— twoyearsfromnow

Article by Carl Berrisford, published in the South Morning China Post
Nov 07, 2011

Gaining purchase
Hong Kong’s retail sector enjoys a mainland boom that looks set to last

There has long been a whiff of superiority in Hongkongers’ perception of  mainlanders.  But if one’s livelihood is even remotely connected to the city’s surging retail economy, you might want to think again about that powerhouse consumer of luxury goods and all items high-margin: the mainland shopper. An ever-increasing part of the local economy (about 10 per cent) stems from the sale of  branded bags, skincare products, expensive timepieces and the like to mainlanders.

China alone makes up 15 per cent of global luxury consumption – some estimates place it as high as 50 per cent – and Hong Kong is a main point of purchase for these items.

Already numbering 22.6 million visitors a year – three times the territory’s resident population – and spending an average HK$7,400 per visit, their economic impact has  been significant.

Not long ago, the city was filled with stories of disgruntled tourists on fly-by-night package tours forced to shop against their will. They were perceived as low-income punters and were treated as such.

Times have changed. Mainland shoppers have gone dramatically upmarket, and now the focus is on the impact of such high-spending visitors on gold and jewellery sales, and the record-breaking revenues of Macau’s casinos.

One major factor in the shift in the local perception of mainland tourists and their gradual transition to a “better class of visitor” is perhaps the Individual Visit Scheme, introduced in 2003 and broadly extended across China in 2005.

The scheme allows individual visitors from the mainland – a break from the old system of letting people enter only in tour groups. The easing was much welcomed by mainland tourists, and thus was born a boom in Hong Kong retail and Macau gambling. This boom has helped shelter the Hong Kong economy from much of the recent global turmoil. The shopping blitz was fully evident through the 2008-09 credit crisis and continues today – through the bad debt woes in Europe, slowing  growth in the US and monetary tightening in China.

The key incentive to shop in Hong Kong for most mainlanders is simply lower prices. The absence of high duties on luxury goods can mean a discount of as much as 50 per cent compared with mainland prices. Furthermore, shoppers get guarantees of authenticity on their products – an important draw given widespread counterfeiting at home.

Mainland consumption is enormously beneficial to the Hong Kong retail market. So far this year, Hong Kong has enjoyed a 30 per cent rise in the number of mainland visitors, driving a 38 per cent growth of retail sales. The highest turnover has been in electronic goods (with sales up 80 per cent from January to August) and in watches, jewellery and gifts (up 51 per cent).

Unsurprisingly, these items, together with skincare products and luxury branded goods, top the shopping lists of mainland visitors because they carry the heftiest duties on the mainland and, therefore, the biggest discounts in Hong Kong.

The spillover economic effect has also been transmitted via the sharp rises in retail property rentals. Hong Kong’s average retail rentals have risen 12 per cent this year, contrasting with an average annual growth of 5 per cent since 2009.

The scramble of  luxury brands to establish themselves in Hong Kong – and therefore the mainland – has helped drive the relentless rise of Hong Kong’s retail rents.

The big branded firms are also tapping into the local stock market to fund their expansion. So far this year, Prada, Milan Station (a purveyor of second-hand bags) and Samsonite have listed on  Hong Kong’s stock exchange, with initial public offerings believed to be planned by Coach, Tumi, Ferrari and Aston Martin.

So how resilient is this boom? Analysts argue that the luxury consumer sector is “ultra-cyclical” in that it is highly correlated to growth in gross domestic product. Big-ticket discretionary items are typically purchased in good times but are the first to be cut when times are tough.

This produces big demand upswings in a growth environment and severe downswings in a recession (but bear in mind that the super rich are  less sensitive to recession and  are generally not deterred from luxury spending because of a downturn).

Luxury spending tends to be “aspirational”, which means aspiring middle class also makes up a large piece of luxury goods demand. This segment tends to be sensitive to the state of the economy, so demand for luxury goods from such consumers will fall sharply during a recession.

In the case of China, there is an additional contributing factor: much of the present-day affluence is tied to private enterprise, with much less legacy wealth or “old money” than in developed markets. Therefore, the  state of the economy can be expected to have an impact on China’s spending habits.

But the relationship between mainland consumer spending and economic growth is less direct  than such theories suggest. Aspects of China’s economy and financial system complicate the question of what is  luxury discretionary spending and what constitutes spending for practical purposes.

For example, a slump in China’s stock market over the past year and the imposition of investment restrictions in residential property suggest that investment channels for the nation’s rising disposable income and retail savings have become limited, especially in a regime of capital controls.

China’s negative real rates (interest on savings is below the rate of inflation) also motivate consumers to put money in non-financial assets or collectibles that offer a “store of value” instead of in cash deposits that lose purchasing power.

The attraction of gold to consumers in times of inflation or depression has historic roots. During the Great Depression, the US government famously prohibited the public from buying gold.

Ironically in China, despite capital controls, gold is one “currency” with no investment restrictions, especially when purchased in jewellery form.

Asia’s cultural bias towards gold as a store of value is reflected by the fact that China and India together compose most of the global gold jewellery market, which itself is almost half of global gold demand.

All of this suggests there is more underlying mainland luxury spending than just an economic boom. Several conditions unique to Hong Kong and Macau imply that the mainland retail tourist phenomenon is not just a short-term fad that will disappear in a downturn.

For example, Hong Kong and Macau are often the first offshore ports of call for China’s affluent simply because of proximity, ease of access and the fact that  Putonghua is widely spoken.

In this sense, Hong Kong enjoys a captive market on the doorstep of an economy producing millionaires at a steady clip of almost one million every five years.

It is also reasonable to believe that if the Chinese economy deteriorates further, mainland consumers may curtail overseas travelling plans to more exotic destinations, and cost-conscious “high-end spenders” would even increase their visits to Hong Kong, so the city would benefit from a substitution effect.

Nevertheless, there are factors that could slow down Hong Kong’s retail boom. These are largely regulatory, such as a slowdown in the pace of renminbi appreciation, falling onshore luxury goods duties and new visa restrictions on mainland tourists.

Duty harmonisation with Hong Kong on luxury goods sales is one particular area of risk, especially as Beijing has expressed a desire to keep high spenders at home and boost domestic luxury consumption. China has already established a duty-free zone in Hainan province  and may soon target reduction in nationwide import duties of 2 per cent to 15 per cent for goods ranging from liquor to cigarettes to cosmetics. However, harmonisation is likely to be gradual since duties on luxury goods are an important source of income.

Another area  of regulatory risk is the Individual Visit Scheme itself. Although the rising integration of Hong Kong with the mainland  via the Closer Economic Partnership Arrangement and the offshore yuan trade clearing scheme suggest visa restrictions would be unlikely, politics, especially in southern provinces, and other factors could see visa restrictions enforced – as has happened in the past.

But such changes would only serve as friction to the bigger trend of a growing, mainland-powered, retail boom. Unless offshore centres like Hainan and Taiwan can develop the competitive advantages and range of retail goods and services offered in Hong Kong and Macau, the high-end spending trend by mainland visitors is unlikely to disappear in the foreseeable future.

Carl Berrisford is an analyst at UBS Wealth Management Research