China Battles Aging And Debt

Arthur Kroeber, head of research and founding partner of Gavekal Dragonomics, spoke with Global Finance about China’s politics, its markets and its future role in the global economy.

Global Finance: What are China’s most significant economic challenges?

Arthur Kroeber: Following the financial crisis, Chinese state firms today generate return on assets of about 3%, and private firms generate 9%. State firms borrow twice as much money to deliver a third of the private firms’ return. The inefficiency of the state sector explains slow growth and high levels of debt in China. But state-owned enterprises are integrated into the power structure of the Communist Party, so reducing their role is politically risky. Another challenge is China’s negative demographic trend, where a rapidly aging population is a drag on economic growth.

GF: Global investors worry about the state of the Chinese financial system. What are your thoughts?

AK: We estimate total gross-debt-to-GDP ratio in China of around 240%. It is 100% higher than in 2008, when we were not worried about a Chinese financial bubble. While foreign borrowing represents only 10% of total debt and China is a net creditor to the rest of the world, China is potentially still exposed to an internal funding crisis due to insufficient bank deposits. China currently has a credit-to-bank-deposit ratio of around 110%, but it is constantly growing and may be 140% in 2020. In three to five years, funding will become an issue in a highly leveraged financial sector. My biggest concern is not households or government debt but corporate debt, which is 160% of GDP—one of the highest in the world.

GF: How can foreign companies penetrate the Chinese market?

AK: Foreign companies are critical to China’s growth. Foreign firms in China manufacture half of its production. But US companies have complex relationships with the Chinese market; they complain about discrimination and over-regulation but they want access, so they don’t support actions against the Chinese government on trade and investment. Generally, companies have been most successful with a step-by-step strategy, building market share over time.

GF: What Chinese asset classes are most interesting?

AK: In general, real estate and private equity investments have been a good way to invest in the Chinese market. But private equity valuations are too high now, and the government doesn’t want foreigners in the distressed real estate market. The fixed-income market is promising, as interest rates are expected to be high and the government opens the bond market to foreigners.

GF: How would you describe US-China trade relations?

AK: The protectionist tide is rising. The US steel industry, for example, is asking the government to ban Chinese steel imports. Yet, China itself understands that it has to downsize its steel industry. Protectionism is a concern more on the investment than on the trade side. China needs to recycle surplus through foreign investment abroad, and Chinese companies need to expand globally. The Chinese government would like free access to world markets while remaining restrictive at home. China’s biggest market is actually the EU. China is working to create demand for its products in the developing world. You have more countries in the world with China as the leading trade partner than the US.