

Xi said he is “focused on promoting high-quality development” and that he wants to “bring per capita disposable income to new heights” and “substantially grow the middle-income group as a share of the total population.” He said, “development is our Party’s top priority,” and that “we will provide an enabling environment for private enterprises.” He pledged to “raise total factor productivity.”

Xi’s Team

The consensus take on the new leadership lineup announced at the Congress is that they are all yes-men, who will be afraid to disagree with Xi. The Politburo Standing Committee—the top leadership of the Chinese Communist Party—is packed with Xi supporters, but that doesn’t mean they won’t advocate for the pragmatic approach that served the Party well in the past. Li Qiang, who is second in command, spent almost 40 years working in China’s most economically dynamic and entrepreneurial province, Zhejiang (home to Alibaba), so he is well familiar with the importance of private companies to the success of the economy and the Party.

It is possible that a leadership team handpicked by Xi will have greater freedom to offer constructive criticism and challenge his ideas—because Xi trusts that they do not represent a political threat. Time will tell.

Xi and Zero-COVID

The most important decision Xi has to make—and soon—is about his COVID-mitigation policies, which are slowly strangling China’s economy.

Zero-COVID worked well prior to the arrival of Omicron. There were almost no deaths in China, and the economy was strong. Last year, consumer spending in China, the largest part of the economy, was up more compared to 2019 than in the U.S. and the Euro Area. Manufacturing was healthy and China held up its end of global supply chains.

After Omicron arrived, zero-COVID continued to be successful from a public health perspective. There have been no COIVD deaths in China since June, while the U.S. is now averaging over 300 COVID deaths per day.

But under Omicron, the economic and social cost has been significant. Fear of lockdowns has made families and companies reluctant to spend. Growth has slowed and unemployment has risen, especially among young people. Under zero-COVID, China’s economy is on an unsustainable path.

I’m confident, however, that the Chinese government will return to a more pragmatic approach, which strikes a better balance between public health and the economy:  Key to a more pragmatic approach is the end of widespread lockdowns.

I’m confident primarily because, as I noted earlier, pragmatism has made China rich and kept the Party in power over the last few decades. Taking an unpragmatic path would not be in Xi’s own self-interest.

Milestones To Watch

I expect Xi to take a more pragmatic approach towards COVID after the winter flu season, when many expect a rise in cases. Xi may not provide a clear roadmap for an end to lockdowns, but we can look for two milestones which should enable investors to anticipate a return to pragmatism well in advance of an economic recovery and a rebound in sentiment. These milestones are changes in COVID rhetoric and increases in jabs.

While Xi may not give a speech which clearly lays the foundation for an end to lockdowns, he will have to prepare Chinese people for living with COVID like the rest of the world. I will be watching for a gradual shift in official rhetoric away from a zero-tolerance for COVID cases and towards encouraging people to get vaccinated so they can live with the virus.

The second, most important milestone will be a rise in vaccination rates, especially for older Chinese. There are now about 25 million people (roughly the size of Australia) over the age of 60 who have not received any COVID vaccinations, as well as another 62 million (California plus Florida) older Chinese who have received only two shots, and who need a third for better protection. This is a very large number of people who would be at risk if COVID policy is relaxed prior to a major vaccination campaign. Moreover, in recent weeks, the pace of new vaccinations for the entire country has been declining. This must be reversed in order to prepare for ending lockdowns and living with COVID.

Closely following these milestones should enable us to anticipate a return to pragmatism well in advance of an economic recovery, and a rebound in sentiment.

Signs of Pragmatism

Although zero-COVID lockdowns continue, there have been signs of pragmatism in Beijing. In August, China resolved a long-running dispute with the U.S. Public Company Accounting Oversight Board, and PCAOB inspectors are now in Hong Kong, checking the accounting workbooks for Chinese companies listed in the U.S. This agreement goes beyond keeping 200 Chinese companies trading here. It signals a desire, in my view, on the part of Xi Jinping, to avoid economic decoupling with the U.S., and to steady his relationship with Joe Biden.

I believe U.S. – China relations will remain tense, but conflict, including over Taiwan, will be avoided. China’s economy is driven by domestic consumption, and active investment in Chinese companies selling goods and services to Chinese consumers mitigates the impact of political tensions.

A second pragmatic development came last month, when Xi made his first trip abroad since the start of the pandemic.

More recently, the government approved resumption of a marathon race in Beijing on November 6. This will bring tens of thousands of runners together in the capital—without masks, but with booster shots required—for the first time since the pandemic.

I’m anticipating a broader return to pragmatism in the coming months.

When that happens—only the timing is uncertain, in my view—keep three things in mind:

• China is likely to remain the only major economy engaged in serious easing, while much of the world is tightening.
• Chinese households have been in savings mode since the start of the pandemic, with family bank account balances up 42% from the beginning of 2020.
• Those funds should fuel a consumer rebound, and an A-share recovery, as domestic investors hold about 95% of the that market.

Andy Rothman
Investment Strategist
Matthews Asia