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By Meera Venu

Rich, poor. Urban, rural. East coast, western interior. The disparities in China's health-care market are striking for a country that values egalitarianism.

Some critics even claim that China's current health-care crisis is more dramatic than the U.S. crisis, and when we dig into the figures (some of which are shown in Table 1 below), we can see validity in that claim.

Reform efforts are underway in China, and in this article we explore the government's goals and the market opportunities that could be created as a result of those reform efforts. (Click to enlarge)

Demographics Beginning to Mirror the U.S.

The sheer size of the potential Chinese market is difficult to ignore. With 1.3 billion people, China stands head and shoulders above any country in terms of potential patients. However, a closer look at the composition of China's populace reveals a much smaller, albeit still very large, likely patient pool. About 600 million people are considered urban residents, while over 700 million are considered rural residents. Some critics even claim that this statistic overestimates the urban population several times over by including some relatively small population centers where most people likely can't afford substantial care. Either way, the urban and rural distinction is important because the rural population is disadvantaged in terms of access to and quality of care.

However, even without significant uptake in rural patients, China's health-care market could continue growing at a blistering pace. With improving nutrition and better control of infectious diseases, life expectancy has risen dramatically from the mid-30s in 1950 to over 70 in recent years. Given this rise in life expectancy and the one child per couple policy, China's population is aging in a similar pattern as developed countries with similar disease trends as shown in Table 2. China's elderly population looks on the verge of exploding, and the incidence of chronic diseases associated with aging such as Type II diabetes, heart disease, cancer, and osteoarthritis could surge in the coming years. Industry leaders in the treatment of several chronic, more Western-style disease states, such as Johnson & Johnson (NYSE:JNJ), Novo Nordisk (NYSE:NVO), Pfizer (NYSE:PFE), Roche (OTCQX:RHHBY), and Zimmer (NYSE:ZMH), could all stand to benefit from targeting opportunities in China.

Insurance Coverage Levels Still Low

In our opinion, America's insurance coverage problems look tame compared to China's dilemma. Table 3 shows that while many wealthy, urban people in China carry insurance, a huge portion of the population remains uninsured, particularly the rural poor.

Coverage for catastrophic events is limited primarily by wealth in China; about half of all health expenditures are paid out of pocket. Insurance in China primarily covers hospital care and still requires large deductibles. The burden of health care in China is largely on individuals, and rising costs--driven by increasing utilization of technology such as drugs and devices--have priced many people out of the market.

Profit-Driven Delivery System Highlights Differences in Urban versus Rural Care

Since the government has largely privatized care, Chinese caregivers run on a for-profit, fee-for-service basis similar to the U.S. system. While the government has maintained tight controls over routine services, it permits caregivers to earn significant profits on new drugs, tests, and other technology. With new technology serving as the key profit center for caregivers, prescription levels of these products and services can be quite high. Critics of China's system claim that drugs are often prescribed for unintended uses to pad the profits of caregivers.

We think this profit-driven mentality has led to care levels that correlate with patient wealth levels. Today in China, wealthy, urban patients who can afford it are demanding modern medicine practices with high-priced new technology that is highly profitable for caregivers. Many rural patients don't have the means or insurance to receive such care. Caregiver incentives appear to be reinforcing the have/have-not dynamic in Chinese health care, and China's health-care system can be characterized as swollen in urban centers and razor-thin in rural areas as a result.

Reform Should Increase Demand for Drugs and Devices

The problems above and rising medical costs are fueling health-care reform efforts. The Chinese government will spend about $125 billion by 2011 to accomplish several goals. First, China wants to cover 90% of the population with medical insurance by 2011 and cover the whole population by 2020. The government will try to equalize the disparity between its basic urban and cooperative insurance for rural citizens and increase the subsidies to $18 per year to help citizens deal with the cost.

Another initiative involves improving the quality of rural care. This reform involves building more hospitals, especially in rural areas, and purchasing medical equipment with the goal of each county having one standardized hospital. The sharing of medical expertise will also bolster care in these local hospitals. The reform bill mentions training programs and moving personnel to rural areas. We think medical device and equipment companies that can win a bid in the tender process at either the provincial or central level can benefit from this increased construction and demand.

China will attempt to increase access to pharmaceuticals by building a list of essential medications and mandating their availability in rural areas. The government will select these drugs based on considerations like disease prevalence and cost, and insurance schemes will cover these drugs at a higher rate. The government will set prices and oversee the distribution of these medicines. Efforts to mediate drug prices should limit a hospital's incentive to profit from prescribing expensive and unnecessary drugs. In return, hospitals could get government subsidies or charge additional fees. We think firms that make generic drugs will benefit from this provision.

However, skepticism still remains about the effects of reform. In particular, critics worry whether government subsidies and regulation will be enough to change hospitals' incentives to profit from prescriptions or tests. Some wonder what the new reimbursement will be like and how much will be paid out of pocket. For now, it seems too early to tell whether these reforms can dramatically improve the disparity in care between rural and urban areas. However, we think that it will positively impact the demand for drugs and devices for companies that effectively invest in China.

Julie Stralow, CFA, also contributed to this article.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes. Tim handles their stock strategist posts (separate feed) if you need help formatting or have other Morningstar-related questions.

Source: A Tale of Two Chinese Healthcare Markets