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Summary: The 20th CCP Congress had a shocking conclusion: President Xi packed the entire seven-member Standing Committee of the Politburo with his men. The purging of all who were not from his faction, including Premier Li, Yang Wang, the economic czar Liu He, the banking regulations and reforms chief Guo Shuqing, and the PBOC Governor Yi Gang, was taken by the market as regressive. However, I do not believe this knee-jerk reaction will necessarily be proven to be correct.

1. It is important to separate the policies from the personnel. The shocking part about the personnel changes overshadowed President Xi’s declaration that economic development will remain the primary policy goal.

2. Even though the new leaders of the CCP are relatively unfamiliar to investors, it may not be the case that all of them are loyalists with weak competences. For example, the new Premier Li Qiang has impressive experiences and a track record of pragmatism. Investors should be careful not to underestimate the new team. The market is assuming an ‘ugly’ scenario for China in the coming years, when there are also other superior scenarios that are possible, in my view.

3. President Xi surrounding himself with only ‘yes men’ will create higher policy risks and volatility. But there is also the possibility of a Lee Kuan Yew scenario, where political dominance could facilitate the implementation of policies.

4. The 20th Party Congress’ focus is on the next 5-10 years. For the next 5-10 months, I continue to believe there will be policy support delivered to the property sector, and the Zero Covid Policy will likely see modifications.

5. Going forward, Chinese equities will likely continue to be laden with a risk premium because the Xi Administration will likely favour the public sector at the expense of the private sector, though the sectors favoured by President Xi should see significant out-performance. But this should also mean that Chinese bonds will likely perform well, with suppressed volatility: more than 95 percent of the on-shore Chinese bonds are issued by public entities. The CNY is in a great position, in my view, to strengthen against the dollar and will, thus, enhance the attractiveness of Chinese bonds to foreign investors in the coming quarters.

Much has been written about this week-long event that just took place in Beijing. This is a quick summary of some of my thoughts, to add to the discussion. The note is not meant to be a comprehensive deep analysis of all the points made at the Congress, but one that highlights some key implications relevant for most investors in Chinese assets.

Policies versus personnel

It is important to distinguish the policy orientation of President Xi’s third term and the personnel changes. While the latter has grabbed much media attention, which is wholly justified and I will discuss this in more detail below, it is equally important to appreciate the declared policy orientation, which in my view, is not diametrically different from the past, in the whole, even though there were some changes from the 2017 declaration. Indeed, over the weekend, my initial reactions to the personnel changes were acute, like most others. But upon further reflection, I now think it is important to be considered.

The speech delivered by President Xi during the opening session on Monday, October 17, 2022, importantly, had ‘economic development’ as the top priority, even though loaded terms like ‘security’ and ‘stability’ were mentioned more times than in the 2017 speech. This tension between ‘development’ and ‘security’ had been intense in the period leading up to the Congress. ‘Development’ means economic development, in that policies would be oriented to allowing the economy to progress toward greater overall economic prosperity, just like in the past 20 years. But ‘security’ is more about, internally, income distribution, market competition and abuses, and overall qualitative features of China’s financial sector and the economy that do not always get revealed in the overall growth rate of the economy. Externally, ‘security’ has its usual meaning.

In short, one might think of ‘development’ as seeking to maximise the growth and size of the overall economic pie, while ‘security’ is more about how this pie is divided.

The focal point at this twice-a-decade gathering is 5-10 years backward-looking and 5-10 years forward-looking. This meant that the CCP would take stock of the accomplishments over the past one to two terms of Presidency and look forward over the next one to two terms of Presidency. It’s not a forum to discuss the key issues over the next 5-10 weeks or months, which include the Zero Covid Policy and what to do with the property market correction – two issues most investors care about.

In any case, if President Xi’s declaration of ‘development’ remaining the primary policy objective over the coming 5-10 years is to be believed, then it is not as major a deviation from the past policy stance as many had feared before the Congress. Specifically, there was the expectation that ‘security’ would take precedence over ‘development’.

I suggest, thus, that we think about the 20th CCP Congress in a 2x2 matrix as described in the stylised diagram below.

CCP 2x2 matrix

The horizontal axis shows the quality of the economic policies: good to the right in the diagram, and poor to the left. On the vertical axis, I show the people implementing such policies: competent technocrats versus incompetent political operatives loyal to the President but possessing weak operations skills.

While most analysts, including myself, have recoiled from the shocking personnel changes at the very top of the CCP, which will surely translate later (at the National People’s Congress, which is the Congress to be held next March for the country, rather than the Party) into top policy posts for the country itself, it is important for investors not to lose sight on the fact that President Xi did not abandon economic development as the top goal. In terms of the diagram above, this means that, in the coming 5-10 years, policies will still likely encourage China to stay on the right side of the diagram, not perpetuating the disruptive and destructive policies witnessed since the summer of 2021.

The reader can easily imagine that there are good, bad, and ugly scenarios that are possibilities in the coming years. But, unfortunately, most of the press (especially the Financial Times) have drawn the knee-jerk conclusion that we will see the ‘ugly’ scenario of Beijing making huge policy errors like the Great Leap Forward or the Cultural Revolution and driving the country toward the model of North Korea.

I’m not saying that the ‘ugly’ scenario is not possible. I’m merely reminding investors that there are multiple degrees of freedom, based on the policies declared in President Xi’s speech, that may keep China on the right side of the diagram.

The personnel changes were shocking

Let’s discuss the personnel changes – the vertical axis in the diagram.

What just happened is equivalent to the US choosing a President; the entire House, the Senate, the Supreme Court, the Fed, and the Treasury all aligned and loyal to the President.

Anyone who has ever voiced any idea that deviated from President Xi’s thoughts on the best political regime for China was purged. Out of 2,296 Party Congress delegates, 205 were selected for the Central Committee, 24 for Politburo, and 7 for the Politburo Standing Committee. These seven members are the key decision-makers of all policy aspects of China, including the economic, social, environmental, developmental, and foreign policies. In other words, the seven members of the Standing Committee are all-powerful.

The shocking development is that four members were purged and replaced with loyalists to Xi. Members of other factions were purged. Most prominently, Premier Li Keqiang and Wang Yang were purged.

My thoughts

  1. The new Premier. The new Premier-to-be, Li Qiang, was the secretary to President Xi years ago. The Premiership will only be made official at the NPC in March 2023. Li has been the Governor of the Jiangsu Province and the Zhejiang Province – two of China's most economically dynamic provinces. (Jiangsu has a GDP double the size of Switzerland or roughly equal to that of Texas. It has the highest per capita GDP in China, at around USD22,000 per person. Zhejian is also a rich province in China, with a GDP equivalent to that of Florida or the Netherlands, and specialises in electromechanical products, textiles, chemicals, food, and construction materials. Both provinces are major exporters.) At present, Li is the Party Secretary of the Metropolitan of Shanghai and is known in the business community as being effective and pragmatic. It was reported that he personally oversaw the construction of the Tesla factory in a short 10 months, compared to 16 months to build a similar factory in Berlin. My point here is that this is a very strong CV that exudes pragmatism and a results-oriented focus. Despite his lack of experience working for the central government, it would be difficult to justify labelling Li Qiang as an ineffective political operative, in my view. Further, while it is true that Li Qiang oversaw the tight Zero Covid lockdowns in Shanghai, his liberal mobility policies led to the virus's spread in the first place. I suggest we reserve judgement on the capabilities of the new Premier and not be swayed by the ultra-bearish pieces on China in the Financial Times, which only paint a part of the picture.
  2. Greater policy risks and volatility. All investors agree that having only ‘yes-men’ around; there will be much greater scope for policy errors. I won’t elaborate on this point but only raise another possibility. Mr Lee Kuan Yew – the Prime Minister of Singapore between 1959-1990 – also suppressed dissents but managed to raise Singapore to its current entity, which many countries envy.
  3. A, K, and L. These letters refer to the variables in Robert Solow’s Nobel Prize-winning growth model that a country’s economy can grow due to capital (K), labour (L), and technology (A). Professor Solow’s theory is elegant and insightful, but I will just use these letters to explain a point. During much of the period 2001-2021, China has favoured K (owners of capital), assuming that cheap labour would generate employment and overall prosperity for the nation. But President Xi has harboured a different focus, that labour (L) has been abused and mistreated in many ways, and a rebalancing between K and L is necessary to restore balance and harmony in the Chinese economy. Further, President Xi has emphasised the need for China to embrace technology (A) for the next phase of its growth to help elevate labour productivity and value-add in its production. By the way, the US’ announcement to ban exports of semiconductors and semiconductor machinery to China poses a serious challenge to China. In any case, the point here is Xi no longer favours the K; this is problematic because K is the focus of investors.
  4. Foreign policies. President Xi has, for a decade, been carefully and methodically prosecuting his plans to build his political dominance in domestic politics. He has succeeded. However, he has not made commensurate progress in conquering international politics and suppressing foreign dissenters. If anything, President Xi’s domestic political dominance has attracted alarm in some foreign countries. The experience of the Ukraine War has shown that all sides involved are likely to escalate rather than de-escalate, creating a lose-lose situation for all in the short-run. An explicit confrontation between the US and China would be multiple times more devastating for the world, both militarily and economically. Such a confrontation, while possible, is still avoidable, in my opinion. The situation is so complex that I think the progression of the storyline will not likely be linear, and investors are advised to pay attention to the nuances rather than provocative newspaper headlines built on simplistic extrapolations.
  5. Cyclical policies in the coming months. Shortening the focal point to the coming months, my prediction is that there will likely be (i) a gradual relaxation in the Zero Covid Policy and (ii) incrementally more policy support to alleviate the liquidity crunch in the Chinese property market. Recent variants of Covid are much milder, leading to low fatality rates worldwide. President Xi has already taken his first foreign trip since 2020 (to Kazakhstan) and is planning to attend the G20 Summit in Bali, Indonesia, from November 15-16. In addition, Hong Kong has recently relaxed its inward tourist travel restrictions. These are all signs that, in the absence of a more virulent strand of Covid in the fall/winter, and with the 20th Party Congress behind us, China will have more political space to contemplate modifying its implementation of the ZCP, I think. At the same time, support for the property sector began a couple of months ago with several measures. The aim is to ‘let the air out of’ the property bubble without ‘popping’ the bubble. It is worth noting that the phrase ‘houses are for living, not for speculation’ was not mentioned in President Xi’s speech. I believe more measures will be rolled out to enhance the overall liquidity of the property sector, without removing the solvency challenge that some property companies face. The property sector in China and elsewhere is simply too big to be allowed to implode.
  6. Prospect for the Chinese financial markets. Overall, the key messages from the 20th Party Congress suggest that the public sector will be promoted at the expense of the private sector. As a result, Chinese equities in general will likely carry a higher risk premium. But equities in sectors favoured by Xi’s medium-term strategy (e.g., hard tech, renewable energy, and other sectors named in China’s Vision 2035 Plan) could significantly out-perform. Chinese bonds, in contrast to general equities, will likely fare well and enjoy a safe haven premium, mainly reflected in ultra-low volatility. Indeed, for several months now, in contrast to foreign bonds and Chinese equities, Chinese bonds have had exceptionally low volatility, despite the disturbing headlines. I would even argue that this suppression of volatility in Chinese bonds is because of the disturbing headlines. More than 95 percent of on-shore bonds are issued by the central government, quasi-sovereign entities, and SOEs. These entities will be protected under Xi’s third term, and the bond market will likely remain liquid because of the vast domestic savings that still need to be intermediated and utilised. Perhaps the most interesting prospect for Chinese bonds, in the quarters ahead, is the CNY. Regular readers should know my constructive view on the CNY and my belief that the CNY’s weakness against the USD is mostly a USD story. The underlying balance of payments data suggest that there is a large stock of excess dollars in the Chinese banking system ready to be sold as soon as the USD turns south. For foreign investors in the Chinese bond market, in the coming months, the low volatility and risk-diversifying traits of Chinese bonds will likely be further enhanced by a prospective rally in the CNY that is significant in size and precipitous in speed.

Bottom line

The knee-jerk reaction to the 20th Party Congress is understandably negative for investors in Chinese assets. Dictatorship is generally not good, and total suppression of dissents is outright dangerous. But as global investors, we need to pay attention to the nuances in the developments in China. One of the key nuances not discussed much is the primacy President Xi continues to place on economic development. Without a strong economy, China may never supplant the US as the largest economy in the world and would not be able to fund the army Xi wants. It is critical for investors to think at least in multiple dimensions and not be swayed by the sensational newspaper headlines (most of which are valid) that bypass the important nuances. The 2x2 diagram I suggested in this note is, in my view, key: we need to separate out the policies from the people, especially when some of the new people have in the past demonstrated remarkable competence. Whether we see the ‘good’, ‘bad’, or ‘ugly’ scenario will become clearer over time. The presumption of the ‘ugly’ scenario being pre-ordained is incorrect, in my view, even if it is one of the possibilities.

The views expressed were accurate as at the time of publication.

Opinions expressed by the authors are their own and do not necessarily reflect those of Eurizon SLJ Capital Limited, Eurizon Capital SGR or the Intesa Sanpaolo Group.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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    Views accurate as at the time of publication. Opinions expressed by the authors are their own and do not necessarily reflect those of Eurizon SLJ Capital Limited, Eurizon Capital SGR or the Intesa Sanpaolo Group.
    The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.