Big challenges, big rewards for luxury drinks companies in Asia

The consensus is that the world’s centre of financial gravity is moving to the East. China and India individually have the two largest populations and two of the fastest growing economies.

Even after allowing for the upheaval caused by Russia’s invasion of Ukraine and the global recession, India’s economy is predicted to grow by 8.8% this year but China’s will slow to 5.5%.

And that might be a cause for concern.

While the Shanghai region is starting to reopen after almost two months of covid clampdowns, potentially volatile market conditions are prompting leading some analysts to pose again the question of whether luxury goods producers – including the global drinks giants – are hoping too much from China, in the short-term at least.

The idea that the Covid-19 outbreaks around key Chinese cities are receding is wide of the mark. Even as activity slowly re-emerges in Shanghai, Beijing and numerous provincial cities are subject to ever more strict restrictions as the government targets zero covid.

The outbreaks highlight the challenges China faces in pursing that policy as well as the ever-present risk of disruptions that have already taken an enormous economic and social toll.

Some economists predict that the current lockdowns in some 43 cities – where the wealthy live – could cost ten times as much as the initial coronavirus outbreak two years ago.

According to one LVMH board member, Hubert Védrine, some luxury goods groups are trying to develop demand in China much too quickly. In a recent interview with the blog Miss Tweed, Védrine said: “For those luxury brands who can, it would be prudent, even if it is difficult, to avoid increasing their exposure to China and even reduce it.”

As luxury brands struggled with extended lockdowns and coronavirus restrictions in Europe, North America, and Japan, China reopened in spring 2020, with the inevitable “revenge spending” boom encouraging many brands to open new stores and vastly extend their online and e-commerce presence.

As a result global consultants Bain & Company calculate that domestic sales of personal luxury goods in China rose by 48% in 2020 and by a further 36% last year to total more than $70.7 billion a year. That’s a near doubling of sales in just two years.  Is that sustainable?

All the big drinks companies see large opportunities in China where imported spirits account for less than 5% of the alcohol market. It is Pernod Ricard’s second largest market (after the US) and is crucial to Remy Cointreau’s fortunes because Remy Martin is by far the leading cognac brand.

Diageo is building its own distillery in China and has a research facility in Shanghai to develop products tailored explicitly to Chinese tastes. Pernod Ricard has gone one better by bringing its own distillery on stream already. Treasury Wine Estates chief executive Tim Ford announced earlier this month that the first “made in China” Penfolds would hit the Chinese domestic market later this year and that he is stepping up output of the flagship range in the US and France to circumvent Beijing’s punitive tariffs on Australian-produced wines.

But while that is a rapid strategy response, Treasury is not ahead of the game. Moet Hennessy, the drinks arm of LVMH, introduced Ao Yun, a locally-produced luxury red wine brand in China in 2016 after planting several varieties in 2013 in Yunnan province.

Chateau Lafite Rothschild launched its first Chinese-made prestige wine, Long Dai, in 2019 but the venture has proved problematic because of the difficult climate, notably the monsoon rains. Everyone is targeting China’s middle class, the grouping producers believe will generate the payback for their extensive investments. For instance Treasury’s Tim Ford said that his first China-made wines would be aimed at middle income groups, retailing at between $30 and $50, not the $950 per bottle which the much-faked Penfolds Grange commanded.

By 2018, more than half of China’s population – 707 million people – had entered the middle- income bracket, according to the Centre for Strategic and International Studies which defined the middle class as those spending between $10 and $50 a day.

According to Hurun Research Institute China has some 4.7 million high net worth consumers. So 0.3% of the population account for some 80% of its spending on luxury goods, including top end wines and spirits. The hope is that a rising young middle class will swell that demand, but the picture would look very different if that segment of the population finds its spending power curtailed, as some economists fear.

House prices are soaring and domestic inflation is set to hit almost 6% this year, which has prompted Max Zenglein, chief economist at the Berlin-based Mercator Institute for China Studies, to suggest that China’s middle class will soon face very similar challenges to their American and European counterparts.

“Wage growth is not strong enough to make it easy for them to afford their dreams,” he says. “It’s very difficult to move upward, but there is a risk for them to move down, and that’s something new. They might be hitting a ceiling.”

If true, that would put discretionary spending on luxury items under pressure. Meanwhile, pre-Covid Chinese tourists comprised an ever-growing segment of the travel retail market but since then they have been unable to make their annual sorties to Hong Kong or South Korea.

After reaching a peak of 170 million border crossings in 2019, Chinese outbound tourism crashed to just 18 million crossings in 2020 and a paltry 8.5 million in 2021. Many have shifted their shopping to Hainan, the vast southern free trade area, which recorded a more than 120% increase in duty-free sales in 2020 and an 83% rise last year. The domestic lockdowns may curb that business this year, but that is likely to be a slowdown, not a reversal. For instance, LVMH’s Bernard Arnault recently described his first-quarter business in China as “so far, so good”. While outbound Chinese tourism is still a long way from returning to pre-coronavirus levels, new projections by the China Outbound Tourism Research Institute predict “a strong wave” of Chinese international travel to kick off next year and to return to 2019’s level in two years’ time.

So Chinese travel demand will soon be on an upward curve again and brands that invested in improving customer experience and the convenience of online sales over the past few years will benefit the most.

As the economic centre of gravity shifts eastwards, those long-term investments will bear fruit unless, of course, politics intervene. Just ask Treasury’s Tim Ford. Two years ago 30% of his revenues came from China but then Beijing took umbrage at Australia’s criticism of its human rights record and the possibility that it covered up the origins of the Covid 19 pandemic.

Its punitive tariffs on Australian wine destroyed Ford’s biggest export market.

Given that imported spirits hold only a minuscule percentage of the alcohol market, they are vulnerable to political whim in Beijing. China has cracked down on extravagance and gifting in the recent past and could do so again.

The prizes are big but the road could remain bumpy for some while yet.