DECEMBER 2017DIGITAL CHINA: POWERING THE ECONOMY TO GLOBAL COMPETITIVENESSAbout MGICopyright © McKinsey & Company 2017Since its founding in 1990, the McKinsey Global Institute (MGI) has sought to develop a deeper understanding of the evolving global economy. As the business and economics research arm of McKinsey & Company, MGI aims to provide leaders in the commercial, public, and social sectors with the facts and insights on which to base management and policy decisions. The Lauder Institute at the University of Pennsylvania has ranked MGI the worlds number-one private-sector think tank in its Think Tank Index. MGI research combines the disciplines of economics and management, employing the analytical tools of economics with the insights of business leaders. Our “micro-to-macro” methodology examines microeconomic industry trends to better understand the broad macroeconomic forces affecting business strategy and public policy. 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Jonathan Woetzel | Shanghai Jeongmin Seong | Shanghai Kevin Wei Wang | Hong Kong James Manyika | San Francisco Michael Chui | San Francisco Wendy Wong | Hong Kong DECEMBER 2017DIGITAL CHINA: POWERING THE ECONOMY TO GLOBAL COMPETITIVENESSPREFACE China is already a global leader in the digital economy. It is a major investor in and one of the worlds leading adopters of digital technologies in the consumer sector. Chinese consumers are proving to be enthusiastic about all things digital, powering e-commerce and mobile payments. But there is much more to come. A new wave of digitization is now unfolding in which many more businesses put digital at the heart of their operations and strategy. As they do so, there will be significant restructuring in value chains, creative destruction leading to higher efficiency, and large productivity gains. As a result, Chinas economy will become more dynamic, and more Chinese businesses will be able to compete globally and even export “Made in China” digital business models and solutions. MGI has undertaken wide-ranging research on the impact of digital technologies on Chinas economy. In this research, we have focused on how three digital forcesdisintermediation, disaggregation, and dematerializationare reshaping value chains and, in the process, boosting productivity. We examined in detail four very different sectors: consumer and retail, because it was one of the earliest to digitize in China; automotive and mobility, to test whether and how digitization can transform an advanced manufacturing sector; health care, because of its huge potential for digital disruption; and freight and logistics, because it is very inefficient and still relatively less digitized in China than elsewhere. This research was led by Jonathan Woetzel, a McKinsey senior partner and a director of MGI based in Shanghai, and Jeongmin Seong, an MGI senior fellow in Shanghai. Also closely involved in this effort were James Manyika, chairman of MGI based in San Francisco; Kevin Wei Wang, a senior partner in McKinseys Hong Kong office; and Michael Chui, an MGI partner based in San Francisco. We also thank Gordon Orr, a former McKinsey senior partner in China, for his thoughtful guidance throughout this research effort. Wendy Wong and Jonathan Kuo-Yanagawa led the research team, which comprised Karen Chen, Daniel Cheng, Yuan Hu, Tim Lin, Qu Qu, Feng Shi, Yingzi Tian, Mike Wang, Hank Yang, Qian Yao (alumnus), and George Zhao. At MGI, we would like to thank Janet Bush for her editorial support. We thank MGIs Marisa Carder, Margo Shimasaki, and Patrick White, and Fanny Chan, a designer in Hong Kong, for their design expertise; Dennis Alexander, Cathy Gui, and Rebeca Robboy of MGIs external communications team, and Glenn Leibowitz, Xiaoyun Li, and Lin Lin of the Greater China Offices external relations and communications team; Lauren Meling, MGI digital editor; Julie Philpot, MGIs production manager; and MGI knowledge operations expert Tim Beacom. Many McKinsey colleagues gave their time and expertise as we developed this report. At MGI, we are grateful to Jacques Bughin, Susan Lund, and Sree Ramaswamy. From McKinseys Greater China office, we would like to thank Lambert Bu, Elisa Chen, Grace Cheng, Karel Eloot, Xiyuan Fang (alumnus), Flora Feng, Paul Gao, Eric He, Martin Hirt, Sheng Hong, Forest Hou, Daniel Hui, David Jiang, Martin Joerss, Jean-Frederic Kuentz, Franck Le Deu, Martin Lehnich, Nick Leung, Yuanpeng Li, Nianling Liao, Joe Ngai, Felix Poh, Erik Rong, Steve Saxon, Sha Sha, Zhicheng Su, Florian Then, Christopher Thomas, Arthur Wang, Jin Wang, Yang Wang, Bill Wiseman, Ting Wu, Chenan Xia, David Xu, Lei Xu, Fangning Zhang, Haimeng Zhang, Lizzie Zhang, and Daniel Zipser. We are deeply indebted to our academic adviser, Martin N. Baily, Bernard L. Schwartz Chair in Economy Policy Development and senior fellow and director of the Business and Public Policy Initiative at the Brookings Institution. And we thank the many business leaders, experts, investors, and entrepreneurs who shared their insights confidentially. This report contributes to MGIs mission to help business and policy leaders understand the forces transforming the global economy, identify strategic locations, and prepare for the next wave of growth. As with all MGI research, this work is independent and has not been commissioned or sponsored in any way by any business, government, or other institution. We welcome your comments on the research at MGImckinsey. Jacques Bughin Director, McKinsey Global Institute Senior partner, McKinsey & Company, Brussels James Manyika Chairman and Director, McKinsey Global Institute Senior partner, McKinsey & Company, San Francisco Jonathan Woetzel Director, McKinsey Global Institute Senior partner, McKinsey & Company, Shanghai December 2017 © BJI/Blue Jean Images/Getty ImagesCONTENTSHIGHLIGHTSChina is already a leader in the digital economyDigitization will reshape value chains How to capture huge upside potential in China 173751In briefExecutive summary Page 11. Chinas digital economy: A leading global force Page 172. How digitized are Chinas sectors? Page 373. Three digital forces are reshaping value chains Page 514. Implications for policy makers Page 1295. Implications for business Page 143Bibliography Page 157IN BRIEF DIGITAL CHINA China is already a major player in digital technologies at home and around the world, and it has enormous growth potential. As digital forces shake the status quo and restructure value chains, an even more globally competitive Chinese economy and dynamic firms can emerge. China has become a leading global force in the digital economy. The country has 42 percent of global e-commerce, processes 11 times more mobile payments than the United States, and is home to one-third of the worlds unicorns. Three factors suggest huge upside for China: a large and young Chinese market enabling rapid commercialization of digital business models; a rich digital ecosystem expanding beyond a few giants; and the government allowing space for digital companies to experiment, and being an investor in and consumer of digital technologies. The new MGI Industry Digitization Index for China reveals that a large gap vs. counterpart sectors in the United States has been closing rapidly. In 2013, the United States was 4.9 times more digitized than China; in 2016, that figure was 3.7 times. Three digital forcesdisintermediation, disaggregation, and dematerializationcan potentially shift (and create) 10 to 45 percent of industry revenue pools by 2030. Disintermediation and disaggregation can have the largest impact. Consumer and retail. Disintermediation (omnichannel, data-driven business models) is a major force for meeting evolving consumer demand. Disaggregation (sharing economy) and dematerialization (3-Dprinted goods) can serve niche demand in specific categories. These forces can impact 13 to 34 percent of the industry revenue pool. Automotive and mobility. Disintermediation (omnichannel, connected cars) enables technology suppliers and automakers to reach consumers directly, and disaggregation (shared-mobility solutions) may reduce demand for new car sales. Overall, digital forces can have an impact on 10 to 30 percent of the industry revenue pool. Health care. Disintermediation (Internet of Thingsand artificial intelligenceenabled solutions) can help to address chronic diseases, while disaggregation (health-care big data) can minimize overtreatment. There could be an impact equivalent to 12 to 45 percent of health-care expenditure. Freight and logistics. Disintermediation (real-time matching platforms) can address industry fragmentation while disaggregation (crowdsourcing delivery) can enable flexible capacity. These forces could impact 23 to 33 percent of the revenue pool. Chinas government can enable digitization by continuing to be a major investor in, and consumer of, digital technologies, promoting healthy competition, managing labor markets as the economy transitions to digital, and contributing to the effort to reach consensus in the global debate on issues such as technology standards and digital sovereignty. Companies in China need to embrace digital even more than elsewhere because Chinas rapidly growing and changing economy will magnify gains for winners and risks for losers. They may consider six approaches: adopt bold strategies; use the power of Chinas vast ecosystem; maximize value from analytics by using Chinas massive data pools; build an agile organization; digitize operations; and engage with Chinas policy and regulation. 1 Defined as a privately held startup valued at over $1 billion.2 Top three investor in technologies including big data, artificial intelligence and machine learning, wearables, virtual reality, autonomous vehicles, 3-D printing, robotics, and drones. GOVERNMENT CAN: Be a major investor in, and consumer of, digital technologies Promote healthy and dynamic competition Manage labor markets transition during digital disruption Reach global consensus on digital governance BUSINESS PRIORITIES INCLUDE: Adopt bold strategies Use Chinas digital ecosystem Maximize value from China's massive data pool Build an agile organization Digitize operations Engage with policy and regulation THREE DIGITAL FORCES CAN SHIFT (OR CREATE)1045% OF INDUSTRY REVENUE POOLS BY 2030DISINTERMEDIATION Using digital to cut out the middle man DISAGGREGATION Breaking up large items (cars, properties) and repackaging as servicesDEMATERIALIZATIONTurning the physical into the virtual (3-D printing, virtual reality) THE POTENTIAL IMPACT OF THE THREE FORCESIN FOUR KEY SECTORS IS LARGECONSUMER AND RETAIL1334% AUTOMOTIVE AND MOBILITY1030% HEALTH CARE1245% FREIGHT AND LOGISTICS2333% CHINA IS ALREADY A GLOBAL FORCE IN DIGITAL TECHNOLOGIES IT LAGS BEHIND THE UNITED STATES ON THE DIGITIZATION OF ITS INDUSTRY, BUT IS CATCHING UP QUICKLY share of global e-commerce transactions of global unicorns¹ in the world for venture capital investment in emerging technologies²gap in 2016 3.7xTop three 4.9x gap in 2013 34% 42% Digital Chinaviii McKinsey Global Institute © Real444/Getty ImagesEXECUTIVE SUMMARY China has become a force to be reckoned with in digital at home and around the world. As a major worldwide investor in digital technologies and one of the worlds leading adopters of the technologies, it is already shaping the global digital landscape and supporting and inspiring entrepreneurship far beyond its own borders. But there is much more to come. As China digitizes, industries will experience huge shifts in revenue and profit pools across the value chain. This creative destruction is happening globally as the world digitizes, but it is likely to happen more quickly and be on a relatively larger scale in China given a combination of inefficiencies in traditional sectors and massive potential for commercialization. In this report, the McKinsey Global Institute (MGI) assesses the strengths of Chinas digital system and the degree of digitization of industries. In order to understand how digitization is shaking the status quo and creating winners and losers, MGI looks at how three digital forcesdisintermediation, disaggregation, and dematerializationcan restructure value chains and increase the magnitude of disruption. The research explores how policy makers can facilitate the transition toward a digital economy and what choices companies can make to prepare for the impending wave of change. CHINA IS HOME TO DYNAMIC DIGITAL INNOVATORS AND IS A LEADING GLOBAL INVESTOR IN THE LATEST TECHNOLOGIES Conventional measures of digitization in China suggest that the nation is only in the middle of the pack. However, our view is that digital China is already more advanced than these measures suggest, and its potential is far larger than most observers realize.1In e-commerce, China accounted for less than 1 percent of the value of worldwide transactions only about a decade ago; that share is now more than 40 percent. The current value of Chinas e-commerce transactions is estimated