This month we examine an important question in understanding the power of the Chinese consumer.

Is the level of consumption higher than government data suggest, and are China’s rich being captured by official statistics?

A recent China Daily editorial called on the Chinese government to enact measures to ease personal tax burdens, break up monopolies and promote the free flow of economic resources, thereby making the country “more attractive to its talent”. The editorial cites a survey conducted by China Merchants Bank and Bain & Company that found that 27% of entrepreneurs and business owners with more than RMB 100 million of assets had emigrated under investment immigration schemes, while 47% were considering doing so, in order to benefit from better healthcare, education and legal protections. Emigration is an undertaking that requires disposable income well above that of the average Chinese citizen. Similarly, our April 2012 private equity outlook noted the unequivocally robust demand for luxury goods by wealthy Chinese consumers domestically and abroad.

And yet, average annual household income was USD 10,220 in 2010, and the consensus amongst most economists is that China’s household consumption contributes a low percentage of China’s overall GDP.

Given this, are China’s emerging consumers and new rich actually showing up in the official statistics?

A study published in 2010 concludes something is amiss. The study, entitled “The Size and Distribution of Hidden Household Income in China”, updated an earlier survey completed in 2005 and focused on uncovering the hidden income of Chinese urban households, particularly in the high income segments. The authors, Xiaolu Wang of the National Economic Research Institute and Wing Thye Woo of the University of California Davis, hypothesized that official statistics are likely to be flawed because the National Bureau of Statistics (NBS) collects its data through voluntary participation, which may encourage wealthy individuals to opt-out or downplay their income due to the potentially “grey” nature of their hidden income or tax liabilities.

Wang and Woo approached this problem by employing professional survey firms to approach a broadly distributed group of families in China and apply the established relationship between Engel’s coefficient and income levels. Engel’s coefficient is a well-developed economic theory that measures the food expenses of a household as a proportion of total household consumption expenditure — once the basic needs of a family have been met, they tend to spend an increasing amount of their disposable income towards other items such as transportation, luxury goods, education and entertainment etc.

Covering 64 cities in 19 provinces, across all age groups and educational backgrounds, their results are split into 7 income groups as per NBS guidelines: lowest income, low income, lower middle income, middle income, upper middle income, high income and highest income.

Their results, when compared to the official NBS statistics, showed the following:

1) Lowest income groups are more accurately represented by official statistics. Engel estimated data showed marginally higher household incomes versus official data for low income (12.5%) and lowest income (0.9%) households.

2) Highest income group is dramatically understated. Engel estimated income for highest income households was RMB 139,000 — 319% greater than official statistics.

3) Overall household disposable income rose faster than reported. Engel estimated figures showed average household disposable income growth of 69.3% between 2005 and 2008, versus official data of 57.4%.

4) Urban per Capital Disposable income growth is also understated. Engel estimated figures showed 63% urban per-capital disposable income growth, versus 52.1% officially reported.

5) Engel data may be conservative. The authors noted that 76 statistical outliers were excluded from their survey data, which would have skewed the estimated results even higher (annual per capita disposable income of more than RMB 400,000 to RMB 1.76 million).

6) Excepting outliers, groupings show strong statistical match. Engel coefficients of the official data and the estimated data are statistically almost perfectly matched, excepting the aforementioned samples.

The survey overall came to the conclusion that official NBS data sample does not contain the highest income households in China, and that what official data classifies as “highest income” is likely to more accurately belong to “upper middle class” bucket. Though the study does not investigate in detail the sources of this hidden or “grey income”, we estimate that likely it comes from the murky areas of the Chinese social structure, such as tax avoidance, corruption and shadow banking.

We draw three conclusions from this data in relation to China’s recent growth story:

First, while we have often expressed concern regarding Chinese real estate prices, the data in Table 1 suggests why there has been such strong demand for real estate that officially no one should have been able to afford. Based on official statistics, housing prices have been running at 10 times the average urban income, versus the three to five times that would normally be expected, or which may be implied by the Engel estimated data.

Second, the report offers an explanation for the statistically abnormal level of luxury good consumption, and corresponding storefronts, in major Chinese urban centers, as well as Chinese tourist destinations.

Lastly, it gives us hope that the rate of domestic consumption, and growth of the consumer market as a whole, is more robust than official statistics imply, and hopefully forecast.