China's consumer revolution

The growth story in China is far from over, with Jonathan Wu pointing to the rise and rise of China’s second and third tier cities – all of which boast populations in excess of one million people.

For a long time, Beijing, Shanghai and Shenzhen have been the centre of media attention and the basis upon which China’s growth has been viewed as sustainable.

However, while many great pictures of skyscrapers, bridges and highways have been shown at fund manager presentations over the years, these three cities make up only around 3 per cent of China’s population.

So what is happening with the other 1.26 billion people that make up the ‘middle kingdom’? Most reside in the second and third tier cities, and of course, many who are still in the rural areas will continue the biggest urbanisation story in human history. These future cities of China will be the key to sustainable growth for years to come.

The second and third tier cities of China are by no means small. Currently, there are 160 cities with a population larger than one million. Europe only has 35 cities with a population over one million.

The McKinsey Global Institute forecasts that by 2025, there will be over 221 cities with more than one million in population in China.

These mini economies are slowly being linked through China’s rail system, which is a mix between high speed rail (HSR) and normal rail.

For example, the Wuhan to Guangzhou HSR (1,100km) has shortened the time required to travel between the cities from 11 hours down to three hours (what we call ‘time/cost compression’) allowing for greater productivity gains due to more free time to work.

Moreover, it also encourages people to live further away from their work, as they now have easy access to efficient transportation while paying less for property prices outside of urban centres.

The Hong Kong Trade Development Council released a study in 2008 looking at spending patterns for the population in China living in second and third tier cities.

The growth in consumption from food to medical to appliances was staggering.

Total consumer spending in the 18-year period has grown almost tenfold. This doesn’t even take into account first tier cities where spending power has been even stronger.

Local retailers are seeing this as an opportunity, which is clearly reflected in their expansion models. For example, the sportswear company, Li Ning in 2008 opened 81 per cent of new stores in second and third tier cities.

For Belle International, which is another footwear and sportswear company, revenue growth is 22.9 per cent first tier, 31.4 per cent second tier and 48.2 per cent third tier for 2008.

Staying on the question of consumer goods, brands are becoming more important as part of the shopping experience – and overseas brands are also penetrating the market with mixed levels of success.

One example is Louis Vuitton (LV), which entered 20 years ago and now has more than 15 boutiques spread across 13 cities. Not all brands can be successful, but because of LV’s tier-one consumer status, it can succeed.

A study conducted by Asian Demographics in 2009 looked at the relative importance of ‘shop’ versus ‘brand’. Asian Demographics looked at 13 different consumer goods from automobiles to apparel, and asked one simple question: “Do you first decide which shop to buy at, or which brand to buy?”

For automobiles, motorcycles, digital cameras and air conditioners, brand was more important for over 80 per cent of the surveyed population.

So the question is, how is China managing to be such a powerful consumer nation – and especially out of second and third tier cities?

Looking back to 2008, the government implemented a 4 trillion RMB stimulus package, which included providing universal healthcare, free education as well as the establishment of a government pension system.

This allowed the regular mums and dads to unlock their savings and spend on the goods they previously were not comfortable buying because they didn’t have a welfare safety net.

The analogy of human wants is simple.

If a farmer’s child goes into the city to work and earns 10 times the income compared to if they stayed on the farm, and subsequently they come back to the farm each holiday season with a new pair of shoes, a brand name T-shirt or iPod to the envy of their friends, their friends will wonder why they can’t achieve the same.

Applying this theory to over 50 per cent of the 1.3 billion population of China, you realise how consumer power grows exponentially.

In the same way that retail sales growth has been strong among the middle class, the other growing opportunity is property.

While some commentators have continually portrayed a property bubble, there is a need to look at the hard facts rather than the emotionally driven headlines.

The clear fact is that for the calendar year 2010, tier one cities accounted for only 5 per cent of China’s property sales by volume.

And the other 95 per cent of properties sold were on average 75 per cent cheaper by price than tier one cities.

Consumers outside of tier one cities can afford to purchase properties in line with their living standard.

The closest Western comparison is the United States, where you see Park Avenue penthouses in New York City sell for well over $20 million for 100 square metres in some cases, but in central Texas you wouldn’t need to pay that price because it simply doesn’t match the earning rate in that region of the US.

Overall, as consumers reach higher levels of disposable income, and move into a ‘spend more, save less’ mentality, we identify the following areas which will have positive flow-on effects: real estate, transportation, power supply, roads, railway, consumer products, logistics and fast food industries.

But most of these cannot be captured by simply buying global brands that have some exposure into China and adjacent southeast Asian economies, since they have and will continue to suffer the lag generated by declining levels of consumerism in the western world.

The power of China moving into the future will be in second and third tier cities.

Jonathan Wu is head of distribution and operations at Premium China Funds Management.