LONDON 15 Regent Street London SW1Y 4LR United Kingdom Tel: (44.20) 7830 1000 Fax: (44.20) 7499 9767 E-mail: [email protected]NEW YORK 111 West 57th Street New York NY 10019 United States Tel: (1.212) 554 0600 Fax: (1.212) 586 1181/2 E-mail: [email protected]HONG KONG 6001 Central Plaza 18 Harbour Road Wanchai Hong Kong Tel: (852) 2585 3888 Fax: (852) 2802 7638 E-mail: [email protected]Coming of age Multinational companies in China June 2004 An Economist Intelligence Unit white paper In co-operation with Citigroup, DHL, KPMG and Monitor Group With additional support from Alcatel, Bates Asia, Bayer, Fuji Xerox, Hitachi Data Systems, Norton Rose, Primasia, Russell Reynolds Associates, Sheraton Hong Kong, Timken e g a f o g n i m o C a n i h C n i s e i n a p m o c l a n o i t a n i t l u M
Many hands and minds came together to create thisreport. The Economist Intelligence Unit would like tomake special mention of the lead sponsors—Citigroup,DHL, KPMG and Monitor Group—and in particular thosewho took time to give us valuable input: Tony May, Wu Xinand John Diener at Monitor Group; Paul Kennedy, AnsonBailey and Andrew Weir at KPMG; Gary Clinton at Citi-group; and Christina Koh at DHL. They are not responsiblefor our analysis, of course, but they were enthusiastic andinformed participants in the discourse. We would alsomake special mention of our colleagues at the EconomistCorporate Network, in Hong Kong and in China—LoisDougan Tretiak, as always for opening doors in China, andHarris Vertlieb, Jerry McLean and Pieter Tsiknas for theirgenerous and important help with our survey. Also wewould like to extend our gratitude to the many executivesof multinational companies in China who agreed to beinterviewed, and who often went out of their way to pro-vide us with insights into their businesses, and doingbusiness in general in China. Without their input, it wouldhave been impossible to produce this report.
The main authors of the report were Simon Cartledge andPaul Cavey. Simon Cartledge, a former chief editor at theEconomist Intelligence Unit in Hong Kong, runs his ownconsultancy, Big Brains, and is a regular contributor to ourpublications. Paul Cavey is the Economist Intelligence Unit’sChief China Economist based in Hong Kong. Additional sec-toral contributions were made by: Graeme Maxton (automo-tive); Ross O’Brien (telecoms); Joanne McManus(pharmaceuticals); and Elizabeth Cheng and Rick Bullock.Other contributions to the report were made by: Edgar Fer-nandez, Michele Lee and Sam Wong. Thanks are also due toElisabeth Paulson for her keen editorial judgement, MikeKenny for the design of the report, and to Gaddi Tam forskillfully seeing it all through production.
All information in this report is verified tothe best of the authors' and the publisher'sability. However, the EconomistIntelligence Unit does not acceptresponsibility for any loss arising fromreliance on it.
Neither this publication nor any part of itmay be reproduced, stored in a retrievalsystem, or transmitted in any form or by anymeans, electronic, mechanical,photocopying, recording or otherwise,without the prior permission of theEconomist Intelligence Unit.
The seven years that have passed since the EconomistIntelligence Unit last tackled the subject of multinationalcompanies in China is a short period when set against theage of Chinese civilisation. But it is an awfully long timein a country that is changing as rapidly as modern China.Since 1997 the stock of inward foreign investment hasincreased by US$265bn, the country’s exports have morethan doubled and the economy grown by more than 50%.A fourth generation of leaders has taken the stage, andChina has joined the World Trade Organisation.
In this context Coming of age: Multinational compa-nies in China is a report that is long overdue. Its centralpremise is that in the last seven years the experience ofmultinationals companies operating in China haschanged as much as the country itself.
This is a more controversial proposition than it mightsound. There is still a widespread perception that Chinaand foreign firms simply do not mix, that as a marketChina is “bound to disappoint”.
No doubt there will be losers. Competition is intense,and the operational environment remains challenging.But increasingly there will be winners as well. In the lastfew years China has emerged as one of the world’s largestmarkets for a variety of products—and for a number ofleading multinationals as well. China is no El Dorado. Butit is a market that has started to come of age.
A new environmentFor multinational companies, China’smarket has started to come of age.The growth of the “middle class” iscreating strong consumer demand,and there is also a burgeoning busi-ness-to-business market. Improve-ments in infrastructure and arelaxation of regulations have madethese markets much more accessiblethan was the case just a few yearsago. A broadening and upgrading ofthe activities of multinational firmshas accompanied these changes. Formany big companies China hasbecome a major global market and,in some cases, a large profit centre.China’s importance is currently notevident in all industries, but thesesectoral differences are likely to easeover the next few years.
Addressing the marketAccompanying the rise in demand inChina has been an intensification ofcompetition. While this represents anew strategic challenge for multina-tionals, the development of China’seconomy has also opened up newways in which they can respond. For-eign firms have more opportunity tobring their sophisticated brand-building and marketing capabilitiesto play in the China market, and tolocalise production, markets andsourcing to lower costs. The emer-gence of a local market for mergersand acquisitions is allowing big for-eign firms to buy up local competi-tors. The net result? Executives inChina are spending more time think-ing about the kind of strategic plan-ning issues that tend to pre-occupytheir counterparts in more developedmarkets.
Persistent headachesAt an operational level, doing busi-ness in China remains very challeng-ing. Infrastructure has improvedduring the last few years, butremains deficient relative todemand. Restrictions on foreignfirms in the manufacturing sectorhave been eased, but in the servicessector they remain oppressive.Across the economic spectrum, skillsshortages are severe and violation ofintellectual property rights is rife.These issues affect all companies, butpresent the most serious challengeto small foreign firms that are new toChina and lack international andcountry-specific experience. Largerfirms are coming up with strategiesto address these issues, if not resolvethem.
AutomotiveGood times today, but an uncertaintomorrowChina’s automotive sector continuesto expand rapidly. As developed-world markets have stagnated, therehas been a headlong rush to China bythe major foreign automakers—mostof which are now present in the mar-ket. Profit margins are high but riskbeing undermined by over-capacityand competition. Multinational autofirms will need to devise long-termstrategies that take into account apotentially diminished role in themarket.
Financial and profes-sional servicesStill dreaming of the futureOf all industries in China, the finan-cial and professional services sectoris the one where the gap betweencurrent reality and future expecta-tions is the greatest. Market accessrules remain strict, and so whiledomestic demand has been growing,China remains a minuscule marketfor most multinationals. Foreignfirms are nonetheless expanding. Ingeneral they are leveraging highservice standards and the need ofdomestic firms for outside expertiseand finance. Individual expansionstrategies are, however, determinedby the nature of individual compa-nies outside China as much as theregulatory and commercial environ-ment within the country.
LogisticsNot yet connectedThe logistics industry has developedrapidly in recent years, with statedomination of the sector giving wayto strong competition among foreignand domestic third-party logisticsproviders. The supply-side of theindustry has nevertheless failed tokeep pace with the even fasterincrease in demand. Restrictions inthe sector are being relaxed, butlogistics providers still face a numberof regulatory hurdles. The develop-ment of the industry is restrainedalso by China’s over-stretched physi-cal infrastructure and other problemsranging from limited IT systems topilferage of freight in transit.
PharmaceuticalsCultivating demand and biding timeChina remains a small market formost foreign pharmaceutical firms.But sales have been growingstrongly, and the business environ-ment has improved. Regulations andthe nature of the national healthcaresystem complicate the ability of for-eign firms to build bigger businessesin China. Reforms are eventuallylikely, but in the meantime foreigncompanies can start to use market-shaping strategies to create newdemand in areas that currently passunder-diagnosed or completelyuntreated. Multinational drug com-panies have already started to investin more research and developmentactivities in China, mainly focused ondrug-development clinical trials.
Retailing and consumer goodsOvercoming regulations and buildingbrandsBig companies like Carrefour andWal-Mart have already establishedthemselves in key cities in China, andwill benefit from the lifting of restric-tions on foreign retailers at the endof 2004. The further expansion ofthese and other foreign chain storeswill ease some of the distribution dif-ficulties currently faced by the inter-national fast-moving consumergoods companies. Procter & Gambleand Unilever have already estab-lished large businesses in China,although their early dominance ofsome markets has been broken downby domestic competition. Theincreasingly crowded market rendersbrand-building more important.
TelecommunicationsA strategic and crowded marketChina is a prodigious market for for-eign telecoms equipment manufac-turers. In few other sectors is Chinaas important to the global perform-ance of leading multinational firms.But China’s market is not just big, itis also increasingly crowded. Tocounter the competitive threat posedby Chinese firms both within Chinaand increasingly outside as well, for-eign equipment makers must focuson further integrating China intoglobal supply chains. Foreignproviders of telecoms services do notface the same considerations as theirmanufacturing counterparts. Despiteincremental market liberalisation,China’s service market remainstightly controlled by a small numberof state-controlled operating compa-nies.
The broad premise of this report is quite straightfor-ward, self-evident perhaps, yet curiously it has notso far been articulated in a systematic fashion, noris it firmly and unambiguously rooted in the corpo-
rate mind, even if it is on many a radar screen. The prem-ise is simply this: as China's economy and businesslandscape have been transformed fundamentally over thepast five or so years, so too are multinational companies(MNCs) thinking differently about China, or beginning todo so; and if they are not, they should be.
There is a paradigm shift afoot in the way foreign com-panies are approaching China because the country itselfhas changed. In many ways and in many sectors, China islooking more and more like a real market with all the asso-ciated challenges and opportunities that this implies. Sec-tors that seemed rather distorted in the early days—due tohigh regulations or a lack of competition, for example—are beginning to look more normal. Regulations remain,but are being relaxed. Competition is emerging, frombrash, local companies as well as new foreign entrants. Allthese firms are being drawn to markets which, for manysectors, are becoming some of the world’s largest. Thevery visible growth of demand within China has madebuilding a business there not only feasible but also essen-tial for any performance-oriented multinational. Thesedays, a truly global company would no more ignore Chinathan it would the UK or France.
Not unusually for a transition of this nature, there areconflicting threads. The survey of foreign firms carried outas part of our research, and the interviews we conductedwith senior corporate decision-makers, suggest that for-eign companies are conceiving of China with a new frameof mind, and realigning their strategies too. Not all, cer-tainly, but many. Yet for many foreign firms, this new par-adigm is still hazy; foreign companies (again not all, butquite a few) are struggling to define the new reality andcan remain quite attached to the mental models of doingbusiness in China that were forged five, even 10 years ago.
There is a sense that the old reality has yet to be com-pletely discarded, and the new yet to be fully framed. Theintention of this report is to throw light on the paradigmshift—particularly its causes and what the shift means forforeign firms seeking to make sense of their plans andstrategies for the China market of the future.
A new paradigmChina attracts ambivalence. Few markets can claim tohave fuelled such unbridled, naïve optimism from compa-nies and analysts alike, nor simultaneously drawn sus-tained scepticism and pessimism from others. The‘sceptical-pessimist’ view that “China is bound to disap-point” remains a fashionable and influential one: it holdsthat foreign businesses have been blinded by numbers;that investment decisions have been based on illusorypremises; that by-and-large foreign firms are not makingmoney, or if they are, margins are thin; and that they havefailed, also, to anticipate or adequately factor in the risksin the business environment and beyond. Foreign compa-nies, in short, have been lulled by the China dream intoentering the market at any cost—into spurious loss-lead-ing and opportunism—and have been opening themselvesto disappointment ever since.
This view—in its varying shades—might be familiar ter-ritory for some foreign businesses in China. Not a few havestumbled, and got their strategies wrong, after all; not afew will continue to do so. If the sceptical-pessimist viewbears merit, it is that it highlights the many risks—busi-ness and otherwise—that foreign companies face in China,and serves as a reminder to temper naïve optimism. Multi-nationals, remember, are riding the crest of a third wave offoreign direct investment (FDI) into China, and inevitablythe present elation will falter, as it has in the past. Thesceptical pessimist does have a certain point.
Yet this view describes only a partial reality, one inwhich China’s business environment seems almost frozenin the concerns of the mid-late 1990s, and in which for-
eign companies focus their energies on operationalissues—on reticent joint venture partners, intellectualproperty violations and markets that are only a fraction ofthe size companies had anticipated.
China, undoubtedly, is still an emerging market, andone too with peculiarly Chinese characteristics. Yet it isnot simply any emerging market; it is the world’s mostimportant emerging market, thriving on a virtuous cycleof globalisation. This is a recent phenomenon. Last year,China became the world’s fourth largest exporter by value,and the third largest importer (a measure in part of theinputs needed to create exports); only a decade earlier itbarely made it into the top ten. China is now enmeshed inthe global trading system and in global business net-works—in complicated webs and chains of manufacturing,sourcing and supply—to a much greater degree than couldhave been imagined just a few years ago.
The impact on China’s domestic economy of its rapidascendancy as a trading power has been profound. A 50%expansion of GDP since 1998, according to official statis-tics, might overstate the performance of the economy as awhole, but income growth in the major cities—particularlyon the coastal belt—has been very rapid indeed. A marketof one billion consumers remains a fallacy, of course, butthis no longer matters. Foreign businesses can legiti-mately point to a serviceable “middle class” of ten of mil-lions of people. And the domestic market does not endhere. Just as important, perhaps more so, for foreigncompanies are the burgeoning business-to-businessopportunities found further upstream the productionprocess. China has become a voracious consumer of rawmaterials. The intermediates market—for chemicals, plas-tics, synthetic materials, optical fibre, steel, glass, elec-
tronics, in fact components of all sorts—has also growndramatically in recent years.
A need for strategyIt is not just in terms of raw demand that China has begunto approximate a real market. It is also in the emergenceboth of competition, and of strategic options for firmswishing to compete. In addition to foreign firms, smallercompanies from the US and Europe, as well as large corpo-rates from other Asian countries, all want a piece ofChina’s market. So do China’s firms, ranging from state-owned giants through partly privatised corporations tothe up-and-coming private sector.
In this intensely competitive environment foreignfirms are far from powerless. The improved business envi-ronment is giving them the opportunity to use sophisti-cated brand-building and marketing strategies.Infrastructure improvements have made it possible forforeign firms to move production to the cheaper, inlandareas of China and thus begin to emulate the cost struc-tures of their local counterparts. Finally, and perhapsmost critically, the emergence of a local market for merg-ers and acquisitions (M&A) is allowing big foreign firms tobuy up local competitors.
This is not to say that China has changed so much thatforeign firms are no longer troubled by basic operationalissues. The operating environment in China remainsextremely challenging. Despite the huge investmentsmade by the government in recent years in the country’sphysical infrastructure, the capacity of transport networksand electricity generation continues to fall short ofdemand. Foreign firms operating in China still have todeal with regulation, either in the form of red tape or for-
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mal restrictions aimed at restricting their involvement inthe domestic economy. Human resources shortages areendemic, and theft of intellectual property rife.
Moreover, China's economic system is far from beingmature—and thus stable—despite the far-reaching eco-nomic reforms implemented since 1978. Indeed, the riskthat the economy will suffer not just a slowdown but awrenching crisis, triggered perhaps by the ailing bankingsector, remains far from negligible. Huge social chal-lenges also loom: for one, more than 400m people,roughly the population of Europe, will move from thecountryside to towns and cities over the next 25 years.Inevitably, too, China’s political system appears brittleagainst this background of continued rapid economic andsocial change.
But the problems and risks associated with China’s mar-ket should not be over-played. At least for better-estab-lished firms, operational issues are not the all-consumingproblems they once were. The business environment hasimproved, and firms are beginning to work out systems andprocedures to alleviate the challenges that remain. For awhole range of multinationals in China, the focus of man-agement attention has moved, with executives spendingmore and more time thinking about the kind of strategicplanning and development issues that tend to pre-occupytheir counterparts in more developed markets.
If thinking more deeply about China is not an activitythat senior management in headquarters in Europe or theUS is encouraging, then they should be. China operationsare making a real difference to the global performance ofmultinational companies today; for many, China revenuesare in their top 15 or 10 countries world-wide, and not afew breaching the top 5. It clearly matters that foreign
firms get their China strategies right. And this all meansthat performance-oriented multinationals no longer facerisks only from entering China. Staying outside is fastbecoming if not more, at least equally as risky a strategy.
Coming of ageThis purpose of this report is to address some of the new,strategic questions facing foreign firms. The first half ofthe report explores in greater detail how, for foreignfirms, China’s market has begun to come of age. The firstchapter, “A new environment”, examines how the expan-sion of demand and improvements in the business envi-ronment are creating new incentives and a newaccessibility for foreign firms looking to develop theirChina operations.
As the attraction of the market increases and the busi-ness environment improves, competition is hotting up.Fortunately, accompanying the rise of demand and com-petition has been the emergence of strategic options forforeign firms wishing to fight back—a theme explored inthe second chapter, “Addressing the market”.
The operational problems that were such a pre-occupa-tion in the 1980s and 1990s are no longer the only issuestaxing the time of executives, although they remain realchallenges, as the third chapter, “Persistent headaches”—will explain.
China’s economy and business environment are nowcoming of age, and these shifts have created a new levelof complexity for executives managing China operations.And there is certainly much variation across differentindustries, with all of these changes evolving at a differ-ing pace across different sectors. The second half of thisreport aims to add nuance to the broader developments
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Bursting on the sceneExports of the world‘s biggest traders, US$bn
discussed in the first half, examining the ongoingchanges and strategic outlooks for six key sectors.
Overall, this report focuses on what decision-makers atmultinational companies on the ground in China arethinking, how their companies are faring and what kind ofsense they are making of the business environment and
its likely developments over the next few several years. Itsfindings may prove particularly useful to executives view-ing China from abroad, offering a sense of how the opera-tional and strategic parameters on the ground areaffecting company strategy at the highest level, today andin the future.
China’s leaders are particularly busy at the moment.Apart from having to manage the unimaginablycomplex transition of the world’s most populouscountry from communism to capitalism, they are
also granting interviews on an almost daily basis to thechief executive officers (CEOs) of the world’s largest multi-national companies. Impressed perhaps by their top-leveltalks, or by the fast-rising skyline of Shanghai, many CEOsare quick to lavish praise on their host country. In theinevitable post-interview talks with the press, the foreignbusinessmen tend to extol the virtues of the country’s“economic miracle” and seem to compete with each otherto announce large investments that prove their “commit-ment” to China.
Experienced China watchers—and the large and deter-mined legions of China sceptics—tend to roll their eyes at
this spectacle. After all, while the intensity of interest hasvaried, foreign businessmen have been beating their wayto the doors of the Zhongnanhai leadership compound inBeijing ever since the ruling Chinese Communist Party(CCP) started to introduce economic reforms in the late1970s. In the past the enthusiasm of the initial trip rarelylasted long, with companies soon realising that thepotential market was, in reality, better measured in thou-sands rather than millions, and that accessing even thispool of consumers was made difficult, if not impossible, bypoor infrastructure and anti-business policies. Chinabecame famous as a market in which foreign firms losttheir shirts. For many multinationals, it became a marketto bypass, not cultivate.
Some evidence might suggest that little has changed.By many measures, the country remains extremely poor.
Part 1
A new environment
● For multinational companies, China’s market has started tocome of age, transforming both the opportunities availableto foreign businesses and the way they think about thecountry.
● Foreign businesses can now legitimately point to a servicea-ble market of substantial size. The growth of the “middleclass” is creating strong consumer demand. But there is alsoa less-noticed but probably bigger business-to-business mar-ket, associated with China’s emergence as the workshop ofthe world.
● For overseas firms China’s market is not only real, it is alsomuch more accessible than was the case a few years ago. Thetransport infrastructure has been upgraded and regula-tions—including those aimed specifically at limiting partici-pation in the economy of multinational firms—have beenrelaxed.
● The emergence of domestic demand, together with the realimprovement in the business environment, has helped tobroaden and upgrade the activities of foreign firms in China—and enhance the influence of multinationals on the Chineseeconomy.
● For many big companies China has become a major globalmarket, and in some cases even a large profit centre. China’simportance is currently not seen in all industries, but surveydata and interviews with executives suggest these sectoraldifferences will ease during the next few years.
● For much of the 1980s and 1990s the experience of multina-tionals seeking to tap China’s domestic market was definedby unrealistic expectations and disappointment. Now it ischaracterised by real opportunities, revenue growth andsometimes even profit. China is no longer a market thatmultinationals should or can ignore.
Average income per head in China remains pitifully small,at around US$1,100 in 2003, and still below income levelsin countries like Syria, Albania and Kazakhstan. The stateremains a significant economic player, retaining owner-ship of some sectors of the economy and binding others ina web of restrictions and reams of red tape. For someexecutives the issue of profitability remains a difficultone. Our own survey shows that foreign firms still judgesuccess in China by revenue growth and market sharerather than return on capital.
None of these facts are irrelevant but they form onlypart of the story and, as this report will argue, an increas-ingly secondary one for foreign firms operating in the Mid-dle Kingdom. In stark contrast with the picture in 1997when we last produced a report on this subject, for manyforeign firms China is an economy that has started to comeof age. In this chapter, we will explore how the maturationof the Chinese market in the last few years has transformedthe opportunities available to foreign businesses and theway they think about their China operations.
A serviceable market of substantial size
China’s emergence as a more mature market for foreigncompanies is the result of a bundle of factors. Central tothe process, however, has been the continued rapidgrowth of the country’s economy. According to officialdata, China’s GDP has grown by more than 50% since1997. (In the late 1990s there was widespread suspicionthat government statistics overstated the speed of eco-nomic growth. Since then, however, these doubts havebeen replaced by a consensus that official numbers, whichsuggested growth of 8% in 2002, 9.1% in 2003 and 9.7%year on year in the first quarter of 2004, have been under-stating the rate of real economic expansion.)
The economy grew rapidly throughout the 1980s and1990s but China still proved a disappointment for manyfirms. Fast rates of GDP growth were insufficient to gener-ate a nation of a billion consumers, largely because baseincomes remained very low. This reality seemed to comeas a surprise to many firms in China: in the survey con-ducted for our last report in 1997 on multinational com-panies in China, more than half of respondents—56%—said they had overestimated the size of the market.
By contrast, 43% of respondents to our 2004 surveyreported that operations in China were either outperform-ing or outperforming by a wide margin original businessplans. The change is partly the result of less naive expec-tations, itself a welcome development. The dream of sell-ing a billion soap bars, telephones or family cars to abillion Chinese consumers gave way to a more temperedview of the Chinese marketplace.
In particular, many foreign companies began to realisethat they did not need a billion consumers to justify theirpresence in the Chinese market. Continued, low averageincomes have not prevented China from becoming a majorglobal market for many types of goods and services. In1997 the country was already the world’s third-largestmarket for mobile-phone handsets but there were still just13.8m subscribers. By 2003 China had not just becomethe world’s largest market but subscription numbers hadsurged to 269m. Similarly, in 1997 car sales in China, atunder 500,000, trailed behind 13 other countries, includ-ing India. Last year, however, local car sales grew to morethan 2m, with China overtaking France to become thesixth-largest market in the world. The value of domesticmortgage lending totalled less than US$2bn in 1997 buthad swelled to US$142bn last year, with China’s marketfor house lending thus rivalling that of Italy.
These are just a few of the markets that were virtuallynon-existent only a few years ago and that have nowgrown to become among the biggest in the world. Severalrespondents to our survey alluded to the growth andtransformation of China’s market when they referred totheir firms’ reassessment of the China market from“totally obsolete and marginal to critical to global strat-egy” or from “an emerging market to one of our top tenfocus countries”. In fact, although 38% of the respon-dents to our survey still see China as a prospective market,a substantial 77% of respondents view it as an actual mar-ket. After all, there is little question that the world’s top
car manufacturers must have a presence in France, one ofthe world’s largest car markets. Likewise, with China’s carmarket just behind France’s in size, the choice is whatstrategy must be employed to best tap this new market,not whether to be in the market in the first place.
Pockets of wealth, with deep pockets
The emergence of these consumer markets is a reflectionof the widening income inequality that has accompaniedthe recent growth of the economy. For instance, annualdisposable incomes per head in urban Shanghai grew byover 75% in 1997-2000, rising from Rmb8,440
What is the role of China to your global business? Select all that apply(% responses)
One of several export production sites globally 24.0
A critical part of your global supply chain 27.6
A prospective market 38.2
An actual market 77.0
Other 4.6
Source: Economist Intelligence Unit survey, March/April 2004
Most of the firms that responded to our sur-vey are seeking to sell into China. Just underone-quarter of companies represented inthe survey indicated that China was “one ofseveral export production sites globally”and nearly 30% said it formed a “criticalpart of the global supply chain”. But almostfour-fifths of respondents claimed Chinawas an actual market and 38% said it was aprospective one.
Some global companies, initiallydisappointed in or sceptical of the domesticmarket’s potential, scaled down plans ortapped China’s advantage through thecreation of export-oriented manufacturing.But these days there are signs of anincreasing emphasis on the development ofthe domestic market. A survey conducted bythe Economist Intelligence Unit in 2003found that the most common reason cited byTaiwan firms already operating in China forincreasing investments further over the nextthree years was to take advantage of theopportunities in the mainland’s domesticmarket. Firms from other countries report asimilar change of focus. Corning, for example,
has been able to switch sales of domesticallymade goods from exports to the local market,thanks to growing demand for many of itscore products from China’s rapidly growingautomotive and telecommunicationsindustries (see case study in the next chapter,Addressing the market).
Most platitudes or broad perceptionsabout the Chinese market are rife withexceptions. This one is no different. While anumber of companies are reassessing theirstrategy for tapping the domestic market,there are also those who are expandingtheir focus on export-generated sales fromChina. In the survey conducted for thisreport, the single largest group ofrespondents (47% of the total) claimed thatthe ratio of exports to domestic sales intheir business currently stands at 0:100 or25:75. But when asked where the ratio willstand in five years’ time, the largest numberof firms (44%) reported 25:75 or 50:50. Inother words, and in contrast to the commonperception of an increasing focus on thedomestic market, companies thatresponded to our survey expect an increase
in the proportion of sales generated byexports over the next five years.
It is not difficult to find examples of firmsplanning to increase China’s importance asan export base. The proportion of outputexported by Alcatel of France has alreadyrisen from around 5% at the end of the1990s to 15% today, and the companyexpects the share to rise further to around33% by 2006. The US ball-bearing maker,Timken, came to China to manufacture itsproducts for the domestic market but 70% ofits production in the country is now exported(see case study later in this chapter).
This does not suggest that companiescannot sell into China but rather that theyare gaining a better awareness of whichgoods will find a domestic market and whichare better earmarked for sale to other partsof the world. In Timken’s case, the firm isnow addressing local demand for higher-end products (such as those used in steelmills) by importing from its manufacturingoperations in Europe, and retargetingabroad the China output that was originallyintended for the domestic market.
(US$1,015) to Rmb14,870. In the same six-year period,net incomes per head in rural areas in the south-westernprovince of Yunnan grew by less than 25%, and even thenfrom just Rmb1,375 to Rmb1,695. The poverty in ruralareas is a serious social problem that is causing increasingconcern for the government. But in urban areas, the dis-proportionately strong growth of incomes has generated a“middle class” that has the financial ability to buy themore expensive products that foreign companies oftenwant to sell.
The government-backed Chinese Academy of SocialSciences (CASS) claims that 250m people in urban Chinabelong to the “middle class”, defined as households withtotal assets of US$18,000-36,000. According to a NewZealand-based company, Asian Demographics, the middlethird of households (approximately 130m in number) inChina now earns Rmb12,500-25,000 (US$1,510-3,020) ayear. These are all small figures compared with the assetsand income of even low-income households in developedeconomies. But the cost of living in China is lower than inthe West and it is clear that there are now tens of millionsof people who can afford to buy—and furnish—a smallflat, take one holiday a year (perhaps overseas) andmaybe buy a small car. While the market of one billionconsumers might remain nothing more than a twinkle inthe eye of China-virgin executives, foreign businesses cannow legitimately point to a serviceable market of still sub-stantial size.
Moreover, the country’s domestic market does not endwith the high street or shopping mall. Perhaps moreimportant for foreign firms are the burgeoning business-to-business opportunities found further upstream in theproduction process. This is partly related to surgingdomestic consumer demand. Rising car and home sales
have, for example, fuelled a need for everything fromsteel to paint. China is by far the largest consumer of steelin the world and in 2003 the country overtook Japan tobecome the second-largest consumer of oil, trailing onlythe US. Strong demand for mobile phones and other elec-tronics products has contributed to surging sales of semi-conductors. According to the Semiconductor IndustryAssociation, China is now the fastest-growing chip marketin the world, accounting for nearly 11% of global demandin 2003, up from just 3% in 1998.
An export powerhouse
As a result of strong growth in external sales, the value ofChina’s merchandise exports grew by 22% in 2002 (repre-senting an absolute increase of US$60bn) and by 35% in2003 (jumping by a further US$113bn), propelling Chinaup the ranks of the world’s largest traders. In ninth posi-tion in 1997, China last year overtook France to becomethe world’s fourth-largest exporter. With overseas sales inthe first four months of 2004 growing by a further 34% onthe year-earlier period, it seems unlikely that it will belong before China surpasses Japan to become the biggestexporter in Asia and the third largest in the world.
Totally isolated from the world economic mainstreamat the end of the 1970s, China has now become a majortrading power. Its economy is enmeshed in global busi-ness networks to a much greater degree than could havebeen imagined several years ago.
Given China’s emergence as a major exporter, it shouldnot be surprising that the country is now the world’s dom-inant producer of several individual categories of goods.For some light manufactured products such as garmentsand toys, as well as for some heavy industrial goods likecrude steel, China’s global importance is nothing new.
(The country has been the world’s largest steel producerfor several years, although demand remains well abovedomestic supply.) But even for many of these sectorsChina’s lead has grown in recent years. The phased relax-ation of export quotas that have long restricted worldtrade in apparel is, for example, allowing even more gar-ment production to migrate to China. In the early to mid-1990s China’s steel production, at around 90m metrictonnes a year, was only slightly above that of the US. Inthe following years, however, US steel productionremained fairly steady whereas Chinese output rosestrongly, reaching 220m tonnes in 2003.
At the same time as output of existing products hasgrown, China has begun to move into the manufacture ofother goods. Annual domestic output of passenger cars,for example, jumped from under 500,000 in 1997 to morethan 2m last year. China has also emerged as a leadingproducer of electronics products. According to the Taipei-based Market Intelligence Centre (MIC), China’s produc-tion of information technology (IT) hardware almostdoubled between 2000 and 2003, from US$25.5bn toUS$49.1bn. This allowed the country to overtake both Tai-wan and Japan to become the second-largest producer inthe world, trailing only the US.
An ugraded business environment
While the change in domestic demand in China and theever-expanding appeal of the country as an export baseare undoubtedly important factors behind the country’scoming of age for multinational companies, they are notthe only ones. A number of ground-level changes havealso transformed the business environment and the wayforeign companies think about doing business there. Inthe last few years several features of the operating envi-ronment have undergone dramatic change, easing theway for foreign businesses and opening up new opportu-nities for well-prepared companies.
Improvements to infrastructure networks
Thanks to vast state spending, China’s infrastructure,both soft and hard, is much improved from a few yearsago. The betterment of the IT network has allowed compa-nies to make operating changes that would have beenunthinkable a few years ago. Unilever, for example,moved out of Shanghai to Hefei in Anhui province in2003. It can now manage many of its human resourcesoperations in its ten subsidiaries spread across China, inShanghai and Beijing as well as Hefei, using a single cen-tralised human resources database that handles payrollmanagement and other tasks using just a couple of staff.Aside from improving efficiency within Unilever, it alsoreflects both the coverage and reliability of China’s com-munications infrastructure stemming from the massivetelecoms rollout of the last 10-15 years. This has laid thebasis for the rise in individual ownership of mobile andfixed handsets but has also made life much easier for busi-nesses, with many cities now offering broadband connec-tions to the Internet.
In recent years the transport infrastructure, which wasthe target of a government spending programmelaunched to support domestic GDP growth in the after-math of the Asian financial crisis of 1997-98, has alsoimproved significantly. The railway system is now betterthan it was, albeit more because of steady incrementalupgrading than high-profile projects. (Although China isthe home of the world’s first magnetic levitation line, this430-kph service only runs 30 km from Shanghai’s Pudonginternational airport.) The biggest beneficiary of the gov-ernment’s transport spending binge has been the roadnetwork. Before 1997 China had virtually no expressways.By 2003 there were 30,000 km of them, although this isstill small compared with the US, which has an arterialnetwork that stretches for 120,000 km. Nonetheless, any-one who travels frequently within China can attest thatthe transport infrastructure has indeed improved dramati-cally. This has greatly raised the efficiency of distribution,particularly in the eastern part of the country, with jour-
World’s leading tradersExports, US$ bn
1993 20031 US 465 1 Germany 7482 Germany 380 2 US 7243 Japan 362 3 Japan 4724 France 222 4 China 438
5 UK 181 5 France 3856 Italy 169 6 UK 3047 Canada 145 7 Netherlands 2938 Netherlands 140 8 Italy 2909 Hong Kong, China 135 9 Canada 27210 China 92 10 Belgium 255
Imports, US$ bn1993 2003
1 US 603 1 US 1,3062 Germany 343 2 Germany 6023 Japan 242 3 China 413
4 France 217 4 France 3885 UK 209 5 UK 3886 Italy 148 6 Japan 3837 Hong Kong, China 141 7 Italy 2898 Canada 139 8 Netherlands 2619 Netherlands 126 9 Canada 24610 Belgium-Luxembourg 118 10 Belgium 23411 China 104 13 Hong Kong, China 233
neys between key cities in provinces such as Guangdongshrinking from tens of hours to several hours.
It is not just the internal communications and trans-port networks that have improved in leaps and bounds.China’s connectivity with the rest of the world has alsoimproved. Just ten years ago, for example, making anoverseas phone call from anywhere outside the largestcities was a complicated procedure. Today, internationaldirect dialling (IDD) is possible from almost anywhere inthe country. In terms of transport, heavy investmentshave been made in the country’s port infrastructure, mak-ing it easier for companies to import and export goodsdirectly from their nearest port. In the past goods made inGuangdong, for example, were transported back to theport in neighbouring Hong Kong for export to the rest ofthe world. However, although Hong Kong’s port remainsthe busiest in the world, handling an all-time high of over20m twenty-foot equivalent unit (TEU) containers in2002, its monopoly on shipping in the region is fast disap-pearing. Guangdong’s largest container port, Yantian,started operations only in 1994 but by 2005 it is expectedto have the capacity to handle 6.5m TEUs. China’s civil avi-ation infrastructure has been similarly improved: sincethe late 1990s a new, modern terminal has been openedin Beijing and flashy new airports have been constructedin Shanghai and Guangzhou.
Smoother soft infrastructure
The upgrading of the physical transport network has beenaccompanied by improvements in China’s soft infrastruc-ture. Customs regulations, for example, are being liber-alised, with the result that larger foreign firms are gainingthe unprecedented freedom to consolidate cargo beforeshipment. The international connectivity of China’s portshas been improving rapidly as more international ship-
ping lines design routes including stop-offs in the coun-try. China’s overseas air links have also been mushroom-ing: the number of weekly international departures fromShanghai rose from 41 in 1985 to 554 in 2002, and fromBeijing, from 44 to 405.
Ongoing moves towards market orientation
The improvements in the soft infrastructure and policyenvironment in the transport sector are part of the gov-ernment’s ongoing effort to make the economy moremarket-oriented. Large state-owned enterprises (SOEs)have been downsized and partly privatised, and a stalleddrive to sell off, close or otherwise restructure the thou-sands of smaller state-owned firms has recently beenrelaunched. The government has aimed to end destruc-tive over-competition in some sectors by closing or merg-ing smaller firms, whereas in other industries it has triedto promote efficiency by breaking up state-ownedmonopolies. The private sector has been given morescope, even official encouragement, to grow. Since 1999the state constitution has been amended twice toupgrade the status of the private sector. The ideologicaldislike of capitalists that was a shared principle of com-munist parties everywhere has in China dissolved to suchan extent that private-sector entrepreneurs have beenallowed to seek CCP membership.
The state still remains a significant player in the econ-omy: in 2002 China still had over 160,000 SOEs, control-ling assets of Rmb18trn (US$2.2trn). The structure of theeconomy has nonetheless changed radically. By 2002 theshare of state-owned and state-holding enterprises ingross industrial output value had shrunk to 41%, downfrom 50% in 1998; the share of wholly state-owned firmsfell from over 30% in 1999 to almost 15% in 2002. Thegovernment has found it difficult to consolidate frag-
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An IT hubProduction of computer-related products, US$ bn
mented industries but it has been quite successful in pro-moting competition in previously regulated industries.The rapid growth in the telecoms service market, forexample, has been triggered in part by the entry of severalnew firms into the industry. The same is true of the insur-ance sector: whereas just eight years ago China had onlyone domestic insurance firm, there are now five local com-panies competing in both the life and non-life markets.
WTO gives reforms a boost
The process of reform and liberalisation began long beforeChina joined the World Trade Organisation (WTO) in 2001.Nevertheless, the country’s entry to the trade body wasstill important. It had a strong symbolic significance, par-ticularly for foreign executives living outside China whosaw accession as a signal of the country’s entry to themainstream of the international economic community.China’s long and detailed WTO accession agreement alsopromised tangible changes in the rules governing the
activities of foreign firms operating in the country, includ-ing the liberalisation of rules that had previously pre-vented or restricted the operation of overseas firms insectors ranging from automotive to financial services.
China has by and large kept to the letter of its openingcommitments, if not always the spirit. In some of the moresensitive sectors, such as banking, regulators have begunto open up the market, allowing foreign institutions tobegin lending local currency to local firms. But overseasbanks are still subject to heavy branch capitalisationrequirements (see Part 2, Financial and professional serv-ices) that curb operations and expansion.
Nevertheless, China has largely abided by a formalunderstanding of its WTO market opening pledges. Thegovernment was clearly attracted by the internationalkudos to be gained from entry to the WTO, but leadingofficials also viewed accession to the trade body as a toolthat could be used to drive through their programme ofsometimes painful domestic economic restructuring. It isfor this reason that the government was for the first timesince 1978 willing to commit itself to a timetable ofchange, marking a distinct shift from the ad hoc andexperimental approach that had characterised the previ-ous passage of reforms.
Foreign investment grows—and grows up
The development of a larger, wealthier and more sophisti-cated market, together with the emergence of a much-improved and more accessible business environment, hasled to an associated broadening and upgrading of theactivities of foreign companies in the country. Annual for-eign direct investment (FDI) inflows, for example, haverisen consistently since 2000, reaching US$52.5bn in 2003according to the Ministry of Commerce. This increase is all
Foreign firms are important% of total industrial output
the more impressive when set in the context of global FDIflows, which plummeted by almost 50% in 2001 and thenby a further 27% in 2002. In 2002 China overtook the US asthe destination for more FDI than any other country in theworld. China lost the top spot in 2003 when inflows intothe US rebounded by more than US$50bn but remainedthe second-largest destination for FDI in the world.
The sources of FDI have diversified dramatically, too.In 1992 Hong Kong, Macau and Taiwan between themaccounted for nearly 80% of all FDI. This share has almosthalved since then, with the proportions of US and EUinvestment more than doubling to around 22% of thetotal, Japan’s rising a little to around 7-9%, and SouthKorea and Singapore now both accounting for around 5%each.
It is not just the quantity and diversity of FDI that haveincreased; manufacturing investments in China have alsosteadily moved up the value chain. The toy and garmentmakers from Hong Kong and then Taiwan that were thepioneers of foreign investment in the 1980s and 1990s
have been joined by their IT-making counterparts.According to the MIC, of the total global computer-relatedproduction of Taiwan firms, the proportion manufacturedin factories on the mainland rose from just 31.3% (worthUS$14.7bn) in 2000 to over 60% (totalling US$35.2bn) in2003. Multinational companies from other countries havealso been jumping on the China bandwagon by setting uplight manufacturing facilities in the country, as havesmaller foreign firms. Indeed, there is currently a trend ofsmall and medium-sized enterprises (SMEs) from the OECDwith no experience of any market outside of their homeeconomy seeking to set up shop in China. In many casesthese SMEs seek to lower production costs to competewith the wave of cheap, China-made products that areappearing in markets in the US and Europe.
Capital-intensive firms with huge investment planshave also begun to arrive in China. Five years ago, in thewake of Asia’s economic crisis and less than a decade afterthe 1989 Tiananmen crisis, long-term planning had a pro-visional feel to it. Today, companies are not shying away
China is the world’s foreign direct invest-ment (FDI) powerhouse. But China has notsought FDI because it is short of money. Thecountry has one of the highest householdsaving rates in the world, with the banks sit-ting on personal savings of Rmb10.4trn(US$1.3trn) at the end of 2003. As an econ-omist, Yasheng Huang, points out in hisstudy of the role of FDI, Selling China: “Theneed for FDI as a source of financing is defi-nitely not present in China.” China, as wellas being the world’s largest FDI recipient, isalso one of the world’s largest exporters ofcapital, mainly through its investment in USTreasury bonds.
With so much money sloshing aroundinside China, why has the government beenso eager to attract FDI inflows? Of course,FDI projects often involve a transfer ofvaluable technology and managementexpertise, in addition to an inflow of funds.But in China, this is not the end of the story.According to Mr Huang, China’s huge FDIinflows can be interpreted as a signal ofpolicy failure rather than unadulteratedeconomic success. The US-based academicargues that state-owned banks have
traditionally based their lending decisionson government instruction, rather thanmarket forces. As a result, banks havetended to make loans predominantly tostate-owned enterprises (SOEs) and otherofficially supported projects, with little orno concern as to whether the borrowerswould be able to make repayments.
In addition to causing a huge stock ofnon-performing loans, this state bias hasmade it more difficult for China’s up andcoming private sector to win loans from thebanking sector. The World Bank’s privatecapital arm, the International FinanceCorporation (IFC), in its 2000 report,China’s Emerging Private Enterprises, foundthat even when “compared with theircounterparts in other transition economiesChinese firms appear to depend to a largerextent on internal sources of finance andhave more limited access to bank loans”. Inthis situation, China’s buddingentrepreneurs have been forced to lookeither to their own networks—friends andrelatives—or overseas for capital. Foreignmoney, however, is not a perfect substitute.To gain the backing of foreign firms, private
firms in China have had to pay with equity,making this a far more expensive form offinancing than ordinary bank loans.
The emerging private sector has notbeen the only recipient of foreigninvestment. During the 1980s and 1990sforeign firms also invested huge sums to setup joint ventures with SOEs. Mr Huangargues that these ventures have been lesspartnerships than acquisition vehicles, inwhich “SOEs have turned over their existingbusinesses and management controls tomultinational companies and have become,in many instances, passive shareholders”—this was, in other words, a “veritableprivatisation process”.
Even this process produced a less thanoptimum aggregate result for the Chineseeconomy. SOEs in need of money had littlechoice but to seek deals with foreign firmsbecause ideological issues prevented thegovernment from adopting an officialprivatisation policy—one that would haveopened up the process to domesticinvestors. This reduced competition and,consequently, the sale prices of state-owned assets.
How many times does a business need tochange its strategy to get things right inChina? Probably quite a few. Many compa-nies have found their initial assumptionswere simply wrong, and even if they weren’t,the market has changed so much and so fastthat rethinks may well be called for everycouple of years.
Take the US bearing maker, Timken, forexample. Like many companies, it came toChina aiming to sell into the local market. Itbegan by setting up a joint venture at Yantai,on the Shandong peninsula, in 1996 tomanufacture automotive bearings.
This didn’t work. The company foundlarge state-owned enterprises difficult towork with. Not only were they not willing topay for anything which looked like a service,but often they were not willing to pay foranything at all.
This created enormous problems forTimken, so it switched its initial “local forlocal” strategy—local production for thelocal market—to “local for transplant”—meaning it followed its global customers andwould sell to them if they were in China.
This seemed to hold better prospects,especially when it teamed up to sell toBeijing Jeep, a joint venture betweenBeijing Automotive and Chrysler (since 1998
DaimlerChrysler), to sell it hub units.But this also didn’t work. After the Asian
financial crisis of 1997-98, automotivedemand in China slowed and volumeremained too low for Timken to be profitablein China.
So once again the company changedstrategy, in its third phase going for a “localfor export” strategy—making goods forChina for sales overseas.
Finally, the company found the rightstrategy: 70% of its output is now exported,largely to Europe. And it has set itself a100% export target for its newest plant, ajoint venture with a Japanese bearingmaker, NSK, in Suzhou, which is due to gointo operation this year.
Demand now in China, too
At the same time, however, demand forTimken products in China has grown enor-mously—particularly because of the massiverise in capital investment and infrastructurespending funded by the government overthe last five years.
This demand is satisfied with importsfrom Timken plants elsewhere—for high-costitems made in the US, or in machinery andequipment made elsewhere but which haveTimken bearings inside.
This market is both attractive in its ownright and has long-term potential for after-sales service—especially given China’s toughoperating conditions. Just how muchdemand has grown—and how fast—is spelledout in the rise in the number of people inTimken’s Shanghai office: from three at theend of 2002 to 40 by the end of 2003 after itopened its own distribution centre inShanghai’s Waigaoqiao Free-Trade Zone.
The way Timken’s strategy has evolvedhas some advantages. Its operations inChina are insulated from any slowdown inthe economy, although its sales to Chinafrom abroad would be affected. However,the company is hurt by the changes inChina’s tax rebate rules—lowering its rebateon value-added tax paid on exports from17% to 14%—meaning that China will beone of the few countries which taxesexports. (It is worth noting that Timken’spayments, at least for a while, will at least benotional: the company is owed US$5m inback rebates.)
But most significantly, to get to where itis now Timken has had to change its thinkingand strategy three times in just eight years—fair going for a company that has thereputation of being traditional in itsoutlook.
Timken’s export niche
from projects with long time horizons, requiring largecapital investments. BP, Shell, BASF and ExxonMobil, forexample, are all involved in large multibillion-dollarpetrochemical projects in China. Between 2001 and 2005BASF plans to invest Euro2bn alone and Euro4bn togetherwith joint-venture partners. Since 2001 almost all of theworld’s major vehicle manufacturers have announcedplans to either start plants in China or extend existingones. The investment plans of just three firms, the currentmarket leader, Volkswagen (VW), together with twoJapanese companies, Nissan and Toyota, total more thanUS$10bn. Huge spending by foreign firms has also playedan important role in the improvements in China’s trans-port network that have been achieved in recent years. TheGerman firm, Siemens, hoping to roll out the technologyon longer routes around the country, built the US$1.2bnmaglev train link in Shanghai, and foreign operators likeHong Kong’s Hutchison Port Holdings and the UK’s P&O
have been instrumental in the upgrading of China’s ports. Service-sector firms that were previously kept out by
government restrictions and lack of a market are alsobeginning to make their mark. In the last couple of yearsforeign asset management firms have begun for the firsttime to sell investment funds in China, and internationalaccountancy firms have been seeking to strengthen theirpresence in cities, including Shanghai. Internationalbanks like HSBC, Citigroup and Standard Chartered arestill heavily restricted but have established small retailnetworks in China, as have less well-known foreign play-ers like Hong Kong’s Bank of East Asia. Retailing giantslike Carrefour and Walmart are rolling out nationwidestore networks, and the British homewares chainstore,B&Q, which only established its first store in China in1999, plans to have 75 outlets across the country by 2008.As with so many firms, B&Q began its China operations inShanghai. But it quickly chose to move into the interior,
opening a store in the south-western city of Kunming in2001 and the central city of Wuhan in 2003. It is not onlythe retailers that are expanding away from the relativelytried and tested southern and eastern areas of the countryto investigate opportunities in the centre and west. TheUS insurance firm, Liberty Mutual, decided to establish itsChina general-insurance venture in Chongqing, a hugemunicipality in the west of the country.
Growing influence of foreign firms
This picture of an economy in which foreign firms areestablishing an ever-larger foothold—and having greaterinfluence on the local economy—is supported by bothmacroeconomic and sectoral statistics. The proportion ofChina’s exports manufactured by foreign-invested enter-prises (FIEs, traditionally any firm where foreign owner-
ship exceeds 25%) rose from an already high 41% in 1997to almost 55% in 2003. It is little exaggeration to say thatChina’s rise up the table of the world’s largest exportershas been fuelled by foreign money: FIEs accounted foralmost 66% of the US$256bn absolute increase in thevalue of China’s exports recorded in this period.
Admittedly, it is in the export sector that foreign firmshave had the clearest impact, but foreign firms have alsobeen establishing themselves in the domestic economy.Even excluding enterprises supported by money from HongKong, Macau and Taiwan, FIEs still generated 17% ofChina’s total industrial output in 2002. If firms from else-where in Greater China are defined as foreign, the propor-tion of output generated by FIEs rises to almost one-third.A large amount of this production is exported but nearly60% is not, instead being sold in China’s domestic market.
Notes: % of global sales. For VW and Coca-cola, figures are based on volumes rather than values. HSBC figures refer to loans and advances. Data for P&G and Novartis are estimates. % of relevant market. For Danone the statistics are estimates based on the market for bottled water. Nokia figures refer to the handset market, Coca-cola to the carbonated drinks market, P&G to shampoo, and HSBC to bank lending.
Source: Economist Intelligence Unit; Euromonitor; company reports; media reports
Foreign companies have a growing influence on thedirection of the Chinese economy. Many firms have a big-ger say in the running of their own companies as well,owing to the growing prominence of wholly owned, for-eign-invested operations. In the 1990s the joint venture(JV) was the principal vehicle by which foreign companiesentered China. In the early to mid-1990s JVs accounted foraround 75% of all foreign investment. These arrangementsallowed multinational companies (MNCs) to establish jointventures with local firms, giving them the opportunity toaccess China’s market. But, more often than not, the joint-venture structure denied foreign firms management con-trol over their domestic investments. Horror storiesabounded and the caricature of Sino-foreign co-operationbecame that of famed MNCs watching almost powerless asthe joint venture piled up losses, while the local partnerstole expertise and intellectual property.
By the early 2000s, however, JVs had been pushedaside by wholly owned operations, which now account formore than half of the foreign investment entering eachyear. The reasons for this change are various but they canbe summarised as a much more relaxed attitude on thepart of China’s authorities to allowing foreign companiesto operate in their country, combined with the desire ofalmost every locality to attract as much foreign invest-ment as possible. While the government has made nosecret that it wants to see Chinese companies emerge asthe eventual winners from the country’s market opening,it has also consistently maintained that foreign compa-nies have a major role in this process. Foreign companiesbring capabilities, skills, technologies and expertisewhich domestic companies lack and, through competi-tion, can compel Chinese companies to improve andstrengthen themselves.
For many of the recently opened service sectors, suchas retailing and parts of the financial services sector, for-eign firms are still restricted to investing in China onlythrough JVs. Overseas executives operating in these sec-
tors tend to put on a brave face, claiming that their busi-ness partnerships are sound and their choice of JV partnercorrect. Managers of manufacturing firms are more san-guine and with good reason: not only do they have moreexperience dealing with JVs, many of them no longerneed to deal with this bothersome regulation at all. Theliberalisation and opening of the economy over the lastfew years has allowed many foreign firms more latitude toestablish wholly owned enterprises in China. Many over-seas firms have jumped at this chance, buying out part-ners in existing JVs or making new investments on awholly owned basis.
No longer bound to disappoint
The experience of foreign businesses in China is no longercharacterised exclusively by failure. One respondent toour survey stated that there is “a much stronger percep-tion of both strategic importance and the possibility tosucceed” in China. Over 43% of respondents to our surveyreported that their China operations were either outper-forming or outperforming by a wide margin. Also, leadingMNCs are now well represented in some of China’s fastest-growing sectors. According to Beijing-based Norson Tele-com Consulting, in 2003 sales by foreign firms accountedfor 56% of all mobile handsets sold in China. Through JVswith domestic firms, foreign brands also dominate China’scar market, with VW alone taking a market share of30.8%. In the fragmented pharmaceutical market, for-eign companies are thought to have a market share of 20-30%. In the similarly fractured retail market, Ministry ofCommerce figures show that Carrefour has become thefifth-largest player in China. The photographic film indus-try is more consolidated and is dominated by the US’sEastman Kodak.
China has also become an important market for someleading MNCs. One executive who responded to our surveyindicated that “China has grown into one of our mostimportant markets in terms of turnover and sales…China
Roughly what proportion of your company‘s global revenue is generated in China?(% responses)
6-10% 15.71-5% 51.5
More than 31% 7.8
Less than 1% 11.3
11-30% 13.7
6-10% 24.01-5% 30.5
More than 31% 13.5Less than 1% 3.5
11-30% 28.5
What do you expect the proportion to be in five years‘ time? (% responses)
Source: Economist Intelligence Unit survey, March/April 2004
is now and will remain the main growth market for thenear/medium-term future.” These comments were echoedby other respondents and are reflected in individual com-pany results. In 2003, for example, 13.9% of VW’s world-wide sales were achieved in China, more sales than in anyother market except Germany. China in 2003 was Nokia’sfourth-largest market (trailing the US, UK and Germany),generating revenue of Euro2bn, equivalent to almost 7%of the company’s worldwide sales. China is Motorola’slargest market outside of the US, generating sales for thecompany in 2003 of US$4.7bn. In 2003 Siemens madesales totalling Euro2.8bn in China, accounting for around4% of total global sales. In the same year China generatedsales for the French food group Danone of over Euro1bn,equivalent to 8% of the global total.
There are big sectoral differences in the importance ofChina as a global market for foreign firms. The China busi-ness of the world’s leading pharmaceuticals companiesand financial- and professional services firms remains verysmall on a relative basis. For example, China accounts for
less than 1% of the total sales of Novartis and the totalconsumer lending of HSBC. This sectoral diversity isreflected in the results of our survey. For 26% of respon-dents, the figures was 1% or less; for 62% of respondents,it was 5% or less; and for 78%, it was 10% or less. How-ever, for a respectable 15%, the answer was 20% or more.If the companies that earn a high proportion of their rev-enue from China are stripped out—on the assumption thatthese companies are essentially “China” companies ratherthan global ones—nearly one-quarter of respondentsindicated that they derived between 10% and 35% of theirglobal revenue from China.
What is noteworthy, however, is how the respondentssee their revenue changing over the next five years. Thenumber of respondents seeing China accounting for 5% orless of their global revenue drops from 62% to 35%,whereas 35% see it accounting for 10-25% and 31% formore than 20%—double the number today. If currentexpectations are borne out, the sectoral disparities thatare currently so evident will not be as obvious in a few
It is accepted wisdom that the China accountsof almost all foreign firms drip with red ink.Executives in multinational companies(MNCs), dazzled by the prospect of selling toone billion consumers, have failed to noticethat few of these people actually earn muchmoney, that selling even to this group ismade difficult by the country’s poor infra-structure and that any resultant profits wouldbe siphoned off by corrupt local officials. His-torically, this perception has not been farfrom the truth. It is not difficult to uncover anumber of horror stories detailing the misad-ventures of foreign firms that have overesti-mated the size of the domestic market andunderstated the difficulties of accessing it—and ended up losing lots of money.
But China has not been nearly theunmitigated disaster for foreign firms thatthese stories suggest. Many big Westerncompanies have found the going tough butthe China operations of lots of companiesfrom Taiwan and Hong Kong have beenhugely profitable. Although many MNCs havelost money trying to sell to the domesticmarket, they have made a great deal byusing China as a sourcing and export base.
This aspect of foreign firms’ businessesin China is often overlooked because it isdifficult to record. The financial gainsgenerated by cheap sourcing in China areimpossible to document because they showup not as an item in their own right butrather in the profits MNCs make in theirtraditional markets in the US and Europe.Similarly, that the export operations offoreign firms often show little or no profit isless a reflection of reality than of transferpricing as foreign firms attempt to avoidcapital controls and taxes in China.
It works like this. Imagine that a parentcompany in the US receives an order from aEuropean customer for 1,000 notebookcomputers at, say, US$700 each. Assumealso that the computers cost US$600 a unit.Typically, the parent company wouldsubcontract its factory in China to producethis order and pays it US$610 for each unit(foreign firms know that a factory operatingat a loss would be suspicious and so attractthe unwanted attention of officials). This isthe value of the export from China, althougha change of invoice en route means it entersthe US at US$700, which is the price the
European customer pays directly to theparent company in the US. In this way, theUS firm keeps most money offshore. Soalthough official records may show theChina factory is making a profit on the dealof US$10,000, in reality it has generated netearnings of ten times that amount.
The money multinational companiesmake from using China as a sourcing andexporting base might be difficult to tracebut it is far from negligible. Wal-Mart buysmore than US$12bn-worth of goods in Chinaevery year, Motorola’s sourcing in thecountry totalled US$2.8bn in 2003 and GEplans to raise sourcing in China to US$5bnby 2005. Moreover, more than 50% ofChina’s total exports, equivalent toUS$240bn in 2003, are produced in foreign-invested factories.
The focus of this report is howmultinational firms are approaching China’sdomestic market. But it is important toremember that when trying to assess theiroverall performance China, it makes lesssense to ask how much money foreign firmshave made in the country than how muchthey have made from it.
years time. For example, managers at one of the world’sleading asset management specialists, Franklin Temple-ton, believe that, based on current growth rates, Chinacould become one of their most important internationalmarkets in five years time, and KPMG thinks its Shanghaioffice will be one of its biggest in the world within tenyears.
Importantly, some firms are also now beginning toearn money from their domestic market operations. Thedegree of success depends to a great extent on the sector.Profitability is most apparent in the industrial sectors thatwere first opened to foreign investors and that have beenfurther liberalised over time. In the service sector, by con-trast, foreign firms are only just gaining the opportunityto access the market and even then only on a veryrestricted basis. Nevertheless, in a survey of their mem-bers, the American Chambers of Commerce in Beijing andShanghai found 75% declaring themselves to be eitherprofitable or very profitable in 2002. VW’s Chinese jointventures generated net earnings of Euro561m in 2003compared with total group operating profit ofEuro1,780m.
Detailed profit breakdowns of this kind are difficult tocome by but other evidence at least suggests that, for for-eign firms, China’s domestic market is no longer synony-mous with losses. As explained by an executive in aconstruction firm that responded to our survey, China ismoving “from an emerging market to an important profitcentre”. Another company stated that the “perception ofChina has changed from a drag on the bottom line to amajor contributor”. Moreover, a recurring theme amongmany respondents was that, having been given time toestablish themselves, China operations were nowexpected to move towards profitability or, where theywere already profitable, to increase their margins. Typicalwas the comment: “Changing from top line growth tomore focus on profitable growth.”
Given all the changes that have taken place in the Chi-nese market, it would be surprising if foreign firms hadnot begun to look at China in a different light. More than50% of respondents to our survey stated that China was“critical to global strategy”, with another two-fifths ofcompanies reporting that it was “strategically important”.Only 6% of firms thought of China as “a location on a parwith other emerging markets”. “The importance of theChina market has been recognised by every key decision-maker in headquarters, and operation has been re-engi-neered to accommodate this mindset change,” explainedone respondent.
In a reflection of the importance attached to theirChina businesses, big firms have been upgrading manage-ment structures in the country. Companies that were pre-viously represented in China by managers of individual
How many times has the global CEO of your company visited China in the last 12 months? (% responses)
No visits 21.8More than 5
visits 6.5
3-5 visits8.8
1-2 visits63.0
Where does your China CEO fit within your global decision-making structure? (% responses)
As head of the China business, reporting into the regional headquarters34.7
Other 9.9
At the levelof the global
board 13.6
As head of theAsia-Pacific
regional business,reporting into
the global board16.0
As head of the China business, reporting into the global board 25.8
From the perspective of your global headquarters, China is... (% responses)
...a locationyour company
is still onlyexploring
1.4
...a location on a par with otheremerging markets5.5
...strategicallyimportant,but not critical40.6
...critical to global strategy
52.5
Source: Economist Intelligence Unit survey, March/April 2004
joint ventures have been appointing more senior countryheads. In 2000 HSBC relocated its mainland China head-quarters from Hong Kong to Shanghai. Other large firmshave moved regional headquarters to China. Of companiesthat took part in our survey, only around 35% stated thattheir China management was subordinate to regionalheadquarters. The remainder said that their China CEO hadaccess to the global board, either through membership ora direct reporting line.
Managers of China businesses often find that they havethe ear of senior global executives even more than wouldbe suggested by formal reporting lines—and sometimesmore than they would want—simply because many CEOscannot stay away from China. Almost fourth-fifths of com-panies that responded to our survey said that their globalCEO had journeyed to China at least once during the lastyear, with over 15% of firms saying the top boss had vis-ited more than three times. Admittedly, our sample doesinclude some foreign firms that look more like China busi-nesses than multinationals, but anecdotal evidence con-firms that the heads of even some of the largestcompanies in the world find their way to Beijing or Shang-hai from time to time. Despite having been chief executiveof Citigroup for only seven months, for example, CharlesPrince has already visited China three times.
A new environment
To sceptics, all the enthusiasm over the Chinese markethas worrying echoes of the naivety that fuelled the firstflood of foreign investment to China in the 1980s and1990s. Such concerns are not without justification and, aswe will argue, ensuring expectations remain rooted inreality is one of the most important challenges facingmultinational companies in China. Nonetheless, for manyleading foreign firms it would be reckless not to devotemore senior management time to China. As one respon-
dent to our survey explained, “Five years ago, China wasan interesting market possibility. Now it is central to oursuccess.”
This is partly all a function merely of volume. With lead-ing companies now spending significant sums sourcinggoods in China, managing factories that account for largeproportions of global corporate output and beginning tosell more to the domestic market, the country matters in away that just was not the case ten or even five years ago. Itis now of global importance that multinationals get theirChina strategies right.
At the same time, succeeding in China is no longermainly a case of addressing the operational issues that pre-occupied multinationals in the 1980s and 1990s—an over-burdened infrastructure, excessive regulation, shortages ofhuman capital and intellectual property rights. None ofthese issues have disappeared and indeed form the focus ofthe third chapter of this report. But neither are they the all-consuming problems that they once were. The businessenvironment in China has improved. In any case, the biggermultinationals, now with several years of experience operat-ing in the country, have a good on-the-ground understand-ing of just how to run operations in China.
But merely producing a good and shipping it to marketis no longer enough for foreign firms wishing to be suc-cessful in China. This is because it is not just in terms ofraw spending power that China has begun to resemble areal market in recent years. It is also in the emergence ofcompetition. Other MNCs, SMEs from the OECD, large com-panies from other Asian countries and ambitious localfirms all see their future in China’s domestic market. It isno exaggeration to say that China is turning into the mostcompetitive market in the world. For MNCs wishing to sellwithin China, it is this competitive element that posestheir biggest challenge. In the next chapter we turn to theadvent of competition.
The very visible growth of demand within China inthe last few years has made building a domesticbusiness not only feasible but also essential for anyperformance-oriented multinational company
(MNC). These days, a truly global company would no moreignore China than it would the UK or France.
Just as demand has emerged, however, so has compe-tition. The MNCs that first tested the waters of the domes-tic market in the 1980s and 1990s faced many challenges,but a crowded market was generally not one of them. Butas China moves from being a peripheral to a mainstreameconomy, other foreign firms are joining their pioneeringcounterparts. MNCs must also now contend with the riseof local competitors, which have emerged quickly and
fight dirty, often stressing investment and market sharerather than productivity and profit, and using below-costpricing to achieve their aims.
Fortunately, accompanying the rise of demand andcompetition has been the emergence of strategic optionsfor foreign firms wishing to fight back. An increasinglysophisticated business environment is giving MNCs theopportunity to use sophisticated brand-building and mar-keting strategies. Infrastructure improvements have madeit possible for foreign firms to move production to thecheaper, inland areas of China and thus begin to emulatethe cost structures of their local counterparts. Finally, andperhaps most critically, the emergence of a local marketfor mergers and acquisitions (M&A) is allowing big foreign
Part 1
Addressing the market
● Foreign firms in China now face strategic challenges. Compe-tition, which in many markets was almost non-existent in the1980s and 1990s, is becoming intense. Big multinationalcompanies, smaller firms from Europe and the US, ambitiouscompanies from the rest of the Asia region and domesticplayers all want a slice of the market.
● The challenge from up and coming domestic companies is themost intense. Competing against these firms is difficultbecause they have the advantage of operating on their hometurf and often seem to fight dirty, stressing investment andmarket share rather than productivity and profit, and usingbelow-cost pricing to achieve their aims.
● The development of China’s market has not just generatedcompetition. It has also opened up new ways in which multi-nationals can respond to this challenge. Foreign firms arehaving more opportunity to bring their sophisticated brand-building capabilities and marketing techniques to play in theChina market. This is true even for firms in regulated sectorslike pharmaceuticals.
● Multinational companies are now also more able to engage incomprehensive localisation and thus bring their costs moreinto line with those of domestic firms. Borrowing fromdomestic banks, moving production facilities inland, sourc-ing inputs from within China and expanding local productdevelopment are all strategies that are being employed tonarrow the cost gap.
● Regulatory changes are giving multinationals that enteredChina in the 1980s and 1990s the opportunity to consolidatecontrol of their Chinese ventures. Foreign firms are alsostarting to use mergers and acquisitions in the same waythat they do elsewhere, to accelerate growth or buy outcompetition.
● Multinational firms do not always manage to bring theirstrategic planning strengths to bear in the Chinese market.In particular, while the foreign business community in gen-eral is becoming less naïve, many companies still seem totake leave of their critical faculties when judging the size ofChina’s market.
firms to buy up local competitors. Not all foreign firms are in a position to exercise these
options fully. Ownership restrictions, for example, limitM&A in the automotive and financial services industriesand foreign pharmaceutical firms continue to be heavilyregulated. Nevertheless, for a whole range of multination-als in China, the focus of management attention hasmoved. The operational problems that were such a pre-occupation in the 1980s and 1990s (see the followingchapter, Persistent headaches) are no longer the onlyissues taxing the time of executives. Instead, managersare spending more time thinking about the kind of strate-gic planning and development issues that tend to pre-occupy their counterparts in more developed markets.
Changing competitive landscapeIt was the experiences of big multinationals trying to tapthe local market in the 1980s and 1990s that fuelled thewidely held perception that foreign firms in China areprone to losing money. Suffocated by regulations, frus-trated by the weaknesses of the transport network anddisappointed by an apparent lack of spending power,many of these companies quickly changed tactics, eitherwithdrawing from China altogether or refocusing localproduction for export.
Not all companies were forced out. But even those thatpersevered found that basic operational issues, ratherthan strong competition, posed the biggest challenge totheir business. In many consumer-goods sectors therewas no competition of any kind. Before the early 1980s,for example, shampoo did not exist in China; regular soapwas used to clean hair. According to International Flavors& Fragrances (IFF), as late as 1984 there were just fiveshampoo offerings in China’s market. In other sectors,such as insurance, domestic suppliers did exist but only inthe form of monolithic state-owned enterprises (SOEs),institutions that were about as far removed from beingconsumer-oriented and profit-seeking firms as it is possi-ble to imagine.
In this environment, foreign firms achieved high mar-ket shares. Leveraging their production technology andmarketing skills, foreign firms quickly dominated any mar-ket in which they were given relative freedom to operate.In the 1980s and 1990s MNCs like Procter & Gamble andUnilever virtually controlled China’s detergent and sham-poo markets. In the mid-1990s three foreign-investedjoint ventures (JVs), two involving Volkswagen (VW) andone Daihatsu/Toyota, controlled more than two-thirds ofChina’s car market. The take-off of the mobile-handsetmarket in the second half of the 1990s was dominated byforeign firms like Motorola and Nokia. In the mid-1990sAlcatel’s Shanghai Bell joint venture was making morethan half of the switches for China’s fixed-line telephone
network. Many foreign companies quickly took advantageof this rather unnatural market, in which competition wasvirtually absent.
The current challenge How quickly things have changed. Competition in mostsectors is now intense. In recent years multinationals thateither left or did not try to enter the market in the 1980sand 1990s have joined their now well-established compa-triots. Less well-known regional firms have also piled in.For these firms, which come from small home economiesand have found it difficult to penetrate the rich butmature markets of the OECD, China’s large market repre-sents a unique opportunity to establish a brand. Apparelretailers from Hong Kong like Espirit, Baleno, Bossini,Giordano, Jean West and Moiselle are common features ofshopping districts from Beijing to Chongqing. Taiwancompanies like Giant (bicycles) and Tony Wear (a men’sclothing brand established by Tainan Enterprises) are nowleading players in China.
China’s domestic firms have also moved quickly intothe home market. Initially shell-shocked by the arrival offoreign competition, local companies now seem to be rel-ishing the fight. The survey conducted for this reportfound that nearly two-thirds of respondents identifieddomestic competition as either significant or very signifi-cant. According to IFF, the number of shampoo offeringsin China’s domestic market has increased exponentiallyfrom the five found in 1984 to over 2,000 in 2003. Duringthe same period the number of toothpastes rose from 100to almost 800. Twenty years ago China had no fruit juicesuppliers, but now there are over 160.
The emergence of this new challenge is partly theresult of government policy. Chinese officials have estab-lished real companies in markets like insurance which pre-viously operated like extensions of the governmentbureaucracy. Existing SOEs have been partly or even fullyprivatised and, consequently, have begun to judge suc-cess using financial rather than social criteria. Finally, inrecent years, China’s official ideology has become increas-ingly less hostile towards the private sector. Private firmsstill face discrimination when, for example, they seek toborrow from China’s largely state-owned banking sector.But a burgeoning capitalist sector has nonetheless begunto emerge: government statistics show that the number ofprivate firms with annual sales over Rmb5m (US$600,000)rose from under 15,000 in 1999 to almost 50,000 in 2002.
The market for foreign firms in China is increasinglychallenging. According to Euromonitor, a global marketresearch company, the domestic Diao brand now domi-nates China’s detergent market with a share of almost25%. Unilever’s Ono brand now stands in third place, witha share of just 10%. The reversal of fortunes for foreign
The threat posed to multinational compa-nies (MNCs) by Chinese firms no longer endsat China’s borders because, in recent years,larger Chinese firms have increasingly beenexpanding overseas. China’s most promi-nent multinational has been the conglomer-ate Haier. In addition to having offices andfactories in more than 100 countries, Haierclaims a sizeable market share in the US forsmall fridges (30%) and wine coolers(50%), not to mention a 10% share inEurope’s airconditioner market.
More recently, Haier has been joined byTCL, another final-goods producer, thistime of telephones and electronicsappliances. TCL’s strategy has been toexpand by acquisition. In 2002 it purchasedthe assets of a bankrupt German televisionproducer, Schneider Electronics. This wasfollowed in late 2003 by an agreement witha French firm, Thomson, to establish a jointventure to produce televisions and DVDplayers. In April 2004 TCL teamed up withyet another European firm, this timeFrance’s Alcatel, to form a joint venture tomanufacture mobile-phone handsets. TCL’sinternational deals in particular have beenquite high-profile.
Attracting less attention from generalobservers has been the overseas expansionof China’s business-to-business firms.Leading the charge has been China’s leadingmakers of telecommunications equipment,Zhongxing Telecom (ZTE) and HuaweiTechnologies. Huawei claims itsinternational revenue rose by 90% in 2003to just over US$1bn. In 2003 a localconglomerate, China National Bluestar,launched a bid (ultimately unsuccessful) tobuy Ssangyong Motors of South Korea.China’s biggest overseas investors in recentyears have been the country’s leadingenergy firms, China Petrochemical Corp(Sinopec), Petrochina (the listed arm ofChina National Petroleum Corp, or CNPC)and China National Offshore Oil Corporation(CNOOC). The three companies haveinvested in 14 countries, includingKazakhstan, Yemen, Sudan and Myanmar.
The international expansion of these and
other firms has been led by several factors.Not surprisingly for China, governmentpolicy has been one, with officialsencouraging overseas investment both tosecure oil and other resource supplies and,more recently, to offset the strong capitalinflows that have been generating pressurefor a revaluation of the exchange rate.
Going internationalThe overseas expansions of firms like TCLand Huawei are also being motivated by thesame factors that drive the internationalstrategies of companies everywhere:crowded markets at home and raw businessambition. According to the head of Haier,Zhang Ruimin, after entry to the World TradeOrganisation (WTO), “every multinationalset up in China. Margins are low here. If wedon’t go outside, we cannot survive.”
Expanding by acquiring the assets ofOECD companies, the approach followed byboth TCL and Bluestar, demonstratesincreasing confidence on the part of Chinesefirms. But it is a strategy that is stillrelatively uncommon. Indeed, the approachused by many local companies to moveoffshore is not dissimilar to that used toexpand within China itself. Just as manyindigenous firms started out at home bytargeting the less-demanding lower-end ofthe domestic market, so companiesexpanding overseas have tended to begin inother developing countries where price isoften the single most critical element in anypurchasing decision. It is no coincidencethat of the ten existing markets highlightedby ZTE on its corporate publications, four arein Africa, with a fifth located in Bangladesh.
According to our survey, foreigncompanies do not yet see their Chinese
counterparts as much of a global threat. Butthis is beginning to change. Some 16% ofcompanies that responded to our surveysaid they expected Chinese companies topose a major threat to their internationalbusiness in five years, with a further 50.5%expecting them to pose something of athreat. MNCs are already beginning to loseout to Chinese companies in other emergingmarkets. For example, in recent yearsHuawei and ZTE have both beaten outleading European and US equipmentsuppliers to establish a foothold in theIndian market (in an example of the extentof the competitive challenge posed byChinese firms, one of ZTE’s recent winningbids in India came in at half the priceoffered by Motorola and one-fifth that ofEricsson). But just as in China itself localfirms quickly migrated from the low end ofthe market to the middle and high end, sothe likes of Huawei and ZTE are beginning tochallenge European and US firms on theirhome soil. In April 2004 Huawei won acontract to supply equipment to BanverketTelenät, a network service supplier inSweden.
Nevertheless, the globalcompetitiveness of Chinese firms should notbe exaggerated. Sectors like telecoms andoil where the domestic market is large andconsolidated enough to support the growthof powerful local conglomerates remain fewand far between. Even China’s biggestcompanies tend to trail their foreigncounterparts in terms of technologyprocesses and management. Finally, withstandards of corporate transparency inChina being generally poor, it is difficult toassess how successful the internationaloperations of local firms are, and how muchthis is the result of good management andhigh levels of corporate efficiency ratherthan the support of the government andbanks at home. Perhaps paradoxically, thetrue competitiveness of China’s buddingmultinationals will only become clear whengrowth in their home market begins to slowand the country’s banks apply morestringent lending criteria.
China’s multinationals
How much of a threat will domestic companiesbe to your business globally in five years’ time? (% responses)
A serious competitive threat 15.9Somewhat of a competitive threat 50.5Not a threat 33.2Other 0.5
Source: Economist Intelligence Unit survey, March/April 2004
firms in other markets has been just as dramatic. In 2003the 30 firms that offered more than 700 different kinds ofmobile phones in China were mainly domestic. Accordingto Beijing-based Norson Telecom Consultancy, domesticfirms now control around 45% of the market and havepushed the market share of European and North Americanvendors to below 50%. In the consumer-durables market,Haier, a company that started off making refrigerators buthas recently entered the mobile-phone market, claims tohave a 30% share in the domestic market for refrigerators,freezers, airconditioners and washing machines. The abil-ity of local firms to win market share has been so pervasivethat some observers consider it only a matter of timebefore foreign domination of the automotive sector isbrought to an end.
More than a typical home advantageForeign executives are often full of praise—tinged with adose of fear—for the entrepreneurial spirit of China’s com-panies. The rise of the country’s capitalist class is oftenportrayed as a natural phenomenon, with regulatory lib-eralisation freeing up a cultural propensity to trade thatwas so visibly on display in China a century ago, but wasthen stifled by 50 years of communist-style central plan-ning. There may be an element of truth to this theory butthe competitiveness of local firms also owes much to fac-tors that are more easily quantified.
As is the case with indigenous companies everywherein the world, local firms have a home-turf advantage. Theyknow how to do business in China and are much morecomfortable than foreign firms navigating through thecorruption and regulatory grey areas that remain such animportant feature of the country’s business environment.Local companies also do not have to support the salariesof expensive expatriates and are generally in a strongerposition to know how and where to find talented staff andsuppliers.
Local firms, at least those that are more prominent, alsobenefit from easy access to bank capital. That banks arewilling to be more supportive of companies they know wellis hardly a phenomenon unique to China, although theunderlying importance of guanxi—cultivating personalrelationships—in the business environment probablymakes the relationship element of banking stronger inChina than elsewhere. Still, guanxi alone does not explainthe easier access to, or lower cost of, capital offered to localfirms. The banking system does not yet function on a fullycommercial basis. Wanting to raise local economic growthand thus their own chances of promotion, lower-level offi-cials often pressure banks to lend to local firms. More gen-erally, despite the aggressive bank reforms pursued by thecentral government in recent years, the enforcement of riskmanagement procedures in the banking sector remains
inadequate. The overall result? According to business con-sultants, for many domestic companies in China the cost ofcapital is low if not wholly non-existent.
Local knowledge, access to cheap bank capital that hasallowed the ramping up of capacity, together with a no-frills approach to service, give local firms operating coststhat are almost universally lower than those of foreigncompanies in China. Worse still, local firms seem willing toaccept profit margins that are well below those generallydemanded by their overseas counterparts. In general,success for domestic companies appears not to be meas-ured by profit margins at all but by market share. As aresult, local firms are able and willing to price goods at avery low level. Of the foreign companies that responded toour survey, almost two-thirds identified lower prices asthe main competitive strength of domestic companies.
Meeting, and being beaten, in the middleThe initial strategy followed by most foreign multination-als was to focus on the middle and top end of the market,selling high-quality goods at Western-style prices—astrategy motivated more by a desire to target the richerconsumer than an eagerness to avoid local competition.Up and coming domestic companies, by contrast, startedby developing cheaper goods for low-end segments. Thus,according to Christopher Nailer of Australian NationalUniversity, in 1999 the cheapest microwave sold in Chinaby Japan’s Matsushita cost US$70, way above the US$36price tag for the cheapest model sold by the largest localproducer, Guangdong Galanz Enterprise. Procter & Gam-ble priced its Pantene shampoo at 60-70% above the levelcharged by its local peers. Similar examples in otherindustries, ranging from glue to stock flavouring, abound.
Since then, however, international companies havebeen looking to broaden their appeal, to establish massand thus economies of scale. At the same time, havinggrown in confidence and improved the quality of theirgoods, domestic companies have started to push theirproducts into the middle and even upper segments. Thishas been a painful development for multinationals. Theyhave been losing market share almost overnight to firmsthat have seemingly appeared from nowhere. Even worse,profitability has shifted. By selling upwards, domesticfirms have been able to raise their average selling pricesand, consequently, profit margins. Foreign firms, mean-while, have been forced to move in the other direction,cutting prices in an attempt to hang onto market sharebut losing profitability as a result.
The international advantageWhen asked about their competitive strengths vis-à-visdomestic companies, most overseas firms tend to empha-sise the characteristics that have made them successful in
other markets. “Better product, better brand and know-how that cannot be matched by domestic firms (as yet)”was the response of one foreign executive who took partin our survey. Another manager said the local strength ofhis firm lay in the introduction of “a service quality thatdoes not really exist in China at present”. Other represen-tative responses included “adherence to professional eth-ical standards”, adoption of “international best practice”,“greater knowledge and experience with internationalbusiness”, “superior marketing capabilities” and “generalquality management”.
Of course, the fact that a company practices high ethi-cal standards is of little help to the business when itsproducts and services are five times more expensive than
those of a local rival. Moreover, that foreign firms havebuilt up well-known and successful brands outside Chinadoes not necessarily help them when competing insidethe country. B&Q, for example, has a very strong retailname in the UK and parts of Europe but before it enteredthe market it was unknown in China. Franklin Templetonmay be one of the world’s leading specialist fund man-agers but this is a fact lost on most retail investors inChina. Even true global brands such as HSBC, despite itsorigins in Shanghai and Hong Kong, are far from house-hold names in China.
Brands and marketingThat said, foreign companies are right to identify brand as
The French food group, Danone, firstentered the China market in the 1980sthrough a partnership with a regional dairyin the southern city of Guangzhou. Thissmall venture came to nothing. The com-pany found that “supplies of fresh milk andpackaging were lacking, as was refrigerationfor reliable production, transport and stor-age. Most important of all, consumers weresimply not accustomed to drinking milk, letalone eating yoghurt.” This didn’t look likean auspicious start.
In the 1990s, however, the companytried again. Through the 1991 purchase ofAmoy, the Hong Kong food-productscompany, Danone gained some exposure tothe market for Chinese food. The followingyear Danone made its first real foray into themainland market, establishing the ShanghaiDanone Biscuits Foods joint venture.Another joint venture, the Shanghai DanoneYogurt joint venture, was formed in 1994. In1996 Danone purchased 41% of theHangzhou-based drinks company, Wahaha.
Since then, China has emerged asDanone’s third-largest national market.Sales reached Rmb9.9bn (US$1.2bn) in2003, up from Rmb8.1bn (US$980m) in2000. The firm has leading brands in thewater, dairy-drinks and biscuit markets. Likemost companies, Danone does not publishprofit figures for China, but its Asia-Pacificdivision achieved an operating margin of14.4% in 2003, beating the group averagefor a second time.
Danone has certainly benefited fromrapidly rising demand in China. But thecompany has also made use of the strategicoptions presented by the development ofChina’s economy.
The international perspective● Market segmentation: In the late 1990s
Danone focused its attention on 30cities, accounting for 15% of China’spopulation and 30% of its wealth.
● Product development: Launchinglocalised products, such as soda crackers(sold as helping to make up the lack ofcalcium in local diets) and Maidong, avitamin-enriched energy drink that cameonto the market in April 2003 and sold100m litres in eight months. Wahaha,Danone’s leading water brand, has beenbranching into the tea-drinks and fruit-juice segments.
Localisation● Local staff: In 2003 Danone had nearly
23,000 employees in China but just 30 ofthese were expatriate managers.
● Diversified production: In 2001 Danonehad 38 bottled water factories in 26 dif-ferent cities.
● Nationwide sales: Danone’s leading waterbrand, Wahaha, is sold in 2m outletsthrough 10,000 distributors, and thecompany claims to be increasing sales inmedium-sized cities and rural areas.With volume increasing, the cost of pro-
duction fell from 4 US cents/litre in 1997to 2.2 US cents/litre in 2001.
Mergers and acquisitions● New brands: In the early 1990s Danone’s
water brand in China was Evian. But in1996 it purchased 41% of Hangzhou-based Wahaha, China’s largest domesticbrand of bottled water (Danone nowowns 47.7% of Wahaha but controls51%). In 1998 Danone purchased 60% ofanother water producer, ShenzhenHealth Drinks, and in 2000 93% ofRobust, China’s second-largest bottledwater brand.
● New markets: In 2000 Danone alsosigned an agreement to buy 50% ofAquarius, China’s leading company forhome and office deliveries of water (theHOD market). Aquarius operates in theShanghai area but Danone’s other ven-tures—Robust and Health—give the firmexposure to the HOD market in otherareas of the country.
It has not all been smooth-sailing forDanone in China. Like other multinationals,the company invested in the brewery busi-ness in the 1990s, only to pull out later. ButDanone appears to have been very success-ful in the bottled water sector, and its expe-rience does provide a useful case study ofthe kind of strategy available to foreignfirms wishing to build real businesses inChina.
one of their most important competitive strengths inChina. This is because brand-building is something thatdomestic firms in general do not yet do very well. Domesticplayers typically lack the quality and innovative productsthat form the foundation of any strong brand: by compet-ing on price, many local firms simply do not have theresources to invest in innovation. In addition, althoughsome domestic firms are big advertisers, their promotionalefforts tend to be brief affairs—for example, five-secondtelevision commercials—that focus more on achievingimmediate sales than building a brand that would positionthe company to achieve longer-term profitability.
These, of course, are generalisations. Some local play-ers are investing in innovation: both Huawei and ZTE claimto spend more than 10% of revenue on research anddevelopment (R&D), and Haier gives all of its engineersthe freedom to design and build their own products. A fewdomestic companies are undertaking quite sophisticatedadvertising campaigns which attempt—in marketingspeak—to promote the “values” of a good rather than itsmere “attributes”. In one example highlighted byMatthew Rouse of IFF, a local company has been runningtelevision commercials with a plot based around theplight of China’s unemployed. Far from being the focus,the good being promoted, the Diao detergent brand, doesnot appear until the very end of the advertisement.
But for domestic firms these examples remain theexceptions rather than the rule. By contrast, having aninnovative and high-quality offering is a defining charac-teristic of MNCs. Moreover, foreign firms understand justhow to build on their platform of goods and services toestablish a brand. Finally, as the example of Diao shows, itis now possible in China to use the kind of sophisticated
promotional techniques that multinationals have devel-oped elsewhere. The biggest foreign firms in China arenow devoting considerable resources to ensure their pro-motional activities are tailored to appeal to the prefer-ences of their target markets. Finding out “What ChineseWomen Want”, the title of a vivid presentation deliveredin 2002 by the Greater China head of J Walter Thompson,Tom Doctoroff, is becoming something of a science.
With larger and better-understood client bases, biggermultinationals are gaining the opportunity to start usingfairly advanced market-segmentation techniques. In morerestricted industries like pharmaceuticals, firms are farfrom reaching this stage, but even here companies havethe ability to use some strategic marketing techniques.This is because there are a whole range of common dis-eases in the country, from hypertension to hepatitis, thatcurrently pass either under-diagnosed or completelyuntreated. This is the kind of situation that the interna-tional pharmaceutical firms, with their existing range ofdrugs and experience of market-shaping in the West, arewell placed to exploit. By focusing their marketing effortson grass-roots doctors and consumers, in addition to keyopinion leaders, pharmaceutical firms have an opportu-nity to cultivate demand for drugs in these areas.
Going localIn one way at least, going local is not a new strategicoption for foreign firms. Just how fast to localise staff inChina operations has been a question taxing multination-als ever since they started to invest in the country in the1980s. It is an issue they continue to grapple with today(see next chapter, Persistent headaches).
Nevertheless, the parameters of the localisation
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debate have shifted. Previously, staff localisation wasseen only as the most obvious way of cutting costs atunprofitable businesses in China. Now replacing expen-sive expatriates is just one of a whole range of localisationoptions foreign firms are exercising in an effort to remainor become competitive. Borrowing from domestic banks,moving production facilities inland, sourcing inputs fromwithin China and expanding local product development—these and other localisation strategies are beingemployed in an effort to narrow the cost gap. Foreignfirms want to better understand and even shape localdemand. But they also want to match the cost structuresof local firms, allowing them to compete on price withoutwrecking profit margins.
Credit, production and inputsChina’s banks are willing participants in this localisationdrive. Domestic banks are under great pressure tostrengthen balance-sheets and foreign firms are seen asoffering safer lending opportunities than domestic firms.According to sources that spoke to the Economist Intelli-gence Unit, if one of China’s Big Four banks, the Agricul-tural Bank of China, knows that a Taiwan firm on the
mainland is listed at home—which indicates a degree ofaccounting transparency—it is willing to provide a line ofcredit within a month. Domestic banks give higher-profileMNCs an even easier ride. The overall cost of finance isprobably still not as low as that enjoyed by local compa-nies because foreign firms will be under more pressure topay loans back. Nevertheless, overseas companies cannow access more competitively priced loans than was thecase in the past.
Localisation in other functional areas requires moreeffort but can still be rewarding. For example, the areasfirst favoured by foreign investors—Shanghai, Beijing andShenzhen across the boundary from Hong Kong—arebecoming richer and thus more expensive. Thanks toimprovements in the road network, however, it is possibleto find much cheaper locations in which to base opera-tions that are still within relatively easy reach of theseurban hubs. For example, while being just a couple ofhours’ drive away from Beijing, costs remain relatively lowin Tianjin. The same is true of the string of cities stretch-ing from Ningbo to Wuxi that lie close to Shanghai andlarge swathes of the Pearl River Delta surrounding Shen-zhen. And all of these are only the most obvious choices.
In recent years, foreign firms have becomemuch more enmeshed in local business net-works in China than was ever the casebefore. This is the result of several develop-ments: the desire of overseas companies tolocalise supplies and so reduce the need formore expensive imports; the increasingconfidence with which at least the moreestablished foreign firms approach the mar-ket; and the growth of China’s own corpo-rate sector.
This localisation process has not,however, been without its problems. Forforeign firms selling to local companies,there is the issue of securing timelypayment. One telecoms-equipmentmanufacturer told us that accountsreceivable are the one thing that hasbecome worse across the board over the last20 years. In the 1980s a company could becertain it would be paid; now that isanything but the case, especially whendealing with private businesses in China.
Foreign companies sourcing suppliesfrom domestic firms also have the problem
of ensuring the flow of inputs is consistentlyof a high quality. The pool of domesticsuppliers suffers from the same kind ofweaknesses that afflict their final-productcounterparts: production quality is oftensacrificed for the sake of low prices. But thismay not be obvious to potential foreignbuyers because local firms are not abovecheating, for example producing sampleproducts that are of far higher quality thanthe goods that are finally delivered.
Foreign firms are not defenceless in theface of these challenges. In terms ofpayment, for example, it may be sensible todemand a down-payment, payment ondelivery and, recommends one high-endvideo-equipment maker, to be persistent,ignoring appeal for delays based on culturalor social norms. The same manufactureradds that China may not have a long historyof litigation but foreign firms should not beafraid to take a bad payer to court. It shouldalso be remembered that foreign firms areclearly in a stronger position to extractpayment if ongoing support and servicing
forms an integral part of any sales package.In other words, there are similaritiesbetween securing payment andsafeguarding intellectual property (see nextchapter, Persistent headaches)—foreignfirms should think through systems frombeginning to end to make payment morelikely.
Foreign firms are also not powerless toensure a flow of quality inputs. Foreignfirms with more experience in China arelikely to have built up some knowledge ofthe reputations of local firms. For greenerfirms, inspections of the factories andfacilities of potential suppliers might bepossible. Also, it has to be remembered thatdomestic firms have some incentives to sellquality inputs to foreign firms. Building apositive and strong relationship withoverseas companies could bring greaterbusiness in the future, and not just from theoriginal customer: being able to claim acustomer-relationship with a prominentforeign firm will help a local company winthe trust of others.
The improvement in the transport infrastructure has madeit possible for foreign firms to cast their nets even furtherafield, as demonstrated by Unilever’s decision to move itshousehold and personal-care goods manufacturing oper-ations from Shanghai to Hefei, the provincial capital ofAnhui.
Foreign companies are also seeking to reduce costs bylocalising input procurement. Of the companies thatresponded to our survey, the proportion that expects tobuy more than three-fifths of their components frominside China (rather than importing them) rises to over30% in five years’ time, up from just 19% today. But for-eign firms are not just buying more from within China;they are also purchasing more from domestic rather thanforeign-invested enterprises (FIEs). According to our sur-vey, the proportion of firms purchasing more than two-fifths of their components from local companies rises from37% now to 44% in five years.
This development is not surprising: domestic supplierfirms share all the cost advantages enjoyed by their fin-ished-goods producing counterparts—although they alsoshare some of the quality problems as well, which is whythe proportion does not rise more quickly. This trend illus-trates that local companies should not be thought of
exclusively as competitors and stealers of intellectualproperty; sometimes they can also be valuable partners.
Moving away from the coastForeign firms are also employing a localisation strategy ofsorts to address the demand side of their businesses.After all, the recent convergence of the target markets ofmultinationals and their domestic counterparts is not justthe result of local companies seeking to sell up to thericher cities. Multinationals have also been taking advan-tage of higher incomes and a much-improved infrastruc-ture to move beyond the eastern seaboard to market tothe less-developed inland areas, and in some cases evento establish a national presence.
As the next chapter, Persistent headaches, willexplain, this is no easy task but it does offer the attractionof greater scale and thus lower per unit costs. For exam-ple, when the French company, Danone, produced 500mlitres of its Wahaha brand of bottled water in 1997, theaverage production cost was 4 US cents/litre. But over thecourse of the next five years, output rose to 2.4bn litres,an increase in scale that helped to cut the average pro-duction cost to 2.2 US cents/litre.
What percentage of your inputs on a value basis is sourced from within China (as opposed to being imported)? (% responses)
0-20% 26.6
Not applicable 32.7
80-100% 12.1
60-80% 6.540-60% 9.3
20-40% 12.6
Where do you expect this percentage to stand in five years‘ time? (% responses)
0-20% 11.6Not applicable 32.6
80-100% 18.6 60-80% 13.5
40-60% 8.8
20-40% 14.9
Of the inputs that you source from within China, what percentage is sourced from domestic Chinese companies (as opposed to foreign-invested firms)? (% responses)
0-20% 20.6Not applicable 34.6
80-100% 11.260-80% 15.0
40-60% 10.7
20-40% 7.9
Where do you expect this percentage to stand in five years‘ time? (% responses)
0-20% 10.3Not applicable 35.0
80-100% 16.4 60-80% 14.0
40-60% 13.6
20-40% 10.7
Source: Economist Intelligence Unit survey, March/April 2004
Research and development in ChinaGrand announcements of localisation of R&D need to begreeted with a degree of scepticism. Big firms know thatbeing seen to transfer technology and expertise is oneway of winning the favour of powerful government offi-cials. But the political gains are potential at best, imagi-nary at worst, and in all cases need to be set against thevery real risk of intellectual property theft in China. As aresult, it probably remains true that the R&D facilitiesbeing established are not as grand as media relationsdepartments would like us to believe. For example, whilethe pharmaceutical firm, Roche, is establishing an R&Dcentre in China, initially it will employ just 40 chemists, avery small number when set against the more than 5,000
scientists employed at the firm’s other four global facili-ties (see Part 2: Pharmaceuticals).
Still, it would be surprising if foreign firms were notundertaking any R&D in China. Although skilled labourcosts are rising quickly (see next chapter, Persistentheadaches), they remain lower than in western Europe orthe US. So, while many firms remain reluctant to transfertheir more sensitive “research” activities to China, theyare willing to move lower-level “development”. Globalpharmaceutical firms, for example, are conducting clinicaltrials in the country and manufacturing firms are under-taking pilot production runs. And, with China buying upmore mobile handsets than anywhere else in the world, itshould not be surprising that foreign telecoms companies
The US technology company, Corning, is anexample—a prime example—of a companywhose China business has been transformedin the last five years.
In 2000 it had a small stake in a jointventure in Shanghai, employed 100 peopleand had annual sales of US$80m.
By the end of 2003, it operated five jointventures (two in Shanghai, one each inChengdu, Wuhan and Beijing), another twowholly owned plants in Shanghai, plusanother one in Taiwan. Between them,these eight operations had sales ofUS$380m and employed 1,500 people.
From barely featuring on the company’sradar, its China operations now account formore than 10% of Corning’s US$3bn annualturnover.
For Corning, China matters. So whathappened in the last few years which madethe country suddenly become important?
Simon MacKinnon, its Greater Chinapresident, says the explanation is simple:Corning is an “extraordinary barometer forChina’s high-technology development.”
His company specialises in just a fewareas: optical fibre and cabling, high-quality and ultra-pure glasses such as thoseused in LCD screens or in the lenses used foretching semiconductors, and catalyticsubstrates used to clean vehicle exhausts.Five years ago, China had little demand forthese products: its telecoms networks stilllargely used copper wiring; its computermarket, although growing, was still small;
and its auto market had not taken shape.All of these industries have seen a major
surge in growth since then. China hasbecome the world’s second-biggest marketfor personal computers, as well as a majorsource of manufacturing them; its mobileand fixed-line telephone network has grownfrom having tens of millions of subscribersto having hundreds of millions; and last yearits auto industry finally began registeringthe sort of sales that foreign auto executiveshad been promising for years.
With half of its China operationsproducing telecoms equipment and theother half producing LCD glass, plus sales ofCorning goods imported from other parts ofthe world, the company has had a Chinaboom.
Mr MacKinnon, who has worked on andoff in China since the 1980s, for the UK’sP&O and Japan’s Mitsui before joiningCorning, suggests the key element inmaking a company successful for China isbeing able to determine whether itscompetitive advantage or ability can beapplied there.
“This is the question for CEOs,” he says.Corning’s key advantage is its technicalknow-how, which makes it a world leader inall its key businesses, combined with itsmanufacturing ability, which gives it aquality edge.
Coming to China was not such an obviousmove: the company’s business is capital-intensive so attractions such as its low
labour costs were not important. But fiveyears ago it saw the potential of using thecountry as a regional manufacturing hubexporting to the rest of Asia with theprospect of being able to ride the localmarket up if demand rose.
As with any manufacturing business,being able to source the right inputs is amajor challenge. The right suppliers, MrMacKinnon says, are “stardust”. The smarterforeign companies—and he singles outHong Kong’s trading and sourcing company,Li & Fung, as one such business—aredeveloping deep relationships with anetwork of strategic partners able toprocure the inputs needed.
Being involved in telecomsmanufacturing, which is still restricted bythe government, has meant entering intojoint ventures for most foreign investors.This is likely to change as the industryrestructures over the next few years.
Another change is likely to be the growthin demand for environmentally soundproducts–hard to envision now but perhapsnot as unlikely as it might appear. MrMacKinnon suggests China has already put inplace environmental regulations largely inline with those of North America and Europe,and in some areas pushing beyond them.
For now, many of these rules areunenforced. But when they are, Corning,with its range of environmentally advancedproducts, stands to benefit from anotherwave of new demand.
are establishing facilities to develop new products, or atleast adapt existing ones, for the local market.
But the on-the-ground R&D presence of some foreigncompanies goes further than this, in part because China’smassive telecoms market is not just of local but of globalimportance. Siemens has established the global headquar-ters for R&D of voice-centric phones in Beijing. In MayNokia announced that it would expand R&D activities inChina, with the result that 40% of handsets produced by itsmobile-phone business division would be designed anddeveloped in the country. Alcatel has taken the localisa-tion theme even further. Shanghai Bell has become one ofAlcatel’s global R&D centres, with the French firm givingthe joint venture full access to (among other things) itsworldwide technology base, including patented products.Alcatel’s goal, according to its Asia-Pacific president,Christian Rainaudo, is to be in a position to capture andexport new telecoms technology coming from withinChina, rather than merely importing existing trends fromother countries.
This, no doubt, is music to the ears of officials in China.Feeling its companies spend too much to use the technol-ogy royalties owned by foreign companies, transformingthe country from a follower of trends to a setter has beena specific aim of China’s government. This drive has incor-porated data storage systems and wireless land-area net-works (WLAN), but is an effort that has progressedfurthest in the telecoms arena with the development ofChina’s own third-generation (3G) telecoms standard, TD-SCDMA. While some observers have expressed scepticismthat this standard will ever gain a commercial following,foreign firms have been working to ensure that they willnot be left out if it does. Indeed, Siemens, in partnershipwith the China Academy of Telecommunications Technol-ogy and a local telecoms firm, Datang, has played a keyrole in developing the standard. The German firm has alsoteamed up with Huawei to develop TD-SCDMA equipment,and similar ventures have been formed by other foreignfirms including Nortel (Canada), Philips (the Netherlands)and Samsung (South Korea).
Mergers and acquisitionsA third choice for foreign firms looking to strengthen theircompetitive position is mergers and acquisitions (M&A).While a relaxation of restrictions on foreign ownership isallowing new arrivals to enter China on a wholly ownedbasis (see previous chapter, A new environment), it is alsoallowing existing firms to buy out local partners. Today,joint ventures formed in the 1980s and 1990s do not tendto be short of the kind of resources that the Chinese side isable to offer (land and people) but rather the ones that theforeign side can supply (capital and technology). ManyMNCs have been able to capitalise on this change. In
recent years both Siemens and Alcatel have been able toturn minority holdings into majority stakes with manage-ment control in their respective telecoms equipment-mak-ing joint ventures. In February this year Samsung paidUS$30m to increase its holding in the Shenzhen ElectronicGroup from 21% to 35.5% and take management control.
For some firms, the opportunities to consolidate donot end here. The restrictions of the last two decades haveleft many MNCs with a whole range of often unrelatedoperations spread right across the country. The changedregulatory environment is clearing the way for this frac-tured presence to be converted into a more centralisedone. Nokia, for example, has taken four separate jointventures and persuaded the partners in each—Capitel,Beijing Hangxing, Dongguan Nanxin and ShanghaiLianhe—to convert their shares into stakes in one cen-tralised company. In so doing, Nokia has sought to con-centrate more of its China activities at Beijing’s XingwangIndustrial park. The Finnish company still has to deal withseveral different partners but now only one joint venture.
In the future, it would be surprising if this restructur-ing trend did not emerge in the service sector. Fromretailing to financial services, foreign firms wishing toenter the China market are still being required to startjoint ventures. As a result, several service multinationalsare ending up with the kind of complicated corporatestructures their manufacturing counterparts are currentlytrying to shed. The retailer Carrefour, for example, hasexpanded across China by finding different JV partners ineach location. In a set-up typical of the continental Euro-pean financial services groups, Fortis has two bankingbusiness centres in China, a fund management joint ven-ture and a minority investment in one of China’s smallerbut rapidly growing life insurance firms, Taiping Life.Under World Trade Organisation (WTO) rules China is sup-posed to allow foreign firms to establish wholly ownedretail operations from the end of 2004. Foreign-owner-ship restrictions in the financial services arena are likelyto remain for longer, but companies like Fortis may stillgain the opportunity to consolidate their operations inthe next few years as China eases prudential rules thatcurrently restrict the amalgamation of banking, insuranceand securities firms.
The M&A market is developing, but slowlyBuying out and consolidating joint ventures is no longerthe only M&A option available to foreign firms. Since late2002 the government has put into place a regulatoryframework that is aimed at allowing the kind of broadM&A activity that forms such an important component ofcorporate activity in more advanced markets. Foreignfirms have begun to take advantage of these changes. Inrecent years, leading multinationals ranging from BP to
November 2002. “Notice regarding the trans-fer of state shares and legal person shares oflisted companies to foreign parties.” Issuedby the China Securities Regulatory Commis-sion (CSRC), Ministry of Finance (MOF) andState Economic and Trade Commission(SETC)
It has traditionally been very difficult foroutside companies to buy control of themore than 1,000 firms, mainly state-ownedenterprises (SOEs), that are listed onChina’s stockmarkets. This is because onlyaround one-third of the shares in listedfirms are publicly traded. The rest are ownedeither by state institutions (known as stateshares) or other bodies, often other state-linked firms (legal person—LP shares). As aresult, only around 33% of China’s totalmarket capitalisation is actually tradable.Foreign firms have generally had a difficulttime buying these non-tradable shares. Anattempt by two Japanese firms to buy LPshares in 1995 led to a government ban onall such sales. The November 2002regulation was aimed at ending this ban,thereby clearing the way for foreign firms tonegotiate to buy bigger stakes in listed firmsby converting non-tradable shares into“foreign capital shares”.
December 1st 2002. “Takeover provisions forlisted companies.” (CSRC)
This regulation laid out China’s firstcomprehensive takeover code for listedcompanies. According to Teresa Ko fromFreshfields, one of the leading internationallaw firms, major features include:● Three methods of acquiring a listed com-
pany are allowed: acquisition by agree-ment; acquisition by offer; andcompetitive bidding on the stockmarket.
● Mandatory offers must be made to allshareholders of the target company if
the acquirer buys more than 30% of theshares. Acquisitions of less than 30% ofthe shares, but which result in de factocontrol of the listed company, are sub-ject to notification to the CSRC, and a 15-day comment period.
● Use of securities to pay for shares in alisted company is allowed (previouslyonly cash offers were permitted).
● Different offer prices for different classesof shares are permitted (listed and trad-able shares versus non-listed and non-tradable shares).
● The CSRC has the power to issue waiversfrom the obligation to make a mandatoryoffer.
● Takeovers have to be conducted in anopen, fair and just way, with proper dis-closure of accurate information.
● All parties involved are required to main-tain order in the securities market.
● Fiduciary duties are imposed on playerson both sides of the deal.
December 1st 2002. “Provvisional measuresfor administration of domestic securitiesinvvestment by qualified foreign institutionalinvvestors.” (CSRC and People’s Bank ofChina)
The existence of non-tradable shares isnot the only peculiarity of China’sstockmarket. Another is the division oftradable shares between local-currency-dominated “A shares” and hard-currency-denominated “B shares”. Traditionally,foreign investors were only allowed to buyshares on the B-market, which consisted ofonly around 100 thinly traded stocks. TheDecember measures, however, cleared theway for overseas firms to buy A shares, aswell as other financial instruments includingTreasury bonds, corporate bonds andconvertible bonds, via a Qualified Foreign
Institutional Investor (QFII) scheme. There are limits on the size of the
position that a qualified foreign investorcan take in a stock and capital remittancesare subject to quotas and mandatory lock-inperiods. Nevertheless, the introduction ofthe QFII scheme did mark a welcomeliberalisation of China’s stockmarket.
January 1st 2003. “Tentativve provvisions onthe use of foreign invvestment to restructureSOEs.” (SETC, MOF, State Administration forIndustry and Commerce—SAIC—and theState Administration of Foreign Exchange—SAFE)
These provisions laid out a generalframework for the involvement of foreigncapital in the restructuring of SOEs (apartfrom firms in the financial sector, which aresubject to special rules). These regulationsdid not make everything clear but, accordingto the official publication, the People’sDaily, it “clearly drives home the authorities’determination to expedite SOEs’ reform.”
April 12th 2003. “The provvisional regula-tions on merger and acquisition of domesticenterprises by foreign invvestors.” (Ministryof Commerce, SAIC, SAFE and the StateAdministration of Taxation)
In the past, foreign firms wishing toinvest in China have almost always had toset up a new firm in order to do so, either ajoint venture with a Chinese partner or awholly foreign-owned enterprise. Foreignfirms were sometimes allowed to buy equityinterests in local firms but there were nonational rules to regulate such investmentsand permission was thus granted only on acase-by-case basis. These new regulationsare therefore significant, laying the legalbasis for foreign firms to invest in Chinathrough the acquisition of an interest in alocal firm.
The evolution of M&A regulation
AIG have taken small stakes in large SOEs such asPetroChina and PICC. In 2003 Eastman Kodak of the USfinalised an agreement to buy 20% of Lucky Group,China’s largest producer of traditional photographic film.This appeared to be a breakthrough, marking the largest
acquisition by a foreign player of the state shares of alisted Chinese company. In a further illustration of thenormalisation of the M&A market, the British beer com-pany, SABMiller, in May launched an attempt to buy con-trol of Harbin Brewery. Harbin was not flattered by the bid
from the UK firm, which it described as “wholly unso-licited”, indicating that it was more willing to entertainthe advances of another budding suitor, the US’sAnheuser-Busch.
In reality, these kind of events remain few and farbetween. Kodak’s breakthrough with Lucky has not led to aflurry of other deals, and SABMiller’s attempt to buyHarbin was the first-ever attempt by a foreign company tolaunch a hostile takeover of a domestic firm. AIG’s pur-chase of 9.9% of PICC Property & Casualty is just one of anumber of similar deals announced by foreign banks andinsurance companies. But these all mark the establishmentof a tactical presence in a sector that is still heavily regu-lated rather than signalling major forays aimed at develop-
ing business fast. The rapid increase in the total size ofChina’s M&A market in recent years has been fuelled bydomestic rather than crossborder deals. Indeed, while for-eign firms proceed only cautiously, local companies havebeen using M&A aggressively. The Urumqi-based D’Longhas already completed more than 100 acquisitions, start-ing with Chinese food and agribusinesses but now alsoincluding overseas purchases: in 2003 it bought the Ger-man aircraft maker, Dornier Fairchild.
Digging the dirtThe main factor discouraging foreign firms from followingin the footsteps of their domestic counterparts has beenpoor standards of corporate governance. Foreign profes-
Eastman Kodak took a major step towardsdominating China’s photographic film mar-ket—the world’s second largest after theUS—when in October 2003 it reached aUS$100m agreement with Lucky Group tobuy 20% of Lucky Film, the company’sShanghai-listed arm, offering a mixture ofcash, technology and equipment.
The deal came after years ofnegotiations, stemming not least fromdivisions within Lucky’s managerial ranksover whether it should tie up with Kodak orJapan’s Fuji. Some in the company favouredFuji on the grounds that it was weaker thanKodak, which in turn would allow Lucky tohave more control and to keep its ownbrand. Others supported Kodak because ofits strength in China and its more advancedtechnology.
Kodak’s stronger position in China stemsfrom its US$380m investment in 1998, whenit bought three money-losing state-ownedfilm makers, one based at Xiamen in Fujian,one at Shantou in northern Guangdong andone at Wuxi in Jiangsu.
As part of that deal, which also included acommitment to invest another US$700m bythe end of 2003, the central governmentundertook to stop all other foreign filmmakers from setting up film productionfacilities in China for three years.
The agreement was principally aimed atFuji which, barred from opening its ownfacilities in China until the end of 2002, had
no alternative but to seek an alliance withLucky, which had managed to retain about20% of the market.
Kodak’s victory in this struggle appearslinked to its willingness to take a minoritystake in Lucky, contrary to its usual practiceof requiring majority control whenlaunching joint-venture subsidiaries. Fujimay not have been willing to take this step.
Certainly, Lucky should be congratulatedon how well it played the companies offagainst each other. As the only domestic filmmaker left after 1998, its position has beenprecarious and is one reason that it has beenconstantly negotiating for an agreementwith a foreign partner since then.
Its vulnerability was highlighted by a37% fall in net profit in the first nine monthsof 2003 to Rmb66m (US$8m). AlthoughLucky blamed fallout from the respiratorydisease, Severe Acute Respiratory Syndrome( SARS), as the main reason for its earningsdrop, more important was competition fromKodak, other film makers and counterfeitproducts.
The agreement with Kodak could helpLucky fight back. But the question it faces—as does Kodak—is whether it will be able tomake the transition to digital photographyand imaging. Kodak is expanding its networkof processing outlets with digitalcapabilities, signing deals with Chinesebanks to allow licensed Kodak store ownersto take out loans for the purchase of digital
photo-processing equipment.Kodak and Lucky have announced they
will be working together in digital imaging—possibly taking advantage of Lucky’spartnership with Seiko-Epson to offer digitalimaging in its retail outlets.
Whether Kodak will be able to make theleap to digital imaging in China remains asmuch of an unknown as whether it will beable to make that transition elsewhere.Nonetheless, what is striking about Kodak’sstrategy is how it has constantlyconcentrated on the big picture—and howbeing clear in this respect can help acompany drive some tough bargains inChina.
Its 1998 deal showed just how muchleverage a company could get if it waswilling to go to the government for support.It is unlikely such a deal could be struck now.Since the late 1990s, the government’sdirect involvement in business has declinedmarkedly; moreover, now that China is amember of the World Trade Organisation,such a discriminatory practice as restrictingentry to another company in the sameindustry might be harder to pull off.
Now, while the circumstances may bedifferent, it has managed to buy into the onebig domestic player left. Assuming aroundfive more years of the traditional film marketin China, it has more than a useful platformfrom which to build—especially comparedwith that of its main foreign competitor.
● Basic market access and expansion.M&A allows companies to establishthemselves or expand an existing pres-ence fast. Given China’s size and complexbusiness environment, many companiessee M&A as the easiest way to gaingrowth—much less hassle than starting agreenfield operation and expandingorganically. An example is SABMiller’scurrent bid for Harbin Brewery.
● Stealing a march on foreign competi-tion. With entry or operational restric-tions remaining in many industries, oneway in which foreign companies can out-manoeuvre other international competi-tors is by buying into a domestic firmahead of any opening of the sector. Ininsurance, HSBC acquired 10% of PingAn Insurance and AIG secured a coup by
taking 9.9% of PICC Property & Casualtyahead of its share flotation in HongKong.
● Eliminating local competition. Domes-tic companies pose an increasing com-petitive threat for foreign firms in Chinaand, in some sectors, in overseas mar-kets as well. Foreign firms can neutralisethis threat and seek to strengthen theirown competitiveness by buying up theirlocal counterparts, much as Kodakacquired Lucky.
● Buying assets cheaply. In the state-owned sector, many companies are interrible shape, with antiquated machin-ery, work practices and management.But there are also enterprises that havespent heavily on technology and equip-ment but which lack the soft skills to use
them effectively or market the productsthey manufacture. With local govern-ments seemingly queuing up to privatisetheir SMEs, foreign firms are in a strongposition to negotiate good deals.
● Acquiring new abilities. According toone observer we spoke to, “There are alot of Chinese companies that have inter-esting positions and technologies whichforeign companies can use.” An exampleof one with its own subset of skills wassearch engine business 3721 NetworkSoftware, for which Yahoo! is payingUS$120m. Managers at other Westerncompanies, particularly technology andtelecoms firms, also say that they seepotential targets in software houses,both for their skills and for their abilityto adapt goods for the Chinese market.
Buying in China
sional services firms say due diligence exercises almostinvariably uncover a mess: companies that have not paidtheir welfare contributions, do not own the land on whichtheir factories are standing, have government subsidiesshowing up as income in their accounts or—the biggestsingle problem—have not paid all their taxes. These prob-lems are not restricted to SOEs in China. Standards oftransparency remain poor even at the largest firms: wit-ness the disclosure problems at China Life, the leadingdomestic insurer which recently listed a subsidiary in HongKong and the US. One foreign accountant says he startsout by telling his multinational clients that all domesticacquisition targets will fail due diligence tests. The ques-tion is not whether a domestic acquisition will be risky buthow much risk the foreign firm is willing to take on.
Even after a firm decides it is willing to accept the like-lihood of nasty post-acquisition surprises, it still has theproblem of closing the deal. For one thing, a foreign firmneeds to identify exactly who owns the domestic target.This is more difficult that it might sound: often several dif-ferent government organisations may lay claim to an indi-vidual SOE. Only when an ultimate owner is eventuallyfound does the hard work begin: negotiating a price. It isoften difficult for Chinese and foreign companies to agreeon what is a fair valuation for a target. Chinese sellerstend to overvalue hard assets and see less value in intan-gibles, although this is changing, particularly as Chinesecompanies become more aware of issues such as brand-
ing. Policy is part of the problem: Ministry of Finance rulesstate companies cannot be sold for less than their netasset value. These values are set by government-appointed teams, which must—among other things—value fixed assets at their replacement cost not theirdepreciated value.
All these difficulties are beginning to ease. Standards offinancial transparency and corporate governance, particu-larly for listed firms, are improving as a result of govern-ment policy (quarterly reporting for listed companies hasbeen introduced, a regulatory requirement that is stillmissing in Hong Kong) and the activities of an increasinglyinquisitive financial press. There is now also a growing sup-ply of companies available for foreign firms to buy, owingto a renewed government drive since late 2002 to restruc-ture the SOE sector. This latest reform effort is expected toresult in most of China’s more than 150,000 SOEs—many ofwhich are small and medium-sized enterprises, SMEs—being put up for sale. On the demand side, meanwhile, for-eign firms are beginning to realise that M&A in China canserve the same functions as it does in other markets. Givenall this, it should not be surprising that even though theenvironment remains far from perfect, many multination-als we spoke to said they were scouting around for possiblebuying opportunities in China.
Keeping their headsMultinational firms do not always manage to bring their
strategic-planning strengths to bear in the Chinese mar-ket. In particular, while the foreign business communityin general is becoming less naïve, many companies stillseem to take leave of their critical faculties when judgingthe size of China’s market. Dazzled by current surgingsales and the thought of an eventual consumer base of1bn people, foreign companies overstate potentialdemand and invest too much as a result. Telling them-selves that China is “important”, foreign firms also fail toapply to the market the same rigorous performance stan-dards that are used elsewhere. While 66% of respondentsto our survey stated that the yardsticks used to judge suc-cess in China were the same as those applied to operationsin other countries, more than one-fifth of companies saidthey were more lenient. Our survey results also show thatmost foreign firms continue to commit the sins they wouldlike to suggest are limited to their domestic counter-parts—assessing performance by revenue growth andmarket share rather than return on capital or equity.
Some missteps on the part of foreign firms can proba-bly be excused simply because judging future demandtrends in China is a difficult task. There are simply noprecedents from which to gauge the economy’s likelydirection. China’s size, combined with the gradual evolu-tion of the economy from central planning to some kind ofmarket system, makes it unique. The economy is alsoprone to cyclical booms and slowdowns. In this context, itwould not be surprising if car companies were unsurewhether the almost tripling of sales in 2002-03 is the firstsurge in a market that is finally coming alive, or a cyclicalissue related to the unsustainable rate of overall GDPgrowth recorded last year.
It may also not be altogether unreasonable for foreignfirms to apply to China operations more lenient perform-ance criteria than those used elsewhere. Business consult-ants characterise China’s market as being in a state of“chaos”, a phase that will not last forever. A more maturemarket will eventually emerge, an event that is likely to betriggered in China when banks start to tighten credit crite-ria, thereby forcing the consolidation of the domestic cor-porate sector. In the meantime, normal market rulessimply do not apply, making it difficult to judge just whatsuccess a business is achieving. For example, the Chinaoperations of a foreign firm may currently be underper-forming relative to the global business. In the process,however, the firm may be building a brand and workingtowards creating a nationwide distribution network, all ofwhich will put the company in a strong position when mar-ket consolidation eventually occurs.
Still, while it might be reasonable to cut China opera-tions some slack, good business practices should not becompletely thrown out of the window when firms look to
the market. China is not so unique as to make irrelevantall lessons multinationals have learnt from operating inother economies, most notably that it is income, not puredemographics, that matter. For example, over-investmenton the scale currently being rolled out in the car industrylooks dangerous. Although it is difficult to measure pre-cisely, the multibillion-dollar investment plans of localand foreign firms are likely to add 4m-5m units of capacityin China by 2005 or 2006. As a result, according to MikeSteventon, the head of the auto practice at KPMG, overca-pacity in the industry in China is likely to hit 70% beforetoo long.
Our own interviews suggest that it is executives inheadquarters in the US or Europe, rather than managerson the ground in China, that are most guilty of this kind ofirrational exuberance. The China knowledge of these out-side executives is often very skewed, based on headlinerates of GDP growth, the almost saturation coverage “therise of China” receives in the international media and per-haps a trip to be wowed by the soaring skyline of Shang-hai. Visitors would be well advised to remember thatneither the buildings nor average incomes in China’s mostcommercial city are anywhere near representative of therest of the country.
Addressing the marketIn recent years, foreign firms have been facing increas-ingly intense domestic competition. This represents a newstrategic challenge for multinationals. But the develop-ment of China’s economy has also opened up new ways inwhich they can respond and, as a result, foreign firms arein no way being pushed out of all the markets. Domesticbrands have overtaken multinationals in markets such asdetergents but overseas companies remain dominant inother sectors, like shampoo and cosmetics. In the marketfor automatic washing machines, foreign firms increasedtheir market share from 15% in 1999 to around 40% in2003. Even in the much-watched telecoms-handset mar-ket, foreign players are beginning to fight back. NorsonTelecom Consulting thinks overseas brands will have amarket share of 57% this year, up slightly from the 56%recorded in 2003.
This new level of challenges has created an addeddegree of complexity for executives managing businessesin China. But still sitting below this strategic challenge arethe operational issues that have taxed MNCs ever sincethey began entering China in the 1980s: infrastructureand distribution, regulation and corruption, shortages ofskilled managers and violation of intellectual propertyrights. At least for better-established firms these are notthe all-consuming problems they once were. But, as thenext chapter will show, they remain very real challenges.
At an operational level, China remains a very chal-lenging place in which to do business, despitethe many changes that have taken place over thelast few years. In the Economist Intelligence
Unit’s business environment rankings, China is ranked38th out of 60 economies, putting it below countries suchas Brazil and Thailand. This overall score masks consider-able regional disparities, with the environment being farmore business-friendly in the eastern seaboard than thewest. But this is of little consolation to the big multina-tional companies (MNCs) that are increasingly expandingout from cities like Shanghai and Beijing to try to tap mar-kets in other areas of the country.
The burden of China’s weak business environment isnot, however, felt evenly by all companies. Best-placedare the big manufacturing MNCs that have solid experi-ence in difficult operating environments in emerging mar-kets around the world and that have now several years ofexperience operating in China. Some global service-sector
firms have an equal amount of international and country-specific experience, but are handicapped in China byextremely tight regulatory restrictions. Then there aresecond- and third-tier MNCs and even one-country firms,many of which are just arriving in China and do not havethe depth of international experience to fall back on. Evenfor the biggest firms like Deloitte and Procter & Gamble,shortages of human capital and counterfeiting in particu-lar remain huge problems. But unlike their smaller coun-terparts, these firms are often in a better position toensure that these operational issues do not completelycrowd out strategic planning.
Infrastructure and distribution China’s economy is certainly experiencing some growingpains. Since late 2001 China has experienced a strongeconomic upturn. GDP grew by 8% in 2002 and, despitethe economic disruption caused by the outbreak of SevereAcute Respiratory Syndrome (SARS) in the second quar-
Part 1
Persistent headaches
● At the operational level, China remains a very challengingplace to do business, despite the vast changes that havetaken place in recent years. China’s business environment israted worse than almost two-thirds of the other 59economies included in the Economist Intelligence Unit’sbusiness environment survey.
● China’s infrastructure has improved during the last few yearsbut has still been overwhelmed by the recent upturn in eco-nomic activity. Deficiencies in the transport network and theregulatory environment impede the ability of companies todistribute goods around the country.
● Regulations in the manufacturing sector have been relaxedbut in the services sector they remain oppressive. Multina-tionals across the industrial spectrum must still deal with redtape and corruption.
● China has an intense shortage of skilled labour, the resultboth of rocketing demand and low supply particularly of peo-ple with the ”soft skills” required by multinationals. Firms areforced to pay high wages to recruit senior staff and must stillfight to retain them in the face of poaching by competitors.
● The violation of intellectual property rights in China is rife.Counterfeit goods are easily available. Although some arepoor copies, others have been produced with the use ofstolen designs and technology. Enforcement remains inade-quate despite the introduction of new laws and regulations.
● These issues affect all companies, but present the most seri-ous challenge to small foreign firms that are just arriving inChina and that lack international and country-specific expe-rience to fall back on. Larger firms are coming up with strate-gies that at least address these issues, if not resolve them.
ter, by a further 9.1% in 2003. This growth helped fuel afurther, sharp rise in incomes, particularly in urban areas.But it has also raised overall demand to the point whereelements of China’s infrastructure, despite the very realupgrading that has occurred since the late 1990s, havesimply been overwhelmed. According to some observers,imports have increased to such an extent that bulk cargovessels must wait for 18-24 days—at vast expense toimporters—to unload cargo at China’s ports mainlybecause of the lack of railway infrastructure to removecargo from docks. China’s newly extended road network isalready showing signs of becoming congested—a result ofthe more than doubling of the number of cars on the roadin just the last five years.
The current economic boom is also causing a return ofthe electricity shortages that dogged China in the 1980sand first half of the 1990s. Shortfalls started to appear inJune 2002 and by 2003 had spread to two-thirds ofChina’s 31 provinces. These shortages were at timessevere—state media reported that some cities lacked suf-ficient electricity to power traffic lights—but are set toworsen further in 2004: according to the deputy chair-man of the State Electricity Regulatory Commission, SongMi, the overall electricity shortfall will double this year to20m kw. The industrial areas around Shanghai andGuangzhou, the main drivers of China’s manufacturingjuggernaut, are already rationing electricity and short-ages are likely to become more severe as the approach ofsummer raises temperatures, and thus demand, for air-conditioning.
These infrastructure bottlenecks, never easy to solve inany country, are particularly tough to tackle in Chinabecause they are often interlinked. Local media havereported, for example, that efforts to raise electricity pro-
duction have been hampered by the deficient rail infra-structure, which has prevented adequate supplies of coalreaching power stations.
The government is throwing money at the problem,approving plans to raise China’s total generating capacityfrom the current 385m kw to 515m kw within the next fewyears. But even the Chinese government thinks that seriouselectricity shortages will not disappear until 2006. The defi-ciencies in the transport sector are likely to last even longerbecause they are not related only to a simple shortage of
China’s business environment rankings
Value of index Global rank Regional rank(out of 10) (out of 60 countries) (out of 16 countries)
Note: A higher score signifies a better environment 1999-2003 2004-08 1999-2003 2004-08 1999-2003 2004-08Overall position 5.3 6.2 42 38 11 11Political environment 4.3 4.5 49 46 14 14
physical capacity. The different types of transport infra-structure are poorly integrated: train services, for example,generally do not terminate at dockyards, so goods must betrucked from railyards to ports. Computerised inventorymanagement systems are rarely used, making it impossibleaccurately to track the progress of deliveries.
No national market In a reflection of the transport network’s continued weak-ness, only one-fifth of the respondents to our survey indi-cated that they thought of China in terms of a nationalmarket. Although regional income disparities are typicallythe main reason for this perception, a significant propor-tion of executives—almost 40%—also attributed this viewto deficient infrastructure linkages. The distribution prob-lems facing foreign firms do not end here. A further 28%of respondents attributed the lack of a national market tocentral government regulation. Wholly owned foreignenterprises in China are, for example, currently preventedfrom conducting international trade, distributing goodswithin the country or establishing warehousing opera-tions. Foreign transportation and logistics companies arealso required to obtain separate licences for each provincein which they operate.
As part of China’s 2001 WTO entry agreement, some ofthese regulations are to be removed at the end of 2004.But rules imposed by the central government are not theonly ones that make life difficult for foreign firms wishingto distribute goods around the country. Multinationalcompanies also face ad hoc regulations imposed by localgovernments, designed to frustrate imports not just fromoverseas but from other regions within China. For exam-ple, the 2003 white paper of the American Chamber ofCommerce (Amcham) in China complained that ”in manylocalities, out-of-province trucks are arbitrarily stopped atcity borders and subjected to tolls that local trucks are not
required to pay.” Indeed, 17% of respondents to our sur-vey stated that local protectionism was a further factorcontributing to the lack of a national market in China. Inmany cases the frustrations of foreign firms with theselocal, ad hoc rules are shared by the central government,which is well aware of the possible benefits in terms ofeconomic efficiency and a more even distribution ofwealth that would result from the creation of a less-frag-mented internal market. Still, China’s vast size and thedegree of autonomy enjoyed by local governments sug-gest that such local protectionism will remain a persistentchallenge.
None of these issues should be ignored. They all causeproblems for foreign firms, which often translate into realexpense: according to Amcham, logistics costs account forup to 16% of product costs in China, compared with just4% in more advanced economies. But companies are com-ing up with strategies to address these difficulties (seebox: Distribution strategies). Even though the distribu-tion system requires substantial improvement, it isundoubtedly becoming easier to distribute goods aroundChina. The transport network, particularly on the eastcoast, has improved considerably in the last five years, ashas the regulatory environment. The distribution prob-lems faced by foreign consumer-goods makers are alsoeasing with the emergence of both local and foreign chainstores—Carrefour, for example, already has 44 hypermar-kets in different parts of China—and specialised logisticsproviders within the country.
Regulations and corruptionThe gradual easing of official restrictions in the distribu-tion sector is symptomatic of an economy-wide trend.During the last few years much of the economy has beenderegulated, a process that was well under way wellbefore December 2001, the date of China’s accession to
When planning for domestic sales within China, you think in terms of...(% responses)
What determines this view of China?(% responses)
Income disparities 54.8
39.6
27.6
17.1
24.0Other
Infrastructuredeficiencies
Central governmentregulation
Local-level informalprotectionism
0 10 20 30 40 50 60
...distinct regions(north-east, Yangtzeriver delta etc) 30.7 Other 6.0
...1st, 2nd, 3rd-tier cities 34.9
...east coastand the
interior 7.4
...a national market20.9
Source: Economist Intelligence Unit survey, March/April 2004
the WTO. During the 1990s almost all of the former indus-trial ministries and state commissions were abolished,cutting the number of institutions and officials at the cen-tre looking to be involved in business affairs. Some old-school planning apparatchiks have no doubt survived butthere are fewer options for them to slake their thirst forcontrol. Many state-owned enterprises have been sold offand a large proportion of those that remain have lost mar-ket share to private domestic firms and foreign-investedenterprises (FIEs). China’s thicket of regulations has beencut back and the rules that remain have gradually becomemore institutionalised. The picture that characterisedmuch of the 1980s and 1990s—everyone from multina-tional managers to Chinese officials groping their way for-ward, often making things up as they went along—is nolonger representative of the business environment. For-eign firms in different sectors have greater understanding
of the broad regulatory framework and can have someconfidence that it will not be subject to sudden or arbi-trary change.
A socialist market economyWhile the improvements have been real, managing theregulatory environment remains a real issue for foreignfirms operating in China. Red tape in China is still perva-sive. In order to open a new joint-venture private hospitalin Shanghai, the US’s Chindex International had to collect150 chops (name stamps signalling approval from a par-ticular department). Even simple banking procedures inChina remain bureaucratic. It is still far from rare for newregulations to surprise and concern MNCs, as was the casewith 2001 proposals from the People’s Bank of China(PBC, the central bank) to limit borrowing by individualforeign banks on the interbank market to 40% of their
Self-distributionSelf-distribution is an option for individual foreign ventures thatmanufacture in China, typically larger multinational operations.This is also the model favoured by local firms: according to a studypublished in 2002 by the State Council’s China DevelopmentResearch Centre, 70% of China’s commercial enterprises have theirown fleet of vehicles and 80% own their own warehouse facilities.
There is also disguised self-distribution, practised by foreigncompanies with multiple ventures. Some companies with multipleventures have used a holding company to act as a sales agent forsubsidiary ventures, assisting them with after-sales service andmarket development, and providing distribution services such astransportation and warehousing. Other firms have established a”service company", for example by designating one joint venture asthe sales agent for all of its ventures. While continuing to issueinvoices for their products, the other ventures sign a contract thathands over all sales and distribution activities to the designatedagent.
Working with local firms It is possible for foreign firms to contract use of warehouse space andvehicles from distributors but supply and directly manage all staff.The terms of such an agreement might include a small cut, perhaps a1% margin. The risk is that these management contracts exist in alegal grey area, making it difficult to obtain redress if anything goeswrong.
Another option is to set up a joint venture between a Sino-foreign joint venture and a Chinese company for distribution.Because both entities are Chinese legal persons, the joint venture isconsidered a domestic rather than foreign-invested enterprise (FIE)
and, as such, is not subject to restrictions on FIEs. But this alsomeans the joint operation is excluded from the tax breaks allottedto FIEs, adding to costs. Furthermore, flirting with restrictions onforeign involvement in the service sector can trigger a responsefrom regulators.
Foreign firms may also seek to identify distributors that meetcertain criteria and then work with them to improve their services.Generally, companies start at the end of the chain—retail outlets—and determine the key stores in each city where their product needsto be. It is then a straightforward matter to identify the majordistributors that supply similar products to those retail outlets.Through direct talks with those distributors, a company can thendetermine which ones will fit into its strategy, and target them forco-operation.
To upgrade the domestic firm, the foreign manufacturer mightguarantee a certain amount of business and support in exchange forthe distributor investing in new vehicles or warehousing. Inaddition, the staff of the foreign firm may work out of the city-leveldistributors’ offices to provide sales forecasts that enable theregional distributors to manage their inventory more effectively.Another foreign importer ”gives” employees to each of its four maindistributors to help increase consumer awareness of its product.
Using a middlemanAnother strategy, frequently employed by Japanese consumer-products companies, is to include Hong Kong-based trading firms aspartners in a productive joint venture. This is not an approach com-monly adopted by Western companies, which tend to view the elimi-nation of Hong Kong middlemen as one of the main advantages ofsetting up a domestic production base.
total renminbi liabilities, denying them an importantsource of funding.
Burdensome red tape, surprising and ad hoc rulesimposed by overbearing local officials—these operationalheadaches can overwhelm day-to-day operations and dis-tract managers from longer-term planning. Firms in sev-eral industries must also cope with formal regulationsaimed at restricting their access to the market. Foreignautomotive firms in China, for example, can only producecars by teaming up with local firms and the governmenthas made no commitment to allow wholly foreign-ownedoperations. The car industry is a sensitive one for the gov-ernment; such a level of regulation in the manufacturingsector as a whole is now rare. But the same cannot be saidfor the service sector, where many foreign firms have beenall but denied access to China’s local market.
That protectionism remains alive and well in the serv-ice industry is perhaps unsurprising. Until the late 1980s,domestic companies simply did not exist in sectors such astelecoms or insurance. These industries were run as partof the governing bureaucracy. The government is probablyrightly concerned that, with easy entry, foreign firmswould quickly displace the fledging locals. The risk of for-eign domination is particularly real in the financial serv-ices sector where domestic companies are not only youngbut also financially weak. Years of bad lending have leftChina’s state-owned banks with a non-performing loan(NPL) ratio of at least 20%. Local insurance companies aresitting on an equity shortfall of several billion US dollars.Domestic banks and insurance companies need time notjust to learn the basics of healthy competition but to puttheir finances in order.
Playing the systemThe good news is that foreign firms are gaining new waysto deal with regulation. Lobbying, for example, hasbecome a much more effective tool. In sectors across theeconomy, regulators now tend to listen more to the con-cerns of industry players. Domestic companies obviouslyhave the loudest voices, sometimes to the direct detri-ment of foreign firms. For example, while the activities offoreign lawyers in China were initially restricted becausethe government was concerned they would bring to thecountry such heretical concepts as ”rule of law”, theretention of the regulations is largely a reflection of theinfluence of an expanding domestic legal profession. For-eign firms are, however, not entirely powerless. The PBC’s2001 regulation on interbank borrowing has yet to beimplemented, a delay that according to Amcham is theresult of a ”strong and unified reaction by various foreignbank associations and chambers of commerce”.
That multinationals are not entirely free of influence ispartly because the government recognises that they play
an important, and often positive, role in the economy.Foreign firms obviously generate much of China’s indus-trial output and a majority of the country’s exports, butthey also directly help with the upgrading of the economy.The research and development (R&D) investments ofpharmaceutical firms, Siemens’ involvement in the devel-opment of an indigenous third-generation (3G) technol-ogy in China and the willingness of executives throughoutthe financial and professional services sectors to giveadvice that help regulators to better understand interna-tional standards are all examples of the direct guidanceand modelling that foreign firms can offer. Cynics mightsuggest that such apparent pandering to the governmentcosts foreign companies resources without producing anyreal gain. Certainly, the government is still more thancapable of riding roughshod over the wishes and desiresof multinationals. But just because lobbying does notalways succeed does not mean that the effort of foreignfirms to show their commitment to China does nothing toraise their influence with the government.
The ability of foreign firms to influence the regulatoryenvironment in their favour does not just stem from thesecorporate-level investments. Cultivating personal rela-tionships—guanxi—is still very important in China. Thiswould be the case even if China was a much more deregu-lated economy than it is today: guanxi is a basic elementof Chinese business culture and is therefore somethingthat no foreign firm seeking to sell to or buy from localcompanies cannot afford to ignore. Cultivating relation-ships with government officials, joint-venture partners,suppliers and clients thus remains an important part ofthe job of senior managers in many foreign financial serv-ices firms. This task is not always easy. Domestic firms areinevitably in a better position to build guanxi, not onlybecause their managers are personally steeped in thelocal business culture, but also because the corporatestructure offers them the necessary degree of flexibility.Foreign firms, even those with Chinese managers, oftenhave tighter standards of accountability that make com-pany procedures more rigid. For example, stricteraccounting procedures result in smaller entertainmentexpenses, making it more difficult to wine and dine busi-ness partners in the expected style. The insistence ontransparency in expenditure, a requirement that appearsso reasonable in a Western context, is also a disadvantagein China: officials will be more wary of accepting hospital-ity from multinationals if they believe their actual namewill be documented in corporate records.
Of course, there is a wider issue involved here: at somepoint the cultivation of guanxi becomes outright corrup-tion. In recent years the Chinese Communist Party (CCP)has been taking stronger action against graft, a pro-gramme that has involved the execution of some very
high-ranking officials. Nonetheless, corruption remainswidespread, a point illustrated by our survey: corruptionwas named by more foreign businesses as having a detri-mental impact on their business in China than any otherfactor.
Human capital constraints Finding and retaining human resources remains one ofthe most taxing day-to-day issues facing foreign compa-nies in China—and its associated challenges have bedev-illed foreign companies since the early 1990s. The 2003Best Employers in Asia survey conducted by a humanresources (HR) consultancy, Hewitt Associates, found thatof the top five issues that CEOs believe determine successin China, four relate to human capital. Labour shortagesin the world’s most populous country may seem counter-intuitive. After all, China’s over 750m-strong rural popu-lation does offer a rich source of low-skill, low-wagemigrant workers. The problem for foreign firms is that assoon as they start to look for people even slightly higherup the value chain, the number of staff available falls andthe price goes up.
Where are all the people?The HR challenge is partly a problem of demand. ExistingMNCs are expanding and new ones set up operations inthe country almost every day. Competing with these for-eign firms for skilled workers are domestic companies.These firms are increasingly able to offer attractive oppor-tunities, particularly for mid-career staff who already havethe credibility and solid professional skills gained fromhaving first worked for a foreign firm. The ability of localfirms to poach staff is particularly high in industries likeinsurance, where the scope for advancement in foreigncompanies that are subject to heavy government restric-
tions remains distinctly limited. But even in more openindustries, such as manufacturing and consumer goods,foreign firms are no longer the automatic choice for ambi-tious people. Budding local MNCs like TCL and Legend canalso offer positions with attractive opportunities foradvancement and foreign travel.
At the same time, the supply of skilled workers is verylimited. In 2003 the country’s tertiary institutionsaccepted 3.8m new students, up from just under 1m in1996, a tiny number in such a populous country. More-over, only a small proportion of graduates will have theskills necessary to work at management level in a foreignfirm. For a start, potential senior staff must have foreign-language skills in addition to their basic training in engi-neering or finance. But MNCs also want to find workerswith soft skills, such as the ability to make decisions andinnovate. It is this that forms the crux of the human capi-tal problems facing foreign companies in China. Overseasexecutives are almost universal in their praise of thestrong core knowledge of local graduates. However,across the spectrum of sectors, from electronics firms toaccountants, these same managers are almost equallycritical of the inability of young people in China to applytheir skills in the workplace. According to Hewitt Associ-ates, companies in China report that ”soft skills includinglonger-term thinking, comfort with ambiguity and uncer-tainty, and innovative problem solving are not what theyneed to be”.
Another issue that is by no means unique to China isthe rigidity of ”mind sets” and a lack of openness tochange—a hangover, perhaps, from several decades of atop-down, state-led economic system as well as an educa-tion system focused on learning rather than thinking. Onefinancial director at a large Sino-American manufacturingjoint venture (JV) who spoke to the Economist Intelli-
0
500
1000
1500
2000
2500
3000
3500
4000
Still not enoughNewly-enrolled students in higher education, ‘000
gence Unit complained of the difficulties in trying toencourage local managers to focus on productivity, still arelatively new concept in a society that tends to measuresuccess in terms of sheer investment in infrastructure andequipment. Many Chinese businesses still hope to advancetheir businesses by investing more and buying new tech-nology, rather than getting better returns out of existingcapital assets or even selling them. Another executivesaid that the biggest challenge ”is making people takerisks and bear the consequences”.
Labour shortages undermine flexibility, increase costsSome financial and professional services firms complainthat shortages of skilled staff pose the biggest obstacle toexpansion in the country, hampering the ability of compa-nies to keep up with the rapid changes in China’s businessenvironment and grab opportunities.
The shortages also mean that the skilled and experi-enced local managers who are in the market can almost
name their own price. Indeed, wage inflation at the upperend of the labour market has been rapid. According to fig-ures from Hewitt Associates, salaries for technical andprofessional staff in MNCs have increased by more than25% over the last three years, a period during which con-sumer prices rose by just 1%. Cash wages sometimes stillappear low relative to other countries but, according toHewitt Associates’ Vincent Gauthier, this is not entirelyaccurate. Financing government-mandated and otherbenefits can add 60-110% to the basis salary of a worker.The result is that hiring such people is no longer as cheapas might first be imagined. According to foreign man-agers, the fully loaded cost of skilled local engineers inChina is around the same as that in Taiwan, and aroundhalf as much as in Germany.
Worse still, even if foreign firms accept these prices,there is no guarantee that they will be able to retain theiremployees. Job-hopping is endemic. Again, according toHewitt Associates, attrition rates for local senior and mid-dle managers working in MNCs in China average around30-40%, well above the global average of just 5-10%.
Addressing the human capital problem is one of themajor operational challenges facing foreign firms inChina. In a market as fast changing as China’s, it is ofutmost importance that foreign companies have in placeskilled and loyal managers. Given the dearth of qualifiedlocal staff and the likely, comparable professional experi-ence of foreign staff, expatriates may be the most obviouschoice. Yet foreign firms must also localise staff, to avoidboth the high costs of expatriate executives and the per-ception that there is a glass ceiling limiting the promotionprospects of local staff. Even if this dilemma can beresolved, foreign firms face spiralling wage costs forskilled employees. With competition and overcapacity
Lagging behindTertiary gross enrolment ratio, % of relevant age group
1980 2000China 2 7
India 5 10
Thailand 15 35
South Korea 15 78
UK 19 60
Japan 31 48
Source: World Bank, World Development Indicators
-2
0
2
4
6
8
10
Top
man
agem
ent
Man
agem
ent
Prof
essi
onal
tech
nica
l and
sup
port
Cler
ical
Man
ual
Con
sum
er p
rice
infl
atio
n
Not so cheap anymore Annual change in wages and prices, %
2001 2002 2003 2004*
Source: Hewitt Associates, Economist Intelligence Unit * Projected
continuing to push down the prices of many finishedgoods, this puts further pressure on profits.
Education, education, educationThe human capital challenge is not, however, experiencedevenly. In particular, the bigger MNCs that have been inChina for several years are in a much stronger position todeal with HR issues than smaller, less-experienced firms.The large companies have a wealth of HR managementexpertise to bring to their China operations, gained fromtheir long experience in many different markets aroundthe world. These firms should be in a better position tounderstand what makes Chinese employees tick—accord-ing to Mr Gauthier, this is opportunities for career devel-opment and training—and have the resources andinstitutional framework to act accordingly. They can, forexample, offer potential local employees positions onwell-established, multi-year executive development pro-grammes. These often include postings overseas but, evenwithout this, some multinationals have developed to sucha size in China that there is considerable room for localemployees to advance, even if there are glass ceilings atthe very top of the organisation.
These programmes help develop local staff and giveforeign firms a supply of skilled and experienced localmanagers who can run the China business in the future.But the training initiatives of foreign firms do not endhere. Companies like General Electric (GE) are establish-ing in China the sort of training structures that they main-tain elsewhere, such as chief learning officers. Severalmajor corporations, such as Motorola, Nokia, IBM andGeneral Motors, have established formal on-site trainingcentres. GE is in the process of building in Shanghai whatwill be the company’s largest staff training facility outsideNew York.
Many companies have also started mentor programmesunder which expatriate managers help develop their localcounterparts. HR professionals in China emphasise thatthe ability to mentor local staff should be a key criteriaused when selecting expatriate managers to work inChina. GE, Intel, Nortel, BASF and Microsoft all requiresenior managers—whether expatriate or local—to desig-nate their successors. In some companies, expatriates arespecifically evaluated on how well they nurture their localsuccessors, a measure that helps prevent the crowdingout of training by the very real day-to-day demands ofmanaging a rapidly growing business. None of these ini-tiatives makes even the biggest firms immune from skillsshortages, wage inflation and staff poaching. But they doshow that multinationals have ways of addressing them.
Intellectual property theftLosing staff to rival firms has secondary, but potentially
more damaging, costs beyond the expense of recruitingreplacements: the loss of valuable company-specific ideasand expertise to rivals. This, of course, is but one cause ofthe piracy and theft of intellectual property that is ram-pant in China. More damaging, perhaps, has been the vul-nerabilities of the JV structure itself, which until recentlyforced almost all foreign firms entering the country to setup partnerships with local companies. The porousness ofthe JV arrangement, combined with a notoriously weaklegal environment, has allowed the theft of trade secretson an almost institutionalised scale.
For even the most casual visitor, it does not take longto stumble upon the pervasiveness of intellectual prop-erty theft in China. Tourists do not have to stray far fromtheir hotels to find shops selling DVDs of the latest Holly-wood films (often before they are released in cinemas),Louis Vuitton handbags and North Face clothing. Thequality of these fake products is often impressive. But thestory does not end on shop shelves. According to theBusiness Software Alliance (BSA), China’s software piracyrate of 92% is the second highest in the world, trailingonly Vietnam. BSA figures show that China was responsi-ble for almost 20% of the global counterfeit losses,equivalent to US$2.4bn, suffered by the software indus-try in 2002. Perhaps the most remarkable illustration ofthe depth of the intellectual property rights (IPR) prob-lem is the emergence of counterfeit cars in China (seebox, Counterfeiting cars in China: Eat your hat). TheDevelopment Research Centre of China’s State Councilestimates the total value of counterfeit goods in thecountry at US$19bn-24bn. Even these large figures donot convey the full extent of IPR violations in China,excluding, for example, the value of stolen technologiesand production techniques.
Counterfeiting and piracy are clearly major problemsfor MNCs operating in China. Our own survey found thatforeign firms think inadequate protection of IPR trailsonly corruption as the factor with the biggest detrimentalimpact on their business in China. More than 50% ofrespondents stated that IPR violations were a problem fortheir China operations.
Tackling rampant counterfeiting and piracy has simplynot been a priority for the Chinese government. Perhapsbecause few local companies own much intellectual prop-erty, the local business community can be seen as a netbeneficiary of the weak protection given to IPR in thecountry, at least in the short term. Arguably so also hasChina as a whole, since the piracy problems have seem-ingly done little to cut the queue of foreign firms waitingto enter the country. In any case, the institutional envi-ronment in China does not naturally lend itself to protec-tion of IPR. The country’s modern political and economicsystem was built on an ideological opposition to the very
concept of private property rights. Moreover, at leastsince 1949, the judiciary in China has not been independ-ent but rather subordinate to the authority of the CCP.Officials at all levels of government have thus viewed thecourts and the legal system as a tool to protect their owninterests and power, including favoured local companies.As a result, legislation protecting IPR has been inade-quate and enforcement of these laws weak.
China’s IPR record is beginning to change. A group oflocal capitalists with a stake in a more rigorous IPR envi-ronment is beginning to appear. A 2003 report by theOffice of the US Trade Representative (USTR), assessingChina’s compliance with its WTO commitments, notes the
emergence of a ”domestic Chinese business constituencythat is increasingly active in promoting IPR enforcement”.The legal environment for the protection of IPR has alsoimproved. Upon entering the WTO, China signed up to theAgreement on Trade-Related Aspects of IPR (the TRIPSagreement), which sets minimum standards of protectionfor intellectual property. According to the USTR, officialefforts to introduce a legal framework consistent withTRIPS had resulted in ”major improvements that moveChina generally in line with international norms in mostkey areas”. Finally, the independence of the judiciary isimproving as China slowly moves towards institutionalis-ing rule by law, if not quite rule of law.
Martin Poste, then head of Volkswagen (VW)Asia in 1996, just laughed. ”Could they evermake counterfeits cars in China?” heretorted, echoing the question. ”Good grief,no! Cars are not like watches or CDs, youknow. A car is too complex a product. Theengineering required to design one and,even more so, to manufacture one is muchtoo difficult to copy.”
That was then. Mr Poste has long-sinceretired. And VW—still the largest carmakerin the world’s fastest-growing market—hasrun into, well, counterfeits. The first copiesbegan appearing in 2000-01. Today, thereare counterfeit Volkswagens, Toyotas, andMercedes and General Motors (GM) cars,among others. Some are made insubstantial numbers and to quality levelsthat have shocked the global majors. Worse,the range of copied vehicles is likely to growfurther and any recourse to law is provingdifficult.
What goes round...The first VW counterfeit—a copy of its Jettamodel—appeared in late 2001, re-badged(as a Chery), altered slightly in appearanceand priced 20% cheaper. A number of com-ponents were even sourced directly from theGerman company’s own parts’ suppliers (andstamped with VW’s logo to prove it). But themajor surprise was the comparatively hightolerances and quality of the new car—close,
in fact, to VW’s own levels. And there wasgood reason. The Spanish carmaker, SEAT, asubsidiary of VW, had sold a car plant to aMexican group a few years previously, andthis had been sold on to a company in China:the counterfeits were being built in an oldVW factory. But there was another twist. TheChinese company that had bought the plant,Anhui Chery, was 20% owned by VW’s joint-venture partner in Shanghai, Shanghai Auto-mobile Industry Corp (SAIC).
VW demanded a halt to the Chery. Itspartner, SAIC, said it would do everything inits power to help: it then persuaded AnhuiChery to stop using original VW parts and topay VW ”a substantial sum” in damages. ButSAIC, apparently, has been unable topersuade its provincial offshoot to ceaseproduction altogether. Chery volumes,instead, have continued to rise, breakingthrough the 100,000 mark in March 2003—almost half the total for VW’s Jetta.
Anhui Chery is not stopping there. InMay last year it launched the QQ—anothercounterfeit of a model not yet in productionbut scheduled to be introduced later thisyear by SAIC’s other foreign joint-venturepartner, GM. Executives at the US carmakertold Anhui Chery last year that they would”not appreciate” them copying GM’sproducts without referring to a specificmodel, and received assurances that nosuch thing would happen. Fast forward:
Anhui Chery’s QQ is said to be ”99% like theGM Chevrolet Spark”, a claim themanufacturer denies.
Toying with ToyotaAnhui Chery is not alone. A separate com-plaint revolves around the Zhejiang Jili(Geely) Group and Japan’s Toyota. Since2000 Geely has produced three differentmodels of cars, each of which look remark-ably similar to models licensed by Toyota’sDaihatsu subsidiary to Tianjin Auto. TheGeely cars even use Tianjin Auto engines,bought legitimately, but at as little as halfthe price of the Japanese-designed car.
Arguments between Geely and Toyotafirst began over the design of the vehicle.But it was similarities in the logo, and thefact that Geely mentioned Toyota in itsadvertising, which irritated the Japanesecompany most (in a poll, 67% ofrespondents thought the offending logowas a Toyota badge, while less than 7%knew it to be a Geely Group brand).
Toyota alleged the Chinese firminfringed on its patented design and tookGeely to court, demanding Rmb14m(US$1.7m) in compensation. In earlyAugust last year, realising it stood littlechance of legal redress, Toyota withdrew itsclaim. But given the extent ofcounterfeiting in China, this legal battle isunlikely to be the last.
An unavoidable operational issueNevertheless, inadequate IPR protection will remain oneof the most vexing problems for foreign firms operating inChina. While the balance is changing, the number of localChinese firms with an interest in demanding better IPRprotection is still far outweighed by those with none.More importantly, despite the improvements that havebeen made during the last few years, enforcement ofChina’s near state-of-the-art legal and regulatory frame-work for the protection of IPR remains extremely weak.According to the USTR, neither administrative nor crimi-nal enforcement of IPR protection provisions have much,if any, deterrent effect. Civil action to protect intellectualproperty can be more effective, but to pursue even thisangle requires an element of luck and a considerableamount of time.
In these circumstances, foreign investors are notentirely powerless. But the hard reality is still that, giventhe weak enforcement, some loss of control of intellectualproperty is inevitable for all large foreign companies inChina. It does not take much imagination or investment,for example, for a local businessman to mimic the logo ofone of the best-known global corporates, or even fordomestic firms to make good versions of designer hand-bags and to burn DVDs. It is likely, however, to becomemore difficult for local companies to learn the detailedproduction techniques that form the heart of the propri-etary knowledge of many of the world’s leading industrialfirms. For example, many foreign manufacturing firms areno longer compelled to form JVs with Chinese companies,closing off one of the main routes of IPR seepage.
Of course, all foreign firms wishing to build substantialbusinesses in China still have to work closely with domes-tic firms, either as clients, suppliers or even productionpartners. Even in these circumstances strategies to pro-tect IPR need not be the stuff of rocket science. Foreignfirms that assume all domestic companies are potentialcompetitors are probably on the right track. For example,a foreign company may ask why the products of a buddinglocal supplier are so cheap? Is it that the firm simply hasan admirably low cost base? Or is it that it wants to gainother advantages, such as the ability to advertise its rela-tionship with a foreign firm or, more dangerously, to pro-cure technology such as the information necessary tomake a component?
Foreign firms operating in the country would be welladvised to take a more sophisticated approach to the pro-tection of company secrets than would be necessary else-where. Simon McKinnon, the president of Corning GreaterChina says: ”You have to build concentric moats, you musthave multiple layers of protection.” When a companybrings in a manufacturing plant, he adds: ”You have tothink about things all along the chain, from how you build
the plant and security at the manufacturing site to whichbits of technology you bring in and what you keep off-shore; which employees have access to what in the plant;and how you handle the future—what do you do in a year’stime.”
There are many reasons to operate in China and for-eign firms will undoubtedly find it useful to tap into thebusiness networks of their local counterparts. Yet a doseof caution remains a good rule of thumb. The EconomistIntelligence Unit learned of one case involving a majorforeign engineering company and a local firm caught in aprotracted set of negotiations. All looked to be going sowell that when the Chinese side asked to view some blue-prints, the foreign company complied, believing that thegesture would increase trust between the two sides.Instead, the prospective partner broke off the discussionsand went its own way, blueprints in hand.
With a careful strategy, even very IPR-intense foreigncompanies can be successful in China. A good example isthe US firm, Qualcomm, a company that produces andsells intellectual property rather than physical products.But Qualcomm’s competitive strength lies in technologythat works only as a sum of its parts—knowing just one oreven several different individual elements is not muchuse. This approach is well suited to China and Qualcommrecorded revenue of more than US$310m (equivalent toaround 8% of the firm’s global total) in China in 2003.Other firms have found ways to trade on their non-manu-facturing skills in an effort to keep the outflow of theirtechnology within sanctioned channels. One foreignmaker of large-screen projection equipment with a fac-tory in south China has found it better to pitch its equip-ment as a way of generating revenue fromadvertisers—which it could help find—rather than ashardware for buyers to use as they sought fit. Further-more, by offering to help set up and operate its equip-ment, it has also found a way of keeping an eye on itsgoods and helping prevent rivals obtain damaging accessto them.
Persistent headachesThat China’s operating environment is perceived as being sodifficult is partly a sampling issue. Attracted by the size ofthe market and the low cost of low-skilled labour, manycompanies that would simply not enter other challengingmarkets around the world nonetheless feel prepared to takeon China. This is the case even for some big names, such asB&Q, whose parent company, Kingfisher, has a non-Euro-pean presence in only three countries (Turkey, Taiwan andChina). B&Q claims to be making good progress in China. Itwould be surprising, however, if other firms lacking muchinternational experience were not overwhelmed by theoperational challenges presented by the country.
A dose of perspective is also needed to better under-stand the challenges to true multinationals posed byChina’s operating environment. Many of these firms havebeen operating for decades in other emerging marketsand thus have accumulated a wealth of expertise andexperience that can be bought to bear in China. In build-ing businesses in China during the last few years, these
companies have started to put in place mechanisms toaddress issues such as labour shortages and theft of tradesecrets. At an operational level, China will remain a chal-lenging location for foreign companies for years to come.But for the more experienced multinationals, at least,operational issues now have a much less dominant impacton corporate performance in China than they once did.
From certain angles, the prospects for China’s auto-motive industry could not look better. China is thefastest-growing automotive market in the world.Sales of trucks and (the focus of this section) pas-
senger cars have been booming for most of the lastdecade. Car sales—driven by rising incomes, decliningprices and, more recently, consumer access to finance—have risen sixfold, from around 300,000 units annually inthe mid-1990s to just over 2m in 2003; sales rose byalmost 80% last year alone, with the majority of cars—some 70%—purchased by private individuals, comparedwith less than 10% in 1995. Similarly, sales of light com-mercial vehicles have risen fourfold during the sameperiod, to around 1.8m units in 2003. Sales of heavytrucks and buses have performed slightly less well, butoverall vehicle sales leapt from 1.4m units in 1995 to4.4m in 2003.
It would be difficult to argue that growth prospects donot remain good. With an estimated 12m cars on the roadtoday—just under one car per 100 people—car ownershiprates in China remain very low; the US, by contrast, makesmore cars each year than China has stock—some 16m—and boasts almost one car for every two people. It is nosecret why car ownership levels in China are still low.Average annual income per head in China is aroundUS$1,000, well below the price of even the cheapest car,and well below the US$4,000 threshold at which car buy-ing appears to take off. Patently, all China will not soon bebuying cars. But where incomes are higher in the maincities and coastal regions, the addressable market isgrowing and will continue to do so as the economyexpands. Driven by passenger-car sales, vehicle salesgrowth for 2004 is forecast to be between 30% and 40%(it was 34% last year); as an indicator, car sales rose by
Part 2
AutomotiveGood times today, but an uncertain tomorrow
● China’s automotive sector continues to expand rapidly. Asdeveloped-world markets have stagnated, there has been aheadlong rush to China by the major foreign automakers—most of which are now present in the market.
● Restricted to 50:50 joint ventures, foreign automakers havehelped to bring major state-owned carmakers into the modernage, if not yet to global standards. Market access has beengiven in exchange for transferring technology and manage-ment skills. Local firms have built multiple partnerships withforeign firms, often playing one off against another.
● The early development of a competitive domestic car industryhas taken many by surprise. Local companies not only com-pete effectively with multinational companies in the Chinamarket, but their number is growing. Many have ambitions tocompete overseas too.
● Although there are good growth prospects and profitability isstill healthy by world standards, the huge capacity expansionunder way is raising concerns about future levels of prof-itability. Already, end-prices are falling quickly as competi-tion heats up.
● In the face of these threats, companies are wrestling withnew strategies to sustain margins.
● The government’s explicit longer-term goal of developing astrong and independent domestic automotive industry, onepredominant in the market, is at odds with the expectationsand plans of foreign investors.
● Given the risk over time to profitability, multinational autofirms will need to devise long-term strategies that take intoaccount a potentially diminished role in the market.
44% year on year in the first quarter of 2004. The Econo-mist Intelligence Unit expects passenger-car sales toreach almost 5m in 2008—even as annual car sales growthmoderates to between 15% and 20% during this period.
The auto sector is profitable, too. Average marginsacross all vehicle types are about 30%, according to theinternational rating agency, Standard & Poor’s; estimatesfor passenger cars are somewhat less, at between 10%and 20% (depending on the manufacturer), but contrastthis with a global average of just 5% and the China marketundoubtedly is an attractive proposition. General Motors(GM), for example, reported earnings of US$437m from itspartnerships in China last year, tripling its profit from2002. On sales of 487,000 cars, this compares veryfavourably with the performance of GM’s North Americaearnings of US$811m on sales of over 4.5m cars. China’smarket leader, Volkswagen (VW), with a 30% market sharein 2003 (down from more than 50%), reported consoli-dated operating profits of Euro561m, around 25% ofgroup operating profits, on sales of almost 700,000 cars.
Investment in the sector continues to surge. Globalauto manufacturers have turned to China at a time whenthe industry in traditional markets is mature and compar-atively static; in the US, car sales have long reached aplateau, whereas European and Japanese markets are inslow decline. With little growth elsewhere, the nascentChina market—with all its apparent potential—is one fewmajor players feel they can ignore. This was not always so.Throughout the 1990s, the market was dominated bythree main joint ventures (JVs), one between ShanghaiAuto Industry Corporation (SAIC) and Germany’s VW,another between Changchun-based First Auto Works(FAW) and VW, and the third between Tianjin Auto (nowowned by FAW) and Daihatsu/Toyota of Japan. But in thelast few years there has been a headlong rush of newentrants. Nissan, GM, Ford, BMW, Hyundai, Daimler-Chrysler—most of the industry’s big names are now pres-ent, each with ambitious plans to build or increasecapacity and market share. Among the plans recentlyannounced:● VW is to invest Euro5.3bn (US$6.4bn) to double
capacity to 1.6m cars by 2007;● the French carmaker, PSA Peugeot Citroen, is to invest
Euro600m to double production capacity at itsDongfeng Motor joint venture to 300,000 cars by2006;
● Japan’s Toyota has formed a strategic alliance withFAW to produce 400,000 cars in China annually by2010; and
● Kia Motors will invest US$645m to build a secondplant in China with its joint-venture partner,Dongfeng Motor.
There has also been a influx of local entrants into the mar-
ket. Names such as Geely, Chery and Great Wall—someattached to established local players, others not—arebecoming familiar badges on China’s roads. Even China’sautomotive aristocracy—SAIC, FAW and Dongfeng—haveindicated they will expand their range of own-label vehi-cles too; SAIC is building a new facility to manufacture itsown cars and others have announced their intent to followsuit. New entrants continue to appear, with some ofthem—like AUX, a home-appliance maker which plans toinvest US$966m to build 450,000 cars annually by 2008—diversifying from their core businesses to cash in on theburgeoning auto market.
Heavily circumscribedChina has good reason to see the automotive industrythrive on its own shores. According to the Michigan-basedCenter for Automotive Research (CAR), auto manufactur-ers and their ancillary industries account for 10.5% of theGDP of OECD nations, or one job in nine. Industry leadersare giants by almost any measure: in 2003 the turnover ofthe US automaker, GM, was 50% greater than the GDP ofThailand and equal to 13% of the GDP of China. There are ahost of other benefits, too: the auto sector is a source ofintelligence in products and manufacturing technologythat stretches far beyond the vehicles themselves—frommaterials innovation to global positioning systems. Ahealthy market for vehicles also greatly increases personal
mobility—another primary driver of economic growth anddevelopment.
China has long designated the automotive sector a pil-lar industry, with all the attendant implications of creat-ing a strong and viable domestic automotive sector. Thisnational strategy, and its subsequent refinements (seebelow), has permeated the entire history and nature offoreign involvement in the industry.
Since foreign automakers made their entry in the early1980s, they could, and can only still, establish operationsthrough JVs with local partners, and then only with up to50% equity. The model was quite rigid. Usually the localpartner was designated by the central government (from asmall coterie of large state-owned firms), and usually aforeign company would have just one such joint venture(the maximum permitted was, and remains, two) at a sin-gle plant producing a single model. There were strictrequirements for local sourcing of components (usually40% plus) and little operational control (nor control overmarketing and sales). Although foreign companies nowhave far greater latitude to work within their joint ven-tures, on all aspects of their business, the basic entry andset-up rules have remained the same.
The regulations circumscribing foreign involvementwere designed quite intentionally. The right to marketaccess had a clear price—by transferring technology andmanagement skills, foreign automakers were to help bringChina’s major state-owned car companies into the modernage, if not yet quite up to international standards. Thesearrangements also permitted the big state-owned firms tobuild multiple partnerships and to play foreign competi-tors off against each other, often to great advantage (insecuring newer technology, for example) and sometimesto ill effect through the leakage of technology and man-
agement skills and, worse, violations of trust. The impactof foreign carmakers on the industry has been enormous,yet their influence has been heavily circumscribed.
The arrangements were, and remain, an unpalatablenecessity to foreign companies. VW arguably has playedthis difficult, and lop-sided, system most successfully. Itcame to China in the early 1980s, setting up two separatejoint ventures (one with FAW in Changchun, the otherwith SAIC in Shanghai). In the initial years, at least, itmanaged to control, and limit, the pace of technologytransfer, often for good reasons (China could not serviceand maintain more advanced cars until recently). In thesevery early days of foreign investment, when governmentrelations meant all, VW worked slowly and patiently,building relationships, and gradually building its share ofa small market of less than 250,000 cars to 60%.
VW was helped by the fact that the market was largelyclosed to other entrants; the German carmaker even had ahand in the appropriate legislation, arguing—rightly—that a free-for-all would not help the country establisheconomies of scale. Its only serious rival was Tianjin Auto,producing (not especially well) small cars under licencefrom Daihatsu. Two small French joint ventures proved lit-tle competition: one, Guangzhou Peugeot, ended in disas-ter, as did the other, Beijing Jeep, an alliance betweenBeijing Auto and Chrysler which suffered many partner-ship teething problems, some of which reportedly remainto this day (Hyundai has now taken on Beijing Auto as apartner and seems to have made more of a success of therelationship, however).
By the mid-1990s these firms controlled more thantwo-thirds of the local market, albeit a market with salesof around 400,000, well below what foreign carmakershad anticipated. Even so, the government was getting
China Brazil Spain Australia South Korea Italy UK
A serious market, at lastPassenger car sales, ‘000
impatient for more technology and more choice. In 1996it decided to offer one more car manufacturing licence,which it awarded eventually to GM in 1997, after a fiercebidding contest between GM and Ford. It was widelythought at the time that GM had paid a high price—the UScarmaker had entered a joint venture to build a US$1.5bnplant, and to bring in its latest technology and cars. And ithad agreed to work with one of its prospective rival’s mainpartners, SAIC. The plan proved to be astute, allowing thestate-owned automaker to play GM off against VW, raisingthe bar for the German firm to bring in its latest technol-ogy as well.
The market was now undergoing a transformation, withsales picking up and, in anticipation of eventual member-ship of the World Trade Organisation (WTO), clear commit-ments to open the market and reduce tariffs. A new waveof interest among foreign automakers was gathering. InJune 2001 the government issued a development planunder which smaller domestic firms would eventually beshut down and the remaining ones consolidated aroundthree of the largest firms: FAW, China’s largest manufac-turer based in Changchun in the north-east province ofLiaoning; SAIC, the second-largest producer based inShanghai; and Dongfeng, the third largest located in thecentral province of Hubei.
Foreign firms, too, have been drawn inexorably intothis constellation. With a limited number of viable Chi-nese partners in the market, many new entrants havebeen forced into alliances with partners that are alreadyaffiliated with their global rivals. As with VW and GM shar-ing SAIC, Toyota and VW share the same partner in FAW,and Renault, Peugeot and Nissan are all working withDongfeng (Nissan is the only carmaker to have brokenthe joint-venture mould, by acquiring a 50% stake inDongfeng for US$1bn; the fact that it was unable tosecure a majority stake suggests, however, that its expe-riences will not be dissimilar from its joint-venturerivals). Unsurprisingly, these arrangements are creatingtension.
Competition and overcapacityGrowing competition among foreign players is one thingbut few seem to have anticipated the emergence of new(and surprisingly competent) local rivals or the growingstrength of established local firms. The market is certainlybecoming crowded. China has 100 or so domestic carmanufacturers. Many of them are small admittedly, andlikely to be consolidated or driven out of business, but asignificant number are real competitors.
With every carmaker eager to grab market share, theconcern is that collectively they are over-investing, andbuilding too much capacity too quickly. Although it is dif-ficult to measure precisely, the plans of foreign and local
firms together are likely to add another 4m-5m units ofcapacity by 2006. According to Mike Steventon, the headof the auto practice at the management consultancy,KPMG, overcapacity in the industry in China is likely to hit70% in the next few years. Most analysts agree that over-capacity is looming—it is just a question of how severe,and how long-lasting, it will be. Much will depend on howcurrent aggressive capacity-building plans play out. Car-makers themselves say that new investments will followthe pace of demand and that capacity forecasts tend tooverestimate the potential of local carmakers; GMobserves that the market has been continually undersizedby carmakers in recent years. Yet it is worth bearing inmind, too, that the market already carries overcapacity—among foreign carmakers, estimates automotive consul-tancy Autopolis, utilisation rates were around 65% in2003; purely domestic firms—those whose capacity isknown—could manage only 40% last year. Exceptionallyrapid rises in car ownership will be needed if both existingfacilities, and the huge new ones currently being built, areto be profitable. This is unlikely.
Foreign automakers are entering a period whenfalling prices—and margins—will be their primary con-cern and the focus of their business strategy. The fear isthat margins—until now quite healthy—will soon drop toglobal norms. Falling prices are now a characteristic ofthe market as competitive pressures—exacerbated bycheaper imports (under WTO, vehicle tariffs beganfalling in 2002)—increase. Domestic car prices fell byaround 11% last year and industry analysts forecast amore than 10% drop on average in 2004. Add to this therising costs of inputs—steel, rubber—and margins lookquite fragile.
The risks to foreign manufacturers are significant. Thedominant manufacturer in China, VW, which has plans tolocate almost one-third of its productive capacity in Chinaby 2010, is likely to suffer most as pricing power evapo-rates. The days when it was earning a net profit of up toRmb20,000 (US$2,400) per car, twice its average globalmargin, have long gone. But equally, all other manufac-turers must now live in a market in which sales are likely torise and margins are likely to fall. The common quest willbe to come up with new strategies to sustain margins orprevent them falling so quickly.
Among the solutions are:Scale back capacity and expansion plans. For many com-panies this is simply not an option. Most have enteredChina to seize market share and, currently in their build-out phases, have fairly rigid commitments and timelinesto achieve capacity and market-share targets. Inevitablythey are not in a good position to counteract pricing pres-sures and sustain margins.
Gear up for exports. Most foreign carmakers in Chinahave plans to export, yet, with the exception of Honda(whose Guangzhou plant is export-only), few seem partic-ularly serious about doing so—despite growing govern-ment pressure to make China a global production hub.Most set up operations in China to meet local demand andhave little incentive to export to markets where they havemore than enough capacity already—and often labourunions to think about, too. Nor is it assured that exportswould fare well abroad in any case. The quality of Chinese-made cars is not up to international standards. The lowcost of labour in China offers little benefit to potential carexporters; being capital-intensive, the average labourcontent in a US$20,000 vehicle is around US$1,500,according to Deutsche Bank; the most efficient plantstoday are in high-cost Japan. Components, which typi-cally require greater scale than the vehicles themselves, isnot a fully developed sector, nor yet cost-efficient.Exporting vehicles from China only really makes sense as away of repatriating profits or making a show about com-mitment—the theme, it seems, behind most foreignexport plans in the sector so far.
Car financing. Margins on the cars themselves may befalling but sales volumes will certainly increase, as will the
opportunities therefore for financing—and for leveraginga lucrative service business on the back of the core prod-uct. Car financing is a major and integral component ofthe business of global car firms. In the past couple ofyears, China’s domestic banks have been rushing to pro-vide individual car loans; foreign firms had been excluded(despite WTO provisions allowing their participation).That has now changed. In October 2003 long-delayed leg-islation was finally announced and three major players—VW, GM and Toyota—each received approvals forestablishing auto financing companies (AFCs). Car compa-nies certainly have great hopes for AFCs. Ease of consumerfinance should help propel sales, reduce the threat ofovercapacity and, in a virtuous circle, feed more financingitself. These are big hopes—demand will have to rise veryquickly indeed to keep up with new supply. In any case,the wait for foreign AFCs is not yet over. Numerousbureaucratic hurdles must be negotiated and car compa-nies expect AFCs to be up and running only in the third orfourth quarter of 2004. Even when AFCs are set up, carcompanies would be well advised to take a conservativeattitude to customer selection. Defaults with banks so farhave been high, unsurprisingly perhaps: the average com-pact car costs 2.3 times the average annual householdincome in China, compared with just 20% of averageincome in Japan.
Imports. Like financing, imports are very much icing onthe cake. Lower import tariffs have not yet had a majorimpact on the proportion of imported cars sold in China;although numbers have risen, imports account for lessthan 5% of vehicle sales. But they are potentially a richsource of added value, particularly given that income doesnot have to be shared with a partner.
Local sourcing of components. Perhaps the single mostimportant strategy to combat falling margins is to reducecosts (cars are relatively expensive to produce in China;generally, economies of scale are not especially good).Cars are made largely of components sourced from (usu-ally separate) parts makers. Typically, car companies arerequired to buy a certain percentage of locally made partsand many have encouraged their traditional parts makersto join them in China in order to be able to secure localsourcing lines able to produce quality parts. But compo-nents made in China typically also cost above the globalaverage—usually by around 10-20%, and in some cases byas much as double the price of parts elsewhere; most com-ponent makers do not yet have the economies of scale toproduce in China cheaply. As demand from carmakersincreases, component makers are expanding their capaci-ties and investments in China. There are no immediateand quick solutions but companies like GM, for example
0
500
1000
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2000
General Motors* Volkswagen**
Very sizeableShare of global profits, 2003, US$m
* GM figures are solely for automotive operations (not financing) ** VW China figures are not included in Group figures. Converted at Euro1:US$1.20
(and not untypically), are now working closely with localsuppliers to bring down costs over time; GM is extendingtechnical help (on quality issues and training on improv-ing scrap rates, for example) and is also extending larger-scale orders to encourage economies of scale. Mostforeign carmakers are looking to increase local content toabove 70% in established models (new models takelonger).
Differentiate, differentiate, differentiate. Technology,design, brand—all are important distinguishing featuresin a market where copying remains rampant and lack ofbrand innovation acute. All foreign carmakers, withoutexception, already pay heed to this mantra but difficultiesmay come, especially for foreign brands at the bottom of
the market, as these would be the first to come under seri-ous attack from emerging domestic firms.
A road-map for...Chinese companiesThe desire to capture the China market, and all that itpromises, has compelled many major foreign carmakers toaccept rather unpalatable arrangements and, in somecases, violations of trust. But overcapacity in the marketand underwhelming partners are, perhaps, only near-termcomplications. A greater concern is the government’sblueprint for the future of the local car industry—anddetermining where foreign carmakers fit into the picture.
Since 1994, the government has said that its long-termobjective is the establishment of a strong and independ-ent domestic automotive industry. Plans have been
Counterfeiting. The idea of counterfeit carswas laughed off when, in 1996, it was putby the Economist Intelligence Unit to a sen-ior foreign automotive executive in China.Cars are too complex, he replied. Yet today,counterfeits—near-complete copies, insome cases, of foreign-designed vehicles—are now being produced in substantial num-bers across the country. Imitation VW,Toyota, Mercedes and GM cars are crowdingChina’s roads alongside the more expensiveoriginals; and counterfeiting of auto partsis also rampant in China—by some esti-mates, as much as 90% of aftermarket partsare fakes. Counterfeit cars are being built toquality levels that have shocked the majorcompanies, and the range of copied vehi-cles is expected to grow further. Theauthorities, certainly, are doing a better jobof enforcing laws against counterfeiting butpenalties remain inadequate, according toforeign automakers and suppliers. More-over, recourse to law is proving difficult(several cases have been lost) and litigationsuggests even the more respectable localpartners cannot be trusted. (See Part 1,Persistent headaches, for a detailed casestudy.)
Repatriating profit. There may be profit tobe made, but how to get it out when the ren-minbi is not fully convertible and the local
party in the (50:50) joint venture wants themoney retained? VW, for example, tries to“export it out” with engines. But still, withpressure from its partners, VW says it is rein-vesting much of the profit and expects,instead, to be able to get the money out atan unspecified point in the future. Only forHonda, with its export-only plant inGuangzhou, can margins be taken where thevehicles are sold.
Sales and service networks. China is a vastplace and national distribution and servicenetworks hugely complicated to set up. Acar sold to a customer in Beijing mightneed to be fitted with spare parts in InnerMongolia, Lanzhou or the far westernregions. Many joint-venture firms areforced to sell their cars through provincialgovernments and allied organisations. Insuch uneven circumstances, how can car-makers build a consistent brand? Thebiggest carmaker, VW, has just 900 outletsafter being in the country 20 years. Toyotahas just 100; Honda twice that.
The right product. What sort of cars willChina’s new motorists want? The truth is, noone knows. The market is currently in anexperimental stage; most car buyers aretasting the different models on offer, hencethe plethora of sizes, models and brands on
the roads. There is, as yet, no fixed patternand no second-hand market to indicate howthe market will evolve. Will the Chinese wantmanageable cars for the family, pick-ups(70% of the market in Thailand) or smallcars and MPVs (the two segments that makeup the bulk of the market in South Korea)?How, indeed, do foreign firms know what tobuild when they establish factories to makeone model in volume?
The darker side. China’s car market may, inthe medium to long term, be constrained bya number of other factors. The availability ofpetrol (at affordable prices) is one possibleconcern, as China soaks up increasing vol-umes of world oil and questions begin to beraised about the sustainability of globalsupply. China’s urban environment, too, issuffering markedly as a result of the explo-sion of cars on the road. Particulate pollu-tion is increasing dramatically in cities likeBeijing and Shanghai, and traffic snarls andaccidents are increasingly common, andserious. Both these have significant eco-nomic and health implications and costs,and the risk is that governments at all levelsin China may feel obliged to bring in restric-tions on car ownership to tackle them;already Shanghai limits the number of newcar registrations each month, and othercities may well follow.
steadily updated and refined since. The detailed objec-tives spelled out in the Tenth Five-Year Plan, which runsuntil 2006, specify a very precise vision for the sector’sdevelopment. The Plan outlines the projected pace oftechnology development for the industry, the competitivestructure (including the numbers of companies in eachproduct segment), the consolidation of the sector around
three dominant carmakers (FAW, SAIC and Dongfeng), thetypes of vehicles that will be needed and by when, and asequenced plan for the development of component tech-nologies. These plans are extremely detailed and part ofwider government development objectives. The market sofar has evolved almost exactly as the government decreed.
Further refinements have followed. In May 2003 the
Glance at the vehicles parked on the streetsof Beijing, Wuhan or Shanghai and you willrarely see a Mitsubishi badge. Yet the com-pany has a higher share of the light-vehiclemarket than many other big names inChina’s auto sector, such as Audi of Ger-many, Ford of the US and Japan’s Honda.
“We have a different strategy for China,”says Mitsubishi’s Tokyo-based marketinghead, Steve Torok, as he explains how hiscompany grabbed 6% of the light-vehiclemarket, with revenue of US$300m in 2003.With sales of more than 145,200 cars andmulti-purpose vehicles (MPVs), it achieved avolume almost three times that of Audi,seven times that of Ford and 40% more thanHonda.
More ventures, not lessMitsubishi’s approach is certainly different.For a start, it has pursued several separateventures, unlike most of its foreign rivals.Most critically, it has not, for the most part,pursued partnerships with the big names ofthe business. Rather, it has operated on thefringes, seeking partnerships with severalsmaller firms. Through these arrangements,the company has four vehicle-assembly andtwo-engine production alliances—yet itcontrols not even half of any of them. This isanother distinguishing feature of Mit-subishi's strategy: while it has some equityparticipation in some of the ventures, mostare purely licensing arrangements. Eventhen, the stakes and licensing agreementsare sometimes held through a third party.
According to Mr Torok, Mitsubishi MotorsCorporation (MMC), in which Germany’sDaimlerChrysler has a controlling stake(though this is now under review), has“chosen less visible partners deliberately”.
Instead of getting into bed with a still-state-owned company which is in need oflarge-scale restructuring, lay-offs and aninvestment overhaul, Mitsubishi’s morenimble partners have been able to raisecapital locally, Mr Torok says. He adds thatbeing linked to smaller partners makes iteasier to avoid having the sorts of overlypoliticised negotiations with the authoritiesthat have dogged many other foreigninvestors in the sector.
The bulk of Mitsubishi’s sales come froman alliance with South East Motor (SEM), acompany formed in 1995. SEM sold close to80,000 Mitsubishi Lancers, Delica vans andFreeca small multi-purpose vehicles in2003—all under its own brand. Therelationship is controlled through ChinaMotor Corporation (CMC) of Taiwan, one ofMitsubishi’s most enduring and successfulAsian partnerships. CMC, which controlsone-quarter of the Taiwan vehicle marketitself, owns 50% of SEM. (It is still illegal tocontrol more than 50% of a vehicleassembly venture in China.) The local Fujiangovernment owns the remainder. AlthoughMitsubishi has made no direct investment inthe venture so far, it has been able to buildhealthy volumes. Moreover, the vehiclesrely completely on Mitsubishi technology.Because Mitsubishi owns 15% of CMC, it hasalso been able to draw royalties and earnrevenue through licensing agreements.
The Japanese company has also takenminority equity stakes in two engine jointventures, Harbin Dong (in which it has a15% stake) and Shenyang Aerospace (25%).These companies also have licensingagreements for Mitsubishi technology.
The strategy specifically encouragesMitsubishi’s partners to take a stake in the
business, according to Mr Torok. This meansthat the motivation to counterfeit—aphenomenon that has been a bane to othersin the industry—is much less, especially ifthe local partners can be helped to maintainhigh margins. “We have never had a lawsuitor a fight,” he adds.
Next, the brandSo far, the company has not insisted on theuse of its brand: less than 10% of the vehi-cles sold in China in 2003 carried the three-diamond-shaped Mitsubishi badge. Butthere are now plans to introduce the Mit-subishi brand on all vehicles and bring in awider range, which the company sees as akey step in creating a more powerful base forfurther growth. It recently introduced thePajero Sport through an alliance with BeijingJeep (one of the bigger Chinese names in thesector) and the Outlander. Both carry theMitsubishi badge and are sold throughbranded dealerships. Again, however, MMChas no equity stake in the business.
Mitsubishi’s unusual portfolio strategygives the company greater flexibility toachieve these goals, claims Mr Torok. Itopens more options and gives it leverageover where to put future production. Thisgives the company a stronger hand innegotiations, a rare thing in the auto sectorin China where pressure to “cut a deal” andthe fear of being left out make most hot-headed entrants almost dizzy.
Nothing is ever certain in China’s autosector, of course. But with a growing share,good returns, little investment, seeminglyhealthy relationships and, it says, nocounterfeit problem, taking a different roadcertainly seems to have paid dividends forMitsubishi so far.
Under-utilisedChina’s passenger car capacity and production, 2003
Capacity, Production, Utilisation Foreign joint ventures ‘000s ‘000s rate, % Plans/commentsBMW—Brilliance Automotive 30 7.5 25 Investment to treble by 2005DaimlerChrysler—Beijing Jeep 80 19.4 24 Production 80% lower than in 1995
Mercedes to make 25,000 own-brand cars a year by 2012Fiat Auto—Yuejin Automotive 100 37.4 37Ford—Changan Automobile 50 18.5 37 Plans to increase capacity to 150,000 by 2006
Affiliate Mazda plans to have 300,000 units of capacity by 2010Ford—Jiangling Motor 100 60.3 60General Motors (GM)—Jinbei Automotive 30 3.5 12 GM expects to have 750,000 units of capacity in China by 2006GM—Shanghai Automotive (SAIC)—Wuling 180 0.5 0GM—SAIC 200 207 104GM—SAIC—Dongyue 100 na naHonda—Guangzhou Automobile 120 117.2 98Honda—Dongfeng Motor 30 na naHonda China (export) 50 na naHyundai—Beijing Automotive 50 55.1 110 Hyundai (which owns Kia) plans to have 300,000 units
of capacity by 2006Hyundai—Dongfeng Yueda Kia 100 52 52Mitsubishi—Hunan Changfeng 50 29.2 58 Mistubishi plans to have 200,000 units of capacity by 2006Nissan—Dongfeng Motor 100 66.1 66 Plans for 300,000 units of capacity by 2006, affiliated Renault
plans to have 300,000 units of capacity with Dong Feng tooNissan—Zhengzhou Light Automobile 60 10.1 17PSA Peugeot Citroen—Dongfeng Motor 150 105.5 70 Plans to raise production to 300,000 units within “the next few years”Suzuki—Chongqing Changan 100 102.1 102Suzuki—Jiangxi Changhe 100 37.3 37Toyota—Tianjin Automotive 50 49.5 99 Toyota plans to double capacity in Tianjin in 2004 and
increase it to 400,000 units a year by 2010Toyota—Sichuan 10 0.4 4 New plant. Toyota also plans to make up to 300,000 cars a year
in GuangdongVW—First Auto Works (FAW) 300 302.3 101 In all, VW wants to increase capacity to 1.6m units a year by 2007VW—SAIC 450 405.3 90Total foreign JVs 2,590 1,686 65
Domestic companiesDongfeng Motor Luizhou 50 10.3 21 With its own production and that of affiliates, DFM says it will
Notes: For domestic firms, known additional capacity is cited. There are many other domestic firms making cars, though few have ready information available. A significant number of new firms are entering the sector aswell; AMX, a home-appliance maker, plans to add 450,000 units of capacity by 2008
The titans of China’s automotive industry—big names like Shanghai Auto Industry Cor-poration, First Auto Works andDongfeng—get most of the attention. Butcar producers, on average, buy parts worth75% of the value of each car and so arehighly dependent on a vast array of partssuppliers. While much attention has beendevoted to the corporate strategies of themajor car companies, it is worth consideringhow part suppliers, China’s automotive foot-soldiers, are faring in the world’s fastest-growing vehicle market.
In the first survey of its kind, the top 300automotive-parts makers in China have justbeen asked their views. Just over half ofthese were purely indigenous firms, the restmostly foreign-invested joint ventures and afew entirely foreign-owned firms. Theresults of the survey, which was carried outby the Economist Corporate Network, asister company of the EconomistIntelligence Unit which also participated inthe survey for this report, suggest that thecar-components sector is in some confusionabout what it originally hoped to achieveand what it now believes it really will.
The biggest issue for those questionedwas growth, although not in the way thatmight be imagined. Obviously enoughperhaps, the companies thought thatChina’s automotive sector would continueto grow rapidly (in fact, none evenquestioned the idea). More than 70%thought that the market would expand bymore than 11% in each of the next fiveyears. Yet most expected themselves togrow even faster—almost half planned toadd capacity by more than 20% a year. Thissuggests that the companies all plan toincrease their market share (animpossibility), so there is likely to be aneven greater level of overcapacity in thecoming years than there is today.
The survey also threw up a rather unlikelyfinding over export development, one of themost oft-touted reasons for internationalparts makers to be in China. In contrast tospeculation that China will be theautomotive-parts supply base to the world,the survey found that very few firms are nowexporting much at all. According to thesurvey, 83% of purely domestic Chineseparts makers export less than one-quarter oftheir output, while the majority of foreign-participant companies also export less thanone-quarter of what they produce. Thereason? Cost competitiveness—or rather thelack of it.
Contrary to popular belief, the auto-parts sector is highly scale- and capital-intensive—very few parts actually havemuch of a labour input. The scalerequirements in components are typicallymuch higher than they are for car assembly.In practice, almost every part is stamped,bashed, extruded and wound by machines inmassive volumes. The few labour-intensivecomponents that exist are already made inother low-cost countries such asBangladesh, India and the Philippines.China cannot compete where labour costsreally matter. Moreover, many componentsare too heavy, delicate or integrated withother parts to make overseas productionand shipment very sensible. Even theindigenous Chinese parts makers claimedthat they have to import more than half ofthe value of their end products. Sino-foreign joint-venture firms reported an evenlower local added value.
Firms do not expect these prospects tochange much as a result of China’smembership of the World TradeOrganisation (WTO). Only 20% of all thefirms questioned expected to increaseexports as a result of WTO membership.Companies saw the greatest impact of WTO
coming in the form of lower vehicle pricesand more inward investment—that is, morecompetition. By implication, they see asector where cost pressures will rise furtherand economies of scale will be even harderto achieve.
None of this is the way it was portrayed afew years ago. Foreign parts makers hadclaimed to be in China for three mainreasons. They said they had been forced tobe there by their customers, the vehiclemanufacturers. But many investors alsoclaimed to their shareholders that they weresetting up shop in China because theywanted a share of a fast-expanding market(in a global sector without any growth). Yetthey seem to have found a market which isincreasingly fragmented, where costs arehigh, prices are likely to fall and where mostbelieve Chinese firms are favoured by theauthorities and will continue to be.
Another reason, they claimed, was todevelop an export base. Again though, withplenty of capacity elsewhere, few labour-intensive components in the business (andthose that do exist already being made inother countries), a lack of scale, anincreasingly fragmented supply base, fewparts that can be shipped easily across theworld for the just-in-time needs of theirend-customers 8,000 miles away, as well asan expectation that WTO will not increasethese opportunities much, the argument isbeginning to ring a little hollow.
On the basis of this survey, it isbeginning to look as if the world’sautomotive-parts makers were at bestunrealistic about their initial prospects inChina. As the market grows, the situationmay improve. For now, however, the grandbattle plans of the foot-soldiers of theworld’s automotive industry are looking alittle less well thought-out than they onceclaimed.
government published a draft auto-industry policy thatalarmed many in the industry and raised fears that theability of foreign carmakers and suppliers to protect theirproprietary technology and intellectual property would befurther curtailed. There are some familiar features, forexample on ownership—this would remain at 50%,although foreign car companies had been hoping thatChina would ease rules that limit on foreign investment.But the critical feature is a requirement that, by 2010,50% of all sales in China must be in the hands of whollyowned domestic firms using their own technology. As themanagement consultancy, KPMG, has noted, the “provi-sion could force foreign manufacturers to turn over theirtechnology and patents to their local partners as a way ofremaining in business.”
Whether these new plans are fully implemented—oneissue will be whether limiting the sales of foreign compa-nies to 50% violates China’s WTO obligations—it is clearChina is trying to put its companies at the centre of theindustry and develop a more autonomous and free-stand-ing sector, less dependant on foreign firms. Chinese poli-cymakers have hinted that they may heed calls from theauto industry to make the controversial automotive policyless protectionist. The State Development and PlanningCommission has released a new draft which is softeraround the edges. But there continue to be concerns thatthe key policies (which remain almost unchanged) willinhibit foreign involvement in the sector.
Determining the future balance of local versus foreignis difficult—often such long-term policy documents arebroad in nature and articulate a preferred rather than asingular vision. Yet it is worth contemplating what a morepessimistic scenario might be. Autopolis forecasts that asChina’s market for cars and trucks grows to around 13m by2020, as much as 80% of total sales will be from whollydomestic firms. Autopolis argues that the pattern ofdevelopment in the auto sector already mimics the evolu-tion of other key sectors of the economy. The model, itnotes, works something like this: the government sees anopportunity; it develops plans; invites foreign partners(but only in minority or equal partnerships with localfirms); builds domestic capabilities (partly with counter-feits); and then gradually assumes control of the market.Such a pattern was followed in the development of thetelecoms sector, computing and white goods, and in otherindustries where the maturing process took ten years orless. In the auto sector, the pace of development is likelyto take 20 years or more, according to Autopolis, but theinitial stages of the industrialisation pattern are alreadyidentical and recognisable.
Autopolis also sees China mimicking Japan and SouthKorea. Both these countries developed their auto sectorsas China is doing now (although neither had a problemwith counterfeiting): state-supported industries initiallyforged alliances with global names or signed licensingagreements and built their own skills until indigenousmanufacturers became dominant. Today, both have mar-ket demand patterns in which imported or foreign brandsaccount for less than 5% of sales. Autopolis’s projectionsmake China similar in construct to Japan and South Korea,the only other countries in the region with automotiveindustries that now have deeply rooted, indigenous skillsas well as technological depth, industrial scale and devel-oped brands.
Good times today, uncertain tomorrowWith most major car markets in a slump, China is the mostattractive automotive market in the world at present. For-eign carmakers have been falling over themselves to get afoothold, or to expand, in a market that, understandably,is seen as having good long-term potential. Yet clearly,there are reasons for prudence. There is a risk to the long-term profitability of multinational car companies in thegovernment’s explicit policy goal of building an inde-pendent auto industry using JVs with foreign firms as con-venient stepping stones. Foreign companies will certainlybe an important factor in the China market for many yearsto come, but at the same time they need to developstrategies that are cognisant of these realities—and of thepossibility of being marginalised.
More immediately, companies need to think of whatcan be achieved now and in the next few years, and how todevelop strategies to cope with the host of difficulties anddisadvantages (particularly of ownership and control)that they face. Untrustworthy partners, technology leak-age, counterfeiting, the rising cost of inputs, burgeoningcompetition, falling prices and falling margins are allcharacteristic of working within a rapidly expanding andmaturing market.
Equally, China is an emerging market with an over-heating auto sector; a further risk, and one experiencedby almost every emerging automotive market from Mex-ico to Indonesia, is of a collapse in demand and sales. Carcompanies would be well advised to think about how theycan limit their exposure. So great is the fear of being leftout in this peculiarly global industry that too many firmsseem to be rushing in headlong. China calls for lesshaste, more focus on building working relationships andmore attention to the evolution of the market and tobuilding brands.
Coming of agePart 2 Financial and professional services
Of all industries in China, the financial and profes-sional services sector is the one where the gapbetween the current reality and future expecta-tions of foreign firms is the greatest. Currently,
China is a minuscule market from a global perspective,even for the most committed of foreign firms. More thanhalf of the firms in this sector that responded to our sur-vey reported that China currently accounts for 2% or lessof global revenue. For the world’s largest financial serv-ices firm, Citigroup, for example, the mainland China mar-ket remains small relative to even Hong Kong and Taiwan,let alone its home market of the US. In 2003 China con-tributed just 3% of the foreign first-year life insurancepremiums collected by American International Group(AIG), a company that in recent years has gained privi-
leged access to China’s market. One of the world’s largestaccountancy firms, KPMG, admits that China is currentlyvery small relative to its global business. A leading inter-national law firm, Shearman and Sterling, reports thatChina is small relative to its West coast office in the US orits Paris office in France.
Pinning down exactly how important China is to foreignservices companies is tough, not least because few firmsare willing to reveal detailed revenue data. Instead theytend to lump their operations in the world’s most populousnation with those generated by the rest of the Asia andAustralasia region. This reticence is perhaps surprising,given that most foreign and professional services firmsthat responded to our survey indicated that top-linegrowth was the criteria used internally to judge success.
Part 2
Financial and professional servicesStill dreaming of the future
Of all industries in China, the financial and professional serv-ices sector is the one where the gap between the current real-ity and future expectations of multinational companies is thegreatest. From the perspective of the global financial andprofessional services industry, China is a minuscule market,even for the most committed of foreign firms.
But there is an almost universal belief among big foreignfinancial and professional services firms that within ten yearsChina will emerge as one of their biggest global markets.Recent growth suggests that China has the necessary level ofdemand. The question is, will it be foreign or domestic firmsthat provide the supply?
Foreign financial and professional services firms are subjectto tighter restrictions than companies in any other sector.Overseas banks and insurance companies also face domesticcompetitors that have huge branch networks and veryaggressive pricing strategies.
All is not lost for foreign firms. Domestic players tend to befinancially weak and thus open to co-operative and even own-ership arrangements with their overseas counterparts. Also,foreign firms have much higher service standards—a traitincreasingly appreciated by China’s growing middle class.
There is no common strategy among foreign services firms.There is the Anglo-Saxon approach (exemplified by the likesof HSBC and Citibank) that takes advantage of any opportu-nity to expand corporate presence in China. The continentalEuropean financial services groups, by contrast, have a lowerprofile and more diversified strategy. Then there is the spe-cialist approach favoured by the likes of Franklin Templeton,Chubb and the legal and accountancy firms.
Strategies are determined more by the nature of individualfirms outside China than by conditions inside the country. Inthis way, while the market remains difficult, foreign firms areplaying to their strengths.
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Coming of agePart 2 Financial and professional services
Still, the shyness about revenue is nothing when comparedwith the almost universal caginess with regard to prof-itability. It might be thought that of all sectors, executivesin the financial and professional services industry wouldknow a thing or two about net earnings and return on capi-tal. This, however, is far from apparent when bankers,accountants and even management consultants are ques-tioned about their own profitability in China. One of thefew organisations that is willing to publish specific earn-ings numbers is HSBC, which claims that in 2003 mainlandChina operations generated profit of US$42m—a figurethat hardly registers when set against the UK-based bank-ing giant’s global pre-tax net earnings of US$12.8bn.
The insignificance of China in terms of revenue andprofit is not obvious from the amount of corporate atten-tion paid to the country by many of the world’s leadingfinancial and professional services firms. For example,since becoming chief executive of Citigroup in October lastyear, Charles Prince has already visited China three times.Foreign insurance companies are restricted in all sorts ofways from accessing China’s domestic market and yet mostof the top global firms have set up operations in the coun-try. China was the destination for the first official overseasvisit made by the global chairman of KPMG, Mike Rake. Oneof KPMG’s rivals, Deloitte, chose Shanghai to host its firstglobal management committee (GMC) of 2004 and plans toincrease its China staff from 1,500 to 4,500 over the nextfive years, an expansion that is claimed will involve thebiggest investment in the organisation’s near 100-yearhistory. Many foreign legal firms in China may be losingmoney but few are passing up the opportunity to establishsecond offices in the country. Securing premises alone maynot cost much but putting partners in them represents aconsiderable investment for these firms.
China may be a minor market for foreign financial andprofessional services companies at the moment butamong most of these firms there is an almost universalbelief that within ten years the country will emerge as oneof the world’s leading markets for the largest foreignfinancial and professional services firms. In a reflection ofthis, almost half of the companies in these industries thatresponded to our survey said that, from the perspective oftheir central headquarters, China is ”critical to globalstrategy”. More specifically, according to HSBC, China is a”critical long-term growth area”. Citibank has identifiedChina, along with India, Brazil and Russia, as one of themain growth markets of the future. A big European bankwe spoke to thinks China could become one of its topfive—perhaps even three—global markets within the nextten years.
The excitement is not limited to the banking sector.AIG believes that ”with a population of 1.3bn and a highsavings rate, there is enormous opportunity” in China.According to an executive from another leading insurancefirm, ”In 15 years China will be the second-largest insur-ance market in the world.” Managers at one of the world’sleading asset management specialists, Franklin Temple-ton, believe that, based on current growth rates, Chinacould become one of their most important internationalmarkets in five years. Meanwhile, KPMG believes that itsShanghai office will be one of its biggest in the worldwithin ten years. The list goes on. Only the law firms tendto be a little less effusive but even they expect solidgrowth over the next few years.
Optimism without giddiness A focus on revenue. Little if no current profitability. Hypeabout the future. All this looks disturbingly like the misin-
0
2000
4000
6000
8000
10000
12000 96
94
75
3942
149
198
Profit
69 80
54
83
Australia &New Zealand
India Indonesia Japan China Malaysia Singapore SouthKorea
Taiwan Thailand Brazil
A small market for HSBCLoans and advances, 2003, US$m
Source: HSBC annual report 2003
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Coming of agePart 2 Financial and professional services
formed mentality that fuelled the first wave of largelyloss-making manufacturing investment into China in the1990s. Certainly, even at current rates of growth it isunlikely that China will fulfil the expectations of all theforeign firms that are currently piling into the country.Some markets are already beginning to look very crowded:there are, for example, around 30 foreign insurance com-panies in China and by the end of last year 15 foreign fundmanagement JVs had either started operations or were inthe process of entering the market.
Nonetheless, the optimism felt by foreign financial andprofessional services firms does appear less naïve than thebullishness of earlier investors in China. For example,HSBC could well be disappointed in its effort to boost, infive years, its presence in cities like Shanghai to a level onpar with Hong Kong. But its broader expansion plansseem sensible: branches in 20-30 cities in the few years,up from nine currently. In a country of 1.3bn people this isa cherry-picking, rather than mass-market, strategy.
Optimism without giddiness seems to define the per-spective of many of the foreign services firms thatresponded to the Economist Intelligence Unit’s survey.Financial and professional services companies are adopt-ing a cool-headed strategy for the China market but alsofinding some inspiration in the rapid evolution of thesemarkets in recent years. After all, China has alreadyemerged from a tiny to a reasonably sized market for anumber of financial services in recent years. Swiss Re fig-ures show that, in 2002, China’s insurance market waslarger than that in, say, Taiwan, Switzerland and Belgium,albeit still smaller than that of South Korea and Spain.China’s mortgage market, which was virtually non-exis-tent just a few years ago, is likely to have rivalled Italy’s in2003. In 2003 Chinese firms again beat out their Aus-
tralian counterparts to take the title of the biggest issuersof equity in Asia ex-Japan. (According to Thomson Finan-cial, companies from China accounted for 23.9% of theequity issued by the region’s firms last year.)
Room to grow
There is certainly room to grow. The market for financialand professional services in China is highly underdevel-oped—virgin territory, according to one executive. Pene-tration rates for many financial services products remainvery low on an international basis. For example, it is esti-mated that there are only 3m-4m real credit cards inChina, the equivalent of just one card for every 400 or sopeople. When it is considered that many consumers inmore advanced economies have not just one but severalcredit cards each, it is clear that usage in China remainsvery low. Similarly, life insurance premiums in China areequivalent to just 2% of GDP, compared with 7.3% in Tai-wan and more than 10% in the UK.
There is little reason to believe that local individualsand companies will not eventually find such services asnecessary as their counterparts do in more advancedeconomies. Indeed, in recent years growth in some finan-cial services markets has been very strong. According togovernment statistics, the value of mortgage lendingincreased from US$1.6bn in 1997 to US$142bn in 2003,the value of life insurance premiums more than tripledbetween 2000 and 2003, and media reports have sug-gested the amount of assets under management in Chinarose from Rmb130bn at the end of 2002 to Rmb227bn atthe end of March 2004.
The demand from China’s growing corporate commu-nity for more sophisticated services is also rising rapidly.The more than doubling of China’s exports over the lastfive years has created strong demand for services such astrade finance and cargo insurance. The US$70.7bn infunds raised in 1999-2003 by China-linked companies onthe Hong Kong stockmarket alone has created much workfor investment banks, accountants and lawyers in main-land China. More recently, the financial and professionalservices sector has benefited from the increasing numberof foreign investments made by China’s larger companies.
In fact, it is no longer far-fetched to think of Chinabecoming an even more important market for financialservices in the next few years. For example, even assum-ing that annual premium growth halves in the next fewyears from the 26% recorded in 1999-2003, China’s insur-ance market in 2008 will still be worth US$90bn, a thresh-old which in 2002 had only been passed by the US (whereannual premiums have already risen over US$1trn), theUK, Germany, France and Japan.
Nevertheless, while thinking business will grow rap-idly, no executive we spoke to thought foreign institu-
0 2 4 6 8 10 12
China
Australia
South Korea
Italy
Spain
UK
Brazil
US
2.0
5.0
7.2
4.4
3.6
10.2
1.0
4.6
%
Virgin territory?Life insurance premiums as % of GDP
Coming of agePart 2 Financial and professional services
tions would overrun China’s bank or insurance industries,with most executives thinking that a collective 10% mar-ket share—up from only around 1% now—is a conceivabletarget for the next 5-10 years. Neither is China expectedto begin to dominate global corporate performance:almost half of the financial and professional services firmsthat responded to our survey reported that they expectedChina to account for less than 5% of total corporate rev-enue in five years’ time.
Barriers to faster growth
For foreign services firms, the challenge is not lack ofdemand but how to capitalise on it. A number of barriersstill complicate the ability of financial and professionalservices firms to capitalise on current opportunities andpotential growth.
The financial and professional services sector suffersfrom an acute shortage of qualified and experienced staff.Some foreign firms have been investing in education to tryto bridge this gap. For example, two US insurance compa-nies, John Hancock and CIGNA International, have helpedfinance insurance-related programmes at universities inChina. These kind of investments by foreign firms are notuncommon in other markets around the world and havethe advantage of bolstering a foreign firm’s local brandimage, as well as generating skilled service-sector person-nel. Nevertheless, they add to the cost of doing businessand, given that wages in service industries in China arebeing bid up quickly, do not necessarily win the loyalty ofthe students whose education the firms help to fund.
The regulatory straightjacket
Even with a better supply of human resources, foreignfirms’ ability to access the market would be limited by reg-ulatory measures. There are two angles to this: the gov-ernment’s willingness to allow foreign firms greateraccess to the market; and the wider issue of the structureand regulation of China’s domestic financial servicesindustry.
Restrictions on operations have prevented, for exam-ple, foreign banks from undertaking local-currency busi-ness with domestic corporations or individuals, mostforeign life insurance firms and all overseas fund manage-ment firms from starting wholly owned operations, andinternational law firms from practising mainland law. For-eign banks and insurance companies can only operate in alimited number of cities.
As China begins to fulfil the market-opening commit-ments made in conjunction with its 2001 accession to theWTO, these rules are being gradually eased. China isexpected to honour the remaining pledges that fall due in2004-07. According to the views of many executives work-ing in the country, the government’s attitude towards for-
eign firms is becoming less hostile. For example, inDecember 2003 the government began to allow foreignbanks to undertake renminbi business with, and overseasgeneral insurance firms to write policies for, domesticcompanies, in line with China's commitments to the WTO.Also in December, in a goodwill gesture not directlyrelated to WTO entry, the main bank regulator, the ChinaBanking Regulatory Commission (CBRC), raised the ceilingfor any individual foreign stake in a Chinese bank from15% to 20%.
Despite this gradual liberalisation, market-accessrestrictions for foreign firms remain tighter in the finan-cial and professional services sector than in most otherindustries in China. Regulators have found ways ofrestricting the activities of foreign financial and profes-sional services firms even as the market officially opensup. Upon entry to the WTO, China pledged in five years toremove geographical restrictions imposed on banks andinsurance companies and allow foreign banks to under-take local-currency transactions for individual citizens.However, working capital requirements for bank branchesin China are high, more than 15 times higher than thoserequired in the EU according to the European UnionChamber of Commerce in China. These requirements makeit very expensive for foreign banks to expand—for exam-ple, HSBC head office injected Rmb435m (US$52m) intoits China operations to allow three of its branches to beginproviding renminbi services to foreign enterprises andindividuals in 2003—but do not violate clearly the termsof China’s accession to the trade body. Even those banksthat are willing to invest the necessary capital are pre-vented by the government from opening more than onenew branch a year. In the professional services sector, theWTO agreement made no mention of further opening thelegal services market.
The reality is that foreign firms will not be given muchgreater freedom in China until the government is certainthat domestic companies can withstand the subsequentincrease in competition. Even when this condition is met,the market is unlikely to become as open as some foreignfirms would wish because by then new constituents willemerge with an interest in protecting the domestic mar-ket. The changing motivation for protectionism is alreadyvisible in the legal profession. The activities of foreignlawyers in China were initially restricted because the gov-ernment was concerned they would bring to the countrysuch heretical concepts as ”rule of law” and ”equalitybefore the law”. The government has now realised thatforeign law firms are generally more concerned with mak-ing money than promoting democracy, but now there is anew dynamic: a domestic legal profession that is lobbyingthe government for commercial protection. Thus, while itcan be hoped that domestic reforms will, in the future,
Permitted business Foreign currency business; renminbi Renminbi business Renminbi businessbusiness with foreign-invested with domestic firms with local individualsenterprises
Minority investments Single foreign ownership limited to Ceiling raised to 20%15% of equity
Broking Large-scale commercial risks, for reinsurance and for international marine, aviation and transport insurance
OwnershipLife Joint venture with 50% ownershipNon-life Branch or joint venture with 51% ownership Wholly-owned subsidiariesBroking Joint venture with 50% ownership Joint venture with Wholly-owned
51% ownership subsidiariesMinority investments Total foreign investment to be less
than 25% of equityReinsurance restriction All insurance companies must reinsure Minimum falls to 15% 5%
20% of business with a domestic reinsurer
Source: Economist Intelligence Unit, Goldman Sachs
give officials less reason to worry about the macro stabil-ity of the financial services industry, restrictions couldremain in place as the government becomes beholden toincreasingly powerful domestic interest groups.
It is not all bad news for foreign companies. Even ifmarket access rules are not eased further, the position offoreign firms in China will improve in the next few years.This will be the result of changes to the domestic regula-tory structure, in particular an expected easing ofrestrictions that China’s government has traditionallyplaced on integration of different aspects of the financial
services industry. Officials have already taken some stepsin this direction: last December legislative measureswere approved first to allow banks some leeway to diver-sify into other areas of the financial services industry,such as broking, and second to lay the legal basis for anew committee to supervise and co-ordinate the sepa-rate bank, insurance and stockmarket regulators. Giventhat many foreign companies position themselves glob-ally as financial services ”supermarkets”, they will bene-fit from any changes that allow such structures to beformed in China.
Coming of agePart 2 Financial and professional services
Most notably, Chinese companiescommand huge branch networks that cover the entirecountry. Whereas many foreign companies operating inmanufacturing sectors face the emergence of new domes-tic competition where little existed before, foreign banksand insurers must compete with a massive, existing net-work of competition from the existing Chinese bankingand insurance sector. One of China’s four largest domesticbanks, for example, the state-owned Agricultural Bank ofChina (ABC), had almost 40,000 branches around thecountry at the end of 2002 (latest available data) and thebiggest general insurance company, PICC, has 428branches and sub-branches. By contrast, government sta-tistics show that the 64 foreign banks active in China haveunder 200 offices between them, whereas AIG, which hasthe largest wholly owned foreign insurance business inChina, operates in just a handful of cities. Moreover, localservices companies have long-established relationshipswith their clients, a particularly useful asset in a countrywhere guanxi remains important. These factors givedomestic firms very strong brand recognition and a verydeep presence in a very large country.
In addition, like many of the foreign companies oper-ating in manufacturing sectors, foreign financial servicescompanies are faced with very aggressive pricing by localfirms—pricing strategies that few foreign firms are eitherable or willing to match. More than half of the almost 30
professional services firms that responded to our surveycited ”lower prices” as the main competitive advantage oflocal companies. Foreign insurance firms (particularly inthe non-life sector) and banks complain that their domes-tic competitors simply do not price according to risk.
The price advantage of local institutions is not just theresult of mismanagement; their costs are also lower. Localfirms, for example, do not have to cover the cost of expen-sive expatriate staff. Domestic banks also, in general, havea lower cost of funding, relying on retail deposits whichcurrently pay interest rates as low as 0.7%. In a reflectionboth of their critical mass and the rapid business growth oftheir major foreign clients, many of which over the last twoyears have moved from being net borrowers to net deposi-tors, the larger foreign banks in China are now overfunded.But smaller foreign banks, denied the right to undertakerenminbi business with local consumers, often have toborrow on the interbank market where rates_particularlythose charged overseas institutions—are higher.
A complex competitive environmentFacing entrenched local players with huge distributionnetworks and low pricing, China might seem a hopelessmarket for foreign financial and professional servicesfirms. But price and distribution are not the whole story.While the aggressive pricing of domestic firms has helped
The competitionThe Big Four, branch and staff numbersBanks Branches StaffAgricultural Bank of China 39,286 480,931Bank of China 12,090 174,919China Construction Bank 21,616 406,441Industrial & Commercial Bank of China 25,960 405,558
Even if China reduced the current restrictions on foreign firms, it cannot be assumed that multinationals would suddenly dominate the local market. Chinese firms have some notable strengths vis-à-vis their budding foreign competitors in the financial and professional services sectors.
Coming of agePart 2 Financial and professional services
to generate sales in the short term, it has also contributedto the longer-term deterioration in the capital strength ofmany of China’s largest financial services companies. Thisweakening of balance-sheets has been exacerbated byother, more sector-specific factors. Close links betweenbanks and the government have, for example, resulted inloans to loss-making state-owned industrial enterprises.The financial strength of the largest insurance firms hasbeen undermined by previous sales of policies that guar-anteed annual returns of 7.5-10%, when interest rateswere falling and premiums were mainly invested in theform of bank deposits. As a result, official figures showthat at the end of March this year 19.2% of the state-owned commercial banks’ loan books are non-performing;outside observers estimate the figure to be much higherstill. The insurance industry, meanwhile, is sitting on anequity shortfall of several billion US dollars.
Chinese firms' balance-sheet weakness makes themkeen to work with foreign institutions. China’s banks,which have traditionally been dependent on revenueearned from simple deposit and loan activities, are nowkeen to boost fee income and the influx of foreign playersinto the market is giving them an opportunity to do justthat. Foreign banks, for example, are paying to utilise thehuge branch networks of the domestic banks. In this way,the likes of Citigroup and Standard Chartered are able toprovide nationwide cash management services to theirglobal clients, while domestic institutions earn non-inter-est related income. Overseas fund management and insur-ance firms are also beginning to sell their productsthrough the domestic banking network.
Nascent ownership relations
The financial weakness of domestic players also makesthem more willing to accept equity investments from for-eign competitors. Some overseas firms take such stakesmerely as a financial investment. Others, however, lever-age their investments to win real business opportunities.For example, in 2002 Citigroup purchased 5% of theShanghai Pudong Development Bank, with the ”focalpoint” of the alliance being a joint credit-card business. InOctober 2003 AIG purchased a 9.9% stake in the People’sInsurance Company of China (PICC), an investment thatincluded an agreement to develop the market for accidentand health products through PICC’s branch network.
While the need for money is important, it is not theonly reason domestic firms have been co-operating with,and courting investments from, foreign institutions. Atleast some local firms are also keen to learn from theexpertise of their overseas counterparts. By working withforeign firms, particularly by accepting a minority invest-ment, local institutions can benefit from exposure tointernational standards of management and draw on the
deep product-development capabilities of their foreigncounterparts.
An illustration of just how far domestic firms trail inter-national standards in these kind of areas is given by theexperience of the International Finance Corporation (IFC),the private finance arm of the World Bank. In one of sev-eral investments it has made in recent years in China’sfinancial services industry, between 2000 and 2002 theIFC paid US$50m to take a 7% stake in the Bank of Shang-hai. In so doing, the IFC gained a seat on the board of thebank, and one of the first suggestions of its appointee wasthe establishment of audit and compensation commit-tees. This was no doubt a sensible initiative but one thathighlighted that such basic elements of the managerialhierarchy did not exist in the first place.
The extent of the gap makes it possible for improve-ments to occur rapidly. According to executives fromacross the spectrum of foreign financial and professionalservices providers, local firms, even those without foreignpartners, are progressing in leaps and bounds. This is notjust true of management techniques. According to thehead of the recently launched strategic credit-card co-operation between Citibank and the Shanghai PudongDevelopment Bank, China’s emerging credit-card marketalready has some of the features of an advanced market,such as fee waivers and free gifts.
The foreign advantage
Still, even in the areas of management expertise andproduct development, foreign companies retain an edge.Local firms, for example, will find it difficult to imitate thecapital markets expertise of the world’s leading legalfirms. When China’s government eases controls on out-ward capital flows, foreign asset management firms willbe at a huge advantage in selling, say, internationalmutual fund products.
Local firms can also hope to learn something of theclient service standards employed by global institutions,although copying service quality is not as easy as produc-ing pirated DVDs. Service standards in China are famouslylow, a malaise that is just as evident in the financial andprofessional services sector as in any other industry in thecountry. Expectations of service standards are rising asincomes increase, a trend highlighted by consumer sur-veys. Recent research by Millward Brown Firefly (MBF), forexample, shows dissatisfaction with local banks in wealth-ier cities such as Shanghai. (The survey carried out by MBFalso shows that consumers in less developed urban areastend to be less demanding of their banks and so more sat-isfied with local institutions.)
All this puts foreign banks in a potentially strong posi-tion, as the same surveys suggest that overseas financialinstitutions are associated with better standards of serv-
Coming of agePart 2 Financial and professional services
ice quality than their local counterparts. A recent surveycarried out by the investment bank, Credit Suisse FirstBoston (CSFB), indicates foreign firms may have similaropportunities in the insurance industry. While 56% of thepeople surveyed who reported an indication to buy insur-ance said they would do so from a domestic company, themain reason for this choice was reliability. Only 18% ofrespondents indicated a preference for buying fromwholly foreign-owned or Sino-foreign joint-venture insur-ance firms. But the survey found that people choosingthese firms did so because of a perceived ”good reputa-tion/credit, overall capability and service”.
The local challenge
For foreign firms, the issue of the relative competitive-ness of local institutions has become more pressing asthe crossover between the markets served by overseasfinancial and professional services companies and theirdomestic counterparts grows larger. It is a similar storyacross many sectors in China. Foreign companies arrivedaiming at the top end of the market—in this case ,servingforeign companies—where they faced little if any domes-tic competition from domestic firms. However, as foreigncompanies have looked to sell down into the middle sec-tion of markets they have met Chinese companies lookingto sell up.
The domestic financial services sector, which was pre-viously a part of the government bureaucracy, is nowbecoming much more like a competitive, commerciallyminded industry, albeit one that both pricing strategiesand the testimony of foreign executives suggest is stillfocused on the top rather than the bottom line. China nowhas a variety of different-sized banks (although only onenationwide private institution) and, whereas the countryjust eight years ago had only one domestic insurance firm,there are now five local companies competing in both thelife and non-life markets.
The resultant rise in competition, combined in thebanking sector with government pressure to strengthenbalance-sheets, has compelled local financial institutionsto seek sales to the high-quality global clients that werepreviously the almost exclusive preserve of multinationalbanks and insurance companies. In an illustration of thischange, some estimates suggest that local banks nowserve as much as 40% of the banking demand of multina-tional companies in China. Foreign services firms of alltypes are seeking to break out of their dependence on theChina business generated by their global clients and sellinto the domestic market. This partly reflects a recogni-tion that it will be demand from China’s domestic firms,rather than from foreign companies, that will be the driverof the country’s financial and professional services marketin the future. The foreign services community has already
been selling to China’s biggest firms, which to undertakeinitial public offerings (IPOs) on foreign stockmarketshave needed to tap the expertise of international invest-ment banks, law firms and accountants. As firms that sellmore than 25% of their equity overseas are generallyregarded as ”foreign-invested enterprises”, this processhas also created potential clients for foreign commercialbanks in China.
The easing in December 2003 of rules that had pre-vented foreign banks from undertaking renminbi servicesfor domestic enterprises has, of course, opened up awhole new market for foreign banks. But foreign firms arenot quite as excited about this prospect as might beexpected. Wary of generally weak standards of corporategovernance, foreign banks—and for that matter interna-tional accountants—are expected to expand into thepurely domestic market only cautiously. (One foreignbank told us that of every ten domestic companies it sees,only one or two has the quality to qualify them as poten-tial clients.) Nonetheless, foreign banks are expected tobecome more active in the domestic corporate market inthe next few years, an expansion that will lead to morehead-to-head competition with local banks.
The evolving China strategy
Foreign financial and professional services companies areoperating in an extremely complex environment. On theone hand, the market is deepening and broadening. Anincreasing number of basic financial services products(such as life insurance) can now be sold across the coun-try, while newer products (such as credit cards andinvestment funds) are introduced to the richer cities onthe east coast. Demand for more sophisticated legal andaccountancy services is also growing as China’s industrialrevolution continues. Foreign firms are, in theory, wellplaced to capitalise on this demand, both because oftheir financial strength, product depth and service stan-dards and because many local firms are eager to findoverseas partners.
On the other hand, foreign firms face immense diffi-culties in recruiting and retaining skilled staff, and com-petition is often cut-throat and irrational, at least from apricing point of view. In this context, government policylooks designed to ensure foreign firms supply capital andexpertise to support the development of the local indus-try without allowing them to build up significant marketpositions.
Despite this challenging picture, it is clear that somefirms are managing to build real businesses. Citigroup’sChina revenue grew at a compound annual rate of 43% in1999-2003. HSBC’s 2003 profit might be small in a rela-tive sense, but US$42m is not negligible in absoluteterms, especially given that, until recently, the bank's
Coming of agePart 2 Financial and professional services
activities were limited to servicing mainly the foreignbusiness community. In 2003 the value of first-year lifeinsurance premiums written by AIG in China was almost45% larger than in 2002. According to a report released in2003 by Goldman Sachs, AIG’s life insurance operations inChina still made a loss of US$10m in 2001, but its generalinsurance business generated profit of US$2m.
Foreign fund managers also seem to be doing well. Thefund management JV between the Belgian financial servicesgroup, Fortis, and a domestic securities company, HaitongSecurities, only gained regulatory approval in late 2002 andyet already has US$2bn under management (giving it a mar-ket share of around 12%). Fortis claims to be reachingbreakeven ahead of the schedule laid out in its original busi-ness plan. Another fund management JV, Guotai Jun’an
Allianz Fund Management (GJA), between Allianz DresdnerAsset Management and Guotai Jun’an Securities, expects tobreak even at the end of its second year.
As for the professional services industry, accountancyfirms have been rapidly increasing staff numbers in Chinato cope with an expansion in business, while some lawfirms, especially those that are chasing large IPO man-dates, claim already to be profitable.
Choosing an entry
These days, foreign financial and professional servicesfirms in China have a large number of entry options and agrowing array of expansion strategies. In terms of green-field choices, foreign banks and general insurance firmscan start wholly owned branch networks. Banks can also
Foreign banks in China should feel some pityfor their Taiwan counterparts. Banks from theisland have to put up with the stifling restric-tions imposed on all foreign institutions by thegovernment in Beijing. They also have to dealwith another set of regulations, imposed byTaiwan’s own authorities, which seek to limitthe island’s economic interaction with China.
Taiwan’s manufacturing companies haveemployed all kinds of ingenious methods toevade their own government’s restrictions oncross-Strait economic interaction. Theattractions of China for local banks areperhaps even stronger than for theirindustrial counterparts. Expanding to themainland certainly gives them theopportunity to win new clients by tappinginto China’s potentially huge domesticmarket. But, perhaps more importantly, withso many of the island’s manufacturers havingalready invested in China, moving across theStrait may be the only way that Taiwan’sbanks can hang on to their existing clients.
Consequently, despite the islandgovernment’s restrictions, some smallerprivate banks in Taiwan have found ways toestablish footholds in China. Taiwan’sShanghai Commercial and Savings Bank, forexample, has established a representativeoffice in China through its Hong Kong-ownedsubsidiary, Shanghai Commercial Bank(which, helpfully, is co-owned by the
mainland’s own Bank of Shanghai). SinopacFinancial Holdings, meanwhile, has arepresentative office in Beijing through its USaffiliate, Far East National Bank. Moreuniquely still, Sinopac has a ”strategicpartnership” with a licensed Shanghai lender,First Sino.
Missing linksOfficially, there are no shareholding linksbetween Sinopac and First Sino. But tiesbetween the two institutions are close: mostof First Sino’s senior management are formerSinopac employees and the Taiwan bank alsoprovides information technology (IT) assis-tance. First Sino also has a strategic partner-ship with the Shanghai Pudong DevelopmentBank (SPDB), which owns a 5% stake of FirstSino’s equity.
These partnerships are immenselyimportant for First Sino. Sinopac, forexample, is keen to refer clients, in anattempt to keep customers in the Taiwanbank’s orbit, and to limit their exposure toChina’s increasingly predatory domesticinstitutions. The link with First Sino also givesSinopac a source of information on theactivities of its mainland-bound corporateclients. Given the enthusiasm with whichTaiwan firms have moved to China, this ishelpful in Sinopac’s attempts to control itsown credit risk.
Clients introduced by Sinopac do not justprovide First Sino with opportunities forlending and trade finance deals, whichcurrently form the bulk of its commercialactivities. The referrals also generaterenminbi deposits, a supply of funds that isbolstered by credit lines provided by SPDB.Gaining access to local-currency funds is aparticularly big issue in China, where untilrecently government restrictions haveprevented foreign banks from undertakingrenminbi business with domestic companies.
According to First Sino’s vice-chairmanand CEO, David Kiang, First Sino does not justlimit itself to clients referred by Sinopac. Itwould be foolish to do so: as the only Taiwan-linked bank operating in China, First Sino is ata considerable advantage in winning businessfrom the many thousands of Taiwan firms thatnow have investments in China. With itsmanagement of experienced Taiwan bankers,the bank can deal with Taiwan clients moreefficiently than other mainland-based banks.That its senior staff speak Taiwanese is alsoimportant in building trust with clients. Allthis puts First Sino in a powerful position,helping to explain the eightfold increase inthe bank’s client base that has been achievedsince 2001.
Despite its inherent advantages in dealingwith firms from the island, not all Taiwanfirms in China are potential First Sino clients.
Coming of agePart 2 Financial and professional services
invest in joint ventures (JVs) in China, as can life insur-ance firms (limited to 50% ownership) and fund managers(currently restricted to 33% ownership, a ceiling that willrise to 49% by the end of 2004). All these firms are alsoable to take minority stakes in existing Chinese firms.Even accountants have a choice of entry strategy, beingallowed to set up joint ventures or establish businessalliances with local firms.
Wholly owned branches, JVs and minority investmentsall have their advantages and disadvantages for foreignfirms. With the former, overseas companies can exercisefull management control but are subject to severe restric-tions on expansion and are faced with the task of buildinga business from scratch. Some foreign-invested JVs arealso subject to expansion restrictions, and have the added
risk of a loss of management control, but could allow anoverseas firm to leverage the official and client contacts ofits local partner. Last but not least, minority investmentsinvolve an even greater loss of management control. Localfirms selling small stakes to overseas companies are not,however, reclassified as foreign firms and so continue tobe subject to easier local regulations on expansion. Thisfinal option may thus give foreign firms the fullest oppor-tunity to be involved in the rapid growth of China’s finan-cial services industry.
The nature of the initial investment decision is usuallydetermined by a firm-level consideration of the pros andcons offered by the different entry vehicles (whollyowned, JV and minority investment routes). However,what seems to differentiate the broader China strategies
It is difficult, for example, to imagine IThardware manufacturers of the size of, say,BenQ or Hon Hai having much to do withsmall bank like First Sino. But in some ways,such firms are also unattractive clients,driving hard bargains through their size andtheir relative attractiveness—big, Taiwan-listed firms are targets for other foreignfinancial services institutions, as well asChina’s aggressive domestic banks.
First Sino’s target market is thus not largebut SMEs. The bank does not limit itself toTaiwan-linked clients: around 10% of itsclients are from Hong Kong, helped by MrKiang’s own experience as a banker in theformer UK colony. First Sino has also beentargeting the retail market, opening, forexample, a branch in Shanghai’s Gubei andXujiahui suburbs, where many Taiwan andHong Kong expatriates live. Partly as a result,even though the bank has around 400corporate clients, it also services more than2,000 high-net worth individuals.
The combined Taiwan and Hong Kongmarket is big. But Mr Kiang stresses theimportance of winning business fromdomestic firms and individuals, and hopeslocal companies will soon account for 25-30%of the bank’s client portfolio. Achieving thiswill be challenging: foreign banks are onlynow obtaining the right to offer renminbiservices to domestic companies. There is also
the far from negligible problem of weakstandards of corporate governance, whichmakes even the most adventurous of foreignbanks wary of jumping too quickly into thedomestic corporate market.
To gain exposure to the domestic market,First Sino is considering buying stakes insmall local institutions and has become thefirst foreign bank to pursue a relationshipwith the China Export and Credit InsuranceCorporation. First Sino is also seeking to gainlocal customers by leveraging its foreignclient base. It works like this: First Sino has atrusted Taiwan client, Firm A. This companysources materials from a local company, FirmB. First Sino has little information about FirmB and so is unwilling to deal with itindependently. Instead, First Sino lends toFirm B but is repaid by Firm A, which routespayments for its supplies from Firm B throughan account held by the bank. The bank takesprincipal repayments, with the remainderaccruing to Firm B. The trusted client, Firm A,is in essence the source of the repayments.
This scheme benefits all involved. Keen tocut costs, bigger Taiwan firms in China areeager to cultivate a network of domesticsuppliers. But domestic banks in China arefamous for discriminating against local SMEs,so without the intervention of a bank like FirstSino potential suppliers such as Firm B wouldstruggle to survive. First Sino also wants to
tap a new market that is potentially verylarge, but presently very risky. This, then, is awin-win-win arrangement. Taiwan firmsfoster new suppliers, emerging domesticcompanies access funds that allow them togrow, and First Sino uses a low-risk method toestablish a relationship with local firms.
On borrowed time?Success for First Sino is not guaranteed. Thebank remains small and its links with Sinopacare truncated by the restrictions on cross-Strait links. First Sino is also not alone inidentifying the Greater China niche. Speakingin 2003, a senior executive at one of Taiwan’slargest state-linked banks became distinctlyanimated when discussing the possibilitiesthat would arise from a link-up between a Tai-wan, Hong Kong and mainland China bank.The Bank of Shanghai, through its differentguises, is close to having the framework inplace, and in 2003 one of Sinopac’s Taiwancompetitors, Fubon Financial Holding, took astep in this direction when it purchased asmall Hong Kong-based lender, the Interna-tional Bank of Asia.
Still, competition is not new. First Sino atleast has first-mover advantages over otherTaiwan banks. First Sino also illustrates that,with a focused and innovative approach, it ispossible even for small banks to build realbusinesses in China.
Coming of agePart 2 Financial and professional services
of foreign services companies is not how they enter China,but what they do once they are there. This, in turn, isdetermined as much by the nature of the company in therest of the world as by the challenges encountered inChina’s financial services market.
Different routes to market
It is possible to identify three broad strategies. The first,what might be termed the Anglo-Saxon approach, is exem-plified by HSBC, Citigroup and AIG. All three firms havetaken any advantage of any opportunity to increase theirpresence in the China market. The banks have been rollingout new branches as quickly as they are allowed, and mov-ing into new product markets as soon as regulations per-mit them to do so, most recently credit cards for consumersand renminbi loans for domestic companies. In addition,all three firms have been taking stakes in other financialinstitutions. Citigroup has a link with SPDB and AIG withPICC, but most aggressive has been HSBC. In December2001 the UK-based bank purchased 8% of Bank of Shang-hai and just ten months later bought a 10% stake in PingAn Insurance. Through a Hong Kong subsidiary, Hang SengBank, HSBC also owns 16% of China’s Industrial Bank. Inyet another small acquisition, HSBC in December 2003announced it was buying, in partnership with Ping An,100% of a small Sino-foreign JV firm, Fujian Asia Bank.
The continental European financial services companieshave taken a slightly lower-profile, and also more diversi-fied, approach to the market. The business interests inChina of the German financial services group, Allianz,include its wholly owned bank, Dresdner, a general insur-ance operation in the southern city of Guangzhou, and aJV life insurance company in Shanghai with China’sDazhong Insurance. In addition to its fund managementJV with Haitong Securities, Fortis has a banking presencein three cities in China and a 24.9% stake in one of China’ssmaller but rapidly growing life insurance firms, TaipingLife. ABN Amro has a larger retail bank presence than itscontinental European counterparts and in February 2003it purchased a 33% stake in an existing fund managementcompany, Xiangcai Hefeng Fund Management. It is alsoworking to sell investment products to China’s domesticfinancial institutions.
Other firms have a more specialist approach. FranklinTempleton, for example, only has its fund management JVin China. General insurers like Chubb of the US and RoyalSun Alliance of the UK have wholly owned general insur-ance ventures in Shanghai but not much else. The mainexposure of the Bermuda-based insurance firm, ACE, is inthe form of its 22% stake in and strategic alliance withHuatai, one of China’s smallest general insurers.
The exponents of the Anglo-Saxon approach are diver-sified firms but with one particularly dominant business
line that forms the core of the drive into China. They arealso huge companies that can afford to take risks in Chinathat other firms can not—buying stakes in Ping An andBank of Shanghai, for example, cost HSBC US$663m, nota large amount when set against the US$14bn the firmspent buying the US consumer lender, Household Inter-national, in 2002. All these firms also have long experi-ence in emerging markets in general, with strongcorporate links to China in particular: both HSBC and AIGwere formed in the country and Citigroup boasts it estab-lished its first branch in China in 1902. (While theirShanghai roots may be especially strong, these threefirms are far from alone in stressing their Chinese history;it is far from uncommon for managers in foreign financialservices to start conversations about China strategy withthe comment, ”Well, or course we have been here for ahundred years….”)
This financial and historical background encouragedall three firms to take an early interest in China as thecountry started to reopen to the world in 1978. As aresult, in the banking industry HSBC and Citigroup, alongwith perhaps the UK’s Standard Chartered, ABN Amro ofthe Netherlands and Hong Kong’s Bank of East Asia (BEA),have now been able to establish critical mass at theexpense of other foreign players. The first mover advan-tage is even clearer in the insurance industry, where AIGmanaged to get a licence to sell life and general insuranceproducts in China in 1992, two years before the next for-eign entrant. It also managed to open wholly owned lifeinsurance branches, an entry strategy denied to all otherforeign entrants, and has been given more freedom toexpand than its international rivals.
The continuing importance of relations
AIG would not have been able to gain such privilegedaccess to the market had it not assiduously built relationswith leading officials in China. This is a lesson that stillhas relevance today. In other industries, the importanceof relationships has begun to fade—although not disap-pear—as market forces have become more dominant. Inthe financial and professional services sector, however,guanxi remains as important as ever. This is partlybecause the sector is heavily regulated, with the resultthat the attitude of government officials can have a signif-icant bearing on the success or otherwise of a business.Foreign executives do report that regulatory criteria arebeing applied more evenly and transparently across dif-ferent firms. Nonetheless, retaining good relations withthe regulators—the CBRC in the banking sector, the ChinaInsurance Regulatory Commission (CIRC) for insurers, andthe China Securities Regulatory Commission (CSRC) forfund managers—is essential for foreign firms looking tobuild successful businesses in China.
Coming of agePart 2 Financial and professional services
It is not just relationships with officials that are impor-tant. With regulations forcing many foreign financial andprofessional services to enter the market only through JVsor minority investments, choosing good local partnersand retaining guanxi with them is also essential. Neitherof these tasks is necessarily easy to achieve, as demon-strated by the experience of the foreign manufacturinginvestors who were the first to form JVs in China in the1990s, only to move to wholly owned structures as soon asregulations allowed.
Know thyself
The role of guanxi may be particularly strong in the Chi-nese market. But China is not so unique as to make lessonsfrom other markets entirely irrelevant. As crucial as under-standing China’s business environment may be, it is just asimportant for foreign firms to know their strengths, toknow what they want to achieve in China and have a clearstrategy of how this can be done. Few retail banks, forexample, have successfully established overseas opera-tions, so aiming to set one up in China would seem risky, ifnot foolhardy. It is no surprise that the handful of banksthat do have international branch networks are the onesthat are leading the pack in China. Despite the apparentscattergun nature of, say, HSBC’s China investment strat-egy, the market approach of the British bank and Citigrouphas a clear focus: to provide the full range of financialservices they supply elsewhere in the world to the emerg-ing middle class of Chinese consumers.
Other banks cannot and should not hope to copy such astrategy but this does not mean they should not be inChina. For example, the French bank, Societe Generale,has a completely different approach, concentrating onproviding investment options for domestic financial insti-tutions. In another example of a successful niche strat-egy, a Taiwan-linked bank, First Sino, has been growingrapidly by leveraging mainland China’s large communitiesof Taiwan and Hong Kong businessmen.
Still dreaming of the future
China can certainly be a frustrating place for foreignfinancial and professional services firms to operate. Mar-kets for the services they are providing are expandingstrongly but most companies are prevented by regula-tions from fully tapping this demand. Nonetheless, insome ways foreign services firms are in a stronger posi-tion to succeed than their better-entrenched manufac-turing counterparts. There are signs that consumers inChina value the kind of services that foreign players canprovide and copying service standards is a far more diffi-cult proposition for domestic firms than, say, makingpirated DVDs. Moreover, despite the regulation thatexists, there are signs that firms with well-defined strate-gies are managing to build real businesses in China. Thebelief of many of the world’s leading financial and profes-sional services firms that China will be one of their majormarkets in the future may not be as far fetched as it cur-rently sounds.
By the end of 2004, China is scheduled to open upits distribution and logistics markets in line withthe commitments it made upon accession to theWorld Trade Organisation (WTO). Foreign compa-
nies are gearing up for the “big bang” of expanded marketaccess. China’s market for carting goods into and aroundthe country is huge—estimated at some US$270bn annu-ally—and opportunities abound in logistics services suchas storage and warehousing and wholesale and retailoperations. With logistics costs in China currently esti-mated at around 20% of GDP according to World Bankestimates—compared to just 10-12% in developed mar-kets—the potential for both profit and efficiency gains isconsiderable.
The China market looks to be fertile ground for sellinginternational-quality logistics and supply chain services.Foreign investor optimism about the market for logisticsservices in China is justified but must be tempered by theon-the-ground reality of the sector’s regulatory, infra-structural and operational limitations. Although the dis-tribution and logistics sector will, in theory, be largelyopen to foreign investors by the end of 2004, foreignlogistics operators will still have to navigate patchy,locally-enforced regulations. Moreover, even though
China has invested vast sums of money in infrastructure inrecent years, the country’s transport system is likewise aregional patchwork that frustrates the ability of logisticsfirms to offer seamless inter-modal services. Morerecently, that transport network has been overburdenedby the strain of moving goods to keep up with China’s fasteconomic growth.
The logistics sector was once dominated by state-owned enterprises (SOEs) but in recent years foreign anddomestic third-party logistics suppliers (3PLs) and largenumbers of small-scale providers have emerged in theindustry. There are now some 510,000 logistics companiesoperating in China, according to official media. Inte-grated services are best provided by independent special-ists. Although just 3% of China’s distribution marketcurrently belongs to 3PLs, the sector is a focus for foreignservice providers and overseas participation is expected toexpand rapidly as a result of increased levels of foreigninvestment in China’s manufacturing industries (espe-cially in the retail and automotive sectors). Dickson Ho,an economist with the Hong Kong Trade DevelopmentCouncil (HKTDC), projects an increase in market penetra-tion for 3PLs to 6%—or US$35bn—by 2010. As there arevery few domestic players—the domestic giant Sinotrans
Part 2
LogisticsNot yet connected
● China’s economic and foreign trade growth has increaseddemand for international-calibre logistics services.
● The logistics sector has developed fast in recent years, fromstate-sector dominance to strong competition among foreignand domestic third-party logistics providers.
● Many foreign logistics service providers eagerly await the fur-ther opening of the sector under China’s World Trade Organi-sation commitments.
● Despite expanding market access, foreign logistics firms willcontinue to face a number of regulatory hurdles in China.
● The logistics sector is also limited by China’s transportationinfrastructure, which continues to struggle to keep up withdemand.
● Logistics firms face considerable operational difficulties inChina, ranging from limited IT systems to pilferage of freightin transit.
is only beginning to develop significant 3PL capacity—most of these services are currently offered by foreignspecialists such as Panalpina, Maersk Logistics, DHL, Exel,SembCorp Logistics and APL Logistics.
Despite the development of 3PLs in China, many com-panies still prefer to handle their own logistics. Based onthe results of its 2002 China Logistics Provider Survey—asurvey of 33 leading logistics companies—the LogisticsInstitute-Asia Pacific concluded that “the biggest chal-lenge facing China’s logistics industry is to generatedemand”. Many companies consider logistics to be a corecompetency or see it as “too important to outsource”,according to the Logistics Institute-Asia Pacific’s 2003China Logistics User Survey. Companies also cited the dif-ficulty of shedding existing logistics facilities as anotherimportant reason not to outsource.
For the international logistics firm Panalpina, by con-trast, the problem is not generating demand but manag-ing it. Panalpina’s biggest source of revenue in China isin sea and air export freight-forwarding services, accord-ing to Claus Schmidt, the company’s executive vice presi-dent for marketing and sales in Asia-Pacific. Panalpinahandles a larger volume of air- and sea-freight in Chinathan in any other country, according to Mr Schmidt. Thecompany’s biggest challenge in its export operation inChina is in “capacity management”, Mr Schmidt says; “tohave the right capacity because it is such a volumeincrease.”
Logistics providers in China also face an increasinglycompetitive environment. The Logistics Institute-AsiaPacific’s survey of logistics users found that companieswere more satisfied with domestic 3PLs than with foreignand joint-venture (JV) providers, even in the provision oftechnology-intensive logistics services. Based on theresults of the survey, the Logistics Institute-Asia Pacificconcluded that “domestic 3PL providers have closed theperceived gaps with foreign and JV providers in servicequality and capabilities”. In addition to larger domesticlogistics providers, foreign companies have also felt com-petition from small private transportation companies thathave developed increasingly comprehensive logisticsservices at very low costs.
Partnering...or not?Although large shipping companies such as APL andMaersk benefit from grandfathering provisions that allowthem to operate wholly foreign-owned enterprises(WFOEs) for some types of distribution services, most for-eign firms have been severely restricted in their scope ofoperations by domestic regulations, which specify, amongother things, that foreign logistics providers can onlyoperate as JVs with domestic partners. This throws up arange of problems. Many foreigners prefer not to workwith Chinese players for various reasons. Correspondingly,many Chinese distributors have their own agendas too—with ready access to domestic sources of capital, there isoften no pressing reason for them to find a foreign part-ner. This makes finding a suitable match even more com-plex for foreign companies even if they are open to theidea.
Partnering with Sinotrans has been a common strategyfor foreign transportation and logistics firms. Accordingto Sinotrans’ most recent annual report, the company isinvolved in 25 Sino-foreign JVs. Sinotrans has partneredwith some of the biggest global names in the sector,including DHL of Belgium, US-based UPS, Exel of the UKand Japan’s OCS. In March 2004 alone, Sinotrans formed astrategic alliance with Rickmers-Linie, a German shippingline, to co-operate in logistics services in China and set upa joint venture with Mitsui OSK Lines of Japan to ship fin-ished cars in China. Partnering with Sinotrans gives for-eign companies access to the domestic giant’s resourcesand also helps with government relations. “But our com-petitors are doing the same thing,” notes a manager atone foreign company which has partnered with Sinotrans."It’s no more advantage for us than for others.” For manycompanies, however, it is still a strategic necessity.
DHL has been one of Sinotrans’ largest foreign partnerssince the establishment of their 50:50 JV, DHL Sinotrans,in 1986, which made DHL the first foreign express carrierto enter China. DHL claims that the venture now holds
The big and the fast in China’s foreign trade
Top three trade regions, US$ bn
Province 2003Guangdong 283.6Jiangsu 113.6Shanghai 112.4National total 851.2
Three fastest exporting regions, % change, year on year
Province 2003Xinjiang 84Qinghai 81Gansu 60National 35
Three fastest importing regions, % change, year on year
Province 2003Jilin 107Anhui 67Xinjiang 61National 40
almost 40% of China’s express delivery market. Accordingto DHL, the company’s business in China has registeredannual growth rates of 35-45% in recent years. In May DHLannounced expansion plans for several of its China opera-tions, under which the company will invest US$215m inChina over the next few years. The most intrepid of the ini-tiatives was the launch of China Domestic, the first door-to-door domestic parcel delivery service offered by aninternational carrier. The move was not spurred by regula-tory changes allowing foreign firms to offer such servicesbut DHL said that nothing in Chinese law expressly forbidsthe service. DHL is also expanding its logistics operations,with plans to open three express logistics centres and 16spare parts centres in China. DHL Solutions, which pro-vides custom logistics services, is stepping up its presencein China, and DHL Danzas Air & Ocean opened an 11,500-
sq metre air- and sea-freight logistics centre in Shanghai’sWaigaoqiao free-trade zone. With an infrastructure invest-ment of US$12m, DHL plans to expand its logistics pres-ence from 20 to 37 cities by 2007.
Another prominent foreign player in the sector, TNT ofthe Netherlands, broke off its long-standing partnershipwith Sinotrans. TNT Express established a joint venturewith Sinotrans, called TNT Skypak Sinotrans, in 1988 tooffer express services in China. The venture expandedfrom five to 12 branches and reportedly boasted strongrevenue growth. The companies decided not to renew thepartnership, however, when their contract expired in May2003. The two companies “have decided to pursue theirown plans in China”, TNT said in a press release. After end-ing the JV, TNT announced plans to expand its operationsfrom 12 to 25 branches by the end of 2003 and to form a
Distributing any product in China can be dif-ficult. Frontier Foods, a small Australian-based food distributor, faces the challengeof distributing a perishable product thatrequires strict temperature control: cheese.The company ships cheese from Australia tosell to China’s rapidly growing middle classthrough fast-developing supermarket andfast-food chains and in bulk to ShanghaiBright, a large Shanghai-based dairy com-pany.
Distributing perishable goods to such awide range of end-users in China is no meanfeat, and the company’s experiences overthe last few years are instructive. RajivKumar, Frontier’s general manager at itsHong Kong regional headquarters, explainsthat the food products are shipped bycontainer from Australia to Hong Kong,where the company maintains a distributioncentre. This is convenient for customers inneighbouring Guangdong, who can bereached by road directly. High-margin orurgent deliveries are distributed by air, whilefoods bound for other Chinese destinationsare transhipped directly to a local port, suchas Tianjin, via an import agent. Once clearedthrough customs, the products aredispatched by the refrigerated vehicles of alocal trucking company (or possibly by rail)to various regional distribution centres,which are then responsible for delivery tolocal branches of Wal-Mart, Carrefour or
other supermarket chains. According to Mr Kumar, the biggest issue
for Frontier’s imports “has been asignificant increase in non-tariff barriers”since China joined the World TradeOrganisation (WTO). Most recently, thesehave come in the shape of labelling laws.Although the rules are not new, localcustoms officials only began enforcing themin March in a strict—and apparentlyarbitrary—manner.
The rules require the labels of foreignfoods sold in China to comply with localstandards, such as a provision requiring theChinese lettering on packaging to be largerthan the foreign lettering. In the past, therequirement was not a problem, Mr Kumarsays, because importers could simply attachstickers, a solution also widely accepted inother markets. Now, however, stickers areno longer acceptable and productspackaging must be specifically tailored tocomply. This has significantly increasedproduct costs and detracted from theproduct's appeal as local buyers assume it isdomestic (or worse, faked) rather thanforeign. Worst of all, says Mr Kumar, therules are impossible to meet because,although they must be signed off by Beijing,no one knows which department isresponsible for compliance. Meanwhile, thenew interpretation of the regulations hasbadly disrupted imports of food and other
consumer goods. Aside from the opaque regulatory
environment, Frontier Foods’ distributionalso faces particular infrastructurelimitations. Although Chinese roadscontinue to improve, the shortage ofrefrigerated transport capability and theabsence of trucking companies withnationwide reach create supply- chainproblems. To save costs, perishable goodsoften share the same vehicle with othergoods, creating risks of cross-contamination. Also, because goods mustbe frequently transferred between vehiclesand are subject to arbitrary delays, they facea high risk of spoilage when, for example, adriver decides to turn off refrigeration tosave fuel when stuck in a traffic jam.
Nonetheless, Frontier remains positiveabout the long-term prospects for itsbusiness in China. The company isparticularly encouraged by the developmentof foreign-owned hypermarkets andincreasingly competitive domestic players,who have kept supermarket listing fees to areasonable level. While non-tariff barrierstherefore continue to create problems—andmay even threaten the ability of smallerbusinesses to ride out periodic storms—in-country, at least, the experience is fastimproving. For now, as Mr Kumar says, “theretail channel is the brightest star in thedistribution sky”.
JV with Mach ++ Express Worldwide, a small Beijing-basedfirm.
While the major global express delivery companieshave expanded to offer a wider range of logistics offeringsin China, other foreign players have built warehousingfacilities and logistics centres to offer integrated servicesin industrial parks. Exel, which set up a joint venture withSinotrans in 1996, offers warehousing space for logisticsservices in 15 locations in China. The company says it isfocusing on the retail and automotive sectors, which aregrowing fast but require integrated logistics services,before expanding across other sectors. In September2003 Exel’s JV in China was awarded a contract to providelogistics services to Legend, the domestic personal com-puter manufacturer.
SembCorp Logistics is likewise focused on supply-chainlogistics services. The company established a wholly ownedsubsidiary in Shanghai’s Waigaoqiao free-trade zone inApril 2004 to serve as the company’s regional office fornorth Asia. Schenker opened its first office in China inGuangzhou in 1979 but has only recently developed logis-tics centres to offer supply-chain management services.The company is now building two major logistics centres, a15,000-sq metre facility in Shanghai that is slated to beoperational later in 2004 and a 16,500-sq metre facilityclose to the Beijing International Airport for SchenkerBITCC Logistics, Schenker’s US$5.7m joint venture withBeijing International Technology Co-operation Centre.
Regulatory reformExpanded market access provided under the WTO will opensome new opportunities for foreign logistics providers butfirms will still face a host of problems ranging from inade-quate infrastructure to various bureaucratic and regula-tory obstacles. As a result, the impact of policy changeson foreign business will differ from company to company.
For small operators such as Shanghai-based EmergeLogistics, which offers specialist distribution and supply-
chain services to importers, regulatory reform is an impor-tant issue. Jeff Bernstein, the managing director ofEmerge Logistics, says foreign companies are focusing onthe WTO-mandated “big bang” that will allow WFOEs tooperate in most areas of the domestic logistics market bythe end of 2004. Since Emerge chooses to operate inde-pendently, it is currently restricted to Shanghai’s Waigao-qiao free-trade zone, which greatly complicates efforts toprovide services to companies outside the zone. Althougha draft regulation relating to market opening began circu-lating in late 2003, there is still no indication of what con-ditions may apply to foreign distributors once the market isopened. Currently, JV distribution businesses arerestricted in geographic scope and require US$5m regis-tered capital—a hefty amount that only the biggest playerscan easily afford. Branching limitations under the upcom-ing rules will be another closely watched issue.
Hong Kong distributors have a first-mover advantageunder the terms of the Closer Economic PartnershipArrangement (CEPA), which opened up key types of logis-tics services—land transport, warehousing and storage,and freight forwarding—to WFOEs at the start of 2004,almost 12 months ahead of the WTO measures. However,many of them realised they would still need to workthrough local partners, who are more familiar with localtraffic rules and conditions, distribution practices, cus-tomer preferences, tolls and fees.
For Panalpina, which is a registered company in HongKong, CEPA offers a chance to accelerate its applicationfor an ‘A’ licence to offer international freight-forwardingservices in China as a WFOE, according to Mr Schmidt; thiswould give the company more flexibility to operate inde-pendently in China. Even if it is awarded the licence, MrSchmidt says, the company will continue to use its localpartners for many operations because they boast the sizeand infrastructure that a foreign company could onlymatch with a very substantial investment.
A relatively low minimum registered capital require-
ment of US$1m could make Hong Kong distribution busi-nesses attractive takeover targets for international logis-tics companies, however, as the merged companies willqualify for CEPA privileges just one year after takeover. Onthe face of it, therefore, CEPA seems a viable entry strat-egy for small or specialist foreign players, and the level ofinterest has been high. By March 2004, 98 of a total of177 certificates of origin handed out by the Hong Konggovernment were granted to companies in the logisticsand distribution sectors. Nonetheless, many playersremain dubious of taking this route–most are waiting fornew WTO-related rules before making up their minds onapplying for CEPA eligibility.
The logistics sector lacks a coherent body of laws andlogistics firms are forced to rely on trial regulations andgeneral foreign investment laws for guidance. Apparentlyaware of the need to structure the sector, the central gov-ernment established a logistics authority, the NationalCommittee for Standardisation of Logistics InformationManagement, in August 2003. The committee is chargedwith formulating, revising and implementing standards inlogistics. There is a perception among managers active inthe sector that the central government has a high level ofcommitment to market opening and liberalisation. Never-theless, foreign firms should not take it for granted thatdoors will be opened automatically at every level as soonas Beijing gives the word.
Although national rules and regulations in China havebecome clearer and more standardised than before, this hasnot prevented local officials from finding ways to bar certaintypes of foreign goods from being imported or delivered.Protectionist behaviour comes into play at internationalports of entry, where strict interpretation of rules relating toarcane subjects such as labelling or health standards cancreate non-tariff barriers that, in effect, close the market to
some products for long periods (such as last year’s spat withthe US over China’s soybean imports). This can also affectpurely domestic deliveries, with officials finding ways to dis-courage outsiders from muscling in on local markets. Thelowly clerk at a Chinese checkpoint or approval office canstill have enormous influence on scheduling; a just-in-timeprovider ignores the need to promote relations with thiscontact at his peril.
Many cities still impose measures such as “traffic-con-trol” regulations that restrict out-of-town trucks fromentering built-up areas during rush hours. Whether theserules are protectionist or not depends on how they areenforced. While these issues can be devastating for indi-vidual importers or distributors, the fact that they usuallyoccur arbitrarily and at low operational levels makes themdifficult to combat effectively.
Transport infrastructureDespite the fast growth in logistics in recent years, the dis-tribution network in China remains seriously fragmented.Although thousands of logistics providers exist in China,none is in a position to offer a fully integrated seamlesspackage. Besides regulations limiting such comprehensiveservices, the sector is also limited by China’s physical infra-structure. China suffers from poor connectivity between dif-ferent types of transport, meaning that goods must oftenbe warehoused while in transit, thereby increasing costsand wastage, especially for perishable goods. This makes itextremely difficult for integrated logistics providers to offerseamless inter-modal transport services (that is, a combi-nation of rail, road and water). Train services, for example,generally do not terminate at dockyards so goods must betrucked from railyards to ports. Computerised inventorymanagement systems are rarely used, making it impossibleto track accurately the progress of deliveries.
The problem has worsened in recent years as China’sastonishing growth in foreign trade has put new strain onits already over-stretched infrastructure. Despite billionsof dollars invested in building roads and highways, portsand airports, telecommunication networks and powerplants over the years, new capacity is quickly used up. Allof China’s transportation networks are in need ofimprovements.
PortsChinese ports have been more successful in keeping upwith the rapid trade growth than other infrastructure sec-tors, thanks to central policy support and foreign invest-ment. A mere ten years ago China was still building itsmodern container ports and none were significant globalplayers. Last year, Shanghai elbowed out South Korea’sPusan to become the world’s third-busiest port with con-tainer throughput at 11.28m twenty-foot equivalent units(TEUs), while Shenzhen jumped two notches to fourthplace at 10.65m TEUs. Despite additional capacity, Chi-nese port facilities are straining at the seams. Bottlenecksat ports have become especially acute since the beginningof this year, according to Koay Peng Yen, the president forgreater China operations at APL, the container-shippingarm of Singapore’s NOL group.
Although container turnaround at the ports is stillkeeping schedule, bulk freight is choking up docks, delay-ing unloading. Most ports in China handle both containerand bulk cargo, with common access to road and rail. Thelogjam in bulk-freight handling reflects long-term localgovernment neglect in investing in bulk docks. Bulk carri-ers are now subject to delays as long as 30 days at Chineseports, says Mr Koay. Container shipping terminals are sub-ject to hold-ups averaging no more than a day, he adds,although tight schedules normally kept by the containerlines mean that delays of even a few hours can have a sig-nificant impact on operations and profitability. Condi-tions in southern Chinese ports have deteriorated,especially at Shenzhen’s Yantian port, already notoriousfor its snarled docks. Mr Koay believes that container ship-ping facilities in China should be able to keep up withdemand as new facilities come on stream but says there isno end in sight for bulk carrier delays. Four new berths areunder construction in Yantian that would boost the port’srated capacity to 5m TEUs by 2006, although this wouldstill meet only half of the actual throughput in 2003.Shanghai is building an enormous deepwater port atnearby Yangshan islands that will take 18 years to com-plete, with capacity rivalling Hong Kong’s port. The focushere is on modern container facilities.
RoadsWhen China opened its door to foreign investors 25 years
ago, among the first building projects were roads andhighways. The country’s first superhighway—initiated byGordon Wu, the chairman of Hopewell Holdings, a HongKong-listed firm—linking Hong Kong to Guangzhou, theGuangdong provincial capital, and Zhuhai took ten yearsto build and became fully serviceable in 1994. By 2002China had doubled the length of highways to 1.8m km,much of it built with foreign investment. However, Chinastill does not have enough highways to meet its needs.According to a report published last summer by DrewryShipping, a UK-based consulting and research firm, thedensity of land transport systems in China amounts to just157 km per 1,000 sq km. This compares with equivalentfigures of 720 km in the US and 3,138 km in Japan. Chi-nese highways are also notoriously expensive to use. Tollfees amount to 10% or more of freight costs, much higherthan in developed countries. Much of the toll collection atlocal levels is arbitrary and illegal.
RailYears of neglect have resulted in acute undercapacity inChina’s railway system. Having invested heavily in roadand port infrastructure over the past decades, the govern-ment has only recently turned its attention to the country’soverburdened and underfunded rail network. However, thefocus appears to be on restructuring rather than throwingmoney at the system—a wise move. The national railway isoverstaffed, employing over 1m people, compared with theUS, for example, where the network is run by a few thou-sand people. The sector is not directly affected by China’saccession pledges to the WTO as the government has notpromised to open up the national rail system to foreigninvestment. Nevertheless, in the interests of efficiency, thegovernment will break up the rail system into three parts:passenger operation, freight handling and infrastructurebuilding. Foreign participation will be allowed in cargotransport services and railroad construction.
Since 1996, the start of the ninth five-year plan (1996-2000), railways in China have expanded by only 4,000 kmcompared with 624,000 km of highways—up by 7% and53%, respectively, by 2003. A major reason for rail’s slowdevelopment is tight government control, unlike roadswhere there is greater official tolerance for foreign owner-ship and hence foreign investment. The Ministry of Rail-ways is planning to increase the entire network by lessthan 40% to 100,000 km by 2020. Double tracking andelectrification will rise to 50% from the current 39%. Trainspeeds are also being increased to 160 kmh—so far only28% of the tracks are capable of taking the increasedspeed—and bigger wagons are being added to take heav-ier shipments.
The expansion could help overcome some of the railnetwork’s structural problems. For instance, much of the
rail system is oriented along a north-south axis, leavingmany east-west routes underserved. Service to importantdestinations in China’s interior—cities such as Wuhan,Chongqing and Nanjing—also remains weak. Moreover, alack of regularly scheduled freight services prevents effi-cient movement of goods and creates a build-up of inven-tory for shippers. Container block trains are available,although limited: only companies with sufficient cargocan charter entire trains, giving them better control overfreight movements.
Other problems remain. Services are subject to substan-
tial delays during holiday periods, such as the Chinese NewYear, booking systems are antiquated, cargo tracking isnegligible and there is room for improving tariff structures.
AirAlthough air freight has expanded fairly rapidly in recentyears, it still accounts for only 0.1% of total freightthroughput in China. Domestic airlines were not allowedto operate dedicated air-cargo routes until 1998, givingrise to scheduling problems and capacity shortages.Although these problems have eased somewhat, service
The home improvement retailer, B&Q, firstentered China in 1998—the first overseasbuilding materials retailer to do so. B&Q’sparent company, UK-based Kingfisher, hadkept watch on China for several years afterlaunching the only do-it-yourself (DIY)chain in Taiwan in 1995. With the increasingwealth of Chinese consumers and growth inhome ownership, the mainland marketlooked promising. Moreover, the universalpractice of selling new apartments in Chinaas empty shells—largely unpainted andlacking basic fixtures and fittings—madepersonal home renovations commonplace,but DIY enthusiasts bought solely fromstreet stalls or small shops. With no organ-ised competition, B&Q made its move,designing its stores to provide a full interiordesign service for Chinese customersattempting to refurbish their empty shells.
Today, B&Q has 15 outlets across thecountry, including in Beijing, Hangzhou,Kunming, Shanghai, Shenzhen and Suzhou.The company’s Beijing store, which openedin 2003, is its largest anywhere in the world.In 2004 B&Q launched an aggressive retailexpansion strategy with plans to open atleast ten stores by the end of the year andgrow to a total of 75 stores by 2008. Most ofthe stores will open in China’s wealthyurban markets along the eastern seaboard,although B&Q has also started to locatestores further inland in cities such as Wuhanin Hubei province.
The importance of logisticsAfter a rocky start, B&Q’s China operations
have started to show a profit—despite thecost of opening new outlets. This successstems in part from careful planning andclose monitoring of its logistics supplychain. The company has set up its regionalheadquarters in China to help direct thedevelopment of an effective supply-chainnetwork, monitoring the management oflocal outlets and looking at the best ways togrow its procurement chain. Like othermultinational chain-store operators, B&Qcan call on a low-priced global procurementnetwork to match or beat the prices offeredby local building materials dealers. At thesame time, it can win over local suppliers toits procurement network: B&Q sourcesgoods worth at least US$1bn each year—including electrical goods, kitchen appli-ances and daily-use products for sale at itsstores in Europe and elsewhere.
Like other national retailers in China,B&Q faces an underdeveloped transportnetwork, a lack of sophisticated logisticssystems and the need for countlessmiddlemen to make the supply chain work.These obstacles have made it difficult to setup regional distribution networks, let alonenational ones. B&Q’s 350 stores in the UKare supplied by 600 vendors but thecompany has to deal with as many as 1,800for its 15 outlets in China.
George Zhao, the vice-president oflogistics for B&Q China, says the commonproblems facing large retailers are poorwarehousing facilities and the lack of anintegrated logistics network andsophisticated IT systems. For now, B&Q is
getting around these issues by outsourcingto a third-party logistics provider (3PL),although this is an expensive strategy. Thecompany also plans to invest in IT systemsto improve communications with vendorsand so control inventory management moreeffectively—a move that will pay dividendsin the longer term.
Challenges for 3PLs3PLs are forced to charge high fees becausethey themselves must cobble togethermulti-modal transport networks with thehelp of numerous smaller, inefficient localdistributors. Basic transport services remainthe mainstay of even the largest 3PLs inChina, and value-added services on offer—such as tracking and tracing solutions—arestill rudimentary.
3PLs must also bear the cost of localprotectionism. Even in China’s largest cities,non-local logistics firms facediscrimination. The central government isunable to enforce fair-trade rules in theprovinces. Logistics firms operating on anational level will face higher expenses atbest and, at worst, exclusion from markets.
Overall, Mr Zhao is bullish about B&Q’sprospects in China. However, he warns thatlogistics and the supply chain will play a keyrole in determining the extent of thecompany’s mainland development. China’slogistics infrastructure inevitably willimprove significantly but Mr Zhao believes itwill take more time to make improvementsin the supply-chain system—notably co-operation with vendors.
providers are concerned about the lack of inter-modalsupport, complex customs procedures, and excessiveclearance delays and restrictions on flight frequency.
Operational problemsIn addition to the difficulties of moving goods alongChina’s strained infrastructure networks, supply chainmanagers must also overcome operational difficultiesstemming from a lack of professionalism in the distribu-tion chain. The key problems include:● Slow take-up of IT systems. Although the benefits of
information technology (IT) are widely recognised inChina’s logistics sector, the massive investmentrequired to transform logistics systems remains a keyobstacle to development. “Many companies choose touse less expensive solutions for now, not consideringthe future,” says George Zhao, the vice-president oflogistics for B&Q China. Nevertheless, the use of ware-house management systems is becoming more popu-lar, even though transportation management andlogistics planning systems—and their integration—still have a long way to go.
● Poor collaboration between logistics partners. Theabsence of a nationwide logistics network has forcedcompanies to build up a patchwork of different localand regional logistics providers in a bid to operatedistribution networks across provincial borders. Butco-ordination between different logistics providersremains poor, creating high inventory and poor cus-tomer service for the industry.
● Obsolete warehousing facilities. Many facilities lack
basic inventory management and security systems, letalone offer chilled or refrigerated facilities for perish-able goods.
● Damage to goods in transit. For rail shipments, prob-lems crop up when goods are off- and on-loaded totrucks—a boxed cargo may look very different by thetime it arrives at its final destination. For long-haultrucking, bad roads and poorly maintained vehiclescan result in high damage rates.
● Pilferage in transit. Companies booking less thanone container load on trains and trucks are more sus-ceptible to theft, which frequently occurs as goods areloaded on or off a container. The problem is worse forrail cargo than freight transported on trucks.
Not yet connectedDespite the regulatory, infrastructure and operationalproblems of conducting logistics services in China, mostplayers are positive about the market’s long-termprospects. The Chinese government is pushing hard forreforms to improve train services, while opportunities forexpansion in integrated services make it a particular focusfor companies like APL going forward, says Mr Koay. Hesees necessary infrastructure upgrades as taking at leastten years to implement, however. Smaller companies,meanwhile, must await the upcoming regulatory reform togauge just how far the market will be opened. Althoughtheir expectations for what the new rules will bring aregenerally not very high, there is a consensus that, eventu-ally, they will come good. With such a large prize at stake,many are prepared to bide their time.
● On an international basis China is a small market for most for-eign pharmaceutical firms. But it is a market that is growingrapidly, a trend that many foreign firms expect to continue.
● In addition to strong demand growth, other aspects of thebusiness environment for pharmaceuticals firms have beenimproving. The regime for the protection of intellectual prop-erty is still far from perfect, but is improving, and tariff barri-ers and rules on participation are slowing being relaxed.
● Structural issues complicate the ability of foreign firms tocapitalise on the emerging market. Chief among these is thenature of the national healthcare system. In China's govern-ment-run, hospital-based health system, drug registration,pricing and reimbursement are strictly controlled. And in aneffort to control costs, the Chinese government is cuttingprices and favouring generic drugs whenever possible.
● The hospital system will be reformed, with the developmentof health insurance, community-based primary care and thefull range of private healthcare services. These changes willtake many years to implement but will have important knock-on effects for the pharmaceuticals market.
● Even in the current environment, pharmaceutical firms haveoptions. They can, for example, start to use market-shapingstrategies to create new demand for drugs in areas that cur-rently pass either under-diagnosed or completely untreated.
● Many foreign pharmaceuticals firms already have manufac-turing facilities in China. But recent investment in researchand development activities is an indication that drug compa-nies are starting to think more broadly about their China ven-tures. Most of this investment has been and will continue tobe focused on drug-development clinical trials.
Selling drugs is different from selling mobilephones, televisions, computers or refrigerators.Certainly, some of the challenges facing overseasdrug companies in China mirror those that compli-
cate foreign firms’ operations in other sectors: a lack ofintellectual property protection; complex and opaque reg-ulations; complicated and costly distribution networks; ahighly fragmented local industry; and an undeveloped pri-vate sector.
Drug companies also face a unique set of structuralchallenges. In every country in the world, pharmaceuticalcompanies must operate within a highly regulated envi-ronment that imposes many restrictions, rules and regula-tions. China certainly has those in spades. In itsgovernment-run, hospital-based health system, drug reg-istration, pricing and reimbursement are strictly con-trolled, complicating the business strategies of even themost experienced companies.
Given this laundry list of operational and strategicchallenges, it is perhaps unsurprising that foreign phar-maceutical companies have not achieved huge success inthe Chinese market, even though it has been open to for-eign investment since the 1980s and, by the mid-1990s,20 of the world’s top 25 drug firms had established a pres-ence in the country.
Yet there is still room to grow. China’s healthcare sec-tor is in the midst of a transformation, one that could cre-ate new opportunities for growth. Although it will takeyears for the sweeping changes to be fully realised, somedrug firms are starting to make the strategic changes nec-essary to tap into this changing market, and are reconsid-ering how to tap into today's opportunities as well.
The demand pictureDrug multinationals were initially attracted to China forthe same reason as other foreign businesses: the possi-
Part 2
PharmaceuticalsCultivalting demand and biding time
bility of selling their products to as many of China’s 1.3bnpeople as possible. The first foreign pharmaceutical firmsto enter China, which included Bristol Myers Squibb(1982), Janssen (1985) and SmithKline & French (1987),found a virtually untapped market. By employing basicmarketing and advertising techniques, they easily tookmarket share from local state-owned producers, whichwere lethargic and inexperienced after decades ofbureaucratic control. Their early success stories con-vinced many other drugmakers that China was the land ofplenty and many followed in their footsteps, arriving inChina with a naïve and wildly unrealistic view of the mar-ket potential for their wares. The over-optimism of thoseearly days was dampened in the mid-1990s by disap-pointing sales and a realisation of just how difficult it wasto do business in the country. That sober mood prevailedfor a number of years, during which time corporate head-quarters were nervous about their future in China. Invest-ment was cautious, expectations were modest andstrategies were mainly geared towards simply maintain-ing a presence in China.
In recent years, growth has been solid but not explo-sive. The total market for ethical and over-the-counter(OTC) drugs in China in 2002 was US$7.4bn (ex-factoryprice) according to IMS, a US-based pharmaceuticalresearch firm, up from US$5.5bn in 1997 and US$6.2bn in2000. By some measures, China is still a substantial worldmarket: in 2002 China was the seventh-largest drug mar-ket in the world, behind the US, Japan, Germany, France,the UK and Italy, and close in size to Brazil, Canada andSpain. However, to put the overall size of the Chinese mar-ket in perspective, one blockbuster pill generates moresales in the US alone than the sales of all foreign compa-nies' products in China combined. The world’s bestsellingdrug in 2003, Pfizer’s cholesterol-lowering pill Lipitor, hadglobal sales of US$10.3bn, more than all the medicinessold in China that year. A blockbuster drug in China, bycomparison, is any that reaches just US$75m in sales.
Sales in China by foreign-invested enterprises (FIEs)total no more than US$2.2bn, equal to about 20-30% ofthe Chinese market (although the share is bigger inGuangzhou, Shanghai and Beijing). But the market ishighly fragmented. There are about 1,700 Chinese-foreignjoint ventures (JVs) operating in the country, according toIMS, with the top ten global companies controlling lessthan one-fifth of the market. By comparison, the top tenpharmaceutical manufacturers have 50% of the globalmarket, with the biggest, Pfizer, capturing 9.25%, fol-lowed by GlaxoSmithKline (GSK) with 7% andAventis/Sanofi with 6.6%. In Europe, the top ten compa-nies hold 45% of the market, with the leader, GSK, at7.2%. The weight of the Chinese market on these compa-nies' overall portfolio is still quite light, representing less
than 1% of these firms’ global business, according to anumber of executives interviewed for this report.
Disappointment about market share, however, masksthe rather satisfying performance of individual compa-nies. The past couple of years have been good for manyforeign drugmakers and many already have, or are consid-ering, increasing their investment in China (see box,Development, and perhaps even some research). For somecompanies, China has become their fastest-growing mar-ket and many are predicting continued growth. Novartis’sales, for example, were up by 30% in 2003 (to aboutUS$120m from US$92.3m in 2002) and it expects 20-30%growth each year for the next five years. Roche expects itsprescription medicine business to double in the next fiveyears to US$240m. AstraZeneca and GSK are also opti-mistic.
A better outlook for growthIf this rapid growth continues, IMS predicts that the phar-maceutical market will top US$15bn (at ex-manufacturerprices) by 2010. Although this is still a tiny fraction of theUS and Japanese markets, it would make China the fifth-largest market in the world, on par with Germany, France,the UK and Italy.
It is clear, therefore, why many multinationals regardChina as an important part of their global strategy: the
country is already one of the world’s top markets and thepotential for long-term expansion is great. For foreigndrug companies, a number of ongoing changes to thebusiness environment are buttressing their optimismabout the market's future growth.
One reason the Chinese market has been so difficult topenetrate is simply that, despite the economy's expan-sion, the majority of the country’s 1.3bn people cannotafford to buy expensive medicine; they have no access towhat many foreigners would consider a basic level ofhealthcare. But preferences play a part, too. Among thosewho have the ability to pay for drugs, many prefer tradi-tional Chinese medicine to Western medicine, especiallyfor chronic conditions that require long-term treatment.Drugs such as Celebrex (for arthritis), Lipitor (to lowercholesterol), Premarin (hormone replacement therapy)and Prozac (for depression) have not been hugely suc-cessful in China, as they have been in the West, primarilybecause Chinese consumers prefer traditional Chinesemedicines for long-term treatments and Western medi-cines (such as antibiotics) for short-term treatments.
Rising income levels, particularly in the bigger Chinesecities, will begin to open up new sources of demand. Theincreasing number of young (25-35 years old), middle-class urban residents is already having a growing influ-ence on the healthcare market. As consumers, themembers of this group are quality healthcare seekers whoare involved in making treatment decisions not just forthemselves but also for their parents, grandparents andchildren. In addition, they will opt to pay for the conven-ience of private healthcare or be covered by health insur-ance. They are already beginning to dip into the nascent
private sector for services such as eye care, dental careand cosmetic surgery. As doctors, they are quality health-care providers who are better able to discern and digestinformation and make more informed decisions concern-ing patient care.
The business environmentAn improving, but still imperfect, IPR regimeAnother important change in the business environment isthe ongoing improvement in protection of intellectualproperty rights (IPR) and patent recognition. In its 2003white paper the American Chamber of Commerce(Amcham) in China described 2002 as a “milestone year inChina for the promulgation of laws to improve intellectualproperty protection of pharmaceuticals”. The mainchange was legislation extending the period of patentprotection to 20 years, but improvements were also madein the areas of data protection and patent linkage.
Still, inadequate protection of intellectual propertyremains one of the biggest bugbears of foreign drugsfirms in China. Despite the changes that have been madein recent years, in its white paper Amcham still called forfurther progress to be made in the areas of data exclusiv-ity, patent linkage and Patent-Term Restoration. Amchamalso highlighted the problem of counterfeit drugs, whichaccording to some estimates account for 10-15% of OTCpharmaceuticals sold outside of hospitals in China. Drugenforcement authorities at the central government levelhave devoted significant resources to anti-counterfeitingefforts. But more needs to be done at the local level toenforce the law and prosecute offenders. One problem islimited criminal sanctions. Currently, only counterfeiters
0
5
10
15
20
25
30
35
Pfizer GlaxoSmithKline
Aventis/Sanofi
Merck J&J AstraZeneca Novartis Hoffman-La Roche
Bristol-MyersSquibb
Wyeth
Big playersRevenues of the top global pharmaceuticals manufacturers, US$ bn
38.9
29.627.9
22.0
19.016.9
15.6 14.8 14.411.8
Source: International Federation of Pharmaceutical Wholesalers
who produce substandard drugs that result in seriousinjury can face criminal sanctions.
Easing restrictions on participation Market-opening measures may also support growth. For-eign participation is now permitted in the previouslyclosed drug distribution industry. China’s first pharma-ceutical distribution JV was announced in 2003 ahead ofthe date China promised to the WTO. The joint venture,called the Zuellig Xinxing Pharmaceutical Co, has a totalinvestment of US$14.5m, with China Xinxing holding a51% stake and Zuellig Pharma the remaining 49%.Although based in Switzerland, Zuellig Pharma carries outits main business as a distributor of pharmaceutical andhealthcare products in the Asia and Australasia region. Aswith local manufactures, drug distribution has been con-trolled by the government for decades and is costly, inef-ficient and overcrowded. (There are currently more than16,000 drug distribution companies in China.)
Other developments that have aided, and will continueto aid, the growth of the market include the reduction ofimport tariffs. As part of China’s WTO obligations, averageimport tariffs were lowered to 4.2% in 2003 and compa-nies were allowed to import into any part of China. Theefficiency and transparency of the regulatory environ-ment, particularly with regard to issues such as drug reg-istration and imports, is also improving.
Enduring systemic barriersA growing and more sophisticated market, coupled withan improved business environment, offer some cause foroptimism among the foreign pharmaceutical companiesoperating in China. But there are a number of offsetting
features that continue to complicate the operating envi-ronment as well as the formulation of the appropriatestrategic response to changing conditions. Chief amongthem is the structure of the national healthcare system.The promise—and in some cases application—of majorhealth system reforms supports some of the more opti-mistic forecasts for the market, but deep changes are stilla long way off.
In China’s government-run, hospital-based healthsystem, drug registration, pricing and reimbursement arestrictly controlled, complicating the business strategiesof even the most experienced companies. Most medicalcare is provided in government-controlled hospitals,where 70-80% of drugs (both ethical and OTC medicines)are sold. Reimbursement in the state-controlled hospi-tals is limited to drugs on provincial and national druglists that, in turn, largely determine which products apharmaceuticals manufacturer can sell to which hospitalsand at what price.
According to some executives at foreign drug compa-nies, the system of pricing and reimbursement greatlycomplicates, and sometimes threatens, the success oftheir business in China. In an effort to control costs, theChinese government is cutting prices at the central andprovincial levels for reimbursed medicines, and aims toreduce the price of off-patent drugs from multinationalsto no more than 30-35% above the price of locally madegenerics. Moreover, the Chinese government is favouringgeneric drugs whenever possible and is restricting the listof drugs sold through hospitals. As with anti-retroviralmedicines to treat AIDS, there is certainly a case for low-ering the price of drugs directed at diseases such as dia-betes and hepatitis, which are major medical and socialproblems, in order to expand access to treatment. Morebroadly, it must also be acknowledged that the pharma-ceutical industry does battle against restrictive pricingand reimbursement policies in just about every Westerncountry, with the notable exception of the US.
The long-term solution to the enormous challenge thegovernment faces in trying to provide an adequate level ofhealthcare services for the entire population with verylimited resources lies in hospital reform as well as thedevelopment of health insurance, community-based pri-mary care and the full range of private healthcare serv-ices. The government also hopes to restructure andmodernise the domestic pharmaceutical industry (makersof both Western and traditional Chinese medicine), bringmanufacturing up to international quality standards andmaintain the dominance of local companies. But thesechanges are likely to take at least ten years to implement,even though, ever so slowly, progress is being made. Mostof these changes will have important, knock-on effects onthe pharmaceutical market.
0
3000
6000
9000
12000
7,47
1
8,16
1
8
,947
9,90
3
11,
110
12,
511
2003 2004 2005 2006 2007 2008
HealthierChina‘s pharmaceuticals‘ sales, US$m, actual prices*
The near-term strategiesWith the completion of deep, structural reforms a decadeaway, many foreign companies are being forced to investi-gate how to maximise opportunities in today's market,while keeping an eye on the future. To that end, the ideaof applying the same marketing and communicationsstrategies in China that are used to such great success inother countries is a concept many of the big drugmakersare now beginning to explore. Patent recognition hasmade this possible, as have other changes over the pastfive years, such as the growth of the market and the Chi-nese middle class.
GlaxoSmithKline (GSK), the world’s second-largest drug-maker, still has less than 2% of the Chinese market. Thecompany is re-evaluating its China strategy to determinewhat, if anything, it can do differently to make a break-through in the market. Will GSK, and other drugmakers, tryto find a way to break the mould or continue on a “businessas usual” approach? Will they be satisfied with organicgrowth along conventional lines or take a risk and possiblyjeopardise what has already been achieved? Companieslooking to elevate China from an interesting market to a pri-mary one are now wrestling with their next strategic steps.
To make the most of opportunities in the near term andto be as well placed as possible in the longer term whenhospital and insurance reform are implemented, Westerndrugmakers will have to make some strategic changes totheir business development plans. Mergers and acquisi-tions (M&As) are not a favoured route for growth in theChinese market. Local drug companies—rife with ineffi-ciencies, overproduction and losses—offer nothing tomost foreign firms. Manufacturing strategies are alreadywell developed, as this was the first wave of investmentafter drug multinationals began setting up their commer-cial businesses in China (see box, Making drugs). A new
phase involving investment in research and development(R&D) is emerging and seems all but destined to become amore important strategic area for drug companies, both interms of their business in China and their regional andglobal operations (see box, Development, and perhapseven some research).
Stressing sales and marketingThe strategic approach taken towards sales and marketingis likely to separate the winners from the losers in thecoming years. When foreign drugmakers first came toChina, they tended to manufacture and sell their more“mature” products, that is medicines that were off-patentand already facing generic competition in home markets.Because patents were not recognised and intellectualproperty not protected, companies understandably with-held their most innovative drugs from the Chinese mar-ket—these drugs were certainly not manufactured inChina and, in many cases, were not even imported. Overthe last five years, this has begun to change. Pfizer, forexample, offers 40 products in China, including all of itsglobal bestsellers (Lipitor, Norvasc, Celebrex, Viagra,Diflucan, Zithromax and Zoloft). Novartis launched fournew drugs in China in 2003—a record for the industry.
According to a number of company executives, foreigndrug companies are eager to include China in the globallaunch of all their new products, although there is still alag between the international launch of many drugs andtheir Chinese debut. The time delay is not a result of a cor-porate strategy decision but rather because of China’scomplex rules and regulations, which can delay the regis-tration of a new drug in China by two or three years com-pared with registration in the US or Europe.
On the one hand, introducing the latest patent-pro-tected products to the Chinese market is a step in the right
China’s healthcare reforms Ongoing/proposed healthcare reform Impact on drug market or foreign drug companiesCreate community-based primary healthcare to take some of the patient load Faster, more convenient access to healthcare services are likely to grow away from hospitals the market, opening up new channels for doctor and patient marketing as
well as education campaigns
Separate OTC from prescription drugs. Encourage significant growth in the retail More convenient access to medicine should expand the drug market. pharmacy sector and thus create an OTC market similar to that in Europe and the US The OTC market, in which brand awareness and loyalty is all-important,
will become the target of marketing and advertising campaigns, as will pharmacists. This reform will require strategies to limit/restrict the OTC sale of potentially dangerous prescription drugs without a prescription
Introduce a basic health insurance system for urban employees Opening and expanding a range of private healthcare services (from diagnostic centres to clinics to hospitals) will increase demand, especially for new and expensive patent-protected medicines.
Develop an effective system to deliver basic healthcare to the rural population of Long-term goal with little impact on overall drug market or foreign over 800m people drug companies in the foreseeable future
Restructure and modernise the domestic pharmaceutical industry, bringing Local companies will continue to dominate the marketmanufacturing up to international quality standards
Since the late 1980s, after the central gov-ernment announced the imposition ofrestrictions on imports and a policy favour-ing locally manufactured products, foreigndrug firms interested in the China marketwere compelled to set up manufacturingjoint ventures (JVs). (A local partner wasobligatory.) A pharmaceutical JV typicallyinvolved a US$10m-30m investment in aplant engaged in formulating, filling andpackaging low-technology products such aspills and creams. (Formulating, or second-ary manufacturing, involves mixing activechemicals with inactive ingredients.) Oncethe ink was dry on a JV deal, it was easier toget drugs on the reimbursement lists and toimport finished products into the country.
In the latter half of the 1990s companiesbegan to take greater stakes in their JVs, insome cases opting to form a wholly ownedforeign enterprise, which also became anoption for companies willing to manufacturehigher-technology products. Typicalinvestment levels in a plant increased toUS$100m or more as companies built moreexpensive formulating plants and began tomanufacture higher-technology goods suchas time-released capsules, injectables,aerosols and inhalers. (Primarymanufacturing or chemical manufacturingplants cost US$200m-400m to set up anddrug companies by and large have not optedto locate such plants in China.) Many rawmaterials are sourced locally but most activeingredients for patented drugs are imported.
As a result of global mergers, some drugcompanies now have complex JV structuresin China with several factories and severalpartners. In these cases, it is difficult tocentralise manufacturing operations sincethe registration of a drug is tied to theplace it is manufactured and not easilychanged.
The global trend in the industry,however, is to rationalise manufacturing,and some firms consider China and Indiaincreasingly attractive locations—a changefrom just five years ago, when they were stillconsidered risky owing to the lack ofintellectual property protection andconcerns about quality of supply. Some useChina as a manufacturing base for the localmarket as well as for export to other Asianmarkets. Some foreign companiesmanufacture locally the majority of theproducts they sell in China. Somemanufacture only high-volume, low-priceproducts for the local market.
The merger between Glaxo andSmithKline Beecham left the new company,GlaxoSmithKline (GSK), with US$400minvestment spread over five plants and fivedifferent partners. Pfizer has invested themost—US$500m—primarily owing to thelarge manufacturing presence in China ofPharmacia, which it acquired in 2003.AstraZeneca, by contrast, has a simplestructure with one US$134m formulatingplant in Wuxi, which it owns outright.Inaugurated in 2002, the plant is
AstraZeneca’s largest manufacturinginvestment in Asia. Some 80% of theproducts it sells in China are manufacturedat the plant; the remaining 20% areimported because the volumes are too smallto justify local manufacture. Novartis,another one of the leading players in China,has only a US$30m formulating plant for itstablets and creams and imports 50% of itsproducts.
In the future, companies will continueto both manufacture locally and import.Decisions to expand manufacturing aremore likely to be based on demand andcosts, and not whether the expansion willwin favour with local drug regulators.These will be internal decisions, part of alarger global plan, that are unlikely to havea big impact on a company’s sales inChina—at least not to the degree that itwill separate winners from losers—but willbe reflected in a company’s globalperformance. So in terms ofmanufacturing, at least, China is becomingmore like other developed markets. If thissame trend emerges in other areas,investment levels could rise further. Afterall, manufacturing, which accounts formost of the official US$2bn in “equityinvestment” that foreign drugmakers havemade in China, is in general not drugcompanies’ biggest expense. They spendmuch more money on sales and marketingand on research and development—and arebeginning to do just that in China as well.
Making drugs
direction. Those that continue to satisfy head officebudget figures with sales of “mature products” are goingto face hard times ahead. This is not a viable long-termstrategy, as it will become increasingly difficult to lobbyfor placement of these medicines on reimbursement listswhen far cheaper alternatives of the same treatment areavailable. And so it should be; foreign drugmakers coulddo themselves a collective favour by accepting this simplereality and concentrating on their new drugs, just as theydo elsewhere in the world.
On the other hand, launching a company’s entireglobal portfolio is not necessarily the best strategyeither. There is little point launching a product in China,
even the most “innovative” one, if there is little chanceof obtaining a spot on the all-important provincial andnational reimbursement lists (because the governmentcannot afford it) or if there is little chance of sales in theprivate sector because of a lack of demand from doctors(who would prescribe it) or consumers (who would payfor it).
Picking winnersDrugmakers need to try to pick the winners. Sometimes itis clear, as was the case with GSK’s Heptodin, a novel treat-ment for hepatitis that has been a Chinese blockbustersince it was launched in 1999. It was the tenth bestselling
drug in China in 2003. Novartis’ Glivec, a new treatmentfor leukaemia, broke records when it was registered afteronly six months and was one of the top ten bestselling newdrugs in China in 2003. These were truly novel treatmentsthat met a clear and significant medical need. But matcheslike these are few and far between. In general, determin-ing which products to launch, and how many should beincluded in the China portfolio, is no easy task.
Few foreign companies can make the investmentrequired to promote a whole slew of drugs effectively. Butcompanies must bear in mind that there are more andmore people who can afford to use drugs, and more peo-ple who want the “best” drug and will pay for it if theyhave to. Drug firms also need to consider the launch mar-kets, looking beyond Shanghai, Beijing and Guangzhou toinclude as many of China’s first- and second-tier cities asthe budget allows.
Marketing by market shapingPicking the right drugs and the right cities is only part ofthe marketing battle. Companies must also begin to cre-ate demand where demand did not previously exist. Mar-ket shaping is a strategy employed successfully acrosssectors and around the world, and the time is ripe for itsutilisation in China.
The concept of market shaping has been around a longtime in the pharmaceutical industry. The marketing his-tory of Lipitor, a drug to lower "bad" cholesterol, is a clas-sic example. It was a late arrival to the statin field,following in the footsteps of Zocor and Pravachol, whichboth enjoyed considerable success. Pfizer, however,reshaped the market by changing the approach to theclinical management of heart disease and, in so doing,made Lipitor the world’s bestselling drug.
Another more recent example of market shaping is the
Although foreign drug firms have had a pres-ence in China for more than 20 years, most ofthem viewed the world's most populousnation as a manufacturing centre and anexpanding market, instead of a place to con-duct innovative research. Recent investmentin research and development (R&D) is oneindication that drug companies are startingto think more broadly about their China ven-tures. It is impossible to put a figure on theamount that the industry is spending, but itis fair to say that it is minuscule comparedwith overall spending on R&D worldwide andthat greater investment in China seemsalmost certain.
Pharmaceutical R&D comprises two arms:basic and preclinical research (drug discoveryand all the testing that goes on in laboratoriesbefore a treatment is tried in humanvolunteers) and clinical trials (testing drugs inhumans). In China, foreign drug companiesare investing in basic research through varioussponsorships and alliances with academicinstitutions, research groups and biotechstart-ups (local drug manufacturers are absentfrom the list of close collaborators becauseinnovation is not part of their business).Roche, for example, is collaborating with theChinese National Genome Centres in Shanghai
and Beijing on genetic epidemiology studiesabout conditions such as diabetes andAlzheimer’s disease. In 2001 AstraZenecasigned a collaboration agreement withShanghai Jiao Tong University to study thegenetic basis of schizophrenia.
A few have even set up their own researchfacilities, something that was unthinkablefive years ago, so great were worries aboutintellectual property rights (IPR). InNovember 2002 AstraZeneca opened itsregional Clinical Research Unit–East Asia,which is responsible for overseeing clinicalresearch in China, Hong Kong, Taiwan andSouth Korea. Eli Lilly, NovoNordisk, Pfizerand Roche have also opened R&D centres orhave made announcements that they will bedoing so soon. Both GSK and Novartis saythat it is just a matter of time before they,too, invest in an R&D centre in China.
In February 2004 Roche announced that itwas establishing a wholly owned andoperated R&D centre in Shanghai, which isscheduled to be fully operational by the endof the year. It will be the group's fifth R&Dfacility worldwide (the others are located inthe United States, Japan and Europe). Rochehas not put a dollar figure on its investmentbut clearly the company is just testing the
waters: the new centre will initially be staffedby 40 chemists—rather few when comparedwith the more than 5,000 scientists Rocheemploys in its four other facilities.
Sceptics say the opening of a researchfacility is mostly a token gesture made togain favour with the Chinese government.The sceptics may be partly correct. Besidesthe possibility, however small, ofcontributing to an organisation’s global drugdiscovery efforts, an investment in an R&Dcentre in China will indeed please theauthorities, perhaps offering foreigncompanies some leverage in negotiations onissues such as the new drug applicationreview process, drug pricing, reimbursementand IPR protection.
Clinical trialsCurrying favour with the government aside,R&D investment is a step towards building astronger presence in the Chinese market.Given China’s weak IPR track record, it iseasy to understand why drug companies areonly just now beginning to make invest-ments in R&D centres. They have, however,been somewhat less cautious about involv-ing China in global drug-development clini-cal trials, which is where most R&D
investment has been and will continue to befocused.
Although drug development is one of thebiggest areas of spending for a multinationaldrug company (costing hundreds of millions ofdollars to test each new drug), such trials donot require investment in a research facility.They are conducted in hospitals and involvedoctors, nurses, patients and many others whoserve as administrators, regulators andoverseers. After a new drug candidate passespreclinical testing in the laboratory and onanimals to assess safety and biologicalactivity, it moves into three phases of clinicaltrials involving testing on humans. Phase IIItrials generally involve thousands of patientvolunteers in many hospitals in manycountries throughout the world.
There are many compelling reasons whyforeign drug firms are increasing investmentsin drug- development trials in China. For one,such trials are faster and cheaper to performin China than in the US and other Westerncountries. It may take longer to obtainpermission to conduct a trial but patientrecruitment is extremely rapid. This is a bigdraw. The faster a drug can get to market, thespeedier the return on investment; the fastera drug can be developed, the longer it is
protected by its patent. A second reason isthat by including Chinese sites, drugs can getto the China market faster. Chineseregulatory authorities require local trials forall new drugs, even if a drug has beenapproved elsewhere in the world. If Chinaparticipates in initial stage trials, this speedsup the drug registration process. This cantranslate into millions of dollars in sales. Italso helps sales and marketing effortsbecause it is a way to get top hospitals andinfluential key opinion leaders on board asearly as possible.
Today, most of the big foreign companiesare conducting such trials in China. GSK saysthat at any one time it has 4,000 patientsenrolled in trials in China. Novartis is testing anew treatment for hepatitis, which, if it provesto be effective and safe, may be launched inChina before the rest of the world.
Of benefit to allAssuming international ethics and standardsare adhered to, it is difficult to find fault withthe strategy. All players stand to benefit. Ifthe government’s dream of one day spawn-ing Chinese versions of Pfizer and GSK is everto be realised, the country will need to havethe infrastructure and skills in place to test
new treatments once they are discovered.The drug company benefits for all the rea-sons already explained. The central and localgovernments benefit because they bringinvestment and expertise and help upgradethe standard of the local industry. Govern-ment regulators, ethics board members andmedical personnel acquire the skills and gainvaluable experience in clinical trials of aninternational standard. Hospitals, doctorsand researchers are keen to participatebecause they bring training, money, newdrugs and technologies for which they wouldotherwise have to wait years. They also bringprestige to an institution and the chance foran investigator to be published in an inter-national medical journal. Patients benefitbecause they get access to a potentiallyeffective treatment for free and they receivecare, which is often better than that avail-able to regular patients.
The biggest risk in the strategic decisionsto conduct clinical trials in China is a breachof ethics, which could seriously damage adrug firm’s business in China andinternationally. The other main concern forforeign companies investing in any form ofR&D in China remains the protection of IPR,and this concern is likely to remain.
erectile dysfunction market. Viagra created the categoryand the general thinking in the industry was that the newentrants like GSK’s Levitra could not grow the market;they could only take market share from each other. But insome places elsewhere in the world, clever and creativesales and marketing departments found a new way toposition their new drug instead of competing head-to-head with Viagra. To the surprise of many, not only hasthe total market grown but the new entrant has taken aleading position.
Opportunities abound for market shaping in China andthere is no inherent reason why it cannot be done just aseffectively. Diabetes, hypertension, hepatitis, heart dis-ease, dementia and other diseases related to ageing,women’s health and men’s health are just some of theunder-diagnosed and untreated health problems waitingto be tapped by foreign drug companies looking to pro-
mote their patent-protected drugs.A market-shaping strategy will also entail a jarring
shift in current marketing techniques. Until recently, for-eign drug companies have focused marketing efforts ongaining access to hospitals, winning over key opinionleaders and doing whatever it takes to get their productson provincial and national reimbursement drug lists. Inother words, the companies have targeted the supplyside, with teams of 700-1,200 medical reps playing thesame market share game and competing head-to-headwith each other. But perhaps a more effective strategy isto create demand with doctors and consumers—a strategythat might require, for example, a company to investigatestrategies for changing the opinions about Western medi-cines versus traditional Chinese medicine or buildingbrand awareness.
This strategy will begin to pay off when consumers are
given more choice over their own pharmaceutical pur-chases. One ongoing reform—the rapid expansion of retailpharmacies in China’s larger cities—presents both anopportunity and a challenge to the industry. Officially, adoctor is allowed to write a prescription for a medicinethat is not on the reimbursement list. A patient can takethis prescription to a retail pharmacy where he or she paysfor it out of pocket. In practice, the need for a prescriptionis rarely enforced, with the result that prescription drugsof all kinds are as easy to purchase as OTC cough medi-cines. Moreover, consumers will sometimes self-treatrather than go to the doctor, opening up the potential formisuse. The concern about misuse is perhaps greatest inthe case of medicines for diseases (such as cancer) thatare simply too expensive for government reimbursementlists. The trade-off between price and benefits for mostchemotherapeutic agents is not favourable—the Chinesegovernment, for instance, cannot afford to pay hundredsif not thousands of dollars to prolong a patient’s life bytwo or three months. A small but growing portion of thepopulation is, however, willing and able to pay for suchtreatments. The conundrum for a drugmaker is whether tosupply the treatment at the retail pharmacy level, wellaware of the risks involved, or avoid it altogether until thegovernment is better able to police the system andenforce regulations. In the medium term, the develop-ment of the private retail pharmacy network opens up newpotential for foreign firms but current concerns aboutcontrol are slowing the process.
Big hopes for a still small sectorEven though the cash-strapped, public hospital-basedsystem will continue to dominate the pharmaceutical mar-
ket in the foreseeable future, foreign drugmakers shouldcontinue to experience solid, but not explosive, growth.Price cuts will contain overall revenue growth despitelikely increases in sales volume over the next few years.But individual firms may experience breakthrough if theycan launch truly innovative patented drugs that clearlymeet an unmet medical need, such as GSK’s Heptodin orNovartis’ Glivec. Multinational pharmaceuticals compa-nies must continue to seek more effective ways to engagedoctors and hospitals, and work with local and centraldrug regulators to get their drugs on provincial andnational drug reimbursement lists. At the same time, theongoing reform of the healthcare system will create moreopportunities to tap demand from private pharmacies,doctors, consumers and patients. The current market issatisfying for some. But there is still real potential to beunlocked by the right strategy.
Top 10 companies Top 10 products Top 10 new productsYangZiJiang Fty Zuo Ke Rui Pu Xin Nt ZhuHai LiZhu Group Da Li Xin Nobex Pfizer Group Kai Shi SeretideNovartis Group Glucobay Ka Bo PingGlaxoSmithKline Lu Nan Xin Kang Nexium AstraZeneca Group Sulbactam/Cefopera Glivec Roche Group Sandostatin Herceptin L.Y.G. Hengrui Rocephin Femara HLJ.Haerbin Pharm. Cefuroxime Simulect GuangZhou Tianxin Heptodin Xin Ke
In the early 1990s, fast-moving consumer goods(FMCG) was one of the first sectors in which multina-tional companies (MNCs) established a large pres-ence in China. Two main factors helped to advance
the progress of foreign consumer-goods firms. First, bythe mid-1990s around 350m people had an annualincome of US$500 or more, helping to create a consumermarket that could afford basic consumer goods such assoap and detergents. Second, the government did notview consumer goods as a strategic sector, unlike steel ortelecommunications which were subject to greaterscrutiny and restriction. As a result, foreign companiessuch as Procter & Gamble, Unilever, Colgate and Gillette
all found market entry relatively easy. Faced with littledomestic competition, most of these companies quicklyfound themselves able to sell their goods and even reportprofits.
Life has not been so simple since then. For a start, therather imbalanced market that opened up in the early1990s, with a mass of foreign companies and little localcompetition, has begun to tilt sharply in the other direc-tion. Chinese companies have spent massively on manu-facturing equipment and are now making everything fromshampoos to batteries. With this sudden tilt toward mar-ket overcapacity in just about every subsector, local pro-ducers have slashed prices and claimed sizeable market
Part 2
Retailing and consumer goodsOvercoming regulations and building brands
● The big international retailers, notably Carrefour and Wal-Mart have established themselves in key cities in China. Theyare likely to expand their chains fast in the next few years, andbe joined by other retailers with global ambitions. The over-crowded domestic retail sector will see huge consolidationover the next few years, especially once restrictions on theoperations of foreign companies are lifted at the end of 2004.
● The leading international fast-moving consumer goods com-panies established a strong presence early in the 1990s, butmaking money has been hard. Procter & Gamble managed itwith a focused strategy starting with shampoo, but Unilever,which early on launched products across a host of personaland household sectors, has only succeeded in approachingbreak-even recently after embarking on a programme of con-solidation and cost-cutting at its ventures.
● Bitter competition from domestic companies emerged in thelate 1990s. Chinese brands have taken large market sharesfrom the international companies at the lower-end of themarket and are moving up into the middle tier.
● China’s consumer markets remain largely focused on the firstand second tier cities of the coast. The country’s economicgrowth will bring in growing numbers of inland and third-tiercities over the next few years, but markets will remain cen-tred on Greater Shanghai, the Pearl River Delta and the Bei-jing-Tianjin axis.
● Brand building is an area where foreign companies havestruggled—but local companies have even more so. With fewconsumer brands yet established strongly, market shares forfast moving consumer goods firms will fluctuate sharply overthe next few years until companies have worked out how bestto build brand equity.
● Human resources, or rather the lack of them, remains a majorchallenge for businesses in both sectors. The problem is find-ing staff able both to overcome pressing and immediateoperational issues but who can also undertake long-termstrategic thinking required to make a company’s productsand services a more permanent fixture of China’s consumeruniverse.
shares from foreign companies. The quality of somelocally produced goods might not match that of interna-tional firms. But with consumers, especially those in thecountryside and lower-tier cities, basing their purchasingdecisions largely on price alone, these domestic busi-nesses have proved a threat to both the early foreignentrants and other Chinese companies.
In retailing, the story is not so dissimilar. Chinaannounced in late 1995 that it would allow the entry offoreign chain stores. The French retailer, Carrefour, wasthe quickest off the mark and established an early lead.But others have arrived or are on their way—includingWal-Mart of the US, Makro from the Netherlands, Metro ofGermany and UK-based Tesco—while Chinese companiesare looking to organise themselves into groups and havethe strong backing of the government.
Both sets of experiences have useful and contrastinglessons for foreign companies in general. Whereas theexperiences of the FMCG companies offer some practicalpointers on operating in a relatively open sector of theChinese economy, retailing has remained restricted, withthe final barriers on entry and operation only due to beremoved at the end of 2004. Nevertheless, companieshave managed to establish themselves—none moreprominently than Carrefour, now China’s fifth-biggestretailing operator. In consumer goods, the struggle hasbeen less to do with getting established than how to oper-ate in a market that is maturing and expanding fast.
The consumer market Foreign companies have long recognised that China hasthree principal areas of wealth: the Pearl River Delta, justacross the border from Hong Kong; Greater Shanghai,encompassing Shanghai proper and the string of citiessurrounding it in northern Zhejiang and southern Jiangsuprovinces; and the Beijing-Tianjin axis. Between them,these three regions embrace around 100m-150m people,depending on how widely the net is thrown. From theearly 1990s onwards, when people talked of China’s con-sumer market they were generally referring to these threelocations, which are thousands of kilometres apart. Notonly was there no national market but even the submar-kets were as far—or further—apart than those betweenmany countries. The transport links between them werepoor at best, as were the people who lived between them.
In the last five years, however, this picture haschanged. Today, it makes more sense to think of China’sconsumer market in terms of these three areas, plus thecountry’s other leading cities, plus a series of tier-twocities. Some of these cities are much richer than others.Dalian, for example, tops the league of the leading citiesand could be compared with parts of the Pearl River Deltaor Greater Shanghai. It is, however, isolated from a
wealthy hinterland. Some of the lesser cities of, say, theGreater Shanghai region, may not be as well off as Dalianbut they have other compensating factors, such as accessto the Shanghai market and better links into China’stransport network.
Another tier of cities, the so-called tier-three cities,will come into the reach of foreign companies over thenext decade. Most of these will be in the vicinity of exist-ing markets, or in fact extensions of them, as road net-works reach further. For example, foreign companies areexpected to branch into cities in eastern and northernGuangdong, southern Hunan and Jiangxi, as well asdeeper into Fujian.
The survey conducted for this report confirmed that themajority of companies tend to think of China as a series ofdistinct markets. Asked how their businesses conceptu-alised the China market for domestic sales, two responsesstood out: first, from companies which see it as a series ofcities belonging to separate tiers (35%); and second, fromthose which see it as a series of distinct regions (31%).
The principal factor determining both these views ofChina’s markets is the disparity in incomes between differ-ent locations, with infrastructure deficiencies and theproblems these create in accessing locations.
The consumer-goods firms that participated in the sur-vey tend to think of the China market as sets of cities. Ofthe 18 companies that responded, 12 said they thought ofthe country in terms of first-, second- and third-tier cities,whereas three each said they thought of it either as anational market or a series of regional markets. Their viewof the country—either as a collection of cities, regions or anational market—was overwhelmingly determined bytheir perception of income disparities: 15 of the 18 com-panies declared this to be the reason underlying theirconception of China’s markets. The only other factor torecord a significant response was infrastructure deficien-cies, cited by five companies, all of which had alsodeclared income disparities to be a factor. In short, andunsurprisingly, consumer-goods companies go to wherepeople have money; some—though not a majority—findinfrastructure a problem in accessing the markets theywant to reach.
Within a decade, China is likely to look less like anassociation of three separate markets and more like anational market, albeit one with major regional distinc-tions and almost certainly with cities arrayed in a seriesof tiers. To a certain extent, this can already be seen inthe rise of provinces between the main centres, such asShandong, whose growing industrial strength and heavyinvestment in infrastructure is making it a major marketin its own right between Beijing-Tianjin and Great Shang-hai. Fujian similarly is becoming more accessible fromboth Guangdong in the south and Shanghai in the north,
moving away from its history as an isolated province. Forthe meantime, however, companies must cope with acountry that is divided into relatively isolated marketsplus the leading, and tier-two cities, although with thecompensation that the pool of consumers within eachmarket is rising fast.
Retailing takes off As a result of the growing market, improved businessenvironment and aggressive strategies, retailingexpanded quickly throughout the 1990s. After the marketwas opened to foreigners in 1992, Malaysia’s Parkson wasone of the first overseas foreign retailers to test thewaters. Its initial strategy—offering premium goods at apremium price—flopped badly. People came and looked,but did not buy. Only after it changed tack to sell everydayitems at regular prices was it able to spread across thecountry. Other retailers have had similar experiences,with most later entrants concentrating on offering low-frills experiences rather than trying to trade on theirnames. As the fast-moving consumer-goods makers havefound, China remains essentially a price-driven market,with little ability to charge a premium for anything out-side the very thin top layer.
The market has undergone an additional series of qual-itative changes over the last five years. Across the coun-try, supermarkets and hypermarkets have been replacingtraditional state-owned department stores. According toAC Neilsen, an international ratings agency, between2001 and 2002 the number of supermarkets and hyper-markets doubled. The number of modern trade outletsincreased by a further 44% in 2003. By contrast, the tradi-tional multi-storey outlets of such formerly well-estab-lished names as the Beijing and Shanghai number onedepartment stores have seen their sales decline. State-
owned retailers have been merging to form supposedlymore powerful groups, while foreign entrants—both thosealready present and others with little or no presence—have been announcing massive expansion programmesinvolving hundreds of millions of dollars of investmentand nationwide networks of stores.
Foreign-funded stores have already had a major impacton the retailing market. A survey conducted by the StateEconomic and Trade Commission (now part of the Ministryof Commerce) in late 2002 found that foreign retailersaccounted for nearly one-quarter of major supermarketsin China. According to another official report, foreign-funded retail groups now occupy five of the positionsamong China’s top 30 retailers. Two of these stand out:Carrefour and Wal-Mart. Carrefour has been by far themost aggressive entrant: by early 2004 it had more than40 stores open across China, with plans to keep this num-ber growing by 10-12 annually. Wal-Mart began by con-centrating on establishing itself in south China’s richestprovince, Guangdong, only venturing further afield afteropening a string of stores there. It has now opened some35 stores, including one in Beijing and several across thenorth-east. Domestic retailers, by contrast, have manytimes more stores, and have been trying to increase theirclout by consolidating into big groups. Bailian Group,formed though a merger of six retailers in 2003 (includingthe country’s largest supermarket chain, Lianhua Super-market) operates more than 5,000 stores.
Competing in a crowded marketAs with many industries in China, oversupply is raisingitself as a potential problem. ACNeilsen found that whilethe number of modern stores increased by almost half,total sales made rose by a more moderate 18%. It alsofound that this tendency was worse in the major cities.
Such rapid and broad expansion has created a very frag-mented market: even China’s biggest supermarket chain,Lianhua, now has only around 5% of the food market.
In the short term, this phenomenon is certain to con-tinue. Bailian, for example, aims to add more than 1,000stores in 2004, dwarfing even the most ambitious plans ofall the foreign companies. In addition, the government isplanning to lift various restrictions on the activities of for-eign retailers, encouraging a further burst of investmentand expansion by overseas companies.
But clearly such growth cannot continue indefinitely.Much of the rapid expansion by domestic companies is anattempt to grab market share before companies are forcedto merge; as with many other sectors, the imperative is sur-vival rather than commercial logic. Given the government’ssupport for local firms, and its desire to develop a smallnumber of Chinese retailing giants, it is likely to force con-solidation of the retail market at some point—unless theovercrowded market kickstarts the process on its own.
Domestic companies are going to find the competitioneven tougher after this year. In December 2004 the gov-ernment will lift geographical restrictions on retailers andend the rule requiring all foreign retailing companies tohave a local partner. Foreign retailers will find themselvesoperating in a more open environment but one thatremains crowded and tough.
Carrefour’s testing of China’s regulations—bothexploring grey areas and sometimes explicitly ignoringrules—has put it into a strong position ahead of these reg-ulatory changes. Its risk-taking does not seem to haveendangered its activities. The key to its success, however,would seem to be less its early mover advantage than theexperience it has built in negotiating China’s distributionand supplier chains.
Wal-Mart, by contrast, looks to be building off theexperience it has gained in sourcing from China. The vol-ume of goods it buys from the country for sale in the US—US$12bn-15bn annually in recent years—makes it China’ssingle biggest customer. Clearly, this has given it a lot ofknow-how in buying goods cheaply in the world’s majorcheap manufacturing centre. (Carrefour is also a signifi-cant buyer of Chinese goods; it sources around US$1.5bn-2bn worth from China each year.)
Given Carrefour and Wal-Mart’s strong foundations,perhaps the biggest issue for the next round of entrants iswhether they will find themselves paying too much toenter. In early 2004 Tesco was reported to be consideringspending US$200m on acquiring a 50% stake in 25 storesrun by Taiwan’s Ting Hsin International Group.
Consumer goods—battle commencesRetailing is still very much in its formative stage, with thefull form of the market only likely to become visible after
the final moves allowing foreign companies full freedomto operate become effective at the end of 2004. In con-trast, the fast-moving consumer-goods industry has beenopen since the end of the 1980s when a string of leadingglobal companies entered the market—Procter & Gamble,Unilever, Gillette, Colgate-Palmolive, SC Johnson,Henkel, Revlon, Shiseido, Kao, Maybelline, Estee Lauderand a host of others.
Given the lack of restricting regulations and local com-petition, FMCG was a relatively straightforward market toenter, if not a normal one. Most of the early entrants arestill present in one form or another. Gillette still makesrazors, even if its early estimates of the size of the shavingmarket proved seriously overblown, and the shelves ofsupermarkets and chemists are lined with international-brand haircare products, makeup, toothpaste and sanitarytowels. As might have been suspected, FMCG makers, withexperience of other developing markets—includingtougher ones, such as India—fared well in their first fewyears, with competition mainly between themselves.
Of the first wave of entrants, Procter & Gamble of theUS stands out as having both the most focused strategyand the biggest success. It began by concentrating onestablishing its shampoos, backed up with heavy spend-ing on advertising, and only broadened its portfolio ofgoods once it had firmly established itself.
In contrast, its biggest rival of those years, the Anglo-Dutch concern, Unilever, launched several different prod-uct types in rapid succession, including soap, toothpaste,detergent and ice cream. But doing so meant it had tospread its energies too broadly and thinly. The outcomewas that where Procter & Gamble was able to take lessonslearned in launching its shampoos and apply them to othergoods as it brought them into the market, Unilever failedto get a satisfactory handle on its portfolio of business.
More recently, however, Unilever has both unified andstrengthened its marketing as part of a global strategychange aimed at moving away from its previous largelydecentralised model to one with greater control fromheadquarters, particularly in brand management. Procter& Gamble has found the going harder: its original brandpositionings, particularly for shampoo, have become lessdistinct over time, while a decision to focus on rural saleshas proved hard to implement.
Across the sector, other new foreign entrants mishan-dled a number of issues. One is overpricing. Typically,international companies have launched their products inChina at price points that are way too high. Believing,often correctly, that their goods will be of higher quality—and perceived to be of higher quality—the assumption hasfollowed that premium prices can be justified. There isexample after example of this—from glue, where Ger-many’s Henkel decided to launch its Pritt at Rmb6 com-
pared with local products priced at around Rmb2, toshampoo, where Procter & Gamble priced Pantene at 60-70% above its local peers, to stock flavouring, where Nes-tle’s Maggi has been sold at three times the localequivalent.
Foreign companies have also, in many instances, failedto appreciate China’s differences. While much businesssuccess in China can be attributed to getting the universalbasics right, too little attention is paid to differences thatdo exist between China and other places. As a conse-
quence, goods and the ways of selling them are too infre-quently tailored to local tastes. Companies tend to imposea Western model of consumer dynamics across categoryafter category, failing to play to Chinese concerns andcontinuing to sell on the basis of what works elsewhere,even though hardly any products can be sold on globalmarketing. Examples abound: advertising campaignsbased on an appeal to individual freedom compared withChina’s traditional emphasis on group values; advertisingfor nutritional foods that emphasise physical strength and
Carrefour, the world’s second-largestretailer, made little secret of its bending ofChina’s retail rules during its first five yearsin China. Willingly aided by local govern-ments, the French company opened storesacross the country in which it retained wayover the 65% ownership share permitted bythe government, taking full advantage of itsability to offer a modern shopping environ-ment, plus jobs, rent and taxes.
When the central government called thecompany to account in 2001, the consensuswas that it would be fined, asked to mend itsways and allowed to continue. Given thatretailing was certain to be opened to greaterforeign participation under the terms ofChina’s WTO accession, the company waswidely regarded as doing nothing moreserious than anticipating changes thatwould occur in any case.
In the event, the sentence was a bitstiffer: Carrefour was prevented fromopening new stores for more than twoyears. The company’s expansionprogramme is finally back on track, and in2004 plans to open at least a dozen newstores.
Did Carrefour’s flaunting of China’s retailregulations hurt it in any way? Certainly,during its enforced pause, its rankingslipped. At the end of 2000, after just fiveyears in operation, it was China’s second-biggest supermarket chain by turnover.Now, although it remains the biggest foreignretailer, it has dropped to fifth place. But itmanaged to keep its revenue growing, withsales rising from Rmb8.1bn in 2000 toRmb13.4bn 2003, according to reports from
China’s Ministry of Commerce. Moreover,Carrefour’s China operations were reportedlyprofitable before its restructuring, so it hasnot bled cash over the last couple of years. Italso did not wait for all its previous venturesto be untangled before talking with newpartners—since 2002 there have been aseries of reports of agreements to start newventures across the country. Many of theseare now being realised but others went intooperation with no great fanfare, hence thejump in store numbers from 28 when its banon expansion was announced to more than40 now.
As the company is now expanding again,it is possible to argue that the pause mayhave helped its performance. Given itscontinuing growth in turnover—up by 26%last year—being forced to take a breather onits expansion schedule allowed it toconcentrate on developing business withinits existing network.
The lesson from Carrefour, however, isnot necessarily that you can skirt rules andget away with it. Rather, it is that a companymust have a good idea of what it wants toachieve and must then determine whether it
will do what it takes to get there. Carrefour was determined to develop a
nationwide network ever since it arrived inChina. Its strategy of finding a differentpartner in each location (rather than tryingto find just one to work with across thecountry) could have backfired by giving thecompany too many different partners tohandle. Instead, it has turned its localsupport in each location to its advantage.Clearly, these partners have preferredsupporting Carrefour and its presence intheir locality rather than supporting Beijingofficials keen to clamp down on the Frenchcompany’s business. A locally based partnercan also help obtain access to good sitesand can aid stores in developing a localflavour—while the company, in theory, hasa central ordering system based inShanghai, most purchasing decisions aredecided locally. In addition, Carrefour doesnot run its own distribution network, relyinginstead on suppliers to deliver their goodsto its stores, which further enhances thelevel of local support.
No other company was able to takeadvantage of the lull in Carrefour’s growth.Wal-Mart has expanded but not at such arate that it is likely to squeeze Carrefour, atleast for a few years. New entrants haveeither only just entered the market (as is thecase with Germany’s Metro) or have yet toarrive (as with the UK’s Tesco). Assumingthat it has learned from the operationalexperience accumulated in the last fewyears, Carrefour would seem to be wellpositioned to continue expanding andremain profitable.
Carrefour’s experience: does rule-breaking work?
Already a big playerChina’s top five retailers, 2003
robustness instead of protection of the body’s ability todefend against disease; and so on.
Considering how basic some of these problems are,why are they not attended to? Three reasons stand out:● China is still a difficult place to do many things. Infra-
structure may have improved enormously over the lastdecade but distribution remains a big problem for allcompanies—even, or maybe especially, for thosewhich do it themselves. Petty corruption—endlessdemands from officials for fees and other charges—eats away at the attention of managers. The result isthat there remains a tendency for operations to crowdout much else, including long-term thinking on mar-keting and brand-building.
● Finding enough good people of any kind is hard (onemanager interviewed for this report said one-fifth ofhis time was spent interviewing potential job candi-dates), doubly so for marketing staff, while findingones with experience is almost impossible.
● Advertising costs are high largely because the media,especially television, remain very undifferentiated—reaching a mass audience is easy but expensive; tar-geting smaller, specific groups of people is still largelynot possible.
The rise of competitionAs with almost every sector in China, what is complicatingboth Procter & Gamble and Unilever’s strategies, andthose of their other foreign rivals, is the rise of local com-petition. In the space of just several years, local companieshave claimed a sizeable market share back from foreignproducts for many types of consumer good.
If foreign companies were able to establish themselvesin part because pre-reform China had no consumer-goodsindustries, local companies have moved very fast into theareas ignored by the international companies during theirentrance programmes. In particular, taking advantage oftheir lower costs, they have focused on the bottom seg-ments of China’s consumer markets—the second- andthird-tier cities and the countryside—initially leaving theupper segments to foreign companies. Chinese companieshave also closed the quality gap for almost every kind ofgood. They may not be able to manage exactly the samequality levels as foreign companies (though increasingly,especially in the last two years, they can), but they canoffer an excellent value proposition, especially to low-income consumers.
Chinese companies, with a few exceptions, have yet tomove into brand development, however. Two reasons forthis stand out. First, Chinese companies compete almostsolely on price; their products are copies or clones, withfew or no innovative or distinguishing features. Second,while the concept of branding has taken hold, there
remains little awareness of brand equity or how to buildan enduring series of associations with a good. Accordingto Tom Doctoroff, the Greater China CEO of J WalterThompson, this explains why Chinese television features alot of five-second advertisements. With the high cost ofadvertising also a feature, the consequence, he pointsout, is that Chinese companies are good at on-the-groundpromotions and guerrilla marketing.
Further reinforcing this outlook is the corporate out-look of most domestic companies, which are almost with-out exception sales- rather than marketing-driven. Thisoutlook is a product of their business environment—theymay be ambitious but not only is China’s experiment withmarket forces new, it is also one that is certain to see amajor shake-out in the next several years because of itsover-reliance on credit and short-term financing. Whenthe FMCG sector does finally consolidate and the huge sur-plus of productive capacity is destroyed, domestic compa-nies will be more inclined to focus on brand-building andother long-term strategies. For now, the emphasis has tobe on immediate realisation of cash.
Building a strategyFor foreign companies, the conflicting pressures on Chi-nese companies can only be good news. However, the riseof local firms will also add confusion to an increasinglycomplex market. Against this background, how shouldforeign companies think about the market? For makers ofconsumer and many other types of goods, perhaps themost important challenge of the next few years will behow to handle a series of markedly different tiers in a mar-ket that is rapidly broadening and deepening, whileweathering the short-term competition from local compa-nies at all levels. The following issues will have to beborne in mind:● Brand architecture. For a foreign company, this typi-
cally means coming in at the top with a premium nameand then moving down into the middle segments withlower priced variants. As companies do this, however,they must constantly bear in mind that China is a not aone-strategy-fits-all country: strategies have to bevery different, especially in the lower-tier cities andrural markets, where price remains the determiningfactor for almost all purchases.
● Local appeal. What are the concerns of Chinese con-sumers and how can they be addressed? Health is amajor worry for many people—allowing one successfullocal company, Skyworth, to devise a series of adver-tisements based around the features which made itstelevisions safe for their users.
● Trend arbitrage. As incomes increase, markets can beridden both upwards to appeal to new tastes anddemands (fashion) and downwards to new groups
with no previous experience of buying anything butthe necessities of life. It is unlikely that the same mes-sage can be used to sell a product to all market seg-ments, let alone across a country as broad and diverseas China.
● Constant change. China’s markets are both so rawand, thanks to its rate of economic growth, changingso fast, that brand-building strategies have to be con-stantly reviewed and renewed. Procter & Gamble’sshampoo market segmentation worked excellentlywhen it started but now appears out of date as prices
of all shampoos have been squeezed close together bycompetition.
● Central versus local balance. Companies may betempted to hand over control to its managers on theground, hoping to trust in their experience and know-how. It is important, however, to maintain a balancebetween using local operational expertise and cen-trally supported brand-building. Coca-Cola estab-lished itself well by using bottlers with localknowledge while keeping control of marketing;Unilever relied too much on local fiefdoms for each of
The Anglo-Dutch consumer-goods and foodmaker, Unilever, arrived in China in the late1980s, at around the same time as the UScompany, Procter & Gamble. But Unileverhas found the going much harder than itsrival. Why? Two main tenets of its Chinastrategy—its initial attempts to offer abroad portfolio of products and a decen-tralised approach to selling its family ofgoods—are likely to blame.
Unilever’s plans were ambitious. Withinten years, it had 12 joint ventures inoperation. But its strategy of attempting abroad attack on China’s markets mightexplain why it struggled—and offer lessonsfor other, ambitious foreign companies.Among its main headaches were:● Too many partners. For each of its
diverse range of products—toothpaste,detergent, ice cream, sanitary napkinsand so on—Unilever teamed up with alocal company. From the start, therefore,Unilever found itself negotiating simul-taneously with a stream of partners.Moreover, many partners were not ableto deliver what they promised. From theoutside, it might look sensible to teamup with a Chinese company in order togain access to its distribution network,but in practice many of these networkseither barely existed or were highly inef-ficient products of central planning withno information or interest in the cus-tomers they served.
● Lack of focus. Because of its broad rangeof products, Unilever was compelled forthe most part to let each venture get on
with its own promotion and marketing,unable to draw on synergies or eventransfer experiences from one product toanother. This, in turn, made teamwork aproblem; selling ice cream obviouslycalls for different marketing and strategythan selling sanitary napkins, lesseningthe need or motive for working together.
● Staff turnover. Staff retention proved aproblem for Unilever. While managinghuman resources is a persistent prob-lem for many companies in China,Unilever’s record stands in contrast tothat of Procter & Gamble, which built upa reputation for being tough but loyal toits staff.
Procter & Gamble, by contrast, began with amore focused approach, launching anddeveloping only its shampoos. Only after ithad successfully established its shampoos inthe market did it then move on to otherproduct lines. It spent heavily on advertis-ing but was able to focus its spend on asmall range of products, enabling it toestablish separate identities for each mem-ber of its shampoo range. This, in turn,allowed it both to claim market share on theback of a clearly differentiated range ofshampoos: Vidal Sassoon for fashion, Head& Shoulders to cure dandruff, and so on.
Procter & Gamble worked hard to get itsgoods into every available retail outlet:taking maps of cities, marking the locationof stores—small and large—then sendingpeople to every one of them.
Internally, it worked to develop teamspirit. This task was made easier by the
creation of narrow and defined goals as wellas the fact that it did not have a host ofjoint-venture partners to manage andintegrate. (Procter & Gamble started withjust one.)
This is not to say that things always wentProcter & Gamble’s way. Having reached outto stores across cities to get its goods ontoshelves, it had big problems with accountsreceivable in its early days. It also took afinancial hit as a result of having grantedeasy credit terms to a lot of customers. Inthe last three to four years, it has also facedcompetition from low-priced localalternatives.
At the same time Unilever has madeseveral, big changes that have improved itsperformance. Unilever’s cost-cuttingmeasures have allowed it to become morecompetitive and also more unified. Movingits household and personal-care productionlines to Hefei in Anhui, one of China’spoorer provinces, not only saves moneyowing to its cheaper location but alsobecause it can use fewer people. Thischange, in turn, has helped the companyaddress some of its other weaknesses listedabove: fewer people means a stronger, morefocused team, which in turn allows astronger concentration on issues such asbrand architecture. On the back of all thesechanges (lower costs and a more coherentstrategic outlook), Unilever has been ableto take the struggle with Chinese companiesto their ground: a 30% cut in the price of itsOmo detergent helped double sales volume,the company says.
its product categories instead of concentrating onstrengthening its brands.
● Market data. Little market information exists in China,so a company that can collect its own data will own avaluable knowledge base of everything from wherethe stores are it wants to reach to understanding cus-tomer taste and needs.
One strategy does not fit allTaken together, these points underline the fact that,although the China market is still relatively new, it cer-tainly is not simple. This idea has been taken on board interms of operations. But the difficulties still appear to beunderestimated in the more abstract and less immediatelypressing area of marketing and brand development. Somecompanies, such as Unilever, have tried to do too manythings too fast. Other companies simply have tried to workwith a partner that fails to see the importance of long-terminvestment in brand equity. Among carmakers, for exam-ple, Daihatsu and Volkswagen achieved early recognitionwith their Santana and Xiali cars. But their associationwith low-end models could prove of little assistance whenwarding off competition from even cheaper local cars whilelessening their appeal against brands launched later withhigher-segment marques, most notably GM and itsentrance with the Buick.
As the example of the supermarkets show, it is unlikelythat any one strategy will prove the inevitable winner.Carrefour and Wal-Mart have entered China in distinctlydifferent ways: the former going nation-wide early andflaunting regulations, the latter starting in one regionand playing within the rules. The advantage of Carrefour’sapproach is the wealth of experience it has acquired overthe last nine years, experience operating in differentcities and negotiating the country’s bureaucracy. Wal-Mart, by contrast, looks to be bringing its US strengths toChina, and applying them incrementally, knowing that itsbuying power gives it substantial leverage.
Over the next decade, retailing and fast-moving con-sumer goods will come together. As the foreign retailchains take off and the local ones consolidate, distribu-tion will become much simpler. Within regions, consump-tion patterns are likely to become more homogenous—thePearl River Delta and Guangdong converging with HongKong, the lower Yangtze area sharing tastes and styleswith Shanghai, and Beijing’s influence spreading acrossnorthern China. Knowledge of consumer tastes willbecome more important, especially the degree of varia-tion across income bands and regions. It is possible thatthe development of communications, particularly massmedia, will see different becoming more alike. But varyingrates of change in different parts of the country willensure this will not happen consistently. As a result, it will
be difficult to retain strategic insights for long.The next several years will see market shares rise and
fall, particularly for Chinese companies. On the one hand,doing things “right” in these circumstances should help acompany maintain or increase its market share, but thiscannot be guaranteed. On the other, managing to imple-ment standard marketing practices should give a companythe best chance of succeeding:● Remember that China is a brand-building market—so
play by the rules of brand-building. Do not be temptedto go down guerrilla routes—these may bring fastresults but they probably will not prove sustainable.
● Develop a corporate structure focused on brand-build-ing and long-term marketing, not short-term sales.
● Work on developing consumer insights: what do Chi-nese consumers want? How are these different fromother markets? How can you capitalise on them?
● Accept that China’s media is undeveloped and expen-sive for now, but will become more refined and differ-entiated; build brand strategies around this reality.
As with much in business, most of these observations arelittle more than common sense. But the trick is in theapplication. There have been enough corporate successstories to produce a fair number of useful models. Car-refour and Procter & Gamble in their different ways haveproved that China is not an impossible place to buildprofitable businesses. Wal-Mart, in some regards, isgoing in the same direction as Procter & Gamble, estab-lishing itself in one region before going nationwide. Car-refour has used other means: building alliances in manylocations but preferring to pass the problem of distribu-tion to the companies that want to sell through its out-lets by requiring that they deliver their goods to itsstores. And Unilever looks to have learned from its earlyerrors, emerging as a more focused company, able toboth lower its costs and develop a more coherent market-ing and brand-building strategy.
Of course, there are many other stories in China, butthese experiences point to the importance of getting afew key things right rather than trying to do everythingat once. With some successes in place, others can bedeveloped.
Overcoming regulation and building brandsIn many ways the retailers, despite entering the marketlater and in a more restricted way—or possibly because ofthis—appear to have developed and applied long-termstrategies in a more rigorous way than the FMCG compa-nies. Both Wal-Mart and Carrefour have had to tread war-ily in applying their strategies because of centralgovernment concerns over foreign domination of retail-ing. They both, however, have found ways of establishingbases from which they are now expanding—particularly
The fashion houses and luxury-goodscompanies that set competing trendsin design are beating a very similarpath in their corporate strategies byannouncing retail expansions inChina. This year the heads of a numberof such companies have come to Chinaand Hong Kong for the openings offlagship stores and announcements ofambitious expansion plans to targetthe growing market. The French lux-ury-goods company, Richemont,which counts Cartier, Montblanc andDunhill in its portfolio of 18 luxurybrands, calls China its “priority mar-ket” this year. The company’s turnoverin China increased by 24% year onyear in 2003, according to FrancisGouten, the regional CEO ofRichemont Asia Pacific.
The Italian men’s clothingcompany, Ermenegildo Zegna,entered the China market 13 years agoand has grown to be one of the largestluxury-goods outlet chains in China.By the end of 2004 the company willhave 60 point-of-sales sites in 24cities there. Zegna is currentlyprofitable in China and has beenprofitable since its first outlet openedin China in 1991, according to ItsuroHiguchi, the company’s Asia Pacificmanaging director. According to MrHiguchi, Zegna’s turnover in mainlandChina increased by 25% year on yearin 2003, while Greater China—including Hong Kong and Taiwan—accounts for 11% of the company’sglobal turnover. Mainland customersrepresent 35% of the company’s salesat its seven stores in Hong Kong,according to Mr Higuchi. Themainland is Zegna’s fourth-largestmarket, while Greater China rankssecond behind the US, but that gap isstill quite large, Mr Higuchi says.
Zegna entered the China market,like many foreign luxury brands, inthe shopping arcade of The PalaceHotel in Beijing. Now renamed ThePeninsula Palace Beijing, the hotel’s
arcade hosts 50 top-tier brands.Zegna first gauged the market for itsgoods and plotted its expansionstrategy by tracking the developmentof similar five-star hotels in Chinesecities and opening its early outletsinside them. The company’s profile inChina has evolved alongside widerdevelopments in the country’s retailsector—when high-end shoppingmalls developed, Zegna openedoutlets there. “We have to find asuitable location to support thebrand," Mr Higuchi says. The companyis now moving to larger-scale outlets,starting with the opening of twomajor outlets in China later this year,a flagship store in Beijing in June anda 500-sq metre store with a 1,700-sqmetre showroom—its largest in Asia—along the riverfront Bund in Shanghaiin September.
Although Zegna plans to continueto expand to new cities, the companywill focus on consolidation of itsproduct lines in larger stores. In termsof number of outlets, Zegna has“quite enough”, Mr Higuchi says. Aspart of the consolidation, thecompany now plans to integrate itsZegna Sport line into its largeroutlets. In its smaller outlets, 60% ofthe merchandise on display wasselected according to guidelines fromheadquarters, while the remaining40% was chosen according to “localtaste”, Mr Higuchi says. The largeroutlets will allow the company tofeature more products through its“wardrobe concept” of offeringclothing for every possible occasion.“It’s image,” Mr Higuchi says. “Wehave a lot of small-scale shops. Weneed something to show the wholerange of Zegna.”
Although Shanghai and Beijing aremajor markets for Zegna, thecompany’s outlets in China are as far-flung as Changchun, Urumqi andKunming. Zegna has three saleslocations in Chengdu, a city which Mr
Higuchi calls the “shopping centre”for Sichuan province—drawingcustomers from outside the city itself.Outlets in other provincial capitalshave likewise been supported bycustomers residing outside the citiesthemselves. Although the companydirectly owns most of its outlets inChina, Zegna has franchised 13 of itsoutlets, in cities where it was lessfamiliar with the local market, thecompany says.
Aside from its retailing operations,Zegna is also involved in production inChina. In March 2003 the companybought a 50% stake in SharMoon, aWenzhou-based company thatproduces men’s suits and jackets. Theinvestment is one of Zegna’s seveninvestments in production unitsoutside Italy. According to MrHiguchi, Zegna bought into SharMoon“to try to support SharMoon productsfor the China market”. SharMoon doesnot currently produce any clothing orcomponents for Zegna-brandclothing, but Mr Higuchi did notforeclose on that possibility for thefuture. Zegna does procure rawmaterials in China for its global line,as a large buyer of cashmere in InnerMongolia.
The growing presence of foreignluxury brands in China brings morecompetition for Zegna but thecompany still aims for 20-25% growthevery year in the market. Like itscompetitors, the company is usingstore openings to raise its publicexposure. The company spends 6% ofits turnover in China on advertising,according to Mr Higuchi—a slightlyhigher proportion than in othermarkets. More than branding,however, Mr Higuchi says thecompany is focusing on fundamentalslike quality control, customer service,human resources and training—tomanage outlets in China to the sameinternational standards as itsproducts.
Ermenegildo Zegna tailors its retailing operations
vigorously in Carrefour’s case.By contrast, the FMCG companies, including the most
successful, Procter & Gamble, concentrated more on solv-ing operational problems such as how to get their goodsto market, postponing the handling of various longer-term issues, such as a greater emphasis on brand-build-ing, or being able to defend themselves against nascentcompetition. Perhaps their early entry, the relativelyunregulated nature of the sector and lack of early compe-
tition are to blame for this approach. As a result, many of the FMCG companies are looking a
little vulnerable as Chinese companies confront themhead on. However, as the market grows more developed,and domestic firms also find themselves squeezed, itwould seem unwise to bet against the international firms.Expect them to call on their corporate expertise outside ofChina to turn their early footholds into long-term posi-tions of strength.
China today is a telecoms superpower. Never beforehas a country added so many telephone sub-scribers in so short a time, or raised its teledensityso rapidly. Contemplating China at the start of the
1990s one would have confronted a country bereft of com-munications: its fixed-line telephone network was pitiful;there was no mobile network; fax machines in theory hadto be licensed, and of course there was no Internet or e-mail.
Today, things could not be more different. By the endof 2003, there were 230m fixed-line telephones and wellover 50m Internet users. By the end of the first quarter of2004 there were about 290m mobile subscribers, and with
nearly 7m additions a month in this period this is onemarket where the otherwise fantastical promise of 1.3bnconsumers is actually making good. Together, mobile andfixed-line subscriptions have grown from one subscriptionper ten people to less than one in three in the past fiveyears alone. From being a nation with virtually no connec-tivity at all, China is today the world’s largest market forboth fixed-line and mobile telephony: a surprisingly largeproportion of the population can now talk on the tele-phone, send text messages, even wile away time in Inter-net chat rooms.
If China’s government has any concerns about peoplebeing able to communicate with each other easily and
Part 2
TelecommunicationsA strategic and crowded market
● China is a prodigious market for foreign telecommunicationsequipment manufacturers, and lucrative too. The country’smain service operators continue to invest billions annually intelecoms-infrastructure equipment, a healthy proportion ofwhich is used to purchase products made by foreign-investedcompanies.
● The price of market access for foreign equipment makers hasalways been explicit: to demonstrate an extensive commit-ment to local manufacturing and to technology transfer.
● Through joint ventures and other similar arrangements withforeign companies, and by offering financing (for mobilenetworks, in particular), China has been able to roll out itstelecoms networks at an unprecedented speed.
● The access-for-technology contract has been instrumental inthe creation of a viable and highly competitive domesticequipment industry. Local companies not only now competeeffectively with multinational companies in the China mar-ket, but ever more so internationally.
● China operations are increasingly treated as distinct fromother regional markets. This reflects not only China’s impor-tance as a domestic market to foreign manufacturers but alsothe fact that it is even more embedded in their global produc-tion and supply networks. Few other markets contribute asmuch in terms of revenue, the global supply of componentsor research and development.
● As domestic competition intensifies, and price pressures rise,and as Chinese players move out into the world, foreignequipment makers must focus on remaining cost-competitiveand further integrating their China production and researchand development facilities into global supply chains.
● The very factors that have created success for foreign equip-ment manufacturers—strong state-directed policy and con-trol—have proved equally formidable barriers to foreignservice providers. Despite incremental market liberalisa-tion, China’s telecoms service market remains tightly con-trolled by a small number of large state-controlledoperating companies.
cheaply it certainly has not shown them. It may stampdown on dissident websites, prevent access to websites offoreign news organisations and discourage online discus-sion of topics it deems taboo, but it has shown no indica-tion of wanting to restrict the means by which peoplecontact and communicate with others. Considering themicro-control the Chinese Communist Party (CCP) exer-cised over daily life until the end of the 1970s, this too isastonishing.
How has this transformation been possible? China hasdriven telecoms-infrastructure investment through state-owned monopoly carriers, at the same time throwing openthe doors to foreign direct investment (FDI) in equipmentmanufacturing. Central planners, charged with kick-start-ing what was regarded (in both security and developmentterms) as a strategic sector, understood well what Chinalacked—technology and capital. Foreign companies couldprovide much of the former and a lot of the latter.
The deal on offer was explicit: market access in returnfor technology. China was able to roll out its telecoms net-works at an extraordinary high speed with the help ofjoint ventures, notably Alcatel’s in Shanghai for fixed-lineswitching supplemented by, among others, Siemens’ inBeijing and similarly, first Motorola and Ericsson for ana-logue mobile networks, joined later by Nokia for digitalones. The government also aided the process by offeringfinancing, particularly for mobile networks. By equalmeasure, the telecoms services market has largely beenoff-limits to FDI, although as a result of World TradeOrganisation (WTO) commitments, this will graduallychange (see box, “Service, please”).
China has done remarkably well out of this but so toohave foreign companies—all earning billions of dollars inrevenue annually. For US-based Motorola, Finland’s Nokia
and Ericsson of Sweden, China accounts for between 10%and 20% of their global revenue; it is currently Nokia’sfourth-largest market. Between them, these companieshave invested several billion dollars. Motorola’s total, atUS$3.4bn, is the biggest of any foreign investor; Nokia, atUS$2.4bn, is not far behind.
Their success, and that of other major equipment mak-ers, including Alcatel (France), Siemens (Germany) andthe US-based Cisco Systems, has stemmed from the phe-nomenal sum China has spent on developing its telecomssystem. According to a telecoms research company, Pyra-mid Research, in the five years between 1999 and 2003,China spent US$70bn on its telecoms infrastructure.
Not to have profited from this would have been anextraordinary dereliction. Yet it is difficult to assess justhow profitable foreign companies have become; mostrefrain from divulging net earnings figures or margins forChina, instead leaving sensitive statistics buried inregional or global totals. Mobile-handset manufacturersclaim to be making money but proffer—at best—onlyglimpses at the numbers: Nokia, for example, claims tohave a higher profit margin in China than in westernEurope, but does not disclose either. The profitabilityissue is complicated also by the increasingly global natureof telecoms investments in China: where and how profitsare taken in the supply chain will depend on individualcompany preferences.
Building a China marketIn some ways, the experiences of foreign equipment man-ufacturers in China have been atypical. All have benefitedfrom being in a sector ascribed high priority by the gov-ernment and benefiting from high levels of state invest-ment in foreign equipment and technology. (Indeed, in
virtually no other country is the state so intimatelyinvolved in telecoms, owning all the major companies,choosing technologies and determining equipment pur-chasing decisions, among other tasks.)
Interestingly, there has been no single model of suc-cess. A notable feature of the big five—Motorola, Nokia,Ericsson, Siemens and Alcatel—is the different strategiesemployed to enter and build their positions in China.
Two of them, Siemens and Alcatel, sought to becomeclosely involved with the government very early on. Thereare various possible reasons for this strategy. Siemensand Alcatel are both familiar operating in “statist” envi-ronments because of their respective national back-grounds; Ericsson, Nokia and Motorola, by contrast, aremore “free market” in both origin and outlook. Familiarityin dealing with government officials may have helpedSiemens and Alcatel in the early days, as did the fact thatthey were (and are) less beholden to stockmarketinvestors than Ericsson, Nokia and Motorola, and morefamiliar with joint-venture (JV) arrangements in general.
Both Siemens and Alcatel accepted minority stakes instate-owned entities as an entry into the market. In thosedays, the government was wary of allowing foreign com-panies to have majority stakes in JVs in industries deemedstrategic. Siemens and Alcatel adopted a strategy aimedat establishing themselves by demonstrating a commit-ment to technology transfer and localisation of manufac-turing operations, even if this meant accepting lesscontrol than they might have wanted.
For Alcatel, the strategy worked particularly well in itsfirst few years: its principal joint venture, Shanghai Bell,established with an arm of the then Ministry of Posts andTelecommunications, quickly became the country’s lead-ing supplier of fixed-line switching equipment—the core
of any telecoms network. Siemens’ principal telecomsventure, Beijing International Switching Systems (BISC),in which it initially took a 40% stake, also thrived in itsearly years, as China’s massive roll out of its fixed-linenetwork through the mid-1990s created enormousdemand for switching equipment.
Nokia, Ericsson and Motorola have maintained agreater degree of independence and thrived as well. Nokiaand Ericsson also entered the market through JVs butboth have, in general, been more successful in retaininggreater control over their operations than Siemens andAlcatel. This is partly because they entered the market alittle later but mainly because the high demand for theirmobile-infrastructure equipment could not be met bylocal companies, thus giving them stronger bargainingpositions. For most of the last decade, Ericsson has beenthe most successful seller of mobile infrastructure; Nokia,after establishing itself with mobile infrastructure, hasmoved away from this subsector to concentrate on hand-set production both for sale in China (where it is rankedsecond to Motorola) and for export to other markets.
Motorola, the US chip and handset maker, took a stilldifferent tack. Despite establishing itself early—it set upits first manufacturing facilities in Tianjin in 1992—it haslargely managed to maintain its principal China busi-nesses as wholly owned operations from the start. Politi-cal astuteness was the key. The company forged strongties at a central government level by promising technol-ogy transfer through the building of a US$1bn semicon-ductor facility and at a local level by identifying itselfclosely with the Tianjin Economic-Technological Develop-ment Zone (TEDA ). Riding on the back of Motorola’s pres-ence there, TEDA is widely acknowledged as one of thebest-run zones in China.
The threat of local competitionThe abiding similarity for all foreign equipment makershas been the requirement to transfer technology. Theconsequence of this condition is the ascent of domesticcompetition. The speed with which local competitors haveestablished themselves—in fixed-line telecoms equip-ment, mobile handsets and mobile infrastructure—hassurprised most observers. Local competition is also
acknowledged by every company in the sector as the sin-gle most significant change of the last half decade.
Two companies, Huawei Technologies and ZhongxingTelecom (ZTE), both based in the southern city of Shen-zhen, set themselves up as manufacturers of telecomsequipment in the 1980s but only began making names forthemselves from the mid-1990s onwards, selling into thedomestic market and increasingly, especially in Huawei’s
Without the government’s clear vision andintent, China’s telecoms boom may wellhave been a whimper. The state has played acentral role in telecoms development andundoubtedly will continue to do so—andcertainly the rapid growth of telecoms inChina has taken more than a set of (admit-tedly advantageous) technology transferarrangements with foreign equipment man-ufacturers. Indeed, since the start of China’stelecoms age in the early 1990s, a series ofother key factors have been at play in thisextraordinary growth story:● Strategic mindset. Not unlike the auto-
motive industry, China’s leaders have seencommunications as strategic to the coun-try’s broader industrial and economicdevelopment. Technology transfer hasbeen a primary, driving goal of state pol-icy, the aim of which has been to create astrong domestic manufacturing industry—as well as real R&D capabilities and spin-off IT industries—able to compete withglobal players at home and abroad.
● Eager technocrats. Socialism’s emphasison “hard” knowledge in areas such asengineering and infrastructure had cre-ated a body of technocrats versed in cen-tral planning, and eager and able tobuild telecoms networks, especiallyadvanced ones.
● Telephones for all. There has long been aconcern, also stemming from the coun-try’s socialist heritage, to build universaltelecoms provision. This worthy goal iscomplicated now by the fact that most ofChina’s telecoms operators are listedinternationally and have shareholderconcerns to worry about. Yet the factthat the government continues to injectthe networks of poorer provinces intothese companies indicates that building
networks for all remains a priority;growth and access may still be as impor-tant a motivation as profits and returnon investment.
● China’s face. National prestige undeni-ably has played a role. In the 1990s,telecoms was the flagbearer for advance-ment and sophistication: to prove Chinawas a major power, why not concentrateon giving it the world’s biggest, mostmodern communications network?
● Foreign money. Building this world-beat-ing network has required huge invest-ments in infrastructure. In addition to itsown funding, particularly of mobile net-works, the government has sought at var-ious times, and in various ways, to tapforeign funds to finance infrastructure:early network roll-outs were often fundedby multilateral and bilateral loans; morelately, China has allowed state-ownedtelecoms firms to list minority stakes oninternational markets.
The changes have not only been quantita-tive, however. China may have come late toappreciate the software side of telecoms butin recent years both the regulatory andcompetitive structures of the country’s tele-coms industry have been through severalwaves of change. From being a monopolyoperated by a government ministry, thetelecoms network has been divided betweenvarious corporations. In 1998 the govern-ment broke up the main operator, ChinaTelecom, into separate companies for fixed-line (China Telecom) and mobile (ChinaMobile). It again restructured the rump ofChina Telecom in 2002, hiving off the northand east regions to China Netcom, a tele-coms company established in 1999 (and theonly one yet to be listed internationally).China Mobile was also joined by a rival:
China Unicom.The effect of creating distinct markets for
fixed and mobile telecoms services, and ofintroducing limited and carefullyorchestrated competition, has been totrigger improvements in all aspects oftelecoms supply in recent years. Mostnoticeable have been a proliferation ofadvanced telecoms services in richer areas,including the emergence of China as theworld’s largest market for mobile telecoms,and the improvement in the speed ofInternet connection—and the current rollout of broadband capacity. But lower-income people have also gained access totelecoms services. Importantly, theintroduction of limited competition hasbeen a conscious effort to prepare theservices market for eventual foreignparticipation (see box: “Service, please”).
These changes have been mirrored onthe regulatory side. The ministry whichoverseas the development of the industry(now the Ministry of Information Industry,the MII, previously the Ministry of Posts andTelecommunications) has gone through aseries of transformations—changes thathighlight the government's gradualadoption of market forces as the acceptedmeans for promoting economic growth.From being an old-school, Stalinist-stylecentral planning agency, overseeing everyaspect of China’s post and telephone system(including the manufacture of equipment),the MII has shed all of its operational side,leaving it essentially the role of regulator.At some point it is likely to see itselfstripped of its ministry status, probably toemerge as a body resembling the US’sFederal Communications Commission,although less independent of thegovernment than the US body.
case, internationally. Both companies began by develop-ing and selling fixed-line equipment. They grew fast andtook market share (especially from JVs set up by Alcateland Siemens) by adopting the universal Chinese practiceof pricing lower—aided by strong government support inthe form of financing and a preference for buying Chinese.Alcatel’s Shanghai Bell joint venture, which in the mid-1990s was making more than half of the switches forChina’s fixed-line telephone network, has seen its marketshare drop to less than one-third. Huawei’s revenue,meanwhile has risen quickly, to US$3.8bn in 2003. ZTEposted revenue of US$1.9bn in 2003.
A host of companies has started making mobile phonesas well. In 1998 Chinese-made handsets barely existed; in2003 firms such as Ningbo Bird, TCL, Eastcom and a hostof others were making and selling enough handsets toclaim nearly half the market by volume. Other foreigncompetitors—notably two South Korean firms, Samsungand LG—have entered the fray too. In this environment,and particularly with prices of locally made handsetsfalling (a handset can now be bought for around US$60),maintaining margins has been a special concern. Highinventory levels are also encouraging further price dropsamong domestic players, adding to the pressure on for-eign makers to reduce prices (although evidence of exten-sive price-cutting is, so far, thin).
Foreign equipment makers are perhaps right to be a lit-tle apprehensive about the effect China will have on theiroperations. Yet the risks to them of China developing acompetitive market, or at least the chaotic and difficultbeginnings of such a market, should not be overstated.Learning to live with competitors (even those “dumping”equipment onto the market), and no longer having the
undue advantages of a market with no competitors,should not in principle fill a global company with fear.Certainly, foreign companies may share important disad-vantages in China—they are shareholder (not market-share) driven, for example, and they must contend withthe government’s vision of a strong domestic telecomsindustry. But they also share important advantages. Theyhave far higher spending on technology development,better know-how, better management and productionprocesses, products with greater innovation and function-ality, better after-sales service, brand appeal and the lit-mus test of global markets to sell into as well. Not all ofthese advantages will last; local brands, for one, coupledwith low prices, have increasing resonance. But theycan—and are—being leveraged to bring greater competi-tiveness.
Taking controlThe principal response by the foreign equipment makersto the rise of Chinese companies has been a move toincrease control over their operations, both to be betterpositioned to meet the threat local competitors pose andto try to restrict one of the principal reasons for theiremergence: the leakage or appropriation of technology. ● In 2002 Alcatel announced the amalgamation of vari-
ous of its China JVs into a new entity, Alcatel ShanghaiBell, in which it held 50% plus one share—and overwhich it has management control. The new company,which was set up shortly after the company relocatedits Asia-Pacific headquarters from Australia to Shang-hai in 2000, is also one of Alcatel’s global researchand development (R&D) centres.
● Siemens, in early 2004, similarly bought its way to a
0
1
2
3
4
5Nokia Motorola
2000 2001 2002 2003
The telecoms majors and ChinaNet sales, US$ bn
Source: Economist Intelligence Unit, company reports
majority stake and management control in its maintelecoms-related joint venture, BISC, whose sales offixed-line equipment had been faltering in recentyears because of competition from domestic compa-nies. It also wanted to inject new investment toupgrade its product technology.
● Nokia, similarly, has united various of its joint ven-tures—spread as far apart as Dongguan, just acrossthe border from Hong Kong in Guangdong province,Suzhou, inland from Shanghai and Beijing—into onecompany centred on its operations in its own Xing-wang industrial park, just outside the Chinese capital,where it has surrounded itself with its suppliers.
● Motorola has taken a different route. Although it hasmanaged to maintain its main facilities in Tianjin as awholly owned operation, it has always sought to nur-ture close ties with the government. Notably in thisvein, it set up a partnership with a domestic manufac-turer, Eastcom, in Hangzhou in the early 1990s, towhich it has transferred mobile-handset technology,as well as the undertaking to build a semiconductorfacility in Tianjin. Retaining its independence has hada high cost, although the return has been that it hasby far the highest revenue of all the foreign telecoms-equipment makers in China. Perhaps the company isbest seen therefore as a hybrid—it has all alongretained the greater freedom to manoeuvre that itswholly owned status has allowed it, but to do so it hasalso shown itself willing to help China with its tech-nology goals.
While the reasons for foreign companies wantinggreater control over their various China operations areself-evident, there remains a divergence of views on howbest to put this greater control to work.
Siemens and Alcatel both look to be continuing theirclose collaboration with state-owned entities, seeing theadvantages for sales of being identified with the develop-ment of China’s own telecoms industry as outweighingother issues such as technology leakage. AlthoughSiemens has raised its stake in BISC, it continues to col-laborate with Chinese companies and on the developmentof domestic technology, in February this year founding ajoint venture with Huawei to develop third-generation(3G) equipment using a Chinese-developed standard. Thetwo companies have agreed to contribute US$100m to theventure, in which Siemens will have a 51% stake. AlcatelShanghai Bell, the venture in which the French companybrought together its China operations, is similarly com-mitted to helping China develop indigenous technologicalcapabilities. The venture is one of Alcatel’s global R&Dfacilities; it has access to all of the worldwide technicalknowledge base, including proprietary technologiespatented by the company.
The other companies appear to be using their greatercontrol to keep Chinese competitors at bay. Nokia is work-ing on strengthening its handset distribution network. Itis trying to get closer to provincial rather than national-level distributors in order to increase its penetration inmore second- and third-tier cities, to which the biggerdistributors were paying less attention, preferring insteadto focus on the very biggest markets. Ericsson’s strategy,by contrast, is concentrated almost entirely on sellinginfrastructure equipment. Its approach focuses on main-taining a position in the market by constantly being ableto deliver better technology. Its task is helped by its vir-tual non-involvement in the handset market, which itabandoned in the early 2000s, meaning it can concentrateits efforts on selling mobile infrastructure to a relativelysmall number of buyers—the mobile networks.
Motorola, which already has a strong lower-level distri-bution network, is focusing on driving sales of code divi-sion multiple access (CDMA) phones, in preparation forthe move to the next-generation mobile communications.It sold its underutilised semiconductor plant to China’sleading domestic chipmaker, Shanghai-based Semicon-ductor Manufacturing International, in early 2004. As thebiggest seller of handsets in China, it has the advantageof being the best exposed of all companies. However,executives admit that price pressure is ferocious, forcingthem to focus on reducing the cost of making what is,increasingly, a commodity. This is a difficult transition fora company that has traditionally been a producer of tech-nologies rather than a seller of consumer goods.
So far the foreign handset makers have resisted mov-ing into the manufacture of low-end products or embark-ing on price-cutting to maintain market share, althoughboth Motorola and Nokia have licensed technologies tolocal companies to produce low-cost handsets. The prob-lem they are facing—and which will grow worse over thenext few years—is how to cope with declining margins inmid-range handsets as margin domestic manufacturersmove up the value chain, and so be able to continue toinvest in R&D. That challenge, however, is not unique toChina, explaining the general nervousness surroundingthe outlook for Nokia and Motorola worldwide.
A global strategy, tooThere is another, broader dimension for foreign equip-ment manufacturers to balance in their strategies. Inaddition to the large and lucrative domestic market, theirChina facilities are becoming more embedded in theirglobal production and supply networks. Few other mar-kets contribute as much revenue-wise, or in terms of theglobal supply of components and, increasingly, R&D. Ifmeasured on net value, China is arguably the most strate-gic of markets.
As domestic competition intensifies, price pressuresrise and, as Chinese players move out into the world, for-eign equipment makers must focus on remaining cost-competitive globally, further integrating their Chinaproduction and R&D facilities into global supply chains.Companies such as South Korea’s LG are deepening theircommitments to handset production in China, not simplyto break into the domestic market but to lower productioncosts so as to feed their global supply chain competitively.Existing suppliers, too, are likely to move more produc-tion to China. Increasing volume will lower costs, soallowing them to be more competitive in both the localand international markets. They will be helped in this bythe critical mass of component manufacturers and suppli-ers which have already set up in the country and which willcontinue to come.
Making sure they are cost-competitive is, in itself, no
different a strategy in China than elsewhere for foreignfirms. Except that China is now a fulcrum for telecomsmarkets globally—a market in which there is not only aprodigious domestic appetite for telecoms technology (3Gphones will undoubtedly give a new and lucrative lease oflife to suppliers) but where global products increasinglyhave an important, if not their chief, node of efficiency.This makes the strategy of foreign equipment makers inChina extremely important for their global success. Chinais not simply a large emerging market, it is the globallypre-eminent market.
The global dimension is important too because thetelecoms market in China—prodigious though it is—maynot be growing fast enough to sustain itself. China may beincreasing its teledensity by a percentage point every twomonths but there are signs that growth is slowing andthat new users are significantly poorer than those added
The US telecoms technology- and equipmentmaker, Qualcomm, is the anomaly amongsuppliers to China’s telecoms markets. Italso has perhaps the most interesting strat-egy. Although originally a telecoms-equip-ment maker, the company has long sinceconcentrated its business on research anddevelopment of technological know-how,which it then earns money from throughlicences and royalties rather than makingthings itself. By far its most important intel-lectual property is that embodied in codedivision multiple access (CDMA) mobile-phone technology, a lot of which it can layclaim to, and much of which lies at the heartof third-generation (3G) mobile systems.
Through the 1990s Qualcomm lobbiedthe Chinese government hard for theadoption of CDMA mobile networks, withlittle success. The country adopted theEuropean standard, Global System forMobile Communications (GSM), for almostall of its digital networks. This changed inthe early 2000s when China’s second-biggest mobile network, China Unicom,under heavy pressure because of thegovernment’s dislike of being too beholdento one technology, announced it would rollout a CDMA network. Although Unicom hasstruggled to find subscribers, Qualcommfinally had a presence—and some revenue.
Because it produces and sells intellectualproperty rather than physical goods,Qualcomm might at first glance appearhighly vulnerable to the theft of its know-how. Instead, the opposite seems to be thecase: the company's expertise lies inbringing together its intellectual property insystems that work as the sum of their parts—knowing just one bit is not much use, and awhole lot of separate bits is not much betterif you cannot make them work together.
The beauty of this strategy is it can thensell its technology to everyone. In the caseof its mobile communications technology,this means selling to the people who buildnetworks and handsets, those who operatethem, and those who develop theapplications which run on them—toMotorola, Nokia and Ericsson, to ChinaUnicom and China Mobile, to Huawei andZTE, and to software developers (hence itsinvestment in a JV with China Unicom toincubate applications developers, which sofar has invested in around 150 businesses).
While Qualcomm's strategy was notdeveloped specifically for China, it has thepotential to work in the country: indeed, itcould already be working there. Thecompany has signed licence agreements forCDMA products with various companies,including both Huawei and ZTE, and around
20 handset makers. Pyramid Research, atelecoms research company, estimates thatin 2002 the company earned US$200m inprofit from revenue of US$500m—animpressive return.
How far it can take its business willdepend on various factors. One isgovernment policy and which route it optsto go down for next-generation mobilesystems. Related to this is China’sdetermination to develop its own standards,not least so that its manufacturers do nothave to pay royalties and licence fees toforeign companies such as Qualcomm.
Another factor is the development ofChina Unicom, the main uptaker of CDMAtechnology. If Unicom were to falter in itscompetition with China Mobile and themobile services being launched by fixed-lineoperators China Telecom and ChinaNetcom— both of which are using a ratherdifferent kind of technology—thenQualcomm would suffer.
But with its technology being used bymore or less every maker of mobileequipment, including one of the fastest-growing handset sellers in China of the lasttwo years, South Korea’s Samsung, it is hardto envisage Qualcomm not benefiting fromthe continued growth of China’s mobileindustry over the next several years.
over the last decade. Moreover, China’s telecoms-equip-ment production capacity far exceeds its domestic needs.It now has the capacity, for example, to make nearly aquarter of a billion mobile phones a year; domesticdemand will not exceed a quarter of this amount at best.
A question of innovationThe advantage of the foreign companies—both in Chinaand overseas—will remain not whether they can producecheaper telecoms products but whether they can producebetter ones at a competitive cost. While Chinese compa-nies will always be able to compete on low-end cost, whatthey are less good at doing—and will continue to struggleto do—is to develop innovative products. The trick for for-eign players will be either to stay ahead of local innova-tion and technology developments, be involved in them,or both.
China is increasingly a source of technology and designinnovation for foreign suppliers as much as a market intowhich to sell such innovation. As more global productioncomes to China, so too does supporting R&D and design.Here, one of the most intriguing strategies is that of Qual-comm and its technology-licensing approach (see box:Qualcomm: Know-how is king). At the heart of its businessis the confidence that it will be able to continue develop-ing advances that can only be incorporated into networksusing Qualcomm's own know-how. Other companies thatcan conceptualise their activities similarly are likely tofind themselves less vulnerable to local competition thanthose who see themselves principally as manufacturers.
But, equally, the Qualcomm strategy raises a new andpotentially important regulatory risk for all foreign equip-ment makers creating and licensing technology. China’sgrowing weight in the telecoms world, and its long-stand-ing vision to have a globally competitive telecoms sector,means it will want—indeed it is determined—to beinvolved in the development of its own technical stan-dards.
The risk at present is particularly acute for mobile tech-nology, as China attempts to boost home-grown stan-dards at the expense of those offered by foreigncompanies. Repeated delays in the roll out of high-speed3G mobile technology are widely accepted to be the resultof government efforts to back a local standard known asTD-SCDMA. When 3G licences are eventually handed out, itis expected that some service providers at least will berequired to use the local standard—despite it beingplagued by technical problems.
On the face of it, there is nothing wrong with Chineseconsortia co-operating to develop new standards. Theeffort may be wasted if the new products cannot competebut that is what competition is about. Nor is there any-thing unusual in governments cheerleading for domestic
companies, as US support of Qualcomm’s CDMA mobiletechnology attests. But China certainly crosses a difficultline when it tries to impose standards by requiring manu-facturers to produce them and consumers to use them.(The Ministry of Information Industry dictates both thetechnologies used in China and the products sold.) This isespecially of concern in a market the size of China’s wherewhatever becomes the norm quickly generates economiesof scale that could be transferred to markets across theworld.
The issue that will tax foreign companies, however, ishow closely they wish to work and co-operate with thegovernment and state-run companies—and what thismeans in terms of further technology transfer.
A strategic and crowded marketChina is now playing a fundamental role in the globaltelecommunications industry. Foreign equipment suppli-ers were initially attracted to China because of its marketpotential and, unlike many other sectors, were richlyrewarded with access, billions of dollars of business and,at least initially, market domination. Local competition—the result of the access-for-technology contract struckbetween government and foreign firms—has taken marketshare from foreign companies—and probably loweredmargins as well. But the evolution of China’s importanceto foreign suppliers as a domestic market, and increas-ingly as a global production and R&D platform, has givenChina operations a unique place in their global strategies.
The government’s outlook has also evolved over thelast few years. It is certainly as interested in the industryas ever it was but it appears more confident that itsgoals—which include making China a major power in man-ufacturing and standard setting as well as increasing tele-phone access and usage—can be achieved without itsdirect, day-to-day involvement. Its primary means forachieving these goals is the retention of a major policyrole at the centre and the ultimate control over the vari-ous manufacturing and service (see box, “Service,please”) operators through continued majority state-ownership. Although the state’s involvement hasretreated to a considerable extent, making telecoms amore “normal” market, the playing field is not entirelyeven, as the government remains intent on making thesector as Chinese as possible.
What is likely to be seen over the next several years is aseries of complicated dances between foreign and localcompanies. With China now playing such a big role in themanufacture of telecoms components and equipment, acompany such as Huawei can simultaneously be a co-oper-ative partner, a competitor, a supplier and a buyer ofgoods from an overseas equipment maker. The market hascertainly become more complex and nuanced.
In stark contrast to the success that foreignequipment makers have enjoyed duringChina’s telecommunications boom of thepast two decades, foreign carriers of tele-coms services have barely benefited at all.The very factors, ironically, that have cre-ated success for foreign equipment manu-facturers—strong state-directed policy andcontrol, and a singular focus on rolling outinfrastructure—have proved an equally for-midable barrier to foreign service providers.A closed market with tight state controlover carriers and their operational budgetshas allowed central planners to build outinfrastructure in line with their technology-heavy five-year targets and to do so withoutletting a strategic (and security-sensitive)sector out of the state’s grasp. Contracts forworld-class switches, fibre optics and cellu-lar networks have been plentiful; newlicences for foreign operators almost non-existent. China’s services market remainstightly controlled by a small number oflarge state-controlled operating compa-nies.
This state of affairs is only nowbeginning to clear. Prohibitions againstforeign operators running public telecomsnetworks, of course, remain in place,despite incremental market liberalisationand the introduction of limited competition.Yet, importantly, there is now a frameworkand schedule for permitting foreignparticipation in telecoms service markets, asspelt out upon China’s accession to theWorld Trade Organisation (WTO) in 2001: by2007, inter alia, up to 49% foreignownership is permitted in telecoms servicenetworks nationwide.
On paper, WTO-mandated market-opening is already under way: the “value-added service” (non-voice) sector has beenderegulated and the door opened to foreigninvolvement. Yet there have been few takers,despite the promise of a slice of China’sUS$20bn-plus annual service markets. It isnot difficult to reason why. Limited licencesmay now be available but little else in theway of a functioning telecoms regulatoryframework exists. Licensing policy isarbitrary, nor is there formal legislation onsuch vital issues as interconnection, to nameone requirement critical to a working,deregulated market. China, in fact, has very
little in the way of basic telecommunicationslaw at all; the sole piece of unambiguouslegislation is that which prohibits foreignownership of telecoms networks. Potentialforeign investors are not exactly brimmingwith confidence.
A few foreign-invested serviceoperations have slipped through the cracks,although their impact has been marginal. Ofthe two strategies explored, the first hasbeen for foreign carriers to take equitystakes in state-controlled incumbents. Thishas left foreign operators with small, costlyholdings and little leverage or prospect ofsuch—witness the more than US$3bnVodafone (UK) spent to acquire a thin 3% ofChina Mobile between 2000 and 2001.
The second strategy has been the manyand (often) protracted efforts to buildservices JVs from scratch. Usually—andperhaps unsurprisingly—these have endedin failure; most were risky circumventionsof the ban on foreign participation inservices. Between 1995 and 1998, mostnotably, some 40 foreign carriers andinvestment firms sunk nearly US$1.5bn inJV operations with China Unicom, thesecond-largest mobile carrier, only to havethem declared illegal (and subsequentlydismantled). The only significant foreign-invested services joint venture to havesurvived is that between AT&T, ShanghaiTelecom and Unisiti, the ShanghaiInvestment Institute. AT&T spent morethan a decade of lobbying to get thisventure running; it remains confined toreselling AT&T’s enterprise services tocompanies in the Shanghai area.
In theory, things may be different after2007 when WTO commitments begin to takehold and foreign carriers are able to ownnear-equal stakes in telecoms operationsnationwide. But by that time foreign serviceproviders may have lost some of theircompetitive advantages: China’s four maintelecoms players will be stronger and moreprepared. The Ministry of InformationIndustry (MII), the de facto regulator, hasbeen preparing for market liberalisation forsome years. It began by carving off thecellular operations of China Telecom, themonolithic monopoly operator, into theseparate (yet still state-controlled) ChinaMobile; it then created a competitor, China
Unicom. It then went a step further bybreaking up China Telecom’s fixed-linebusiness into northern and southernoperating companies.
This deck-stacking—in part preparingthe services landscape for foreignparticipation by forcing state-ownedoperators to shadow-box each other—hasgiven rise to a remarkable level of inter-incumbent competition. Although all havethe same parentage, there has beenferocious rivalry for subscribers between the(separated) state-owned operators; if (as isbelieved) each is given its own 3G licencethis year or next, that battle for marketshare will carry into the next generation ofservices. But, because this competition hasbeen fiercer and more price-based thanperhaps intended, it has also had the effectof sending China’s operating companieslooking abroad for acquisition opportunitiesfor growth—China Netcom, the northernhalf of the bifurcated China Telecom, hasrecently completed its acquisition ofinternational bandwidth provider AsiaNetcom (formerly the beleaguered AsiaGlobal Crossing).
With China’s carriers increasinglyinterested in becoming global players (notunlike their manufacturing compatriots),they realise the value of deregulated, open-access service markets. This, more thananything, may be the catalyst to finally openChina’s service markets more fairly forforeigners. But in the meantime, whatstrategies should foreign service operatorsbe adopting? They are probably twofold:● For the less risk-averse, that see China as
a crucial area of growth, they can seek topartner and invest in any of the smallervalue-added service companies that arecropping up as a result of deregulation.This in the hope that they, too, can gaina foothold in the broader services sectoronce the market is fully deregulated.
● For the more risk-averse, they can con-tinue to cultivate relationships withChina’s incumbents in the hope that,over time, the relationship will evolveinto more equitable partnership oppor-tunities.Both are predicated on a fairly high
But the threats posed by local companies should nei-ther be underestimated nor exaggerated. The real ones,the threats that will remain for a good many years, aremore political than business-derived: government pres-sure to share technology, unpunished intellectual prop-erty theft, preferential treatment (including financing forlocal firms) and, of course, the relentless pressure fromlocal competitors as they make further inroads into themarket. The challenge for foreign companies will be howto maintain their profitability in the face of local manufac-turers commodifying what were high value-added prod-ucts. Technological leadership will, of course, be essentialbut, if Chinese companies can either develop or buy theirown alternatives, it will also call for a ruthless approach tocost-cutting in manufacturing. On present evidence,those which focus on aligning themselves with China’sneeds—Ericsson with its emphasis on network equipment,Qualcomm with its ability to sell to all players and Alcatelwith its strong government partner—may have the edgeover those such as Nokia and Motorola with more seem-ingly precarious competitive positions to defend.
For all these companies, however, success or failurewill be a matter of degree. All are well integrated intoChina’s telecoms industry—indeed, they have played themajor role in building it. There may not be another goldenage quite like the 1990s, especially now that the big listedtelecoms operators have to be more careful about theircapital expenditure. But the domestic market offers rea-
sonable growth potential in 3G mobile networks, forexample, if broadband uptake is rapid. Foreign equipmentmakers should do well, providing they can:● Offer well-priced alternatives to local equipment and
handsets—not necessarily cheaper but with a clearadvantage in terms of functionality, technology or evenstyle.
● Retain or increase control over their operations, bothto be able to restrict technology leakage and not to bebeholden to partners with conflicting agendas.
● Use China’s advantages as a production base to makeit a key part of their global production strategies.
● Be involved in China’s development of its technicalstandards.
● Have the flexibility to react quickly to changes in theform of China’s market—be it changes in technologyor the nature of customers, at both an equipment pur-chasing and consumer level.
The last of these is perhaps the most important. The mostcharacteristic feature of China’s telecoms market has beenthe rapidity of change—from a small, backward, badly runstate monopoly 15 or so years ago to today’s enormousand modern series of networks operated by competingcorporations. The roll out of next-generation mobile net-works, expansion to the next few hundred million users,increase in competition and further changes to the struc-ture of the industry should see changes of a similar mag-nitude over the next decade or so.
The survey was conducted between late March and earlyApril 2004 among senior decision-makers of multinationalcompanies in China. Respondents were drawn from usersof Economist Intelligence Unit and other Economist Groupproducts and services, in particular members of theEconomist Corporate Network who shared both their timeand experienced insights.
MethodologyThe survey was conducted via emails which provided a“click-through” facility to the Internet for respondents toaccess and fill in the survey itself. Additional follow-up was
provided by trained telephone surveyors. Results werecompiled, and conclusions drawn, by analysts at theEconomist Intelligence Unit in Hong Kong.
The survey received 217 responses, largely fromexecutives at large multinational corporations: 38% ofrespondents were from companies with annual globalrevenues of US$8bn or more; almost 70% of respondentsrespresented companies with revenues of US$1bn plus.The respondents were almost all senior managers, withfunctions across the entire spectrum of businessresponsibilities. Every major industry was represented.
What are your organisation’s annual global revenues in USdollars? (% responses)
$250m or less 13.4
$250m-$500m 8.3
$500m-$1bn 8.8
$1bn-$3bn 18.1
$3bn-$8bn 13.9
$8bn or more 37.5
Which of the following best describes your title? (% responses)
SurveyComing of age?Multinational companies in China
In the light of these objectives, how has your China businessbeen performing during the last three years? (% responses)
Out-performing by a wide margin 9.2
Out-performing 33.6
In line with expectations 42.4
Under-performing 12.4
Seriously under-performing 2.3
Roughly what percentage of your company’s global profits do youexpect China to be contributing in five years’ time? (% responses)
Less than 1% 5.8
1–5% 37.4
6–10% 16.3
11–30% 29.5
More than 31% 11.1
Approximately what is the ratio of exports to domestic sales inyour business? (% responses)
0:100 23.1
25:75 23.6
50:50 5.6
75:25 7.9
100:0 3.7
Not applicable 36.1
Where do you expect the ratio to stand in five years’ time? (% responses)
0:100 12.1
25:75 23.3
50:50 20.9
75:25 6.0
100:0 1.9
Not applicable 35.8
What percentage of your inputs on a value basis is sourced fromwithin China (as opposed to being imported)? (% responses)
0-20% 26.6
20%-40% 12.6
40%-60% 9.3
60%-80% 6.5
80%-100% 12.1
Not applicable 32.7
Where do you expect this percentage to stand in five years’ time?
(% responses)
0-20% 11.6
20%-40% 14.9
40%-60% 8.8
60%-80% 13.5
80%-100% 18.6
Not applicable 32.6
Of the inputs that you source from within China, what percentageis sourced from domestic Chinese companies (as opposed toforeign-invested firms)? (% responses)
0-20% 20.6
20%-40% 7.9
40%-60% 10.7
60%-80% 15.0
80%-100% 11.2
Not applicable 34.6
Where do you expect this percentage to stand in five years’ time? (% responses)
When planning for domestic sales within China, you think interms of... (% responses)
...a national market 20.9
...1st, 2nd, 3rd-tier cities 34.9
...East coast and the interior 7.4
...Distinct regions (North-east, Yangtze river delta etc) 30.7
Other 6.0
What determines this view of China? Select all that apply(% responses)
Income disparities 54.8
Infrastructure deficiencies 39.6
Central government regulation 27.6
Local-level informal protectionism 17.1
Other 24.0
What kind of companies pose the biggest competitive threat toyour business in China? Select all that apply(% responses)
Large state-owned enterprises 27.2
Other state-owned enterprises 9.2
Collectively owned enterprises 13.8
Private companies 44.2
Foreign-invested enterprises 67.7
Other 6.9
How significant is competition from domestic (as opposed toforeign-invested) firms to your China business? (% responses)
Very significant 25.3
Quite significant 38.7
Not significant 32.3
Other 3.7
What are the competitive advantages of domestic (as opposed toforeign-invested) firms? Please rank in order of significance,with 1 being most significant
Rank
Lower prices 1
Better understanding of domestic market 2
Support of local officials 3
Support of the national government 4
Stronger local brand recognition 5
Access to cheap bank credit 6
Has your company changed its China strategy in response to thechallenge of domestic competition?
(% responses)
Yes 47.2%
No 52.8%
Are domestic (as opposed to foreign-invested) companies acompetitive threat to your business globally?
(% responses)
A serious competitive threat 5.6%
Somewhat of a competitive threat 28.2%
Not a threat 65.7%
Other 0.5%
How much of threat do you expect them to be in five years’ time?
Uncertainty about the stability of the renminbi 3.4 20.4 50.0 19.4 6.8
Equal official treatment for foreign and domestic firms 5.8 16.0 43.2 21.4 13.6
Corruption 22.1 38.2 28.9 7.4 3.4
Protection of intellectual property rights 11.2 31.1 32.0 10.2 15.5
Restrictions on cross-border capital flows 10.2 21.5 50.7 12.2 5.4
How do the following factors affect your business in China? Please rate on a scale of 1 to 5, where 1=detrimental to the operation ofyour business, and 5=beneficial
(Percentages) 1 (detrimental) 2 3 (no impact) 4 5 (beneficial)
Availability of skilled managers/support staff 18.4 25.3 5.1 20.7 30.4
Availability of English-language skills 4.6 27.6 23.0 25.8 18.9
Availability of professional support services 7.0 25.6 27.0 23.7 16.7
Transport and communications infrastructure 5.5 27.2 27.2 23.5 16.6
Electricity infrastructure and supply 10.2 13.0 49.1 18.1 9.7
