Investors should understand that autocracy has greater legitimacy in China than is appreciated, says Jerry Wu, a fund manager at Polar Capital. In early October last year, running up to the 20th Communist Party Congress, chatter in the City of London was gaining momentum that President Xi may not be re-elected. It seems, however, that there is too much misunderstanding of how China works, which leads to horrible investment decisions and returns.
To understand China better, investors need to (1) realise and accept that autocracy has stronger legitimacy in China than currently accepted and (2) we need to separate politics and bureaucracy and focus on the bureaucracy. China’s annual National People’s Congress concluded on March 13, with a new prime minister (Li Qiang) and the government leadership finally in place.

Autocracy's strong legitimacy

It began with geology. China’s geology is very straightforward: to the west, there are the Himalayas; to the north, the vast and dark Steppes and Gobi Desert; to the south and east, the Pacific Ocean. Within China, though, natural barriers are few, so it is very easy to attack and very difficult to defend.
In contrast, with its many great mountains and rivers, many parts of Europe are easy to defend and hard to attack. Charlemagne and Napoleon would have loved to be in China because if you can mobilise the most amount of people and resources and are highly efficiently organised, you can rule the whole country within a short space of time. This lays the foundation of the geological and historical legitimacy of autocracy in China.
In 221 BC, from a small city-state in the middle of China, Qin Shi Huang went on to conquer and unify China for the first time. The most important factor to his success is a trusted adviser, Shang Yang, the Great Reformer. Among many reforms Shang Yang made, the most critical one that went on to change the course of history is the idea of political meritocracy. From the third century BC, political power is no longer hereditary in China. This not only helped Qin gain strong grassroots support but also significantly improved his ability to organise and govern.
In the West, politics is where exciting things happen, and bureaucracy is boring and almost a negative word. In China, it is the opposite – politics is boring, but the most interesting reforms and innovations happen at the bureaucracy and governance layer.
This combination of a relatively stable political autocracy at the top, an efficient, innovative and competent bureaucracy in the middle and agricultural technology innovations at the bottom created one of the greatest agrarian civilisations that peaked sometime in the 14th and 15th centuries.

Deng Xiaoping’s governance reform: the profit-sharing model

Then capitalism and the Industrial Revolution happened. Without new markets, industrial technology innovation and a governance model suited for capitalism, China, and the East in general, started to lag a long way behind.
Another great reformer was determined to change that. Deng Xiaoping set about reforming the bureaucracy and governance for the capitalist era without touching the political autocracy. The solution he came up with is the ‘profit-sharing model’, which works like this: the business elite gives out stakes to the political elite in exchange for privileges to operate. This removed the temptation for the political elite to loot the economy for their own benefits.
On the other side, the rank-and-file bureaucrats no longer needed to resort to petty corruption for speedy money by providing good service to the business elite and facilitating the market economy. Their reward was ancillary benefits and bonuses. The profit-sharing model has very strong buy-ins from all stakeholders, and the result was growth on steroids and China’s gilded age.
If the patronage and graft sound familiar to you, they should because the Americans perfected this 150 years ago. Both went through massive destruction – civil war in America; the cultural revolution in Maoist China – followed by growth on steroids, gilded ages, new technology innovations and deployment – railroads, steel-making and oil-refining in the US; mobile internet, electric vehicles, batteries and big data in China. For every Rockefeller, Vanderbilt, Carnegie and Morgan, there is a Chinese doppelganger.

Managing capitalism: experimenting, failing, repeating

The huge side-effects of the robber-baron capitalism of the past 40 years are now outweighing the benefits. Many of these challenges are the very same capitalism is facing elsewhere, issues like extreme inequality and the environment. How to evolve the profit-sharing model while at the same time not hurting entrepreneurism and growth is a hugely tricky task.
There was a very interesting speech given by Xi in late 2021, in which he expressed self-reflection and course correction. In that speech, he walked back on the common prosperity campaign, telling central bureaucrats: “Remember, our point is not to take China back to egalitarianism. We just wanted to regulate the markets.” The point he tried to make was that Deng Xiaoping had a roadmap to take China out of poverty and generate wealth. That was hard enough, but the Party did it. Now the challenges they are facing, and President Xi needs to solve, have no existing solutions to follow.
President Xi is often portrayed as an idealogue who has a clear long-term agenda. In reality, he is a pragmatist struggling to come up with good solutions for challenging problems. They are experimenting and testing. Many of the experiments will inevitably fail, and Xi and the Party will learn, adapt and try again. Jerry Wu is fund manager of the Polar Capital Emerging Markets & Asia team. ©2023 funds global asia