Blog

The Communist Party of China (CCP) plans to host the 20th Party Congress in Beijing on October 16 this year. Since 1977, the Congress takes place every five years. It is the most important event on the Party’s agenda because the new composition of the top-level leadership will be announced. Beijing’s political, economic and foreign policy priorities for the next five years and beyond will also be established. Two thousand three hundred representatives will participate in this major political event. They are nominated and elected from 38 provincial and regional units, central government bureaus, state-owned enterprises and the public financial system. The Congress is a tightly scripted event, as every decision, statement and personnel appointment is decided ahead of time following extensive closed-door negotiations [1].

‍

At the centre of attention is the highly anticipated announcement of President Xi’s third term in office. Xi was elected president of China in 2013 and was initially supposed to step down by the end of 2022, as the maximum tenure for a president is two five-year terms. However, in March 2018, the Congress amended China’s constitution to roll back presidential term limits, paving the way for Xi to remain in power beyond 2022. Some observers anticipate that Xi, currently 69 years old, could stay in office for another three terms and retire in 2037 at the age of 84, given that 2035 marks the first milestone for many of Xi’s political goals to achieve “socialist modernisation” by 2050 [2].

‍

Despite having a single ruling party, informal factions built upon personal relationships divide power inside the Party [i] . Several observations indicate that Xi has strengthened his position within the Party since becoming president, especially as factional rivals have been removed in a series of anti-corruption measures[3]. At the 19th Party Congress, the Xi Jinping Thought was added to the fundamental doctrines of the CCP and the country’s constitution, following the Mao Zedong Thought and the Deng Xiaoping Theory, making Xi the third name to appear in the principles[4].

‍

The Xi Jinping Thought has also been part of the ethics and politics curricula in primary, middle and high school since the autumn of 2021 [5]. Xi also broke an unspoken tradition of the Party established in 1992 during the Deng Xiaoping era – the incumbent president always internally nominates the presidential successor, and the previous president’s nominee ought to be appointed to the Standing Committee of the Politburo (PSC), China’s highest decision-making body, for a “grooming term” prior to the transition of power. It is believed that the continuing influence of the current president’s faction can be constrained by skipping one presidential shift (ten years) in the appointment of the presidential candidate. At the 19th Party Congress, when Xi ought to have appointed former president Hu’s nominees, he did not do so. One of the two politicians believed to have been nominated by Hu – Sun Zhengcai – was given a life sentence as a result of the anti-corruption movement in 2018, and the other– Hu Chunhua, also the current vice premier of China and a member of the Politburo — is an anticipated nominee to succeed Li Keqiang as premier. However, Hu Chunhua did not receive a seat on the PSC in 2017’s Party Congress, and Xi could try to block his promotion to become the premier despite his qualifications.

‍

The standing committee of the Political Bureau (PSC) consists of the country’s highest-ranking leaders and is the most important decision-making body regarding major policy issues. Changes in the composition of the PSC are anticipated to be announced at the 20th Party Congress, and the announcement will have profound implications on China’s political stability and Xi’s ability to push through his policy programs. The PSC currently has seven members, including President Xi. Power is divided as follows: Xi and his allies Li Zhanshu and Zhao Leji have three of the seven seats. Premier Li Keqiang and Chairman of the Political Consultative Conference Wang Yang are believed to not belong to Xi’s circle and are often more associated with the former president Hu Jintao. The two remaining members seem to have a neutral standing among factions [6]. There is no official rule which limits the number of terms for PSC members, but, according to the unwritten Party tradition since President Jiang Zeming, any member who turns 68 by the time of the Party Congress must retire from the PSC but can stay for another term if he is only 67 by the time of the event [7]. By this rule, except for Xi, two incumbent members – Han Zheng (68) and Li Zhanshu (72) – ought to retire. The following scenarios would indicate an increase in Xi’s power within the Party: 1) Xi is able to place his allies in the two positions to gain a majority; 2) Xi breaks the unspoken tradition and extends Li Zhanshu’s term; 3) Xi adds additional members to PSC to dilute Li Keqiang’s and Wang Yang’s relative power in the PSC. Eight of the other eighteen Politburo members will also retire based on the age rule, and the extent of Xi’s ability to replace these seats with allies will also reflect on his influence within the Party. The people replacing these seats will enter China’s most senior leadership councils and have a direct impact on policy.

‍

The 20th Party Congress will reflect on the progress made since the 19th Party Congress in 2017 and set policy goals and priorities for the next five years and beyond. Details regarding specific policies will roll out following these directions, as departmental- and provincial-level government create their own five-year plans aligning to the top-level goals. In the last Party Congress, Xi announced that China had successfully achieved the goal set by paramount leader Deng Xiaoping in 1979, of building a moderately prosperous society [8]. In contrast to previous leaders’ emphasis on a “peaceful and quiet rise”, Xi has taken a more assertive approach, envisioning China becoming a “fully developed, rich and powerful” nation with international influence by 2049 and entitling himself as the leader of this movement [9].

The CCP has worked to achieve this by modernising its military, pursuing extensive land reclamation efforts on disputed islands in the South China Sea, investing billions of dollars in countries worldwide through its massive Belt and Road Initiative, and taking on a more active role in international institutions [10]. In the 13th Chapter of Xi Jinping Thought related to economic growth, Xi highlights that China is in the economic transition from volume and export-driven growth to qualitative, innovation- and efficiency improvement-driven growth, at a mid-to-high expansion rate.. The government also plays a crucial role in resource allocation of the economy, while it encourages the vitality of both state-owned enterprises and the private sector. In terms of foreign policy, China continues the Belt and Road Initiative, encourages Chinese companies to invest overseas, and believes that globalisation is inevitable. Xi also reinforces the effectiveness of China’s “one country, two policy” strategy on governing Macau and Hong Kong, and is determined on “one China policy” on the issue of Taiwan [11]. Critique and scepticism around China’s Covid policy and worsening China-US relations are identified as two crucial challenges for Xi and his leadership [12].

‍

What will happen once Xi is re-elected?

• Zero-Covid

The Chinese government chose to prioritise lives over economic activities and growth, a policy that was effective in the first year of the Covid-19 outbreak but now causes the economy to lag its Asian and global peers. We should not anticipate a drastic pivot away from the current zero-Covid policy immediately following the conference. However, some publicised policy suggestions and official announcements indicate that a gradual and a successive international reopening can be expected [13]. We are starting to see first signs. Recently, Hong Kong removed the travel quarantine rules for international travellers after months of lockdown.

‍

• China–Taiwan

The expected continuation of Xi’s regime increases the key man risk, as Xi could view China’s reunification with Taiwan as a personal political goal. However, we view a Chinese military invasion at the current stage as unlikely, because the negative consequences would impact China’s long-term economic prospects, a price too high to pay. China is still dependent on Taiwan’s semiconductor know-how and manufacturing capacity, and a military action against Taiwan could damage capacity and interrupt production, negatively impacting global supply chains. Furthermore, China could face wide-ranging international sanctions and lose foreign investment. Finally, Taiwan is not Ukraine. It is a fortified island with strengthening military intelligence and defence capabilities, which have been bolstered by growing US commitment to the territory. Today, Taiwan and China are more economically integrated than ever before. Since travel restrictions have been fully relaxed in 2008, and investment restrictions were lifted the year after, the two regions developed significant cross trade from US$11bn in 2001 to over US$166bn today. We are monitoring the situation very carefully and are in close contact with our companies and experts on the ground in China and Taiwan.

‍

• Economic Policy

As indicated in the 14th five-year plan of the CCP, we expect China will continue its transition phase under a re-elected President Xi with a focus on improving factor productivity and technology independence. In Xi Jinping Thought the President pointed out that China needs to focus on supply-side problems, including overcapacity on low-end supply and scarcity of high-end supply, as well as dependency on foreign high-tech equipment and technology. The recently announced US export controls on advanced semiconductor chips and manufacturing equipment will very likely accelerate the ongoing efforts of the Chinese government to decrease its dependence on high-end chip imports. In the short term, we expect the government’s pragmatic focus on reigniting growth, supporting internal demand and ensuring stability to continue.

‍

How do we invest in China?

While no emerging market investor can afford to ignore China, we invest very conservatively in the country. A complex regulatory environment, corporate governance issues and a retail-driven market (70% of equity trading value) are among some of the biggest challenges, especially for the A-share market. Currently, we prefer to get exposure to China’s growing demand for products such as semiconductors, consumer electronics, premium health care and renewable energy through investments in Taiwan, South Korea and Hong Kong. These financial markets are more mature and provide better governance and transparency.

A good example is one of our largest investments, Hong Kong-based EC Healthcare, which operates private medical, aesthetics and veterinary clinics in Hong Kong and China. The company profits from an experienced management team and good governance as well as access to China’s growing market for quality health care. MCP used the recent weakness in the share price, which had been impacted by the Hong Kong lockdown to add to the position. EC Healthcare is Hong Kong’s largest non-hospital medical service provider, and is rapidly expanding organically and through M&As. The company is well positioned to benefit from the border reopening and the recovery of medical and aesthetics tourism.

We are delighted that EC Healthcare will be presenting their business, outlook, and progress on ESG factors at the MCP Investor Day 2022 (for Professional Investors only) on Monday, 14 November at 11am (GMT) at the Royal Society of Chemistry, Burlington House, Piccadilly, London W1J 0BA. This will be an in-person event with the option to join via Zoom. We would be delighted to welcome you on this occasion.

‍

‍

Footnotes

[1] Cunningham, M. (2022, March 7). Looking Ahead to China’s 20th Party Congress. Retrieved from The Heritage Foundation: https://www.heritage.org/asia/report/looking-ahead-chinas-20th-party-congress

[2] Thomas, N. (2020, October 26). China Politics 2025: Stronger as Xi Goes. Retrieved from Macro Polo:https://macropolo.org/analysis/china-forecast-politics-2025-stronger-as-xi-jinping-goes/

[3] Some examples include the life imprisonments of ZhouYongkang, a former member of the 17t PSC in 2015, Sun Zhengcai,former member of the Politburo and highly anticipated candidate to the PSC in2018, Ling Jihua, former principal political advisor to Hu in 2016, and,famously, Bo Xilai, former Mayor of Dalian and Minister of Commerce.

[4] Buckley,C. (2017, October 24). China Enshrines ‘Xi Jinping Thought,’ Elevating Leader to Mao-Like Status. Retrieved from New York Times:https://www.nytimes.com/2017/10/24/world/asia/china-xi-jinping-communist-party.html

[5] Ministryof Education of the P.R China. (2021,July 8). 《习近平新时代中国特色社会主义思想学生读本》于今年秋季学期起在全国统一使用. Retrieved from Ministry of Education of the People’s Republic of China:http://www.moe.gov.cn/jyb_xwfb/gzdt_gzdt/s5987/202107/t20210708_543195.html

[6] These include the principal adviser Wang Huning, who has advised Xi and his two presidential predecessors Jiang and Hu; and Han Zheng, who was previously the Party Secretary of Shanghai and is believed to be associated with former president Jiang Zeming.

[7] Fang, B.(2022, August 20). 二十大报道：习近平连任挑战和政治局常委布局. Retrieved from VOA:https://www.voachinese.com/a/xi-jinping-standing-committee-members-20th-party-congress/6709178.html

[8]The moderately prosperous society is defined by sixteen quantified standards related to income, minimum average housing size, infrastructure, forest coverage, literacy rate, education spending, protein consumption, and life expectancy (Central Compilation and Translation Press, 2021).

[9] Xinhua Net . (2017, October 23). [十九大“新”观察]“新目标”怎么干？. Retrieved from Xinhua Net:http://www.xinhuanet.com/politics/19cpcnc/2017-10/23/c_129724802.htm

[10] Albert, E., Maizland, L., & Xu, B. (2021, June 23). The Chinese Communist Party. Retrieved from Council on Foreign Relations: https://www.cfr.org/backgrounder/chinese-communist-party

[11] Xinhua net. (2021). 习近平新时代中国特色社会主义思想三十讲课件. Retrieved from Xinhua Net:http://www.xinhuanet.com/politics/xjpsxkj/

[12]Cunningham, M. (2022, March 7). Looking Ahead to China’s 20th Party Congress. Retrieved from The Heritage Foundation:https://www.heritage.org/asia/report/looking-ahead-chinas-20th-party-congress

[13]Sources include the Suggestions on the revival of international tourism under the normalization of epidemic prevention and control, which advocates for are-opening of touristic regions to international travellers, March 2022; and the 14t Five-year plan publicised by the Civil Aviation Administration of China in 2021 that classifies 2021–2022 as a recovery phase and 2023–2025 as an expansion and growth phase, attached with specific quantified milestones.

[i] A common generalisation divides factions into the “elites” and the “populists”. The “elites” are descendants of former Party members and typically come from political centres such as Beijing and Shanghai. They are generally believed to place greater focus on economic development. Xi Jinping,  son of Xi Zhongxun, who once served as deputy prime minister of China and was an early comrade-in-arms of Mao Zedong, belongs to the “elites”. Xi’s predecessor, former President Hu Jintao, was a “populist”, also known as “tuanpai”. Politicians from this faction places higher emphasis on social equality and have commonly started their political career from the Chinese Communist Youth League – the party’s nation-wide organisation for youth aged 14–28 to study and a training ground for party cadres (Lai, 2012). Party elders are considered to be influential due to their mentor-protégé relationships with incumbent leaders, forming clans such as the “Shanghai clique” or the “Beijing clique”.

In June 2022, we spent a week in Brazil meeting companies across sectors as well as economists, entrepreneurs, local fund managers, investors and artists and have returned with a variety of insights into challenges and opportunities. But what impressed us the most was the level of digitalisation and the significant improvements in the ease of doing business for entrepreneurs.

São Paulo appears to be waking up from hibernation – streets are bustling, restaurants are crowded, high-street retailers are busy, hotels are occupied. The city of 22 million inhabitants – the largest in the southern hemisphere – presents a disproportionate distribution of wealth: a modern, affluent front and an impoverished backyard with over 40,000 homeless. Technology and digitalisation have taken full control of public life (we did not need any physical currency!) – even on the flea markets payments are made digitally, museum tickets can only be purchased via the internet, Uber drivers and food delivery services are omnipresent.

The pandemic has had two very palpable effects: 1) e-commerce and digitalisation have gone viral, and 2) demand for real estate in the non-urban areas has jumped, accompanied by a spur in renovation activities. Another noticeable change is the improvement in the ease of doing business for entrepreneurs. The government has reduced bureaucracy and it now takes less than a week to start a new business, versus months before. It is also far easier to conduct transactions such as land or property sales, which used to be a long and complicated process.

One important observation was that no matter whom we spoke to, “politics” is not (yet) at the top of people’s minds. There is visible frustration with both presidential candidates which has led to political apathy. But there is confidence in the fundamental checks and balances, the powerful and free media landscape and the independence of the judicial system and central banks. We expect the debate to heat up towards August as the country moves closer to the general elections in October.

During our trip we were looking for answers to these key questions:

1) What is the macroeconomic situation in Brazil?

2) Can the elections lead to a further deterioration of consumer confidence?

3) How vulnerable are the banks and the private sector to the rate hikes?

4) What has driven the value destruction in the stock market? (e-Commerce businesses have been facing enormous deratings recently)

5) Most importantly, how are our portfolio companies performing in this environment?

‍

The Macroeconomic Situation in Brazil

1) First of all, Brazil had to deal with a hefty recession in 2015/16 which caused a prolonged cycle of deleveraging which makes Brazil far more defensive today. A vast number of private sector companies went through a phase of cleaning up their balance sheets; large enterprises like Petrobras have reduced debt by over 30%.

Source: Bloomberg

‍

2) The key risk for Brazil today is less related to the war in Ukraine or the Fed’s monetary policy, and more driven by domestic debt levels with interest rates now above 13%, as well as commodity prices as the country remains a key exporter of various commodities.

3) The spike in inflation in Brazil has caused a rapid and almost unprecedented rise in the SELIC rate (Brazilian Federal Funds Rate) from a low of 2% back in March 2021 to currently 13.25%. With these measures, Brazil is leading the tightening cycle globally. The country has been through 16 months of tightening compared to 4 months in the US!

Source: Bloomberg

‍

4) The sharp increase in commodity prices in Brazil has led to a demand shock. Farmers have enjoyed an extraordinarily large dividend from the current prices and have gone on a spending spree.

5) Unemployment – which had jumped from 11.5% at the beginning of 2019 to over 15% at the height of the pandemic – has now for 11 consecutive months fallen to 9.8%. This is the lowest since February 2016 and a clear indicator that the private sector is normalising to pre-pandemic levels.

Source: Tradingeconomics

‍

6) Foreign reserves of USD 355bn and debt/GDP below 60% as well as strong export performance support the general macroeconomic conditions in Brazil.

We are expecting the monetary measures to take effect and slow down consumption over the coming months. Twenty twenty-three will probably be a difficult year for Brazil, with higher cost of funding, elevated inflation and subdued growth. However, the stock market has priced this in accordingly and is now offering reasonable valuations. At the same time, the currency looks reasonably valued. Low external debt serves as a strong support in this period of uncertainty.

Source: Bloomberg

‍

Politics and Elections

We talked to various stakeholders about the upcoming elections to understand the current sentiment. The country appears polarised. While the poorer regions tend to favour the former union leader, ex-convict, and former president (2003–2010) Luiz Inacio Lula da Silva (76), the more affluent regions and the agricultural lobby support the incumbent and ex-military officer Jair Bolsonaro (67). However, almost everyone we talked to appeared unhappy about both candidates. Bolsonaro has failed to win wider support due to his radical stance against minorities, and his mishandling of the Covid-19 pandemic (“it’s just a flu”). The many positive and business-friendly reforms introduced during Bolsonaro’s tenure – including the progress on privatisation (i.e. the $ 6-7bn Electrobras privatisation) – are hardly ever spoken about. All in all, while both candidates have very different political agendas, we believe that neither will harm the economy nor introduce policies that would considerably strangle Brazil’s economic development. Even if Lula were to win, he probably would not have a majority, so the risk of radical changes is contained.

Source: Bloomberg

‍

Banks and Private Sector Debt

It comes as no surprise that asset quality has been deteriorating in Brazil, as interest rates shot up and inflation increased. The government’s social assistance program – which injected BRL293bn into the economy during the pandemic, three times the historical average of social assistance – has contained delinquencies.

Source: Bloomberg

‍

The debt service ratio has jumped from 22% in 2018 to 28% today, which is rather concerning in view of the reduction in real wages. But we need to put the data into perspective: Brazilian (private) banks are well managed, with low NPL levels of less than 3% and particularly low corporate NPLs of less than 1.5%. Loan growth has been slowing significantly and is now below nominal GDP. While there is a risk of further tightening, the wider consensus right now points to a gradual reduction of the SELIC rate into 2023. The recent hikes sharply increased the cost of funding for the private sector. However, private companies have relatively low leverage compared to previous tightening cycles. Nonetheless, we need to monitor the impact on private households and the delinquencies resulting from the rate hikes very carefully. Furthermore, the monetary tightening could cause a recession of some form.

Source: Bloomberg

‍

The Stock Market

Not surprisingly the winners of the Brazilian stock market this year were utilities and energy, driven by spiking commodity prices. The losers were consumer discretionary, health care and technology. Retail and eCommerce have been particularly hard hit on the back of worries about rising interest rates and the cost-of-living crisis. Brazilian retail company Magazine Luisa fell by as much as 67% YTD. After a strong start into the year the stock market has had a difficult time – it is down 6% (in BRL) YTD. With interest rates at double digits, investors can just leave their money in the bank. On a positive note, our trip did confirm our view on Brazilian companies. They are often well-managed, highly innovative and have a strong edge. They have been unfairly punished by the general sentiment and macro-outlook. However, they are in a good position to perform strongly when the recovery sets in.

Source: Bloomberg

‍

Our Portfolio Companies

Over the week, we visited several companies operating in different sectors, including health care, IT, software, fintech, education, pharmaceutical, retail and banking. As TOTVS is one of our larger holdings, we summarise our takeaways from our meeting with the CEO, Dennis Herszkowicz, and his IR manager, Sergio Serio.

TOTVS is the largest technology company in Brazil specialised in the development of business solutions for companies of all sizes. More recently, it is being transformed into a leading fintech operator.

Sergio and his team had prepared a very hospitable reception. When you enter the open, well-designed TOTVS offices you can almost feel the positive working culture and creative energy that drives innovation in this company. Sergio gave us TOTVS’s perspective on the current situation. The company operates across different sectors and has a good insight into how their customers are coping in this environment. He said they were seeing low levels of debt across the corporate sector (their client base) and stable delinquencies. He felt that the interest rate hikes had been well digested by the economy and added that he would only start worrying if the US went into deep recession or local rates were to spike to over 20%. However, neither of these scenarios are his base case.

The backbone of the company is the enterprise resource planning (ERP) software and TOTVS has a dominant market position in this segment in Brazil. Partially aided by deregulation, but also through technological capabilities, TOTVS has ventured into new areas, as clients have sought additional solutions from them. Growth and diversification were achieved organically and through acquisitions. A good example is the recent purchase of RD Station in early 2021. This acquisition is in line with TOTVS’s aim of broadening its product portfolio from enterprise resource planning systems to management tools and systems in the fintech space. RD Station’s CRM system is already being used by TOTVS’s core customer base: Brazilian SMEs. Beyond boosting customer loyalty, an enhanced presence in the business performance space creates more customer lifetime value. Synergies from the existing client bases of TOTVS and RD Station through cross- and up-selling products are expected to enhance performance.

As it is broadening its client offering, TOTVS has reorganised its sales force to reflect this. This has already resulted in over 1,000 clients buying their new fintech products. The fintech joint venture with one of the largest private banks in the country – Banco Itaú – not only lowers cost of funding, but also limits TOTVS’s overall risk from lending activities.

The core risk for TOTVS now seems to be on the execution side of the business. To profit from the potential efficiencies and synergies resulting from the recent joint venture and acquisitions, TOTVS needs to execute on post-merger integration process of RD Station with a strong focus on creating synergies between the different sales teams.

Overall, the company is more diversified than ever before and enjoys a unique position with its dominant market share and fast-growing business with 40% annual growth!