ONE key challenge facing China is to shift away from an investment-led growth model to one more driven by private consumption. On the surface, few inroads have been made.

Consumption as a percentage of GDP, at 36 percent in 2012, is low, compared with other Asian countries. The ratio has remained below 40 percent since 2005. However, empirical evidence shows that it is typical for a country to experience prolonged periods of low consumption before a subsequent rebound as incomes rose. China is in the midst of this process, and it is too early to objectively evaluate the success of China’s rebalancing. The good news is that companies can capture numerous opportunities during the transition because the growth rate of China’s private consumption, at 12.7 percent in 2012, is among the highest in the world. The value and incremental growth of China’s consumption dwarf that of other countries.

An additional concern for China’s consumption scene stems from anti-corruption. Since March 2013, China’s new leadership has embarked on a high profile, anti-corruption program. Both foreign and Chinese companies have been targeted. The program has sharply cut all types of lavish spending and impacted sectors ranging from catering to hotels to beverages. The catering portion of retail sales has fallen significantly since the initiation of the anti-corruption campaign. Room rates at five star hotels have dropped year-on-year, and occupancy rates have fallen. Kweichow Moutai, China’s largest listed manufacturer of the strong and expensive liquor, experienced a share price drop of more than 40 percent since President Xi Jinping took office, compared to a spectacular 30-fold rise in the previous decade. This did not come as a surprise because government officials accounted for about a third of China’s high-end liquor consumption. According to the Hurun Report Chinese Luxury Consumer Survey 2014, spending by Chinese high net worth individuals fell 15 percent from a year ago, while gift-giving purchases were down by a quarter.

Broad impact

While anti-corruption efforts have hit luxury spending, the frugality drive has the potential to affect consumption much more broadly. To give a few examples, officials at the National People’s Congress received bottled water marked with their names, but they weren’t given a second bottle without finishing the first. During the Chinese New Year, state-owned firms were forced to ban the printing of calendars and cancel lucky draws. Gone are the days of extravagance — and such changes in spending patterns may be permanent.

Every threat poses an opportunity. While it is possible to suppress gift-giving behavior, it is not easy to damp a public’s desire to consume. As the most luxurious sectors take the hardest hit, some beneficiaries have emerged. These include companies offering what is deemed “affordable luxury.” For instance, Tissot watches may be a more viable gift option now due to their lower price range. And if giving a watch is deemed too conspicuous, buyers may switch to high-end cosmetics and personal care products as viable alternatives.

The largest growth potential probably belongs to Tier 2 and Tier 3 cities. These cities have been and will likely continue to grow faster than Tier 1 cities in terms of per-capita GDP. There are 22 Tier 2 cities, totaling 38 million households in China. Compare that to just four Tier 1 cities, totalling 16 million households. Tier 2 cities have already surpassed the 75,000-yuan income threshold and exhibit similar consumption patterns as Tier 1 cities. The income threshold has huge implications for discretionary spending.

Consumers in Tier 2 cities are already spending as much on jewelry and watches as those in Tier 1 cities, despite a 21 percent difference in average income levels. The consumption potential for discretionary goods in Tier 3 cities has yet to be realized, with as people there still spending much of their income on food and staples. This is expected to change as incomes catch up.

Consumption is ultimately a function of income. There is no doubt about the potential for China to increase average per-capita income far beyond the present equivalent of US$6,000. Roughly speaking, room for growth in a developing country’s per-capita income depends on the income gap with developed countries. China’s per-capita income in 2008 was about 21 percent that of the US, adjusted for purchasing power. This ratio is similar to Japan’s in 1951, Singapore’s in 1967 and Taiwan’s in 1975. All three were able to achieve about 8-9 percent real GDP growth annually in the subsequent 20 years. Following that logic, there is also room for China to grow at a high speed for another 20 years from 2008.

The issue, then, is how to close the income gap. This ultimately depends on how well structural reforms pan out. Supply-side reforms are needed to boost productivity and sustain long-term income growth. Recently, China further loosened its one-child policy by allowing couples who came from one-child families to have two children. Besides demographic policies, industrial policies are also instrumental to increasing productivity. China has been investing inefficiently for far too long and this has resulted in overcapacity in many industries. Looking ahead, it is imperative that investments are channeled to sectors where comparative advantages lie.

Urbanization efforts

Premier Li Keqiang’s emphasis on urbanizing China should prove a boon to consumption. Li expects that up to 14 million people will migrate to Chinese cities each year up to 2030. The migration of rural people into urban areas will spur demand for goods as people settle in. Certain industries will reap more benefit from the urbanization drive because increasing incomes and the Internet revolution have prompted city dwellers to spend a larger proportion of their income on transport, communications and medical services.

Consumption potential cannot be fully realized without corresponding reforms in the hukou, or household registration system. Under the existing system, more than 260 million migrant workers residing in urban areas without an urban hukou are deprived of welfare benefits. This suppresses consumption and discourages urbanization. Moving whole families to urban areas is often unfeasible because living costs are high and the newcomers will fall outside the welfare net. Very often, only the most productive workers from rural areas move to urban areas, leaving behind family members in the countryside. These migrant workers end up remitting much of their incomes back home. Encouragingly, China has recently revealed plans to grant urban hukou to 100 million people within six years.

Further consumption potential can be released by granting rural people private property rights. If there are clearly defined and legal property rights to the land they sit on and the house they live in, rural residents can choose to monetize their assets by using their land as collateral for loans or by transferring land-use rights. Clearer rural property rights would help revitalize the rural economy and encourage rural spending.