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The Rise of China's 2nd and 3rd Tier Cities

Though Shanghai and Beijing tend to grab the headlines, the future of the country is in its smaller cities, experts say. They are its heartland and the likely source of its most rapid growth over the next few years.

China
AP
China

“The China story is increasingly about Tier Three cities,” Andy Rothman, the China macro strategist for CLSA, said in forecasting 9.5 percent economic growth for China in the year ahead. “It’s where much of the growth is coming from, and where a lot of spending on public projects and low-income housing is going. And you’re seeing an increasing number of foreign and local companies expanding out there.”

More than 300 million people live in China’s smaller cities, roughly equal to the 310 million population of the United States. That’s both an enticing labor pool and an attractive customer base for many companies, which are starting a gradual shift from the developed eastern seaboard into the center and west of the country.

China has 160 cities with populations of 1 million or more, out of around 655 cities in all. Looking at the centers of the megacities, 12 metro areas boast populations of more than 5 million.

There is no formal definition of what constitutes a “first-tier,” “second-tier” or “third-tier” city in China. But it’s commonly agreed that the top tier incorporates Shanghai and Beijing, as well as Guangzhou and Shenzhen, well-off cities just across the border from Hong Kong and at the heart of the industrial Pearl River Delta. That’s thanks not only to their large size but also the fact they have the highest incomes in the country.

But they account for only 9 percent of the country’s population. There are many more people living in the Tier Two cities, often defined as the provincial capitals and special administrative cities — 23 in all.

Any prefecture level or county-level capitals are generally classed in the third tier. But the breakdown between Tier Two and Tier Three is not precise. Property brokerage Knight Frank set the barrier for a second-tier city at a population of 3 million and a minimum per-capita GDPs of US$2,000 or more. Using that definition, there are some 60 cities that are “second tier.”

However you break them down, it’s clear the importance of second and third-tier cities is growing. Just as people are migrating from the countryside to the city in massive numbers, companies are migrating from the expensive coast to tap the interior.

"“With the rising wages in the coastal region, as well as the rising importance of the domestic market in inland provinces, we believe that there will be major moves by companies to relocate their production bases into the inland provinces, with cheaper production costs and easier access to the inland markets.”" -Credit Suisse

“With the rising wages in the coastal region, as well as the rising importance of the domestic market in inland provinces, we believe that there will be major moves by companies to relocate their production bases into the inland provinces, with cheaper production costs and easier access to the inland markets,” a Credit Suisse team wrote in a report on China’s 12th five-year plan.

It expects the biggest beneficiaries to be three areas: Sichuan province and Chongqing in southwest China; the central provinces of Anhui, Jiangxi and Hunan, near wealthy Guangdong and Jiangsu provinces; and Hebei and Henan provinces near the big northern market around Beijing.

Companies in a variety of sectors stand to gain over the next five years. CCCC, a major contractor, should benefit as factories move west and north. With interests in port construction and dredging, as well as highway projects, it’s diversified enough to benefit from China’s infrastructure push.

Factory-automation specialist Delta Electronics produces energy-saving products that will be in demand from new factories, and fits with the central government’s push on carbon emissions.

But consumer companies such as Wilmar, a food-oil maker, also stand to benefit. Hengan, the largest tissue paper producer and second-largest diaper and napkin maker, likewise gets a boost from higher consumer spending. While multinationals focus on Tier One cities, Hengan has worked hard to established its brand in rural areas, giving it a first-mover advantage.

As factories relocate, wages are likely to rise at a faster rate in China’s smaller cities, albeit off a much lower base. That’s likely to contribute to inflation, widely expected to be China’s greatest near-term challenge.

"“Wealth is being created in central and Western China, where more people live...In some ways that is contributing to CPI inflation in China. As more people are contributing to the economy and generating wealth, they are able to spend more money.”" -China Macro Strategist, CLSA, Andy Rothman

“Wealth is being created in central and Western China, where more people live,” Rothman said, noting he expects wage growth of 10 percent this year. “In some ways that is contributing to CPI inflation in China. As more people are contributing to the economy and generating wealth, they are able to spend more money.”

But prices and wages have a long way to rise in China’s smaller cities before they become a problem. Inflation is likely to be higher but average 4.5% in 2011, according to CLSA.

Rothman says focusing on Shanghai and Beijing gives a misleading picture of what’s going on in China. In real estate, for instance, the Big Four cities accounted for only 5 percent of home sales last year, by volume. The average home price is around 75 percent lower outside the Tier One cities, which leads Rothman to believe China is not inflating a property bubble.

Property developers in particular are finding smaller cities increasingly attractive. They are also encouraged to shift their focus by last year’s rule changes, with with tougher rules implemented on sales and developments in the first-tier cities.

China’s first property taxes, long in the works, are likely to be implanted first in Chongqing- sometimes classified in the top tier thanks to its vast 31 million population-and then in Shanghai, according to local media reports.

Credit Suisse, in a report put out on January 11, said developers such as China Vanke and Evergrande have managed to outperform their competitors in terms of unit sales and financial strength by focusing on the mass market. That sets them apart from most developers, which favor mid- to high-end housing projects because they have fatter profit margins.

Most developers are expanding into smaller cities, though. So the investment house says it is also important for developers to diversify their product mix. Smaller cities have much greater demand for affordable, mid to low-end homes.

A move into smaller cities may help developers in another way. Whereas many developers have sat on land for several years, they’re now being held to a much stricter timetable. In the First Tier cities, they often now have to pay 100 percent of the land premium within six months or less.

That could prove a problem for developers such as Shimao , Sino Ocean and KWG . Their apparently comfortable net gearing levels of 50 percent to 70 percent would surge to a more alarming level of around 100 percent, Credit Suisse states.

Evergrandeand Kaisa are in a similar situation, but they have focused their latest land acquisitions on third-tier cities. The land premium payment schedule is longer and much more flexible there, allowing the developers valuable breathing room to deal with their debt levels.

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