July 1, 2009


To sustain growth, China must boost its domestic consumption. That won't be an easy task.

The prosperous face of the new Chinese consumer was on glittery display at the Shanghai Auto Show in April. The world’s major car companies, many that had made only token or no appearances at shows from Detroit to the European Union, flocked to the exhibition in China’s most populated city.

Leading the way was Porsche, which picked Shanghai to debut its first-ever four-door sedan, the sleek Panamera. It starts at US$89,800 in the United States and ranges upward to US$366,000, in China, for the V-8, turbocharged chauffeur-driven version because of China’s beefy taxes on imported cars and family vehicles with large engines.

“The center of gravity is moving eastward,” declared Dieter Zetsche, chairman of Daimler AG, one of Porsche’s competitors and maker of Mercedes-Benz automobiles. Mercedes had its best sales month ever in April after just breaking its record in March in China, bringing year-over-year sales up 72%.

In the United States, there are about 482 cars for every 1,000 people. In China there are 10 per 1,000. Because of the recession, the government offers tax breaks and outright subsidies, especially to rural farmers, to buy new vehicles. Safe to say they will not be putting new Panameras in the driveway any time soon. But China sold more cars than the United States for the first time ever in the first three months of this year. And that is in the teeth of a downturn that saw China’s 2009 GDP growth for the first quarter slow to 6.1%, from the World Bank’s November 2008 estimates of 9.2%.

For contrast, to see the uncertain, even bumbling face of the country’s consumer economy, fly 750 miles southwest from Shanghai to Hong Kong, and drive another 62 miles to the city of Dongguan. There sits the vast and ambitious South China Mall. At 220 acres, with space for 1,500 stores, an indoor amusement park and replicas of seven distinct global destinations including the cities of Venice and Amsterdam, it is the largest shopping mall on earth. It is fully twice as large as America’s biggest, the Mall of America in Bloomington, Minnesota.

The South China Mall, four years after opening, remains more than 90% vacant.

This empty sprawling monster sits waiting, symbolic of what China’s domestic, consumer-driven market can become, but also representative of what stands in its way. “The South China Mall was a stupid project, poorly planned from the beginning,” says Shaun Rein, managing director of the Shanghai-based China Market Research Group. “It’s exactly the type of project the government loves. It’s too big, in a poor location, and you have to have a car to get there. Besides people don’t spend their money in Dongguan because Hong Kong is so close.”

Which is not to say that the mall will necessarily remain a lemon. “It was too much too soon,” says Ira Kalish, director of global research for Deloitte, the international consultants. Kalish has just finished updating his 2005 detailed study of China’s consumer market. “There were not enough sophisticated retailers to fill it and it is hard to get to. Eventually it will fill up and do well.”


Kalish’s prediction is probably an excellent one, considering the dramatic economic transformation that will almost certainly take hold in China over the next decade. As it grows to be the second-largest economy in the world, it is all but certain to become a far more muscular player on the global diplomatic stage as well. Already Chinese officials have been scolding the United States, for instance, for allowing a rapacious Wall Street to torpedo the American and global economies. They also have suggested that it’s time to consider replacing the U.S. dollar as the global reserve currency with something fresher and better controlled, such as the yuan.

But beyond public posturing, in global as in local politics, money speaks loudly. The Chinese know that and are unlikely to be bashful about their new power platform. Perhaps most important, that platform will sit atop a growing, strengthening, diversifying and hence more transparent and less isolationist economy that, in the view of most China watchers, will inevitably be shifting from a reliance on cheap and voluminous exports and giant, government-owned businesses to a more balanced, higher technology and consumer-driven economy.

This will mean that many of the toughest trade issues the United States has with China may ease substantially and even disappear. As China’s consumer markets open to everything from automobiles to medical services, there will be huge opportunities for American and other foreign companies to invest and sell in China. Likewise there will be little economic need to continue the long-standing manipulation of its currency and subsidization of its manufacturing sector that supported cheap exports. China is already losing its position as the low-cost producer of most products, and that will continue. But that loss will only strengthen its economy as it turns to higher-valued goods produced by more skilled, higher-salaried workers and as the flight of its poverty-stricken farmers from country to cities accelerates.

For the world, China will offer vast new markets and wield a heavier political stick. But if its political and economic clout is to be sustainable as the Chinese themselves desire, most analysts and economists agree that China also will be learning another crucial lesson. As House Speaker Sam Rayburn said as he was spearheading the effort to pass New Deal legislation in the 1930s, “You have to go along to get along.” To make their new economy work and last, the Chinese will have to learn compromise, collaboration and inclusion.


China today is still trying to overcome a cultural aversion to spending and borrowing, including a still-strong reluctance to use credit cards, those passports to a consumer economy. As a country, it saves an astounding 25% of disposable income. Even so, this in an economy with a retail market worth US$1.59 trillion (yes, that’s trillion), as estimated by Deloitte, and projections see it remaining on that track.

But it is also an economy that in the last decade has driven its double-digit growth with bottom-feeding wages and devastating air and water pollution from inefficient manufacturing. It has produced a record tonnage of low-cost and too often low-quality, if not outright poisonous, exports of everything from steel to toys. All true as we look in the rear-view mirror.

These days, however, that rear view does not offer much of a business plan, and most especially not for China. “There is a high awareness in the Chinese government of the need to rebalance the economy,” says Pieter Bottelier, economics professor and China scholar at the Johns Hopkins University School of Advanced International Studies. “They clearly see the need to move toward a more domestic-oriented economy. The question is, how soon can they do something about it?”

“There are two stories here, the one- to two-year story and the longer term,” says Ben Simpfendorfer, chief China economist in Hong Kong for the Royal Bank of Scotland. “In the next year, the economy will be increasingly public-sector driven. The [government-announced US$600 billion] stimulus will be continuing the lopsided public economic emphasis, which makes for a fragile economy and fragile growth.

“But the world economic crisis is probably the best thing that ever happened to China,” he says. “Now China has got to boost its domestic market, make it easier to sell into that market, because those huge export markets are not there and won’t be for a long time.”

Little wonder, then, that the Chinese and the world’s economies as well are looking to China’s underemphasized consumer sector for opportunity and a way to sustain growth. Consumer spending in China these days is about one-third of its gross domestic product. In the United States, such spending makes up nearly three-quarters of GDP.

“But the U.S. and China are now moving in opposite directions,” says Deloitte’s Kalish. “The U.S. will be a bigger exporter, especially of higher-value goods, and consumer spending will play a smaller role in the economy, dropping from 72% of GDP to perhaps 60% or 65%. And in China, as the domestic economy develops, consumer spending will move from the present 36% or so to more than 50%, a more normal range.”


Kalish and others expect this to happen steadily and surely. While Shaun Rein at China Market Research Group estimates consumer spending will be half of the economy in the next five years, Kalish puts it at six or seven years, and says that is “not a particularly aggressive prediction.”

“After all, household consumption growth in China has been the highest in the world for the last 10 years, between 8.5% and 9%, and it remains strong,” says Bottelier. “It’s just that the GDP was growing faster. With the slowdown, this imbalance will really take care of itself.”

Recent surveys of Chinese consumers tell much the same story. Remember, too, that in a country of more than 1.3 billion people, measurable consumer spending takes place mainly in big cities. China’s urban population now runs about 575 million and growing. But its middle and upper classes, those with steady jobs and more than subsistence incomes, may total no more than 200 million. And growing. “We are developing a middle class that numbers some 250 million and makes between US$5,000 and US$15,000 a year,” says Rein. “And when we interviewed these people in 10 cities, 60% said they were going to spend more on things this year.”

The Financial Times did its own survey in 189 cities in March and put the number of middle-class or discretionary Chinese spenders at 192 million. It found nearly half saying they would be spending more on stuff this year. The FT described these folks as “brand-conscious, investment sensitive, credit-consuming, well-educated, IT-savvy, leisure-seeking and upwardly mobile.”

It said they would be spending their money on computers, education, tourism, Internet purchases such as games and books, apparel and automobiles. The Chinese Market Research Group study also pointed to computers, but found that high-end cosmetics, online games, $3 to $7 middle-level meals, and second-hand sales of mobile phones and other consumer electronics would be strong as well.

It is hard at first to grasp the scale of China, both in population and potential, especially for Americans with still the most powerful economy in the world built on a population of slightly more than 300 million people. In China, there are said to be more than 670 million mobile-phone subscribers. At the same time, the World Bank reports that by one standard of poverty—people who make less than US$1 per day—that China’s poor number approximately 135 million.

In any case, Chinese consumers with money are spending it and will continue to do so, in spite of savings rates nationally that are a stunningly high 25%. In the United States, savings of disposable income have averaged virtually zero for the last several years, apparently inching up into the 5% range only around the first of this recession-driven year.


Still, China’s savings habits are obviously shifting along with its consumer spending. One of the most recent and certainly most rigorous studies of spending and savings was released last December by the Stanford University-based National Bureau of Economic Research (NBER). It confirmed that Chinese nationally had increased their household savings rates from an average 17% in 1995 to an average 24% in 2005. The main reason, it said, was that, as the country transformed its economy to a more capitalistic, market-based system, it had largely dismantled the free health, education and pension systems that had comprised a so-called “social safety net” for its citizens. Concerned about how they would pay for their health care, their education and their old age, the Chinese people began hanging on to more of their money.

The NBER study concluded that restoring some of that safety net, most crucially for health care and education, would be important to creating a vibrant consumer economy in China.

“China needs a beefed up social safety network to reduce the savings rate,” says Dr. Neil Wang, general manager of Frost & Sullivan China, the international consultants. There is evidence that the government understands this. It has announced, for example, a US$120 billion health care reform program to provide nearly universal care, build new hospitals and put a clinic in every village in the country by 2011. “China is revamping its ailing health care system, setting up a social security system which was largely dismantled over the past three decades,” says Dr. Wang, “and plans to roll out a nationwide nine-year compulsory educational program by 2010.”


The consensus is that the country’s economy will continue to grow through this year and improve further in 2010. The government’s public growth goal has been 8% for the year, down from 13% to 15% in ’08. As April ended, economists who had scoffed at that possibility were changing their minds. Earlier estimates had ranged from a low 5% to a high 7%, but a late April Goldman Sachs report came bellowing out with an 8.3% prediction. “Even at 5%,” says Simpfendorfer of RBS Hong Kong and one of the more cautious economists, “a lot of countries would kill for that.” U.S. GDP declined 6.3% in the fourth quarter of last year.

Even as the China outlook seemed to improve, a number of stubborn financial elephants remained that could stomp out any rebalancing and further improvement in the economy.

Leading the list: a financial system badly in want of retooling, most notably its need for more transparency and a strong, reliable credit system. Perhaps even more important, the government was still not embracing vigorous development initiatives for small and medium-sized businesses.

“Their emphasis really has to be on the employment side, especially in the short term,” says Professor Bottelier at Johns Hopkins. “The fiscal stimulus money very possibly is not being spent where it will do the most for job growth. There is a risk it is ending up in the wrong pockets and might increase the non-performing loan rates in the banking system.”

“My concern is there is too much government investment that is wasteful, loans to these big state-owned enterprises that are terribly inefficient,” echoes Shaun Rein at CMR Group in Shanghai. “I’d like to see more small business loans. China has not made it easy for entrepreneurs, the three- to 15-person small businesses that are tremendous engines of growth.”

“On orders from the government, the state-owned banks have poured three-quarters of a trillion dollars into the economy in the last three months,” says William Gamble, consultant on emerging markets and author of Investing in China and Freedom: America’s Competitive Advantage in the Global Market. Gamble has been a consistent bear on the Chinese economy for more than a year. “I’d guess that at least 5% of these bank loans have been stolen outright. It’s not just the Chinese. You can’t do that kind of thing anywhere without loads of it disappearing. In a country with endemic corruption and self dealing, it is inevitable.”

Bottelier estimates it could be 12 months or more before the extent of bad loans after this round of lending becomes apparent. “But, you know, the [Chinese] economy is so large now and the banks are quite strong, so I don’t see that [bad loans] will be nearly as big a problem as it once was.”


“China realizes it really can’t solve the unemployment problem by giving money to state-owned companies. Its only hope is the private sector, which has been the most dynamic in the last several years,” Bottelier says. “But small businesses don’t have access to big bank loans. They survive on a kind of underground, but well-developed, financial system. That has got to change.”

The government has been insisting that these problems are being addressed. Gamble does not believe it. But each of the other economists interviewed for this piece do. They caution, however, that none of it will happen overnight. The government has set up a fledgling NASDAQ-style stock market, with regulations expected before the end of this year. It has created a number of International Investment Funds with US$20 billion in central government money looking for both foreign and domestic investors to participate to grow China business. “Twenty billion may be a drop in the bucket,” says Clarence Kwan, partner and head of Deloitte’s China Services Group. “But it’s also another sign that the government realizes it has to play a bigger role in promoting investment.”


There is little disagreement that the two most important economies in the world are and will be that of the United States and China. As we know, too, China is the United States’s biggest creditor, holding probably as much as $1.5 trillion in U.S. securities. Some have worried that would give the Chinese government too much leverage to mess with the U.S. economy and government. “It’s a good thing that China has so much U.S. debt,” counters CMR Group’s Shaun Rein. “China has to cooperate with the U.S. or it will lose all its money.”

Currency issues aside, the economists, analysts and academics we spoke with agreed the inevitable rebalancing of the Chinese economy offers tremendous opportunity for American business. But for metals producers, maybe not so much.

American steel makers have been among the most vocal lobbyists for a crackdown on Chinese imports made artificially cheap by currency manipulation. They got a rude awakening in the spring. After declaring China a currency manipulator during his campaign, and promising action that the Bush administration failed to take, Obama as president backed down. Noting that China’s currency has appreciated 21% since 2005, Treasury Secretary Timothy Geithner said the currency is still undervalued but went out of his way to praise China for its “commitment to a greater flexibility and the need to allow the exchange rate to adapt to an equilibrium level.”

Another dark cloud for metals: It is clear that industrial China is already overbuilt and likely to become more so in the short term, as the government pours stimulus money into its state-owned manufacturing sector. Thirty percent of its aluminum capacity is idle, for example. It now has the capacity to make some 660 million tons of crude steel but puts out only some 500 million, still making it, by far, the world’s largest producer.

“China went way overboard building steel capacity in the last 10 years,” Bottelier says, “but it also now consumes at least 90% of what it produces domestically, which is incredible.”

Still, for the next few years at least, it would appear that North American steel makers will be seeing more attempts by China and others to shove low-cost steel into this country. Housing and commercial construction, important engines for metals demand, will not return to the boom years, says Simpfendorfer. Although the auto market will strengthen, he expects the steel for cars to come mainly from domestic mills.


At the same time, China probably will offer markets to foreign producers and vendors that have not existed before. “Here is where I see that the U.S. steps up,” Simpfendorfer says. “It can be a big exporter of health care technology, hospitals, schools and education technology, even tourism. And the Chinese are very keen to hear what the United States has to say about pollution controls and energy-efficiency improvements.”

“American companies have got to be selling into China,” says Rein, “they’ve got to be looking at China as the next great consumer market.”

Already, some major U.S. companies have established a foothold in the China economy, though their rate of investment has slowed with the recession. Overall, for example, foreign direct investment in China dropped 21%, compared to the same period last year, to $US27.7 billion in the first quarter of 2009.

But Deloitte, among others, says foreign business presence in China still has lots of room to grow. It points to Wal-Mart, one of the world’s most aggressive retailers, which only edged into China’s top 10 last year and commands less than 1% of the China market. Likewise, the giant French retailer Carrefour, now China’s sixth largest, holds a similar, miniscule grasp on that market. General Motors has said it plans to double sales to two million vehicles a year by 2014 and will build additional manufacturing there to meet that goal.

“The government has selected 10 industries, from electronics and machinery to petrochemicals, for revitalization, and that is where U.S. and other countries’ business should look for opportunities,” says Clarence Kwan, head of Deloitte’s China Services Group. “There will be tremendous opportunities in green tech, and improving the social safety net, health care, insurance and medical devices.”

For America, China’s emergence may well turn out to be very good news. “U.S. manufacturing was doing very well before the recession,” Kalish reminds us. “And it will do so again, but this country will be less dependent on consumer goods and more on exporting chemicals, aerospace components, high-tech medical devices, software. The things we are good at and that China and the world want and need.”