Structural, political and cyclical trends are converging to boost Chinese consumption, which is poised for a secular uptrend. Crucially, Beijing is experimenting to scrap the household registration system and to allow private investors to set up lending companies.
These are bold moves to restructure the old system by allowing market forces to work better. They are also initial steps to unleash consumption power by reducing labour market distortions and relaxing consumersÆ budget constraints. Investment vehicles that have exposure to Chinese retail and financial sectors are poised to benefit the most. There will also be rising financing needs from companies with exposure to ChinaÆs thriving retail sector, including property.
Structural factors
The structural support includes steady income growth, accelerating urbanisation and a growing middle class. The expected annual average 8% GDP growth in the coming decade would easily support an average 10% retail sales growth a year. This benign growth backdrop is, in turn, a result of structural reforms, which have gone deeper than previously thought.
Urbanisation is speeding up due to economic liberalisation, giving rise to increasing retail demand. Beijing is experimenting with ending the half-centuary old hu-kou (or household registration) system. By tying individuals to their birth place via registration which determines their state benefit entitlements, the system has retarded labour mobility, income growth and urbanisation and, hence, consumption growth.
Starting in 2006, the government of Shangdong province (with the blessing of Beijing) has scrapped the hu-kou system. The move could be a forerunner for a similar national policy later, which will be very positive for consumer demand.
Meanwhile, a growing middle class is boosting retail demand of all sorts. ChinaÆs middle class (defined by the World Bank as the share of population with per capita annual income of US$3,000 or more), estimated to be only 4% of total population today, is expected to grow more than six-fold to about 360 million by the turn of this decade.
The consumption power behind these forces has been unleashed by creative destruction (as inefficient sunset industries are being destroyed to make way for more efficient sunrise industries) and financial liberalisation. The latter makes ChinaÆs greying population a non-binding budget constraint for consumption.
Financial liberalisation allows consumers to borrow to fund current consumption. ChinaÆs personal loan market has grown leaps and bounds since it was opened up in 1997, with mortgage lending growing by an annual average of 80% and other personal loans by 34% per year between 2000 and 2004.
However, this market is still in an infant stage, as mortgage loans account for only about 10% of total bank lending and other personal loans just over 1%. Further liberalisation will thus sharply boost consumption.
Cyclical forces
At the same time, global demand is slowing under the weight of high interest rates and oil prices and trade frictions with the developed markets could shadow ChinaÆs export outlook. In the next few years, Chinese exports are expected to grow at half the 33% average rate between 2003 and 2005.
Contrary to common belief, investment is unlikely to get an extra big boost from the estimated Rmb300 billion Olympic-related spending (about 7% of annual national fixed-asset investment). Most of this investment is urban infrastructure projects, like roads, telecom, environmental projects, hotels and commercial buildings, that would have been undertaken anyway. Sports facilities will account for only about Rmb30 billion.
Crucially, the bottleneck conditions that boosted investment in 2004 and 2005 have been eased, as the government has pumped massive investments into the congested sectors, like coal, power, oil, mining and railways. There are now concerns that these sectors may even face excess capacity.
Domestic corporate profit growth has peaked, though this is not a sign of a sharp economic decline. ManufacturersÆ pricing power has been capped, due to rising competition and excess capacity, especially in sectors like autos, chemical, steel, cement and electronics. Cheaper prices will benefit the consumer but lower margins will drag on investment, thus switching the growth momentum to consumption.
Policy pushing for changes
Government policy is encouraging the shift to consumption-led growth. Monetary policy is likely to be less supportive for investment going forward, as the past monetary expansion and a secular rise in energy prices have put the central bank on inflation alert. Interest rates in China have been kept too low for too long and warrant the authoritiesÆ attention.
Meanwhile, the RMBÆs long-term appreciation and the ending of many export tax rebates will encourage manufacturers to switch from exports to domestic markets. The 11th Five-Year Plan, approved this March, has set policies to boost domestic consumption as a top priority.
To distribute income more evenly, Beijing will spend more on infrastructure and power networks in the rural areas. It has also eliminated all agricultural taxes and lifted the personal income tax exemption allowance to spur consumption.
In a bold move, Beijing has recently allowed domestic investors to run lending companies in the Pingyao county of Shanxi province. This acts to increase the consumersÆ (and small firmsÆ) accessibility to capital and, thus, boost spending. The experiment could be a harbinger of a national policy, which, like the scrapping of the hu-kou system, will be very positive for consumer demand.
Implications
The investment themes under this new macroeconomic backdrop are consumption, urbanisation and financial liberalisation. In other words, investment in these and their related areas should out-perform the market. But for those who are interested in ChinaÆs retail sector û retail properties, stocks or debt instruments û the following should be factored into their risk analysis:
While Beijing is clear on the retail sectorÆs liberalisation, city development plans and their implementation remain volatile. This creates uncertainty for the formation and development of catchment areas for the retail business, thus affecting its profit performance.
The biggest challenges for retailers are logistics and finding suitable space. Coal and grain dominate the rail network, making trucking the only option. But the trucking industry is highly fragmented. Most operators own only a handful of vehicles so suppliers are often forced to have contracts with hundreds of operators.
Then there are problems with copycat products and privacy of intellectual property rights. Illegal substitution, with genuine products being replaced by fake products in the supply chain, is also an issue.
Potential supply of retail property is also uncertain. There is a risk of unexpected supply coming to the market, due to uncertainty in the developersÆ and city governments' development plans. More foreign capital flowing into retail property development will also boost future supply, putting pressure on the asset value.
From a reform perspective, China is moving into a tougher path, as reform goes deeper to shake up the old system. Meanwhile, the success of ChinaÆs economic growth has built up BeijingÆs confidence to keep the growth momentum. However, it remains to be seen if this confidence will be extended to allow more market forces to function.
This growth transformation to a consumption-led economy is still heavily policy directed. However, BeijingÆs recent bold experiments to end the hu-kou system and privatise lending are encouraging signs that the leadership is willing to tackle the root problems inherited from the central planning system.
Chi Lo,is an economic strategist and author of the ôPhantom of the China Economic Threatö, Palgrave Macmillian, 2006
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