Bullish on China's Lower-Tier Cities

China's lower-tier cities are becoming bigger, richer, and more eager to spend. Driven by recent government policies, improved infrastructure and shifting consumer attitudes, private consumption in smaller cities could be on track to triple between 2017 and 2030.

This increased consumption potential could mean bright prospects for a range of consumer-focused industries with implications for the overall Chinese economy and global investors. “We expect consumption in lower-tier cities to surge from U.S.$2.3 trillion in 2017 to U.S.$6.9 trillion in 2030," says Morgan Stanley’s Chief China Economist Robin Xing. “Further, these smaller cities could be the engine driving China's overall private consumption market of US$11.8 trillion over the same period."

In a recent report from Morgan Stanley Research, Xing and his colleagues in economic and equity research identify five key city clusters—Jing-Jin-Ji Area, Yangtze River Delta, Guangdong Bay Area, Mid-Yangtze River Area, and Chengdu-Chongqing Area—where satellite cities will likely be the key beneficiaries of the government’s interregional development plan and the country's expanding transportation network.

Household Consumption in Lower-Tier Cities Set to Triple
(Annual Household Consumption, USD Trn)

A key driver of this shift is a more flexible Hukou policy, lower living costs, and higher fertility rates in smaller cities. Reflecting the diverging population growth in large and smaller cities, population growth in both Beijing and Shanghai declined in 2017, while annual average growth in lower-tier cities held at 3% over the past five years. The upshot is that smaller cities could contribute 76% of the overall urban population increase by 2030.

“The more flexible Hukou policy means easier access to the social security system in lower-tier cities, reducing the need for precautionary savings, and increasing the attractiveness for migrant workers," says Xing.

Urban Population by Tier of Cities (Based on Usual Residence)

Another factor which is boosting population in smaller cities is a greater willingness to have a second child, compared with Tier-1 cities. In the Shandong province, which is dominated by smaller cities and had the highest birth rate in the nation, 52% of new births in 2016 were second children, well exceeding the national average of 40%.

Another key driver of economic integration and consumption growth in lower-tier cities are the efforts to enhance infrastructure connectivity. “High-speed railway has cut travel time on major routes by more than half," says Edward Xu, equities analyst covering China transportation and infrastructure. “Meanwhile, the improved labor and goods mobility could also encourage industrial relocation from big cities to smaller cities."

Xu adds that the government's consistent budget input and the construction of modern transportation networks—high-speed railroad, highways and airports—will help connectivity and accessibility of China's lower-tier cities improve significantly, driving increased prosperity.

A recent survey of 3,346 consumers by AlphaWise, Morgan Stanley’s evidence-based research group, showed that economic trends are also narrowing the household income gap between lower-tier cities and Tier-1 cities.

“These households tend to have a stronger appetite than larger cities for discretionary spending because of their lower housing-cost burden," says Lillian Lou, the firm’s lead equity analyst covering China’s consumer industry. “This confirms our earlier finding that there is a high pursuit of value, potential for upgrades, and strong perception of local brands among consumers in lower-tier regions."

The AlphaWise survey also showed that consumers in lower-tier cities are now catching up with Tier 1 & 2 markets in valuing quality over price. Speed, service and better entertainment also play into purchasing decisions.

For global investors, this upgrade potential will likely benefit home appliances; express delivery; online shopping, including groceries; food & beverage, including milk products; movie theaters; Macau gaming; and online media entertainment.

Consumers in the five city clusters also have a higher intention than the national average to spend on airlines and travel, property investment and education, home decoration, and electronics. In addition, lower-tier city households are spending more for high-frequency/low-ticket products such as beauty supplies, makeup, snacks, beverages and online groceries.

“Consumers in these cities also rely more on mobile devices for online shopping. eCommerce has enabled greater consumption in lower-tier areas with better pricing and improving delivery speed," Lou says. “With improving infrastructure to speed up delivery services and lower logistics costs, we expect online shopping to further drive consumption in lower-tier areas."

Key risks to the bullish outlook for lower-tier cities consumption include policy curbs on household leverage buildup (which could impose some pressures on consumer discretionary spending such as online shopping, discretionary services and consumer electronics), a housing market correction, supply-side policies on the industrial sectors, and a rise in U.S.-China trade frictions.

But Xing says these risks are manageable. “These areas have a resilient job market thanks to a rising service sector, still-comfortable housing affordability, continued population migration, and better economic integration. Long term, the consumption potential in these lower-tier Chinese cities is even more bullish than we first thought.”

For more Morgan Stanley Research, ask your Morgan Stanley representative or Financial Advisor for the full report, “More Bullish on Consumption Potential in Smaller Cities," (March 6, 2018). Plus, more Ideas.