Since the founding of the People’s Republic of China in 1949, China has gone through a series of phases marked by sharply differing conceptions of what its leaders believe is best for the nation.

In 1985, Deng Xiaoping inaugurated decades of rocketing growth with a single commandment: “To get rich is glorious.” The goal was to make China a “moderately prosperous society” defined as doubling the per-capita GDP to roughly $10,000 per year and housing 60 percent of the population in cities. To achieve that, Deng said, China had to “let some people get rich first.” 2020 was set as the deadline. 

What followed was state capitalism with rapid economic liberalization and growth of private enterprise. The poverty rate went from 60 percent to 10 percent, surprising everyone. 

But French economist Thomas Piketty observed in his acclaimed book, Capital and Ideology, “Given that Europe has demonstrated the possibility of achieving prosperity while limiting inequality, it is not clear why Chinese socialism should tolerate levels of inequality on a par with American capitalism.” 

The combined wealth of China’s 415 billionaires rose to about $1.6 trillion, roughly the of Russia’s economy. Their fortunes combined would amount to the world’s 11th largest economy. Meanwhile, 600 million people live on a monthly income of 1,000 yuan or $154, barely enough to cover monthly rent in a mid-sized Chinese city.

Piketty was right. 

In July, Xi Jinping announced the goal of building a moderately prosperous society had been achieved: “We have brought about a historic resolution to the problem of absolute poverty in China. We are now marching in confident strides toward the second centenary goal of building China into a great modern socialist country in all respects.” 

While the party had long allowed some people and regions to “get rich first,” China has now entered a new stage of development prioritizing “common prosperity for all” which Xi has hailed as an “essential requirement of socialism, and an important hallmark in China’s modernization.” 

So far, we’ve seen a crackdown on tax evasion and corruption; a crackdown on anticompetitive practices of tech titans like Alibaba and Tencent; billionaires giving away chunks of their fortunes and being pushed into doing more for society; a court ruling that “996” workaholic culture is illegally exploitative of employees; and efforts to remove the “three mountains” on households of high costs of housing, healthcare, and education.

Now here’s the challenge. People feel strongly about these actions. But the problem is they have no general context. No one has actually read the Central Govt Guiding Plan or the Zhejiang Common Prosperity Plan. It is over 100,000 words.  

This is astonishing given China—the world’s second largest economy—is presently going through a new phase, whose meaning can be understood more fully only if we first understand how its leaders got to where they are today in their thinking about the global economic order.

On what is new and different 

Li Yining is probably the most influential economist in China. Reading his commentary on the common prosperity plan is essential to understand what is new and different from what is familiar. Here’s what he says:

First, the fundamental difference between capitalist economic development and socialist economic development is that the former, capitalism, results in disparity and polarization of society, while the latter, socialism, is the road to the common prosperity of all workers.

Without common prosperity, socialist economic development can only be considered a failure. Assuming economic development results in low gross economic output, then no matter how it is distributed, common prosperity cannot be achieved, and common poverty is more likely to be faced.

In other words, if the cake is small, no matter how its distributed, this cannot be separated from poverty. Only when the cake is made large, and then distributed in a reasonable way, there is hope that everyone gets a large share, common prosperity can become a fact. 

Second, imbalance in the development of things is the universal law. Due to historical reasons, the uneven distribution of resources in various regions, different individual labor efforts and different labor proficiency, and the different degree of risk taking, simultaneous enrichment is not realistic. It is not realistic under socialist conditions to level people’s income and make people’s consumption equal.  

Common prosperity means that all workers can live a better and happier life, not that all members of society have the same income. Therefore, under the condition of socialism, the first meaning of common prosperity is that despite the division between rich and poor all workers have increased their incomes compared with the past and can lead a better and happier life.

 So, a question arises that needs to be studied: What is the relationship between common prosperity and the role of market mechanisms?  

In the process of socialist economic development, the role of market mechanism needs to be used... the widening income gap between individuals is unavoidable... but the meaning of common prosperity is to narrow the income distribution gap between people so that the income gap is not too large. The market itself lacks a mechanism to narrow people’s income gaps or avoid excessive income disparities. 

As noted earlier, common prosperity cannot be viewed in an egalitarian way as leveling people’s incomes. If you do that, it will not only violate the original intention of common prosperity, but also be detrimental to the economic development of socialism, because it will not only discourage the enthusiasm of individuals to operate, save and invest, but also discourage the positive nature of individual labor.

This means that the collection of personal income tax, income adjustment tax, or inheritance tax, property transfer tax, should have a reasonable starting point. In the process of China’s economic development and reform, it is entirely possible through the first wealth of some regions and parts of the population to help the rest of the region and the rest to become rich.

This is the embodiment of the superiority of the socialist system. 

What follows is pared-down version of our salon with Kok Hoi Wong (CIO, APS Asset Management) about the economic, political, and societal components of the Common Prosperity drive, as well as its investment implications. You can watch the full interview here.

The truth of the matter 

Common Prosperity has caused a lot of confusion over the last few months. As far as I can tell, the Common Prosperity plan calls for more capitalism and entrepreneurship, not the other way around.

The plan is about modernizing the Chinese economy over the coming decades. Within the plan, there are nine categories covering 118 wide ranging policy objectives. This includes developing a technologically advanced economy; creating a harmonious, stable, and happy society; protecting and sustaining the environment; building a corruption free and a people-oriented system; correcting dislocations in the economy and minimizing systemic risks. 

Prominent economists have said it could take 100 years to achieve most of the goals in the plan. The plan does have a component of more wealth distribution to workers, but it is a very small portion of the entire plan. If it was really about redistribution of wealth, then the plan would only need to be two or three pages.  

Deng Xiaoping’s brilliance was he combined socialism and capitalism, which has brought phenomenal prosperity to the country. There has not been a period in the last two hundred years or more where China achieved the kind of success that it has over the last few decades. Why would policy makers suddenly want to abandon a system that has brought so much prosperity to China? 

On cats and mice

When Deng took power in 1978, China was very poor, and things were very slow for the first ten years. There was a lot of skepticism around China using capitalism; it was a taboo term. So, he said “It does not matter if a cat is black or white, as long as it catches mice.” 

Deng used that phrase to mean, “It does not matter if we use the term socialism or capitalism, as long as we can achieve proper development and progress for our people. Don’t be too ideological.” That was essentially his message to the Chinese. 

It was only in the past twenty years that China realized it was okay to use laissez fair capitalism. They took capitalism to the limit to maximize profits, but this was at the cost of exploiting workers. Today, Xi wants to provide better working conditions, benefits, and housing for workers. Poorer parents’ children will be given opportunities in education equal to wealthy families’ children. It seems Xi wants to level the playing field in certain areas like education so that wealth does not decide a child’s future. 

Last year, more than $10 billion was raised by education companies. The government found out 85 percent of the funding was being used for marketing to attract more students and to pull teachers away from government schools. The result was parents paying substantially more for their children’s classes for the same quality of education as the government schools. It was a capital market game. Investors were shocked at the crackdown, but the government had warned two years prior that companies should not use education to make big profits. The government decided to put its foot down.

The outlook for Chinese internet stocks

They have corrected 30 to 50 percent this year, but I still think they are grossly overvalued. The business models of some companies are broken. Take consumer finance companies as an example. In the past, they were able to charge interest rates of 30-40 percent per year on loans to less educated people as well as to young people. The government has put a stop to this since there were a number of suicides related to these lending practices. 

Many ecommerce companies will not be able to conduct the monopolistic practices they have done in the past. Tencent, for instance, would forbid any of their competitors from entering their ecosystem, so they would have to go and create their own ecosystem. This made things very inefficient. The government wants to have open ecosystems, and this is beginning to take place. Another example is companies like Alibaba can no longer prevent their merchants from selling on other platforms. Alibaba was fined more than $2 billion for this practice. 

These companies have bent and even violated the rules because the regulators were not watching them, or sometimes they looked away because their old KPI was to make sure these companies grew and created more jobs. Now, though, things have changed, and I still think it is too early to buy any ecommerce stocks. The adjustment to these stocks will take years and not months. 

The old argument claimed that as these companies grew, it was okay for them to lose money so long as their top line continued to grow. But now, top-line revenue growth rates have slowed. When companies release their Q2 earnings it will be clear that online shopping has reached high penetration rates and going forward we cannot expect high growth rates anymore. It will also become clear that these companies, after growing to a certain , still cannot make a profit. Thus, we will see a massive derating of all ecommerce stocks because the old arguments are not working.

On what it means for US corporations

I think this government decided a long time ago they want to operate an open economy since China has been a major beneficiary of this fully global trading system. Beijing realizes they must reciprocate with trade. I do not think this policy will change. 

A lot of international companies like Apple and GM are making more money in China than they are in their home country. Most US companies have increased their capex in China over the last two or three years. In surveys, business leaders say they have no plans to withdraw from China. If anything, they want to increase their investment.  

How to invest 

Vanke is the best developer in China, but it has been negatively affected by Evergrande’s problems. When Evergrande issued bonds, they had to pay a 10 percent coupon. Vanke only paid a 3 percent coupon. Vanke’s properties are sold 20 percent higher than the market average because of the quality of their properties. 

Evergrande’s bankruptcy turned out to be a positive for them because they are now the number one developer, which gives them more opportunity to grow. Their IRR is not the 30-40 percent it used to be, but it is still in the mid to high teens. This is not bad considering the valuation of the company. 

You want to buy the more boring stocks like that. Deep value stocks with business models that are still intact. Another example is China mobile. To me, it is obvious you also want to have some money in SMIC. 

SMIC cannot fail. If it failed, China’s mission to build a technologically advanced economy would fail. High end chips are needed for all tech industries. Tech companies in China will do what they can to make sure SMIC survives. 

For instance, Huawei did not give any business to SMIC because SMIC produced inferior chips but charged higher prices than their competitors. Now that Huawei is banned in a lot of places, many chip companies cannot do business with them, so they now must use SMIC. 

On the Beijing put

I have read reports that say the government does not care what markets do, but I do not believe that is true. When the market crashed in 2015, it caused a lot of misery to not only investors but also business owners of listed companies. This was because many of them posted their shares for loans with banks. Regulators panicked, and Xi was furious the market crashed how it did. Their response was to create a fund to provide support for those affected. 

If the party and the government did not care about the stock market, then they would not have taken those steps. What the government does not want to see is a crazy bull market like 2014 before the market crashed. They want to see a steady bull market, not a speculative bull market. 

On what local founders are saying

All the founders and companies I have talked to were very relaxed about the Common Prosperity plan. I asked founders if they would have to donate their wealth to the government and they told me absolutely not. According to the plan, the tiered distribution is on a voluntary basis. In the investing community we read about the donations of Alibaba and Tencent, and therefore have a misguided perception that all capitalists must donate a certain percentage of their wealth to help the poor, but this is not true. The founders are staying put and growing their businesses. 

Also, if you look at capital flows in recent months, there are very little outflows happening. The currency has even appreciated lately. If people were worried about the Common Prosperity plan, then there would be massive capital outflows and the currency would collapse. 

On accidents and risks

I think the biggest worry in Asia is a US-China military conflict. The probability of this event is low, but sometimes accidents can happen, and accidents have led to wars in the past. A military conflict with two nuclear superpowers would be a disaster not just for the US and China, but also for the whole world.