Middle-class revolution

16 July 2007 00:00  [Source: ICB]

SEAN MILMO/LONDON

THE CONSUMER is King! And China's Middle class could be among the most economically influential in the world by as early as 2015. By then, if reports are correct, it will have overtaken Japan, Germany, the UK and Italy to become the world's second-largest consumer goods market.

India currently trails China in terms of population, with 1.1bn people against China's 1.3bn, and in terms of per capita GDP - $705 (€517) against $1,709 in 2005. However, it is well placed to match the power of China's growing urban middle class.

Recent growth shows that India could experience world's fastest growth over the next 30-40 years, even faster than China, Goldman Sachs points out. Within 30 years, India could be the world's third-largest economy, after the US and China.

It's likely that by the mid-2020s, China and India will boast massive middle classes. Consumer spending is set to soar in construction, household items, automobiles and personal care products, and this surge in demand will roll right up the chemical supply chain.

Burgeoning market

Even today, the middle classes of each nation comprise a significant market. Although China's middle class accounts for only 7-12% of its population, by Western estimates, that is still 100m-150m consumers. India's middle class, estimated at only 5% of its population, still equates to 50m.The annual disposable incomes of members of both middle classes range from around $3,000 to $25,000.

US-based consultancy McKinsey & Company estimates that by the mid-2020s, consumption by India's middle class will account for 60% of total spending in the country. Indeed, the firm predicts that by 2025, middle classes of around 580m people will have emerged in both China and India.

The emerging middle classes should help to maintain the impetus behind the fast growth in demand for chemicals in both countries, which should stem from a combination of rising exports and increases in domestic consumption.

Two years ago, China became the world's third-largest chemical producer, behind the US and Japan, after it surpassed Germany with an output worth $223bn. The American Chemistry Council (ACC) estimates that between 2006 and 2016, Chinese chemical production will rise on average by more than 10%/year.

UK-based consultancy Oxford Economics believes that despite a slowdown in output over the next few years, chemical production in China will still average growth of more than 13% in the early part of the next decade.

"Within the next few years, China will almost certainly become the world's largest consumer of petrochemicals," says Dai Yu, general manager, base chemicals, Shell Eastern Petroleum, Singapore.

By the end of 2006, China was already the biggest consumer of synthetic rubber, monoethylene glycol and purified terephthalic acid, and the second-largest consumer of polymers.

India's chemical output is growing rapidly, but at a slower pace than China. In 2006-2007, chemical production in India should increase by an average of more than 9%, but half the rate of China, according to Oxford Economics.

However, as India's infrastructure improves, it should catch up. By the beginning of the next decade, chemical growth in India should average around 8%. A study by McKinsey has predicted that India's specialty chemical exports could reach $12bn-15bn by 2015, 6-7.5 times higher than they were in the early 2000s.

Nonetheless, some observers are uncertain exactly how much the burgeoning purchasing power of the middle classes of both countries will contribute to these growth rates. Analysts argue that categorizing as "middle class" groups with incomes that are relatively high within their own countries, but not so high in comparison to incomes in more developed states, is not an effective way to measure consumer demand and mistakes can be made when planning investments.

"There is a lot of misunderstanding about what constitutes a middle class, which can lead to poor investment decisions," says Matthew Crabbe, managing director of Bristol, UK-based consultancy Access Asia.

"Western consumer product companies have moved into China and found that levels of consumer expenditure in specific sectors have been greatly exaggerated. As a result, there is oversupply in their target markets, so it becomes difficult to make any money. Some of them have had to pull out," he says.

Forecasting levels of expenditure in middle class groups in developing economies can be fraught with difficulties. A lot can depend on the ability of China and India to maintain unusually high levels of economic growth.

China has been achieving record GDP growth rates - an average of 10% in the last few years alone. Goldman Sachs points out that in the past 10 years, China's exports have increased to a level that Japan took 30 years to achieve.

Doubts over spending power

Between 1993 and 2003, India maintained average economic growth of 6.8%/year -second only to China's 8.3%/year - while over the past five years, its per capita GDP growth has averaged close to 5%, according to the World Bank.

But even if both countries manage to maintain relatively high economic growth rates, economists are still doubtful about each country having a middle class in the near future with the same spending power of counterparts in the west or Japan.

"We consider 'middle class' a dangerous term and reject its use," says Arthur Kroeber, a consultant at Dragonomics Research & Advisory Services, in Beijing.

"All definitions of a 'middle class' income in China begin well below the US poverty line," at a household income of $3,000 per year.

When people in North America or Europe talk about China's middle class, they inevitably conjure up visions of families with the same wealth and lifestyles as those of the middle classes in the west. "This class of people simply does not exist in China," says Kroeber.

Instead, Dragonomics refers to consuming China, which encompasses about 20% of urban households. The remainder of the population, amounting to around 1.2bn, are merely "surviving" on relatively low incomes.

McKinsey argues that the use of the term middle class in developing countries such as China and India is justified when purchasing power parities, or differences in what consumers can buy with their national currencies, are taken into account.

By 2015, India's aggregate private consumption will be equivalent to that of Italy, and by 2025, to Germany's, according to McKinsey. But, it warns that in per capita terms, India's economy will still have a long way to go to match those of wealthier countries.

"On a per capita basis, India will still be a developing nation, even in 2025" with a large middle class, says McKinsey. "Its real consumption per capita will expand more than three times from $334 to $1,064 in 2025. But this will still be roughly equivalent only to present-day Egypt, and will continue to lag far behind developed countries."

CHINA'S CONSUMER MIGHT

In China, private consumption rose around 2.5 times to 7 trillion yuan (CNY) ($886bn, €651bn) between 1995 and 2005. In an economy where growth has been mainly stimulated by large increases in investment and a fast rise in exports, private consumption has been gradually enlarging its share of GDP.

From 2003-2007, private consumption has been rising by close to 8% annually. Its contribution to GDP growth in 2007 is forecast by the World Bank to exceed for the second successive year that of fixed investment - 3.6% versus 3.4% in 2006, and 3.4% compared to 3.1% this year.

McKinsey estimates that household expenditure on necessities, comprising food and clothing, accounted for 45% of the total in 2005 versus 71% two decades ago. As a result, the proportion of discretionary spending has increased from 29% to 55%.

A 52% rise in total average household consumption in the 10 years to 2005 has triggered a big expansion in retailing in urban areas, particularly in the main conurbations of Beijing, Shanghai and Guangzhou.

Between 1999 and 2006, China's total retail market grew by 157% to CNY12 trillion, equivalent to an annual growth rate of 20%, according to Access Asia. In 2005, supermarket sales, some of them coming from Western chains such as Wal-Mart and Carrefour, accounted for 17.5% of the total, according to Dragonomics.

"We are seeing a retail infrastructure being created in the country for all types of expenditure," says Crabbe. "This is good news for the suppliers of packaging and its raw materials because a mass retail market is being established. But it is not necessarily so good for the big chains, because the sector has become overcrowded and highly competitive, with very narrow margins or even financial losses."

In the 10 years to 1995, the proportion of expenditure on housing and utilities in China more than quadrupled to 9%, according to McKinsey. But in the next decade, its share remained stable before beginning to rise again, particularly as a result of an increase in private home ownership. Demand for decorative coatings has been increasing by around 10%/year.

The biggest rise in the proportion of household spending has been in transportation and communications, which jumped from 3% to 14% in the 10 years to 2005, says McKinsey.

Since 2002, passenger car sales have gone up from 1.1m to 2.6m in 2005, and are expected to reach nearly 3.5m in 2007.

China now has 123m internet users, according to Shanghai-based China Market Research Group (CMR). The numbers of owners of mobile phones, sales of which have been rising by more than 20%/year is much higher. CMR estimates that the number of mobile phone users in China billed for mobile games reached 139m in 2005.

CONSUMERS DRIVE INDIAN GROWTH

In India, private consumption has been growing at a similar pace to that in China -at an average of just below 7% over the last four years. Since investment does not provide the same impetus to growth as in China, consumption is making a bigger contribution to GDP growth - around half over the past two years, says the World Bank.

Discretionary spending has risen from 32% of average household consumption in 1985 to 52% in 2005, says McKinsey. In the 20 years to 2005, McKinsey estimates average household disposable income has gone up by an average of 4.6%/year in urban areas and 2.8%/year in rural locations.

As in China, there has been fast growth in retail sales in India, which now represent around 40% of consumption and about one-fifth of GDP.

India's car sales have risen from 800,000 in 2002 to 1.1m in 2005, and this is expected to rise to 1.5m this year, around 40% of that of China. Spending on communications is still low in India, accounting for 2% of household outlay, says McKinsey. But its mobile market is growing even faster than China's. By the end of this year, the country is expected to have 211m mobile subscribers.

Predicting the future size and spending power of the Chinese and Indian middle classes is complicated by their relatively small size at the moment.

Estimates of the size of the Chinese middle class vary from 250m by theChinese Academy of Social Sciences, to 150m by BNP Paribas and 100m by Goldman Sachs.

A joint study by credit card company MasterCard and New Zealand-based economic and demographic forecasting company Global Demographics estimated that, in addition to a 100m people in the middle class, with household incomes of CNY40,000-100,000, there are 5m upper-income Chinese with household incomes of more than $15,000.

Outside of the wealthy segment, most analysts agree that household expenditures, even among the Chinese middle class, are relatively low compared with those in developed countries, and even some of China's neighbors in Asia.

"The low spending is borne out by figures showing small amounts of average expenditure each time a shopper visits a supermarket in China," says Crabbe. "Retailers are finding it so difficult to make money that they are charging fees to consumer goods manufacturers for use of their shelf space. In some areas this is cheaper for the manufacturers than using warehouses."

McKinsey believes, however, that over the next eight to 20 years there will be a huge increase in the spending capacity of China's middle class as the lower middle class - currently with annual incomes of CNY25,000-40,000 and representing 13% of urban households - moves up the earnings ladder.

GROWTH SLOWDOWN

Some experts predict that a large Chinese middle class will develop at a much slower pace - at least over the next 10 years. Dragonomics believes that its category of consuming China will amount to around 270m by 2015, with a total consumption of close to $1 trillion versus $133bn in 2005.

This is a rise "from just under 4% to 18% of current American household consumption," says Kroeber. "It is a very nice increase but it still leaves the average 'middle class' Chinese household in 2015 with less than one-quarter of the median spending power of all American households in 2005."

The much smaller existing Indian middle class amounts to 13m households, according to McKinsey. It splits the group into two segments - the seekers, with annual household disposable incomes of Indian rupees (Rs) 200,000-500,000 ($5,000-$12,000, €3,600-€9,000) and the strivers at Rs 500,000-1m.

McKinsey predicts that by 2025, India's middle class will make up 41% of the country's population, or 128m households. In addition, there will be a highly affluent segment amounting to 2% of the population, which will earn almost one-quarter of total disposable income.

McKinsey, however, warns that its predictions depend on both India maintaining its high growth rate and on government policy. "Crucially [they rely] on the government continuing to pursue a pro-reform, pro-growth, economic agenda, because slower reform and failure to act on India's significant challenges could dampen growth and put opportunities we have described substantially at risk," says the firm.

And there are similar "ifs" over the future of China's embryonic middle class, with the main worry being over what happens if the country cannot sustain its remarkable performance in the export trade

China - Average consumption by product category per household per year,

Share, %	1985	1995	2005	2015	2025
Housing, utilities	2	9	9	13	16
Recreation and education	10	14	15	15	18
Healthcare	1	4	8	11	14
Transportation and communication	1	3	14	18	18
Personal items	6	4	3	4	3
Household items	9	8	6	6	5
Apparel	14	13	11	8	7
Food	57	45	34	25	19
Total average household expenditure, in 2000 constant renminbi, '000s	7.4	12.8	19.5	34.3	54.4Source: McKinsey Global Institute

 

India-Share of average household consumption by product category

Share, %	1985	1995	2005	2015	2025
Healthcare	4	4	7	9	13
Education and recreation	2	3	5	6	9
Communication	0	1	2	3	6
Transportation	7	11	17	19	20
Personal products and services	4	4	8	9	11
Household products	2	2	3	3	3
Housing and utilities	15	14	12	12	10
Apparel	6	5	6	5	5
Food, beverages and tobacco	59	56	42	34	25
Total average household expenditure, in 2000 Indian rupees, '000s	50	60	82	140	248Source: McKinsey Global Institute

MYTH VERSUS REALITY

Executives have been dazzled by the opportunities that China's emerging middle class might provide.

But are the facts and figures real? Well, rapid economic growth is considered the stimulating factor, yet growth so far has relied heavily on investment, not consumption.

Spending may not be quite on the scale that some have predicted. Global management consultant McKinsey & Company suggests that by 2011 China should have what it defines as a lower middle class numbering 290m people, earning $3,200-$5,250 (€2,300-€3,850). By 2025, an upper middle class of 520m will emerge, earning anything between $5,250 and $13,150.

But Swiss bank UBS says that out of China's 1.3bn population, only 100m count as having "significant discretionary power." It's partly to do with how official data is interpreted and cultural notions of what constitutes a middle class in China. Beijing says 577m Chinese are urban residents, but many of these are in towns where income levels not even close to those in the big cities. UBS says the official number is more like 244m, and around 115m if based on the populations of the 50 largest cities where wealth is concentrated.

And, of those with a household income of $10,000 or more, this group totals 70m, but falls to 25m for those households with $18,000 a year.

Definitions create problems. Using McKinsey's numbers and contrasting those with developed countries, most households in China would be considered impoverished. McKinsey and others claim purchasing power parity (PPP) would mean the incomes of the middle class by 2025 would be equivalent to between $13,500 and more than $50,000.

The trouble is that many goods, such as cars, are not adjusted for PPP - an economic tool that allows comparisons of standards of living across countries to be made. And besides, the Chinese tend to save for years just to make that one purchase.

So according to UBS, it is unlikely that a wave of Chinese consumers will be taking the world by storm anytime soon.

Predictions of a boost to Chinese spending powermay be overblown

By Matt Kovac/Singapore

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