The fight for the direction of Chinese capitalism is just getting hotter

03/20/2012 8:30 am EST


Jim Jubak

Founder and Editor,

Sometimes you can’t tell the players in China even with a scorecard.

In recent stories about the extraordinary fall of Bo Xilai, Communist party secretary of Chongqing, a city of 32 million, from a position as a frontrunner for one of the nine slots on the Standing Committee of the Politburo that runs China to house arrest, I’ve seen him called a conservative, a liberal, a reactionary, a progressive, a populist, and a leftist intent on bringing back the Cultural Revolution.

I think most of those characterizations are accurate—even though they position Bo simultaneously at what those of us who live outside of China consider contradictory ends of the political and economic spectrum. In those contradictions, I think, you can find a key to understanding the peculiar current nature of China’s state-run capitalism—and the shape of the coming struggle over the direction of that economy. For an investor in any global market, I don’t think there’s a more important story right now.

Let me explain what has happened in China, the significance of Bo’s fall, and why this is important for investors outside of China.

From the evidence of his history Bo was a gifted popular politician. Refused membership in the Standing Committee of the Politburo in 2007 during the last leadership shuffle, Bo was sent off to languish in obscurity in Chongqing, then an economic backwater in western China. But Bo seized upon big themes of popular discontent in China to send his career into orbit.

He tackled corruption, then rampant in Chongqing, arresting thousands and sending hundreds to jail in an anti-mafia campaign that culminated in 14 executions.

He won more points with the millions of Chinese who had been left behind in the rush to private wealth, pledging to close the increasing gap in China between the haves and the have-nots. He built 750,000 apartments and set up a new program for compensating farmers of their land. More than 2 million migrant workers won increased rights to social services in Chongqing.

At the same time as these programs addressed big issues of mass discontent, there wasn’t anything democratic about Bo’s methods. His anti-mafia campaign managed to sweep up many of his political opponents. His efforts to produce jobs in Chongqing relied on massive state subsidies to attract foreign investment (Apple, Hewlett-Packard and Foxconn to name just three) to Chongqing and a big increase in the role of state-owned companies in the economy. Local government spending on big infrastructure and housing projects went to state-owned companies. Chongqing’s economy thrived but the model mirrored—and possibly exceeded--the move in China as a whole toward more state ownership and control over more of the economy.

Whatever his skills as a popular politician, Bo was an economic conservative on a Chinese scale.

Bo’s downfall probably stemmed from his big success in organizing what increasingly looked like a power base that didn’t rely on the party. Bo promoted a “Red Revival” that organized 10,000 mass gatherings focused on the singing of songs that echoed those from Mao’s cultural revolution. Bo did update the Great Chairman’s techniques, though. Campaigners sent more than half a million “Red” text messages on cell phones.

The party leaders who decided to move against Bo got their excuse when Wang Lijun, Bo’s chief of police in Chongqing, showed up at the U.S. consulate in nearby Chengdu. Allegedly he asked for political asylum and offered to spill whatever there was to spill to the Americans. Chinese police surrounded the building and next morning Wang left with them. Since then he’s been in custody.

For a while it looked like Bo might survive the incident and theories circulated that his popular support was so strong that party leaders would be afraid to move against him. (That public speculation almost certainly helped determine party leaders to make their move. If people are talking about you being weak, you’re likely to want to prove them wrong.)

But then the big guns came out: Premier Wen Jaibao warned against a return to the days of the Cultural Revolution. In fact Wen used part of his three-hour press conference at the conclusion of the National People’s Congress to reference the party’s official 1981 take on the Cultural Revolution—“A Resolution on Certain Questions in the History of Our Party Since the Founding of the People’s Republic of China.”

It’s tempting to see Bo’s downfall and Wen’s use of the “Resolution” to bring up the need for continued political and economic reforms as evidence that the “reformers” have won a round. But I think it’s a mistake to read events in that way.

Yes, Bo’s economic success in Chongqing relied on a shift in the economy in favor of state-owned businesses that is a reflection of a process that has been going on in China as a whole for much of the last decade. The increase in government ownership of the economy in this period is a reversal (or at best the stagnation) of the economic opening that began in the late 1970s.  In 1978, the Organization for Economic Cooperation and Development estimates that state-owned enterprises accounted for 77.6% of industrial production in China By 2004 that figure was down to 30%, accordant to estimates from the People’s Bank of China. Total contribution to China’s GDP from state-owned enterprises came to about 34%, according to the OECD.

At the end of 2010, a report for the U.S.-China Economic and Security Review Commission issued in October 2011 estimates, that percentage had climbed back to 40% or 50% of China’s GDP (depending on how you define “state-owned enterprise”). Revenue for China’s state-owned enterprises was equal to 43% of China’s GDP in 2011, recent Chinese government statistics show.  China’s mixed economy is less mixed than it was six years ago.

Bo’s replacement in Chongqing isn’t some economic reformer but an economist (and one trained in North Korea at that) allied to the party faction controlled by former president Jiang Zemin. I think it’s fair to characterize Jiang’s faction as economic conservatives who believe in continued state control of the high ground of the economy—the strategic sectors that include industries such as steel and oil—and in state control of the financial sector.

In spite of Wen’s rhetoric, the battle for political and economic reform isn’t by any means over. In fact, it looks like it is intensifying and that the forces of economic reform are facing an up hill battle. Wen speech marks the beginning of a fight over the direction of the country that will be determined when seven out of the nine members of the Standing Committee of the Politburo step down—because of age—and are replaced this November. And so far, at least the way I’m keeping score, the best that the economic reformers can claim is a tie: Bo is out and won’t sit on the Standing Committee, but his replacement in Chongqing is an economic conservative.

Why should you as an investor in any of the world’s financial markets care about all of this?

Let me give you three reasons.

First, every economy in the world has an interest in the healthy development of the Chinese economy—just as every economy in the world has an interest in the healthy development of the U.S. economy. A Chinese economy that is dominated—perhaps increasingly so--by big state-owned enterprises that have access to plenty of cheap capital from the state-owned banks at below market rates is not allocating its currently vast capital resources very well. The generally lower profitability of state-owned enterprises will make the Chinese goal of becoming rich before the country gets old starting around 2030 increasingly difficult. And the captive nature of state-owned Chinese banks raises the odds of financial sector trouble if capital is allocated by political decision and not by market forces. (Even the Beijing government doesn’t have an infinite ability to bury bad loans when the loans have been made by banks that have issued shares on global financial markets.)

Second, and less cosmically, a Chinese economy dominated by state-owned enterprises that are less efficient and less sensitive to market signals (such as No profits? Let’s get out of that business) will make life incredibly difficult for non-Chinese companies that pay more for capital and that do have to make a profit to stay in business. It would be helpful to companies ranging from General Electric (GE) to Siemens (SI) to Cisco Systems (CSCO) if the Chinese economy became less dependent on an export at all costs model built around state-owned industries with access to cheap capital from state-owned banks. One danger if economic conservatives prevail and pursue a policy of expanding the state’s role in the economy is that new industries, already targeted as industries of national strategic interest, such as wind and solar, will become increasingly dominated by state-owned enterprises. I’d hate to be a Vestas Wind Systems (VWDRY) or a First Solar (FSLR) competing against state-owned Chinese companies with little concern for profit and lots of cheap cash. (As bad as things are in the wind and solar industries for non-Chinese players, I think things could get worse.)

And, third, the average Chinese citizen—and the consumer companies around the world that sell in China—would be better off if China rebalanced its economy so that Chinese consumers didn’t subsidize Chinese export industries in the form of bank interest rates below the rate of inflation and a yuan-dollar exchange rate that is managed for the benefit of Chinese exporters. Right now if you want to invest in the Chinese consumer sector, I think you’re best served by investing at the high end—say LVMH Louis Vuitton Moet Hennessey (LVMUY in New York and MC.FP in Paris.) Asia is the company’s fastest growing market and in wine and spirits China has become the company’s second largest market. Or at the mass market end with companies such as China’s largest noodle maker Tingyi Holdings (TCYMY in New York or 322.HK in Hong Kong), Home Inns and Hotels Management (HMIN), or Kentucky Fried Chicken and Pizza Hut owner Yum! Brands (YUM.) Home Inns and Hotels Management is a member of my Jubak’s Picks portfolio

China’s leaders have announced in the most recent five-year plan that they want to rebalance the country’s economy toward the consumer sector and away from a reliance on exports and investment in fixed assets. The reformers have had some success—the country is aggressively raising the minimum wage, for example. But economic conservatives have successfully held the line on keeping bank deposit interest rates low and favoring big state-owned enterprises when it comes to bank loans.

The downfall of Bo Xilai shows that the battle a long way from over and is in fact still heating up. I expect the jockeying in Beijing will just get more intense as the actual leadership transition approaches this fall.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Home Inns and Hotels Management, LVMH Louis Vuitton Moet Hennessey, and Tingyi Holdings as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at
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