Since taking power in November 2012, Chinese President Xi Jinping[1] has implemented a strong program to punish corruption.  As we will discuss in more detail below, a very large number of the Communist Party of China (CPC) have been under investigation or punished for their failings.  We believe that these purges, although rather common in Chinese history, are being implemented for reasons beyond the simple exercise in political power. 

In this report, we will discuss the purge in detail.  From this position, we will introduce the concepts of environmental and social capital.  This will allow us to discuss China’s four stages of growth, explaining the country’s current situation.  We believe in order to execute the fourth stage China needs a leader in the mold of Deng Xiaoping, the president who followed Mao.  We will examine what Xi needs to accomplish to be the “next Deng.”  We will conclude, as always, with market ramifications.  

The Purge

Even before Xi took power, there were clear signals that the incoming government was paying close attention to corruption.  Xi made a speech on March 1, 2012, lamenting the fact that many CPC members seemed to have lost the spirit of Lenin and Marx and had succumbed to “money worship, pleasure seeking and extreme individualism.”  Xi stressed the need for “party purity” and worried that CPC members were being seen by the Chinese public as opportunists rather than guardians of the revolution. 

About two weeks later, on March 15, Bo Xilai, a contemporary and rival of Xi and a rising star in the CPC, was removed as party chief of Chongqing and about a month later was stripped of all CPC posts.  He was expelled from the party in September and is currently serving a life sentence for corruption and for his role in the murder of a British citizen (see WGR, The Purge of Bo, 4/2/2012).

Bo’s purge has set the tone for Xi’s administration.  Xi indicated that he was serious about combating corruption by appointing Wang Qishan as head of the Central Committee of Discipline and Inspection (CCDI).  Wang, a fellow member of the Politburo Standing Committee (PSC), carries the moniker “the fireman” for his competency in handling difficult assignments.[2]      

Xi and Wang are contemporaries; they met when they were both banished to the Yan’an region during the Cultural Revolution.

Wang has been given near free rein to combat corruption.  He has taken this role with clear relish; last year alone, 182,000 CPC members have been investigated compared to 15,000 in 2012, the year before Xi took power.  President Xi has indicated that the fight against corruption isn’t just for underlings; he describes it as going after “tigers and flies.”  In the first five months of this year, 62,953 officials have been punished for corruption, including 33 upper level officials such as central government ministers, leading provincial leaders or senior officials at state owned companies (SOE), and four members of the CPC Central Committee. 

The arrests of three powerful CPC leaders have caught the world’s attention. 

  • The aforementioned Bo Xilai was arrested, stripped of membership and rank, convicted and imprisoned. 
  • Zhou Yongkang, a former member of the PSC, former head of state security and, earlier in his career, the head of China National Petroleum Corporation (CNPC), has been detained.  There had been an unwritten rule that former PSC members were immune from investigation and arrest for fear of creating tensions within the ruling elites.  Xi has apparently decided that this rule no longer holds.  According to reports, 300 of Zhou’s former associates or family members have either been arrested or are under investigation and, thus far, nearly $15 bn has been confiscated from Zhou and his group.  
  • General Xu Caihou, the former vice president of China’s Military Commission and a powerful member of the People’s Liberation Army (PLA), was recently arrested on corruption charges.

All three men were close protégés of former President Jiang; apparently, he was unable to protect them.  It is unclear where these investigations will end.  There have been reports of grumblings from the old guard, concerned that Xi is going too far, although Reuters has reported Xi has generally received approval from former leaders for his anti-corruption drive.  By all accounts, the investigations aren’t complete and we expect them to continue.  Thus, there is great fear among CPC members of future investigations and arrests.

We should note that even Premier Li Keqiang appears to have been sidelined.  The premier in China is something like the U.S. vice president, except that the premier is given the economy’s portfolio to manage.  It appears that Li has been sidelined in this effort as Xi is taking a direct interest in the economy.  However, as we will detail below, we believe this is a tactical move and that Li isn’t a target for corruption.

Overall, this purge is at least as large as Deng’s post-Mao consolidation of power and may be as important.  Only the Cultural Revolution was bigger.  To fully understand why this purge is taking place, we need to put Xi and his program in the context of China’s economic history.

The Different Forms of Capital[3]

Since the death of Mao, China’s economy has gone through three stages of growth and it appears it is embarking on the fourth.  To understand these stages, the first step is to detail the two major capital investment categories required for an emerging economy to rise to developed nation status.

The first factor that a nation must acquire is “environmental capital.”  This is the “stuff” that fosters economic growth, including the training and housing of a labor force, acquiring access to natural resources and building infrastructure.  These are the basic building blocks for an economy.  In most emerging economies, these factors are controlled by the political elites and the process of granting access gives these elites rent-seeking[4] opportunities which usually make them powerful and wealthy.

The second factor is “social capital,” which is a social and economic system that gives entrepreneurs, managers and workers the proper incentives to engage in value creation.  Social capital includes a fair and transparent legal system and protection from political interference in the process of combining environmental capital to create businesses and sell goods and services. 

And so, in most emerging economies, there is tension between the elites who usually control the environmental capital and ordinary citizens who want to participate in the economy and need social capital.  Countries that have made the jump from emerging to developed usually are forced, at some point, to quell the goals and aspirations of the elites to create social capital.  Pettis’s research[5] suggests that the best conditions to support the growth of social capital at the expense of the rent-seeking elites are during periods of monetary expansion in the developed world.  When these periods occur, usually due to a new technology or other growth stimuli in the developed world, investors in these nations begin looking for new investment opportunities in emerging economies.  The inflows of capital tend to enrich the elites and weaken their resolve to prevent the expansion of social capital at the elite’s expense.  Pettis’s position is that the changes in social capital that make emerging nations more attractive rarely occur by the country making changes to attract capital, but rather the other way around.  Capital seeking new opportunities becomes the funding that promotes reforms.

China’s Four Stages of Growth

China’s economic growth record since 1979 has been remarkable, with annual GDP increases often exceeding 10%.  Most analysts have viewed this growth over nearly 35 years as an undifferentiated path.  However, Pettis has identified four stages of growth that highlight the challenges China will face in the future.

The first stage of growth lasted from 1979 to roughly 1993.  After Deng consolidated power, he was faced with a sputtering economy that was simply not creating enough growth for China’s large population.  Deng concluded that he needed to create an entrepreneurial spirit by building social capital.  He deregulated the farm sector and introduced market reforms to the coastal provinces in mainland China.  Almost immediately, growth rose.  Deng faced tremendous opposition from hardline Communists to these moves as they were clearly a retreat from socialism.  However, Deng was so politically powerful and savvy that he was able to overcome this opposition.  It should be noted, though, that Deng didn’t fully secure the reforms until 1992, during his famous “Southern Tour” where he showed how the economy could grow and that his methods did bring results.

Although the first stage offered great promise, it ran into trouble due to the lack of environmental investment.  Pettis has dubbed this second stage the “Greshenkron period” after the Soviet economist who described the process.  This period ran from roughly 1993 into 2003.  Greshenkron postulated that emerging economies lacked environmental capital and had two choices for acquiring it; they either accepted foreign investment (debt or equity capital), or they generated savings internally to fund environmental capital investment.  China chose the latter, creating a closed financial system which engaged in financial repression.  Essentially, household spending was restricted by policies that restrained the production of consumer goods.  Consumer debt was discouraged.  The external capital account was restricted, preventing foreign investment.  There was no government-supported pension plan and health insurance was scarce.  The lack of a social safety net boosted precautionary saving.  These policies led to a high savings rate; banks fixed deposit rates below the inflation rate, making the cost of funding environmental investment very cheap.

The CPC elites loved this program.  They were able to direct investment using cheap household saving and were able to engage in rent seeking.  By controlling flows and environmental investment, the elites grew fabulously wealthy.  They also grew in political power.  In the early stages of development, the need for environmental investment was so great that any investment tended to make economic sense, which means the benefits from the investment outweighed the costs.  This new investment led to a significant growth spurt.  Households benefited from rising growth, just not to the same extent that the CPC elites did.  It is often said that China needs strong growth to maintain labor peace; perhaps a better way of looking at it is that China needs strong growth to meet the voracious avarice of the CPC and provide something for households as well. 

The third stage, dubbed “investment overshoot,” began early last decade and continues to the present.  As the economy grew, the need for more environmental investment declined.   At this stage, an emerging economy needs to develop a well-functioning financial system to allocate investment to its best economic return.  However, the CPC elites continued to control the flow of investment funds, meaning that connections and influence determined who received loans instead of lending to the project with the highest return.  Investment became the primary driver of economic growth.  This situation was exacerbated with the 2008 Financial Crisis, which led to a contraction of exports.  After 2008, debt and investment soared.  By some measures, China’s non-financial debt exceeds 250% of GDP and consumption is only around 35% of GDP.  Most developed nations have consumption levels between 50% and 60% of GDP. 

The need for reform is rather obvious.  However, the CPC elites, who have now been dubbed as “vested interests,” oppose reforms because it will end their ability to use their power and influence to generate new economic rent and reduce their economic and political power.  One could argue that the most opportune time for reform would have been from 2003 to 2008; growth was strong, foreign investment would have been easy to attract and exports were high.  There was enough growth to pay off the elites and invest in social capital.  Unfortunately, Hu did not follow this path.  Now, with global growth remaining sluggish, reforms will be much more difficult to execute.

This brings us to stage four, the reform stage.  It is obvious that malinvestment has grown in China.  When the U.S. media regularly reports on “ghost real estate developments” in China, high rise apartment complexes with no renters or condominium buyers, it is clear that China has too much housing in the wrong areas.  If reforms are not implemented, at some point, China’s debt capacity will top out and the country will face a massive bad debt crisis.

China needs to invest in social capital that will encourage private entrepreneurship, which will, in turn, require reforms that will release citizens from funding rent-seeking elites.  This action will lead to higher consumption and probably less investment, although new investment, graded and tested by a modern financial system, will actually add economic value.  Clearly, however, this will be hard because the CPC elites will lose their power and influence under such reforms. 

Xi—The Next Deng?

It is in this situation that Xi finds himself.  His actions to purge the party suggest that he knows what he needs to do.  He needs to frighten the CPC into compliance and prepare them for “monastic” life.  Simply put, he needs to turn the party into something like the “mandarins” from the period of the emperors who were disinterested but effective bureaucrats that supported the common people, at least in theory.  The party members will have less access to wealth and will need to content themselves with doing the will of the working class. 

So, how can we know whether progress is being made?  Perhaps the best signal will be official growth targets.  As long as China has borrowing capacity, and we suspect it does because it is only just starting to tap foreign markets for loans, China can achieve any GDP growth number it wishes.  Hitting growth targets gives the Chinese government credibility.  However, we believe it can only grow around 3% to 4% without causing its debt situation to worsen.  So, the coming year’s GDP growth targets will signal how confident Xi is in his reforms. 

On this topic, we suspect Premier Li has been sidelined because his reform program will anger the CPC elites.  The second signal will be when Li appears rehabilitated.  Li’s program, detailed in the goals of the Third Plenum, if implemented, would go a long way to create the fourth stage of growth.  At present, the CPC elites are mostly giving lip service to these reforms.  However, once Xi believes he can move forward, we would expect Li to be the leader of that effort. 

As part of this effort to cow the elites, we also expect Xi to be very nationalistic and to procure military support, even as he roots out corruption in the PLA.  Bullying China’s South China Sea neighbors is a relatively costless way to get the military on his side since he probably has few worries that the Obama administration will move aggressively to prevent such actions from occurring.  The risk, of course, is that Xi oversteps and triggers a “hot war” with a more formidable power, like Japan.  We don’t expect this to occur, but it is a worry.

So, in sum, we believe Xi’s purge is really an effort to replicate Deng’s program of promoting social investment.  The more active and effective the purge, the faster the fourth stage can begin.


Xi’s attempts to reform China may fail but we believe there is clear logic to his behavior.  In order to coerce the CPC elites into giving up their power, a purge is probably necessary.  We do not believe this is a “garden variety” attempt to consolidate power.  It is too wide and potent to be a method of simply removing political enemies.  Xi is trying to change the attitude of CPC members who have become wealthy under the current system and so this anti-corruption campaign will continue until Xi believes he has the party on board with reform.

The success of the program will bring slower growth to China.  It will be a negative factor for commodity prices and the currencies and economies of major commodity producing sectors.  It should be remembered that Xi doesn’t have an unlimited amount of time to bring about reforms.  Eventually, China will exhaust its ability to turn investment into GDP growth.  We don’t know how much time Xi has; a veritable cottage industry of Chinese analysts argue over this issue, with some very intelligent analysts suggesting it is already too late.  We disagree, but there may only be a few years before that point is hit. 

If current trends continue, eventually new investments will immediately be worth less than the value of the loan to provide that investment.  At that point, the economy will be headed toward a debt crisis.  At best, if Xi’s reforms fail, China will be the next Japan.   At worst, it will trigger a major war to provide distraction and support growth.  We are encouraged by what we have seen thus far from President Xi.  He appears to understand his situation and is taking the proper first steps to respond.  China’s future, and perhaps the world’s future, depends on his success. 

Bill O’Grady

September 8, 2014

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

[1] In addition to the position of president, he is the general secretary of the Communist Party of China (CPC) and the chairman of the Central Military Commission, giving him power over the state, party and military.  Previous rulers did not always possess all three positions when they initially took power.  For example, Jiang Zemin kept the position of chairman of the Central Military Commission until 2004 while his successor, Hu Jintao, was granted the roles of president and general secretary.  By gaining all three positions at the time of succession and transfer of power, Xi was seen as a strong ruler from the outset.

[2] He was named mayor of Beijing during the SARS crisis in 2003.  He was also appointed by Hu Jintao as his special envoy for economics for the U.S.-China Strategic and Economic Dialogue in 2009, shortly after the Financial Crisis. 

[3] This analysis borrows heavily from Michael Pettis, Professor of Finance at Peking University and Senior Associate at the Carnegie Endowment for International Peace.

[4] “Rent seeking” is a term that comes from Public Choice Theory and details the process by which wealthy individuals and firms attempt to increase their wealth through the manipulation of regulation through regulatory capture.  The roots of the theory come from Adam Smith and David Ricardo, who described how landowners of very productive fields benefited without effort from the higher prices dictated from the grain grown in less productive areas.  This “economic rent” describes gains made due to fortunate circumstances, not investment or effort.  The Arab OPEC nations are a good example of low-cost producers achieving excess return because oil is priced at the marginal cost of the world’s highest cost producer. 

[5] Pettis, Michael. The Volatility Machine. Oxford University Press, 2001.

Confluence Investment Management LLC

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri.  The firm provides professional portfolio management and advisory services to institutional and individual clients.  Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach.  The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives.  The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.  

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