Can China Save the Global Economy?
02/02/2010 9:10 am EST
Optimists are counting on the growing Chinese consumer class to spend the world back to prosperity. But a new study suggests that may not be so easy.
If, as I argued in my previous column, the free-spending, never-met-a-credit-card-they-didn't-like US consumers aren't coming back within the next decade, who will pick up the slack? Who will buy all the cars, the flat-screen TVs, and the steel that the global economy is geared up to produce?
The hopeful answer is China and its growing number of middle-class consumers. Not only does that country's growing wealth add hundreds of millions of buyers to the markets for products as varied as designer sunglasses and air conditioners, but the Chinese government is also committed to policies that will grow domestic consumption.
All the world has to do is wait, and the Chinese consumer will pick up the shopping bags dropped by exhausted US consumers and spend the global economy back to prosperity.
At least that's how the hopeful story goes.
But a new study from consulting company McKinsey makes me doubt exactly how much global lifting China's consumers will be able to do over the next couple of decades. The big obstacle is the heavy structural emphasis in the Chinese economy on exports and government-led investment.
In 2007, China was the fifth-largest consumer market in the world, behind the United States, Japan, the United Kingdom, and Germany. But consumer spending accounts for a much lower percentage of the economy in China—just 36% in 2008— than in the United States (71% of gross domestic product in 2008), the United Kingdom (67%), or Japan (55%).
China's consumer consumption-to-GDP ratio is low even for the developing world. Brazil's ratio came in at 65% in 2008, India's at 57%, and Thailand's at 54%. As McKinsey points out, China has the lowest consumption-to-GDP ratio of any major world economy except Saudi Arabia, where oil exports account for a huge share of the economy.
In fact, China's consumer has been losing ground since 1990, when consumer consumption accounted for 51% of GDP.
So what would it take to get that ratio up in China?
The study (you can find a summary of it here) looks at three scenarios for future consumer demand in China:
- First, there's what McKinsey calls the base case. In this scenario, the Beijing government wouldn't do anything to increase consumer spending in China. Any gains in consumer consumption would come from the increasing wealth of Chinese consumers as the economy grew. Under this scenario, consumption would rise to about 39% of GDP over the next 15 years.
- Second, there's the policy scenario. In this case, the Chinese government would fully implement the changes that I have already mentioned for promoting consumer consumption. Under this scenario, consumption would rise to 45% of GDP. That'd be a big increase, but still leave consumer consumption with a smaller share of the economy than in South Korea (where consumer consumption accounts for 48% of economic activity).
- Third, there's what McKinsey calls the stretch scenario. In this case, the Chinese government would implement policies to reorder the country's economy. This effort could push consumption up to 50% of GDP, still short of the consumption-to-GDP ratio of countries such as the US, the United Kingdom, Canada (at 60%), and France (58%), but creeping toward Japan's 55% ratio. This third scenario would add $1.9 trillion a year in consumption to the global economy.
China's government seems committed to the pro-consumer changes that make up McKinsey's second scenario. Those changes concentrate on repairing the social safety net in China so that Chinese families feel more secure and don't believe they have to put away quite so much in savings. The average Chinese family now saves about 25% of its discretionary income. That's three times the savings rate for Japan, a country of notorious savers, and 15 percentage points above the GDP-weighted average for Asia as a whole.|pagebreak|
The changes that have been proposed so far include health insurance and better pensions, plus lower school fees and more aid so that Chinese families don't have to save as much to send their children to college. (McKinsey found in surveys that saving for the cost of a university education was the number one reason for families to save.) Implement those, the theory goes, and Chinese families would feel less compelled to save.
But, according to McKinsey's models, these plans would do little to increase consumption as a percentage of GDP. More financing for education, for example, would add just 0.4 to 0.7 percentage points to the current 36% consumption-to-GDP ratio. Better health care would add just 0.4 to 0.6 percentage points.
To get to the major shift of the third scenario, the one that would pump $1.9 trillion a year in new consumer spending into the global economy, China's government would have to make radical changes in its economy:
- Real wages would have to climb. Currently, even taking into account an artificially undervalued currency and lower prices for many goods in China, it takes a typical Chinese worker seven hours to buy the same goods and services that an average US worker can pay for after one hour of work.
- Interest rates would have to rise from the low levels set by the government so that Chinese savers could earn reasonable returns on their money and save smaller parts of their income.
- The government would have to expand consumer access to credit. Outstanding consumer credit is just 3% of GDP. In Brazil, it's 12%.
McKinsey estimates these steps could raise consumers' share of the Chinese economy by roughly three to five percentage points.
Buy What They'll Buy
All this is important for investors anywhere in the world for two reasons.
First, the Chinese government's announced plan to raise domestic consumer spending as a percentage of GDP will make good investments out of domestic companies (and foreign companies with a presence in the Chinese domestic economy) in fields such as life insurance, medical services, and health care products. And as the share of the domestic economy going to consumers increases, companies selling consumer goods—at the right price points—in the domestic economy will profit.
Some names? Coach (NYSE: COH), Luxottica (NYSE: LUX), China Mobile (NYSE: CHL), China Life Insurance (NYSE: LFC), Ctrip.com (NASDAQ: CTRP), and Home Inns and Hotels Management (NASDAQ: HMIN). Most of these are in one of my portfolios, such as Coach, or on my new Jim's Watch List. I'll be adding Home Inns and Hotels Management to my watch list with this post.
Second, I don't expect that the Chinese government will turn the country's economy inside out to give domestic consumption a bigger piece of the pie than it gets under scenario number two. I'm afraid that means that China's consumers won't pick up enough clout to soak up all the excess capacity built up in the global economy. For more on global excess capacity, see this recent column.
In that column, I mentioned three themes—brands, service and distribution networks, and technology—to use to fill a portfolio with stocks that will profit despite this excess capacity.
For overweighting your portfolio, instead of focusing on China, look at other economies in the developing world that offer a better balance of domestic consumer spending, exports, and fixed-asset investment. I've got one country in mind: Brazil. In my next column, I'll explain why Brazil is better than China as a long-term play— say, over the 15 years.
At the time of publication, Jim Jubak owned shares of the following companies mentioned in this column: Coach and Ctrip.com.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.