Nitesh Shah Director – Commodity Strategist

Maxwell Gold Director - Investment Strategy

ETF Securities Outlook September 2017 China Congress: The Making of a Strongman

Summary • The upcoming Congress meeting is Xi Jinping’s opportunity to consolidate power.

• The extension of Xi’s powers may see the status quo Rising stars are at risk. Sun Zhengcai, once considered a contender maintained: little progress in reducing the scope of state- for the Politiburo Standing Committee and possible future leader, owned enterprises or addressing economic imbalances was replaced last month as Party Secretary of Chongqing by Xi’s including excessive credit expansion. protégé, Chen Min’er. Accused of corruption, Sun Zhengcai appears • The continuing lack of reform may to leave China vulnerable to to be the latest victim of Xi Jinping’s exercise to remove opponents. a large shock. Bending the ‘rules’ Political rotation The so-called ‘rule’ requiring members of the Standing Committee The legislative branch of the Chinese government is set to host its over the age of 68 to retire is unwritten. A senior member of the five-yearly power transition meeting on October 18th: the Party recently described the requirement as ‘folklore’. If the ‘rule’ is Communist Party’s 19th Congress. If tradition is upheld, older ignored, Wang Quishan – a close ally of Xi in the current Politburo members of the political elite – the Politburo Standing Committee Standing Committee could be retained. Also breaking precedent (the ‘Committee’) - will retire to make room for younger ones. Of this year could allow Xi Jinping to stay on the Committee at the the seven members, five are expected to be replaced. The remaining 20th Congress in 2022, when Xi would turn 69. Also the size of the two are the General Secretary/President1 (Xi Jinping) and the Committee has fluctuated from as low as five and as high as nine. Premier of the State Council (Li Keqiang), who are young enough to There is potential for the Committee to trim down from seven lead for the next five years. When Xi Jinping took the helm of the currently to remove likely threats to Xi’s influence. Party in 2012, he had very few trusted allies by his side. Five years The current constitution allows the President to serve a maximum on, through rounds of reshuffles and a war on corruption, he has of two terms. Therefore, Xi would have to hand-over this role in purged more than 200 senior officials from their posts and 2022. Although the role of the President and General Secretary replaced them with his cronies. He has successfully placed have gone hand-in-hand in the past, Xi could pass the baton on to supporters in various branches of government. one of his protégés in 2022, but continue to exert influence on policy from within the Committee if he can successfully manoeuvre • Legislative • Executive around unwritten rules. branch branch Economic status quo National People's State Council Congress While setting out an ambitious set of targets for economic reform in the Party’s Third Plenum in 2013, progress on this front has been rather pedestrian. Chinese leaders had pledged to give markets a Central Supreme Military “decisive role” in resource allocation. However, there appears to be People's Court Commission a constant distrust of markets. There have been countless • Military • Judicial interventions in the equity and property markets to avoid prices branch branch from falling harder. Maintaining a steady economic growth rate of 6.5% to 7% seems to be the product of accommodative monetary policy, credit growth and a reluctance to scale back on over-

1 The President is the head of state with a largely ceremonial office and limited powers. However, since 1993 the presidency has been held simultaneously by the General Secretary (the leader of the Communist Party). 1 Past performance is no guarantee of future results. production. Most examples of capacity constraint can be linked Total credit to non-financial sectors more closely to environmental concerns rather than market- 250 enhancement objectives. Placing so much emphasis on an Augmented public sector SOEs economic growth target has driven debt levels to unsustainable 200 Non-SOE corporates levels. The efficiency of credit is very poor. In 2015-16 it took Households RMB4trn (US$600bn) in new credit to increase nominal Gross 150 Domestic Product (GDP) by RMB1trn (US$150bn). In 2007-2008, it only took RMB1.3trn (US$169mn) in new credit to increase GDP 100 by RMB1trn (US$130).

50 China’s debt balloon Percentage of Gross Domestic Product

It is widely acknowledged that China has a debt problem. While 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 central government debts are low in comparison to other emerging Source: IMF, ETF Securities, data available as of close 18 August 2017 markets, the headline figures fail to account for all the debts, in SOEs need to be reined in, but reform in this area has been sub-par. particular those of local governments which are used in a fiscal The Chinese government has taken aim at cleaning up “zombie” capacity. In 2014, the International Monetary Fund (IMF) created companies – particularly SOEs – by giving them a menu of exit an ‘augmented’ deficit and debt calculation to account for the off- options. However, a lack of details on how these companies have balance sheet funding in China. In its latest estimation, the IMF actually been wound up (or otherwise dealt with) makes it difficult widened the perimeter of its augmented deficit and debt to assess progress. Other reforms of SOEs include consolidating calculation, to include new avenues to fund quasi-fiscal units. In central SOEs, phasing out their social functions to workers, 2014, China implemented a number of changes to bring local transferring state-owned equity to social security funds and government financing through opaque financing vehicles back on individually incorporating subsidiaries of SOEs. Progress in these balance sheet. Local government on-balance sheet borrowing areas has been lackluster. For example, transfer of SOE profits to increased from 0.3% of GDP in 2014 to 2.4% of GDP in 2016. Also the budget has been far less than the 30% target level. the government brought a large stock of local government financing vehicle debts on balance sheet (amounting to 22% of GDP). Despite Financial buffers the efforts by the central government to bring transparency to funding, by encouraging local government debt to be put back on China has unique mitigating features that can help it deal with a balance sheet, new methods of financing local governments have disorderly fallout from the credit market. It has a high household emerged. The IMF includes these new forms of financing in its saving rate, a current account surplus, small external debts, large latest estimate of government debts. foreign exchange reserves, interest rates significantly above the China government debt (% GDP) zero bound and a skilled central bank accustomed to injecting 100 liquidity and using quantitative measures. But these features do not

90 Debt mean that China will be completely immune. Sticking to and Augmented debt (2016 est) 80 enhancing the reform agenda is therefore important, especially Augmented debt (2017 est) 70 with regard to reducing the scale of SOEs and improving efficiency

60 in resource allocation. A combination of all these features is required to deflate the Chinese debt balloon, rather than burst the 50 bubble. 40

30

20 Will a strongman help or hinder reform? Percentage of Gross Domestic Product 10 If Xi Jinping emerges from the political events this year and beyond 0 as a strongman, there is a risk of “more of the same”. Surrounded 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 by cronies, the appetite to challenge the status quo will be lacking. Source: IMF, ETF Securities, data available as of close 18 August 2017 With a support-base including neo-Maoists and a trend of rising Meanwhile private sector debts are large and expanding. inequality in China, a populist backing could drive China to reject Particularly those in the state-owned enterprise (SOE) sector. market-based decision making in favor of the communist ideology While the share of industrial output from SOEs has fallen from that has eroded over the past 20 years. There is an outside chance 40% 15 years ago to 15-20% currently, SOEs account for an that Xi uses his paramount powers to accelerate reform, but, outsized share of corporate debt (around 57% of corporate debt or market-oriented reform is likely to alienate the very people that 72% of GDP). have supported him and for that reason we think it is unlikely to The continuous growth of SOE credit is likely to further crowd out happen. financing to commercial organizations and increase non- performing loans.

2 Past performance is no guarantee of future results. Important Risks

The statements and opinions expressed are those of the author and are as of the date of this report. All information is historical and not indicative of future results and subject to change. Reader should not assume that an investment in any securities and/or precious metals mentioned was or would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future results. RMB = Chinese renminbi or yuan, the official currency of China. Gross Domestic Product (GDP) = the total value of goods produced and services provided in a country during one year. The International Monetary Fund (IMF) is an international organization created for the purpose of standardizing global financial relations and exchange rates. Maxwell Gold is a registered representative of ALPS Distributors, Inc. ETF001215 09/30/18

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