In China’s recent Liang Hui — the annual meetings of the National People’s Congress and Chinese People’s Political Consultative Conference — raising the size and living standards of the middle class were the primary policy objectives. China believes the answer is to urbanize, raise disposable income, and widen the social security net. These new policies fuel our desire to build businesses that deliver products and services to a larger base of wealthier and more discerning consumers in China, but give rise to corresponding challenges, which we discuss in more detail in this month’s commentary.
A scant majority of China’s population lives in urban centers. The current level of urbanization, 52%, has risen over the past 10 years from about 44%. The goal is for this to reach 60% in the coming 7 years through moving 100 million citizens from the countryside into cities. An estimated RMB 40 trillion development package has been authorized to achieve this goal before 2020, which will generate infrastructure development, commercial investment, and job creation to expand regional economies. Even if achieved, China will have a long way to go to reach the urbanization rates of South Korea, the United States and Taiwan, which all exceed 75%. Urbanization will lead to a tremendous addressable market over time, but in the near term is likely to exacerbate regional disparities in taste and affordability. The challenge for Lunar will be customer segmentation within our businesses. This reality drives our thinking in many ways. For example, it has heavily influenced our business plan for our babywear businesses, where we are increasingly pushing our managers to customize their offerings and target clearer segments and price points.
The government has targeted a 100% increase in disposable income, from RMB 21,986 to RMB 43,792, by 2020. To achieve this goal, one of the measures the government will implement is a new minimum wage, resulting in the potential for a 32% wage increase across China by the end of this decade. Although wage inflation will put labor-intensive industries under pressure, the hope is that this will create the impetus for migration to third- and fourth-tier cities, with a corresponding rise in development and incomes. Current wages for typical regions in China, and the estimated effect of new wage policies, are as follows:
The implication for our investment strategy is to focus on higher value added businesses with strong brands and which capture consumer’s desires. For this reason, we remain focused on brands – Yeehoo, Joysun, Yeehoo, Niutou – to a greater extent than labor-intensive services, for example startup fast-food restaurants, which have been a target of significant investment over the past three years. However, it also is a reason why we are so focused on operational value add. Running businesses with the need to relocate work forces and manage rapidly rising wages, all while creating better products, requires more operational value add, i.e., sweat equity, versus cash, i.e., typical Chinese private equity. We need smart managers, and we need the processes to help them do their jobs better.
A Broader Safety Net
China remains fiscally healthy, but is increasing debt to fund the government’s secondary income re-distribution programs. Debt to GDP will rise to 2% this year, versus prior years in which the government ran a surplus of close to RMB 1 trillion. The program will target expanding social benefits on healthcare and social security, and will seek to alleviate the disparity between high rural savings and their lower urban peers. The goal is to create a greater sense of security, and thereby free up capital for consumption and for taking risk. We believe that the lack of a sense of security drives more than savings in China. It also creates the need for brands that address health, safety and quality issues, which remains a challenge and a significant opportunity.
Early Signs of Rebalancing, and the Opportunity to Succeed
While the recent Lianghui brought renewed focus on urbanization, this trend has, to be fair, long been underway. In the cities and provinces where most of our businesses are located – Yunnan, Guiyang and Sichuan, for example – growth rates are already steadily higher than first tier counterparts. Retail sales growth also demonstrates that while concerns persist about slowing demand, the purchasing power for higher quality products is strong. However, these trends are occurring in the context of a highly fragmented market, evident in businesses like snack foods where local tastes have created nationwide interest, but barriers for companies trying to expand. The clearest example may be KFC, which has become China’s most admired fast food franchise, but offers menus that differ dramatically between areas like Beijing, Shanghai and Chengdu. These complexities create barriers to entry and difficulties for management, but also opportunity for those providing the operational expertise and sweat equity necessary to succeed.
Lunar | March 15, 2013