By McKinsey Global Institute

A new McKinsey Global Institute (MGI) report, Urban World: Cities and the rise of the consuming class,analyzes the massive wave of urbanization that is propelling growth across the emerging world in the coming decades. The research expands MGI analysis of the top 2,600 cities globally, including cities’ demographics, household structure, and incomes, and their contribution to activity and growth in different sectors, including buildings construction, port infrastructure, and municipal water supply. Highlights follow.

A wave of urbanization propelling growth across emerging economies is a welcome fillip for a world economy that continues to have pockets of acute fragility. The move to urban living is lifting the incomes of millions of people around the world. In cities, one billion people will enter the global “consuming class” by 2025, with incomes high enough to become significant consumers of goods and services. Around 600 million of them will live in only around 440 cities in emerging markets that are expected to generate close to half of global GDP growth between 2010 and 2025. We are witnessing incomes rising in developing economies faster and on a greater scale than at any time in history (Exhibit 1: NIC Blog – MGI – Urban World – Exhibit 1).

By 2025, urban consumers will inject around $20 trillion a year in additional spending into the world economy. Catering to the burgeoning urban consumer classes will also require a boom in the construction of buildings and infrastructure. We estimate that cities will need annual physical capital investment to more than double from nearly $10 trillion today to more than $20 trillion by 2025, the majority of which will be in the emerging world. How companies and governments react to the fastest shift in the earth’s center of economic gravity in history—will fundamentally shape their future prospects.

The additional consumption and investment that will be part of the urbanization story is a very large opportunity for businesses. But there will be challenges, too. The wave of new urban consumers in the emerging world is already driving strong demand for the world’s natural and capital resources. The global investment rate and resource prices have jumped and could rise further. Cities can be part of the solution to such stresses, as concentrated population centers can be more productive in their resource use than areas that are more sparsely populated. But if cities fail to invest in a way that keeps abreast of the rising needs of their growing populations, they may lock in inefficient, costly practices that will become constraints to sustained growth later on.

Urban growth is highly concentrated in just a few hundred cities and will continue to be. Our analysis suggests that just the top 600 cities by their contribution to global GDP growth to 2025—a group we call the City 600—will generate nearly 65 percent of world economic growth in this period. Today, the City 600 is home to just over 20 percent of the world’s population but accounts for nearly $34 trillion, or more than half, of global GDP. Between 2010 and 2025, we expect the City 600’s combined GDP to nearly double to $65 trillion. But the most dramatic chapter of today’s urbanization story is the role played by the so-called Emerging 440. These emerging market cities in the City 600 will account for close to half of expected global GDP growth between 2010 and 2025 (Exhibit 2: NIC Blog – MGI – Urban World – Exhibit 2).

The incomes of these new consuming classes are rising even faster than their numbers are. This means that many products and services are hitting take-off points at which their consumption rises swiftly and steeply. Growth patterns will vary among products and services for three main reasons. First, as incomes rise, consumers choose where they spend the additional available income, and some products take off at lower incomes than others. Second, products and services vary in the shape of their adoption curve and then in the rate of growth of mature, well-penetrated markets. Third, there are geographic differences in demand for cultural and demographic reasons.

Infrastructure needs will also vary between regions and among different categories. In this research, we focus on residential and commercial buildings, port capacity (due to rising container demand), and municipal water. We estimate that cities will need to construct floor space equivalent to 85 percent of all of today’s residential and commercial building stock by 2025. The capacity of ports to handle urban container traffic needs to rise by more than 2.5 times from today’s level. We expect municipal water demand in cities to rise by almost 80 billion cubic meters, equivalent to more than 20 times the water consumption of New York today and 40 percent above today’s global level.

Again, there will be differences across regions and infrastructure needs.Chinais likely to have a 25 percent share of urban municipal water demand growth and a share of nearly 40 percent of growth in global demand for urban building floor space to 2025. Africa and the Middle East will account for almost 14 percent of the global rise in municipal water demand in large cities, almost twice their share of urban GDP growth. Across all three categories, we expect Emerging 440 cities to account for roughly 60 percent of global demand growth to 2025, although the shares of individual cities will vary.

Differences between the consumption take-off points depending on the product or service underline the need for companies to understand their target markets in forensic detail. The top urban markets in different demographic segments (e.g., elderly higher income consumers; or new young entry-level consumers) as well as for different products (e.g., laundry care) and demand for commercial floor space and municipal water are all different (Exhibit 3: NIC Blog – MGI – Urban World – Exhibit 3). Indeed, on these five “hot spots” for growth, the likely top cities are in three different continents: Shanghai and Mumbai in Asia; Lagos in Africa: and São Paulo and New York in the Americas. So depending on the products they sell, and the segments in which they specialize, companies need to have a detailed knowledge of which cities offer the most promising markets.

Companies that understand the shifting urban marketplaces relevant to their businesses and build a presence early on with sufficient scale are likely to benefit from being the incumbent with better market access and higher margins. Yet, disappointingly, most companies are still not looking at cities as they calibrate strategy. A new McKinsey survey finds that less than one in five executives is making location decisions at the city, rather than the country, level—and respondents did not expect this low share to increase over the next five years. Even those companies that arm themselves with the detailed city-level knowledge to identify the most promising markets for their products then need to allocate resources efficiently and master the art of execution in diverse and rapidly evolving emerging markets.

The challenge for policy makers differs according to whether they are in cities in the developing or the developed world. In a nutshell, the task for the former is to manage growth in a way that avoids diseconomies of scale and builds the basis for sustainable economic performance. For the latter, simply maintaining a healthy rate of growth can be tough, particularly in the aftermath of recession. Many developed cities are aging and no longer attracting migrants. Instead, they have to seek new vigor from higher productivity, new business investors, and enhanced links with the urban dynamos of emerging regions.

The McKinsey Global Institute (MGI) is the business and economics research arm of McKinsey & Company. Its mission is to help leaders in the commercial, public, and social sectors develop a deeper understanding of the evolution of the global economy and to provide a fact base that contributes to decision making on critical management and policy issues. MGI works with leading economists, including Nobel laureates, who act as advisors on its research.

By Drew Erdmann

The 2012 London Olympic Games will begin later this month. While the world will focus on sport, this Olympic Games also reminds us that the cities of the world are in constant competition as well. The history of 2012 London Olympic Games will be as much a story of the City of London’s effort to remain a leading, globalized city in the 21st Century as about the Gold Medal winners. We see this in the aspirations for the redevelopment of London’s East End to the “re-branding” of London as a global hub for commerce and services to innovations in reusable and environmentally friendly venue design. London’s success is by no means inevitable. The Economist recently described London as both “the world’s most international city” and “a precarious brilliance.” Other rising cities are challenging London and Western cities for economic, cultural, and political influence. Symbolically, the London Games follow the 2008 Beijing Games and precede the 2016 Rio de Janeiro Games. Although costly, the Beijing Games introduced the new Asian superpower to many in the world, and the Rio Games will undoubtedly help mark Brazil’s rise on the global stage as well.

The competition among such cities will continue in the decades ahead. The overall “megatrend” of increasing urbanization is clear, i.e., the world is becoming more urbanized literally every day. The implications are less clear. The blog’s objective for this week, therefore, is to explore the urbanization trends that will help define humanity’s history in the next twenty years and their implications for economics, governance, and security. Cities like London, Beijing, and Rio will be important characters in this history. Perhaps even more important, however, will be the host of new urban centers that are rising rapidly throughout the developing world.

This week’s blog hopes to provoke discussion and raise questions as much as provide answers. And the blog will feature diverse contributors to help stimulate this discussion. Picking up on Steven Weber’s plea to readers from 2 weeks ago, please take advantage of the “leave a reply” link to contribute to the discussion. The more voices and points of view the better!

Here are six observations to help jumpstart this week’s discussion of urbanization.

First, the pace of this era’s urbanization is unprecedented and it is already one of the most important forces reshaping the world. A future historian will likely point to the year 2008 as a historic turning point – not only because of the Beijing Olympics, but also because 2008 marked thefirst year in humanity’s history when a majority of people lived in towns and cities. As Edward Glaeser’s recent The Triumph of the City (2011) underscores, cities are one of mankind’s greatest creations, the centers for innovation, the prime drivers of economic development, and, as such, they will continue to attract hundreds of millions of the world’s poor as they seek a better life. The scale and pace of this change is hard to grasp. Around 1.3 million people will migrate to cities and towns every week for the next two decades, according to United Nations statistics. Most of this movement will continue in emerging markets, but transnational flows will be important as well.

Second, urbanization is driving the rebalancing of global economic power toward emerging markets, especially in Asia. This movement of people is a major driver of the rapid economic growth experienced in countries around Asia as well as parts of Latin America and, increasingly, Sub-Saharan Africa. Just as the developed economies of the West did decades ago, emerging markets are now capturing the huge productivity gains that cities’ concentration, economies of scale, and innovation afford and that. The implications are profound. For the first time in over 200 years, the majority of the world’s economic growth during this decade will occur in emerging markets, not the developed economies of the “West.”

Third, urbanization and the rise of new middle classes are two sides of the same coin.Estimates suggest there will be by 2025 more than 1 billion new consumers with incomes sufficient to purchase consumer goods beyond those needed for subsistence. More than 95% of these new “middle class” consumers will live in emerging market cities. Likewise, the majority of new high-income households – with annual incomes of over $70,000 (in terms of Purchasing Power Parity) – will be found in emerging market cities. This massive increase in urban consumers will drive a corresponding increase in demand for a full range of products and services from home appliances to telecommunications to automobiles to recreation (e.g., dining out, travel). New middle class consumer demand in emerging cities will thus be a major force in the global economy. This demand will, in turn, reshape business strategies, supply chains, talent and capital flows, and potentially regulatory regimes.

Fourth, urbanization will place unprecedented strains on resources and societies. If the pace and scale of the new cities’ growth in population and wealth is staggering, the resources required are no less so. Infrastructure investments will need to soar to keep pace. The McKinsey Global Instituteestimates that new physical capital investments in cities will need to increase over $10 trillion per year by 2025. That is equivalent to more than the combined current economies of Japan and Germany! The demands on natural resources and the environment will also be historic in scale and scope. At the same time, because cities can be relatively efficient, increasing urbanization does afford opportunities for improved resource productivity as well.

Fifth, urbanization will stress governance at all levels – local, national, and international. This is a corollary to the preceding observation. For instance:

  • Local and national governments the world over will struggle to provide basic services to burgeoning urban populations while maintaining some reasonable fiscal boundaries.
  • New middle classes will make demands upon their governments. We will likely see new middle classes in some countries seeking to extend their economic clout to greater political influence. At the same time, there is no inevitable alignment of interests among middle classes across national boundaries (i.e., an “outsourced” American job may be a stepping stone to the middle class for someone in Asia).
  • The flow of peoples from countryside to cities, and between countries, will pose their own challenges for governance at all levels (see, for instance, the recent Global Trends 2030 Blog entries related to migration).
  • The vast resources required to sustain urbanization will not only influence global markets in important commodities, but also place new strains upon governments. Consider, for example, the challenge of water scarcity in China. Given current trends, some basins within China will remain in surplus in the coming 20 years, while others will likely confront significant gaps between supply and demand. How will the Chinese government manage its water resources across its different regions? Many other governments will face analogous resource dilemmas.
  • Increasing urbanization, combined with this era’s global interconnectivity, will challenge how individuals define their own identities. Will people think of themselves first as citizens of a particular city or a country or a transnational Diaspora community? Or, as Chrystia Freeland suggested in The Atlantic last year, will we see the rise of a “new global elite”? Such a cosmopolitan elite could live inside gated communities – whether in Florida or Rio or Johannesburg – and share common education, experiences, and values with others of the same jet set class, but little with “fellow citizens” of their respective countries of origin. This could be an era defined by struggles to reduce inequality.

Sixth, urbanization will challenge our traditional approaches and tools for national security.The 20th century experiences of the Second World War and the Cold War, for example, still heavily influence the United States’ diplomatic footprint, alliance relationships, and intelligence capabilities. The 21st century’s rise of new urban centers in the developing countries and concomitant shift in economic power are already challenging these institutional legacies. Alliance relationships will be redefined and new ones forged. New capabilities will be needed. Diplomats will need to be deployed in new cities and able to engage with new kinds of players. Militaries around the world will need to prepare to operate even more in urban environments.

In sum, how well leaders around the world in the public, private, and nonprofit sectors comprehend this new wave of urbanization, identify its manifold implications, and then adapt institutions, norms, and practices to harness its potential will have a profound impact on the trajectory of international development, peace, and security in the coming 20 years.

Drew Erdmann is Principal in McKinsey & Company’s Washington, DC office. He previously served with the Department of State, the Department of Defense, and the National Security Council staff. The views expressed herein represent his personal views and do not necessarily reflect the perspectives of any organization with which he is affiliated.