Xi-Li Inherit Weakest Growth Legacy Since Deng Opened China

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Xi Jinping, vice president of China.

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Xi Jinping, vice president of China.

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Li Keqiang, China's vice premier. Close

Li Keqiang, China's vice premier.

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Workers sew shirts at the Lever Style Inc. factory in Shenzhen, Guangdong province, China.

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Technicians work in the high throughput purification laboratory at the WuXi PharmaTech facility in Wuxi, China.

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China’s new leaders are poised to inherit the weakest economic growth since Deng Xiaoping three decades ago and may need to borrow from his market-opening tool kit to avert a steeper decline.

As the Communist Party prepares to anoint Vice President Xi Jinping, 59, and Vice Premier Li Keqiang, 57, next month as its so-called fifth generation in charge, data from exports to production signal the government will struggle this year to reach its 7.5 percent expansion target. The retiring top echelon took power in 2003 with growth above 9 percent and their predecessors were bequeathed a 14 percent pace in 1993, a year after Deng toured the southern boomtowns he’d spawned, urging more change.

U.S. and European consumer spending that fueled expansion for decades is waning, while the young labor force that filled China’s factories is starting to shrink. Unless Xi and Li can succeed where their predecessors came up short and curb state enterprises, boost access to credit for private companies and raise consumption, annual growth could slump to about 4 percent by 2014, according to Roubini Global Economics.

“China faces its most pivotal challenges in more than a decade, with a structural economic slowdown coinciding with a major political transition,” said Ramin Toloui, global co-head of emerging-markets portfolio management in Singapore at Pacific Investment Management Co., which operates the world’s largest bond fund. “The old-growth model is gone, but there is not yet a clear and present plan for replacing it.”

Expansion Driver

China’s slowdown is adding to headwinds complicating the global economy’s struggle with Europe’s debt crisis and stunted U.S. job gains. China’s economy, the world’s second-largest, accounted for 36 percent of expansion last year.

Toloui, who helps manage $100 billion in emerging-market bonds at Pimco, sees China’s growth moderating to 7 percent in 2013 and remaining at about the same level through 2015, compared with about 10 percent since Deng began dismantling Mao Zedong’s command economy in the 1980s. Pimco has $10 billion invested in Chinese corporate bonds, yuan debt issued in Hong Kong and currency contracts, Toloui said.

“The global economy has become hooked on supercharged Chinese growth, and we’re not going to have that in future,” said Susan Shirk, chairwoman of the 21st Century China Program at the University of California-San Diego, who was responsible for China at the U.S. State Department from 1997 to 2000. “For the past decade to 15 years, we’ve had a reversal of the reform impulse and the challenge is to get that back on track.”

Overcome Opponents

The next generation of leaders must overcome opponents of change, including state-owned companies and banks that are “powerful, resourceful and resolute in protecting their interests,” according to a February report by the World Bank and the Development Research Center of China’s State Council.

While former Premier Zhu Rongji continued Deng’s legacy of reducing the government’s role by closing some state-run companies in the 1990s and firing millions of workers, the public-sector retreat slowed under current President Hu Jintao and Premier Wen Jiabao. Since 2003, policy has shifted toward supporting state-owned enterprises as a source of strength, Beijing-based GK Dragonomics wrote in a May 24 report.

“The political system has been captured by vested interests,” said Minxin Pei, a professor who specializes in China at Claremont McKenna College in California. “If you want to change the status quo, these interest groups are going to lose out. They are inside the system and will resist.”

Consumer Grail

Officials have vowed since at least 2006 to make domestic consumption an engine of expansion, even as its contribution to GDP slumped to about 35 percent this year from 44 percent a decade ago, according to Capital Economics Ltd. in London.

“Consumer consumption in China is not increasing at a significant rate, contrary to everybody’s hopes,” said Fred Smith, chief executive officer of FedEx Corp. (FDX), operator of the world’s largest cargo airline, on a Sept. 18 analyst conference call. “The locomotive that has driven China’s growth is its export industries, and with the situation in Europe and to a lesser degree in North America, that is a significant issue for the Chinese economy.”

China’s overseas shipments rose less than 3 percent for a second consecutive month in August, industrial output grew at the slowest pace in three years, and foreign direct investment fell for a ninth month out of 10.

Optimism Dims

Manufacturers and retailers have grown less optimistic about sales, with more employers cutting back jobs, a quarterly survey compiled by New York-based research group CBB International LLC showed today. The number of companies reporting net hiring gains this quarter fell nine percentage points to 32 percent, according to the report, which is modeled on the U.S. Federal Reserve’s Beige Book.

Another challenge is that China’s pool of 15-to-24-year- olds -- a mainstay for factories making cheap clothes, toys and electronic products -- will shrink by about 67 million by 2030, according to the United Nations. As the economy moves more toward services, labor shortages will worsen, reaching a shortfall of almost 18 million workers by 2017, said Tao Dong, Credit Suisse Group AG’s Hong Kong-based head of Asia economics excluding Japan.

China’s new leaders can unleash new sources of growth by developing services, getting capital to more innovative private companies, boosting wages, and bolstering pension plans and health care, said Stephen Roach, former nonexecutive chairman at Morgan Stanley in Asia.

Urbanization Trend

He said China still has lots of “low-hanging fruit” to harvest from urbanization, with the Organization for Economic Cooperation and Development estimating as many as 300 million more people will move from the countryside by 2030 to join 600 million already living in cities. With higher-paying jobs, these migrants will boost consumption and trigger more infrastructure and housing construction if the government can improve the social safety net, said Roach, now a senior fellow at Yale University in New Haven, Connecticut.

“The focus has been on expanding the number of people covered by the plans, but not on increasing the benefits,” Roach said. “Until they do that, there’s a risk that all the labor income that China generates through new jobs and urbanization will be saved and not spent.”

Savings Rate

China’s savings rate is estimated at more than 50 percent of GDP this year, the highest among major economies, exceeding 31 percent in India and 13 percent in the U.S., according to the International Monetary Fund.

To boost services, China’s government needs to “get out of the way,” said Stephen Green, head of Greater China research with Standard Chartered Plc in Hong Kong. The new leaders must simplify rules and reduce the involvement of state and provincial governments in businesses such as real estate, hotels, financial services and entertainment, he said.

“This kind of supply-side reform will make or break the growth outlook for the next decade,” Green said. “The real danger” is “a gradual descent into a rigid, uncompetitive and more state-dominated economy, growing only at 3 to 4 percent and vulnerable to shocks.”

The incoming officials should deliver “quick wins” and address short-term risks, said the World Bank and Development Research Center report. These include increasing the flexibility of bank deposit and lending rates, narrowing interest-rate spreads, increasing dividends that state-owned enterprises pay to the national budget and raising the retirement age, currently 60 for men and as high as 55 for women.

Services Gains

The transition to more service-based growth will create investment opportunities in stocks such as Shanghai-based Wuxi PharmaTech (Cayman) Inc. (WX), China’s biggest provider of research and development services for drug companies, said Charlie Awdry, a fund manager at Henderson Global Investors Ltd. in London.

“We are not interested in guys that manufacture T-shirts in China because that’s a sunset industry that is moving offshore,” said Awdry, whose firm had 63.6 billion pounds ($103 billion) in assets at the end of June. “We are interested in guys like Wuxi who are looking to help the big western companies develop their drugs in China and reduce their R&D costs.”

Wuxi’s stock price may surge almost 53 percent within 18 months, from $14.40 on Sept. 21, estimated Ingrid Yin, a New York-based analyst at Oppenheimer & Co. Awdry said he also owns shares of Baidu Inc. (BIDU), China’s biggest Internet search engine, and Tencent Holdings Ltd. (700), its biggest Internet company, partly because the Web is at “the epicenter of all these positive trends of rebalancing and income growth.”

Spending Power

Rising spending power prompted Templeton Emerging Markets Group to hold fashion retailer Giordano International Ltd. (709) and China Merchants Bank Co. (600036), which “reach down into the middle-and even the lower-middle class,” said Hong Kong-based Executive Chairman Mark Mobius, who helps manage $40 billion.

China’s GDP is more than 129 times bigger than in 1978, when Deng ditched hardline Communist policies. His order the following year to create a special economic zone in Shenzhen sparked a market-driven boom that would transform the nation’s economy, luring manufacturers from Hong Kong and Taiwan with tax breaks and cheaper labor.

Other zones sprang up along the coastal belt, following an investment-export formula that propelled industry and construction, driven by what Goldman Sachs Group Inc. called the fastest investment rate of any country it could find in history. That rate is “likely to decline” from about 46 percent of GDP even as it remains a key contributor to growth, Goldman Sachs said in a Sept. 3 note.

‘Not Over’

“China’s investment story is not over,” said Wang Tao, an economist with UBS AG in Hong Kong. “The issue is the pace of investment and to make it sustainable and less wasteful.”

The National Development and Reform Commission this month published approvals for infrastructure projects, including as many as 2,018 kilometers (1,254 miles) of roads, that Nomura Holdings Inc. estimates will cost about 1 trillion yuan ($158 billion). This means that the government still is relying on investment to support expansion in the short term, Wang said.

The men poised to take the helm have given mixed signals about their desire to fashion a more balanced economy. Xi is known both for his market-friendly approach and his support for state-owned enterprises, said Cheng Li, a China scholar at the Washington-based Brookings Institution.

Princeling Leader

He’s a so-called princeling -- a child of Xi Zhongxun, one of the nation’s leading revolutionary figures, whom Deng chose to oversee the economic transformation of Guangdong province, which includes Shenzhen.

As Xi rose through the party ranks, he governed provinces including Zhejiang, home to some of China’s richest private companies, and Shanghai, the commercial capital. He developed a reputation for fighting corruption -- leading an anti-graft campaign in Zhejiang and taking over Shanghai after a 3.7 billion-yuan corruption scandal that brought down the city’s previous party chief, Chen Liangyu.

While Li has championed low-cost housing and improved health care, he may lack Zhu’s “political courage” and “Wen’s quick sense of how to respond to crises,” said Brookings’ Li.

Neither of the two are “big thinkers like Deng,” with the political might to push through economic restructuring, said Melanie Hart in “China’s Real Leadership Question,” an August report from the Washington-based Center for American Progress.

Political Challenges

Even without the economic challenges, the new leaders face a raft of social and political problems. Thirty years of largely unbridled industrial waste will cost at least 680 billion yuan to clean up, estimates the Washington-based International Fund for China’s Environment. The nation’s rural wealth gap last year neared a level the UN says may spawn social unrest. And escalating tension with neighbors from Japan to Vietnam over territorial disputes has led to attacks on Japanese factories in China and the closing of Japanese retail stores there.

China’s new leaders also may suffer from a period of relative inertia as they concentrate on consolidating power within the upper strata of the party, said Steve Tsang, director of the China Policy Institute at the University of Nottingham in England. The ouster in April of former Chongqing leader Bo Xilai from the ruling Politburo created the country’s biggest political scandal in a generation.

All this may further hamper their desire to take on financial institutions and other state businesses. The World Bank and Development Research Center report recommends setting up a commission, supported by top leaders, to deal with enterprises that enjoy partial or full monopolies and benefit from special relationships with decision makers. Postponing market-driven change could “risk the possibility of an economic crisis,” the report said.

Or as Deng once put it: “Reform is China’s second revolution.”

--Kevin Hamlin. With assistance from Mike Forsythe in Beijing. Editors: Adam Majendie, Melinda Grenier

To contact the reporter on this story: Kevin Hamlin in Beijing at khamlin@bloomberg.net

To contact the editor responsible for this story: Paul Panckhurst at ppanckhurst@bloomberg.net

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