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Magazine Issues » June 2020

China’s premium scale

China_buildingsSince its economic rise, premiumisation has emerged as a key trend in China, but what are the opportunities and limitations? Romil Patel reports from Hong Kong and the mainland.

China has undergone rapid change. Data from the World Bank shows that urbanisation has been expanding by at least 1 percentage point annually over the past two decades and Beijing has no intention of slowing down. It is still more than 20% below the UK and US, however, and while it ranks as the world’s second-largest economy, China’s globalisation story still has further to go.

“The first phase of globalisation is really trade-related,” says Dong Wang, chief executive of HSBC Jintrust on a crisp January morning in Shanghai. “But in order to make that much more integrated, you should really open the capital markets, and capital flow should be integrated to the global world as well.”

The opening up of China’s onshore markets to the outside world was a major theme of 2019 and in terms of significance, akin to – and indeed a natural extension of – its inclusion into the World Trade Organization in December 2001.

As China has grown in size and significance over the years – partly by leveraging on its demographic dividend – incomes have risen, towns have become part of larger cities through better transportation networks and expanding education services, and people are thinking about different consumption choices and lifestyle aspirations. All of this contributes to an active demand for premium products and services.

“Across different product categories – from spirits to beer, infant formula and even toothpaste, Chinese consumers have very high levels of willingness to trade up,” says Hyomi Jie, a portfolio manager at Fidelity International.

“It doesn’t mean they can trade up today, but there is a very strong willingness, while in the UK there is strong willingness to trade down – that is reflected in the retailers’ performance, like the low-cost competitors such as Aldi, who are doing very well at the expense of more mid to high-end service providers, like M&S,” she adds.

“But in China, you are seeing the premiumised brands really flourish. It’s the right environment at the moment for these brands, retailers and platforms who can make that happen.”

When a product adoption rate reaches a peak, the sales volume tends to stabilise, which is the case for a number of products. People cannot drink more beer, they will not take more soy sauce or eat more sweets, but they do buy better-quality products across all sub-sectors, observes Jun Li, chief investment officer at Sagard China.

“That’s the meaning for us – investing in companies that are able to meet the need of premiumisation, able to generate high profits as a result of that and able to continuously invest in the future in terms of research and development (R&D) and marketing. That’s what we see in China,” she says.

Becoming truly global
From a heritage steeped in manufacturing, global players are starting to wake up to the size of China’s domestic consumption market and to the fact that being truly global means tapping into the Chinese consumer market. Marketing and distribution are key success factors for a consumer company brand and in order to meet Chinese demand, companies may set up factories there (like Tesla has in Shanghai) or find distribution partners. But what about investors?

“As an investor, the way we access premiumisation of the Chinese consumer market is by picking the companies with the capability of moving up, with the product pipeline and a strong track record showing that they are executing premiumisation – that is one key criteria for us to screen and select consumer names in China,” says Li.

If a consumer name is no longer able to premiumise, they face greater competition, declining sales prices and margins – all red flags for investors.

“We are trying to avoid companies that are under a lot of competitive pressure, and having to lower prices to sell their product is a bad sign,” adds Li. “We prefer companies that have a very strong product quality, values and are able to innovate and raise prices. These are the implications for us as direct investors – and we own plenty of them – which means there is not a shortage of those companies. There are sufficient choices for global investors in sectors and areas they like and in different companies.”

Technology the enabler
While China was essentially a mystery to many retailers and brands just five or six years ago, they recognised that through the sheer size of the population there were a number of consumers who were open to new experiences. As tier one and tier two cities grew, the rural market was largely ignored due to physical obstacles. And then came far-reaching technology.

“Technology has been a really important enabler to improve the overall premiumisation trend to be more equitable,” says Fidelity’s Jie.

“Premiumisation is not just happening in Shanghai and Beijing, but it can happen in third and fourth-tier cities and the small counties. The internet giants are really the main driving forces behind this trend. In the past two years, Alibaba’s key focus has really been penetrating into rural markets, and that’s how their daily active users of Alibaba’s ecommerce platforms like T-mall and Taobao could jump from 300 million to 600 million people.

“The recent outbreak of COVID-19 and subsequent lockdown of much of China has actually led to a big jump in online users across a range of goods and services. Those who were maybe hesitant to move their consumption habits online have now crossed over, and while some will move back to offline as life returns to normal, many have seen the ease and convenience of online and will remain converts.”

China has previously leveraged on its demographic dividend, but after high growth over consecutive decades, it has its sights set on transitioning to a more consumption-focused and innovation-driven economy, i.e. technology. But how is it aiming to deliver this?

To a significant degree, the strategy counts on reaping the benefits from the skills that are steeped in the country’s past and now embedded in its DNA.

“We are talking about seven million college graduates and half a million postgraduates every year – that’s to be found nowhere else,” says HSBC Jintrust’s Wang. “A high percentage are going into science, technology, engineering and mathematics (STEM), which is different when you compare it to the rest of the world.

“Chinese people’s general willingness to work hard to change lives is still there, and generally they are encouraged by their parents to work hard,” he adds. “China is easy, you can deploy hundreds of highly qualified and skilled engineers – in other markets, you won’t be able to find such a thing so easily, so that scale provides a lot of the further resilience of overall development and people are now appreciating the benefits of those innovations.”

Given the accumulation of know-how over decades, China has also built up the prerequisites for the next stage of development – and it’s always about scale.

A mature supply chain
When it comes to mobile handsets, over time China has built up an expertise in delivering innovation in the form of more cameras and applications, as the rise of brands such as Huawei and Xiaomi demonstrates. According to research and advisory firm, Gartner, Huawei grew its market share by 37% last year despite being a focus of the protracted trade war between the US and China, while Xiaomi sold more than 32 million units in the fourth quarter of 2019 – a year-over-year increase of 16.5%.

The supply chain is already in China, explains Sagard’s Li. With the camera, speaker and screen-makers all in China, there are sufficient resources to innovate, and further innovation of consumer electronics is to be expected.

“China benefits from very mature engineers available in the domestic market, a very mature supply chain that manufactures this product,” she adds.

“Chinese handset manufacturers are located next door to each other. Their speed and innovation are much faster, so for that particular segment – and maybe for electric vehicles as well –premiumisation is driven by technology, innovation and R&D capabilities.

“That’s where Chinese OEMs [original equipment manufacturers] are very good. There are areas where they are not good, such as branding. So, if you want to sell a pair of luxury shoes, no, that is not existent because there is no branding capability or putting a product to a level where everybody desires it and all the billionaires want it.”

As China increasingly caters to its own population, and a sizeable market with a strong culture where local creativity is increasingly coming to the fore, both talent and global markets are happy to join the burgeoning market of entertainment and services.

This works both ways, so we are starting to see China’s locally developed entertainment platforms gaining very strong global traction. The video-sharing social network Tik Tok, for instance, is looking to capitalise on AI to analyse user habits and optimise.

But global consumers are smart. They will react positively to a brand that lives up to expectations, but will not appreciate a brand image that cannot be supported. Consumer products inevitably have to serve not only the functions of the product, but also the psychological needs of human beings – a fact that has never been more evident as the world grapples with the consequences of coronavirus.

This story first appeared in the Spring 2020 edition of Funds Global Asia.

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