Income effect vs. Wealth effect

Just some thoughts I had to write it down during the recent vacation trip – not well organized but maybe on something…..

Property price, if starting to decline in 2H11, due to a combination of increase in housing supply with govt social housing effort and (probably delayed actual implementation of) restricted demand, could put a stop on China’s decades’ rising wealth trend. While I don’t believe such trend will reverse any time soon, any pause in wealth creation of average Chinese household, if no meaningful offset from stock market gains, should have impact on some sectors of the economy.

Nevertheless, despite 90% of Chinese wealthy people (mostly in urbanized areas) owning property, only 1/3 have a mortgage, an unofficial estimate but largely consistent with factual observation if you live in China long enough.

As a result, there would be much less damage in China from the negative leverage factor alone, which differentiates China from most developed countries. Growth will certainly slow down if there is a severe drop in property price, as those leveraged house buyers will be affected and headline news made of it would hurt general mkt psychology, which is important in the short term.

It is therefore reasonably concluded that in the longer term China’s overall consumption growth should be largely driven by rising income and population, rather than wealth increase.

It’s interesting to note that an average Chinese actually out-spends an American on entertainment/travel, healthcare as well as education on percentage basis, if excluding groceries (a big distorting area given China’s relatively low average personal income level vs. USA), clothing and rent/mortgage (a not apple-to-apple comp between China and US). The disproportionate spending on entertainment/travel might be caused by lack of competition in airline and tourism industries (Chinese leisure travellers’ preference of int’l destination and air vs. cars might also be a factor) while education is obviously one area Chinese are most aggressive on consumption (and hence pricing power enjoyed by service providers). Both areas should continue to see above global-average returns.

But the fact that an average Chinese actually spends the same weight on healthcare is not only troubling as China just starts to get old before it gets rich but also a reflection of low efficiency in the whole healthcare system. If this can’t be addressed, China’s other consumption growth will inevitably hindered. The implication on healthcare industry is price erosion will stay with us for much longer.

Spending on communication is about the same and both carries small weight. It probably reflects good enough competition in both countries. While overall growth is limited in both places, data service should be a common driver of future growth.

Chinese still lags US in transport spending as a percentage of total, despite not cheap fuel price in China. This is one area, if fuel price not contained, could bring huge surprise on the upside – good for global energy price but not necessarily for Chinese refiners as their pricing power is not a given if the government has the last say. Also, American spend much more on utilities, which are another gap to be narrowed as China becomes richer.

In summary, a secular rise of income, combined with structurally positive drivers, should be good environment for volume beneficiaries in healthcare, utilities and energy (e.g. pipelines, pharm distributors, etc.) as well as market leaders in education industry. Travel is also another place to be as pricing power there is strong.

Of course, some kind of consumption is closely related to wealth effect, particularly high-end and luxury goods.

One other low-probability event, which, however, might more likely occur this time if property bubble gets out of control before it bursts, is derivative impact on general economy if property price not only just corrects, but collapses. Then unemployment will rise and income effect will take hold.

I believe the CCP understands this very well and hence all the austerity measures in place. The concern would be the implementation of such measures and subsequently mis-timing risk. Investors can only hope that China would not overshoot neither undershoot this time – a wishful thinking in most time of human history.


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