Stop calling them emerging markets: the lesson of luxury goods in China
During a recent talk on behalf of AHK, the Italian and German Chamber of Commerce, Mr. Robert Scheid was reviewing the economic performance of Germany following the financial crisis with respect to other European countries. He highlighted how the country, differently from most of its continental neighbours, was able to perform well despite the rather difficult situation. GDP growth, in particular, was consistently higher than those of stagnating economies like Italy and Spain, but, he stressed, also higher than those of France and the UK, and performed remarkably well when compared to other developed economies, like the US. How was that possible?
“We just sold more Volkswagens in China: that’s it”.
An apparently straight-forward but over simplistic answer like his has, in reality, lot to say when we think about the backbone of Germany’s economy and the relative importance of all the subsets of industrial manufacturers that rely on the gigantic automotive industry. But even if focusing on Germany’s automotive industry’s value chain might let us grasp the importance of exporting cars at a superior rate for the network of companies involved in the process, we are still missing half of the story: who is buying these cars. In the severe economic slump that followed the financial sector crash in 2008, China was one of the very few countries that was relatively less affected by the sudden stop and keep pushing with its mind-boggling growth rates.
According to official statistics, economic growth has averaged 9.5 to 10% per annum until 2014. National income has been doubling every 8 years since the end of the ‘70s and GDP per capita has increased 49x, from around 150 American dollars to about 7600 in 2014. The convergence effect that characterises lagging economies mostly awarded the middle class, which found itself in an unprecedented wealthy state. This was made possible by the trade liberalizations that were supported by the government, which gradually allowed the country to become the world’s export-led, labour-intensive manufacturing hub that is today.
China’s growth was fundamental in pulling developed markets’ growth when they were most struggling. An economy that was traditionally sought only for cheap labour and convenience products, was slowly transforming in a full-grown market economy, with its vices and virtues. The booming disposable income of Chinese shoppers made the market extremely attractive for players in mature industries that were struggling to expand their market share or squeeze even more their loyal (or not so) customers, especially during the financial crisis. This is the case of the luxury industry, with players nose-diving in the Asian market hoping to reap effortless profits from unsophisticated customers.
A colonial-like approach to unspecified customer segments in Asia was successful at first. Companies like LVMH and its subsidiaries, Prada and Hermes, all made massive financial commitments to secure a first comer position, with countless, flashy and expensive flagship stores in the main Asian cities. The Italian brand, which IPOed in Hong Kong back in 2011, owns 600 directly operated stores, two hundred more than the French giant, of which 40% located in Asia.
A plain-vanilla market development strategy worked until the Chinese economic engine started to behave differently than expected; the economy struggled in the process of evolution and transformation to fully-developed, GDP growth slowed down and political hiccups worsening the situation. At the same time, customers started to evolve and be more demanding; the unexpected behaviour in the market resulted in a terrible slow down for luxury-goods producers, who where found by surprise with a rigid cost-structure. 2016 growth – 6.7%, still high for Western standards – was even lower than the 6.9% registered in 2015 and, while in the target range set by local authorities, was the lowest in 25 years.
It is true that the economy rose again to a higher pace of 6.9% in 2017, but only thanks to Chinese government pulling a series of stimuli to keep it lively, mainly through infrastructure investment and bank lending. In the medium term, however, as suggested by Yuan Yang and Tom Mitchell of FT, these attempts will probably only increase the likelihood of bubbles; total debt, private and public, has reached in fact more than 230% of GDP, up from 148% in 2007. Additionally, in 2013, a country-wide anti-corruption campaign was launched by Xi Jinping, aimed at taking down high and low-level officer corruption in the administration.
The combination of these factors resulted in a severe hit to the Western luxury industry, which plummeted exactly as the anti-corruption campaign was launched and pushed back only at the end of this manoeuvre. Companies, like Prada, that had gone all in on the Asian market, struggled to revamp from the slowdown of the Chinese market and still suffer from the lack of strategically viable options to turn around the market.
As suggested before, broad based market growth strategies started to crack when customers shifted their preference to different distribution networks and away from status-symbol luxury goods, as reported by McKinsey & Company. Big logo brands failed to capture the new dominant taste for subtle, exclusive products, and only the companies that foresaw the surge of internet purchasing and social media marketing were able to adapt their strategies to the context. Chinese e-commerce market is, in the end, estimated at around $600B and currently the largest in the world; the increasing popularity of this channel decreased impulse shopping and allowed buyers to become more literate about the products they were buying, something that companies like Prada never even considered possible. Traditional companies were wrongly assuming that customers would buy their products without knowing anything about the brand, except for its perceived exclusiveness; only those who gradually educated their target segments about the tradition and history of the company, like Hermès, were able to overcome the downturn in the luxury spending in a better shape.
The underestimation of Chinese customers’ savviness resulted in a stronger correlation between the economic slowdown of the country and the financial performance of less adaptive firms, giving a very good example of how large markets, regardless of their perceived lack of sophistication, can pose huge threats to companies that don’t know how to meet customers’ expectations and adapt to local taste. China and many other so-called emerging countries can no longer be treated indistinctly, as their critical mass can easily shift the balance of entire industries and economies with simple fads and trends. Companies that understood the shift in consumer taste were able to rebound from the stall in luxury consumption, but those who didn’t were badly hit by the economic downturn.
WRITTEN BY FRANCESCO PATRONCINI FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT