Recent news from China about slowing growth and exports, the depreciation of the renminbi, and volatility in the stock market, has painted a pretty gloomy picture.
But from my vantage point here in China, I take a more positive view toward the country’s economic situation. The progress that private companies are making, and the success of many firms at selling to China’s rapidly rising middle class, are just two of the reasons why I remain positive toward China’s economic prospects.
In this post I focus on why I continue to feel broadly positive about the economy, and what are the four trends that business leaders should pay close attention to. In a follow-up post, I will cover some of the risks that could throw the economy off course, if not handled well.
Why I remain positive
China’s actual and potential growth path has slowed considerably, but it is still a US$10 trillion economy, and it is growing faster than most of the world’s top 20 economies. This growth is mainly driven by consumer spending and is spending that increasingly goes toward services and not products.
Chinese consumers still feel confident and are spending to reflect that. Chinese consumers feel secure in their jobs (with over 7 million new urban jobs in China year-to-date) and have rising incomes (up 8% over the last year). Much of China’s wealth is concentrated in the younger generation who see much less reason to save than their parents did, and for whom paying for a service that saves them valuable time is a trade-off worth making.
Not only are they willing to spend, but they also don’t really see good options for investing. The stock market is a lottery, property investments are generally not rising in value, and banks offer negligible interest rates. Spending seems a pretty good alternative to saving. These consumers have over US$9 trillion in financial savings today, according to JP Morgan. The potential for them to spend more in the years ahead is already in place.
While China’s manufacturing sector has grabbed our attention, China’s service sector has quietly been powering ahead with the Purchasing Managers’ Index at 54-55 (anything over 50 indicates an expansion in purchase of services). This year will likely be the first on record in which services represents more than 50% of GDP (up from 46% only 2 years ago).
This is not just about Internet enabled services, such as e-retail and taxis. Very traditional service sectors are growing fast. Take cinemas for example – box office revenues in the first half of 2015 rose almost 50%, the turnover of second hand car dealers rose over 30%, rail travel was up by over 10%.
Services that were almost non-existent in the past such as elderly care and vocational retraining are becoming job creation engines. Foreign investors should pay close attention to the opportunities in services as the majority are fully open to international investors.
On more specific issues:
- Currency – we had similar scale adjustments in the past, and certainly the trade weighted exchange rate is still stronger than a year ago.
- Equity – the market is still up 30% year-on-year.
- Capital outflows from China have been much larger as a % of GDP in the past.
- Housing sales have been up for the last two quarters.
Four trends that matter in China today
There’s lots of noise in the system, but where are the real underlying signals? Let’s take a look at four trends that are shaping the economic landscape in China today:
Trend #1: Consumers have money and are increasingly willing to spend it.
China’s middle class feels secure in their jobs today after a decade of rapid income growth and widespread availability of opportunities. Consumer confidence is closer to 110 than 100 on most surveys, consumption growth was higher in Q2 than Q1 of this year with real disposable income up 8% year to date, and spending rose 10%.
So China’s middle class is finally spending more and saving a little less. Yet there is a long way to go – consumption is still only 37% of GDP in China versus 60% India and 70% in the USA.
There are several reasons for this shift. Most Chinese middle class own their own home and car now. They don’t need to save for these lumpy purchases. And the generation that is 25-35, where most of the wealth resides, has never known a recession. The experiences of their parents and grandparents of needing to save for bad times is just a history lesson to them, not personal experience.
And with the stock market looking less attractive, good investment options are scarce, so why not spend a little more. With over US$9 trillion in the bank, according to JP Morgan, Chinese consumers certainly have the firepower to drive the economy forward.
With over US$9 trillion in the bank, according to JP Morgan, Chinese consumers certainly have the firepower to drive the economy forward.
Trend #2: Consumer spending is shifting to services, and could grow a lot faster if supply issues were fixed.
The service sector’s share of the economy is rising fast, from 46% in 2013 to 50% this year. Unsurprisingly, the Purchasing Managers’ Index (PMI) has held at 54-55 pretty consistently over the last 4 years (over 50 indicates growth in purchase of services). Sector value rose 8.4% in Q2, employment rose 5-6%, and investment was up 11%. All good numbers, but they could be much higher.
As Chinese consumers place a greater value on their time, they are seeking better quality services to free up time for what they really want to do -and they are willing to pay for them. Consumers have historically held back from spending on services not only because they wanted to save, but also because what was on offer was not really worth spending on:
- Lack of access to services. Many services just were not even available, like elderly care and credit services to start-up businesses. The same has been true in healthcare and education. Outside of the big cities, options were very limited.
- Poor quality of services. Even where services have been available, they have been poor. Traditional banking services and healthcare services took hours of a consumer’s time. Consumers are often forced to feel that they are lucky to get any service at all. And if you look on sport as an entertainment service, the quality of sports like soccer lagged far behind other much smaller Asian economies.
- Inefficient and high cost. A third reason not to spend on services is that they are expensive and inefficiently delivered. Service sector productivity in services is only about one-third that of the OECD average. Logistics, for example, consumes 18% of GDP in China versus 7% in the US.
A totally realistic set of improvements to China’s service sector could easily add $2 trillion to China’s GDP by 2025. The good news is that the private sector is investing to deliver better services. Some are going overseas to acquire skills – for example, Wanda just bought the world’s leading organizer of triathlon events.
Chinese theme park companies are closely observing the development of Disney in Shanghai to learn how to upgrade their performance. The explosion of Internet enabled services from banking, to retail, to transportation and healthcare, is transforming sectors within only a few months.
A totally realistic set of improvements to China’s service sector could easily add $2 trillion to China’s GDP by 2025.
But it isn’t all Internet driven, for example:
- Second-hand car sales in July saw value up 33% and volume up 40% over last year.
- After lots of investment, cinemas are now offering a great product and service. Consumers are willing to pay up to US$20 a ticket. In the first half of 2015, ticket sales were up nearly 50%.
- Even passenger rail revenues are up 8% and air passengers are up 11% in recent months.
Trend #3: Capital is substituting for labor almost everywhere, except in government.
With slower growth, greater efficiency has become the priority across all businesses. CEOs tend not to be looking to borrow more, or to invest more (overcapacity is common), nor are they looking to hire more. The message to management is how we get more from what we have. There is a lot of low-hanging fruit.
Energy for example has been treated almost as a free resource by many state-owned enterprises. I have seen simple energy audits that lead to a 20-30% reduction in energy consumption within 3 months.
Production lines look very different than a few years ago. Not no people, not full automation, but an intelligent combination of automation and higher skilled labor.
In services, we are just starting to see the impact of investments made in the sector on employment – how many bank branches will be needed when banking is largely conducted online, how many insurance agents will be needed when insurance is largely sold online; certainly not the millions that exist today.
The result is a much more dramatic separation of winners and losers in many sectors. Winners execute in world-class fashion on this drive to greater efficiency; they embrace opportunities to innovate; and are ready to challenge more internationally. Losers fall back on the traditional request for government support and protection.
However, the government is lagging in applying these experiences to itself. In a country where citizens are willing to do almost anything online to save time, money and get better service – interaction with government is a series of time-consuming battles. A more efficient option, if offered at all, is only available to those willing to pay a massive premium.
It is important for its credibility that government applies technology to its own services. Being able to make a doctor reservation online is good, but is essentially a private sector provided service. What about all the license renewals and fee payments that citizens have to make?
Running China is becoming much more expensive even though teachers, doctors, civil servants, security forces remain underpaid relative to their private sector peers. The impact can be seen in fewer students taking civil service exams, and fewer of the best students joining government. For a government less cash rich and more talent hungry, this is a growing problem.
Trend #4: Property is holding steady.
Despite what you might have inferred from some press articles, construction will remain a pillar industry in China. The need to upgrade China’s stock of residential housing and office space remains. Indeed, much of what was built only 20 years ago will soon need extensive refurbishment.
The overshoot that resulted from the 2008-10 stimulus is slowly (and unevenly across the country) being unwound. Year-to-date sales are up 18%, starts are down 21%, and prices are holding steady. This results in a reduction of GDP growth of up to 1.5% (source: UBS) in 2015. By 2016, property will be contributing to economic growth again.
There will also be a flight to quality in property. One of the legacies of the recent explosion in Tianjin is that consumers will not buy property that is anywhere close to what they perceive might be a risky location. This event has also driven a flight toward quality developers who have a reputation for constructing buildings that don’t degrade badly within the first 20 years of their life.
China retains the potential to generate 20-30% of the world’s economic growth for many years to come. Realizing this potential requires accelerating an already rapid shift to a strong service economy. But that will only happen if tens, if not hundreds of millions, of people are retrained to succeed in 21st century service businesses, and if service industries become more widely available, are of better quality, and are delivered at lower cost. This is at the heart of the current economic challenge for China’s government.
So what about the risks? What could go wrong?
That’s the topic of my next post.