(reposted from SCMP here, May 9, 2014)

Jonathan Woetzel is the “go-to guru” for Chinese urbanization. He is a senior partner at McKinsey & Company and the co-Chair of the Urban China Initiative, a thinktank. Whether it is Chinese city officials, multinationals or government officials in Riyadh and Moscow, he is the person everyone calls for this subject.

I interviewed him about the current state of Chinese urbanization – and in particular about what people are getting wrong.

Jeff: Looking at Chinese urbanization today, what are the main trends that you see?

Jon: Generally, the main China trends are going be the same in 10 years as they are today.

You can start by saying that people will continue to move to cities. So the size and the scale of the urban population will grow incrementally for the next 10 years at 1% to 1.5% per annum. After 10 years, I wouldn’t place any more bets on that.

The other thing you could say is rock solid, or relatively rock solid, is the demographics. Every year, the Chinese urban population will get older.

I should also say something about costs inherent to urbanization. But I think probably the only thing we can really say is that the cost of labour will go up every year. It may be there’s a little more volatility around that in the short term. But over the medium term, it’s hard to avoid given the demographics and the productivity growth.

I would also point to a huge amount of volatility in the financial system, somewhat related to urbanization. The move to cities implies a restructuring of the financial system itself. It can’t be funded otherwise.

I also think about the mobility of goods and services. I think along with the move to cities there’s certainly an implication for mobility both of goods and people. There will be a secular trend towards more of that.

In terms of the consumption patterns, there are underlying demand trends such as a move toward an urban diet. Being separated from the food chain introduces a change in the food chain.

I guess the other thing I can say is that I’m a technology optimist. I believe costs will go down for most things. Even as labour costs go up, the cost of most manufactured products will decline each and every year. Capital-intensive logistics costs will decline. Productivity marches on. So we believe that the productivity in China’s economy will continue to grow each year between 3% and 5%. Professional, educational and other services, on the other hand, might not get cheaper as these are basically driven by labour costs.

Jeff: If we assume that the populations of the cities will go up 1% to 1.5% per year, does that necessarily imply increasing congestion? Or does that imply increased expansion? Do you see increasing population outpacing or under-pacing infrastructure? Or do cities just naturally get denser, the bigger they get?

Jon: It’s a technology question. In the absence of technologies or productivity increases, you’ll go with what you’ve got in cities. Historically, that meant a lot of density because we didn’t have cars. So that’s why Chinese cities are relatively dense at their urban cores. Having a 3,000 year-old city without technology meant density.

What’s happened, of course, is that now we have cars and trucks and the ability to sprawl. So that technological revolution has enabled the growth of a city on a much larger spatial scale than historically had ever been possible. This also implies the ability to really screw up a city without having to pay much attention to it. Because you don’t live or work there yourself.

Jeff: How do you mean screw it up? What would be something that could screw up?

Jon: No sewage. Just pure and simple underinvestment in everything – people’s healthcare, sewage, power, roads and so on.

Jeff: You just keep moving outward?

Jon: You just keep moving outward and you kind of ignore the dark spots because they’re not me. I’m somebody else. That is a feature of most emerging markets cities and many US cities. To China’s credit it hasn’t been as much of a feature in the past, partially because, I guess, of the legacy of density. We actually do all live in the same place. It’s pretty homogeneous. It’s also clearly a function of the government’s commitment to provide a one-size-fits-all social infrastructure.

But increasingly, you can argue that there are patches of this in Chinese cities, notably where the countryside and the city come together. The city starts to grow, the countryside decides that it doesn’t want to move and the city kind of builds around it and ignores it. It sticks out as being a relatively substandard set of buildings. Again, the whole infrastructure just doesn’t get connected. That’s the so-called “villages in the cities” phenomenon, which is a very Chinese phenomenon.

So I think it’s possible to mess up cities through underinvestment. Combine that with the fact that we have this automotive technology, this mobility technology, that allows us to under-invest and not have to live with it in daily life, and it actually will take a conscious effort on the part of city governments to say no.

We shouldn’t necessarily use this technology, this automotive technology, to continue to sprawl. Or at least we should recognize the cost of that, especially the infrastructure cost. Historically, infrastructure was subsidized for people who lived in farther away communities, possibly under the misguided notion that they were subsidizing farmers. But in fact they were subsidizing upper middle class villas.

Anytime we price or sell something that scales with distance without recognizing the actual amount of distance involved, we underprice it, whether it’s a road or utility or anything else.

Jeff: What about income levels and spending per capita? There is always this sort of blanket assumption that as people urbanize, incomes go up, or at least the two lines seem to go up in parallel. Is that necessarily true?

Jon: Income growth is a function of productivity and so the question you’re asking is do people become more productive as they urbanize. Most global examples would say yes, that urbanization is necessary for incomes to grow, but it’s not sufficient. There are no rich countries that aren’t urbanized. On the other hand, there are plenty of poor countries that are urbanized.

So I think yes, in general, as people urbanize their incomes go up, at least for a while, because cities are more productive than the countryside. But that’s not true for every category of income. A lot depends on the distribution of income, because in some cases all the consumption might be taking place in a fairly narrow band, particularly at upper middle class incomes. There’s much greater income stratification within a city than there is within the countryside. In the countryside, people tend to be equally poor.

There’s obviously a huge gap between country and city, which is the effect of the city. But then within a city, there is much greater income inequality than there is within the countryside. So we have some people who get to the top of the pile and some people who don’t. And that drives their consumption patterns. In most cases, the luxury market will certainly take off. It’s somewhat of an open question as to how big the next tier, the upper premium, the premium goods market will be. And that is the market that the middle class will buy. And then you’re left with the question of how much disposable income does the lower class actually have?

Jeff: Let’s shift to that second aspect you mentioned, which is, people are getting older. What does that mean in terms of consumption and income? What sort of business trends will develop out of the fact that people are just naturally getting older?

Jon: Well, I think it has an implication for family size and for household size, which translates into dwelling space and real estate.

Historically, Chinese grandparents have lived with the family. Now where they’re moved into cities, that’s not the case. In many cases, the kids have moved into a separate dwelling. Those middle-income people start getting older, they live longer, and there is again a shrinking of household size. I guess that’s one possible implication.

Jeff: Another thing we look at is continental integration. You lay down roads in the US and more goods start moving in more places. You blanket a country with phone lines and people start calling each other. In the US, you would look more at continental integration, because the whole country pretty much interacts with itself. How is that different in China where you have less continental integration? And more of a focus on regions and city clusters?

Jon: I think the clusters are stable trends. I think the intra-region linkages are growing stronger, and that’s most where most migration happens. There’s a tremendous productivity effect from linking up within a cluster. Much more so than linking Shanghai and Beijing, or for that matter Shanghai and Wuhan. Integrating greater Wuhan, there are a lot of productivity effects there. That’s most of infrastructure’s last mile. Whether its warehouses or factories, it’s about the closer you are to your market and the more integrated your market is, the more cost effective you are to serve it.

The big pipes between regions, they just have to be big enough to manage the critical flows of scarce raw materials, the things that can’t be done locally. That would typically be energy and resources and sometimes raw materials. Then you have the high-value added infrastructure for high value flows at the other end of the spectrum, which is mostly about airports. But that’s less important frankly. High-speed rail is an interesting one as it has a huge cultural effect linking up second tier cities to their big city cousins. But as an economic driver I’m not so sure.

At some point we’ll get to the stage where we can think about China as one country. But it’s a long way off, because just looking at the numbers, logistics costs are still 13-14% of GDP, if you add the financial and the carrying cost of inventory and all the rest of it. In the US it’s closer to 3% or 4%. So we would have to have an order of magnitude improvement in productivity, maybe several orders of magnitude improvement in productivity before we can say that in China you can run one national logistics management company.

Jeff: Do you think that’s a function of productivity or infrastructure? Why the disparity?

Jon: Fundamentally, you can’t do it unless you have enough infrastructure. So the system isn’t built yet – the ports, the rail, the warehouses and so on. To the extent it is built, it’s built in a fragmented and uncompetitive way. There isn’t the IT to know where a shipment is. There are bottlenecks. There are physical bottlenecks. There are virtual bottlenecks with electronic information and so forth. Obviously, there are also skills issues.

Jeff: You implied that there’s volatility in China’s resource situation.

Jon: Energy efficiency is something that people generally discount. They don’t think that China will do a lot to shape its demand profile. But my experience has been that they can and probably will do more than people are counting on. That would fundamentally change the load profile of the country and could change the energy mix too towards renewables.

The only thing that I think is relatively certain is the increasing importance of the consumer-driven energy requirement. Whereas the industry was the driver in the past, it’s going be the consumer going forward. So the consumer is going to be much more of a factor.

Jeff: In China today, what’s the one thing we should look at that people aren’t looking at?

Jon: First of all, I think they underplay the role of the service sector and its potential for wealth creation. It’s quite non-transparent. So the idea that the Chinese economy will eventually be driven by service sector entrepreneurs in five or six years, I don’t know if I see as much about that as I might.

I think the service sector is viewed as being chronically underperforming, and I think that’s actually going to change. Even though it’s been growing faster than industry, it still looks small as a share of the economy. I think that we’re actually going to see dramatic growth in service sector productivity. And it’s going to be largely under regulated and unreported.

The other thing that people don’t talk about is the impending restructuring of the financial system. The municipal bond market in China is something I’ve been on for a long time. I think people are missing the single biggest movement of capital in the world ever, the creation of a Chinese municipal bond market.

Jeff: Last question. What is everyone getting wrong about urbanization?

Jon: Urbanization is actually almost over. Another 10 years give or take, which is nothing in the time frame of a 5000 year-old civilization. In the blink of an eye, the country has changed and it can’t go back.

We should start thinking about life in the city as the new normal and figure out what makes it work better. All the new buildings and stuff are impressive but miss the point. Buildings and places are for people to live in. Figure out if people are getting better off and you’ll figure out China. Some places are, some aren’t. It takes local insight to know which is which.

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