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Luxury product companies drool at the blooming Chinese market. Already the third largest luxury goods market in the world behind Japan and the United States, luxury mavens believe China will continue to grow as China’s emerging middle class tops 250 million by 2010. Goldman Sachs estimates that the global luxury goods market is approximately $50 billion USD with Chinese consumers accounting for 12% of worldwide sales, for a total of $6 billion USD.

First tier cities Beijing, Shanghai, and Guangzhou have seen the most investment by the world’s leading luxury good retailers like Giorgio Armani, whose China flagship store is ensconced in the Michael Graves designed Three on the Bund. While 1st tier cities have the most developed retail infrastructures and highest per capita GDPs, it would be a major mistake for the world’s luxury product makers to neglect the rest of China, which is fast becoming a driver in the consumption of luxury products in China.

China has one hundred cities with populations greater than one million, compared to nine in the US. Many of these cities lack the flash of Shanghai, but they are catching up quickly as consumers have the disposable income to express their uniqueness or aspire to certain social strata.

As one senior executive at French cosmetic company L’Oreal told me that after Beijing and Shanghai, L’Oreal’s Guizhou store is growing faster than any of their others. True, the total sales are much lower, but the growth is an indication of pent up demand in even China’s poorest provinces as Chinese women spend more beautifying themselves.

Senior executives of luxury product companies often ask me, what is it that motivates consumers in these areas? Is it different from consumers in Beijing and Shanghai that have been exposed to luxury products for a decade or more? Is the retail infrastructure in place to set up operations or is it better to focus on selling to wealthier regions that have a transparent retail arena?

The 1st Tier Cities

China is still unfortunately an economically stratified society; however, for a lot of people finding the money to spend on luxury goods is not the issue it once was. This bodes well for the stock prices of luxury product companies like BMW, the Swatch Group, or the PPR Group that have been able to seize advantage of the Chinese market. 1st tier cities have seen the bulk of the spending, but it is the 2nd and 3rd tier cities that luxury brands must move into if they want to keep their market share.

Some examples:

• Last year 23,595 BMWs were purchased on the Chinese mainland, up 52% from 2004 – this is compared to a 10% global increase in sales. In the first six months of 2006, BMW has already sold 16,833 vehicles on the mainland, a 78.4% increased from the previous year. China is still the second largest Asian market behind Japan but is closing the gap quickly.

• China imported 20 million bottles of whiskey like Chivas Regal worth 87 million dollars in 2005, an 86% increase over 2004.

• 3 years after its entrance in the Chinese market, Bentley has sold 133 cars (19 of which carried price tags over $1 million USD). In 2004 the total number of Bentleys sold in China was 56, with total revenues of $28 million USD, making China the third biggest Bentley market after America and Japan.

Already there are an estimated 300,000 Chinese with a net worth of $1 million USD or more, but it is not just the millionaires who are spending. In a recent survey by the China Market Research Group -- CMR, 60% of respondents claimed to purchase luxury goods; a large majority, 89%, were between the ages of 20 and 30 with assets less than $25,000 USD.

By 2003 there were already 45 million Chinese with a purchasing power exceeding $30,000 USD. The China Branding Strategy Association claims that some 175 million Chinese can afford to buy luxury products. Most of these people do not live in first tier cities.

Why Companies Should Pay Attention to Second Tier Cities

Of the $6 bil. USD in luxury products that were bought by mainland Chinese last year, only $1-2 billion USD were from purchases made inside China. The rest were purchases by mainland Chinese traveling abroad to hot spots like Hong Kong and Italy as import duties make it cheaper to shop outside of China and there is more cache from shopping at the doorstep of the world’s fashion houses.

Going forward, more citizens in the 1st tier cities will travel abroad to shop, making it difficult for luxury retailers to actually sell to them in China. However, residents of 2nd and 3rd tier cities have more limitations on visas to Hong Kong especially. For a Chongqing resident, there is the same cache shopping in Shanghai as there is for a Shanghai resident shopping in Hong Kong.

Thus, it is imperative that luxury product companies begin to factor in 2nd and 3rd tier residents in their retail expansion as well as in their 1st tier city planning as many of their customers in Shanghai will actually be vacationing folks from the inner cities or businessmen traveling to Shanghai for work.

What Drives the Market in 2nd and 3rd Tier Cities

While 1st tier city consumers are becoming more savvy in what they purchase and want to differentiate themselves from others, luxury consumers in China’s 2nd and 3rd tier cities are generally motivated by a variety of factors besides an increase in disposable income. These factors include prestige, peer pressure, advertising, optimism about the future, and greater reliance on credit. The factors are similar to those that motivated Chinese consumers in Beijing and Shanghai 5 years ago when they first were exposed to and able to afford luxury products.

Prestige

Image is extremely important in the 2nd and 3rd tier cities of China. Luxury goods allow consumers to project an image of success. Young professionals earning $350 USD a month are willing to buy $400 USD mobile phones from Nokia because they can then feel successful. This can be particularly true for second tier cities, where the need to “close the gap” and develop a 1st tier image is strongly felt. One office worker earning $200 USD a month saved for six months to buy a Louis Vuitton bag so that she could "display her success to the world.”

Social Pressure

People do not want to be outdone by their friends. In a society where there are an ever increasing number of wealthy consumers there is a growing drive to keep up. As one Chinese person commented on a BBS forum, “every successful man should own a BMW or Maserati.” A growing number of white collar workers in 2nd and 3rd tier cities are also facing increasing pressure from work and are looking to luxury purchases as a means of escape. Increasingly common on online luxury forums are posts like “I have too much work pressure, so I buy luxury items to forget my daily life.”

Optimism

More and more people are willing to borrow money and are less concerned about saving for the future. The current generation of Chinese spenders in their 20s and 30s did not live through the Cultural Revolution or Chairman Mao’s economic policies so they do not share the previous generation’s uncertainty. The Chinese have a term, ‘yue guang zu,’ for people who spend all of their earnings. In former days people in China would be embarrassed if they paid too much for a product, now people are often willing to overpay and admit to it because it shows their wealth. Optimism about China’s future encourages people to spend a high proportion of their earnings.

According to a recent CMR survey, 15% of luxury goods buyers were willing to borrow money to finance their purchases. A separate survey conducted by Mastercard among 600 college students in Beijing found that 58% of participants were interested in using credit cards. Estimates from Mastercard and Visa are that there will be between 75 and 100 million international credit cards issued in China by 2010. Chinese consumers are increasingly willing to buy big-ticket items like houses or cars on installment. The general sentiment among recent college graduates and young professionals is that they would rather borrow money and buy luxury products now. This marks a huge departure from the traditional Chinese path of saving for the future.

Advertising

Chinese consumers in 2nd and 3rd tier cities are still relatively uneducated when it comes to luxury shopping. They are eager to buy luxury goods, and have the money to do so, but are unfamiliar with many luxury brands. In the West people often purchase lesser-known brands for the exclusivity. Chinese buyers, only familiar with the biggest brands, buy products that visibly display luxury brand heritage.

Another result of China’s comparative lack of knowledge about luxury brands is that foreign brands not considered luxury brands in their home markets may be considered luxury in China. In America Buick is not considered a luxury brand, while in China a Buick is, on par with a low-end Audi.

Chinese consumers can be taught through creative advertising. Companies have the opportunity to educate the Chinese market about their brands, especially in second tier cities where advertising can be more cost effective and where consumers know less about luxury brands.

The cost of advertising is much lower in second tier cities than in Beijing, Shanghai, and Guangzhou. Not only is advertising cheaper in second tier cities but it has a stronger effect; a billboard in Shanghai gets lost in a sea of ads, in Chengdu that same advertisement can stand out and capture more attention at a discount. Television advertising in Chengdu and Chongqing reaches a comparable number of viewers as advertising in Beijing and Shanghai, at a fraction of the cost.

One promising approach for luxury brands wishing to educate consumers is to partner together and conduct brand education seminars. For example, a maker of expensive wines could partner with a cigar company to hold an exclusive event for potential clients to educate them on wine consumption and cigar smoking. These companies could go further and associate with an automaker or a fashion line. Chinese consumers are interested in a wide variety of luxury items but they do not have strong brand allegiance, and they are still uncertain about how to approach certain luxury items. Wine, increasingly popular in China, is a good example. A lot of Chinese put ice cubes in glasses of fine red wine and drink a glass as if it were a shot. They buy wine not to appreciate the taste of a good bottle of merlot but because buying a foreign drink has exotic appeal and makes them look successful and cultured to their peers. By educating consumers about how to use luxury items as part of a lifestyle companies can promote brand allegiance and shape China’s fickle preferences.

Going forward, the luxury brands that can successfully move into the 2nd and 3rd tier cities will become the dominant purveyors of fine good both in China and the rest of the world. Entering these cities is difficult because of poor infrastructure and a lack of understanding, but it is a must for top luxury brands.

Source: Growth in China’s Luxury Goods Market to be Fueled by 2nd Tier Cities