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The Rise of the Chinese Middle Class

(August 28, 2008)

Dear Subscribers and Readers,

In light of the end of the 2008 Olympics in Beijing (one of the most memorable in years), and in light of China's increasing impact on the global economy (such as China's energy and commodities demand, its unparallel foreign reserves, etc.), it is time for an update on the Chinese economy.  Social issues aside, I want to devote a brief discussion on the Chinese consumer – where he has been and where he will be in the future.

We first discuss China in detail in our January 30, 2005, February 6, 2005, and February 13, 2005 commentaries.  At the time, I conjectured that US investors could benefit more by studying the Chinese economy and stock market than the domestic economy and stock market, given my long-term bullishness on China and the fact that the Chinese stock market was much more “inefficient” than the US stock market.  I also tried to put the “emergence” of China into perspective – specifically mentioning the steel sector, China's education levels and the recent increase in advanced degree and PhD graduates, and the exponential growth of the Chinese internet population (incidentally, the “internet population” in China surpassed that of the United States earlier this year).  Finally, I mentioned that the best way to take advantage of “The China Story” was to invest in companies that will cater to the Chinese consumer market or to take advantage of the structural changes in the American economy because of China – as opposed to buying commodities, as the prices of commodities are inherently cyclical and as “investing” in commodities have historically involved careful timing to be profitable.  Moreover, as demonstrated by the boom in the US economy and the re-industrialization of Western Europe and Japan during the 1950s and 1960s (when commodities significantly underperformed equities), buying commodities is not a “sure play,” as being bullish on commodities is also a bet against the innovation capability of entrepreneurs all over the world.  In retrospect, while the Chinese stock market provided a treasure of investment opportunities during 2005 to 2007, the commodities market was not exactly weak either.  In many ways, betting on commodities was the “easier” and more profitable way of betting on the Chinese growth story than by betting on the Chinese consumer.

So what went wrong?  First of all, infrastructure investments in the energy and mining industries were sorely lacking heading into the early 2000s, as years of low commodity prices discouraged commodity producers to invest in new mines, oil wells, pipelines, etc.  Second of all, years of low energy prices also encouraged US automakers to produce gas-guzzling vehicles.  This supply bottleneck – combined with a lack of a “conservation attitude” in the developed world and an ever-increasing demand for energy and other commodities – caused a structural and largely non-cyclical uptrend in commodity prices since April 2003.  On the flipside – while Chinese private consumption has also seen impressive increases, it failed to keep pace with Chinese GDP growth, as Chinese GDP growth has been driven more by increasing exports and investment spending.  There are three reasons for this:

  1. Throughout the late 1990s to early 2006, unit manufacturing wages were more or less stable or declining, despite the great productivity increases in Chinese manufacturing over the last decade (which resulted in not only layoffs in the US, but in China as well).

  2. The People's Bank of China's and the Chinese government's policy of pegging the Chinese Renminbi to the US Dollar – resulting in an effective subsidy to US consumers courtesy of Chinese consumers;

  3. The lack of social services spending increases in China (despite all the talk of a “harmonious society”) – which encourages Chinese consumers to adopt a very high savings rate relative to the rest of the world – as high as 50% by some measures.

Interestingly, the trends underlying the three above points have been and are still weakening.  For example, in light of the political backlash over the US trade deficit with China in 2006, the Chinese government has allowed the Chinese Renminbi to appreciate by nearly 15% over the last two years.  In addition, after nearly a decade of stagnant unit wage growth in the manufacturing sector, Chinese manufacturing wages are actually now slowly rising.  Finally, with a projected fiscal surplus of nearly US$90 billion this year, there's a good chance that the Chinese government will choose to spend a significant amount of this surplus on social services, which would ultimately spur more discretionary spending by Chinese consumers.  To some extent, the increase in the growth of Chinese consumer spending has already been increasing over the last few years, from 6.7% in 2005 to 8.4% in 2006 to 9.3% last year.  Interestingly, a (real) growth rate of 9.3% is still below the rate of GDP growth.  My sense is that consumer spending will most likely grow by a rate closer to 10% this year and next year, even should there be a meaningful slowdown in Chinese GDP growth (to a 7% to 9% range).

Finally – as income levels and as the number of middle class households continue to increase in China – it makes perfect sense (both logically and based on historical experience) to see a much greater increase in both general consumer and consumer discretionary spending.  Based on recent projections by Goldman Sachs, the number of Chinese middle class people (defined as those with annual income between $6,000 and $30,000) is set to nearly double from just over 250 million this year to approximately 500 million by the 2012 to 2013 timeframe, as shown in the following chart courtesy of Goldman Sachs:

The Expanding World Middle Class

In general, as folks reach “middle class status,” they tend to buy a much greater amount of consumer goods that they never bought before.  These include automobiles, annual vacations, major electronic products, and so forth.  With a near doubling of the Chinese middle class over the next four to five years, we should see an accompanying “explosion” in Chinese consumer spending – such as spending in the domestic tourism, automobile, and electronics industries.  The best is yet to come for Chinese consumers and for those investors who want to take advantage of this structural trend.

Signing off,

Henry To, CFA

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