China 2013: A Year in Review with Shaun Rein

January 7, 2014 Posted by China Briefing Reading Time: 7 minutes

This week, China Briefing is featuring a series of specially-commissioned articles and interviews from prominent China-based writers regarding their thoughts on the key developments in the country during 2013, and what lies ahead in 2014. Today’s interview features Shaun Rein, author of “The End of Cheap China: Economic and Cultural Trends that Will Disrupt the World” and managing director of the China Market Research Group.

Jan. 7 – Shaun Rein has written widely on his experiences working with CEOs and country-heads in China since arriving in the mid 1990s. His firm gathers independent market research and provides strategic advice to clients operating and investing in China, including DuPont, Apple, Richemont and Fidelity. In this Asia Briefing exclusive interview, Mr. Rein discusses China’s evolving economic trends and their impact on both the local consumer and business provider in China.

What economic changes do you see taking place in China?

First, China’s economic growth model of the last three decades is broken. The country can no longer rely on exports and heavy investment for economic growth. It is also no longer cheap to do business in China anymore—wages are increasing 10-15 percent a year, real estate costs are also going up in the double digits—so companies are either moving up the value chain in terms of manufacturing, getting squeezed margins, or they are relocating to other markets, such as Vietnam, or another market internally within China, like Sichuan.

Second, China faces a growing pollution problem. The government is making it difficult for high-polluting, high-water usage, capital intensive enterprises to expand in China. The government is also launching new initiatives like the Shanghai Free Trade Zone to shift the economy from being heavy investment and export oriented to an economy that is driven by consumption and services. In the next five to ten years, I expect consumption and services to take up a larger percentage of the overall economy. In 2012, over 50 percent of economic growth came from consumption. We estimate that consumption accounts for about 45 percent of the economy, which is far higher than most economists’ estimates of 30 to 32 percent, because most economists underestimate the size of the underground economy. The shift towards more sustainable economic growth, rather than growth at all costs, means we are no longer going to see double-digit growth rates anytime soon. I expect growth to come in around 7 percent over the next three to five years.

How can a company take advantage of this changing economic model?

There are great opportunities for companies that are already in China, and ones that are moving in. The major growth story of the next five years is going to be the Chinese consumer. Retail sales are still growing about 13.7 percent a year and wages are continuing to see double-digit growth, so we expect to see consumer-oriented companies doing very well, especially in tourism, food, and leisure—those are the three that I think will come out really strong in 2014. Now the key is that Chinese consumers are changing what they like and what they want. Five years ago, everybody wanted Louis Vuitton, but because of the pollution problem, a lot of consumers started telling us, ‘Who cares if we can buy an LV bag or a Gucci wallet if the water and air will kill my family.’ They are starting to reprioritize what is important in life, so we started seeing this year consumers moving away from status items, like an LV bag or Gucci wallet, and moving more into experiential, lifestyle issues, and that’s why we are very bullish on travel and leisure.

The number of tourists to Thailand has already doubled in the last year and the number of tourists to Korea has gone up about 40 percent. People are going there because they want clean air and fun experiences that are healthy, like scuba diving or hiking up a mountain. The new theme in consumption is experiential spending. Truly wealthy are going to South Africa on safari or on cruises in Alaska.

This is a good opportunity for new players and new entrants into China to fulfil these niche markets and to cater towards fears of pollution and food safety. That could be a new great piano company, it could be a massage chair firm, anything that is getting into this health and enrichment trend. A great example is Manuka Honey, which has boomed in China in the last year because consumers are so concerned about their health that they are willing to buy the best honey from New Zealand, even though prices top $250 USD for many bottles.

While there is great potential for profits in China, senior executives need to understand that it is not as easy as it might have been five years ago and definitely not as cheap. Companies are going to have to get a lot smarter in what products they sell, what type of sales channels they use, the types of people they hire, and they have to manage expectations at headquarters about the real potential in China. I think a lot of companies are expecting a 40-50 percent growth rate, but I think with the slowing and shifting economy, it’s now going to be now more 10, 15, 20 percent growth rates for brands, rather than the 40-50 percent of the past.

What edge can a company gain in the new Chinese consumer economy?

Companies have to understand that they need to create an aspiration and a sales channel that fits what Chinese consumers want. I will give you a great example: Ralph Lauren has never done particularly well in China, even when luxury was booming here. The problem was they always used models that were blond haired and blued eyed summering in the Hamptons. But whenever we spoke to Chinese women, they always say, ‘That’s a great image, but I’m not blonde, and I have a different body shape. The clothes won’t fit me.’ The image of Ralph Lauren never really fit what Chinese consumers wanted. I think positioning your brand with the right aspiration is going to be even more important as we go forward. You will really have to segment your consumer market better and fit what they truly want

This will be true even for the companies that have been successful here. If I was a Zegna or an Omega or a Louis Vuitton who really dominated the market before, I would be really scared about the marketplace right now, because before, Zegna could say, ‘We’re the best menswear company,’ but that doesn’t fit anymore. Some men want to be athletic in their menswear now, others want to be low profile, others want to have sharp-cut suites, others want to be boxier, so I think brands have to get a lot smarter about what consumers here want and position properly for them.

It is a great opportunity for niche players to come in on both the lower and high-ends, like a Brioni or a Hugo Boss. You are no longer going to see companies dominate with the 70 percent market share, like Omega or Louis Vuitton used to have. It’s a good opportunity for brands that are trying to cater to self-expression and more niche markets.

What role will China’s middle class play in the coming years?

We estimate there are about 350 million people who earn between 6 and 15 thousand US dollars each year that most people would define as middle class. A lot of brands have said, ‘We need to target China’s middle class.’ Now, there are two notions we need to keep in mind when targeting this group. First, calling them middle class and expecting them to exhibit the same spending patterns as American middle class consumers is a mistake. China’s middle class do not exhibit the same patterns and behaviors as middle class elsewhere. In America, people are born middle class, blue-collar and they are proud of it. Their kids will be middle class and their grandkids will be middle class and they shop at Macy’s on special occasions. But when you talk to Chinese middle class, they feel like they are on their way to riches. So they don’t really want brands that emphasize a middle class lifestyle. You see brands that fall into that middle class demographic, like Esprit, Li Ning, Gap, they don’t really do well here. Consumers either trade for something more prestigious like Adidas or something cheaper,.

Second, contrary to what most analysts say, middle class Chinese are actually the most pessimistic consumers in China today. They still think they are going to get rich, but not in the short-term, because of the slowing economy. Importantly, they are concerned about rising housing prices, about the difficulty in buying a car or getting a license plate, so for many middle class Chinese, they are starting to worry that they will never realize the Chinese dream. Many worry that their children’s lives might not be as good as their own financially. You need to be cautious in how you target the middle class because they are much more pessimistic than people think.

Now, the group that analysts often underestimate are low-income Chinese who make RMB3,000 a month or less that live in more urban-type areas. There are about 850 million of them. They are actually the most optimistic consumers in China right now. Blue-collar workers’ salaries are going up around 15-20 percent. As China shifts from manufacturing to services, the service-oriented jobs are higher paid. These workers are often moving to new cities in the search for better work, so have to buy many new items. Food inflation has also only been about 3.5 percent this year, down from the 10-15 percent we have been having annually for the last five years. These low income Chinese have more disposable income than at any time in recent history. They never expected to be able to buy a car or a house, so they are quite optimistic.

Do you see a future for manufacturing in China?

In my book “The End of Cheap China” I wrote that China is no longer a cheap place to do business. I think a lot of people misread what I wrote. I never said that China would lose its manufacturing dominance. In fact, I believe it’s going to maintain its manufacturing dominance because it has far superior infrastructure and eco-systems in place.

Light industry has already moved to Vietnam and Indonesia, where it is cheaper to produce items like a shirt or shoe. But China is still going to dominate because it has the infrastructure and logistics that other place don’t have. What will happen is the manufacturing will either go more up the value stream or there will be more automation of the production line. What we recommend to our clients is to focus on improving worker efficiency because a Chinese worker is still only about a quarter as efficient as an American worker, so there are still a lot of gains to be made in manufacturing efficiency. China will continue to dominate, but instead of shoes, it will be things like automobile parts or airplane parts.

Overall, I am quite bullish on China’s economic growth over the next five years. It will be slower than before, but there will continue to be great opportunities for profit. That said, China is no longer the only game in town and other markets like Indonesia or Cambodia are also worth looking at by investors.

Shaun Rein is the Managing Director of the China Marketing Research Group and author of the book “The End of Cheap China: Economic and Cultural Trends that Will Disrupt the World.” He has written widely on his experiences with CEOs and country-heads in China since the mid-1990s.