Hainan Duty Free’s $47B Opportunity
HAIKOU, Hainan — It’s hard to overstate China’s plans to develop its sole tropical province of Hainan. An island the size of Belgium home to white sand beaches and lush palm trees few people imagine when they think of China, Hainan has for years served as a domestic tourist draw but had little bearing on the world stage.
But as an offshore duty-free shopping haven, that all changed once the pandemic struck, forcing borders to close, and brands were sent scrambling to set up a point of sale in Hainan to try to reach the Chinese consumer. The frenzy was further fueled by the sweeping policy changes announced last summer that boosted the duty-free spending allowance per person to 100,000 renminbi, or about $15,500 at current exchange, from 30,000 renminbi, the most generous offshore duty-free spending cap in the world.
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In the same announcement, the government detailed its plan to establish a free trade port in Hainan, transforming the island into a hub not just for tourism and retail but medical, technology, high-end manufacturing and financial services — a level of investment that has prompted people to call it the next Shenzhen.
The duty-free sector sits at the forefront of that transformation. Duty-free sales in Hainan rose by 127 percent year-over-year in 2020 to 32.74 billion renminbi, or $5.05 billion. The growth over the next four years per a May report from KPMG and Moodie-Davitt shows an exponential curve.
“Hainan FTP duty-free sales should hit 60 billion ($9.3 billion) in 2021, a spike of over 80 percent on 2020, said [acting Hainan] governor Feng Fei…in late January,” according to the report. It further predicted that by 2022 sales are expected to climb to at least $15.5 billion and a staggering $46.5 billion by the end of 2025.
First established in Hainan in 2011, the duty-free industry grew as Chinese consumers gained more disposable income and an appetite for travel. In 2014, state-owned China Duty Free Group opened the world’s largest duty-free location, the Sanya International Duty Free Shopping Complex in Haitang Bay, and the company plans to surpass that with its location in the provincial capital Haikou in 2022. In 2019, a ranking of duty-free operators by revenue had China Duty Free Group in fourth behind Dufry, Lotte Duty Free and The Shilla Duty Free, but by mid-2020, China Duty Free Group had consolidated its number-one position.
Besides the handing out of additional duty-free operator licenses for Hainan, moving away from what was a monopoly by the China Duty Free Group, there are a number of positive measures coming down the pipeline. Later this year, another allowance is expected to be rolled out, giving Hainan’s 10 million residents the ability to purchase up to 30,000 renminbi worth of goods duty free. Nicole Zhang, the partner who oversees KPMG’s Hainan business, said that the draft regulation already sits with the central government and product categories under the proposed rule will focus on more affordable and fast moving consumer goods.
By 2025, the structural plates will shift again when Hainan sees a leveling of the playing field between general retail and duty free.
“After 2025, normal retailers will still pay tax but the tax rate will be much lower than it is now,” said Zhang. “It will be single digit. And even though duty-free players they technically pay no duty, they are paying 4 percent royalties to the Ministry of Commerce. Most foreign investors are not aware of this yet.”
Despite all these indications of a boom, brands are at risk of getting overwhelmed by the market. A Bain & Co. report last year pointed out a number of growing pains. Key to this was balancing the need to generate cash to offset the collapse of other global markets with maintaining brand integrity.
Duty free takes 9 to 13 percent off but in reality, a series of discounts can add up to the end price being closer to 40 percent lower than standard retail, about double what brands typically aim for. For example, staying in certain hotels entitles shoppers to another 5 to 10 percent, which can be combined with the discounts from joining the membership program of the duty-free retailer, the seasonal deal (such as the May 5 shopping festival), or a volume deal (buy three, get one free). Cosmetics set to expire in a year also go for as low as a tenth of the regular retail price.
With so much pent-up demand from closed borders, long lines can form outside stores and inventory gets handled haphazardly. There’s an overall lack of quality manpower and staff training, although many brands have acted to second personnel to the region and restructure reporting lines to better align the travel retail and China market teams.
Another oft-heard criticism is that the market does well for cosmetics and accessories but is of little relevance for apparel, and that the items that perform well are the the ones with big marketing behind them. While government officials talk at length about their goal to create a fresh retail environment with innovative and diversified selection, incentivizing groups like L’Oréal and Shiseido to launch new products at the recently held International Consumer Products Expo in Haikou, the current reality is quite a gap from that. Gray market traders gravitate toward blockbuster products and while there are true travelers, many of them are buying to gift others and also like to play it safe with their choices.
“It’s primarily a reseller channel so it’s going to work for brands that are big enough that resellers know they can sell the product on and won’t get stuck with expired inventory,” said a senior executive of a beauty brand who requested anonymity. “If a smaller brand has a hero product, it’s just going to be that one or two products offered. For us, we have a very limited selection of products in our travel retail locations. People don’t go there to be introduced to new brands and to try new experiences. They know what they want already.”
The source also pointed out that offshore duty free in Hainan operates on different rules to true duty free. Hainan duty-free products are still required to be registered with authorities in China, whereas at an airport or true international space brands don’t have to register each stock keeping unit to sell it.
“It’s not true travel retail,” the executive said. “It takes around six to eight months to register a product. It’s a time-intensive process and if I’m going through the effort of registering, then I’m going to launch it in the domestic [mainland] market because it’s big. I’d launch it in Shanghai and sell it through domestic channels. I don’t know how the rules are going to change in 2025. It might be proper international duty free without registration.”
Nonetheless, Hainan’s long term-prospects are persuasive. Currently, China’s middle class is estimated to be about 400 million people. By 2027, the Brookings Institute forecasts that 1.2 billion Chinese will enter the middle class. Particularly for those new entrants, Hainan will be a natural choice because it avoids visa complications and language barriers, which are big advantages for those traveling with aging parents or young children in tow — similar to Americans choosing Hawaii over Central or South America even though international destinations may be cheaper and closer while offering comparable landscapes.
Another consideration to take into account is that the Chinese military and a large number of civil servants and officials of state-owned enterprise are disallowed from leaving the country due to national security and capital flight concerns. Exceptions for international travel can be made for this group under special circumstances but require applying for trip approval months in advance. This means that for a sizable high purchasing power segment of the population looking to go on a tropical beach vacation, there is only one real choice: Hainan.
“The current market is still in its infancy,” underscored Keith Tam, DFS vice president for strategy and business development. “The state we see today will evolve as the market matures and grows, riding along with the evolution of the Hainan Free Trade Port policy. Duty-free operators will naturally start exploring ways to differentiate their quality of service, environment, experience and partnerships with brands.”
DFS, which opened a concept store in Haikou via a partnership with Shenzhen Duty Free earlier this year, plans to expand the location over the next two years to a 323,000-square-foot space that will host the largest beauty hall in DFS’ global network. The LVMH Moët Hennessy Louis Vuitton-owned company said it has no doubt that Hainan will achieve its ambitions and expects it to become the largest and most critical market in its network.
Once international travel resumes and given the growing addressable market, Tapestry Asia Pacific chief executive officer Yann Bozec said, “some people will continue to go to Hong Kong, some continue to go to Korea and some will go to Hainan as well. So it’s not ‘or,’ it’s ‘more’, ‘and.'”
Bozec added, “The risk for me is that the growth will be so huge that some people may be disappointed on the way. There were 60 million travelers last year to Hainan, and in the first quarter of this year there were more than 20 million. Will everything be smooth and all the infrastructure be ready? No. There will be some ups and downs — infrastructure will have to built, service to be improved but I’m very, very confident that it will happen. In the end, it will be huge.”
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