In the last two decades, the world witnessed the miracle of China's social and economic development. One major driving force was urbanization. Urbanization plays a prominent role in lifting economic development. On the one hand, it pushes up demand for infrastructure and investment. On the other hand, it raises demand for services as a result of the concentration of population, while the aggregation of businesses reduces costs in areas like communication as well as enhances the overall efficiency of supply chains. As a late bloomer in the financial services industry, the credit card market is closely tied to urbanization. Firstly, urbanization engenders a large number of workers with a stable income, who are potential cardholders. Secondly, urban centers bring together a great deal of consumer demand, serviced by many large-scale malls, which offer significant potential for POS machines and credit card acceptance. Moreover, as average personal income and the requirements of consumers rise, cardholders will be more disposed to spend or obtain small loans through credit cards. These are all factors that spur the demand for credit cards.

　　Under these conditions, China's credit card market recorded spectacular growth in recent years. Yet, few card-issuing institutions are making huge profits. With urbanization progressing apace, how will the Chinese credit card market evolve? Will profits from card issuance dramatically improve? These are concerns that have captured the attention of many bankers. As a member of the industry, MasterCard Advisors studied these questions by correlating the development of the credit card market in different countries with the expected progress of China's urbanization and economic development. This article aims to summarize recent developments in the Chinese credit card market and elaborate on forecasts for the mid- and long-term trends in market demand. It will also offer card-issuing institutions insights on how to achieve stable growth in profits.

　　Equally shocking is the rise in per capita GDP in China. After 30 years of reform and opening up, the per capita nominal GDP soared 60 times from RMB381 in 1978 to almost RMB23,0002 in 2008. Such social and economic developments have also furnished favorable conditions for the credit card market to achieve significant growth (See Figure 1). The number of cards issued increased by more than 100% over the past three years, totaling 164 million in 2009 (the figure has already hit 207 million in the second quarter of 2010). The amount of card spending doubled compared to the same period last year, reaching RMB2.24 trillion in 2009. The amount of receivables also rose by over 100%, reaching RMB267 billion3 in the same year.

Looking Ahead – China Has Potential to Become the Largest Credit Market in 15 Years

　　 Of the many research organizations that have conducted in-depth studies on urbanization and economic development in China, the majority have arrived at an optimistic outlook. The present discussion starts with McKinsey's forecast for urbanization in China and Goldman Sachs' forecast for China's GDP growth, and then refers to patterns of credit card market development in various countries to build a quantitative model to predict the long-term trend of credit card demand in the next 15 years. According to McKinsey's projection, China's urban population will approach the 1 billion level (about 926 million) in 2025, a significant increase of 75% from the 2005 total. Goldman Sachs, on the other hand, estimated that in 2025, the per capita GDP in Chinese urban areas will reach US$19,000, equaling the 2008 amount for South Korea in absolute terms and higher than the US$16,000 per capita4 figure for Taiwan.

　　 If these estimates are correct, the near billion strong Chinese consumer base will make China one of the largest credit card markets (See Figure 2). In terms of demand, we expect that the total number of credit cards in circulation in China in the next 15 years would increase at an average annual rate of 11%, with the total number of cards reaching 1.1 billion in 2025 (i.e. 0.75 cards a person). Naturally, the growth rate during the first few years will be higher, following by a period of comparatively slower growth. According to this growth trajectory, the number of credit cards in China will exceed that of the US by 2020—there are about 700 million credit cards in the US in 2008, with limited growth potential. Our projection is based on two key factors: first, eligible applicants for credit cards will grow from 100 million today to around 370 million; second, the number of cards held by cardholders will rise from the current average of about 2 cards to about 3 cards. In comparison, the average cardholder in Taiwan holds around 4 cards while Americans hold even more cards on average.

　　 While the number of cards grows, the amount of spending per card will also go up along with rising income levels. We thus expect the total amount of credit card spending to increase at an average annual rate of 14%—even faster than the growth rate for the number of cards issued—reaching US$2.5 trillion by 2025. This amount is 20%5 higher than the 2008 figure for the US, taking the overall scale of China's credit card spending to a world-leading level.

　　 As consumers increasingly embrace credit financing, the percentage that use credit cards as a form of revolving credit will rise. Our projection is that the revolving credit balance of credit cards will go up at an annual rate of around 25%, surpassing US$500 billion by 2025. Even at this level, the amount is only two-thirds of the 2008 figure for the US. At this point of the analysis, a partial answer to our questions about how China's credit market will evolve can already be gleaned. In short, the scale of China's credit card market will reach a world-leading level in 10 years' time. Yet, will profits of card-issuing institutions improve dramatically from today's level? A number of important market factors have to be analyzed before we can answer this question.

　　 First of all, how will regulation and competition change? As the market gradually matures and the business capacity of card-issuing institutions improves, the regulatory authority could give card-issuing institutions greater freedom in their operations as long as risk exposure remains under control. For instance, card-issuing institutions might be allowed to charge different interest rates depending on the credit risk of cardholders. As well, banks and cardholders will gradually expect more from bankcard networks in their role as industry architects and facilitators. These expectations on card-issuing institutions include: support of capability development (e.g., capability for risk management and product innovation); security, stability, speed and bandwidth of the payment processing network; and co-ordination and management of card acceptance (e.g., keeping interchange fees to standardized and appropriate levels). These requirements will support the introduction of one to two additional bankcard networks on top of the current infrastructure to satisfy the needs of industry development. The aforementioned opportunities for industry development will enable more innovations in terms of product design, marketing and services as well as help raise profit levels, thus laying a good foundation for the growth of the whole industry. Next, leading card-issuing institutions can reduce costs through scale of economy (such as using computer scanners instead of manual input when processing card applications), as well as improve risk and portfolio management capability by investing in information systems and a team of analysts. As the competitive advantage of leading card-issuing institutions strengthens, market consolidation will also deepen. In this environment, small-and medium-sized card-issuing institutions must develop unique business models to come out ahead in the competition. In addition, as the card acceptance environment improves, low- or zero-interchange fee situations will become rarer. And as consumers travel overseas more frequently, the ratio of overseas transaction, with higher interchange fees, will in turn increase. Taking both trends into account, there is definite room for increase in income from interchange fees. Lastly, if the regulatory authority introduces advanced application and usage of credit databases into China and works with card-issuing institutions closely to manage risk exposure, bad debt could be kept under control most of the time. However, it is inevitable that credit card markets encounter difficulties from time to time, e.g., when the economy experiences a significant slowdown immediately after substantial growth in credit card debts.

　　 Having completed the above analysis, we can make further projections about industry's profitability potential. Given the growth in number of cards, card spending, and revolving credit balance, we believe that operating income and net profit of card-issuing institutions will rise accordingly (aside from the occasional challenging year). The gross revenue of the whole industry is expected to reach US$105 billion in 2025, a 20-fold increase from today's level. By then, the average annual revenue generated per credit card will reach US$95. The majority of the revenue is expected to come from net interest income as consumers habituate to credit financing, pushing the revolving ratio to the 60-70% level. We believe this is a relatively reasonable assumption since the revolving ratio in mature markets like the US and Taiwan is as high as 80- 90% and 70-80% respectively.

　　 What about the level of pre-tax profit of the industry? How will that change? Our research suggests that pre-tax profit could potentially reach about US$34 billion in 2025, which would be 30 times higher than the current level, with each credit card generating an average annual pre-tax profit of US$30 for card-issuing institutions. Two key assumptions are involved. One: We believe bad debt ratios could be kept to about 4% if the regulatory authorities and card-issuing institutions continue to handle personal credit with prudence and vastly improve the ability to obtain credit information.  This level is higher than the current 2-3% range, but lower than the annual average of 5-6% in the US. Two: we believe factors like scale of economy and automation will moderately lower operating costs as a percentage of gross income, thus improving profit margins.

　　 While China's credit card market no doubt offers vast opportunities in terms of market scale and profitability, it must also be emphasized that this does not imply the development process will be all smoothly sailing. All markets, whether it be the US, Europe or Asia, go through credit cycles, where periods of rapid growth are often followed by significant corrections. When the economy is strong, there are fewer bad debts and higher profits; when the economy weakens, high bad debt ratios lead to diminishing profits, if not outright losses. For instance, during the recent credit cycle in the US, credit card profits peaked in 2006-2007, only to see bad debt ratios double within a few quarters, leading to huge losses in 2009 for many card-issuing institutions.

　　 In emerging markets, including Asia, the bursting of credit card bubbles is all too common. As emerging markets experience rapid economic growth, the true risk level is often underestimated as the income of cardholders is more stable, resulting in lower default risks while the economy is going strong. Also, in times of rapid economic expansion, new cards make up a larger proportion of total cards issued. Since new cards tend to have lower default rates during the initial period of issuance, they help push down the overall bad debt ratio. Nevertheless, when the market is hit by negative factors, such as a sudden economic slowdown, the true risk level is immediately revealed. At that point, not only does the average rate of default by cardholders go up, the bad debt ratio also rises as fewer new cards are being issued. Emerging markets in Asia have had its share of credit crises: Hong Kong in 2002, Korea in 2003, Taiwan in 2006 and India in 2008. In the event that the Chinese credit card market is hit by a large-scale crisis, the industry could incur huge losses as well. This is why the potential profitability of China's credit card market greatly depends on the industry's ability to manage risks—a responsibility that falls on the collective shoulders of the regulatory authorities, card-issuing institutions and other market participants.   

　　 Even if the industry is developing in a healthy manner, excessive credit expansion will leave some banks in trouble. For example, several leading card-issuing institutions in the US, including Providian and Metris, could not escape the fate of bankruptcy or being acquired at a low price because of risk mismanagement at the beginning of the 21st century. How then can we achieve sustained profit growth in the credit card market? Having conducted case studies of successful card-issuing institutions in various countries, MasterCard Advisors concluded that a business model that is strategically prudent and tactically innovative is critical to long-term profit growth. Capital One, a US-based bank, offers an excellent example of a company that has a keen grasp of this principle. The bank came to recognize the potential of subprime customers by analyzing information in the market and its own data. This group of customers had a high revolving rate and relatively few banks were willing to compete for their business. However, the accompanying risks for these customers were also very high, which makes it necessary to hedge the risks with superprime customers as part of the asset mix—this is being strategically prudent. A prudent strategy is like a solid foundation that enables an architect to exercise his or her creative freedom to construct a great building. In the case of Capital One, the "building" is the huge investment in innovative products and pricing as well as marketing—this is what we mean by "tactically innovative". Although Capital One endured branding and financing disadvantages in its early days, their "strategically prudent" and "tactically innovative" business model assured the bank's sustained growth from 1995 to 2007, during which period pre-tax profits rose by 25% every year, reaching nearly US$2.6 billion6 in 2007. In 2009, the bank was the only card-issuing institution in the US credit card industry that recorded significant profits. Capital One's reputation as a perennial winner in the US credit card market over the past 20 years is well earned indeed.

　　 The realization of a "strategically prudent" and "tactically innovative" business model by no means takes only one particular form. Korea's HyundaiCard, for instance, adopted a different approach. The company selects its partners deftly to achieve specific marketing goals. After the credit card crisis in Korea in 2003, the HyundaiCard targeted high-spending affluent cardholders by forming an alliance with a leading Korean automobile company, whose sales representatives helped to promote credit cards tailor-made for car owners. Consumers who obtained the credit card were offered discounts on the purchase price of the vehicle if they contractually promised to spend a certain amount within three years. This ensured a desirable situation where usage rate remains high and cancellation rate stays low. Through innovative product design and marketing, HyundaiCard was able to double its market share from 2004 and 2009 as well as achieve second place7 ranking in 2008.

　　 China's credit card market should be no exception. For card-issuing institutions looking to attain decisive success throughout the expansion of China's market, MasterCard recommends developing a "strategically prudent" and "tactically innovative" business model that takes account of China's specific conditions. These companies should carefully consider how to enhance their growth strategies in order to avoid being caught in future crises. What kind of model is suitable to China's situation? What type of customers and asset mix are optimal in China? What products or marketing innovations will bring about business growth without causing negative impacts in the future? These are all questions that card-issuing institutions need to ponder with care. The card-issuing institution that is first to master these critical issues may very well become the perennial winner in China's credit market and join the ranks of leading global card-issuing institutions by riding the rise of China's market.