Gordon Orr
December 15, 2004

Over the past four years, business investment, particularly in industrial development and property, has become the engine driving China's economy. During this period, business investment accounted for more than 40 per cent of GDP growth, reflecting the country's determination to clear a backlog of much-needed infrastructure and housing projects.

By contrast, consumer spending accounted for some 33 per cent of GDP growth, down from 45 per cent in the 1990s. This comparative weakness in consumer spending is creating a potential stumbling block for the economy.

To sustain rapid growth, the Chinese government will have to encourage its consumers - especially the 250m with household incomes of more than Dollars 1,000 a year and the 50m with more than Dollars 3,500 a year - to spend more of their hard-earned cash.

The good news is that Chinese consumers do have money to spend, having accumulated well over Dollars 1,000bn in savings. However, they are showing little sign of losing their caution, with the savings rate climbing to 44 per cent of GDP last year - against 26 per cent in Taiwan and 32 per cent in South Korea.

In big cities such as Beijing and Shanghai, savings rates are as high as 50 per cent, reflecting consumers' propensity to save a higher proportion of their growing household income.

Government measures to stimulate spending through the consolidation of national holidays into week-long breaks appear to have had only a short-term effect. Consumers over the age of 45 are probably a lost cause. This generation has experienced so much economic and social upheaval that their propensity to save is now ingrained.

Fortunately, this group accounts for a relatively small proportion of total savings, which limits its potential impact on economic growth rates. The government should target the segment of the urban population aged between 25 and 45. Many of these people are rapidly joining the ranks of the Chinese middle class. Most are still saving for their first big purchase such as a home - a "trigger" that will lead to further consumption.

Only 30 per cent of Shanghai residents own a modern flat, compared with 15 per cent in a typical second-tier city such as Tianjin.

Over the past three to four years, we have reached a first tipping point in the willingness of Chinese consumers to invest in property, releasing pent-up demand from those who had saved enough to make such a big-ticket purchase.

However, while creating fabulous wealth for many developers, this property boom has failed to offset the continual rise in the overall savings rate.

While the first wave of property investment has now swept through several cities, the next wave will depend on the emergence of a new segment of consumers who have saved enough to purchase a home. It will also depend on consumers' willingness to take out larger mortgages and their access to lower-cost flats. This next wave should be a priority for government initiatives aimed at encouraging consumption.

Yet home ownership is only one lever the government can use to stimulate consumption.

It must also help to assuage concerns over a possible rise in personal expenses, which has held back spending by middle-class consumers.

Unlike their western counterparts, few Chinese consumers are afraid of losing their jobs. Thanks to a booming economy, members of China's middle class are confident they can secure new employment almost at will, and often at higher salary levels.

Yet they do worry about a potential increase in healthcare, pension and private education expenses. Many estimate these potential costs to be much higher than they are likely to be.

Their instinct has told them to save against the extreme case rather than the more likely outcome. As a result, people are over-saving for future events relative to what they would have to pay if they could share risk through quality pension programs or health insurance products.

Greater tax incentives to stimulate savings in these products may be needed, along with measures to boost confidence in the providers.

Allowing greater participation of foreign insurers in the sector can help, by giving consumers access to a wider range of healthcare and savings products. Over the past 20 years, we have seen a change in consumer behaviour towards lower savings and higher consumption in countries such as Japan and South Korea. In Taiwan, savings rates have declined from 34 per cent to 26 per cent. China must follow this trend by helping to dispel the misconceptions that consumers have about future living and healthcare costs.

Gordon Orr is a director in McKinsey & Company's Shanghai office.

This article was originally published in the Financial Times.