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In this book Jonathan Garner and his colleagues at Credit Suisse First Boston, argue that by 2014 the Chinese consumer will likely have displaced the US consumer as the engine of growth in the global economy. Government policy is rebalancing demand within the Chinese economy from investment spending to consumption spending. Strong trend economic growth over the cycle, a rise in the consumption to GDP ratio and steady exchange rate appreciation will likely generate an 18% compound annual growth rate in the US dollar value of Chinese consumption spending over the next ten years and lead to a quadrupling in China's share of global consumption spending.
In order to identify the companies and brands which are best placed to succeed in China's rapidly developing mass consumer market, Garner and his colleagues discuss the results of the first comprehensive survey of consumer attitudes and preferences to have been conducted in China, covering 2,700 persons in eight major Chinese cities. This survey provides valuable data for the business executive or academic seeking detailed local information on sectors including automobiles, beverages, electronic goods, financial services, food producers, food retail, food services, household & personal care, luxury goods, telecommunication equipment, tobacco, and transport and leisure travel.
"China is likely to be the single most important influence on the fortunes of investors and corporates alike over the next five years, and yet little is known of what motivates and drives the Chinese consumer. By canvassing the people that matter and reflect the changing face of this massive country, Jonathan Garner has provided investors with a unique insight."
Philip Ehrmann, Head of Pacific & Emerging Markets, Gartmore Investment Management Plc.
In this chapter, we provide a top-down view on Chinese household consumption spending growth, projecting ahead in both absolute terms and relative to key country peers for the period from 2004 to 2014.
We make the following conclusions. For 2004, we estimate the US$ value of aggregate household consumption spending in China as US$704bn. This represents around only 9% of US consumption spending and 3% of our estimate of global consumption spending. Thus currently, in US dollar terms, Chinese consumers are only a marginal force in global consumption spending.
However, major undervaluation of the Renminbi versus its purchasing power parity (PPP) exchange rate means this figure significantly underestimates the underlying quantity of consumption activity within China in our view. For example, in 2003 China consumed 33% of global rice production, 22% of soy bean oil production and 12% of global meat production (Figure 1.1).
Assuming as a base case: (a) that trend real gross domestic product (GDP) growth rises by 7% per annum; (b) that there is a 5.5% increase in the share of consumption spending within GDP; and (c) that the Renminbi rises from 0.2 of its PPP level to 0.55, we conclude that the US$ value of consumption spending in China in 2014 will amount to US$3726bn (in 2004 US$). This represents a compound annual growth rate (CAGR) of 18% for the 10-year period 2004 to 2014.
Our base-case projection is that by 2014 the US$ value of consumption spending in China will represent 37.3% of US consumption spending and 10.5% of our estimate of global consumption spending. Incremental additional annual US$ consumption spend in China will most likely be larger than that in the US by this time. We estimate that China will have an incremental spend of US$524bn (in 2004 US$) per annum 10 years from now compared with the US with US$262bn. The Chinese consumer is therefore likely to have displaced the US consumer as the engine of growth in the global economy.
However, our scenario analysis indicates that there is a wide range of possible outcomes around our base case. In our best-case scenario, the US$ value of China consumption spending will reach 98.0% of US consumption spending while the incremental US$ spend will be four times that of the US by 2014. In our worst-case scenario, China consumption spending will stagnate at only 11% of US consumption spending.
HOW BIG IS CHINA'S ECONOMY?
Current US dollar comparisons lead, in our view, to significant understatement of the true size of China's economy. China's GDP ranks only seventh in the world in current US dollar terms. However, in PPP terms using International Monetary Fund (IMF) estimates, it is already the second-largest economy in the world and 62% the size of the US economy, as shown in Figures 1.2 and 1.3.
PPP is a rate of exchange that accounts for price differences across countries, allowing international comparisons of real output and incomes. Proponents of using PPP exchange rates argue that market exchange rates are based on short-term factors and subject to substantial distortions from speculative movements and government interventions. By establishing purchasing power equivalence, where one PPP US dollar purchases the same quantity of goods and services in all countries, PPP conversions allow cross-country comparisons of economic aggregates based on physical levels of output, free of price and exchange-rate distortions.
In this chapter, we provide some aggregate projections for the size and relative importance globally of China's GDP both currently and in 10 years' time. We have used CSFB's economic team's views on trend real CAGRs of GDP (see Figure 1.4) to project the sizes of various economies over the 10-year time horizon. These economies are the largest and most relevant global economies for comparison with China in our view. We project that real GDP growth in China will average 7% over the cycle for the next 10 years, which would be the highest in the group of countries illustrated. At the other end of the spectrum the lowest trend GDP growth of below 2% is anticipated in Italy and Germany. In the next chapter we explain why it is reasonable to assume that China's economy will be growing at such a rate.
Given China's faster growth rate, how will its share of the world economy change in the next 10 years? Figure 1.5 shows that, assuming no exchange-rate changes, China's economy would reach 20% of the size of the US economy in current US$ terms by 2014. On this measure, China would be the fourth-largest global economy at that time, slightly behind Germany. However, Figure 1.6 shows that in PPP terms, the Chinese economy would be 90% of the size of the US in 10 years' time and almost six times the size of the German economy, while India's economy would be larger than Japan's.
Which is the correct view: China's GDP at 20% the size of the US in 10 years' time or China at 90%; China's GDP slightly behind that of Germany or almost six times the size? The answer is that either outturn or neither is possible, depending on the level of the exchange rate. From the perspective of a US$-based investor interested in US$ earnings streams from investments in Chinese or foreign companies servicing the China consumer market, much hinges on whether China revalues towards the PPP exchange-rate level. It is to that issue we now turn in order to form a base-case view of the likely size of the Chinese economy in 2014.
THE 'REVALUATION EFFECT'
For more than a decade, China has maintained its currency at a level well below its PPP exchange rate (see Figure 1.7). The IMF estimates that at the current pegged rate of RMB8.28/US$1, the Renminbi is valued at around only one-fifth of its PPP exchange rate.
In our view, exchange-rate undervaluation has been a conscious strategy from the Chinese leadership to stimulate export-led growth and inward foreign direct investment (FDI). It also allows China time to undertake important structural reforms in agriculture and financial services before allowing significant import competition. China is not unique in following this growth model. A similar strategy is currently followed by India and was followed by the fast-growing East Asian economies in the 1980s. As GDP per capita and total factor productivity rose in these countries, there was a tendency for policy to shift towards diversifying the sources of growth towards consumption. As a result, currencies in many of these countries have tended over time to appreciate towards their PPP exchange rate (see Figure 1.8). This has particularly been seen in the East Asian export-led economies including Japan and South Korea.
China's GDP per capita and total factor productivity are rising steadily, although in CSFB's view imminent major revaluation of the Renminbi is unlikely. However, we anticipate that China may move to a Singaporean nondisclosed currency basket with an accompanying moderate revaluation as early as H2 (second half) 2005. For some time we have expected major revaluation of the Renminbi to begin during the period 2006 to 2008 with a target exchange rate of RMB5.00/US$1.
Figure 1.8 shows our projected path for exchange-rate revaluation in China as PPP GDP per capita rises. We project that the Renminbi will reach 0.55 of its PPP level by 2014. [For a recent summary discussion on the choices facing China with respect to adjusting its currency regime and the likely scale of revaluation see Frankel (2005).] Figure 1.9 shows the global tendency for PPP appreciation as real GDP per capita increases. In our view, as China either switches to a floating currency or exhibits faster inflation than developed countries, it will tend to follow the same tendency. This would equate, were the current US$ peg regime to remain unaltered, to an exchange rate of RMB3/US$1 by 2014. The methodology used to estimate the convergence rate towards PPP is explained in detail in Appendix A. It draws on the academic literature on the determinants of convergence of exchange rates to their PPP levels. In particular, we make the key assumption of nonlinearity in the mean reversion process: 'the rate of convergence to PPP is faster when initial deviations are large' (Rogoff, 1996). The developed countries and the emerging markets were modelled independently, as were the Asian countries within the emerging markets.
Our projected path for Renminbi convergence with its PPP level implies that by 2014 China's GDP economy would amount to US$7508bn (in 2004 US$ terms) or 49% the size of the US. This is our base case and, in our view, a more realistic scenario than those given in Figures 1.5 and 1.6.
In Figure 1.10, we show China alongside the other major economies. Exchange rates for the other emerging market countries have been revalued (and for developed countries in some instances devalued) towards their PPP levels using the methodology described in Appendix A. The path for the exchange rates relative to their PPP levels is shown in Figure 1.8.
We therefore conclude that the US$ size of China's economy will almost quintuple via the combined effect of underlying growth and revaluation over the next 10 years. This would have major implications for multinational firms with growth strategies and exposure in China.
ECONOMIC GROWTH AND ITS EFFECTS ON AGGREGATE HOUSEHOLD CONSUMPTION
We now turn to analyse the relationship between economic growth and household consumption. Figure 1.11 shows the relationship between household consumption as a percentage of GDP and PPP GDP per capita for the largest economies. We would draw three conclusions.
First, higher-income countries tend to consume a higher proportion of GDP. This is particularly true of the US and UK where the consumption to GDP ratio has drifted higher (and savings rates lower) as incomes rise. In these countries, investment is funded by foreign savings rather than those of domestic households. However, an upward movement in consumption to GDP is also observable from a lower base in the high-income/high-savings economies of East Asia as typified by Japan.
Second, very low income countries such as India and Indonesia (and to a lesser extent Brazil) tend if anything to consume an even higher proportion of GDP than the first category. This is owing to the urgent need of households to meet basic needs. Here savings rates also tend to be low.
Third, we can identify a group of intermediate income countries, including China and Korea, where the consumption to GDP ratio is much lower than in the case of the other two categories. Savings rates are high, which funds domestic investment, and - as long as that investment is productive - there is more rapid than average GDP growth.
It is clear from Figure 1.11 that China represents an outlier in the consumption to GDP ratio. Using official sources, we estimate a figure of 44% in 2004, which is low by peer group standards. In our view, there may be significant underestimation of true consumption expenditure (and overestimation of the savings rate) owing to well-documented inadequacies in China's national statistics. We would note the retreat from state provision in the educational and health spheres and the rise of informal private sector provision, which may not be captured in the official data.
For the time being, we propose to take the Chinese data at face value. China thus appears to be following an extreme version of the path originally taken by Korea. Over time, as PPP GDP per capita in Korea has risen from US$5000 (where China is today) to US$15 000, so the consumption to GDP ratio has risen by 10pp (percentage points) from 50% to 60%.
We project that the consumption to GDP ratio in China will rise by 5.5pp by 2014 as PPP GDP per capita rises from US$5299 to US$10 460. Appendix B explains in detail the methodology used in making this projection. In essence, we assume that the consumption to GDP ratio increases at a rate proportional to its deviation away from the long-term developed world average of 60 %. (We assume a structurally higher long-term ratio of 65% for the consumption-prone economies of the US and the UK.)
BASE CASE FOR EVOLUTION OF US$ VALUE OF CHINA HOUSEHOLD CONSUMPTION SPENDING
We estimate that in 2004, at the current pegged exchange rate, the US$ value of household consumption spending in China is US$704bn. This represents 9% of US consumption spending and 3% of our estimate of global consumption spending, as shown in Figure 1.12.
Looking ahead to 2014, we use the three steps summarised below to form a base case for China:
CSFB's Asian economics team's estimates for trend real GDP growth of 7% over the 10 years to 2014;
convergence in exchange rate to 0.55 of its PPP level (see Appendix A); and
a rise in the consumption to GDP ratio of 5.5pp (see Appendix B).
Using these three steps, we conclude as a base case that the US$ value of consumption spending in China in 2014 would be around US$3726bn (in 2004 US$) (see Figure 1.13). This represents a CAGR of 18% for the 10-year period 2004 to 2014. However, please note that the scenario analysis below indicates that there is a wide range of possible outcomes around this base case.
In order to put China into a global context, we have made similar projections globally for more than 175 countries. PPP GDP per capita starting values were calculated using CSFB economists' projections for trend real GDP growth where available and where not we use those of the IMF.
We conclude as a base-case projection that in 2014 the US$ value of consumption spending in China will represent 37.3% of US consumption spending and 10.5% of our estimate of global consumption spending. While the CAGR for the US$ value of consumption spending in China is likely to be 18 %, it is likely to be 11% on a global basis. By contrast, we project a CAGR of just 2.1% in the US. This results from making the assumption that the US consumption to GDP ratio declines to 65% over the medium term from the current elevated level of over 70%. Note that this assumption (which we also make for the UK) would still leave the US with a 5pp higher consumption to GDP ratio than the global mean. It would of course imply a rise in the domestic savings ratio and some decline from the current high levels of the US budget and current account deficits. We consider this assumption appropriate to make within an overall global scenario, which encompasses exchange-rate revaluation and rising consumption to GDP ratios in the emerging world in general and hence less availability of savings globally to plug the US fiscal and current account deficits.
On this basis, we project that by 2014-5 incremental additional annual US$ consumption spend in China is most likely to be larger than that in the US by a significant margin. We estimate that China will have an incremental spend of US$524bn (in 2004 US$) per annum 10 years from now compared with the US with US$262bn. Other countries' outturns are illustrated in Figure 1.14. If these projections are accurate, the locomotive of the global economy in terms of incremental annual consumption demand will have changed from the US consumer to the Chinese consumer.
IMPLICATIONS FOR GLOBAL CONSUMER PRODUCT COMPANIES OF OUR BASE CASE
Our base case scenario implies that a global consumer products company operating in China whose business is performing in line with that of a market as a whole might anticipate top lines sales growth of 18 % year-on-year (yoy) compound on a sustained basis. Such a figure seems a priori to be high and obviously disguises a complex situation where some sectors are likely to grow more rapidly than others and where some companies are able to achieve a dominant position and earn strong margins while others fail to do so. It is for this reason that we undertook the detailed consumer survey that comprises Section 2 of this book.
At this stage we would simply note that, where the evidence is disclosed, major consumer product companies operating in China do indeed currently appear to be generating sales growth at or in excess of our base case of 18 % yoy. Moreover, it appears that sales growth from their Chinese operations is significantly outstripping their overall sales growth and in some cases is no longer being achieved from a small base. For Nokia, China is already its second largest market for sales behind the US. Figure 1.15 shows that for a group of 15 leading multinationals for which China sales data for 2004 have been disclosed, all but one - Volkswagen - achieved more rapid sales growth in China than they did globally. For all 15 companies the average sales growth in China was 29.5% versus 10.5% globally.
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Section 1: THEORY.
1. Top-Down Projections of Consumption Growth in China.
2. Drivers of and Constraints to China’s Long-Run Economic Growth.
3. Near-Term Risks to Consumption Arising from China’s Efforts to Combat Overheating.
4. China’s Demographic Trends and Their Implications for Household Consumption.
5. Social and Cultural Influences on Consumption.
6. China’s Growth Potential for Key Product Categories.
Section 2: EVIDENCE.
7. Introducing the Proprietary China Consumer Survey.
8. General: Lifestyle, Income and Leverage.
11. Electronic Goods.
12. Food Producers.
13. Food Retail.
14. Food Services.
15. Household and Personal Care.
16. Luxury Goods.
17. Telecom Equipment.
19. Transport and Travel.
Appendix A: PPP Convergence Model.
Appendix B: Global Consumption Function.
Appendix C: Methodology of Product Category Projection.