Waddell & Reed

Market Perspectives

Protecting Economic Growth

China's New Leaders Likely to Stay on Current Path

Story Highlights

  • We think Xi Jinping will have a better opportunity to push economic and political reforms than the prior president.
  • Growing urban populations could be a key driver for future economic growth.
  • We believe China can succeed in a push toward a market-driven economy.
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Investment Team

Manager Name

Michael Avery

Co-Portfolio Manager, Waddell & Reed Advisors Asset Strategy Fund

Manager Name

Frederick Jiang

Portfolio Manager, Ivy Pacific Opportunities Fund

China recently signaled its future new leadership when it presented the members of the Communist Party’s Politburo Standing Committee (PSC). The party announced the members in November at the final day of its 18th National Congress, a once-per-decade event that guides the transfer of power in the party and the country.

China named only seven members – not the previous nine – to the PSC, which is the true ruling body for the country. Xi Jinping takes over the top position as general secretary, as expected, and will become president of China in March 2013. Li Keqiang, the No. 2 in rank on the PSC, will become premier.

The leadership transition in 2002 that placed outgoing President Hu Jintao in the top job was very smooth and – at least publicly – it appears the transfer of power was even smoother this year. Hu Jintao also will relinquish his position as head of the military, which we consider a positive move. It nearly completes the handover of power and reduces the potential for a lingering transition. We believe it also means Xi Jinping will have a better opportunity to push economic and political reforms than Hu Jintao had when he took over 10 years ago.

Many observers had hoped China would use the party congress to send a message of change and a new openness. We had thought there might be more disruption in the leadership change process this time and the potential to move to a younger generation on the PSC. For example, Wang Yang, the head of Guangdong Province and the largest economy within China, was widely expected to be named to the PSC. He is a political reformer and was a driving force behind an experiment in voting conducted in Guangdong.

But Wang was not included in the new PSC, whose members now largely are older, conservative members of the established political order. China’s powerful Communist Party appears to have chosen to stay on the current path, at least with its most visible cadre of top-level leaders.

Building the domestic economy to drive growth

We have heard some reports about how the new leadership will manage the economy going forward, but there are few details at this point. However, in his final speech to the party congress, President Hu Jintao indicated there would be a continued focus on the state-owned sectors of the economy as a driving force. His remarks were based on a report prepared by party officials as a guide for the next five years.

In his speech, Hu Jintao also essentially called for continuing economic growth at an average annual rate of 7% through the year 2020. That is about the current rate of growth but below the much higher rates of recent years. China’s government has taken steps over time to slow economic growth from those prior levels. For example, the central bank has eased interest rates and lowered bank reserve requirements, demonstrating that China wants to maintain steady – but not overly fast – growth. China’s real gross domestic product (GDP) can double over the next 10 years if it can keep an annual growth rate of 7% – in line with the target set in Hu Jintao’s speech. That’s the fundamental reason we remain bullish on China and other Asian markets.

As part of achieving its economic growth targets, we are looking for China’s new leaders to make moves that will increase the rate of urbanization across the country. In our view, the prior PSC ignored a large component of the population in China – we estimate the size at more than 250 million individuals. These people live in urban areas, but do not immediately qualify under current policies for a government-required residency card, or “hukou.” Those who move into cities from rural areas must demonstrate employment, pay taxes and often meet minimum residency times. In larger cities, it can take as long as 10 years to qualify for the hukou.

Without the residency card, individuals and families cannot buy housing and do not qualify for access to healthcare facilities, schools and other benefits. We expect China to begin reforms of these policies and also expect the new PSC to make changes that will improve the quality of life and level of income for this segment of the population, as part of urbanization moves.

In addition, we think Xi Jinping and Li Keqiang want to improve living conditions in smaller cities in order to attract an additional 100 to 150 million people into them from rural areas. In total, that means the potential for moving 350 to 400 million people over the next 10 years into the urban workforce. That could be a significant driver to underlying economic growth for China.

China is the world’s second-largest economy and the world’s fastest-growing major economy. It has grown its economy by an average of 10% per year over the past 30 years. It also is a key driver of the global economy as the world’s largest exporter and second-largest importer.*

Mass market consumption in China is growing across a wide range of products. And we see much more room to grow. China’s ratio of consumer consumption to GDP is about 38%, which is among the lowest of major global economies.* By comparison, the ratio in the U.S. is 70%.

We believe China’s leadership now must move the country from an economy focused on exports to one that focuses on domestic consumption. In order to do that, they need to make reforms that provide safety nets for the Chinese people, giving them the security to reduce savings and increase spending. A push toward urbanization with the reforms to support a growing urban population would move the economy in that direction.

Reforming major areas a key to investment implications

As we described in our May 2012 Waddell & Reed Advisors Funds Special Report, “China at a Crossroads,” we think reform is needed in several areas that are key to China’s economy.

  • REDUCE THE POWER OF STATE-OWNED ENTERPRISES: We continue to think the large, state-owned enterprises (SOEs) should shrink and reforms should encourage the growth of small- and medium-size enterprises that are in private hands. Fiscal stimulus following the global financial crisis of 2008 disproportionately benefited SOEs and impaired the ability of smaller enterprises to obtain financing for growth. While there is no indication yet that the new leadership will move in this direction – especially given the speech by President Hu Jintao at this year’s party congress – we nevertheless will continue to watch for potential reforms in this area because of the potential impact on the economy.
  • LIBERALIZE THE FINANCIAL SYSTEM: We have seen some movement in the past to set interest rates through the market, rather than at the government level. This would further reduce the power of the state banks and benefit private banks, depositors and small- and medium-sized enterprises in China. There have been actions in recent months to open the financial system, including increased quotas related to the Qualified Foreign Institutional Investor program. This program regulates licensed foreign investment in China’s mainland stock exchanges. We also think a revision to the Qualified Domestic Institutional Investor system is needed to allow individuals to invest more outside of China. Finally, we believe China must allow the free flow of capital to help internationalize its currency, the renminbi.
  • REFORM PERSONAL INCOME TAX AND VALUE-ADDED TAX: We continue to believe that China’s tax rates are too high and too concentrated at the central level. China has a top rate for individual income taxes of 45% and a corporate tax rate of 25% – among the highest in the world.
  • RETAIN GOVERNMENT LEGITIMACY: While there were indications earlier this year that an experiment in the small city of Wukan to allow citizens to vote might be the precursor to more western-style elections, we have not seen movement in that direction. And the new leadership appears to be tied to established, conservative principles in China’s Communist Party. It will be important to watch the new government’s response to calls for reform and criticisms about corruption within the party, and to gauge the acceptance of the new government by the Chinese people.
  • FOCUS POLICY ON DOMESTIC CONSUMPTION: As noted, we believe China must move strongly to increase domestic consumption as a key economic driver. We continue to believe the country must move beyond its history of export-driven growth. We expect the government to allocate a significantly larger proportion of total fiscal spending to education, health and social security as part of this change in focus.
Maintaining our optimism and outlook for growth

The transition in China’s leadership has again been a smooth process, which we think in part reflects a desire to avoid negative economic consequences. As we anticipated in our earlier report on China, the new PSC is presenting a picture of unity and is not derailing the overall leadership change process.

We still believe China can succeed in a push toward a market-driven economy focused on increased domestic consumption. We anticipate the economy can maintain its strong pace, with real annual GDP growth sustainable around 7% and inflation of 3% to 4% over the long term.

* Source: The World Bank
News sources: The Washington Post, CNN, Financial Times

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Waddell & Reed and are not meant to predict or project the future performance of any investment product. The opinions are current through Dec. 1, 2012, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

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Waddell & Reed Investment Management Company, a subsidiary of Waddell & Reed, Inc., serves as the investment advisor to the Waddell & Reed Advisors Funds. Waddell & Reed Advisors Funds are distributed by Waddell & Reed, Inc.

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