Morgan Stanley
  • Research
  • Jun 23, 2017

Smaller Cities to Drive China’s Consumption Boom

While much attention is paid to China's largest cities, the country's smaller urban centers could become the larger driver of growth and consumer spending in the coming decade.

The population of Shanghai, at around 24 million, nearly rivals that of Texas (27 million) and China's other large cities aren't far behind. Consumers in these urban behemoths—along with their rising per capita net worth—have naturally captured the focus of domestic and international brands.

As China develops into a higher income society, private consumption could grow from its current $4.4 trillion to $9.7 trillion by 2030, according to a recent report from Morgan Stanley Research. Many investors believe that top-tier cities, which are either provincial capitals or so-called special economic zones, will continue to dominate China's consumer economy.

We expect 166 million people will move from rural to urban areas in the next 14 years, with 75% of them headed toward lower-tier cities.
Robin Xing Chief China Economist

However, the lower-tier cities, which include prefecture- and county-level urban enclaves and already comprise 59% of the country's GDP and 73% of its population, may be bigger engines for spending to fuel economic growth, according to Robin Xing, Morgan Stanley's Chief China Economist. “While investors perceive larger cities as offering the most important consumer base, we believe that lower-tier cities will be bigger, wealthier and more eager to spend, and could contribute two-thirds of incremental growth in national private consumption toward 2030," Xing says.

For investors who are confident in China’s continuing growth, but uncertain about where to find it, these lower-tier cities, such as Xuzhou and Nantong in the east, Quanzhou in the south, or Baoding in the north, may offer significant prospects, as they start to flex their considerable consumer might. Indeed, a number of industries are well-positioned to benefit—from consumer goods and domestic autos to the travel, entertainment and gaming industries. 

Lower-Tier Cities to Fuel Two-Thirds of National Consumption Increase From 2017-30

Source: NBS, Morgan Stanley Research estimates

Population Shift

Urban population growth has slowed or even turned negative in China’s large cities. Case in point, Shanghai's urban population size has contracted since 2015, and policymakers in Beijing are making efforts to relocate people out of the city via plans to set up the “Xiong’an New District,” to ease traffic congestion and overcrowding issues.

In contrast, urban population in lower-tier cities—already nine-times and triple that of tier-1 and tier-2 cities, respectively—has increased at a relatively higher pace over the past five years, due to a more flexible official residency policy and higher fertility rates. “Based on a United Nations estimate, we expect 166 million people will move from rural to urban areas in the next 14 years, with 75% of them headed toward lower-tier cities," Xing says.

Growing Consumer Power

Economists like to keep tabs on what they call “income convergence,” or the closing of the income gap between rich and poor. Such gaps tend to narrow for a number of reasons, including higher marginal productivity on cheaper labor and land costs in lower-tier cities, better economic integration with government-led redistribution of infrastructure and public resources from regional hubs to small neighbor cities, and broader penetration of technology, including smartphones and the internet, according to the Morgan Stanley research.

All these factors are currently at play in China. For example, the lower-tier cities have benefited from government policies that promote the development of public resources, such as hospitals, schools and transportation infrastructure. Case in point: Since March, the Chinese government has announced plans to set up, not only the Xiong’an New District near Beijing, but also "city clusters" in the Yangtze River Delta, and a “Bay area” blueprint for Guangdong.

“These various initiatives are likely to complement market forces and speed the catch-up growth for lower-tier cities," Xing says.

Indeed, the leveling playing field has begun to reduce the income gap between top-tier and lower-tier city populations. A decade ago, per capita disposable income for families in China's smaller cities was 55% lower than those in top-tier cities; the difference has decreased to 45% today, and will likely come down further to 36% by 2030, Xing notes.

Urban Income Gap Between Small and Large Cities to Narrow Further by 2030

Source: NBS, Morgan Stanley Research estimates

For now, however, smaller cities’ seeming weaknesses have become their strengths. Whereas real estate rents and prices in top-tier cities such as Shanghai and Beijing have been notoriously expensive, the relative affordability of property markets in lower-tier cities means lower living costs, which is attractive for both businesses and workers. Meanwhile, the more flexible official residency policy could bring better social-security coverage, reducing the need for precautionary passive savings.

When combined, these advantages could encourage household consumption in smaller cities. The report forecasts that total consumption will increase by 8.7% annually toward 2030 in the lower-tier cities, compared to 6.6% in top-tier cities.

Who will benefit as small-city families grow bigger budgets? Several industries and brands may be able to catch this consumer spending wave. Morgan Stanley economists anticipate Chinese consumers will seek out new products, services and travel experiences that were previously unaffordable—as well as upgrade from low-end brands to higher ones.

More Shoes, More Trips

Consumer products companies, especially sportswear and jewelry, may be the first to capture these newly minted middle-class customers, who will have more money for athletic shoes and accessories. Additional discretionary income also bodes well for fast food and restaurant chains, especially because many have yet to expand into lower-tier cities, according to Lillian Lou, who covers the food and beverage industry.

Families may be more apt to spend money on outside entertainment, including going to the movies, traveling abroad, and taking trips to the resort island of Macau—China’s version of Las Vegas. In fact, 60% of Macau’s 20-million visitors last year came from China’s lower-tier cities, according to the report. Travel-related brands, from airlines to hotels to casinos, should all take note. Lastly, demand for cars also will likely rise in lower-tier cities, where ownership lags behind that of the larger urban areas, especially as incomes grow.

China's transitioning economy will continue to ripple across domestic and global industries. Investors looking to tap into the next wave of growth would do well to look past the obvious, at the potential of the country's smaller cities.

For more Morgan Stanley Research on China’s economic and market outlook, policy and market strategy outlooks, ask your Morgan Stanley representative or Financial Advisor for the full report, “China’s Transition to High Income: Lower-Tier Cities – Bigger, Richer, More Eager to Spend” (May 25, 2017). Plus, more Ideas.