By Chris Ip and Anna Yip
March 31, 2007

A growing middle class and a decade of annual double-digit growth in retail sales have provided a powerful magnet for businesses hoping to cash in on emerging China. Yet, outside of the main cities, in the vast expanse of rural China where around 750 million people live, the reliance on cash makes it difficult for consumers to spend, and retailers to sell.

China has just 530 point-of-sale (POS) and automated teller machines (ATMs) per million people, far below the 10,000 per million found in the US. Accordingly, cash is used in 83 per cent of all payment transactions in China, compared to just 21 per cent in the US. With most of these terminals in the cities, practically all rural transactions are cash-based.

One way to wean rural consumers off their reliance on cash might be to simply add more ATMs and POS terminals. However, we estimate that such an effort would cost at least US$2 billion, and add just 130 terminals per million people. Installing equipment and extending the telecom network into remote areas would also take a prohibitively long time.

Recognising the need for a new rural payments system, in August of last year, the People's Bank of China directed domestic banks to devise a solution. China views the development of a low-cost, non-cash payment network in rural areas as critical to increasing rural spending and closing the wealth gap with urban areas.

The good news is that mainland China can tackle the problem using existing technology, and without a hefty price tag. McKinsey research shows that the mainland's existing mobile short message service (SMS) network could be quickly and cheaply deployed to provide an SMS-based mobile payment system in rural areas.

Because the most expensive parts of the infrastructure—the mobile network and millions of mobile phones—are already in place, we estimate the cost of this solution would be in a range from less than US$40 million to US$60 million. A payment-settlement system between merchants, banks and mobile phone providers would account for the bulk of this. The initial investment would quickly be recouped through transaction commission fees and mobile-phone usage charges.

There are alternative mobile payment solutions gaining exposure worldwide, but these are not well suited to the needs of rural China. For example, Seoul and Tokyo have both introduced a system whereby a transaction can be completed using a mobile phone with a special built-in chip and an in-shop, non-contact reader. However, the need to install the reader and use special—and expensive—mobile handsets renders the solution inadequate for rural China.

Aside from its lower cost, an SMS-based payment system is also versatile and ubiquitous. Users simply send an SMS message specifying the mobile phone number of the payee and the amount to transfer, along with a personal identification number. Within seconds, the payee receives a confirmation message by SMS and receives the money in the nominated account. The payer receives a confirmation message.

Consumers can make retail purchases or pay for such things as utilities, use the system to receive payments, such as salaries and wages, or transfer money to friends and relatives. China's large migrant labour pool would have access to a convenient, inexpensive and secure system for sending money home. Less cash also means less chance for theft.

Consumers would not be the only beneficiaries. Banks could serve a broader base of rural merchants that are currently beyond their reach. And ease of access to funds would encourage potential rural customers to keep their money in the bank rather than under the mattress.

For merchants, mobile-cash-ready customers are more likely to shop on impulse, increasing sales revenues and reducing the cost and risk of handling cash.

Mobile-phone operators would be able to increase their customer base, boost data revenues and lock in customers with additional services. The experience of the Philippines, where SMS has been widely adopted for some time, augurs well for China. Philippine consumers are rapidly catching on to new "mobile wallet" systems. China is similarly well positioned to introduce such a service. Up to 15 per cent of China's rural population already subscribe to a mobile phone network; we expect penetration to reach 22 per cent by 2010 and 40 per cent by 2016. Around 75 per cent of current mobile subscribers use SMS, suggesting there would be few technological obstacles to the adoption of mobile payments.

There are obstacles to the adoption of cashless payment systems, but the SMS option minimises them. For example, customers may be cautious about trusting an "invisible" system. But the involvement of big and trusted brand names—which in China include banks and mobile operators—along with marketing and consumer education efforts, should soothe such fears.

Merchants new to cashless transactions may be concerned that payments will be mislaid. Partnerships with selected merchants and an education campaign can prove that the system works. Regulatory barriers will need to be resolved, but the government has shown it is committed to developing a system for cashless transactions.

The prize is substantial. McKinsey's research shows that consumers in rural China now account for just 22 per cent of the country's total retail payment transaction volumes.

We predict that significant growth in rural household incomes will lift this to 44 per cent by 2015.

By teaming up, banks, mobile phone operators, merchants and regulators could go a long way towards helping rural Chinese consumers part with their hard-earned savings, unlocking the next billion dollars of Chinese spending.

Chris Ip is a partner in McKinsey & Company's Hong Kong office; Anna Yip is an associate principal in McKinsey's Hong Kong office.

This article was originally published in the South China Morning Post.