A Great Leap Forward

The voices in the garden restaurant at the high-end Bulgari Hotel in Milan are what you’d expect: those of Italian businessmen and -women enjoying lunch and a cigarette on a pleasant afternoon. A few Americans mix in, relishing a European getaway — they’re not strangers to Italy. But that would not necessarily be true of the table of Chinese visitors. Or the busload of Chinese tourists gathering in front of the famed La Scala to hear a guide explain the history of opera. Or the others exploring the magnificent cathedral Il Duomo. Perhaps they arrived on one of the three weekly flights Air China now runs from Shanghai to Milan. And more can be expected, since Asian airlines jammed the books of Boeing and Airbus with nearly $20 billion of orders at the Paris Air Show in June.

China’s tourists needn’t leave the country for Western-style hospitality. In Sanya, along China’s southern coast, Marriott recently opened a Ritz-Carlton resort. Both Marriott and Starwood are planting their myriad flags — from the Ritz-Carlton and St. Regis to the more modest Courtyard and Four Points — within China at a furious rate. At the same time, they are preparing to receive a wave of Chinese tourists, as many as 100 million per year by 2020, forecast to descend on popular destinations elsewhere around the world.

They will be tourists like Zhao Lin, a 34-year-old Google manager from Beijing, who says she loves Italy “because of the abundance of culture and history.” And because of Prada, Gucci, Ferragamo and Fendi too. Zhao has made the haul of luxury goods that are requisite for rising Chinese women in the big cities. She and her husband, a technology manager, also own cars — hers is a Volkswagen Passat. To retailers, people like Zhao are becoming increasingly important, says Ellen Jin, head of consumer markets for the consultancy KPMG China. “There are more young Chinese people, including women, running their own business or getting to executive management levels, and they have more disposable income,” she says. “They see luxury goods as their just deserts. They want to reward themselves.”

The world’s largest multinational companies, many of them headquartered in the U.S., have been betting on the rise of the Chinese consumer for many years now. But as the economies in the U.S. and Europe have struggled to revive in the past few years, firms in nearly every sector, from automobiles to consumer goods to telecommunications, have placed a larger share of their chips on the Middle Kingdom. It is simply a matter of numbers: China’s economy grew 9.1% in the last quarter, compared with less than 2% in most of the West. While incomes in the West are stagnant, individual Chinese are expected to get a lot richer.

Consider the cosmic irony: wobbly Western economies are depending on the Chinese Communist Party to save their capitalist bacon. Likewise, the Chinese government’s grand scheme to rebalance its economy hinges on Western-style materialism. By substantially boosting wages, it wants to create a new generation of spenders, including not just urban sophisticates like Zhao but a much broader swath of China’s 1.3 billion people. “Shop till you drop” is probably not what Mao had in mind during the Long March. Nevertheless, wage and spending growth is one way to bridge the still vast gap between China’s poorest workers and its advancing middle class — which will comprise 70% of China’s population by 2020. If successful, the shift to consumer spending will take a good chunk of the weight of the global economy off the shoulders of American consumers and make China a gotta-be-there market for everything from video games to surgical tools to potato chips. “This generation, these strivers, they will be the saviors of the global economy,” says Tim Minges, chairman of the greater-China region for PepsiCo, which is pouring billions into China in anticipation of that growth. “I really do think the Chinese middle class will be like the U.S. baby boomers.”

The role reversal has another component: companies such as Pepsi, Volkswagen and Motorola, whose products were once Made in China, are increasingly developing products Made for China. So while Chinese fashionistas crave imported shoes from Italy’s Ferragamo, that company’s compatriot rival Geox is rapidly expanding by manufacturing and selling in China for the broader market. So is Sony, whose made-in-Japan products Chinese once longed for; now there’s a line of China-made pink gadgets because many women like that color. HP recently opened a factory in Chongqing to build computers not for export to the West but for sale to China’s west. Starwood Hotels, which runs the St. Regis, Sheraton, W and other brands, moved its entire management team and board to Shanghai for a month; CEO Frits Van Paasschen wanted to be a bit closer to where future customers are. Starwood has 84 hotels in China — and 100 under development. A recent announcement by Gap says it all: the famous American jeans company is closing 20% of its American stores and tripling the number in China.

The investments companies are making are big, deep and long term. PepsiCo, maker of Pepsi, Lay’s potato chips and Quaker Oats, is building a massive R&D center in Shanghai that will include pilot plants for each product area, so food scientists can quickly test new offerings created for Asia, including regional varieties, and get them to market within months. Swiss pharmaceutical giant Novartis is spending $1 billion on a six-building campus in Shanghai that will become a third global R&D center. This is not for outsourcing or a cheaper place to run drug trials. “It’s going to be one of our primary research sites,” says Novartis CEO Joe Jimenez; it will join centers in Cambridge, Mass., and Basel, Switzerland. That’s because the Middle Kingdom is a growth market for important drugs. For example, a richer diet among a growing middle class means more diabetes — and more insulin sales.

The key question is, How big can the middle class grow? If there are two Americas, there are about four different Chinas, from millionaires to the desperately poor. In the coastal cities, the average annual income can be $5,000 or more, but in the rural areas, it drops to a few hundred dollars a year. China has a huge wealth divide — its Gini coefficient, the measure of how much inequality there is in a society, is one of the largest and fastest-growing in the world. That divide has created increasing political risk in China. Many notable investors, like hedge-fund manager Jim Chanos, see China as one enormous bubble, ready to explode. According to him, all the speculative capital in the country makes it look like “Dubai times 1,000.”

But if the Communist Party can successfully navigate the risky rebalancing road laid out in its new five-year plan, millions of nonfarm workers will soon get what American workers haven’t had in a decade: a raise. A really big one. The government is targeting minimum-wage increases of 13% to 15% over the next five years, essentially doubling the income of many citizens.

And the government expects the world’s largest workforce to spend it. When economic reforms began in China in the early 1980s, consumer spending was more than 50% of GDP. By 2009, consumer spending had dropped to 36% of GDP even though wages were rising. That’s because the government was doing even more spending itself, pouring cash into export industries and expanding the infrastructure to move people and products around a vast geography.

All that investment sowed the seeds for what Western companies hope will be the greatest generation of spenders ever known — the group of Chinese known as the Post-’80s Generation. Now in their 20s and 30s, they came of age as China shifted from a command economy to a more market-focused one, open to Western products and lifestyles. These younger Chinese have known nothing but nonstop growth, and they are much less likely to save than their more hardscrabble parents and grandparents, who typically put away 35% to 40% of what they earned. “They don’t deposit that much money,” says Victor Yuan, chairman of the Beijing-based Horizon Research Consultancy Group. “Their bank-savings rate is much lower, and it is much easier for them to spend money.”

Can they really spend enough to bail out the global economy? U.S. consumer spending is about 70% of the nation’s $15 trillion GDP, which is what helped get America into trouble. As for China, the numbers behind any big shift toward consumerism there are potentially world altering. China’s 2011 GDP is roughly $6 trillion. If consumer spending goes up from the current 36% to reach 45% of GDP — the government’s stated goal — $540 billion in spending would flow into consumer goods and services. That amount of spending would be enough to lift the U.S.’s GDP by 3.6%, which is a boom. And that doesn’t even factor in China’s economic growth. If the economy expands 9% annually, as it has in recent years, and half that growth goes toward consumer spending, you quickly get to $500 billion in additional spending in two years, using current numbers as a guide. That’s the most bullish scenario, to be sure. But if you are a global corporation, you definitely don’t want to miss out on a piece of that potential stimulus package.

The Reverse Marco Polo

You can almost see the math floating above the head of Symon Bridle, chief operating officer of the Hong Kong — based luxury-hotel company New World Hospitality, as he ponders the possibilities for the travel industry in China: “It’s a country that now has 1.6 million hotel beds. In the U.S. there are 4.8 million. Extrapolate that. There’s a huge opportunity for hotels that’s being driven by domestic growth.” Boston Consulting Group estimates there are 1 million millionaire households in China. When those folks start hitting the road, Bridle wants to be ready, and so New World recently spent $230 million to acquire Rosewood Hotels & Resorts, to lure travelers like Liu Yining, 32, a senior manager at Groupon China. She spends at least two weeks a year on leisure travel in addition to taking business trips. “I like to go anywhere I haven’t been,” she notes. That list is getting shorter. She’s been to most European countries, the U.S., South Korea and Southeast Asia and planned to visit Japan for the first time in October.

The exodus is already under way. There are an estimated 54 million outbound trips from China, a number that has quadrupled in the past 10 years. By the end of the decade, the figure could easily reach 100 million. Already, tourism officials in Paris are trying to puzzle out how to make the numbers work. “We estimate that by 2025, around 2 million Chinese will visit Paris,” says Paul Roll, the city’s head of tourism. That’s more than triple the current number. That could be a problem in a city with 76,600 hotel rooms, even with top Asian chains like Raffles, Mandarin Oriental and Shangri-La bolstering their room counts in the City of Light. That’s why city planners are creating more Paris by replicating famous Parisian neighborhoods in areas just north of the city.

Of course, the Chinese are traveling and spending more in their own country too, in part because of a gigantic infrastructure build-out; China will have constructed more high-speed-rail capacity by the end of the decade than is currently operating in the rest of the world, some 10,000 miles’ (16,000 km) worth. The high-speed trains cut travel time from Wuhan, in central China, to Guangzhou, on the coast, from 14 hours to 3 hours. New airports are being built at a rapid clip, creating travel opportunities that once were unheard of. Tibet Airlines, a new company flying out of Lhasa, is operating the first of its three new Airbus A319s.

Much of the new infrastructure links the already rich coastal areas to fast-growing second-, third- and fourth-tier cities in the west — where domestic spending is often most fevered. (While Shanghai and Beijing yuppies can buy the latest luxury goods on trips to Paris, nouveaux riches in Chongqing can’t wait to hit the newly built LVMH boutique at home.)

That creates all sorts of new opportunities, from retail to bus tours to ultra-luxury resorts catering to rich Chinese in entirely new places like Sanya, where Ritz-Carlton has set up shop. This all speaks to the fact that companies that want to sell to the Chinese have more competition — and they have to work a lot harder than they did in the past. Both Marriott and Starwood are rolling out programs in non-China hotels that provide a special service tier for Chinese travelers, including Chinese-language services and food and beverage offerings. Starwood boss van Paasschen allows that the entire company, as well as its franchisees, may ultimately have to bend more to the will of Chinese travelers.

The New Tastemakers

Sam Su, the CEO of Yum! Brands China, sees a country whose consumer demands are already changing his company. Yum!, the U.S.-based multinational that owns Pizza Hut, Taco Bell and KFC, has been in China a long time; it opened its first KFC there in 1987. It has 3,200 outlets in China, opening one a day in places like Tianshui, a city of 1.2 million that’s 1,000 miles (1,600 km) from the coast. KFC is in every province in China except Tibet and has restaurants in more than 700 cities. “You can say we go in much deeper than even the second-, third- or fourth-tier cities,” says Su. You can also say KFC has parted ways with its American cousins. “We can’t just take the U.S. model and put it in China. We have a very good business model right now. It’s more mainstream.” There, KFC isn’t a chicken joint; China’s consumers want it to be an everyday place. That means, for instance, a breakfast of traditional Chinese foods like congee (a rice porridge) and a teatime menu the Colonel wouldn’t recognize.

As China’s consumers grow more experienced, their relationship with brands is also changing. PepsiCo’s initial focus in its first decades in China was simply to get enough people to try its American soda, Lay’s chips and Quaker Oats products. Now the products have to deliver taste and value to a more sophisticated customer — hence the R&D center that can quickly pivot with products geared to hyperlocal tastes. “No doubt there’s been a significant shift in Chinese consumerism. When I first got here, it was all about the brand, the badge value of a brand. Being foreign was aspirational,” says Minges. As brands became more familiar and Pepsi got deeper into the country, the focus moved away from the ego value of brands to more-traditional values around taste and usage.

And so the company has had to develop flavors that match China’s food culture. About 35% to 40% of the flavors that Pepsi now uses in its Lay’s brand of chips are local. Noticing that chip sales sagged in the summer, the company created a range of flavors to match cool foods the Chinese prefer in that season; a cucumber flavor, for instance, was added. Since China has a number of regions, like Hunan and Sichuan, where spicy food is preferred, the company added a hot-and-sour-fish chip, which mimics the flavor of a popular soup; for the hotheads in Sichuan, it came up with the ultimate “numb and spicy” chip. Meanwhile, Quaker Oats, faced with the task of introducing an oat cereal to a rice culture, instead devised a product to be blended with the congee that Chinese typically eat for breakfast. It includes red dates, wolfberries and white fungus — ingredients that consumers consider to have medicinal properties.

For firms like Novartis, the government’s promise to deliver better health care will be a boon for business. Its generics division can manufacture low-cost flu vaccines that poorer areas of the country need, the growing middle class will have access to medications that it didn’t in the past, and a world-class R&D center in Shanghai — staffed largely by U.S.-educated Chinese scientists (who work for about 60% of what they would earn in Europe or the U.S.) — can develop therapies for diseases that are prevalent in the population. In Shanghai the company is tripling the number of its scientists, to 600, to deal with diseases that wealth brings. As the Chinese become more sedentary, eat more meat and sugar and continue to smoke in great numbers, their disease profile changes. There are more than 92 million Chinese diabetics, for instance; other diseases, like liver cancer, show up in greater numbers now too. The company is even helping China’s food-and-drug administration improve drug safety. “Between vaccines and innovative pharmaceuticals, we are uniquely positioned to go to the government with a broad range of offers,” says CEO Jimenez.

Even in something as esoteric as architecture, China’s pull is too enormous to resist. German-born Ole Scheeren helped design the snazzy, D-shaped CCTV building in Beijing as a partner in starchitect Rem Koolhaas’ firm. Buildings like this have helped China make impressive statements to the outside world. But unlike most of the Westerners involved, Scheeren stayed. He quit Koolhaas’ firm to start his own and is now working with Chinese city planners. One current commission is a massive mixed-use development in Chongqing that Scheeren says won’t look like every other mixed-use project from Dubai to Kuala Lumpur. “I’m not going to design from the West for China,” says Scheeren. “I’m going to design from China for China.” If Scheeren gets it right, he will never run out of projects, because China won’t.

—With Reporting by Jessie Jiang / Beijing