Photo taken on Monday, Sept. 14, 2009 shows the array of Columns of Ethnic Groups Unity, on the east side of Tian'anmen Square, in Beijing. A total of 56 Columns of Ethnic Groups Unity, one of the landmark decorations for the grand celebration of the 60th anniversary of the founding of People's Republic of China, on October 1st, start to be installed. Each column stands at a height of 13 meters and weighs 26 tons, depicting the vivid figures of each ethnic group's people in festival dress who are singing merrily and dancing gracefully. Photo: Xinhua
A popular notion among many market observers is that China over-invests and under-consumes, according to Morgan Stanley economists, based in Hong Kong. However, there seem to be two related but distinct concepts of ‘under-consumption' as far as China is concerned: domestic versus international dimensions. The domestic dimension of ‘under-consumption' is about the underperformance of household consumption relative to the rest of the economy: over the past decade or so, the growth of China's household consumption has been outpaced by fixed investment growth and exports and consumption as a percentage of GDP is low and has been on the decline.
The MS economists Qing Wang & Steven Zhang say that the international dimension of China's ‘under-consumption' is that the contribution of the Chinese economy to the global economy as a consumer is much smaller than as a producer. More specifically, ‘over-consumption' has made the US an economy of US$10 trillion in personal consumption, while China is an economy of only US$1.6 trillion in personal consumption due to its ‘under-consumption'. If US consumers were to stop spending, the negative impact on the rest of the world would be too large for the Chinese consumers to play a meaningful offsetting role.
Underestimation of China's Consumption of Services
The economists say that China's ‘under-consumption' - - especially along the international dimension (i.e., relative to personal consumption in other countries) - - has in part to do with underestimation of China's consumption of services, in their view. According to official statistics, the service sector (i.e., tertiary sector) accounted for 40% of China's GDP in 2008, and they estimate that consumption of services represents 26% of total personal consumption.
The consumption of services in China is substantially lower than that in not only industrialized countries but also China's peers among emerging market (EM) economies. For instance, while consumption of services in industrialized countries like the US, EU and Japan accounts for about 66%, 40% and 57% of their respective overall personal consumption, the shares of service consumption in total personal consumption in China's EM peers in the region such as India (39%), Korea (57%) and Taiwan (56%) are also significantly higher than that in China.
The economists say that the underestimation of the importance of the service sector was more serious before the substantial upward revision of GDP in 2005 after the first nationwide economic census was completed. In the 2005 GDP revision, China's 2004 GDP level was revised up by 16.8%, and 93% of the increase was due to a substantial upward revision in the service sector such that the share of the service sector was lifted from about 32% to 41%. In explaining the revision, the National Bureau of Statistics noted that China had long been using the Material Product System (MPS), which was developed under the centrally planned economic system in its national accounts statistics until the 1980s, resulting in ‘very weak' statistics for the service sector. The second nationwide economic census is now underway, and the results will probably start to be released later this year and next year. The potential revision of the historical national accounts data will likely result in another significant upward revision of the share of the service sector in GDP, in the MS view.
A key source of underestimation of service consumption in China is the consumption of housing, in the view of the MS economists. Based on official statistics, they estimate that the consumption of housing accounts for only about 3% of personal consumption in China. This seems too low to be even close to the reality. As a comparison, consumption of housing represents about 16% of personal consumption expenditure in the US and 6.6% in India.
The economists say that an important reason for the seemingly low housing consumption in China is that the imputed rent of owner-occupied housing is not appropriately accounted for. In other words, the statistical methods used in the US and China to estimate the consumption of housing are quite different. The fact that the house-ownership ratio in China is over 80% suggests that the potential underestimation in this regard could be quite substantial.
Another important source of underestimation of service consumption in China is personal spending on healthcare. While the share of spending on healthcare in the US is 15-16% of total PCE (personal consumer expenditure), this share in China is only about 6%. However, the economists say there is no shortage of anecdotal evidence suggesting that there are substantial gray and black markets in health spending in China - - which are not captured by official statistics.
A like-for-like comparison: a top-down approach
MS says the potentially substantial underestimation of the scale of China's service sector makes a cross-country comparison of the overall personal consumption between China and other countries - - where the size of service sectors is more reliably estimated - - misleading and thus could overstate China's ‘under-consumption'.
The economists sought to make a more like-for-like comparison by examining personal consumption of the non-services, tradable goods sector, where such underestimation is less of an issue.
A comparison of consumption of non-services, tradable goods between the US and China indicates that the gap between the US and China is much smaller than suggested by the headline overall consumption data. In 2008, the personal consumption of non-services, tradable goods in the US and China was US$3.2 trillion and US$1.2 trillion, respectively, or China's figure was about 38% of the US level. This is more than double the ratio of 16% as suggested by the two countries' data for overall personal consumption (i.e., US$10 trillion in US and US$1.6 trillion in China).
Whether excluding the service sector or not makes a big difference in estimating the importance of personal consumption in China relative to the US, which reflects underestimation of the service sector in China. It is also the case that the US spending basket is more tilted to services than goods as the economy is more affluent and mature, and consumers choose to purchase services that are still being performed by Chinese consumers themselves today (e.g., restaurants or take-out meals).
That said, tradable goods should be much more relevant when it comes to assessing the impact of an economy on the rest of the world because they are the primary vehicles through which real economic linkage between economies materializes. In this context, it is worth noting that the negative impact of the recession in US personal consumption has been felt by the rest of the world in the form of a sharp contraction in US consumption of tradable goods instead of services. Specifically, in the first seven months of 2009, while nominal personal consumption expenditure (PCE) on goods in the US declined by 2.6%Y, the PCE on services increased by 1.1%Y.
A like-for-like comparison: a bottom-up approach
A like-for-like comparison of specific categories of goods and services consumed by households in both countries can also shed light on the magnitude of China's personal consumption relative to that in the US.
First, with respect to goods, MS identifies three types of useful candidates for like-for-like comparison - - cars, beer and milk-drink products - - with the former representing big-ticket consumer durables and the latter two consumer staples. In 2008, motor vehicle sales in China reached 9.4 million units, or 69% of the level in the US. In view of the continued rapid increase in car sales in China while those in the US declined so far this year, the annualized units of vehicles sold in the first seven months in China already reached 12.3 million, exceeding those in the US for the first time in history.
Beer and milk-drink products are popular drinks in both countries and their quality is relatively homogenous and generic compared with many other categories of consumer staples, making them suitable like-for-like comparisons. In 2008, the amount of beer and milk-drink products consumed by Chinese households amounted to 38.8 million litres and 13 million tonnes, respectively, which are 158% and 59% of those consumed by their US counterparts, respectively.
The economists say it should be noted that the comparison of car sales, beer and milk-drink products is based on volume. The structural undervaluation of the renminbi means that the underlying US dollar value is lower for Chinese sales than US sales. However, a car requires the same amount of steel or copper and a bottle of beer requires the same amount of barley and wheat wherever they are made; hence, the impact of China's consumption growth is very visible in the international markets for these products.
Second, making like-for-like comparisons for services consumption is a challenge, and the economists make some ‘thinking-out-of-the box' yet reasonable assumptions. To scale Chinese household consumption of services to that of the US, they compare revenues in two key sectors - - financials and telecoms. In both countries, these industries derive the majority of their revenues from their domestic operations, and in both cases the majority of participants are quoted in the stock market. In China's case, this happened through sequential IPOs with the telecom names coming to the market earlier than the banks and insurers; hence, similar financial information for both industries is gathered by the vendor, MSCI, for both the US and China on a like-for-like basis. Recent data indicate that the size of these two markets in China already in value terms is considerable relative to that in the US: in 2008 the revenues of the listed telecoms sector in China amounted to 38% of that in the US, while that of listed financials totaled 23% of that in the US.
While data exist for other domestically oriented sectors such as consumer staples and consumer discretionary, a like-for-like comparison is not appropriate, in MS view, for the following reasons: a) many of the participants in China are not included in the MSCI data set; and b) several of the key players in the US-equivalent sectors are global entities (e.g., Procter and Gamble, Coca-Cola).
Third, MS uses residential electricity power usage as a proxy for consumption of a mix of goods and services by households. In 2008, the total residential electricity power usage in China amounted to 408 billion Kwh, which is about 30% of that in the US.
While this like-for-like comparison under both top-down and bottom-up approaches is by no means a rigorous analysis, the economists argue that the broad message from this exercise is quite clear: the official data for headline aggregate consumption substantially underestimate the scale of China's personal consumption relative to that of the US, which is highlighted by consumption of tradable goods.
China's incremental dominance
MS says the absolute level of personal consumption in China is not nearly as low - - compared to that in the US - - as perceived by many market participants. Moreover, while the domestic dimension of China's under-consumption - - namely consumption growth having lagged investment and export growth in China - - is a valid observation, the absolute level of growth of China's personal consumption is remarkably strong in a global context. The incremental contribution of Chinese consumers in USD terms to the global consumption of tradable goods started to exceed that of the US in 2007.
In the aftermath of the ‘Great Recession' in 2008-09, the Chinese economy is expected to continue to expand at a considerably faster clip than the US over the next decade. For Chinese authorities, promoting domestic consumption is a policy priority. To this end, a multi-pronged approach is being pursued, including boosting domestic consumption directly through improvement of consumption-facilitating infrastructure and promoting non-mortgage consumer financing in the near term, expanding and strengthening the social safety net and other public services over the medium term, and rebalancing the economy and raising the share of household income in national income over the long run.
As progress is made in implementing these consumption- oriented polices, MS expects that consumption growth will catch up with investment and export growth, and is likely to be initially in line with and subsequently outpace overall economic growth over the medium and long run. Going forward, the incremental contribution of Chinese consumers to global consumption demand will probably begin to consistently exceed that for US consumers even in terms of overall consumption.
The thesis laid out in the book, The Rise of the Chinese Consumer, by Jonathan Garner et al., John Wiley & Sons, 2005, remains valid in this post ‘Great Recession' era. The influence of Chinese consumers on the rest of the world is already considerable and expected to become even greater on both marginal and average bases.
This point can be further illustrated by a simple exercise of comparing the growth outlook for China and the US over the next decade. Assume that over the next decade (2011-20), average nominal GDP growth per annum is 5.0% (i.e., 3% real GDP growth and 2% GDP deflator) in the US and 11% in China (i.e., 7.5% real GDP growth and 3.5% GDP deflator) and the renminbi is to appreciate against the USD by 3.5% per year on average. And assume personal consumption in both countries expands in line with their respective overall GDP growth rates, as the biases for ‘over-consumption' in US - - which seems already underway - - and ‘under-consumption' in China are corrected. Under this scenario, China's nominal personal consumption - - of both goods and services - - will outpace that of the US by 9.5 percentage points per annum in USD terms. This implies that China's incremental contribution to global consumption of both tradable goods and services will exceed that of the US by 2018, and China's total personal consumption will have reached US$5.8 trillion (in 2008 USD) per annum by then, representing about 40% of US consumption spending compared with only 16% in 2008.
Since in this exercise, the economists say they intentionally make rather conservative assumptions concerning real growth rates, inflation, (modest) renminbi appreciation, and the (constant instead of rising) share of consumption in GDP for China, the dominance of Chinese consumers over those in the US in terms of contribution to global demand could be achieved well ahead of 2018.
The implications for global consumer product companies and China's home-grown franchise names are profound. Specifically, if a global consumer products company operating in China has business that is performing in line with that of the market as a whole, it should be able to deliver top-line sales growth of 14% annually compounded on a sustained basis. For China's local franchise companies, which have demonstrated a track record of substantially outperforming the market and consistently expanding their market shares, their potential growth could be much higher, emulating the early success of the current US-based global franchise names (e.g., Coca-Cola, Nike) in their original effort to establish their dominance in a huge home market.
Moreover, against the backdrop of rapid expansion in aggregate consumption, the potentially profound impact of China's demographic trends (e.g., one-child policy, population aging) on consumption spending as well as changes in a social (e.g., urbanization, income disparity) and cultural context suggest that companies that are well positioned to ride the trends shaped by these structural changes will be best placed to benefit from the rise of the Chinese consumer.