Making Sense of the Chinese Chaos: What it might mean for portfolio positions

Overview

Recently, Xi Jinping supposedly replaced the number two ranking government officer and leader of the PLA (People’s Liberation Army), China’s army, General Zhang Youxia. Additionally, Gen. Liu Zhenli was relieved. The act was a surprise to many as General Zhang was one of the “princelings” and had grown up close to Xi. Many questions arise with this action and, in turn, the future course of China. While many sophisticated institutional investors and risk managers might have little direct exposure to China, there is little doubt that we all have massive indirect exposure and changes in China are likely to reverberate for years.

The Motivation

The capture of Maduro was one of the most dramatic actions of the past year. Few would have thought a military force could sweep in a heavily protected leader and escape with minimal casualties. While receiving little attention, apparently another princeling was at the center of the event. Apparently, a Maduro insider provided valuable information which enabled the capture. Presumably, the event did not go unnoticed by Xi, who for the past several years has fired a good portion of his top generals.

For better or worse, Xi appears to be pursuing the same path as Napoleon and Stalin, whereby those who might constitute a threat to his rule are removed.

The Broken Rules

Given the fact that China is not a democracy, there must be some pathway for governing the country. There is, and it is along the lines exactly as one would expect. For the most part, those individuals (and their families) who played senior roles in establishing the new regime post the fall of the Nationalist government in 1949 (i.e., the “princelings”) are given preferential treatment. It is via the consensus of the princeling class that major decisions are made, and the country is run. Xi is essentially breaking those rules via recent actions and has also apparently broken another rule by seeking an unprecedented third term.

The Result

With the bell rung via the aforementioned, unprecedented actions, it is impossible to unring that bell. The major issue that leaders are apparently struggling with is whether they support said actions or draw the line. Given the fact that many of the princelings appear to be threatened by Xi’s actions, the power of incumbency might be challenged.

The Threat

There is a Chinese curse: “May you live in Interesting Times.” The idea is that with change comes risk. The risk is that Xi might want to unify the country by pushing for some military action. The irony is that apparently General Zhang was replaced in part based on his opposition to Xi’s proposal for increased pressure on Taiwan.

The Likely Outcomes

All forms of government have their advantages and disadvantages. The biggest drawback of non-democracies is that there are typically fewer checks on power.

Given the fact that Xi is 72 years of age and apparently has health issues, regardless of the outcome of recent actions, he is closer to the end of his tenure than the beginning. A likely outcome is that differences will be papered over, his power will be privately but not publicly curtailed, and the next round of leaders will be identified.

Conclusions

China is critical in numerous respects. Sophisticated institutional investors and risk managers would be well-served by understanding the dynamics and likely outcomes of the recent developments in the country.