Financing the New Middle Class

Shanghai’s skyline, February 19, 2012. Joan Campderros-i-Canas/Flickr CC BY 2.0

The new middle class in developing countries has grown tremendously in the past decade and its impact is expected to reverberate into the next decade. Two middle-class dreams – good housing and a solid education – will exert demands on long-term financing that will not be met by existing financial institutions or government programmes. Instead, this market aspiration will be met by the horde of fintech entrants (technology startups and companies that target the financial sector) and their innovations.

Who is the new middle class?

Those who make up the new middle class expect their quality of life to improve significantly during their working lives, and that this will hold true, perhaps even more so, for their children. They expect to enjoy what economists call ‘intra-generational’ and ‘inter-generational’ mobility.

Since the African Development Bank’s 2011 report titled ‘The Middle of the Pyramid: Dynamics of the Middle Class in Africa’, the new economic middle class has been widely documented, disputed, and analysed by think tanks and multilateral agencies for developing countries across Asia, America, and Africa. The financial press and experts have redefined, repackaged, and breathlessly pitched the new middle class as the next great market opportunity.

This economic middle class is defined by current income rather than expectations about the future. Estimates of its size vary. Size matters, and there are legitimate questions about measurement, such as whether someone living in a household in which the income is $5 per day should be defined as middle class, or whether dramatic changes in household size should also be taken into account.

What Characterises the New Middle Class?

What Characterises the New Middle Class?

The Delma Institute, 2016

Given these questions, the new middle class is as much about identity as it is about economics. It is not who is in the middle class today but who expects to be in the middle class in the coming five, 10, or 15 years. This expectation will determine how they consume, invest, and make decisions about family, education, and housing.

Identity over economics

Those who make up the new middle class are defined more by their aspirations than by how much they presently earn. 7 The new middle-class household is forward looking, and many see themselves among the 3bn people who are predicted to enter the economic middle class in the next 20 years.

Their aspirations revolve not only around freedom from hunger and having basic material security but also on the trajectory of improving their lives and those of their children. How much a person earns at the moment is less important than their life trajectory.

Alternative finance and fintech firms – the startups specialising in disrupting the large financial intermediaries – have discovered the ‘truth’ in providing finance to the under-banked in both developed and developing countries. For instance, college students appear ‘poor’ and uncreditworthy to the banks and, historically, have had limited access to finance.

Founded in 2011, SoFi is a US-based marketplace lender that provides student loan refinancing, mortgages, and other services, such as parent and personal loans. From the 100-loan experiment piloted by its founders in 2011, it has gone on to become one of the biggest lenders to this market segment, providing $6bn in student financing by December 2015. SoFi’s story is one that is likely to be replicated in countless variations, large and small, for the new middle class.

Key expenditures

Housing and education are two of the fastest-growing items of expenditures. They constitute the foundations on which the growing middle class is building its future. This was true for the middle class in the rich countries of the Organisation for Economic Co-operation and Development (OECD), and also holds true for the new middle class. McKinsey estimates that the increase in private spending on education in China will account for 12.5% of the country’s overall growth in consumption until 2030, and annual Chinese education expenditures will grow by $525bn between 2015 and 2030.

Similarly, according to research based on data from the World Bank and the IMF, the growth in Chinese spending on housing has eclipsed the country’s phenomenal overall economic growth. While China’s real GDP quadrupled between 2000 and 2015, its spending on new residential construction increased by a factor of 10 (see Figure 1).

Figure 1: Chinese Growth in GDP vs Residential Housing Investment, 2000-15

Figure 1: Chinese Growth in GDP vs Residential Housing Investment, 2000-15

Sources: The World Bank and IMF, 2016

Big and growing

The growth in education and housing expenditures is driven by two exogenous shifts in the economy. First, the largest rural-urban demographic transition is taking place, and this phenomenon is accelerating. In India, the urban population grew from 288m in 2000 to 373m in 2010 and was estimated to be 420m in 2015. Figure 2 reflects similar trends. Housing for 230m more people will have to be found in the next four years in Asian cities – an incredible challenge and market opportunity that dwarfs any housing boom in OECD economies.

Figure 2: Urban Population of Select Countries and Regions, 2000-20 (billions)

Figure 2: Urban Population of Select Countries and Regions, 2000-20 (billions)

Source: UN World Urbanisation Prospects, 2014

Second, the new middle class households are in the thick of the demographic transition to smaller families that invest more in their children, both financially and in terms of parental time. Education spending will rise as the new middle class continue to upskill, and as their economies increase value addition domestically. Facing weak public institutions and a shortage of quality public schools, “aspirational parents are increasingly seeking alternatives to dismal state schools”. In Africa, one-third of children who have finished four years of school cannot read at the minimum expected standard. Private schooling across the developing world will reflect the Chinese experience.

Financing the new middle class

Housing and education are long-term investments in which banks and governments have been the traditional financiers and service providers. Unfortunately, they are unlikely to play an equally major role for the new middle class. The financial system, especially long-term finance, is not up to the mark in many developing countries. The problem is most acute in underdeveloped countries. In sub-Saharan Africa, less than 10% of banks offer credit with maturities of five years or more, and about 40% only offer credit of 12 months or less. The underlying causes limiting the role of banks as mortgage lenders and providers of long-term credit will persist for the foreseeable future.

Fundamental weaknesses, such as the scarcity of credit bureaus and information, reflect the dominance of the informal economy in developing countries. Basel 3.5 and 4 will further increase risk aversion for the major international banks and their counterparts in developing countries. These regulations will place greater capital costs on the international banks when lending to institutions that on-lend to households in developing countries. As such, much of the new middle class will continue to be excluded from the formal financial system.

Filling the gap: Fintech and new finance

The information technology revolution is marching into this market gap. Non-traditional lenders have entered the financial sector and are expanding access to millions of unbanked and underbanked people in the developing world. They deploy new technology, social graphs, and data science to create new credit profiles. They will build new distribution channels and establish low-cost marketplaces and financial platforms.

International remittances have long been a source of investment finance for families in developing countries, and government capital controls and high remittance fees have always been obstacles. For instance, the cost of sending $200 in remittance averaged $18 (about 8.9%) in 2014. Fintech startups targeting international money transfers raised more than $200m in 2015, and are planning to reduce these costs by 50% and save households in developing countries about $16bn annually.

Peer-to-peer (P2P) lenders have popped up all over the world, displacing banks as financial intermediaries. For instance, China’s Paipaidai started offering unsecured online P2P micro-loans in 2007. By 2015, the leading P2P lender had reported more than 1.2m active borrowers and lenders.

While fintech and P2P financing for housing and education are still in the early stages, there are a host of startups entering this space. These are better positioned to design services and scale for the new middle class than the traditional banks. The challenge of financing the dreams of the new middle class will likely be met by new companies and innovative products.