Chinese Consumers May Have Only Begun to Teethe

Since China opened the flood gates to foreign investment in the 1990s, the country has significantly outpaced the developed world, especially the US, in terms of economic growth (see Chinese vs. US real GDP growth chart).

Consequences of China’s success have included increased urbanization (see population chart) and a burgeoning middle class.  Never before in China’s modern history have so many had so much, and with a population of over 1.3bn this has created more than just a blip on the map.

One statistic that best represents China’s blossoming middle class is domestic car sales, which have risen quite dramatically over the past five years (see domestic Chinese auto sales chart). But these increments are likely just the tip of the iceberg.

Prior to the global financial crisis, Chinese consumption was experiencing solid growth on the back of rising incoming bolstered by large levels of investment and a strong export industry (see consumption and income chart).

However, as economic turmoil spread around the globe, it became clear decoupling was more myth than reality, forcing the Chinese government to react.  Realizing the frailties of an export-oriented growth model in the face of an external crisis, the Chinese government introduced an unprecedented US$586bn stimulus package designed to stoke domestic demand.  The result: Chinese consumption remained robust while domestic demand in the US faced significant declines (see chart US retail sales vs. China).

Over the course of 2009, US corporations with high exposure to the region sought relief in China to help offset significant losses back home.  One measure of China’s resilience over the US market is the fact that on a year over year basis, Chinese imports from the US fell by only -US$842mn, while Chinese exports to the US plummeted -US$5.9bn (albeit from a higher base) (see yearly change chart).  Additionally, not all goods sold by US corporations in China are imported; many US companies have partnerships with Chinese companies and produce goods domestically.  The list of companies that admitted to benefiting from strong consumer demand in China include Intel Corp., Caterpillar Inc., Coca-Cola, Alcoa Inc., Altera Corp., and Cummins Inc., just to name a few.  Recently, Ford Motor Company announced the construction of a third factory in China to produce high-end sedans for sale in the country.  There is no doubt the short-term effects of strong Chinese domestic demand has been positive for western companies. The question is, is it sustainable into the future?

The answer to that appears to be yes.  Increments in consumption over the past decade may only be a drop in the bucket compared to the country’s full long-term potential. China’s government has realized the shortcomings of its investment and export led growth strategies, and will continue to focus on policy toward domestic demand.   As Chinese Premier Wen Jiabao put it, “to boost domestic demand is a long-term strategic policy for China’s economic growth and the way for us to tackle the financial crisis and stave off external risks.”

But how much slack is in the system? China may have the world’s third largest economy, but on a per capita basis, China doesn’t even rank among the top 100 nations, falling between Armenia and Iraq (see per capita GDP chart). However, its performance in this metric has rapidly been improving.

According to McKinsey Global Institute (MGI), present day China, at least in terms of per capita GDP, holds a striking resemblance to the US circa 1850, the same period in which the US was undergoing its own industrial revolution.  However, unlike the US in 1850, China’s consumption as a portion of GDP is amongst the lowest in the world — herein may lie the key to China’s true potential (see chart China’s personal consumption to GDP vs. US & Japan).

According to MGI, by 2025, with the adoption of effective government policies, the proportion of GDP attributable to consumption could recover recent losses begin catching up with the rest of the world.  MGI estimates that under a best case scenario, China would be able to enlarge consumption’s share of GDP from the present level of 36% to 50% by 2025, while elevating nominal GDP to US$13.2trn, versus US$4.4trn in 2008.  These estimates are arguably overly optimistic, but nevertheless the implications of such a jump are enormous—even MGI’s baseline forecast with policy changes has consumption/GDP moving up to 45.2%.  If these forecasts come to fruition, China’s share of global consumption would jump to between 11% and 13%, meaning a quarter of all new global demand would be derived from the country.  Applying linear growth rates to the organization’s forecasts, we can interpolate the projected growth of Chinese consumption through 2025 (see chart consumption forecast).  Putting this into dollar terms, Chinese household consumption could increase from US$1.4trn in 2007 to US$6.6trn – US$5.2trn – in just 18 years. Contrast this to the past 20 years, during which Chinese household consumption increased by only US$1.3trn.  Considering the effect US$0.7trn in consumption growth has brought China since 2000, any realization toward China’s full potential could surely change the world as we know it.

Source for all Charts: MGI & Bloomberg