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Why China will dominate the emerging middle class

Why China will dominate the emerging middle class

10-06-2015 | Insight

The Chinese middle class will dominate the ranks of emerging consumers in the next 5-10 years while predictions about India are too optimistic, says Robeco trend analyst Steef Bergakker.

  • Steef  Bergakker
    Steef
    Bergakker
    Senior Portfolio Manager

Speed read

  • Overly optimistic predictions for India. Negative prospects for more productive jobs
  • China far better positioned to make transition to middle class income level
  • Chinese per capita GDP already ensuring sharp growth in discretionary goods spending
  • Ecommerce in China is attractive

Where will the shoppers of the future come from? The emerging consumer is an important investment theme that appeared during and directly after the financial crisis. At the time, the US consumer was switching into a lower gear, while the growth in emerging economies was still strong.

An influential paper on the subject was written in 2010 by Homi Kharas of the OECD Development Centre. He predicted that the global middle class would double by 2020 and triple by 2030. Most of the growth would take place in China and India. The prospect of hundreds of millions of new consumers spending on more than just the basic necessities could lead to an accelerated demand for discretionary consumer goods.

Bergakker started to investigate whether the assumptions behind the model were valid, especially after growth in some emerging markets began to taper off. He wanted to find out whether this was still an interesting investment theme and where to find the best opportunities. Bergakker found China offers the best prospects. “Investors often talk about the global middle class. But in terms of opportunity, size and relevant investment horizon, this really only means China.”

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The case for China is much better

China is in a much better position to make the transition to middle class income levels, predicts Bergakker. “The outlook for the next 5-10 years is strong. And he gives three reasons why the Chinese economy and middle class will continue to grow in the next five years.

“First, the increased level of urbanization,” he says. “Salaries in the city are three times higher than in the countryside. Urbanization is expected to increase from 54% now to 60% in 2020. Second, the young people in China earn more than the old, because they have received a better education. This is unusual, because normally older people earn more because they have more experience. As the older less well educated retire and younger employees climb the corporate ladder in the coming years, average incomes will increase. Third, there is an increase in the female labor force participation rate and the income gap between men and woman is expected to shrink.”

Bergakker warns that despite the positive medium term outlook there are long-term challenges to overcome. “At some point the old recipe of shifting farmers into factories will no longer work. Countries such as Vietnam can do the same, but at a much lower cost.” The Chinese government understands the need for reform and is taking measures to increase the quality of its economic growth.

Not many countries have successfully made the huge leap required to join the high income group – Bergakker regards it as a daunting task. “To avoid the middle income trap they need to make institutional reforms and change their mentality. Brazil also had an enormous demographic dividend, but could not extricate itself from the middle income trap. Only a few countries have succeeded and South Korea is one of them.”

Chinese growth in consumer discretionary and ecommerce

Chinese annual per capita GDP is already at the point where spending on discretionary goods is taking off, says Bergakker. “Empirically this point is between USD 6,000 and USD 10,000.”

So which segments will grow most strongly in China? Consumer surveys and historical patterns from countries which have followed the same path suggest affordable discretionary consumption will increase the most in volume terms. The sectors with high prospects are education, healthcare, consumer credit, beauty products and tourism. Average growth is predicted for cars and PCs and low growth for food and apparel.“

At some point the old recipe of shifting farmers into factories will no longer work

Bergakker has an interesting addition to this list: ecommerce, which has only a few dominant players in China such as Alibaba, Tencent and Baidu. These companies can help to overcome some of the problems caused by a lack of physical retail infrastructure. “One of the big problems in China is the lack of good retail infrastructure and logistics outside the major cities,” he says.” It is difficult to reach the consumers outside these cities. Ecommerce makes it possible to circumvent these problems with platforms like Tmall and Taobao, Alibaba’s online shopping market places. Physical delivery is still a problem, but a large percentage of the population can be reached like this.“

Companies that solve such problems are favored by the Chinese government, which is a critical success factor. ”It is essential to have a good relationship with the Chinese authorities,” says Bergakker. “And ecommerce fits into their vision of transition from an economy driven by investments to one that is consumer-driven. The Chinese state also supports ecommerce by building distribution centers.”

Investing in western companies to ‘play’ the Chinese middle class investment theme is difficult. “There are western companies with a large presence in China, but these are mainly luxury goods players,” says Bergakker. “For the mass market it is more difficult. For example, Unilever, the Anglo-Dutch company in nutrition, hygiene and personal care, has achieved some success in China. But there will be fierce competition with domestic brands and China will still be a relatively small portion of total turnover. For an investor it makes more sense to invest in companies focused primarily on the Chinese domestic market.“

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