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"When we try to guess where the euro zone’s politicians are heading, we have lots of information, and the trick is to figure out which parts are real and which are deliberate disinformation," one London-based macro trader explained to me. "When we try to guess what the Chinese are up to, we have much less information, and sometimes it feels like it’s all disinformation."

The Communist Party’s 18th Party Congress, which ended this week in Beijing after picking the country’s new leaders and replacing most members of the Politburo Standing Committee, the party’s ruling body, provided plenty of fresh information but left many market participants struggling to make sense of it all. "When the entire leadership of the world’s second-largest economy changes, surely financial markets have to react," the trader mused. "The question is, react to what?"

How will Beijing’s leadership transition move markets, and what do we watch for clues?

Xi Jinping and Li Keqiang came out on top, as expected, and there were few surprises about the other five members appointed to the Politburo Standing Committee, the party’s ruling body. But the politicking and jockeying for position isn’t over yet. "Now that the top seven are in place, we are going to see ripple effects and reshuffling down the line of all their competing and overlapping patron-client networks," one Beijing-based former diplomat e-mailed me.

The date of the party conference had been pushed back, not so much because of the scandal surrounding Politburo candidate Bo Xilai, whose wife murdered the hapless British citizen Neil Heywood, but rather because of deep disagreement over who would sit around the top table. In Beijing, even more than in Washington, personnel is policy.


Every major policy in China is up for review by Xi, Li and their new team. The Standing Committee meets weekly and makes all the important decisions — political, economic, military, social and cultural.

The transfer of power is staggered. The Politburo this week endorsed Xi as the new secretary of the party. The National People’s Congress is due to confirm him as president, replacing Hu Jintao, when it meets in March, as well as approving Li as replacement to Wen Jiabao as premier. Even when they are formally in office, it will take time for them to consolidate power, considering all the party elders looking over their shoulders (neither Hu nor his predecessor, Jiang Zemin, are going to disappear).

But Xi and Li can begin to affect economic policy fairly quickly if they so choose. There are three key policy areas to watch: trade policy with Japan, which is bound up with a maritime border dispute; exchange-rate management, which will be felt in global financial markets; and macroeconomic rebalancing, which could alter how China interacts with global supply and demand.

Welcome to the open-source intelligence world. During the Cold War, Kremlinology was the rage as analysts tried to discern clues to Soviet decision making. Now we puzzle about Zhongnanhai, the leadership compound of the Chinese Communist Party leaders. What are the observables in a one-party state that is still obsessively secretive, particularly about power transitions?

The most important thing to watch is the people: who gets appointed to the Politburo Standing Committee, the Politburo at large and the handful of other appointments that emerge during or soon after the congress. Cheng Li, a senior fellow at the Brookings Institution, keeps tabs on all the new leaders, including their educations, careers and patron-client relationships. "These so-called fifth generation candidates have more diverse political backgrounds, academic credentials, leadership experience and basic worldviews," he says. "For example, most of them got their academic degrees in economics, politics or the law, in sharp contract to both the third and fourth generation leaders who were predominantly technocratic, engineer-turned-political leaders."

The second observable is the formal communications at the Party Congress, particularly the Work Report that Hu presented at the opening of the conclave. The 64-page document was chock-full of self-congratulation for the party’s achievements, a mind-numbing amount of data, a sometimes frank assessment of shortcomings, challenges and future aspirations, and some veiled signals about political intentions.

"The political report is not a speech by the general secretary reciting his personal views on the issues it addresses," says Alice Miller, a China scholar at Stanford University’s Hoover Institution. "It is a synthetic document that reflects the consensus of the broader party leadership." So the rhetoric may be leaden, but it is authoritative as a lens into the views of China’s collective leadership.

The third observable is the swirling commentary and rumor-mongering by the media, party notables and tens of thousands of Chinese citizens on sites like the Sina Weibo and Tencent Weibo microblogs. The Chinese government has been blocking all Google services since the start of the congress, but the wires and cellphones inside China have been humming.

"Reform" was a major theme of the event, with that word dominating state media coverage in the weeks leading up to the congress. Reforms include reining in the privileges of state-owned enterprises, easing restrictions on rural migration to cities and dealing with widespread official corruption — all of which made it into Hu’s keynote speech. He hit the bribery point early on: "The phenomenon of passiveness and corruption has occurred easily and repeatedly in certain realms. The situation for anticorruption struggles is still grave."

Political reform as we know it in the West, however, is not likely. Stability and one-party rule remain top priorities as some senior officials fear that open debate could split the party. Yet the transition could produce a move toward some inner-party debate.

In one important decision, the total number of Standing Committee seats was cut from nine to seven, neatly eliminating the seat of the top public security overseer, Zhou Yongkang, who stepped down. According to Brookings’s Li, "The elimination of this slot sends a signal that a political reform agenda is in the making."

Others view the removal of Zhou as a blocking move rather than a reform. "I call this the Beria effect," e-mailed the former diplomat, referring to Lavrenti Beria, who led the Stalinist purges as head of the Soviet Union’s secret police. "Xi and the new generation of leaders are worried about the risk of a ‘soft coup’ by an ambitious contender like Bo Xilai in cahoots with Zhou and the security services."

Lest anyone mistake what he meant by reform, Hu threw cold water on political reform from the very beginning of his speech. As Hong Kong University’s Qian Gang observed, "Mr. Hu’s speech hit on almost every antichange phrase used by Chinese Communist leaders." He referred to "perfecting the socialist deliberative democratic system" — quite a set of qualifiers to "democratic" — and restricted intraparty democratic discussion to "perfecting the party’s grassroots democratic system."

There are deep cleavages within the party. The final Politburo appointments fall across these cleavages and the multiple patron-client networks within the party. The biggest cleavage is between the princelings, children of so-called revolutionary notables, and the tuanpai, whose roots are in the Communist Party Youth League. Xi is from the former group, Li from the latter. Jiang Zemin is the center of the princeling faction, which represents the interests of the wealthier coastal provinces and is (relatively) more market- and export-oriented. In contrast, Hu is the center of the tuanpai faction, which represents the interests of the poorer inland provinces and is (relatively) more command-oriented and interventionist — not exactly New Left. There are other interest groups within the party as well, some rooted in wealthy cities or provinces like Shanghai, others from industrial sectors such as petroleum or steel. And of course the military and internal security forces have their own power bases. The mosaic of factions and patron-client networks is extraordinarily complex and extends from Beijing down to every township and city in the country.

It is important to recognize how deep the patronage system goes in China. It’s not simply the top seven slots that were at stake this week. Each party member beneath the top tier has spent his or her lifetime allying with certain party officials. Depending on whether or not their patron gets promoted this decade, they can advance or be sidelined. Chinese business executives in the public and private sectors watched the outcome like hawks; their jobs, incomes and maybe even their personal freedom depended on how well or poorly their own patron-client network fares at the congress.

Just like these anxious observers, we can get a sense of how policies may change by examining the appointments, formal communications and informal commentary.

China-Japan Relations

One issue that has already had a major economic effect is China’s dispute with Japan over a group of small uninhabited islands — the Chinese call them Diaoyu, the Japanese, Senkaku — in the East China Sea. Anti-Japanese riots in China have already caused the sales of Japanese auto firms in the country to crater. Many other exports are hurting too.

If the new leadership decided to escalate the confrontation — and there are signs that they may do so — then the negative effects could spread beyond Japanese sales to China as the threat of a shoot-out over the contested islands becomes a bona fide "risk off" event. A flight to quality by portfolio managers would hit asset prices around the world; yen assets, in particular, would get pounded.

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