Commie Capitalism

For weeks, many have wondered: What big reforms would Chinese officials unveil during their highly anticipated Third Plenum—the third plenary meeting of the 18th Central Committee of the Communist Party of China (CPC). After a brief missive released Tuesday left folks wanting, CPC leaders released a deeper report Friday, which put some theories to rest and was widely accepted as a positive for China. It likely is to a degree. Social reforms—like easing the country’s infamous one-child policy, abolishing certain labor camps and expanding property rights some—will certainly have big, positive impacts for Chinese citizens. So, in theory, would the proposed economic reforms: allowing private banks, freeing interest rates and opening the capital. But theory isn’t reality. Reality depends on action, and whether action follows these sweeping plans is far from certain. We’d recommend investors temper their expectations accordingly: Great as some reforms sound, what Chinese politicians do, not what they say, matters much more for stocks over time.

Expectations for this Third Plenum were sky-high—partly because of what leaders said in the run-up, and partly due to history. The Third Plenum of the 11th Central Committee, in 1978, was when Deng Xiaoping launched the push to open China’s economy. When current President Xi Jinping and Premier Li Keqiang started hinting about forthcoming market reforms, many drew parallels between this month’s Third Plenum and 1978’s, expecting groundbreaking change. But Tuesday, the CPC’s closing statement was vague. It said the market would play a “decisive” role in China’s economic development and private businesses should be supported, but state-owned firms would remain the economy’s centerpiece.

That left many observers unsatisfied—what did “decisive” mean? Friday, they got the answer: The government promised to fast-track interest rate reform and property tax improvements. They’ll also apply successful measures from the Shanghai Free-Trade Zone nationwide—like allowing foreign investment in any sector not included on a (10-page) exclusion list. And for good measure, they greenlit private banking and pledged to loosen capital controls. Overall, the plans seemed to mollify those disappointed by Tuesday’s note. Sweeping change!

But before believing China up and left Karl Marx for Adam Smith, a cautionary note: Many of these reforms have been promised or proposed before without subsequent action. Market-driven interest rates have been under discussion for years! Private banking, too has made the rounds. Of course, the government could make good this time, but we won’t hold our breath for dramatic changes any time soon. Many details were lacking, and the implementation timetables were conveniently long-term (if present at all), giving the party plenty of wiggle room in case reform isn’t politically convenient—logical when you consider leaders are clinging to their brand of communism and one-party rule. They have few incentives to change things up much—and every political incentive not to.

Officials have long known economic control is tantamount to political control—something they’re in no hurry to surrender. But the more influence and freedom Chinese leaders give markets and the private sector, the less economic control they have. Historically, they’ve used tactical levers to stoke growth—like boosting loan growth and state-driven fixed investment when they want to hit the gas and cutting lending and letting the currency rise when they need to tame inflation. In recent years, evidence strongly suggests they’ve used these throttles to manipulate growth at key points in their political cycle, like speeding things up during political handovers to keep the masses happy. This has worked (more or less) thanks to the still-largely closed economy. But the more market forces take over, the less powerful these levers will be. Growth could slow significantly at times—as it would in any economy—potentially leading to unrest if many folks feel worse off. And with unrest comes demands for freedom. Considering the government has increased restrictions on citizens’ internet access and cracked down harder on dissidents, it seems safe to say full freedom isn’t high on the agenda.

Chinese officials are politicians, and job security is their number one goal. They’ve already had a taste of unrest, with farmers reportedly rebelling in the face of rising government fees and forced relocation—likely a big driver behind planned reforms to the urban migration system. Considering the political headaches this has caused for party leaders, it’s no wonder they’d prefer to move very slowly toward a market economy and limit potential disruptions. Hence, there is likely some disparity between what Chinese officials said—the expectations they set—and what they’ll eventually do.

Stocks move most on the gap between expectations and reality over time. Too-high expectations could be bad: If reality doesn’t align with investors’ optimistic interpretation of these proposals, Chinese markets could face some headwinds, just as they did when officials announced some less-than-market-friendly measures in the spring. That’s true even if the economy continues accelerating—politics and sentiment are key market drivers, too.

Looking ahead, China’s officials likely continue their balancing act, announcing reforms and, to the extent it makes sense for them, fulfilling their promises. It’s entirely possible investors’ expectations could be met! But it’s important to keep in mind talk of reform isn’t enough—actions matter, and only time will tell whether actions follow this latest round of words.