Big Changes Are Coming to China

NEW YORK (TheStreet) -- In September I recommended going back to China, Time to Buy China, after the exodus over the prior few months. Since then iShares FTSE China 25 Index Fund (FXI) is up 8%. Recent events reinforced my conviction.

First of all, the power transition in Beijing has been the dominant concern and risk for several months, highlighted by the drama surrounding Bo Xilai but supplemented by the very real jostling around the issues of real estate price control, relative support for state-owned enterprises vs. private sector, and a myriad of sociopolitical issues.

As the 18th Party Congress draws to an uneventful end, this risk has disappeared. Furthermore, it's very encouraging for China watchers to see numerous signs of potentially significant changes. "Marxism-Leninism and Mao Zedong Thought" has been dropped from the Party Constitution. (I know, but trust me it's still a huge deal even though no one in power has anything to do with it since the '90s at the latest.)

Official media are talking about limiting "interest groups," a code-word for the existing state-enterprise establishment, in very public and stern tones. There are even some subtle signs pointing to potential revisiting of the 1989 democracy movement.

Nobody is expecting an overnight revolution. But it does look likely that the Beijing leadership collective has come to the realization that some profound changes must be made urgently in order to maintain power and sustain economic growth and social stability.

Economically, in my opinion and shared by the think-tank for economic planning according to a recent report, the top-most issue is reform of the SOEs. Allow me to provide a brief background here.

The economic reform in China started in the early '80s, when virtually the entire economy was controlled by the central government. Despite the Tiananmen Square massacre on June 6, 1989, reform in China continued to push forward (mostly economic but also in most other areas), contrary to the popular misconception in the West.

The '90s marked the single biggest change in Chinese economic landscape since the beginning of time: for the first time the state-owned sector in Chinese economy was forcefully shrunk by the government.

This historic, tremendously significant transformation was, sadly, reversed when the Hu-Wen government took over in 2002. The few surviving SOEs, though nominally "publically traded," quickly formed an untouchable alliance with the government and banks (mostly state-owned and publicly traded themselves) and dominated the landscape.

They are, of course, notoriously inefficient in every way except regulatory arbitrage and pluropoly. But they are the original too-big-to-fail. They have practically unlimited sources of cheap financing and monopoly-like pricing power. Life cannot be easier and more glorious than theirs anywhere or anytime on this planet.

Except it has led to enormous inefficiency and abuse in capital allocation and utilization, as well as contributed to rampant corruption and social discontent, in recent years. In every sense, the SOEs are the pinnacle of structural socioeconomic ills of China today.

If the incoming government manages to re-reverse the tragic trend of the past decade, there is actually a fair chance for the Chinese economic engine to keep chugging for a long time and for the country to continue its three-decade-old, historic transformation. The impact to the world cannot be over-estimated.

In comparison, the pathetic competition of "who talks tougher on China" during the presidential campaign is utterly irrelevant. The rational and wise approach is to embrace, encourage, and influence the transformation in China. But I suspect that's exactly what the U.S. will do, despite the president, whoever it may be.

In the short term, as policy thaws from cryogenesis, I expect to see Beijing taking some concrete actions in the weeks and months ahead. The yuan will probably be nudged lower in some ways. As inflation continues not to explode and fear of leakage from QE3 subsides, some form of monetary stimulus other than the timid reverse repo operations by the central bank, which has been the tool of choice during the cryogenesis, is likely to take shape.

The economic structural shake-up will probably start with the financial sector, with a myriad of regulatory changes. The net effect in the longer term, if successful, would be to stabilize the real-estate market, control growth of bad credit (mostly from local governments and SOEs), and increase market-driven competition in the financial sector.

It's a ginormous undertaking; I'm cautiously half-optimistic. But in the short term, a stimulus effect to the market is quite certain. This is pathetic in a way, as it's entirely based on expectation of government action and the belief in its power. But I try not to pass moral judgment on the market.

There are also numerous technical factors pointing to the same. Hot money has been flowing into Hong Kong in recent weeks, forcing the local government into a scramble to control the exchange rate. The only logical explanation is that speculative money has recently been posturing to enter mainland China. Hong Kong is but the quickest gateway.

While capital exodus by foreign investors seems to have stopped a couple of months ago, that by domestic riches also seems to have slowed down as the power transition comes to resolution. Anecdotal evidence suggests that domestic institutional money is getting excited about the pending changes. In short, capital flow is in the midst of a multi-month reversal.

This transformation could last for years if it works out. But that'd be speculative. Over the coming weeks and months, it seems fairly certain.

At the time of publication the author was long FXI.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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