Special report: The Chinese consumer awakens

XIAHE, China Fri Dec 10, 2010 5:08pm EST

1 of 5. Customers walk out of a Wal-Mart store located in a shopping mall in Yanqing county of Beijing November 20, 2010. China's consumption has lagged well behind other major economies, because the country was mainly focused on investment and exports. But that is beginning to change, as incomes rise and China rebalances its economy. Picture taken November 20, 2010.

XIAHE, China (Reuters)- In the Tibetan monastery town of Xiahe, Gyelyanjia is visiting for a festival and taking the opportunity to do some shopping.

He has spent 20 yuan (2 pounds) at Ding's electrical appliance shop on a heat-belt, which he can fill with boiling water and strap around his waist to ward off the bitter winter chill on the Himalayan plateau.

The 66-year-old grins: "I already have a television at home. But I would like a washing machine and a fridge. I hope to buy those next year."

Timothy Geithner harbors similar hopes. The U.S. Treasury Secretary is counting on hundreds of millions of Chinese like Gyelyanjia to spend more and save less.

That way, Chinese factories would produce more for domestic

consumption and less for export, helping to narrow the trade imbalances that are destabilizing the global economy.

Chinese consumption is, in fact, strong. It has grown by more than 9 percent a year, after adjustment for inflation, over the past decade. China overtook the United States in 2009 as the world's leading automobile market. The real-estate market is on fire, swelling demand for appliances and furniture. China is No. 2 in sales of luxury goods.

There are no luxuries for sale in Xiahe, a rapidly developing town in the western province of Gansu and home to Labrang monastery, the largest outside Tibet.

Tibetans wrapped in long woolen robes, their hair falling in long plaits, crowd the broad pavement lined with shops along the main street leading to the sprawling monastery. Monks, taking a break from their prayers, chat on mobile phones on their way to the tea house or to buy a pair of handmade felt boots.

Renqing, 33, who like many Tibetans uses only one name, watches over her two-year-old daughter, sleeping in her stroller outside a shop. "Life is difficult for us. I only have enough money to feed and clothe my family."

Still, she admits, she has a washing machine, a fridge, a television and a computer at home. And, of course, a DVD player. But it's not enough. "If there's one thing I dream of having, it's Tibetan religious art. I wish I could buy statues to put in my home."

The Ding family are Hui minority Muslims. Mrs Ding Yuying gestures around her store filled with freezers and televisions. "Business is up 50 percent this year because the government has given a subsidy to farmers to buy electrical goods," she said.

Yet appearances are deceptive, at least through the prism of economic statistics.

INVESTMENT TRUMPS CONSUMPTION

Spending might be sturdy in China, but investment has been off the charts. As a result, consumption was just 35.6 percent of Gross Domestic Product in 2009, from 46.1 percent a decade earlier - and that was helped by a massive government stimulus to counter the global financial crisis.

The task for China's policymakers is to lift that proportion by boosting wages, speeding up urbanization and building a social safety net so people do not need to save so much for a rainy day.

"Consumption will be the story of the next five to 10 years, and because we're talking about a fifth of humanity, it will have a huge impact on global business," said David Gosset, director of the Euro-China Center for International and Business Relations at the China Europe International Business School in Shanghai.

Still, he doubted China's consumption share would reach the roughly 60 percent rate of the European Union, let alone the 70 percent rate of the United States. "The Chinese will never consume as we do in the West, especially in the U.S."

The opportunities for retailers are nevertheless mouth-watering, if they can adapt their sales methods to thousands of fast-growing towns across China where budgets and tastes are a world apart from the bright lights of Beijing and Shanghai.

Patrick Kung, Greater China chairman for Koninklijke Philips Electronics NV, sees huge growth in the coming decade in what he calls China's "emerging markets" -- lower-tier towns and the countryside -- while coastal cities will gradually become saturated.

"A smart company will be proactively investing and looking how to tap those markets," Kung told a conference organized by the European Union Chamber of Commerce in Beijing.

Scenting the potential profits, many multinationals are doing exactly that.

General Motors <GM.N >, the biggest overseas automaker in China, is busy rolling out affordable models aimed at smaller cities that it says could account for 60 percent of its business within five years.

"Those big coastal cities are rapidly becoming less than a quarter of our business and the real growth is in what we call Tier-3, Tier-4 cities," Terry Johnsson, vice president of GM's China operations, told Reuters.

German sports goods company Adidas AG ADSG.DE plans to open more than 2,500 stores in smaller Chinese cities by 2015.

Foreign and domestic retailers in sectors from hotels to instant noodles are reporting surging sales from lower-tier cities, which are benefiting from a wave of corporate investment and government measures to support consumption, according to Jing Ulrich, chairman of China equities and commodities at J.P. Morgan.

"If you're not doing well, it's because you have an execution problem," she said. "I think in the next 3-5 years we're going to see the interior really taking over as a major growth driver for China's overall economy."

VESTED INTERESTS

The logic behind aggressive expansion plans sounds compelling. But they will pay off only if the Communist Party is prepared to overturn China's growth model. That means taking on vested interests that thrive financially and politically from the way the economy is run, from well-connected property developers and their friends in local government, to the Party bosses of banks and big firms who wield immense power in their industries.

China has enjoyed three decades of double-digit GDP growth by favoring investment over consumption and export-orientated manufacturing over domestic services.

Heavy industry has benefited from a seemingly bottomless pit of cheap labor; cheap and plentiful credit supplied by state-owned banks; cheap land provided by local authorities keen to generate jobs and taxes; cheap utility tariffs; and, last but not least in Washington's eyes, a cheap exchange rate.

All these factors amount, economists say, to a tax on consumers and a subsidy for producers. Unable to sell all they make at home because incomes are suppressed, manufacturers have to export the surplus -- to the chagrin of critics such as Geithner.

One statistic dramatizes this imbalance at the heart of China's economy: the share of national wealth going to workers as wage income plummeted to 39.7 percent in 2007 from 53.1 percent in 1998.

Seen in that light, it is no wonder consumption has contracted as a share of GDP. But could China be on the cusp of change?

The National Bureau of Statistics (NBS) yearbook shows wages have surged and accounted for 46.6 percent of GDP in 2009. The bureau gave no explanation for the rise, nor has it published figures for 2008.

Louis Kuijs, an economist at the World Bank in Beijing, said he would not be surprised if wages and consumption were bottoming out as a proportion of GDP.

But he added: "It is a bit too early to say that we are obviously in a new era where we will see a quick reversal of these trends. We don't have enough evidence either on the data side or the policy side."

GETTING RICH IS GLORIOUS

China's transformation from an impoverished backwater to the world's second-largest economy has created an army of super wealthy who seized on the market reforms that Deng Xiaoping launched in the late 1970s. "To get rich is glorious," Deng Xiaoping is said to have declared, sounding a rallying cry to astute private entrepreneurs and unscrupulous strippers of state assets alike.

Now the rank and file is beginning to catch-up a little bit. Ting Lu with Bank of America Merrill Lynch estimates that nationwide wage growth this year will be about 14 percent. "

It doesn't feel that way, though, to Wang Yanjun, a 35-year-old migrant worker from a village in the central province of Henan who packed in his job as a carpenter on construction sites and moved to Beijing after the 2008 Olympics. He came with his wife but, typical of millions of migrants, they left their children, a daughter, 14, and a son, 8, back home.

"It was a really tough job and I quit, hoping to make more money in Beijing. But it turned out it's not easy to make money here either," Wang said.

On a chilly Sunday night on a street corner near the biggest gold shop in Beijing, Wang was selling barbecued meat, fish and vegetables for between 0.5 yuan and 3 yuan apiece from an unlicensed flatbed tricycle.

Wearing a black jacket smeared in cooking oil that he bought off the street for 80 yuan, Wang says he and his wife can clear 80 yuan a day, or 100 yuan in summer.

They pay 550 yuan a month for a small room and share a bathroom with another dozen migrant families. Wang says he has not set foot in a department store or a fast-food restaurant since he came to Beijing.

Asked whether they went to the cinema or to a park now and then, Wang looked at his wife before answering: "We don't go to places where you have to pay get in."

The official statistics, though, suggest China's 200 million-plus migrant workers like Wang have seen their earnings rise 18.7 percent in the first nine months.

This partly reflects a catch-up after a year of pay restraint in export factories in 2009, when China was coping with the global financial crisis. But demographic factors suggest wage inflation is here to stay.

NO SHORTAGE OF PEASANTS

China is not running short of labor.

Apart from the unemployed and underemployed in its cities, China could grow its food much more efficiently. Fang Cai, director of the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, estimated in 2008 that China had 107 million surplus rural laborers or 22 percent of the work force in the countryside.

However, more than half of those surplus workers are over 40 -- hardly prime candidates to stitch shirts or snap together an MP3 player. Indeed, China is already starting to run short at the margin of the nimble young workers prized by factories and construction sites.

Lu with BoA Merrill Lynch estimates the 20-45 age group will shrivel from 39.5 percent of the population this year to 34.2 percent in 2020.

"Massive migration from rural to urban areas over the past decade helped cover the manufacturing labor shrinkage problem, but it is widely believed that rural surplus labor younger than 40 is already very limited."

Cities in the southern manufacturing heartlands of Guangdong have responded to the shortages by raising minimum wages by more than 20 percent this year. Foxconn, which employs 800,000 workers and makes electronic gadgets for companies including Apple (AAPL.O) and <Dell .O.>, trumped that with a 30 percent pay rise.

Victor Fung, chairman of Li & Fung, the world's largest sourcing company, went so far as to say, in an interview with the Financial Times, that Foxconn had sounded the death knell for the cheap-labor model that propelled China to become "the workshop of the world."

Worried about China's growing income inequality, the government is happy to see the laws of supply and demand push up wages. Early this year, it turned a blind eye to a rash of strikes at foreign-owned plants in support of higher pay.

Boosting wages will be a central plank of China's five-year plan for 2011-2016, officials say. But would putting more money in people's wallets suffice to spur spending?

"It is tempting to think that high wage increases in the coming years will raise the role of household income and consumption. However, I do not think rebalancing will happen by itself -- it will require significant policy adjustment," said Kuijs, the World Bank economist.

MONEY UNDER THE MATTRESS

Take savings.

China is slowly building up a pension system, mainly for urban workers, and has made compulsory education free, in principle if not always in practice. The government is also extending health insurance and basic health care to fill a vacuum left when the "iron rice bowl" of cradle-to-grave social security for industrial workers was dismantled in the 1990s.

But many Chinese, especially older people and peasant farmers, still salt away as much money as they can.

"It's true that people don't really need to save as much nowadays because there are certain provisions. But it's a habit," said Zhang Weiguo, 48, a former soldier who is now a driver. "You can't get the older generation to change their habits."

But the government could try to change attitudes by spending more on behalf of its citizens instead of making them dig into their own pockets. China's budgeting instincts are deeply conservative. Outlays on education, for example, fall well short of international standards.

Increasing transfer payments to consumers and reducing their tax burden could be financed by requiring state-owned enterprises to increase the paltry dividends they hand over to the central government.

The powerful Party bosses that run big state-owned firms and banks have so far blocked efforts at redistribution, hoarding their cash instead. With government savings also on the rise -- tax revenues are up 22 percent this year -- China's gross national savings rate has soared to well over 50 percent of GDP.

China is awash with cash, but it is in the wrong places, an important reason why consumption growth has lagged growth in incomes for most of the last decade.

"There is no sign yet of the falling household savings rate that many believe is necessary to rebalance the economy," said Mark Williams with Capital Economics, a London consultancy.

GREAT WALL OF RETAIL

Zhang lives in Yanqing, a nondescript town of 100,000 people about 80 km northwest of Beijing, just beyond the Badaling section of the Great Wall popular with visitors to the capital.

Yanqing is the sort of middling Tier-5 town seen all across China. The buildings are forgettable, fronted with white-glazed tiles and blue tinted-glass windows. Lunch of freshly made steamed buns and black bean soup costs 17 yuan for two. The biggest draw in town is the local KFC, a throng of boisterous, plump children testifying to urban China's ready embrace of Western fast food.

What does set Yanqing apart is that it has a Wal-Mart (WMT.N). The world's largest retailer opened shop here in 2009 hoping to catch the wave of the consumer boom beyond China's big cities.

The store, set in a shopping mall, was busy but not humming one recent Saturday morning. Ruddy-faced country folk rubbed shoulders with better-dressed brethren, whom retail specialists might categorize as "aspirational shoppers."

"The prices are slightly higher, but the quality is better," one man said approvingly. Pierre Cardin down jackets were marked down to 700 yuan but were finding no takers. "The most people can afford around here is 500," a saleswoman said.

The proliferation of retail outlets in Yanqing illustrates another salient feature of the Chinese economy: the fierce competition for consumer dollars. Across China, multinational retailers of sporting goods such as Adidas and Nike, for example, face an array of local rivals including LI-NING, Erke, 361, ANTA and X-step.

"These are not small players. They're big boys. They're all big brands and they're all over," said Paul French with retail consultants Access Asia in Shanghai. "A rising tide is not lifting all boats - it's just very competitive, fiercely competitive."

Chinese retailers with big sales forces were often able to respond more nimbly to capitalize on fast-changing markets, added Franc Kaiser with InterChina Consulting, another Shanghai-based consultancy.

"The guys who react fastest to the opportunities are usually the Chinese. If they see a space in the market, boom, they're there!" Kaiser said. "These competitors can come from nowhere, but within three or four years they can roll up the market."

SECOND-CLASS CITIZENS

For all its ordinariness, Yanqing is the sort of place that is destined to flourish if the Party succeeds with another of the fundamental reforms it has proclaimed -- allowing migrant workers from the countryside to settle with their families in smaller towns.

Migrants with a rural certificate of residence, or "hukou," who move to a city to work, find it hard to get access to health, education and welfare services.

"I can't afford to bring my two kids to Beijing, and no school in Beijing will admit them in any case," said Wang, the carpenter-turned-food peddler from Henan.

If migrant workers like him could put down roots without facing such discrimination, they would in theory save less and spend more on everything from subways to noodle shops -- labor-intensive services that do not add to the trade surplus.

As it is, Wang said he and his wife still manage to save 20,000 yuan a year. "If I spend the money, who would pay the school fees for my kids and who would take care of us when we become ill?" But once he's saved 100,000 yuan, Wang wants to go back home and start a business.

Thousands of young graduates from out of town, dubbed "ant tribes," also find the streets of Beijing are not paved with gold. They live in cramped, often squalid conditions on the outskirts of the capital unable to get a foot on the property ladder or find a job that matches their qualifications.

In downtown Beijing, rag-and-bone men rummage through garbage bins. In alleys a few minutes walk from the capital's plushest hotels, indoor plumbing is the exception rather than the rule.

Still, the importance of cities for the consumption story cannot be overstated. They account for 76 percent of China's household consumption even though the urbanization rate is only 47 percent - about the same as the United States a century ago. Incomes in towns are three times higher than in the countryside.

With the urbanization rate not likely to peak until 2030 at around 68 percent, according to the Chinese Academy of Social Sciences, towns thus have the potential to be a big driver of growth led by consumption and services, not investment and industry.

Consultants McKinsey & Co expects China by 2025 to have 221 cities with more than one million inhabitants, compared with 35 in Europe today. Zhengzhou, the capital of Henan, China's most populous province, will have a bigger economy than Sweden, Hong Kong or Israel by 2020, according to the Economist Intelligence Unit.

To accommodate the ever-swelling ranks of urban dwellers, the Communist Party is embarking on another huge policy shift.

It is ramping up construction of subsidized housing for families on low incomes who cannot afford stratospheric market prices.

Ulrich at J.P. Morgan expects China to break ground on six million such apartments every year during the next five-year plan.

The boost to consumption that will come from urbanization and granting more migrants permanent residency has every chance of being reinforced by China's demographic profile.

With the working-age population set to shrink from around 2015, China is destined to grow old rapidly. As it does, retirees will draw down their savings -- as has happened in Japan.

At the same time, a younger generation of well-educated Chinese who never knew the privations their parents and grandparents suffered have fewer inhibitions about spending.

Meet Hou Jiexin.

MOONLIGHT CLAN

Hou, a 27-year-old finance manager originally from southwest China, earns about 200,000 yuan (£18,951) a year and saves barely a penny.

"My parents are saving for me back in Chongqing for when I get married, but I'm not saving," said Hou, a Burberry scarf around her neck and a Swatch on her wrist as she sipped a latte in the posh Oriental Plaza shopping mall in downtown Beijing.

Hou belongs to what is called in China the "Moonlight Clan," young adults who spend their entire monthly salary, earned over the course of a lunar cycle.

In addition to a 4,500 yuan monthly mortgage payment for her 45-square-meter studio apartment, she spends her money on Estee Lauder and Biotherm cosmetics, vacations, restaurants -- and classes to prepare for admission to an MBA course.

Confident that her salary will keep rising nicely, she is planning a trip to Europe and fancies splashing out as much as 40,000 yuan on a Chanel bag.

"My mom says I already have way too many shoes and bags," Hou said. "What I spend in Beijing is about two or three times what my parents spend between them in Chongqing."

Her mobile phone is a Nokia 7100, which she bought in the summer after watching a movie about an office lady who got promoted to be a senior manager in an international company.

"I noticed the phone on the big screen, and I bought it because it looked very nice," Hou said. "But yes, I know very well that it's time to get an iPhone 4."

Put all the pieces of the policy and demographic jigsaw together and the prospects are for a golden age of consumption in China, according to Morgan Stanley.

China's consumption, now just 20 percent that of America's, will reach two-thirds of the U.S. level by 2020, the bank projects. When it comes to incremental consumption in dollar terms, China overtook the United States back in 2008.

Goldman Sachs is equally bullish. It forecasts that Chinese retail sales, now worth $1.8 trillion a year, will leap to $5-6 trillion (£3-£3.8 trillion) by 2020. "That's what this decade is all about," said Jim O'Neill, chairman of Goldman Sachs Asset Management.

YAK MILK BUCKET

It will be a long time before the Moonlight Clan makes it to Xiahe. Life there ticks over more modestly than in Beijing.

In the Sunshine General Goods Store, a middle-aged Tibetan nomad inspects a blue plastic bucket and then a pink one. She turns each one upside down and then shows the blue one to her husband. He grunts at the shopkeeper, who asks for 18 yuan. They settle on 15 yuan, with a lid thrown in.

"They've come in from the pastures to worship and to shop. They'll use it to hold yak milk," the shopkeeper explains.

Down the street, Wangchen, another nomad, is buying thick cloth that looks like a polyester blanket for 15 yuan a meter. It will make her first new dress in five years.

She and her husband are shopping with a friend, a huge black and white sacred Tibetan bead around his neck to ward off evil.

"Our life doesn't get any better. I have three children to raise and it's very costly. I can't spend my money on luxuries," the 33-year-old nomad says. He wears a rough jacket and leather trousers tucked into heavy boots.

Raising the living standards of nomads like Wangchen and of migrants like Wang is the all-consuming priority of the Communist Party. With close to 300 million people still scraping by on less than $2 a day, the task is daunting. Yet an even larger number of Chinese has been lifted out of poverty in the past 30 years. Their lifestyle is modest but it is incalculably better than it was.

Drolma picks through windcheaters and plastic trousers piled high on a Xiahe street stall and hands over 60 yuan for a khaki jacket.

"Of course I can afford to go shopping. We are doing very well these days. We raise yaks." She holds up a yellow box with a picture of Hong Kong film idol Jackie Chan on the front. "I've bought a DVD player. It cost me 700 yuan, but I can manage that."

Her husband drives up on his motorcycle and the couple disappears into a shop selling the gorgeous gold brocades that Tibetans like to adorn their hats. He breaks into a smile and tries on a new jacket.

(Additional reporting by Zhou Xin; Editing by Bill Tarrant)

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