Consumer Credit: The Key to Domestic Growth

Economic Stimulus[1]

China is committed to a policy of domestic economic growth to offset a declining rate of export growth. Export accounts for one-third of Chinese output. Decreasing exports due to global slowdown (recession + protectionism) will result in factory down scaling, shutdowns and skyrocketing unemployment. This will affect all of China’s export regions.

There are two Western ways to stimulate domestic economic growth: 1) Increase consumer demand for goods by increasing employment through infrastructure investment and reduced interest rates for private investment to meet increased demand (Keynesian economics) ; 2) using incentives for people to produce goods and services, such as adjusting income tax and capital gains tax (Supply side economics.). Both approaches aim to increase the amount of money consumers will spend on goods, but takes different paths. Keynesianism increases government spending to increase demand and employment; supply side economics increases private spending and investment to increase demand and employment.

The problem with these models in China is that there is no assurance that increased employment and money in the pocket will be spent to boost the domestic economy. China has a savings culture (over 40% of earnings) while the U.S. has a spending culture (zero savings). This difference is reflected in the size of the retail sector in both countries. China’s retail sector accounts for only 30% of GDP; while U.S. retail accounts for 70% of GDP. In the U.S. people will spend all of the money in their pocket and move on to their credit cards. In China, people will spend only a small portion of new money. They will save the rest. Hence, western models in China would result in much less economic stimulus than in the U.S.

A further fact must be considered to understand the impact of Western models on consumption. The average Western consumer leverages every new dollar in the pocket with consumer credit. Hence, economic stimulus is compounded. China, on the other hand, is still a cash economy, so there is no leverage on added earnings. In fact the opposite is true. An extra dollar in China results in only $.60 cents of spending. Hence it is far most costly in China than in the U.S. to gain an equal amount of demand for a given amount of stimulus.

Some argue that the key to Chinese domestic growth is to convert savings into spending. But this is an intractable cultural problem. How do you change a 3,000 year habit? And how do you win the political battle with National banks and their state-owned industrial borrowers that want to retain savings deposits? It is more reasonable to leverage the 60% of earnings that are spent on consumption by instituting widespread consumer credit.

Expanding Consumer Credit

Government expansion of consumer credit requires a marketing strategy. All marketing strategies consist of nine steps.

1. Vision. Den Xiaoping said, “It is glorious to be rich.” This early vision of China’s export market economy did in fact build wealth at the top through direct foreign investment to a new class of owners who invested that money in factories and capital equipment for an export economy. They paid taxes and fees, which in turn built public infrastructure.

The new policy of domestic growth requires another vision, “It is glorious to consume.” This mantra affirms the pivotal role of the middle class in supporting Chinese domestic growth. They have the resources for consumer credit. They will not spend enough cash to grow the domestic economy. But they will spend credit and work hard to revolve and extend their credit lines. Many other countries have gone through this process. The Chinese government will regulate consumer credit expansion.

2. Objectives. Credit card use is very new in China. There are 100 million credit cards in circulation. Most credit cards are used for business expenses, not personal or household consumption. Credit lines are also very limited. A typical card will carry a credit limit of RMB 20,000. This is hardly enough to make a make a down payment on a car. It is reported that 85% of car sales are cash transactions.

The government has to set a reasonable objective for the projected size of the consumer credit card market. That size has to be a percentage of retail sales and a percentage of GDP. The benchmarks of different countries are all over the place. In the U.S. consumer credit is $2.6 trillion, or 20% of GDP. The U.S. retail sector is 70% of a $13 trillion GDP, or $9.1 trillion. Nearly 1/3 of current retail is supported by current consumer credit. The U.K. is closely approaching the same ratio of consumer credit to GDP as the U.S.; but Germany, Norway and Sweden are at around 10%, while Hungary, Switzerland and the Czech Republic have a 3% ratio of consumer credit to GDP. Mexico has a low percentage of the credit cards to population – only 34%. China has a much lower percentage. So what is a viable benchmark?

The most reasonable benchmark appears to be Germany. Like China, Germany has a high savings rate and an export ratio of 40% to GDP. So it is not unreasonable to project a 10% ratio of consumer credit to GDP as a long term objective in China. The official exchange rate GDP of China is $3.2 trillion. Using the German benchmark of 10%, consumer credit should be at $320,000,000. China’s current ratio is less than 1%of GDP. Hence, China has a long way to go and requires a policy regime to grow consumer credit to a reasonable level to meet objectives of domestic growth. China needs a 5-year plan for consumer credit growth to reach the lower standard of the Czech Republic at 3%. A second 5-year plan could boost it to the German level of 10%.

3. Target Customer Segments. The only way to achieve rapid growth of consumer credit from a very low starting point is to market cards to segments of the population that already have them and use them to some degree for personal consumption. That means more cards and extended credit lines to current users and their demographic and psychographic cohorts. A qualified cohort profile can be extracted from current data. It would include all people similar to the people who already have and use credit cards. In all likelihood, 80% of that cohort either do not yet have credit cards or do not yet use their credit cards for personal consumption.

There are two segments that fall into this target market. The first group is the population under 24 – “the little emperors” of a one child policy. They are at the universities in major cities and have enough cash from their parents to pay credit card bills. They are spending their parent’s savings, so they have taken the first step to be true consumers. Consumer credit will leverage their family cash support for minimum payments and enable this segment to buy several-fold the amount of goods they are buying for cash. Their credit lines are limited because they are not employed, or fully employed. But they are a numerous class and can generate a high volume of credit based retail sales.

The second segment is the professional and young entrepreneurial class 25-50 in age. They need to show success and status and are paying cash for these the emblems of achievement. But they psychologically need to buy more than their cash permits. They are employed and have a rosy future. They can support a substantial credit line. The proper targeting strategy for fast domestic growth through consumer credit is to penetrate the cohorts that have cards and use them. There is no need to try to convert endemic savers into spenders.

4. Value proposition. The value of consumer credit to target segments is that credit cards multiply the goods you need to impress those with whom you are connected and those with whom you wish to be connected. This is an economic value proposition. Consumer credit is an investment in your advancement. As the Chinese economy matures, the value proposition will shift to Western modes of emotional rather than economic purchase, like impulse purchase, cult, or identity purchase, experience consumption, shopping sprees and other non-economic motives. But China is not there yet, and hopefully will not reach the excesses of the West. The economic value of status is enough to greatly expand the domestic economy.

5. Brand strategy. The government and card issuers need a brand strategy to manifest the value proposition with powerful messages, symbols and design. This requires the best way to tell the story of personal success through consumption; consumer happiness through brand identity; portraying leaders and celebrities as consumer role models; improved design to enhance the shopping experience; and the social value of credit use to the country.

6. Products. There are many credit card products. Typically in the West there are many levels of branded card offerings that relate appropriately to different demographic and life style classes. Silver, gold and platinum cards denote wealth classes. Affinity cards that are issued by banks, associations and companies reflect life style hobbies to which cardholders are very loyal. Sport teams issue cards, along with airlines, social cause groups, and so on.

7. Promotion. Cards are typically promoted through direct marketing by mail, online advertising and application or direct enrollment at events of card issuers. Credit card issuers spend a lot of money on print, TV and online marketing. The government will have to play an active role in promoting credit cards by its communications and information agencies.

8. Pricing. Annual fees, interest rates and rewards are key elements in the competition between credit card issuers. China has to be careful to regulate these matters and avoid the usurious interest rates prevalent in the West.

9. Distribution. The backward supply chain of credit card distribution is complex. Applicants have to be evaluated for credit qualification. Credit has to be financed by a chain of financial institutions and service organization. Risk has to be widely distributed. The forward supply chain is also complex. Distribution companies like American Express, Visa, Master Card, and Union Pay need information systems to organize and implement issuance, transactions, payments from buyers, payment to sellers, as well as receipts from and payments to financing sources and regulatory agencies.

Benefits of Consumer Credit

Chinese policy and Chinese enterprise have great aspirations for innovation and branding. But it is very important to understand how these aspirations relate to consumer credit. Innovation creates a useful or desirable value-added object. Branding adds a rational and emotion appeal to the innovation. But consumer credit makes it possible for people to buy these products.

So long as Chinese consumption remains on a cash basis, very few people can afford to pay cash for discretionary goods. They save their cash to purchase a home, a car and educate their children. They lay out a lot of cash for these fundamental purchases and take out banks loans for the balance. There is little cash left for goods that can support status and advancement, like gifts, stylish and fashionable apparel, entertainment, home furnishings, consumer electronics, and other appurtenances of personal success and achievement. They need to purchase expensive goods to display their status. Innovation and branding tempt purchase, but consumer credit enables purchase and accelerates domestic economic growth.

[1] This article was published in February, 2009 in the 21st Century Business Herald.

Crisis and Opportunity*

The Financial Crisis

The private Western financial system is structurally broken. The extraordinary leveraging of capital, into hundreds of trillions of debt, created a bubble that had to burst. Capital assets have been decimated.

Flaws

The excessive leveraging if credit was due to the failure to regulate the debt origination, structure and transaction of mortgage-backed securities, hedge funds, credit-default swaps, derivatives and other innovative capital instruments. Alan Greenspan has admitted his error. This admission is ominous because what he could not have imagined has no intrinsic limits. We have only seen the tip of the iceberg. After the housing bubble, we will see the collapse of consumer credit and auto loans. Defaults on credit cards have reached 7% and auto loans are beginning to unwind.

Government bail-outs throughout the world will not work because there are not enough reserve capital assets to absorb an astronomical scale of debt.
Financial institutions are being nationalized and the financial sector is reduced.

Prospects

Remaining private capital will continue to seek protection in the safe haven of government bonds, which have virtually no yield, when factored for inflation, and the downward speculative arbitrage of currencies. Government financial intervention is a powder keg of inflation. There is no end in sight.

Economic Crisis

The West is in technical recession. Collapse of the financial service economy has caused massive layoffs. The next distressed sector will be retail, which is 70% of U.S. GDP. Retail growth is negative and will be devastated by credit suppression. Commercial real estate and brand equities will decline.

China, India and emerging economies will continue to grow at a lower rate, which distresses their need for higher growth to urbanize large rural populations. Seven percent growth for China looks good in the West, but it is not enough for China. Yet the East will be better able to manage reduced growth than the West, which wrestles with negative growth. The growth imbalance is between the East and West is likely to last for a long time

Flaws

The West became a consumer, financial and technology society while the East has became an industrial economy. The greatest mistake of the U.S. was its refusal to sell advanced technology and weapons to every buyer (its only growth sector in the real economy) to balance its trade deficits. American foreign policy butt heads with real economy, and forced China to build its own advanced technology. The West produced and sold credit, while the East produces things and moves which move forward to added value.

Debt is only manageable as long as there is credit to recycle debt. Once Western credit became paralyzed, its debt had to be devalued. Industrial manufacture in the East can be managed by reducing variable costs. It is more flexible in tough times than finance.

Prospects

There are no new economic growth drivers in the West. The hope of an alternative energy will be vitiated by falling oil prices. Equities will fall to the level of the real economy and it is very difficult to measure what the real economy is. U.S. agriculture is only three percent and manufacturing nine percent of the economy. Europe, traditionally with a higher manufacturing percentage of GDP, is rapidly declining, without a retail expansion offset. We will see soaring Western unemployment, political confusion, protectionism and social unrest. Wealth is shifting from West to East.

Marketing Crisis

Marketing created a consumer society based on consumer credit.
So long as finance was regulated, the leveraging of this credit was limited. Deregulation took the cap off of leverage. Information and media technology vastly enriched the perceived value of brands. The dynamic interplay of brand enhancement, consumer credit and low cost offshore production created vast profits in brand equities. In recessions, brands, which are, after all, only perceived values, lose their perceived value as savings become a stronger value. Consumers turn to value and price only goods. While brand value declines in the West, it is gaining strength in the East. The manifest wealth of brand ownership masks real debt.

Flaws

Marketing became vastly empowered by information technology, product innovation and management sophistication. On the B2C side, product marketing went too far in hyping demand with too many new and varying product models, distribution channels, aspiration and promotions. Financial credit marketing to consumers hyped demand with too many consumer credit instruments (redundant credit cards, interest only credit programs, excessive credit lines, sub-prime mortgages) and leveraged debt to users, who lacked the resources to handle this debt.

On the B2B side, financial marketing technology and management innovation, without regulatory restraint, created sophisticated and impenetrable financial instruments (Mortgage backed securities, credit defaults swaps, repos, and other instruments) and sold them to financial institutions, which were incentivized by bonuses to buy this stuff, rather than scrutinize it. This has been an explosive combination of B2C and B2B marketing to consumers and to financial institutions.

Prospects

It is not enough to regulate financial institutions at a macro-level. Micro consumer credit has to be regulated as well, along with product marketing. Even with a tightening of credit, clever and ruthless lenders will devise and sell new products to desperate consumers to get them out of their mess. They will find ways to sell this paper to traders desperate to grow client accounts. These practices will make matters worse.

Governments will have to empower their retail trade authorities to monitor and restrain both demand and supply products and their advertising claims. Marketing has to be regulated. In desperate situations, criminal penalty is the only restraint on fraudulent invention. Voluntary restraint flies out the window. Branding will have to be compelled to become responsible. In a deep recession we will see a tremendous shift from brand to value marketing…a movement from perceived value to demonstrated value.
We will return to the basics.

Situation in the U.S.

The U.S. is in a recession and it will be prolonged. With the nationalization of financial institutions we are not dealing with a cyclic phenomenon but with structural change. Structural change takes a long time to regain stability and gain trust. In the meantime the bankruptcy of companies and households will lead to austerity instead of “life style”.

Unemployment in the U.S. has reached 7% and will probably jump to 9% by the time the October storm is reported. It will climb higher next year as companies adjust to a weak and almost invisible Christmas buying season. Christmas sales typically account for 30% of annual retail sales. Without a Christmas behind or ahead, companies will retrench in the domestic market. With retail at 70% of the U.S. the magnitude of this domestic retrenchment of employment will be enormous. We will likely see a Japanese style of stagnation for a decade. It happened there. It can happen in the U.S.

U.S. companies will continue to shift marketing investment to the East, where economies will continue to grow, albeit at a slower rate. The economy of large populations growing at a slower rate is much more attractive than smaller populations with no economic growth. U.S. dollar strength, backed by military power, will reduce export and political passions will insure protectionism is a futile attempt to recover domestic manufacture. The trend toward personal and household savings will not fuel a domestic renaissance of manufacture.

Prospects

With falling exports, the U.S. will be compelled to do what it has resisted for years – sell advanced technology and weapons to everyone as the only basis of trade balance or surplus. This will require a strategic alliance with China – a repeat of 1972 Nixon/Kissinger secret diplomacy, but in a new context and a new deal. The deal will probably sacrifice Japan, as 1972 sacrificed Taiwan.

The U.S. population will grow through immigration, legal and illegal, to lower labor costs for the arduous effort to revive the manufacture of low cost goods and expand domestic consumer demand. Protectionism will assist this attempted renewal. Conservative capital will continue to seek the wealth safe haven of U.S. military-based security. Investment capital will fly to growth markets in the East, along with domestic management talent. Foreign currency reserves will finance the Eastern acquisition of Western assets. It is hard to say how the society will manage social unrest.

Situation in Europe

Europe is in a deeper pickle than the U.S. They will have a prolonged recession, political fragmentation, protectionism and a tortured lowering of their fabled life style. The Euro may reach parity with the dollar, or go lower. Indeed, it may disintegrate as a currency.

Prospects

The failure to pass an EU constitution was fatal. If it could not pass in a prosperous time, it certainly cannot pass in a desperate time, when every nation will look out for its own survival and not trust any common accord to insure survival. There is too much disparity of national conditions in Europe for unity of action. Stronger countries cannot carry weaker countries on their back when they can hardly walk themselves.
There is too much embedded welfare in Europe to support capital formation. A serious unwinding of welfare in a continent of high unemployment will cause social unrest. The economy will be paralyzed, which is a step worse than stagnation. Stagnant societies can act; paralyzed societies cannot. Europe’s failure to create an independent military was always the Damoclean Sword of the Euro.

Situation in China

China will be affected by the global economic crisis. Growth is falling to 8% growth and will likely descend to 7%. But China still has $2 trillion of currency reserves, a stable budget and manageable debt. Remarkably, retail is up 30% and exports grew 28% in the last quarter. China’s established model for production of cheap goods is serving her well in these bad times when the whole world needs cheap goods.

Prospects

China will manage a balance between its continuing export economy and the growth of its domestic economy. Chinese policy is smart enough and authoritative enough to induce or force savings into consumption for domestic expansion. Its trade policy and acumen is smart enough to find new niches for the export of cheap goods as well as new niches for value added export. This balance will be a wonder to behold in a messed up world.

Chinese currency reserves will support its enterprises to acquire bargain production, brand and distribution assets abroad for higher profit margins. High distribution margins through ownership can offset higher production costs. In-country production and distribution will off-set protectionism. The economy will have sufficient growth to manage internal harmony. China will augment its world power when technology investment produces competitive value added products and advanced technology. When China has a competitive technology based in its production system it will make the Rmb convertible. It will become a global reserve currency and, unlike Europe, will fortify this currency will increase military strength.

Chinese Opportunity

Prolonged global recession will require more cheap goods, i.e. that is price-only and value goods vs. premium brands. China is the master of cheap goods production through its State policy models of low cost labor, industrial operations, entrepreneurial culture and supply chain management.

The major threat of global protectionism must be pre-empted by the export of its production systems, not just products. China must have internal production and market access in foreign consumer markets so it can flood these recessionary markets with cheap goods. When factoring in high distribution margins, it can offset higher labor costs with distribution profits for a lower total cost than domestic competitors. Chinese production and distribution in foreign markets will be accommodated (grudgingly) for employment and local tax generation.

China can transplant the Shenzhen SEZ (Special Economic Zone) model to foreign markets. SEZ is an integration of public capital support, incentive policies, subsidies and private investment in development, production, logistics and marketing. China’s can develop Sino-U.S. and Sino-EU economic zones in the U.S. and Europe. China and its municipal and provincial governments can retain tax revenues by supporting its enterprises abroad. U.S. state governments, like Kentucky, and certain European countries will welcome this entry to alleviate unemployment and local tax stress. These zones will be partnerships with domestic companies, but Chinese enterprise will have joint control of production, brand, logistics and distribution.

Land costs are cheaper in many State of the U.S. than in Guangdong.
Chinese enterprise will use local management talent desperate for work.
These new zones will be very large and require intelligent planning, artful political negotiations and foreign legislative protection. Unlike current ad hoc Chinese enterprise acquisition in the U.S. and Europe that are scattered and fragmented, these SEZ zones will provide political protection for Chinese local assets. They will represent a new stage of Chinese globalization. Instead of the West penetrating the East during the period of good times, China will penetrate the West during the period of bad times.

Milton Kotler
President, Kotler Marketing Group
October 2008

*This speech was presented to the Asian Economic Forum, Hong Kong. September, 2008. It was published in the China Business Review in December, 2008