the problem Deng faced

In the late 1970s, Beijing came to realize that central planning would no longer work (assuming it ever did).  The economy had become too big and too complex.  So China had to adopt at least some Western free market principles.

The country had two main, related, economic objectives:

–to expand quickly enough to maintain employment and absorb the large numbers of young people looking for a job for the first time, and

–to reduce the importance/power of highly inefficient money-losing state-owned enterprises, which during the early Deng days represented over three-quarters of the country’s GDP.

China had to accomplish these goals without a modern central bank able to temper economic cycles, and without a lot of control over the day-to-day actions of the regional governments being ordered to create economic growth.

The result was an overall Chinese economy that grew very rapidly, using the time-honored developing country strategy of favoring export-oriented manufacturing.  Because Beijing lacked better controls, the economy tended to lurch between periods of speculative excess and of near-recession.

The SOEs were never supposed to fail–that would have created the kind of high unemployment that led to Tiananmen Square.  Rather, they were either to modernize or slowly fade away and be replaced by private enterprise.  Foreign investors quickly realized that the SOEs were an excellent economic policy timing tool.  When the SOEs were prospering, policy tightening by Beijing could not be far behind.  When they were approaching death’s door, Beijing would ride to the rescue.

what’s changed

Not any more, however.

China has reached the point where additional low-wage, sub-scale, highly polluting export-oriented materials or manufacturing operations provide absolutely no economic or political benefit.  So Beijing is not going to provide stimulus that would rescue some of the existing capacity and spawn more.  Waiting for stimulus to happen is a mistake.  Equating no stimulus with economic doom is one as well.

I find it encouraging not only that Beijing is trying to transition toward becoming a domestic demand-oriented economy, but also that it appears to feel comfortable that it can do so without negative political repercussions.  Yes, growth may be slower, but it will be more solidly based.

The investment conclusion I come to is to look for mid-sized domestic-oriented Chinese companies whose stocks have been punished during the current period of global investor disenchantment.