CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

June 26th 2014

Dublin

Where is China’s Economy Headed?

McKinsey & Company | 1

Overview

Next Wave of China Opportunities

Evolution of China’s Economy

McKinsey & Company | 2

China economic trends: Summary

▪ Government promotes shift to domestic consumption and services

▪ Middle class becoming the new mainstream – far beyond tier 1 cities

▪ Cost increase and margin pressure across industries

▪ Urban markets continue to evolve in city clusters

▪ Digital unfolding disruptive momentum

▪ Local innovation at scale – by MNCs and local companies alike

▪ Some broader concerns & risks to watch out for

McKinsey & Company | 3

Among the reforms in the 3rd Plenum , market mechanism and sustainable development are important guiding principles

ENABLE AN EFFICIENT MARKET MECHANISM

▪ Allow the market to play a “decisive” role in resources allocation; apply market-based pricing except for important public services and industries with natural monopoly

▪ Reduce entry barriers to introduce competition from private sector

▪ Enhance the governance and management SOEs

STREAMLINE RELATIONSHIPS BETWEEN GOVERNMENTS AND MARKET

▪ Streamline the responsibilities of central vs. local governments, including the local tax breaks

▪ Increase fiscal transparency, especially for local governments

▪ Reduce government intervention and SOE advantages

▪ Separate jurisdiction system from administrative branch

IMPROVE SUSTAINABILITY OF ECONOMIC DEVELOPMENT

▪ Incorporate environmental protection into government officials' performance review

▪ Enhance balanced growth in population in the long term

IMPROVE SOCIAL FAIRNESS

▪ Enhance farmers’ property/land rights

▪ Grant rural and urban residents fair access to public services

Ensure top-level design with the Leading Group for the Comprehen-sive Deepening of Reform

Enhance cross-department coordination with State Security Committee

SOURCE: Literature search; McKinsey analysis

McKinsey & Company | 4

Upper middle class becomes the new mainstream

SOURCE: McKinsey Insights China – Macroeconomic model update, April 2012

Average annual household income (class)USD

Urban householdsMillions

100% = 2562012, %

100% = 1652002, %

Change in number of households2002-22, millions

100% = 3572022E, %

Poor<9,000

Upper middle class16,000-34,000

Affluent>34,000

Mass middle class9,000-16,000

2

1

90

7 54

14

3

29

22

54

9

16

66

-92

188

29

McKinsey & Company | 5

Geographic epicenter of the middle class shifts

SOURCE: McKinsey Insights China – Macroeconomic model update, April 2012

1 Based on the information for 266 cities

URBAN CHINA

Share of middle class by city tier1

Share of middle class by inland and coastal China1

31

43

45

40

16

815

3

2002

Tier 4

Tier 3

2022E

Tier 1

Tier 2

Inland China

Coastal China

Tier 1 cities

87

61

13

39

Coastal

2002 2022E

Inland

McKinsey & Company | 6

Manufacturing shift from growth to productivity

Revenue CAGR, percent

13

14

15

20

23

Specialtychemicals

Communicationsequipment

Automotive

General & specialpurpose machinery

Iron & steel

9

10

6

11

7 -16

-9

-9

-5

-4

1990-2010 2010-2020

Manufacturing sectors in China

Change

McKinsey & Company | 7

WagesOffice space

Water

7.8%

11.4%

4.6%

Business input costs continue to rise

Consumer price index

2.1%

3.5%

Interest rates

Producer price index

1.1%

China Shanghai

Annualized cost increases

2010-2013, CAGR

McKinsey & Company | 8

2012

6.2%

2011

7.1%

2010

7.7%

4.8%

2013 20132012

4.6%4.5%

2011

5.7%

2010

6.7%

Margins falling

Operating margins of Chinese industrial companies

1 WIND Industrial sector

State-OwnedEnterprises Listed companies1

McKinsey & Company | 9

Estimated penetration, 2013 end:

▪ Broadband: 40%

▪ Smartphone: 30%

Forcing new business models on:– Developers– Consumer service

providers– Financial services– Logistics

China’s e-tailing market size, 2003-20 in 2011 USDUSD billions

10

8

10

35

32

21

Low case

Base case

High case

CAGRPercent

World’s largest e-tailing market

2011-15 2015-20

183

120

7444

22

420

259

100

99

2020

648

128

15

395

37

121110092008

Reached US 2008 size

Reached US 2011 size

McKinsey & Company | 10

E-tailing hotspots

Mobile Luxury

B2C apparel Cross-border

McKinsey & Company | 11

Innovating sectors deepening

BiotechInternet Mobility Medical products

+18%+52% +62% +20%

YoY growth of internet economy

in 2008-12

YoY growth of biopharma in 2010-12

YoY growth of smartphone installed

base in 2008-12

YoY growth of medical products in 2010-12

McKinsey & Company | 12SOURCE: McKinsey database; industry reports; McKinsey analysis

65

Implantables

35

6560

60

40

Capital equipments

40

Lo

cal

MN

C

25

Other high-value medicaldevice

75

In-vitroDiag-nostics

35

Personal medical equipments

Locals are competing with MNCs across many segments – medical example

Product category

Mark

et

seg

men

t

1 Not including low-value medical products which accounting for ~USD 11 bn

Overall local share is ~40%

Estimated market size by product category and by customer segment, Bn USD, %, 20131

McKinsey & Company | 13

Key business issuesPercent of respondents

Worries about doing business in China?

18

19

32

35

37

47

50

61

MNCs Chinese companies

0

31

69

62

38

23

23

54

▪ Growing sophistication / shifting needs of consumers

▪ Intensifying competition

▪ Increased pressure from retailers

▪ Expanding influence of internet

▪ Changing channel dynamics

▪ Others (e.g., Government policy)

▪ Slow-down of Chinese economy

▪ Inflation and rising cost of doing business

McKinsey & Company | 14

McKinsey & Company | 15

Real Estate & Banking Concerns

SOURCE: McKinsey Global Institute, UBS

Real Estate

▪ Property starts likely down 10-15% this year

▪ Prices falling in 3rd and 4th tier cities

▪ Property developers investing outside China and talking down the market

▪ Supply exceeding demand as investor demand falls, taxes rise

Banking

▪ Wealth management products reaching US$2trn – raising cost of funding for banks

▪ New internet banks accelerating the trend

▪ US$350bn of wealth management products to be rolled over this year

▪ Government carefully managed any defaults to date

Common issue: Middle class confidence and willingness to

spend

McKinsey & Company | 16

Mall developers go bankrupt—especially state-owned ones

New South China Mall, Dongguan – Largest shopping center in the world when opened in 2005, now 99% empty

Vacancy rates, 2013Percent

10Guangzhou

Shenyang 17

Chengdu 16

+38%

Planned increase in mall capacity, 2013-2015

McKinsey & Company | 17

Overview

Evolution of China’s Economy

Next Wave of China Opportunities

McKinsey & Company | 18

▪ Urbanization: 15-20 million p.a.▪ Urban incomes rising 10-15% p.a▪ Urban expenditures rising 12-15% p.a.

▪ 51% households will be “New mainstream” by 2020: trade up, spending shifts to services

Drivers of Domestic Growth

Agricultural modernizationCompletion of energy and social infrastructure– modern and green

McKinsey & Company | 19

Economy moving to private consumption and services

Real GDP growth decompositionPercent, percentage points

Others

Net trade

2020E

27%

15%

40%

2005

11.3

Privateconsumption

Investment

6.6

1%

42%

20%

46%

18%

36%

2015E

7.5

2%

18%

13%

39%

2010

10.4

-1%

28%

59%

Examples of high-growth industries:

E-tailing

Protein

Tourism

Entertainment

Private education

Private healthcare

Logistics

IT services

A

B

F

G

D

E

C

H

9%7%

46%

10.4

47%

2005

11.3

48%

2015E

7.5

44% Industry

2020E

Agriculture3%3%

55%52%

42%

43%

6.6

Services

2010E

McKinsey & Company | 20

Implications for Industrial Sectors

1. Smart cities with cleaner energy, better resource utilization

3. Privatization and productivity

2. China Incgoing global

McKinsey & Company | 21

By end of 2013, 193 cities in China have rolled out ‘smart city’ projects

Chengdu

Daqing

Shenyang

Jining

Fujian

Hefei Wuhan

Nanchang

Guangzhou Guangxi

Shanghai

Shijiazhuang

Xi’an

Guiyang

Xiamen

Shenzhen

Chongqing

Mudanjiang

DalianBeijing

Tianjin

Tangshan

Langfang

Kunming

FoshanJiangmenDongguanZhongshan

Quanzhou

Fuzhou

Wuxi Suzhou

Ningbo Hangzhou

Wenzhou

TaizhouShaoxing

Wuhu

Nanjing

YanchengZhengzhou Kaifeng

Xuzhou

Jinan Zibo Qingdao

Yantai

Jiaxing

Yangzhou Zhenjiang Changzhou

SOURCE: press search

Majors cities having ‘smart city’ projects

Tier 1 city

Tier 2 city

Tier 3 city

McKinsey & Company | 22

2. China Inc Going Global: Outbound M&A

IndustryGeography

3

7

4

3

2

19

47

1

4

Food/agriculture

Infastructure/RE

Finance

Metals

Chemicals

Mining

Energy

2

Consumer excl. food

Auto/aeronautics

Tech

Travel/logistics

Other

Healthcare

6

11

5

4

5

North America

Western Europe

Hong Kong/Macau

Latam

Australia/NZ

Africa

Southeast Asia

Other

27

24

12

12

11

Percent of 2008-2013 (Oct.) outbound M&A100% = $267 billion

+

+

++

+

+

++

McKinsey & Company | 23

3. Privatization and productivity

SOURCE: McKinsey

Since 3rd Plenum, local and central governments preparing to bring more private capital in. Preparations nearing completion. Examples include:

▪ Sinochem proposing to sell downstream retail assets

▪ Chongqing has 100 local business from food processing to steel preparing to bring in private capital

▪ Guangdong looking to reduce holdings in water, logistics, travel companies

▪ Shanghai selling local SOE shares to PE firms such as Hony

▪ No barriers to non Chinese capital

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

June 26th 2014

Dublin

Where is China’s Economy Headed?