Zombie companies are China’s real problem, Peterson’s Lardy says

China needs to take on its state-owned “zombie companies,” which keep borrowing even though they aren’t earning enough to repay loans or interest, says Nicholas Lardy of the Peterson Institute for International Economics.

“That’s where the real problem is,” Lardy said yesterday in a Bloomberg Television interview from the Boao Forum for Asia, an annual conference on the southern Chinese island of Hainan. “It’s a component of the run-up in debt that they really have to focus on.”

While flagging this concern, Lardy, a senior fellow at Peterson in Washington and author of “Markets Over Mao: The Rise of Private Business in China,” said anxiety over China’s debt growth is overstated. Household deposits will continue to underpin the banking and financial system, which means the situation with zombie firms is unlikely to reach a critical point.

Household savings are “very sticky, they’re not going anywhere, and the central bank can come in to the rescue if there are problems,” he said.

Chinese corporate profits will probably continue to recover this year and after-tax earnings needed to service the debt load is improving, Lardy said. Another positive sign is a slowdown in the buildup of debt outstanding to non-financial companies. The combination of that slackening and companies’ increasing earning power “is improving the overall situation,” he said.

When it comes to U.S. President Donald Trump’s negative rhetoric on China, the country’s leaders deserve “very high marks so far” for their cool reaction.

“They’ve been waiting to see what Mr. Trump is actually going to do as opposed to what he’s talked about, so they haven’t overreacted,” he said. “They’ve made very careful preparations for the worst case if Trump does move in a very strong protectionist direction.”

Both sides would lose a great deal in any trade war and there would also be collateral damage to other Asian countries tied to Chinese supply chains making products ultimately bound for the U.S., he said. Lardy added that there’s no merit whatsoever to labeling China a currency manipulator, as Trump threatened to do last year during the election campaign.

“The Chinese have been intervening to keep the yuan from depreciating vis-a-vis the dollar and that’s led to the USD1 trillion decline in their foreign reserves, so it would be a very weak case,” he said. “They couldn’t possibly label China a manipulator. They would have to tweak the criteria to label China a manipulator, and I think that would be pretty provocative.” Bloomberg