Newsweek International

Unleashing the Chinese consumer

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The Middle Kingdom can pick up some of the slack left by rich country shoppers: Here's how.

As the global financial crisis ebbs, company and policy leaders around the world are scratching their heads and trying to understand what the post-downturn "new normal" state of the world economy will be. Which nations will become growth engines? Where will new business opportunities arise? How will the global trade and savings imbalances evolve?

We are on the cusp of a period of deep uncertainties—not least about what will happen with consumer spending, now nearly 60 percent of world GDP. Many companies that counted on the United States and Europe as key growth markets in the past are bracing themselves for relatively lower growth. While consumers in these advanced economies will eventually start spending again as the recovery deepens, the aging of the baby boomer generation, coupled with depleted retirement savings and a tax burden that will probably rise in the long run, mean that consumption is likely to expand less rapidly than it did precrisis.

In Asia and other emerging economies, however, the McKinsey Global Institute (MGI), McKinsey's economic research arm, expects one billion new consumers to emerge by 2015, vaulting into the ranks of the middle class with extraordinary spending power. The speed at which this new consumer army emerges and how aggressively they spend (as opposed to save, which is historically what they've done) will be a critical factor in the trajectory of the postcrisis world.

China is pivotal to closing the global consumption growth gap. The world's star economic performer (expected to grow 8 percent this year) suffered its first export decline in seven years in 2008 and continued to decline in the early months of 2009. Yet long before this, the country's leadership had recognized the need to shift gears and unleash consumer spending to achieve more sustainable growth; as far back as 2007, Beijing was talking about the unsustainability of the current system. With private consumption at $890 billion in 2007, China is already 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 the country's huge population and stage of development, China's consumers still punch far below their weight. As a share of China's GDP, consumption stands at only 36 percent—only half that of the United States and two-thirds that of both Europe and Japan. China has the lowest consumption-to-GDP ratio of any major world economy. What's more, the consumption share has fallen by nearly 15 percent since 1990 despite China's robust growth. The speed and magnitude of this decline are unprecedented in modern history. Even during the full-scale industrialization of the US economy during World War II, American consumption never dropped below 50 percent.

China's leaders have stated they want the consumption share to rise in a long-range effort to rebalance sources of growth in the economy away from government-led investment. Whether China succeeds, and how rapidly, will be of enormous importance not only to that country but to the continued recovery of the world economy.

If the government doesn't follow its policies with action, MGI research suggests that China's consumption share of GDP will rise only modestly, to 39 percent by 2025. Yet in purchasing-power-parity terms, even this shift will result in a middle class approximately double the size of America's today. In other words, China is already on track to become the world's third-largest consumer market by 2025.

MGI has modeled another scenario (let's call it the "policy" case) in which Beijing acts on the policies it has outlined, including stimulating consumer consumption directly, bolstering health and education provisions, and making structural reforms in the economy. If that happens, it could increase the consumption share to 45 percent of GDP—boosting total GDP in the process by around $952 billion (or 8 percent higher than it will go on China's current path) and private consumption by $1.71 trillion (26 percent higher). If China took an even more aggressive stance (a "stretch" case) on these policy shifts, that share could rise to more than 50 percent, adding around $1.74 trillion to China's GDP above the trend line, or around 3 percent of current global GDP at current exchange rates. That would pick up some of the slack left by weaker US and European consumer spending.

Making this shift won't be easy. China's households currently save an extraordinarily high 25 percent of their discretionary income, about six times the savings rate in the United States and three times the rate in Japan. China's savings rate is even 15 percent higher than the GDP-weighted average in Asia. The conventional explanation for this is that ordinary Chinese are naturally thrifty and reluctant to spend more due to the country's inadequate health care and pension systems. Stitching together a safety net comprehensive enough to ease consumers' anxieties will require greater government spending. That spending will, of course, provide new business opportunities for health care providers and insurers. Yet because it will also increase the share of state investment within the economy, we estimate that it will boost the consumption share by only 0.2 to 1.1 percent before 2025.

MGI believes that an even more important reason that Chinese consumers save so much is that, outside China's largest cities, there simply aren't attractive products and retail outlets, nor secondhand markets and e-commerce, and prices are relatively high. Even in rural China, close to 70 percent of consumers say they would prefer to shop in Western-style malls, indicating huge unmet demand and a major opportunity for global retailers looking at the Chinese market. China's consumers also tend to save for big-ticket items, which constrains spending. Encouraging the use of credit cards—a promising area for financial-services firms—could add a significant amount to China's consumption share by 2025.

Still, changes in consumer spending and savings behavior are only part of the solution. Undertaking structural reforms in the economy is at least as important. Consumers are capturing a smaller slice of an ever-growing pie. China's household income has shrunk from a peak of 72 percent of GDP in the early 1990s to less than 55 percent by 2007—compared with more than 60 percent in Europe and more than 70 percent in the United States—as corporations' share of national income has risen. This is a systemic issue: by prioritizing investment and industrialization, China has crowded out consumers.

Breaking this cycle will be a difficult and long-term challenge and will require sustained and sweeping reforms to the finance system, industrial policy, and international trade. If successful, however, these structural policies could boost private consumption spending by 10 to 20 percent and China's GDP by 1.8 to 2.9 percent. Action on two broad fronts will be critical. First, China needs to shift toward services. The government's 11th Five Year Plan of 2005 targets a 3 percent increase in the services share of GDP by 2010. If such increases were targeted every five years after 2010, services would reach 49 percent of GDP in 2025. Average household incomes would then be 9 to 10 percent higher than current projections. Creating more access to investment products such as mutual funds would also help boost the consumption share.

MGI is optimistic that China can make genuine progress, even within five years, in all three areas. The nature of China's state-run system means that the central government has significant powers of persuasion that allow it to orchestrate and implement policy initiatives very rapidly. Beijing started aggressive fiscal spending within the same quarter it announced the stimulus package in November 2008, while it took other governments many months to prime the pump.

If China manages to boost its consumption share to between 45 and 50 percent of GDP by 2025, the economy would generate an additional 8 to 15 percent of annual GDP. China would create between 10 million and 50 million more jobs and boost average household incomes by 10 to 20 percent.

The global implications of this are immense. China's trading ties with the rest of the world would be less fraught, with its trade surplus shrinking by up to 40 percent. China would account for more than one-quarter of all new consumption worldwide over the next 15 years, adding more than 10 percent to the growth in global consumer demand in the process, and adding $1.9 trillion a year to net new global consumption. That would make China's consumption equal to 40 percent of US consumption in 2025, up from just 12 percent today—a new normal, indeed.

Dobbs is a director of MGI and a director (senior partner) of McKinsey based in Seoul; Grant and Woetzel are both directors of McKinsey based in Shanghai.

This article originally ran in Newsweek International.