Reforms to Avoid the Predicted Chinese Crackup

Saint Paul, Minnesota – March 17, 2015 – In a recent Wall Street Journal article David Shambaugh predicted an end to the political system of China. His rationale is that the energy, creativity, and constructive power so badly needed for change in China can only be introduced through political reform and that, in the absence of such reform, the endgame was likely to be messy and perhaps violent.

While we do not dismiss the possibility that the current path of China could ultimately end in violent upheaval we believe there is another, more peaceful catalyst for regime change: economic reform.

At Magni, our focus is on researching and evaluating the economic, legal and political infrastructure necessary to put a country on a trajectory to Sustainable Wealth Creation. We use this process to rank 47 emerging and developed countries around the world and structure our portfolios based upon these rankings. Countries that implement the policies and assure adherence by government organizations and corporations to the policies not only attract global investment capital but, not coincidentally, have higher standards of living, better opportunities for economic advancement and are (consequently) more politically stable. Conversely, countries who lag in these areas, like China, can find themselves on the path towards upheaval and regime change.

Prior to current President Xi Jingping’s ascension to leadership, experts had praised immediate past presidents Jiang Zemin and Hu Jintao for being successful in using economic reforms in conjunction with small, more cosmetic political reforms to hold China together and keep it as a miracle of economic development. Under the current regime, however, progress on economic reforms has halted only to be replaced by increased repression and control. Not surprisingly, political tensions in China are again rising.

What economic reforms could occur that make the political endgame less likely and, if it does occur, less violent?

Similar to many 12-step change programs, the first step is about facing reality. In economic reform, facing reality means publishing accurate and open information about the country. China currently receives very low scores for the quality of the information they publish and for the opaqueness of their fiscal policy. Such changes would allow citizens, businesses and investors to make much more informed decisions and reduce the risks associated with business decision making.

The next step would be to implement promised reforms where there is little-to-no evidence of previous action. These fall into two categories: (1) financial activities and (2) regulation of financial businesses. Shareholders of companies experience much greater risks in their investments when shareholder rights are not protected, opaqueness in policies masks “crony capitalism” and corruption, and government-favored businesses unfairly compete with the shareholder’s business and/or extract excessive or arbitrary fees. Ineffective and arbitrary regulation of financial businesses also creates risks for shareholders, especially when the court system is subject to gerrymandering and undue influence from the political elite.

While these changes are systemic to the current economic infrastructure, significant progress has been achieved by other countries. Mexico has achieved large improvements in its economic infrastructure, making it much more robust than China’s. These improvements were accomplished without a “political endgame” and a violent change in political leadership. Mexico currently ranks 17th in the investible world (as compared to China at 44th). Conversely, countries unable to make necessary changes to their economic infrastructure and which have to resort to political repression have experienced mostly unfortunate results (such as Venezuela).

Over the course of the last year, Magni Research has tracked China’s attempts to crackdown on corruption (see commentaries at www.magniglobal.com) In general, the attempts are either superficial or unsuccessful, underscoring the perception of ‘lip service’ when it comes to implementing actual reform.

For Chinese, even small improvements, as long as they were real and not propaganda could have a significant impact. If China were to make small but meaningful improvements in the quality of its information, strengthened shareholder rights, and better application of the rule of law, they could move from 4th worst in the investible world (ahead of only Qatar, U.A.E., and Egypt) to ahead of Peru and close to both Thailand and Turkey. The Chinese citizen would have a basis for renewed faith in their government, the elite would have less reason to move money and children out of the country, and the political reforms would have more time to be realized.

For investors, the changes would make China a more attractive country in which to purchase equities and the surge in equity prices experienced during late 2014 might become a trend instead of a temporary and fading event.

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