How a Chinese political split could hit global markets

China is in the grip of a power struggle. One faction wants a more free market economy - the other longs for a return to the days of Mao, says Matthew Partridge. The outcome will have serious consequences for global markets.

Every day brings another dose of reality for China bulls.

Earlier this week, the mining giant BHP Billiton warned that Chinese demand for iron ore is flattening out. Recent surveys point to the manufacturing sector continuing to shrink.

There are even reports in the Financial Times that Chinese steel mills are turning to pig-farming to try to make up for a lack of demand.

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Optimists still hold out hope that the economy can be moved smoothly towards being a more consumption-led society. But political upheaval could prove an obstacle.

There's strong evidence that a split is emerging between politicians who want to move the Chinese economy in more a free market direction and those who want to keep the status quo, or even turn the clock back to the days of Mao.

The results of the split could determine China's future and have a serious impact on global markets

China's economy is still heavily state-dependent

In 1978, China began a series of economic reforms that moved it closer to being a market economy. This began with small measures such as letting farmers keep any surplus production. Foreign firms were also allowed to set up factories in China.

Later, the reforms became bolder. Small-scale private firms were allowed to exist and some small state firms were moved into the private sector. By 1992, the first stock exchange in China was re-opened after 40 years.

During the 1990s, reform continued. Privatisation increased while China reduced trade barriers. The biggest symbol of this was China's joining the World Trade Organisation in 2001.

However, the changes were more limited than perhaps people generally appreciate. The government still controlled the banking system and nearly all the land. This enabled it to divert credit to state-owned firms a key aspect of economic strategy since 2005.

At the same time, many of the 'private' firms are owned by local government, or at least partly controlled by the state. A report last year by the US-China Economic and Security Review Commission found that, if you include such quasi-public firms, then more than half of Chinese workers are employed by state-owned enterprises (SOEs).

And while China has made huge strides since the end of the 1970s, it remains far behind more developed countries. In simple dollar terms, the average Chinese person has an income of $5,184. This puts the People's Republic 91st in the world.

Even if you account for China's lower prices, the figure is only $8,394. This is less than a fifth of the US level. And it leaves China languishing in 90th place globally just few places ahead of Albania, hardly an economic powerhouse.

The World Bank recently warned that it's easy for countries at these income levels to stagnate. It believes that China has exhausted all the gains from rural-to-urban migration. To progress further, the country needs to innovate, rather than just copy Western technology. Further economic and social reforms are necessary, based around a greater role for markets.

Politics hasn't moved on at all

Economic reforms may have been limited, but at least there has been some progress. The political system remains closed. The Communist Party retains absolute control of policy. A free press remains a pipe dream. Indeed, some experts think that China today is less free that it was during the 1980s.

At the same time, China is becoming more aggressive. As we've noted before, this involves increases in military spending and the stockpiling of many commodities. And this disruptive influence extends outside its borders. China's ongoing investment in Iran is undermining sanctions. This is at least partly to blame for keeping oil prices high if sanctions don't work, then the US or Israel is more likely to have to turn to military means.

Some people think things may be about to change for the better. Every ten years the Chinese leadership changes at all levels. Because the process is not open, there are very few indications about what is going to happen in the future.

However, this year there have been two big incidents. Firstly, high-flyer Bo Xilai who was expected to get a seat on the ruling council has been sacked from his current job over allegations of corruption. Since Xilai is seen as a hardliner who wants to return to Mao-era politics, this was seen as a victory for reformers (you can read more about Xilai here: The surprise downfall of Bo Xilai).

In a recent speech, outgoing Premier Wen Jiabao publicly called for more political reform. There are even rumours that the Tiananmen Square massacre might be formally acknowledged.

Political reform would be good for China. In the longer run it's probably the one thing that would help it to maintain high levels of growth more than any other. It would also make the transition to a consumer-led economy more feasible. Changes in China's banking system and an end to unproductive state investments would allow money to be directed elsewhere, helping to boost consumer spending. This would increase American and European exports to China, speeding recovery in these regions too.

An end to Chinese support for Iran and Syria would also calm tensions in the Middle East reducing oil prices.

Don't get your hopes up

Unfortunately, China watcher Minxin Pei thinks that recent events have been overstated. He thinks the real reason Bo lost his job was due to his "thinly disguised political ambition and unorthodox tactics", not his views.

Dean Cheng of the Heritage Foundation agrees. He sees "no prospects for any significant reforms, political or economic". In any case, the transition process means that there will be "no major policy initiatives in the coming months".

And the bad news is that reform can also move in the wrong direction. Existing political systems have a nasty tendency to react badly when threatened. In one recent move, all lawyers will now have to swear loyalty to the Communist Party something they have never had to do before.

With the economy slowing, and fears of social upheaval even more pronounced than usual, we'd suspect the chances are that Chinese politics will become more conservative and oppressive rather than reform-minded.

As we've said before, if the Chinese economy continues to slow, many commodities will be hit badly.

Australia will also suffer. While its position as China's 51st state' has enabled it to grow strongly, and escape the global downturn a fall in exports to the PRC will push it into recession. This makes shorting the Aussie a good idea.

You can read more about why MoneyWeek regular James Ferguson reckons China's in for a hard landing in this week's Roundtable discussion: The 12 investments our experts would buy into now. Meanwhile, you can read more about the best way to profit from a hard landing here: Brace yourself: China is heading for a hard landing.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri