The Twilight of China’s Online Consumer Paradise

For the past year, Li Weiling has been living large on the cheap in Beijing, courtesy of deep-pocketed investors from around the world. 

The 30-year-old advertising professional's been swinging like a sultan on a salary of just 6,000 yuan ($903) a month: summoning chauffeured cars during the rush hour and getting lunch delivered to her doorstep, all while snapping up cheap movie tickets and just about anything else under the sun. It's the Chinese dream, underwritten by the record sums that titans of the internet, sovereign wealth funds and global investors funneled into the burgeoning on-demand economy. And it's probably too good to last.

Startups backed by Baidu Inc., Alibaba Group Holding Ltd. and Tencent Holdings Ltd. once offered plentiful and steep discounts on everything from on-demand massages to personal trainers in a massive land grab. But as consolidation revs up -- seen most recently in Didi Chuxing's acquisition of Uber Technologies Inc.'s Chinese operations -- this peculiar golden era for smartphone-wielding consumers is waning. Didi's deal wasn't the first merger intended to end internecine subsidy wars, and it won't be the last -- and that means fewer doorbusters for Li and millions of her cohorts.

The subsidy "wars have just been brutal. Well, great for the consumer, but brutal in terms of burning cash," says William Bao Bean, an investment partner at SOSV. "And they've trained Chinese consumers to not be loyal, but instead to go anywhere to seek out bargains. Consumer loyalty means nothing in China."

China's consumers are a force to be reckoned with. They drive global prices on commodities from steel to coal and siphon up exports from the U.S. to Japan. And now they've taken to on-demand services like no other, as startups piled onto the so-called online-to offline (O2O) bandwagon and raged a furious war of discounts to hook users. It worked: the so-called Chinese sharing economy was worth $1.95 trillion in 2015 and involved 500 million people, Didi cited official data as showing.

Yet the discounts they've enjoyed thus far will shrink because of two mega-trends convulsing the domestic industry landscape: consolidation, and a deepening investment drought. In recent years, investment in Chinese tech burst on the scene like James Brown on a dance floor: Get on up! Last year, $20.3 billion of venture capital surged into Chinese internet businesses, eclipsing the $16.3 billion that flowed to U.S. internet firms, and that's after more than quintupling from 2012, according to PriceWaterhouseCoopers.

What goes up can also tumble down. The volume of private equity and venture capital flowing into China's tech sector, as well as investments in the country as a whole, peaked last fall. Wilson Chow, a PwC analyst in Shenzhen, estimates that private equity and venture investment may be down about 25 percent in the first half of 2016 compared with 2015's final six months. Rui Ma, a partner at 500 Startups who splits her time between California and China, surveyed several of the most active VC funds in China, who told her their deal volume has halved from last year.

"The slowdown is a global phenomenon, and it's still ongoing: we're in the middle of the winter," says Kai-fu Lee, founder of prominent VC firm Sinovation Ventures in Beijing. "The Chinese market has a tendency to accelerate uptrends as well as downtrends: When things are trendy, they will double or triple quickly – and then when they're out of favor, they will drop like a brick."

"A lot of VCs believed in the formula that if you have tremendous user growth, there will be some way to convert that into profitability. If you can just get 1 million, or 3 million users, then the rest will work itself out," Lee said. "Too many people believed that and pumped in more cash, and now we see a lot of O2O companies still can't make money."

And that spurs consolidation. The on-demand arena has seen a string of multi-billion-dollar mergers since 2015: Didi-Kuaidi (ride-hailing), Meituan-Dianping (group-buying and food), Ganji-58.com (classified ads), Ctrip-Qunar (online travel). All were backed by at least one of the country's internet troika of Baidu-Alibaba-Tencent (BAT), who as investors were said to have orchestrated the mergers to staunch losses. Uber and Didi alone are estimated to have spent billions trying to undercut each other.

"It's not that they want to feed the Chinese consumer and give them goodies, it's that they thought the end result would be a monopoly that is worth a lot of money," said Richard Lim, a managing partner at GSR Ventures and an early Didi investor. "So the end justified the means."

Didi, Baidu and other prominent players in the on-demand economy are open about their tactics (though none will outline amounts). But now that the wave of big-ticket mergers have created dominant players with unrivalled pricing power, outsized discounts are no longer needed. And given pressure from shareholders to curtail costs, BAT are likely to lean on their startups to back off.

The question now is how consumers addicted to dirt-cheap services will react. 

The Didi Chuxing application is displayed on a smartphone screen in this arranged photograph taken in Shanghai, China, on Sunday, May 22, 2016.

Qilai Shen/Bloomberg

Take ride-sharing: subsidies for several popular services have plunged by more than 80 percent in recent months. Discounts on peak-hour Uber rides in Beijing have dropped to about 1.40 yuan from 8 yuan three months ago, according to a customer's record.  That means a ride that cost 8 yuan in May will now cost about 13 yuan. Users of Shenzhou Zhuanche, a.k.a. UCar, report that they now get 20 yuan towards their next ride for every 100 yuan deposited into their accounts, versus about 100 yuan earlier this year.

Other sectors have begun to cut subsidies as well. Edaixi, one of China's largest online laundry services, has begun to lay off the discounting, said Zhang Rongyao, founder and chairman of Edaixi's owner Rongchang Yao China Network Technology Beijing Co. 

"The laundry service can survive without heavy subsidies because of strong demand," he said. "The key to success in O2O is the size of demand. Laundry and food delivery services are more likely to survive because both businesses can easily scale up."

Plus, new habits may die hard. Consumers could grudgingly pay up to maintain their lifestyles, even if it means fewer savings in the long run. "If people are addicted to new conveniences, they may find it difficult to go back to the old ways," PwC's Chow said. 

Even if Li, the Beijing advertising worker, does cut back on non-essential services – perhaps going to fewer concerts or movies – the overall market for new services will continue to expand, says Arthur Kroeber, managing director of GaveKal Dragonomics, a research service in Beijing. That's simply because Chinese economic expansion, even if it decelerates sharply, will continue to fuel the growth of the affluent class. He estimates middle-income households could more than double to 180 million over the next decade.

For now, there're still discounts to be had -- in some categories. Li will just have to hunt harder for a service that offers the sweet deals on meals that she's grown accustomed to. 

"One of them will offer the rates I'm happy with. It'll just take more time to find them." 

--With assistance from Tian Ying.

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