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Waddell & Reed Special Report: China at a crossroads

Waddell & Reed Advisors Funds Special Report - May 2012

Waddell & Reed Advisors Funds Special Report - May 2012

Transition to new leadership must ensure ongoing economic growth
Waddell & Reed recently completed another in-depth research trip through China to get an additional first-hand look at conditions in this global economic power. The research included stops in the cities of Beijing, the nation’s capital; Shanghai, the financial center; Xi’an, the ancient capital city; and other cities of various sizes and stages of economic growth, including Zhengzhou, Luoyang and Dengfeng.
The Waddell & Reed team gathered a wide range of information about the state of China’s growing economy and its political climate through meetings with business executives, economists, academics and ordinary citizens. A key topic of discussion centered on the upcoming change in leadership in both the Communist Party and the government – events that we believe have clear investment implications.
Process of leadership change
The Chinese Communist Party convenes a National Party Congress every five years to announce new national policy directives and make critical personnel changes. The meeting, which is likely to be held in October, has extra importance this year because it includes changes in the Party Secretary and the Premier, China’s top Party and government positions.
The Communist Party’s membership in China totals more than 80 million out of a total population of 1.4 billion. Looked at another way, those 80 million members could represent as much as 20 percent of the 400 million families in China — meaning one in five families could include a party member. That is an enormous constituency.
According to the constitution of the People’s Republic of China, the highest authority rests with the 3,000-member National People’s Congress, made up of leaders who distinguish themselves at the local level of Party politics.
A nine-member committee of the Party’s top leadership is selected as the Central Politburo Standing Committee (PSC). This committee is the real power in China. Its decisions and the ability of its members to act as a cohesive group drive the Party structure in China. Any loss of legitimacy or fractures within this group can result in big problems with the country’s overall population. But as long as the country is run well and citizens have hope for a better life, the Party is not disrupted.
A number of key personnel changes are expected at this year’s National People’s Congress in addition to the changes in the top posts. Over half of those in China’s top 25 leadership positions will retire at this year’s event, including General Secretary Hu Jintao, the top Party leader, and Premier Wen Jiabao, the top government leader.
In addition, seven of the nine members of the PSC will step down this year, leaving questions about their eventual replacements and even whether the committee still will include nine individuals. A leadership meeting this summer — referred to as the Beidaihe meeting — is expected to select the new PSC members. While no Party announcement is expected after that meeting, the results should be known unofficially by late July or early August.
Potential reforms and Investment implications
We believe the investment implications from recent events point to a need for further reforms in order for China’s economy to become more balanced. In our view, China needs such reforms to move its economy from its base in exports and urbanization to one led by domestic consumption. We think the current political uncertainty may provide the needed catalyst to spur these reforms, which we would put in five categories:
·         Reduce the power of state-owned enterprises (SOEs)
·         Liberalize the financial system
·         Reduce high tax rates
·         Retain government legitimacy
·         Focus policy on domestic consumption
Outlook: Reasons for optimism
We think a smooth transition is likely in China’s leadership to ensure there are no negative economic consequences. We do believe there is a risk – although small – that the underlying political problems are worse than they appear now and could result in some unraveling of the political structure. But we also think the PSC will continue to present a picture of unity, whatever the facts may be, in an effort to avoid derailing the process of leadership change.
Economic activity around the country was in multiple stages of development in the various “tiers” of cities the Ivy Funds team recently visited. For example, we believe Shanghai leads Beijing in growth and modernization by about 10 years, Beijing leads Xi’an by about 10 years, Xi’an leads Luoyang by about 10 years, and so on.
In the last 10 years, China’s growth was led by the coastal cities; in the next 10 years, we expect the growth leaders to be in the central and western parts of the country. China’s rural population still is about 50 percent of the total, and 37 percent of labor still is in agriculture. By comparison, the U.S. rural population is about 17 percent and only about 1 percent of labor is engaged in agriculture. We expect the trend to urbanization will increase in China and the percentage of agricultural labor will decrease, perhaps by half in both cases by 2025.
With this expected rebalancing in the economy and provided that reforms move forward and focus on a market-driven, western-province expanding, consumption-led economy, we see strong growth ahead for China. We think a real annual GDP growth rate is sustainable at 7 to 8 percent and an inflation rate is manageable at 3 to 4 percent over the long term.
This is a summary of the Waddell & Reed Special Report: China at a crossroads. Download PDF for the full report.  
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 May 21, 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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