China’s unexpectedly strong economic rebound may appear miraculous. In reality, it’s derived from a combination of that government’s huge economic stimulus package and increasingly strong domestic consumer demand. Our firm, InterChina Consulting, views Chinese consumer spending as an increasingly important contributor to the Middle Kingdom’s long-term economic growth. It also is offsetting continued weakness in global demand for China’s exports and will be the foundation for sustainable growth in the future.

Consumer Spending

China’s quicker-than-expected recovery has raised questions over whether the rebound, so far stemming mainly from the government’s huge economic stimulus package, is sustainable in the long-term. Once the impact of subsidies used for purchases of cars and appliances wear off, naysayers contend, the surge in consumer spending may evaporate. We disagree.

InterChina believes that China will continue to recover and that domestic demand, mainly consumer spending, will underpin growth for the years to come. “I think that strong consumer demand will become one of the main drivers for China’s economic recovery and growth in the next 18 months,” says Jan Borgonjon, president of InterChina.

China’s GDP to Surpass 8 Percent

The speed and scale of China’s recovery has surprised many: second quarter GDP was up 7.9 percent year-on-year, improving from 6.6 percent in the first quarter. GDP growth for the year is expected to surpass the government’s target of 8 percent and as a result, numerous economists have upgraded their GDP forecasts for this year and the following.

The $586 billion government stimulus package, which included infrastructure spending on an unprecedented scale, has led to a commensurate leap in bank lending, contributing significantly to China’s recovery. Some fear that China may step on the brakes, reimposing curbs on lending that might cause a relapse into the contraction seen in 2008, but InterChina believes that Beijing has learned from its past mistakes and will stick to its pledge to maintain a relatively loose monetary policy in coming months. We do not expect a significant tightening any time soon.

Offsetting Declines

To be sure, China’s exporters are still struggling with weak demand overseas, with little hope for a major recovery soon. But Beijing’s canny economic planners appear to have once again finessed what by standards of other recession-stricken economies is a relatively “soft” landing. Efforts to shift the economy’s reliance on export-led growth to more domestic-oriented demand appear to be taking hold. If 7 percent of China’s growth this year results from the stimulus package, while weaker exports pull growth down by 2 percent to 3 percent, then domestic consumption will offset that, adding 3 percent to 4 percent, says Simon Zhang, a senior consultant with InterChina.

Chinese Domestic Demand Projected To Rise Significantly

As they regain confidence in the economic outlook, Chinese consumers are drawing down their savings and spending more of their growing disposable income. This is fueling a sustainable recovery in real estate, automotive, machinery and retail industries. The stronger consumption may not be fully rational, according to Simon Zhang, as “the decision of buying a house now is spurred by the fear that future inflation could destroy the value of money on hand.” Consumption behavior has never been fully rational.

Renewed strong demand among China’s 1.3 billion consumers is becoming an increasingly crucial economic force in that country. A recent Credit Suisse report projects that Chinese consumer demand will rise from 8 percent of global demand today to 31 percent of global demand by 2020. Meanwhile, the U.S. share in global demand is forecast to contract from 30 percent today to 21 percent over the same period.

InterChina believes that with its steadily growing consumption, China may just reach these projections. A combination of consumer-oriented policies, strong government-sponsored (if not financed) investment and liberal lending policies have boosted the confidence of Chinese consumers, who have been shielded from the worst of the global meltdown and are less burdened by debt than shoppers in most other major economies.

Chinese Middle Class Is Growing

Chinese are earning more on a per capita basis, and the age group whose incomes are growing the fastest—those in the 20-29 year-old bracket—are also spending more. These young consumers are unencumbered by debt and are keen to buy apartments, computers, cars, clothing, fashion and entertainment. They form a large part of the country’s expanding middle class, now at 100 million to 300 million people depending on one’s definition, and is expected to grow to 400 million to 500 million by 2015.

The influence of China’s growing middle class, which was felt before the economic slowdown, is still an influential growth driver and will remain vital to China’s long-term growth.

Retail Is Improving

In the retail industry we are seeing tangible signs of improvement in consumer confidence. Total retail sales of consumer goods shot up 15 percent in the first half of the year, according to official Chinese figures. “We have seen booming sales from June onwards,” says the manager of a foreign retail clothing store that has been expanding heavily in China.

Real Estate Is Strong

The real estate market is one of the best indicators of strong demand among private consumers. Pent-up demand, coupled with fears that Beijing may tighten credit and other related policies, has prompted a surge in home purchases. An actual prospective buyer himself, James Sinclair, Director of our Strategic Practice, has noticed a “rush to acquire property before the government tightens regulations again.” Sinclair acknowledges that this may push prices higher, at least temporarily, “but when the pressure comes off, prices are more likely to stabilize than fall. What’s important here is that fundamentals remain strong: there are a lot of people who are going to need to buy houses over the next 10-20 years.”

Holding appreciating property assets will result in a “wealth effect” that will further boost consumer confidence in coming quarters. A similar surge in share prices will likewise help.

The Auto Industry Is Booming

Chinese are also buying cars. Laura Tsui, a partner at InterChina, recently visited her hometown Qingdao, a second-tier city on the coast, and noticed that in a typical middle class residential area with roughly 200 families, 80 new cars were purchased in the past year. She sees “a lot of optimism among people. Everybody is talking about buying houses and cars,” Tsui says. So far in 2009, auto sales in China are up 19.5 percent over last year, beating most estimates.

A foreign car producer recently complained to us that their company could not keep up with demand. “We are losing market share because we lack production capacity,” he said. While government subsidies for rural vehicle purchases are helping, car purchases by urban residents are surging. This offers great opportunities for parts suppliers and machinery makers.

A rebound in demand for cars and real estate has, in turn, boosted confidence among original equipment manufacturers (OEMs) and machinery companies who stand to benefit from rising car sales. Automotive OEMs have revised their production targets upward, reflecting growing confidence in the economic turnaround.

In early 2009, we visited many of these OEMs and learned that they were unable to meet their 2008 production targets thanks to the fallout from the financial crisis. Many OEMs we interviewed had planned major expansions before the crisis began, and put such plans on hold as the crisis evolved. But by July, many had revised their sales predictions much higher. Estimates for passenger car sales in 2009 are now at 8.8 million units, an increase from 6.7 million in 2008, according to auto industry sources.

Machines and Machine Tools

Sales of machines and machine tools in China have also taken off since June, with many machine producers confident of meeting their original 2009 sales goals thanks to an expected stronger second half. Various companies we have spoken with are making gains in efficiency and shifting their attention to the domestic market.

The crisis has helped some machinery makers previously focused on exports to adjust their strategy towards meeting China’s domestic demand. “This is something many should have been doing for years,” says Franc Kaiser, a Senior Consultant at InterChina’s Shanghai office. Thomas Rohrbach, CEO at Staufen Shanghai, a lean production consultancy, concurs. “Many companies that relied on exports to western companies from China are having serious problems and are seeing a faster recovery in China’s domestic demand, leading them to focus on the domestic market. But the difficulty is that Chinese competitors who themselves were exporting are now doing the same, increasing competition, making cost cutting even more important.”

Such shifts are naturally changing foreign corporate investment strategies and long-term planning. Machinery companies have become more willing to heed local customers’ requirements, and adapt machines wherever possible.

“China subsidiaries are also gaining more independence and decision-making power from their global HQs on such issues as adapting designs and sourcing parts at lower costs in China,” says Kaiser. Manufacturing in China for the Chinese market is becoming vital for global companies around the world. As a foreign car components maker commented in July, “Our global HQ expects the China subsidiary to save the day”.

Domestic Demand Will Continue

Economists and media in the West have focused on China’s stimulus package as the key driver for its recent turnaround. Investment has had a large role in China’s GDP, not just in maintaining investment, but also in the recovery of consumer confidence. However, domestic demand looks likely to underpin continued sustainable growth.

China aims to evolve into a consumer demand-led economy. Japan has tried and so far failed to shift its export-dependent economy to one led by domestic demand.

But China, with a population more than 13 times the size of Japan’s and a much larger, less international economy, may well succeed and the recovery path it is following in the economic crisis is going to be a major indicator.

About The Author David Hofmann [Full Bio]

David J. Hofmann is Senior Advisor at InterChina Consulting North America LLC. Based in Washington D.C., David provides insights on the Chinese market, and leads business development efforts and deal origination on behalf of North American clients.