Cheap China Transitions to Luxury

 

April 25, 2012
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

  • After a decade of double-digit gains in wages, China may be poised for a manufacturing slowdownā€”and the price of goods may rise globally.
  • China's export-market share may decline slightly, but an increase in the Chinese consumer's buying power could help the economy in other ways.
  • European luxury-goods companies will likely benefit from the influx of Chinese consumers into the luxury market.

Cheap labor costs helped make China a global manufacturing powerhouse. So what happens after a decade of double-digit gains in wages for Chinese workers?

Growth is likely to slow, but we believe it will aid the transition of China's economy to a more balanced, sustainable growth model. In fact, China and the globe could benefit as Chinese consumers gain buying power, creating opportunities for luxury-goods companies that can cater to this influential new market.

China may lose export share, but no catastrophe

Wages in China have risen at a double-digit rate in recent years, but so has productivity, resulting in little change to the end price of goods exported. Meanwhile, the manufacturing sector in China shows the following signs of maturity:

  • Productivity gains are getting harder to come by.
  • Wage differentials with other countries are growing less favorable.
  • Exports are steadily moving away from lower-end goods such as clothing and toys, and toward machinery and electronics.
  • Advances in technology, in particular the move toward flexible automation in upper-end manufacturing, are reducing the role of labor in manufacturing.

The less human labor that's involved in manufacturing, the smaller labor's effect on the final price of goodsā€”which means that even if Chinese labor costs were to decline, they wouldn't be much help in holding down the price of exports.

We believe China may lose some export market share and export growth will likely slow in the near-term and coming years. We've written before about how the changing cost equation has contributed to a manufacturing renaissance in the United States, where the smaller labor cost differential has been particularly helpful for makers of goods with high logistics costs. In terms of low-end exports, countries such as Bangladesh and Vietnam have already increased their market share.

That said, it's unlikely China will lose significant market share. With its large base of both skilled and unskilled workers, extensive infrastructure, and supply networks, China will probably remain the global manufacturing hub for some time. Additionally, it would likely take competitor countries of low-end goods many years to duplicate the highways, rail systems and ports that China already has.

Slower but more balanced Chinese economy

In addition to exports, infrastructure and housing construction have helped propel the growth of China's economy. But construction can't grow indefinitely, and over time, continued investment into building more factories becomes an inefficient use of capital.

This is part of why China needs consumers if its economy is going to continue growing. Private consumption plays a much smaller role in the Chinese economy than in the American economy. The Economist Intelligence Unit notes that, during the five years ending in 2011, private consumption accounted for roughly 30% of gross domestic product (GDP) in China. In the United States that figure was nearly 70%. To help foster consumer spending, the Chinese government is targeting a 13% growth in the minimum wage over the five-year period ending 2015.

China's growth is likely to slow during the transition toward a consumer-led economy. However, this could result in an economy that is less reliant on exports and construction, and therefore more balanced. As a result, China's next phase of growth could be more sustainableā€”to the benefit of both China and the world.

Chinese consumers seek luxury

Rising wages may temporarily slow economic growth, but they increase the buying power of domestic consumers. A large number of wealthy Chinese now have ample discretionary income and a newfound affinity for luxury goods.

The Asian luxury market is booming

Source: Bain & Company, Fondazione Altagamma. Luxury Goods Worldwide Study, October 2011.

Measures of the size and growth of China's luxury market are astounding. McKinsey & Company believes the market can double over the five years ending 2015. By some estimates, China may have exceeded Japan as the second largest luxury market in 2011, when including purchases made in Hong Kong and Macau1.

Greater China overtakes Japan as second largest global luxury market

Source: Bain & Company, Fondazione Altagamma. Luxury Goods Worldwide Study, October 2011. Greater China includes Hong Kong, Macau and Taiwan.

Chinese luxury buyers tend to be younger and less wealthy than their overseas counterparts, and they're generally male. According to CLSA Research, Chinese buyers are 15 years younger than their peers in other markets, while McKinsey & Company notes that consumers further down the income ladder are purchasing luxury goods. In addition to the desire for status, the primary reason for purchases is "self-reward," while business gifts are also an important part of luxury spending. As in many emerging markets, most luxury purchases are made by men.

Lastly, despite the perception of China as having a large counterfeit market, Chinese consumers increasingly want the real thing and are willing to pay a premium for globally recognized luxury brands. Consumers associate European brands most strongly with luxury2, a status earned over decades of consistently producing high-quality goods with cachet.

European companies dominate the luxury segment

Investors may have trimmed their exposure to Europe due to concerns about low economic growth and the continued eurozone sovereign debt crisis, but there may be a way to invest in Europe while reducing exposure to the region's risks. Europe has the largest share of luxury companies, producing the highly sought-after luxury brands that Chinese consumers are clamoring for.

What are the risks?

The law of large numbers tells us that the torrid pace of luxury sales should slow eventually. In fact, luxury spending in China already shows some signs of slowing, possibly due in part to a slowdown in exports and the housing market. Additionally, some high-profile corruption cases have highlighted individuals' purchases of luxury items, which may cause some people to moderate overt displays of wealth.

While established luxury brands remain the most popular, they could see declines in market share. Newer luxury consumers and more price-sensitive buyers have shown some interest in local Chinese brands made in Europe. Even the government has funded a luxury clothing company that will manufacture Chinese designs in Italy. This could undermine the size of opportunity for European luxury companies.

Lastly, changes in Chinese import taxes could alter the landscape for retailers. According to ISI Research, the combination of custom duties and taxes currently account for roughly 50% of the price of many luxury goods, making prices in China much higher than elsewhere globally. As a result, over 50% of Chinese luxury spending occurs outside mainland China. China's Ministry of Commerce has proposed reducing import taxes for consumer goods, although disagreements among Chinese ministries means that changes have delayed a decision.

While the pace of growth and individual companies that benefit could evolve as the market matures, the rising incomes of Chinese consumers are likely to generate investment opportunities in coming years.

1. Bain & Company, December 2011.
2. Luxury experiences in China, A KPMG study, May 2011.

Schwab resources

You can invest in the Chinese luxury trend through individual international stocks, but you need to have a high risk tolerance and time to devote to in-depth research before making investments. We've published a guide titled Managing an International Equity Portfolio Using Schwab Equity Ratings, which details our recommended research process for creating and managing an international stock portfolio.

Schwab clients can get the Schwab Equity Ratings International Report on a particular stock. This is an individual stock research report that guides you through our recommended method for researching a stock. It includes insights into a stock's rating along with valuation, earnings and fundamental metrics. With this report, you should have most of the information to help you evaluate the investment potential of a particular stock. This report can be found in the Ratings Summary box on a stock's summary page under the Research tab. To help interpret it, there's a user's guide which you can find directly under the report.

Investors trading foreign ordinary shares in the US over-the-counter (OTC) market using our online and automated trading platforms can contact Schwab's Global Investing Services team at 800-992-4685 for more information.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

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