Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Cindy Li.
I’m Sean Creehan. We’re analysts in the country analysis unit, and our job is to monitor financial and economic developments in Asia. Today, we continue our series Rethinking Asia, as we consider noteworthy and unusual trends in Asian finance and economics. We sat down with Andy Rothman, investment strategist for Matthews Asia, an Asia-only investment specialist.
Andy lived and worked in China for more than 20 years analyzing the country’s economic and political environment, and he now looks at issues like China’s rising consumer class from an investment perspective.
China’s rising consumer class will be one of the most important drivers of global economic growth in the coming decade. Andy gives us a sense of the sheer size of Chinese consumption, and why it’s growing rapidly. We also get into the history of China’s efforts, to rebalance activity towards consumption, and away from the earlier focus on investment and exports, and we discuss prospects for the future.
We’ve talked about eye-popping numbers coming out of China a lot on this podcast, and that’s certainly the case with trends in consumption. Let’s get to our conversation.
Andy, thanks for joining us today.
It’s great to be here. Thanks.
Why don’t we begin talking a bit about the historical context around consumption in China. The country has, at least in modern times, relied on exports, and government investment to generate growth, and now its leadership is trying to rebalance, and transition to a more domestic-focused growth model, with consumption playing a key role. Perhaps another way of thinking about this is, the country and its people have saved and invested for decades, and now it’s time to enjoy the fruits of that effort. What do you see the progress so far in rebalancing towards consumption?
That’s a great place to start, because if I think about many of the folks that your listeners have been listening to for a decade or more, who’ve been really pessimistic about China’s economic future, their thesis—I call those folks the “perma-bears” on China—their thesis was that the Chinese economy could not rebalance or restructure away from a dependence on exports of cheap manufactured goods, and investment, and building stuff, to an economy like ours in the U.S., that’s based on consumption and services. What a lot of people haven’t realized is that rebalancing process is really well under way now.
Last year was the sixth consecutive year in which the tertiary part of the GDP, the services and consumption part, was the biggest part of the Chinese economy. It’s already moving well along the way to becoming more like us, more rebalanced. They’re not done yet. As investors, of course, we’re always investing in the change process, but last year, two-thirds of economic growth in China came from consumption. It is probably a surprise to some of President Trump’s advisors that the Chinese economy is no longer export-led.
Just to level set here briefly for our listeners, what would a typical consumption level be in the United States, or say, Japan versus China? How do we compare the numbers right now?
China still has a long way to go. In a more developed OECD country, consumption might account for 70 to 80 percent of GDP. Now, in China, it’s about 55 to 60 percent depending on how you count it. There’s still a ways to go, but that’s up from about 40 percent 10 years ago. In the reverse, and this is important when we think about the tensions between the U.S. and China on trade, net exports, which are the value of a country’s exports minus the imports, so we don’t double count them, net exports, 10 years ago on the eve of the global financial crisis, were about 10 percent of China’s GDP, now it’s only two percent.
For the consumption part in the GDP equation, in China’s case, is household consumption accounting for a chunk of the increase?
Yeah. We can break it down further, and look at the difference between household consumption, and government consumption adding up to final consumption, but I think that that probably distracts us from the key issues, because there are a lot of questions about how effectively the official statistics count household consumption, with issues ranging from gray income, to how the housing purchases should be accounted for. I don’t want to get too down into the weeds on that, because I don’t think it’s very helpful to people to understanding the change.
Here’s maybe a more concrete way to understand the growth of the consumer part of the Chinese economy. 10 years ago, if you took all of the consumer spending, retail spending in China, and converted it to dollars, it was equal to about one quarter of American retail spending. Last year it was 90 percent. Within two to three years, it’s most likely that Chinese consumer spending is going to be bigger than American consumer spending. Now, you could say, “Well, of course it is. The Chinese population is about four times the size of our population.” But still, almost half of that population is rural, almost a third of it are working in agriculture, there’s still a lot of poor people there.
Here’s another way to look at this. Income growth in China has been phenomenal. Over the last two decades, average household income has gone up threefold. In the last 10 years, inflation-adjusted real household income on average is up 120 percent in China, in 10 years. Over that period of time, income in the U.S. was up nine percent. You’d have to go back to 1972 through to today, to get the same level of income growth in the United States that we’ve had in the last 10 years in China.
Who are China’s consumers? Which age group, in what area? Are they urban? Are they rural? Help us understand a little bit more about the growth in consumption, per se.
I think everybody is a consumer in China, just like you could argue, I guess, that everybody is a consumer in the United States. But the levels of spending versus savings are different, and the kinds of things they’re spending on are different. But for my perspective working for an investment firm, the really exciting stuff is happening outside of the places that we tend to think about as constituting China—what we call the “tier one” cities in China, Shanghai, Beijing, Shenzhen, Guangzhou, that’s where foreigners tend to know about, that’s where the foreign journalists report about. But those cities account for only about five or six percent of the urban population in China.
The really exciting story, I think, in the Chinese consumer space, is in what we call the “tier three” cities. China has 150 cities with a million or more population. We think about Hohhot, the capital of Inner Mongolia, which nobody here has heard about, right? Its population is the size of Houston, which is our fourth biggest city.
In places like Hohhot, or even smaller cities, income growth has been really fast, coming from a much lower base than in a place like Shanghai or Beijing, but the growth is there. House prices are a fraction of what they are in those bigger cities that we’re more familiar with. The infrastructure has been built out, so that’s generating jobs, and wealth, and it means people can bring goods in. You’ve got organized retail, and that’s where the real dynamism, I think, in the consumer part of the Chinese economy is taking place now.
Picking up on that, and Cindy’s question about what the consumers look like, what consumption looks like, those numbers you cited on the growth over the last 10 years, in inflation-adjusted income, and comparing that to the United States of 45 years of growth in comparison. It’s just kind of hard to fathom. But also thinking about this from the perspective of, we more commonly consider how China’s upgrading its industrial, and manufacturing base, but thinking of it from a consumption perspective, upgrading those consumption patterns…With that sort of pace of growth and income, I mean, how do companies even keep up with the consumer habits, and what they’re looking to buy? I mean, of course, you’d imagine they’re looking to buy washing machines, or cars, or cell phones, but how does that look, and can you give us a sense for just the consumption habits of a typical urban consumer?
I think that’s a real challenge for companies that are trying to sell to Chinese consumers, because changes in preferences, and brand allegiances, and buying patterns that might evolve in the U.S. over a five year period, are probably evolving in a five month period in China.
It’s really a challenge for retailers, whether they’re domestic or foreign, to keep up with that. I think it’s especially a challenge for foreigners, both because they’re not used to that change in pace, and maybe they have trouble convincing their head office, whether it’s back in the U.S., or in Tokyo, of the need to change that quickly. And this is one reason why, when Matthews Asia, when my colleagues on my investment team are looking at companies that we can invest in for Americans that are benefiting from this consumer story, we’re generally finding its Chinese companies selling goods and services to Chinese people, because they’re better able to adapt quickly to the trends.
That makes sense. I would guess multi-nationals that are a little bit more agile, and localized, and kind of giving control to those China-based teams to design products, and marketing, and all of that.
Right. For example, a number of years ago, we found that a lot of Japanese tech companies were struggling in China, because they said, “Well, we have the best technology. Why aren’t Chinese consumers buying our stuff?” We looked at it, and we found, “Well, okay. You might have the best technology, but there’s a Korean company whose technology is almost as good, but they’ve figured out that the Chinese consumer wants fake diamonds on the cover of their cellphones, and you’re not doing that.”
It kind of reminds me of when Nokia was driving the American mobile phone business, and they had phones the size of bricks, with huge antennas that would poke a hole in my pocket. I asked a Nokia engineer, “Well, why don’t you reduce the size of the antenna like some of your competitors are?” He says, “Well, that would shave one percent off of the reception.”
Thinking of it from a technical optimization perspective as opposed to how does this consumer actually use it?
One thing that’s interesting to me, just picking off of that, is around the world, U.S. consumption habits have been very influential in other countries. I mean, just look at something like jeans, and how jeans became popular around the world, but looking out into the future are there certain consumption trends in China that you see kind of previewing what we might see in other parts of the world? Whether it’s electric cars, or alternative energy kind of feeding into a house’s heating, or whatever it may be?
Yeah. That’s a good question. I think that the way I would look at that is that China has this advantage of having gone from very, very underdeveloped to rapidly developing in a brief period of time. So they’ve been able to leap over a lot of old technologies, and spending patterns that have kind of held back other cultures, like ours in the United States, from making similar gains.
For example, China went from nobody had a landline phone in their house, to everybody had a cellphone. China went from not really having a brick and mortar retail industry to let’s buy everything online. China went from no credit cards, no checkbooks, to let’s pay everything with our phone.
Whereas, in contrast, in the United States, we struggled with, but we’re used to using credit cards, we’re used to using our landline, we’re used to going into a physical shop. We don’t trust these other things, and that’s been an advantage that was out there, and that both, Chinese companies and the Chinese government, were able to capitalize on.
You had a recent post that looked at this consumption story, and there was a statistic that jumped out at me, which was online retail sales in China are up something like 33 or 34 percent year over year, and that’s an accelerating pace from a year before, 25 percent, which is incredible growth.
I saw that, and I looked up the comparable number in the U.S., and it’s still pretty solid, but it’s something like 16 or 17 percent, so it’s roughly half the rate of growth. We think of ourselves as pretty tech forward, in terms of eCommerce in the Bay Area, and I think a lot of parts of the country are getting more and more used to that sort of shopping, but that was dramatic to me. It kind of underscored what you’re talking about.
The base is bigger. The amount of spending, and the share of total retail spending that comes from mobile platforms, non-cash platforms, is much, much bigger in China than it is the United States by a factor of about 10, I think. You see, I think, a lot of 20 to 30 year olds in China who regularly leave the house with nothing in their pocket but their phone. It’s got their ID in it now, it’s got everything they need to buy anything, pay for anything, and we’re still a ways away from that here.
Make sure their battery is charged.
Well, but the other thing is, you go to a restaurant in China, and they’ll charge your phone for you. Maybe not a…Well, a high-end place, you can probably give your phone to the maître d’, but I regularly go into coffee shops, or fast food restaurants where they have a charging platform, which they can put on your table, and you can recharge your phone while you’re eating lunch.
It seems like Chinese people’s lifestyle changes have also kind of promoted this consumption growth.
That’s true, but I think it’s also important to recognize that they’re not profligate spenders, we’re not looking at a looming consumer crisis in my view, because this is not about Chinese people maxing out their credit cards, it’s about this phenomenal income growth that we talked about before. The income growth is so strong that even though real inflation-adjusted retail sales growth is about eight percent now. Think about how excited we get when we get two percent in the United States. They’re still saving close to 30 percent of their income on average.
One of the statistics I like to cite, when I talk about the sustainability of the consumer story in China is that if you took all family bank deposits, household bank deposits in China, and converted it into dollars, this is just family deposits, it’s bigger than the combined GDPs of Russia, Brazil, India, and Italy.
It’s true that there’s a high savings rate, in part, because Chinese people don’t have a strong social safety net yet. They need to have that money in case somebody gets sick, they need to have money for extra education fees for their kids, but the savings is there. That to me helps indicate that this is gonna be a sustainable story, but compared to, let’s say, a 20 to 30 year old…compared to the way their parents spent, it’s a phenomenal change.
This is also something that I think a lot of us here in the U.S. don’t recognize, or understand well enough, that the life of the average Chinese person is so much better than it was 20 years ago, and impossible to understand how much better than their parents life was, because things were so miserable in China not that long ago.
You see that in kind of polling internationally of just general outlook on life in different countries, and China tends to score really highly from that perspective, because of that trend, I think.
Right. When I tell people that, when I give presentations in the U.S., I think people are pretty shocked that…For example, Ipsos MORI, the U.K. polling firm went around the world asking people last summer, “Do you think your country is on the right track?” Well, only 43 percent of Americans said “yes”, but 87 percent of Chinese said that, and that’s shocking to people here who think, “Well, but China doesn’t have a free press. They can’t elect their version of President Trump. They must be miserable over there.”
It’s all about perspective. The gains in standards of living, and personal freedom, the ability to run your own life, set up your own business, send your kids to school in the States if you want, has expanded so dramatically that Chinese people are actually pretty happy, and that means they’re willing to part with their money.
I’m curious, Chinese households apparently spend a lot of money on housing, but it seems like they are also spending a lot on health and education, and increasingly so. Do you agree?
Yes. Definitely. I think all of those things are linked in many ways, certainly the first two. In the housing story, and this is one of the areas that makes people here quite nervous about China, is the idea that there’s gonna be a giant housing crisis, or housing bubble there. Maybe we should talk about that for a moment.
I think that the Chinese have learned a lot of lessons from us about the property market. For me, the one statistic that illustrates what went wrong here about 10 years ago, is that in 2006, the median cash down payment for a new home in America was two percent of the purchase price. Think about that. That was the median. In China, by contrast, the regulations require a minimum down payment of 20 percent for a primary residence, and I’ve yet to find a bank that will give more than a 70 percent loan, requiring 30 percent cash down. No no-doc loans, no NINJA loans.
Here in the U.S., before the crisis, most banks sold off the mortgages almost immediately, so they didn’t do a lot of due diligence. In China, almost all mortgages are held to maturity, so they do a lot of due diligence. I think that part of the drive, the rise in consumer debt is actually not worrying me, because the quality of that debt, I think, is quite good.
Any concern that shadow banks, or specifically fin-tech firms may be kind of impacting that down payment space, because I did see, a year or two ago they increased the regulation on so called “marketplace lenders” that some of them were apparently lending folks money to use as their down payment. Is that something that was sort of an outlier activity, or is that something we don’t really fully understand yet?
I think it’s difficult to quantify, because it’s illegal, but it’s just difficult for me to believe that this is more than an outlier, because what you’re talking about is somebody willing to pay let’s say 20 percent interest to get a bridge loan on a down payment for a house, for which then they’re gonna have to pay the interest rate on the mortgage. If you’re telling me, would somebody do this for a month or two as a bridge loan? Sure. I can believe that, just like companies will do that, but do we think that a large share of the 30 percent down payment I talked about is from that? It seems really, really difficult to believe anyone would do that when we’re talking about a primary residence.
My anecdotal experience is that a lot of people are borrowing from their family members, because the savings rates are so high. I had one of the well-known perma-bears say to me a number of years ago, “Well, what if there’s a recession in China, and the parents call in those loans from their kids? That would create a housing crisis.” I thought, “That sounds a little weird. I’ll ask a few of my Chinese friends.” Of course, they all laughed at me. They were like, “I have no intention of repaying this loan. My parents don’t expect me to repay this loan, but they also expect that with my new house, I’m gonna take care of them when they get really old.”
Right. I guess, in another…someone sitting here in the United States might also need to understand this distinction. You’re not talking about government finance programs that allow someone to put down three percent at a relatively affordable interest rate.
Yeah. There are schemes, like a housing provident fund that help people buy homes, but they generally are a fairly small share of the total pie. My experience, I’ve owned three residential properties in China, including a house that I lived in for 15 years, which I just sold, and my experience there was the due diligence on the part of the banks was really pretty strict, tougher than it was when I bought property in the United States.
Are there any specific government policies designed to support consumption growth, especially because it seems like this transition from investment to consumption is part of their strategy to rebalance?
There are many programs, but I would say, for me the most important one has been the government’s effort to raise wages. For example, up until several years ago, we had a decade period where the government was raising the minimum wage by more than 10 percent every year. Think about that in the context of the debates we have here about raising the minimum wage by two or three percent.
While the minimum wage only applies to a small share of the workers, it has a knock-on effect across the board. This was the Chinese government saying to low-skill, low-wage factories making toys and shoes, “Hey. If you can’t afford to pay your workers enough so that they can have a good life, and your factory goes out of business, and has to move to Vietnam or Bangladesh, so be it. No problem. That’s not the kind of job we want anymore.” I think that’s had a huge impact on driving the consumption story.
You talked, you alluded to it earlier, as well, the need for high savings, because of a lack of some of the basic social safety nets, whether it’s health insurance, old age insurance, funding for education, I would have to think that’s part of the picture, as well. I mean, I guess in some way, it’s a matter of talking about government consumption versus personal consumption, but how do you view those policy issues, and the way they’re moving in terms of consumption?
Well, when we break out government consumption, one of the positive elements is the government’s share of total consumption hasn’t been rising in recent years. That’s a reflection that the consumer story – the household story – is holding up well, but I think that one of the most important things for the Chinese government to accomplish over the next couple of decades is to build out a strong social safety net that the average Chinese person has confidence in. They have to eliminate the current situation where you’re in an accident, you’re bleeding, you show up at the hospital, and the first thing they ask you is not your blood type, it’s, “Where’s the cash?” That’s one of the reasons why people are saving so much money.
I think the government is moving in that direction. Almost everyone in China is now covered by some form of health insurance. It’s not enough, you still have to have cash, but they’re moving slowly in the right direction. If they achieve their objective of having a good social safety net, including universal health insurance, that will be another boost to the consumption story down the road, because that means that the precautionary savings rate that’s driving up the total savings rate now, can come down and free up some of that saved cash that I talked about before for spending, but that, I think is gonna take a couple of decades.
Andy, China has an aging population. How does this changing demographic trend affect consumption patterns?
The aging of the Chinese population is an important issue, but I also get a little bit annoyed, or distressed when I see headlines about things like the ticking time bomb of demographics in China. One of the good things about demographics is that the trends are relatively easy to forecast, and they play out over an extended period of time. China is getting older, but to put it in context, the share of the Chinese population that’s 65 or older right now is about 12 percent, I think.
It’s not gonna get to the level that Japan is today, which is about 25 percent, until 2040. There is time for China to adjust and deal with this. By the way, I think the U.S. population over 65 is gonna be about the same level as China by 2040, as well. We need to keep that in mind for our own policy debates here.
What this is gonna mean is that the workforce is changing. This is one of the reasons why China is never gonna go back to double digit GDP growth again. One of the big drivers of double digit GDP growth for a couple of decades before was that every year, the workforce was just expanding at an incredible pace, but that’s over. In the last few years, the workforce is actually shrinking a little bit every year, which is one of the reasons why we have to be realistic in that year over year growth rates for everything in the Chinese economy will be gradually decelerating.
It’s driven other things. It’s given the Chinese government the flexibility to keep raising wages, it’s also forced them, I think in a very smart policy response, to start investing a lot more money in education, including technical and vocational training. The number of university graduates in China has gone from one million about 15 years ago, to about eight million now. This is great. This is what they need to do. This doesn’t guarantee that they’ll deal effectively with the aging population, but I think it’s something that I wish we were doing a lot more of in the United States, putting a lot more money into all levels of education.
Yeah. It’s that kind of spending that adds to productivity, hopefully.
Right. We could do a whole podcast on the debate of productivity growth in China. I think the data is pretty weak, so it’s a tough thing to quantify, but if you look at the changes in what China produces, and how effectively, and efficiently it produces, and how much wealth has been created, in my mind, there’s no doubt that productivity gains in China have been terrific.
Another place where they’ve still got some room is that about a quarter of the workforce is still in agriculture in China. I think, in the U.S., we’re at about two percent. Moving more of those people from agriculture into manufacturing and services is gonna generate some significant productivity gains over the next couple of decades.
Picking up off of that, as you step back and talk about the macro story, we began by talking about the historical growth model, and the rebalance towards consumption, and this notion that China has often under consumed. Is there a right level of consumption? You mentioned statistics in other developed economies, maybe a typical level as compared to GDP, but is there a right level, and how do we know what it is? How do we know when we get there?
Yeah. I’m not sure I’m smart enough to come up with a specific number of what the consumption share of GDP should be. I think there are gonna be different balances depending on the different comparative advantages. One of the good things we’ve seen in China is that the government has been flexible with its policy in responding to the changes, the aging workforce, the rising wages. They’re saying, “Look. Let’s provide incentives for more high value-added work.”
For example, a number of years ago, I was talking to a guy who represented a Scandinavian company making high tech manufacturing equipment for the technology industry, and he was trying to bring in secondhand machinery from Japan, because the industry was dying in Japan. The Chinese government found out he was bringing in secondhand machinery, which he said was barely used, only a couple years old, and they didn’t want him to do that. They actually provided a tax break to make it cheaper to import brand new equipment, because the idea was, if you’re bringing it into China, we should have the best.
That may be overkill, but I think the Chinese are doing what we in the U.S. have had a long history of doing, which is supporting, in the early days, technological advance, and sectors of industry that are based on technology that can drive productivity. I think a lot of us forget that the semiconductor industry in the United States was driven for the first few decades by the U.S. government.
In the post-war period, after semiconductors were invented, almost all of the RND funding came from the U.S. government. Up until the early 1960s, the U.S. government, mostly the military, bought almost 100 percent of the output of the semiconductor industry. Then, when we saw competition in the late 70s and 80s from Japan, particularly on DRAMs, the U.S. government stepped in, and put more funding, and created Semitech. What the Chinese are doing with Made In China 2025 is not unusual.
Right. It’s interesting you give that example, specifically the company that was doing that was Bell Labs, and just when you…I read a great book recently called The Idea Factory on the history of Bell Labs, and its relationship with the U.S. government. When you read about it, it actually sounds a lot like some of the companies in China that, sometimes for good reason, we criticize the relationship between the state and the private sector, but that resonates.
Yeah. I think that our response, talking about the United States, I’d like to see our response focus not on trying to derail or block China from moving ahead with its own industrial policy, because we have a long history of doing that too. I would rather see us take strong steps to make sure that the intellectual property rights of foreign companies in China are better protected, but also then say, “How do we compete with them?” Just like the challenge from the Soviet Union with Sputnik, what did we do? We didn’t try and stop the Russians from launching rockets and satellites, we poured money into RND here, and poured money into science education.
Great. Well, this has been a really productive discussion. Really appreciate you coming in.
No. That’s great. I think we covered a lot of ground.
We hope you enjoyed today’s conversation with Andy. For more episodes like this, you can find us on iTunes, Google Play, and Stitcher. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up our Pacific Exchange blog, available at FRBSF.org.
Thanks for joining us.