As the global crisis ebbs, China's leaders realize more clearly than ever that they must unleash consumer spending to achieve sustainable growth. Stoking Chinese consumption has vaulted to the top of national—indeed global—policy agendas. China has already embarked on measures that will shift the focus of its economy away from heavy industry and exports and toward services and consumer products. But if China's leaders committed themselves to a more aggressive program of comprehensive reform, they could raise private consumption above 50 percent of GDP by 2025. Clearing that threshold would bring the consumption rate in line with those in the developed nations of Europe and Asia, vaulting China's economy into a new phase.
These are among the findings of If you've got it, spend it: Unleashing the Chinese consumer, a new report by the McKinsey Global Institute (MGI), McKinsey & Company's economics research arm. McKinsey estimates that comprehensive reform would also enrich the global economy with up to $1.9 trillion a year in net new consumption by 2025, boosting China's share of the worldwide total to 13 percent—four percentage points higher than its share without further effort.
Private consumption in China totaled $890 billion in 2007, making the country the world's fifth-largest consumer market, behind the United States, Japan, the United Kingdom, and Germany (which China recently surpassed as the world's third-largest economy). But relative to China's population and level of economic development, its consumers punch far below their weight. The country's consumption-to-GDP ratio—36 percent—is only half that of the United States and about two-thirds those of Europe and Japan.
In fact, China's consumption-to-GDP ratio has dropped by nearly 15 percentage points since 1990 and continues to deteriorate in the aftermath of the financial crisis. The sources of China's low consumption rate are both behavioral and structural. The country's households have an extraordinarily high ability to save: The average Chinese family squirrels away an astonishing 25 percent of its discretionary income, about six times the savings rate for U.S. households and three times the rate for Japan's. Indeed, China's savings rate is 15 percentage points above the GDP-weighted average for Asia as a region.
Structural features also restrict consumption's share of the national income: Chinese households command only some 56 percent of it, compared with more than 60 percent in Europe and more than 70 percent in the United States. No effort to raise Chinese consumption rates significantly can hope to succeed without addressing the structural factors that both channel income away from consumers and discourage them from spending even their modest share.
Perhaps the most common explanation for the Chinese consumer's reluctance to spend more freely is the frayed social safety net. Many argue that the country's consumers oversave and underspend because they lack adequate health insurance and can't count on government- or employer-sponsored programs to provide for them in retirement. Over the long run, mending the social safety net would ease anxieties about the future and bolster consumer confidence.
But McKinsey doesn't believe that better health and pension guarantees would raise private consumption significantly before 2025. Even a fully fledged program to expand China's health and retirement benefits wouldn't raise private consumption's share of GDP significantly as government will have to provide the majority of the funding. We estimate that, at best, such improvements would boost private consumption by only a percentage point above the 2025 base-case projection.
Measures to make goods and services better and more easily available could encourage consumption much more than would fixing the social safety net. China's consumer infrastructure is incomplete. Too few products are tailored to the needs of those who would use them. Prices remain high compared with income levels: A Chinese worker toils more than seven hours to buy the same amount of goods and services a U.S. worker earns in only one. In rural China—home to more than half of the country's billion consumers—consumers buy only 18 percent of their goods through organized retail establishments, compared with 50 percent in urban areas.
Even when high-quality products are readily available, China's consumers hesitate to buy them on credit. At 3 percent of GDP, outstanding consumer debt in China falls well below that of other large developing countries, such as Brazil, at 12 percent, or Russia, at 7 percent. China's credit infrastructure is underdeveloped. Only the most affluent urban families can obtain mortgages, which thus account for just 23 percent of the value of new homes in China, compared with 65 percent in the United States.
Similarly, concerns about financing the cost of a university education drive much of China's saving: An April 2009 survey of urban Chinese households commissioned by MGI found that this was the number one reason for saving, eclipsing concerns about medical expenses and retirement. McKinsey estimates that, in aggregate, measures to facilitate consumer spending—through better and more easily available products and expanded access to consumer credit and to financing for a university education—could raise consumption's 2025 share of GDP by 2.8 to 4.7 percentage points.
Over time, a stronger social safety net and improved access to better goods and services will encourage China's households to save less and spend more. But the country can't hope to increase its consumption rate meaningfully unless it reverses a major current trend: Households have a relatively small and shrinking share of the national income. Any significant rise in household incomes will in turn require far-reaching policy changes that would transform some of the economy's most basic structures.
China's current growth model tilts overwhelmingly in favor of large industrial companies, which typically are state owned or led, benefit from preferential financing from state-controlled banks, and enjoy considerable monopoly power. The result is an economy dominated by capital-intensive manufacturers with strong incentives to pile profits back into ever more plant and equipment improvements rather than disburse them to households as dividends or wages. Labor-intensive producers—small and medium-sized enterprises—and the services sector get short shrift. Over the past two decades, the corporate share of China's national income has risen to 22 percent, up from 14 percent, even as the share of households has fallen to 56 percent, down from 72 percent.
Ultimately, China can't hope to unleash the power of its consumers unless the economy creates more jobs and pays higher wages, so fiscal and regulatory policies must change. Banks should be encouraged to support the services sector as well as small and medium-sized enterprises. Dividend policies for state-owned enterprises should be changed and the development of equity markets encouraged. By 2025, a comprehensive effort to restructure the economy along these lines could add 3.5 to 6.0 percentage points to consumption's share of GDP, breaching the 50 percent barrier.
"In years past, China has demonstrated a remarkable ability to make major economic changes rapidly in pursuit of broad national objectives. It can do so again by shifting to a new economic paradigm that unleashes the spending power of its consumers. A more consumer-centric economy would allocate capital and resources more efficiently, generate more jobs, spread the benefits of growth more equitably—and grow more rapidly—than China will if it remains on its present course. Foreign ties would become more harmonious because the trade surplus would narrow and the country's consumers would make a greater contribution to global growth," says Jonathan Woetzel, a director in McKinsey's Shanghai office.
"Today, there is a huge gulf between the retail and consumer experience available in China's larger and wealthier cities and that in smaller cities and rural areas. To address this gap, China can pursue a number of actions such as supporting the development of modern store formats, channels, and distribution networks (e.g., secondhand and leasing markets for cars, online shopping for many categories) and encouraging the continued development of both international and domestic players throughout the consumer industry," says Alex Peng, a partner in McKinsey's Beijing office.
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