By Jim Trippon

Touring China’s mega cities can be terribly misleading, so says China’s up-and-coming leader, Vice-Premier Li Keqiang. Li is correct of course. The bright lights of Shanghai, Beijing and Shenzhen tend to conceal the poverty of the nation’s many rural districts. China is huge and only a few hundred million of its 1.3 billion people have successfully risen to prosperity.

That’s the crucial point in understanding China’s economic and political future. Westerners who have seen the evidence of China’s new wealth don’t understand Beijing’s obsession with aggressive economic expansion, with increasing exports and raising internal consumption. Hundreds of millions of Chinese have yet to experience the glory of getting rich (to paraphrase Deng Xiaoping’s famous call to arms).

China’s per capita GDP remains low, ranking 106th in the world in 2008, ahead of Iraq but behind Armenia, according to the International Monetary Fund. China also faces problems such as an inadequate social safety net with little security for the elderly.

That’s why, despite its economic miracle, China is only the fifth-largest consumer market in the world. This perspective comes from a new study by McKinsey Consulting. Consumer spending in China accounts for a much lower percentage of the economy than the United States, the UK, Japan or Germany. China’s consumer spending makes up only 36% of GDP in China. Compare that to the US where spending made up a stunning 71% of GDP (before the global financial crisis).

As we noted in our fist installment on consumer spending in China, Beijing is well aware that increased internal consumption is crucial to reducing the nation’s reliance on exports. The government is taking steps to stimulate spending with cash subsidies, many of them directed at the rural poor. Incremental changes are also being made to improve the nation’s social safety net with increases in spending on health care and pensions.

The world-famous saving habits of the Chinese people are often attributed to a sense of deep insecurity about medical care, pensions and other social benefits that western nations take for granted. Without a social safety net, the Chinese are always careful to save for rainy days.

The McKinsey study, first publicized by commentator Jim Jubak, sets out three options for consumerism in China.

- If Beijing takes no further action, consumption would rise to about 39% of GDP over the next 15 years simply because of the nation’s increasing wealth.
- If the government decides to continue improving the social safety net, internal consumption would rise to 45% of GDP.
- The third option involves a wholesale restructuring of China’s economy to emphasize consumerism. That would boost consumption to 50% of GDP and add $1.9 trillion to global economic activity.

Option number three seems desirable but unlikely because it would involve major changes to the system, including a jump in interest rates, a flood of consumer level credit and sharp wage increases for workers.

Option number two reflects the government’s current incremental policy to improve health care, beef up pensions and assist with educational expenses. Jim Jubak and I agree that China is likely to continue the policies it is currently following, and that means more mild stimulus and gradual improvements in the social safety net. In this scenario, McKinsey projects a rise in consumer spending to 45% of GDP in the coming 15 years.

That’s still a lower spending percentage than South Korea, but the China of the future won’t look like South Korea. Because of the ongoing disparities between urban wealth and rural poverty, China’s mega cities will grow even wealthier. The tastes of city dwellers for luxuries will increase even further. Rural consumers will likely receive ongoing subsidies to improve access to basics such as household appliances.

A projected 9% increase in consumer spending is a vast amount in a country as large as China. Thanks to McKinsey’s projections, we now have an improved long range outlook on consumption. Ongoing growth is very likely in spending on discretionary items and luxuries in China’s numerous mega cities. In the countryside, there will likely be growing demand for inexpensive automobiles, low-end cellular phones and appliances. For investors outside of China, this means ongoing demand for the world’s resources including energy and base metals.

Jim Trippon,
China Stock Digest Editor-in-chief

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