To invest in China?

Note: This is a still in process draft that I hope to turn into a paper at Stanford. Much of it is still poorly developed and explained. It is also quite long. But, as I am leaving China, I think it is appropriate to post it in its current form for those who are interested.

Walking down the neon-lit streets of Shanghai buzzing with energy, shopping in the modern downtown malls of Hangzhou, Beijing, and Xi’an, or studying the massive development projects on display at the Urban Planning museum, it is hard to conclude anything other than China is about to take over the world. When asked in a recent survey, "Do you think you will be richer in 10 years time?" approximately 90% of Chinese respondents chose "quite possibly" or "possibly".

But at the same time, there are problems here which seem nearly insurmountable. The recent US seafood bans and toy lead paint outcry just scratch the surface. The pollution in many parts of the country is unbearable. The northern portion of the country is facing severe water shortages. AIDS is ravaging large portions of the population of Henan province due to terribly misguided government blood gathering practices in the late 1990s. Huge numbers of workers are migrating from rural farms to slums in and around the large cities. Numerous local minority groups want political freedom and independence. The economic disparity between rich and poor is tremendous.

So maybe China is not going to take over the world. Maybe the government will lose control when the economy slows, as the growth slowed in Japan and all of the “Asian Tigers” of the 1990s. Maybe America has just outsourced almost its entire production base to a country with problems growing as rapidly as its economy?

The answer is definitely not clear.

One thing is for certain, the Chinese economy has showed no signs of slowing down yet. Even with the one day 10% drop in the stock market in March when the government suggested there may be new taxes, consider the following:
- Real estate investment and prices have soared (28% annual real estate growth, 25% annual infrastructure growth YoY May)
- The stock market has nearly tripled in the last two years (Shanghai Index up 124% in 2006 and ~70% YTD)
- The Trade imbalance continues to surge (surplus increased 73% YoY May)
- The Yuan is still not free to float (some estimate the currency is 15-20% undervalued)
- Venture Capital money is flowing freely ($220MM was invested just in cleantech directly in China in 2006.

Almost every single person I have met here is working for a startup or a VC. Everyone is getting rich and think they will continue to get very rich, very soon. I have met many people who talk about their plans to retire to the US in 10 years based on their riches from the Shanghai stock market.

Can this growth possibly continue?

I think this answer is actually quite related to my work here at Kijiji. I have been working to expand Kijiji’s presence by entering new markets around China. As such, I have studied the socio-economic characteristics in all of China’s major cities and regions. While today, Shanghai, Beijing, and to a lesser extent Guangzhou and Shenzhen, are wealthy, global economic centers, these cities will not drive China’s growth over the next twenty years. China’s “Tier II” cities will be even more important for China and the world than I ever imagined.

I have analyzed Kijiji’s performance in Tier II cities where we have a presence, and assessed other markets where Kijiji could enter. I have visited China’s Tier II cities firsthand in Hangzhou, Xi'an, and Kunming. It is these Tier II cities, the cities with an average population of 3.5 million and an average purchasing power / capita of just over US$10,000, the cities that most Americans (myself included) have never heard of, that will determine China’s impact on the world over the next twenty years.

Urban household data is one way to see the importance of these Tier II cities. Clearly, Chinese urban households are much better off than they were even ten years ago. While only 6% of urban households are classified by McKinsey as “Global” or “Affluent”, 43% of the urban households are classified as upper or lower aspirant – basically middle class. 10 years ago this same statistic was at only 3%.

One consequence of this growing middle class is a tremendously widening gap between rich and poor. The chart below shows this staggering evolution.


The chart below shows high, low, and base case economic projections for 2025 China. A rising middle class of staggering size seems almost certain. The country is just too big and has gained so many resources that it is hard to see the development of a huge middle class stopping. For reference, if 25% of China’s population is middle class, that would be roughly equivalent to America’s entire population.


Another thing in China’s favor is its long-long-long term outlook. Even in the early 1980s, Deng Xiaoping was writing about how China needed to plan for the next 50 to 60 years to become the dominant global power. Today, China’s long-term economic plan projects that it will “realize modernization” overall by 2050 and that every province will reach its modernization goal by 2070. I am positive there are no similar government projections, let alone 20 volume scholarly plans, planning for US economic development between 2050 and 2070.

So what does all this analysis of Tier II cities and the rising middle class mean? Here are my takeaways:

1) There is probably an investment bubble here today. This is not a consensus view, but it is my view. It may not end tomorrow, it may not end before the Olympics in 2008, but there is a bubble. It will burst, likely sometime between 2008 and 2010, and it may not be pretty.

2) There is a chance that if the bubble bursts in a very messy way, China will not be able to hold together politically. The country is so big geographically, economically diverse, and culturally divided that there may be serious political turmoil which effects China’s economic development.

3) I think the most likely scenario is that the bubble will burst but there will be a relatively soft landing. The slowdown will not be politically catastrophic, and the huge forces behind China’s economic growth will largely continue over the long run.

I think some Westerners will make some money in China over the next 25 years. I think a lot of Chinese will make a lot of money in China over the same span. I am hoping for the former, but not expecting much. I have a little bit of money invested in the Chinese market today, but mostly I am waiting and watching. I plan to invest much more after the bubble bursts. And I plan to target the sectors like healthcare, transportation, and recreation (see final chart, below) that will benefit most from the growing middle class in Tier II cities.

The 20th century was dominated politically and economically by events in Europe. The two major world wars, the cold war, and most of the economic expansion was driven western forces. I see no way that will continue. The 21st century may not be the “China Century” but it will almost definitely be the “Asia Century”. America may still be the biggest and most powerful country, but it needs to change its focus and adapt to a new center of the world in the East.

(Sources: Charts in this posting are all from the McKinsey Global Institute November 2006 report: “From ‘Made in China’ to ‘Sold in China’: The rise of the Chinese urban consumer”. Most other statistics are from Chinese census data, or articles in the New Yorker, the Economist, or the People’s Daily)