Market Extra: 5 reasons why investors need to watch China’s National Party Congress

Investors can’t afford to ignore next month’s China National Party Congress, which is expected to to see President Xi Jinping consolidate his hold on the reins of the world’s second-largest economic power.

Held every five years, the gathering decides the new makeup of the leaders of the Chinese Communist Party and will complete a process of political consolidation for Xi that has been years in the making. The conclave is slated to begin on Oct. 18.

“Every investor needs to have a China opinion, it’s the proverbial middleman in the global economy. China is a poker tell,” said Brendan Ahern, chief investment officer for Kraneshares, which constructs exchange-traded funds offering exposure to China.

Here are five things investors need to consider:

Consolidating power

The meeting will change up the seven-man Politburo Standing Committee and the 200-or-so members of the Central Committee. As Xi enters his second term as China’s leader, he is expected to stuff vacancies with his supporters. Though Xi travels the world with the status as the head of a sovereign nation, outsiders often underappreciated that China’s presidents have historically operated as a first among equals. China’s presidents typically aren’t dictatorial strongmen. Instead, the party has tended to maintain a finely tuned balance of power among opposing factions, providing a framework for policy decisions.

Xi Jinping

But Xi has spent the past few years sidelining his political opponents. The plenum could put an end to the consensus-making which has been the party’s modus operandi. It would also put Xi, who was declared last year a “core leader,” in a position of rare strength. The title, in the past, has been given only to the likes of Mao Zedong, founder of the Chinese Communist Party, and Deng Xiaoping, the economic reformer who opened the country’s economy to the world.

“What we see with China is increasing concentration of power in the hand of Xi Jinping. For sure, it means increasing control of the economy and the central bank. Every time we have some doubts about China to deliver growth, they deliver it,” said Franck Dixmier, global head of fixed income for Allianz Global Investors.

Driver of global growth and trade flows

Global growth is making a comeback, and much of that is underpinned by China’s economic engine. Oxford Economics describes the country as “the world’s leading indicator and shock absorber,” noting an 80% correlation between Chinese economic activity and global trade show since 2010.

Global trade tracks Chinese growth more closely than changes in U.S. GDP

The country’s appetite for raw commodities to feed its factories and its construction industry affect prices world-wide. The San Francisco Reserve Bank estimated that growing Chinese demand could drive crude oil prices back to $100 a barrel by 2025. Chinese demand also helped copper prices to a 3-year high in late August.

Improved global growth has helped to prop up lofty asset valuations in Europe and emerging markets. Moreover, it gives central banks the headroom they need to unwind their balance sheets.

Structural reforms or more of the same?

At the last congress in 2012, Xi was portrayed as a knight in shining armor who would resuscitate the party’s fortunes and reform a debt-laden economy weighed down by sluggish state-owned enterprises. Five years later, it appears the economic model hasn’t changed much, as highlighted by a recent International Monetary Fund report that argued that China was making inadequate progress in cutting down its mound of corporate debt.

It isn’t clear how much emphasis Xi puts on structural reforms.

“For the market, the key issue is whether Beijing will taper its Keynesian credit stimulus and resume its structural reforms. Slower economic growth will have its logical consequences for the rest of the world,” wrote Stephen Jen, head of Eurizon SLJ Capital, a hedge fund.

S&P Global Ratings downgraded the country’s credit rating this week citing its heavy debt load. But it offered a get-out clause, saying it could “raise ratings on China if credit growth slows significantly and is sustained well below current rates while maintaining real GDP growth at healthy levels.”

The future of the yuan

The country’s yuan currency

USDCNY, +0.0015%

has been on a winning streak against the U.S. dollar this year, with the buck weakening 6.7% to a low of 6.482 yuan on Sept. 8, followed by a modest resurgence of the greenback in the aftermath of the S&P downgrade earlier this week.

But the yuan’s “remarkable comeback” was due more to broad-based weakness in the dollar than Chinese fundamentals, said Louis Kuijs, head of Asia Economics at Oxford Economics. A stronger yuan could affect China’s exports, though it’s worth noting the currency’s trade-weighted exchange rate has seen less strength.

Meanwhile, China’s foreign exchange reserves, which ran down sharply in 2016 amid a bout of capital flight and an effort to slow a fall in the yuan, had risen back to $3.09 trillion in August. The rebound came as the dollar weakened in 2017 and yuan outflows ebbed.

“The expectation is that the congress will be economy-positive and reform-positive,” said Peter Ng, senior FX trader at Silicon Valley Bank. Lifting capital controls could make the renminbi, as the yuan is also known, more accessible for international investors.

But on the other hand, if the dollar regained its strength the yuan could come “under renewed pressure, reigniting capital outflows. Then we cannot rule out a further clampdown on outflows, in order to safeguard FX reserves,” Oxford Economics analysts wrote in a note earlier this week.

It traded at 6.5920 per dollar on Friday, marking the yuan’s weakest day against the buck in more than three weeks.

Stabilizing growth this year

Some analysts argue that the stabilization of China’s economic data is politically driven in an attempt to steady the ship ahead of the National Party Congress. Official data shows China largely on track to meet its 6.5% growth target for 2017, attracting the derision of skeptics like hedge-fund manager Kyle Bass, who feel its breakneck expansion is unsustainable.

But economists note the country has made efforts to wean itself from reliance on cheap credit, which it employed to survive the 2007-2009 global recession relatively unscathed. China’s regulators have recently strengthened financial regulation measures to tamp down the bad debts and risks looming in its banking system.

The concern is that once the Congress is concluded Xi will press the pedal on reforms and force debt levels lower. This could weigh on economic growth and depreciate the yuan. But there is a camp of investors that remain upbeat.

Their view is that “the new/old leadership will focus on further suppressing economic and financial volatility through a combination of continued leverage expansion, financial repression including tight capital controls and imposition of supply discipline in commodities industries,” wrote strategists at bond-fund manager Pimco.

“If so, unlike in 2015-2016, China would not be an exporter of volatility to global financial markets.”