Coming of Age Multinational Companies in China

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a Fuji Xerox, Hitachi Data Systems, Norton Rose, Primasia, E-mail: [email protected] June 2004 Russell Reynolds Associates, Sheraton Hong Kong, Timken Coming of age Multinational companies in China

Contents

2 Acknowledgements 3 Preface

4 Executive summary 6 Introduction

PART 1 10 A new environment 26 Addressing the market 42 Persistent headaches

PART 2 54 Automobiles 66 Financial and professional services 80 Logistics 88 Pharmaceuticals 98 Retailing and consumer goods 110 Telecommunications

122 Appendix: Survey results

Acknowledgements

Many hands and minds came together to create this © 2004 Economist Intelligence Unit. report. The Economist Intelligence Unit would like to All rights reserved. make special mention of the lead sponsors—Citigroup, All information in this report is verified to the best of the authors' and the publisher's DHL, KPMG and Monitor Group—and in particular those ability. However, the Economist who took time to give us valuable input: Tony May, Wu Xin Intelligence Unit does not accept and John Diener at Monitor Group; Paul Kennedy, Anson responsibility for any loss arising from Bailey and Andrew Weir at KPMG; Gary Clinton at Citi- reliance on it. group; and Christina Koh at DHL. They are not responsible Neither this publication nor any part of it may be reproduced, stored in a retrieval for our analysis, of course, but they were enthusiastic and system, or transmitted in any form or by any informed participants in the discourse. We would also means, electronic, mechanical, make special mention of our colleagues at the Economist photocopying, recording or otherwise, without the prior permission of the Corporate Network, in Hong Kong and in China—Lois Economist Intelligence Unit. Dougan Tretiak, as always for opening doors in China, and Harris Vertlieb, Jerry McLean and Pieter Tsiknas for their generous and important help with our survey. Also we would like to extend our gratitude to the many executives of multinational companies in China who agreed to be interviewed, and who often went out of their way to provide us with insights into their businesses, and doing business in general in China. Without their input, it would have been impossible to produce this report. The main authors of the report were Simon Cartledge and Paul Cavey. Simon Cartledge, a former chief editor at the Economist Intelligence Unit in Hong Kong, runs his own consultancy, Big Brains, and is a regular contributor to our publications. Paul Cavey is the Economist Intelligence Unit’s Chief China Economist based in Hong Kong. Additional sectoral contributions were made by: Graeme Maxton (automotive); 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 to Elisabeth Paulson for her keen editorial judgement, Mike Kenny for the design of the report, and to Gaddi Tam for skillfully seeing it all through production.

2 © The Economist Intelligence Unit Coming of age Multinational companies in China

Preface

The seven years that have passed since the Economist Intelligence Unit last tackled the subject of multinational companies in China is a short period when set against the age of Chinese civilisation. But it is an awfully long time in a country that is changing as rapidly as modern China. Since 1997 the stock of inward foreign investment has increased by US$265bn, the country’s exports have more than doubled and the economy grown by more than 50%. A fourth generation of leaders has taken the stage, and China has joined the World Trade Organisation. In this context Coming of age: Multinational companies in China is a report that is long overdue. Its central premise is that in the last seven years the experience of multinationals companies operating in China has changed as much as the country itself. This is a more controversial proposition than it might sound. There is still a widespread perception that China and foreign firms simply do not mix, that as a market China 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 last few years China has emerged as one of the world’s largest markets for a variety of products—and for a number of leading multinationals as well. China is no El Dorado. But it is a market that has started to come of age.

PART 1 Persistent headaches Executive At an operational level, doing business in China remains very challeng- summary A new environment ing. Infrastructure has improved For multinational companies, China’s during the last few years, but market has started to come of age. remains deficient relative to The growth of the “middle class” is demand. Restrictions on foreign creating strong consumer demand, firms in the manufacturing sector and there is also a burgeoning busi- have been eased, but in the services ness-to-business market. Improve- sector they remain oppressive. ments in infrastructure and a Across the economic spectrum, skills relaxation of regulations have made shortages are severe and violation of these markets much more accessible intellectual property rights is rife. than was the case just a few years These issues affect all companies, but ago. A broadening and upgrading of present the most serious challenge the activities of multinational firms to small foreign firms that are new to has accompanied these changes. For China and lack international and many big companies China has country-specific experience. Larger become a major global market and, firms are coming up with strategies in some cases, a large profit centre. to address these issues, if not resolve China’s importance is currently not them. evident in all industries, but these sectoral differences are likely to ease over the next few years.

Addressing the market Accompanying the rise in demand in China has been an intensification of competition. While this represents a new strategic challenge for multinationals, the development of China’s economy has also opened up new ways in which they can respond. For- eign firms have more opportunity to bring their sophisticated brand- building and marketing capabilities to play in the China market, and to localise production, markets and sourcing to lower costs. The emergence of a local market for mergers and acquisitions is allowing big foreign firms to buy up local competitors. The net result? Executives in China are spending more time thinking about the kind of strategic planning issues that tend to pre-occupy their counterparts in more developed markets.

4 © The Economist Intelligence Unit Coming of age Multinational companies in China

PART 2 Logistics Retailing and Not yet connected The logistics industry has developed consumer goods Overcoming regulations and building rapidly in recent years, with state Automotive brands Good times today, but an uncertain domination of the sector giving way Big companies like Carrefour and tomorrow to strong competition among foreign Wal-Mart have already established China’s automotive sector continues and domestic third-party logistics themselves in key cities in China, and to expand rapidly. As developed- providers. The supply-side of the will benefit from the lifting of restric- world markets have stagnated, there industry has nevertheless failed to tions on foreign retailers at the end has been a headlong rush to China by keep pace with the even faster of 2004. The further expansion of the major foreign automakers—most increase in demand. Restrictions in these and other foreign chain stores of which are now present in the mar- the sector are being relaxed, but will ease some of the distribution dif- ket. Profit margins are high but risk logistics providers still face a number ficulties currently faced by the inter- being undermined by over-capacity of regulatory hurdles. The develop- national fast-moving consumer and competition. Multinational auto ment of the industry is restrained goods companies. Procter & Gamble firms will need to devise long-term also by China’s over-stretched physi- and Unilever have already estab- strategies that take into account a cal infrastructure and other problems lished large businesses in China, potentially diminished role in the ranging from limited IT systems to although their early dominance of market. pilferage of freight in transit. some markets has been broken down by domestic competition. The Pharmaceuticals increasingly crowded market renders Financial and profes- brand-building more important. Cultivating demand and biding time sional services China remains a small market for Still dreaming of the future most foreign pharmaceutical firms. Of all industries in China, the finan- But sales have been growing Telecommunications cial and professional services sector A strategic and crowded market strongly, and the business environ- is the one where the gap between China is a prodigious market for for- ment has improved. Regulations and current reality and future expecta- eign telecoms equipment manufac- the nature of the national healthcare tions is the greatest. Market access turers. In few other sectors is China system complicate the ability of for- rules remain strict, and so while as important to the global perform- eign firms to build bigger businesses domestic demand has been growing, ance of leading multinational firms. in China. Reforms are eventually China remains a minuscule market But China’s market is not just big, it likely, but in the meantime foreign for most multinationals. Foreign is also increasingly crowded. To companies can start to use market- firms are nonetheless expanding. In counter the competitive threat posed shaping strategies to create new general they are leveraging high by Chinese firms both within China demand in areas that currently pass service standards and the need of and increasingly outside as well, for- under-diagnosed or completely domestic firms for outside expertise eign equipment makers must focus untreated. Multinational drug com- and finance. Individual expansion on further integrating China into panies have already started to invest strategies are, however, determined global supply chains. Foreign in more research and development by the nature of individual compa- providers of telecoms services do not activities in China, mainly focused on nies outside China as much as the face the same considerations as their drug-development clinical trials. regulatory and commercial environ- manufacturing counterparts. Despite ment within the country. incremental market liberalisation, China’s service market remains tightly controlled by a small number of state-controlled operating companies.

Introduction

he broad premise of this report is quite straightfor- There is a sense that the old reality has yet to be com- ward, self-evident perhaps, yet curiously it has not pletely discarded, and the new yet to be fully framed. The so far been articulated in a systematic fashion, nor intention of this report is to throw light on the paradigm is it firmly and unambiguously rooted in the corpo- shift—particularly its causes and what the shift means for rateT mind, even if it is on many a radar screen. The prem- foreign firms seeking to make sense of their plans and ise is simply this: as China's economy and business strategies for the China market of the future. landscape have been transformed fundamentally over the past five or so years, so too are multinational companies A new paradigm (MNCs) thinking differently about China, or beginning to China attracts ambivalence. Few markets can claim to do so; and if they are not, they should be. have fuelled such unbridled, naïve optimism from compa- There is a paradigm shift afoot in the way foreign com- nies and analysts alike, nor simultaneously drawn sus- panies are approaching China because the country itself tained scepticism and pessimism from others. The has changed. In many ways and in many sectors, China is ‘sceptical-pessimist’ view that “China is bound to disap- looking more and more like a real market with all the asso- point” remains a fashionable and influential one: it holds ciated challenges and opportunities that this implies. Sec- that foreign businesses have been blinded by numbers; tors that seemed rather distorted in the early days—due to that investment decisions have been based on illusory high regulations or a lack of competition, for example— premises; that by-and-large foreign firms are not making are beginning to look more normal. Regulations remain, money, or if they are, margins are thin; and that they have but are being relaxed. Competition is emerging, from failed, also, to anticipate or adequately factor in the risks brash, local companies as well as new foreign entrants. All in the business environment and beyond. Foreign compa- these firms are being drawn to markets which, for many nies, in short, have been lulled by the China dream into sectors, are becoming some of the world’s largest. The entering the market at any cost—into spurious loss-lead- very visible growth of demand within China has made ing and opportunism—and have been opening themselves building a business there not only feasible but also essen- to disappointment ever since. tial for any performance-oriented multinational. These This view—in its varying shades—might be familiar ter- days, a truly global company would no more ignore China ritory for some foreign businesses in China. Not a few have than it would the UK or France. stumbled, and got their strategies wrong, after all; not a Not unusually for a transition of this nature, there are few will continue to do so. If the sceptical-pessimist view conflicting threads. The survey of foreign firms carried out bears merit, it is that it highlights the many risks—busi- as part of our research, and the interviews we conducted ness and otherwise—that foreign companies face in China, with senior corporate decision-makers, suggest that for- and serves as a reminder to temper naïve optimism. Multi- eign companies are conceiving of China with a new frame nationals, remember, are riding the crest of a third wave of of mind, and realigning their strategies too. Not all, cer- foreign direct investment (FDI) into China, and inevitably tainly, but many. Yet for many foreign firms, this new par- the present elation will falter, as it has in the past. The adigm is still hazy; foreign companies (again not all, but sceptical pessimist does have a certain point. quite a few) are struggling to define the new reality and Yet this view describes only a partial reality, one in can remain quite attached to the mental models of doing which China’s business environment seems almost frozen business in China that were forged five, even 10 years ago. in the concerns of the mid-late 1990s, and in which for-

6 © The Economist Intelligence Unit Coming of age Multinational companies in China

An investment hotspot Inward flow of foreign direct investment, US$ bn 60

0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: National Bureau of Statistics

eign companies focus their energies on operational tronics, in fact components of all sorts—has also grown issues—on reticent joint venture partners, intellectual dramatically in recent years. property violations and markets that are only a fraction of the size companies had anticipated. A need for strategy China, undoubtedly, is still an emerging market, and It is not just in terms of raw demand that China has begun one too with peculiarly Chinese characteristics. Yet it is to approximate a real market. It is also in the emergence not simply any emerging market; it is the world’s most both of competition, and of strategic options for firms important emerging market, thriving on a virtuous cycle wishing to compete. In addition to foreign firms, smaller of globalisation. This is a recent phenomenon. Last year, companies from the US and Europe, as well as large corpo- China became the world’s fourth largest exporter by value, rates from other Asian countries, all want a piece of and the third largest importer (a measure in part of the China’s market. So do China’s firms, ranging from state- inputs needed to create exports); only a decade earlier it owned giants through partly privatised corporations to barely made it into the top ten. China is now enmeshed in the up-and-coming private sector. the global trading system and in global business net- In this intensely competitive environment foreign works—in complicated webs and chains of manufacturing, firms are far from powerless. The improved business envi- sourcing and supply—to a much greater degree than could ronment is giving them the opportunity to use sophisti- have been imagined just a few years ago. cated brand-building and marketing strategies. The impact on China’s domestic economy of its rapid Infrastructure improvements have made it possible for ascendancy as a trading power has been profound. A 50% foreign firms to move production to the cheaper, inland expansion of GDP since 1998, according to official statis- areas of China and thus begin to emulate the cost struc- tics, might overstate the performance of the economy as a tures of their local counterparts. Finally, and perhaps whole, but income growth in the major cities—particularly most critically, the emergence of a local market for merg- on the coastal belt—has been very rapid indeed. A market ers and acquisitions (M&A) is allowing big foreign firms to of one billion consumers remains a fallacy, of course, but buy up local competitors. this no longer matters. Foreign businesses can legiti- This is not to say that China has changed so much that mately point to a serviceable “middle class” of ten of mil- foreign firms are no longer troubled by basic operational lions of people. And the domestic market does not end issues. The operating environment in China remains here. Just as important, perhaps more so, for foreign extremely challenging. Despite the huge investments companies are the burgeoning business-to-business made by the government in recent years in the country’s opportunities found further upstream the production physical infrastructure, the capacity of transport networks process. China has become a voracious consumer of raw and electricity generation continues to fall short of materials. The intermediates market—for chemicals, plas- demand. Foreign firms operating in China still have to tics, synthetic materials, optical fibre, steel, glass, elec- deal with regulation, either in the form of red tape or for-

Bursting on the scene Exports of the world‘s biggest traders, US$bn 1993 2003 800

700

600

500

400

300

200

100 0 Germany US Japan China France UK Netherlands Italy Canada

Source: World Trade Organisation

mal restrictions aimed at restricting their involvement in firms get their China strategies right. And this all means the domestic economy. Human resources shortages are that performance-oriented multinationals no longer face endemic, and theft of intellectual property rife. risks only from entering China. Staying outside is fast Moreover, China's economic system is far from being becoming if not more, at least equally as risky a strategy. mature—and thus stable—despite the far-reaching economic reforms implemented since 1978. Indeed, the risk Coming of age that the economy will suffer not just a slowdown but a This purpose of this report is to address some of the new, wrenching crisis, triggered perhaps by the ailing banking strategic questions facing foreign firms. The first half of sector, remains far from negligible. Huge social chal- the report explores in greater detail how, for foreign lenges also loom: for one, more than 400m people, firms, China’s market has begun to come of age. The first roughly the population of Europe, will move from the chapter, “A new environment”, examines how the expan- countryside to towns and cities over the next 25 years. sion of demand and improvements in the business envi- Inevitably, too, China’s political system appears brittle ronment are creating new incentives and a new against this background of continued rapid economic and accessibility for foreign firms looking to develop their social change. China operations. But the problems and risks associated with China’s mar- As the attraction of the market increases and the busi- ket should not be over-played. At least for better-estab- ness environment improves, competition is hotting up. lished firms, operational issues are not the all-consuming Fortunately, accompanying the rise of demand and com- problems they once were. The business environment has petition has been the emergence of strategic options for improved, and firms are beginning to work out systems and foreign firms wishing to fight back—a theme explored in procedures to alleviate the challenges that remain. For a the second chapter, “Addressing the market”. whole range of multinationals in China, the focus of man- The operational problems that were such a pre-occupa- agement attention has moved, with executives spending tion in the 1980s and 1990s are no longer the only issues more and more time thinking about the kind of strategic taxing the time of executives, although they remain real planning and development issues that tend to pre-occupy challenges, as the third chapter, “Persistent headaches”— their counterparts in more developed markets. will explain. If thinking more deeply about China is not an activity China’s economy and business environment are now that senior management in headquarters in Europe or the coming of age, and these shifts have created a new level US is encouraging, then they should be. China operations of complexity for executives managing China operations. are making a real difference to the global performance of And there is certainly much variation across different multinational companies today; for many, China revenues industries, with all of these changes evolving at a differ- are in their top 15 or 10 countries world-wide, and not a ing pace across different sectors. The second half of this few breaching the top 5. It clearly matters that foreign report aims to add nuance to the broader developments

8 © The Economist Intelligence Unit Coming of age Multinational companies in China

discussed in the first half, examining the ongoing its likely developments over the next few several years. Its changes and strategic outlooks for six key sectors. findings may prove particularly useful to executives view- Overall, this report focuses on what decision-makers at ing China from abroad, offering a sense of how the opera- multinational companies on the ground in China are tional and strategic parameters on the ground are thinking, how their companies are faring and what kind of affecting company strategy at the highest level, today and sense they are making of the business environment and in the future.

Part 1 A new environment

hina’s leaders are particularly busy at the moment. this spectacle. After all, while the intensity of interest has Apart from having to manage the unimaginably varied, foreign businessmen have been beating their way complex transition of the world’s most populous to the doors of the Zhongnanhai leadership compound in Ccountry from communism to capitalism, they are Beijing ever since the ruling Chinese Communist Party also granting interviews on an almost daily basis to the (CCP) started to introduce economic reforms in the late chief executive officers (CEOs) of the world’s largest multi- 1970s. In the past the enthusiasm of the initial trip rarely national companies. Impressed perhaps by their top-level lasted long, with companies soon realising that the talks, or by the fast-rising skyline of Shanghai, many CEOs potential market was, in reality, better measured in thou- are quick to lavish praise on their host country. In the sands rather than millions, and that accessing even this inevitable post-interview talks with the press, the foreign pool of consumers was made difficult, if not impossible, by businessmen tend to extol the virtues of the country’s poor infrastructure and anti-business policies. China “economic miracle” and seem to compete with each other became famous as a market in which foreign firms lost to announce large investments that prove their “commit- their shirts. For many multinationals, it became a market ment” to China. to bypass, not cultivate. Experienced China watchers—and the large and deter- Some evidence might suggest that little has changed. mined legions of China sceptics—tend to roll their eyes at By many measures, the country remains extremely poor.

● For multinational companies, China’s market has started to ● The emergence of domestic demand, together with the real come of age, transforming both the opportunities available improvement in the business environment, has helped to to foreign businesses and the way they think about the broaden and upgrade the activities of foreign firms in China— country. and enhance the influence of multinationals on the Chinese economy. ● Foreign businesses can now legitimately point to a serviceable market of substantial size. The growth of the “middle ● For many big companies China has become a major global class” is creating strong consumer demand. But there is also market, and in some cases even a large profit centre. China’s a less-noticed but probably bigger business-to-business mar- importance is currently not seen in all industries, but survey ket, associated with China’s emergence as the workshop of data and interviews with executives suggest these sectoral the world. differences will ease during the next few years.

● For overseas firms China’s market is not only real, it is also ● For much of the 1980s and 1990s the experience of multina- much more accessible than was the case a few years ago. The tionals seeking to tap China’s domestic market was defined transport infrastructure has been upgraded and regula- by unrealistic expectations and disappointment. Now it is tions—including those aimed specifically at limiting partici- characterised by real opportunities, revenue growth and pation in the economy of multinational firms—have been sometimes even profit. China is no longer a market that relaxed. multinationals should or can ignore.

10 © The Economist Intelligence Unit Coming of age Part 1 A new environment

Average income per head in China remains pitifully small, The economy grew rapidly throughout the 1980s and at around US$1,100 in 2003, and still below income levels 1990s but China still proved a disappointment for many in countries like Syria, Albania and Kazakhstan. The state firms. Fast rates of GDP growth were insufficient to gener- remains a significant economic player, retaining owner- ate a nation of a billion consumers, largely because base ship of some sectors of the economy and binding others in incomes remained very low. This reality seemed to come a web of restrictions and reams of red tape. For some as a surprise to many firms in China: in the survey con- executives the issue of profitability remains a difficult ducted for our last report in 1997 on multinational com- one. Our own survey shows that foreign firms still judge panies in China, more than half of respondents— success in China by revenue growth and market share 56%—said they had overestimated the size of the market. rather than return on capital. By contrast, 43% of respondents to our 2004 survey None of these facts are irrelevant but they form only reported that operations in China were either outperform- part of the story and, as this report will argue, an increasing or outperforming by a wide margin original business ingly secondary one for foreign firms operating in the Mid- plans. The change is partly the result of less naive expec- dle Kingdom. In stark contrast with the picture in 1997 tations, itself a welcome development. The dream of sell- when we last produced a report on this subject, for many ing a billion soap bars, telephones or family cars to a foreign firms China is an economy that has started to come billion Chinese consumers gave way to a more tempered of age. In this chapter, we will explore how the maturation view of the Chinese marketplace. of the Chinese market in the last few years has transformed In particular, many foreign companies began to realise the opportunities available to foreign businesses and the that they did not need a billion consumers to justify their way they think about their China operations. presence in the Chinese market. Continued, low average incomes have not prevented China from becoming a major A serviceable market of substantial size global market for many types of goods and services. In China’s emergence as a more mature market for foreign 1997 the country was already the world’s third-largest companies is the result of a bundle of factors. Central to market for mobile-phone handsets but there were still just the process, however, has been the continued rapid 13.8m subscribers. By 2003 China had not just become growth of the country’s economy. According to official the world’s largest market but subscription numbers had data, China’s GDP has grown by more than 50% since surged to 269m. Similarly, in 1997 car sales in China, at 1997. (In the late 1990s there was widespread suspicion under 500,000, trailed behind 13 other countries, includ- that government statistics overstated the speed of eco- ing India. Last year, however, local car sales grew to more nomic growth. Since then, however, these doubts have than 2m, with China overtaking France to become the been replaced by a consensus that official numbers, which sixth-largest market in the world. The value of domestic suggested growth of 8% in 2002, 9.1% in 2003 and 9.7% mortgage lending totalled less than US$2bn in 1997 but year on year in the first quarter of 2004, have been under- had swelled to US$142bn last year, with China’s market stating the rate of real economic expansion.) for house lending thus rivalling that of Italy.

Up and up China‘s GDP growth, % 16

0 1978 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03

Source: Economist Intelligence Unit 11 © The Economist Intelligence Unit Coming of age Part 1 A new environment

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

These are just a few of the markets that were virtually car manufacturers must have a presence in France, one of non-existent only a few years ago and that have now the world’s largest car markets. Likewise, with China’s car grown to become among the biggest in the world. Several market just behind France’s in size, the choice is what respondents to our survey alluded to the growth and strategy must be employed to best tap this new market, transformation of China’s market when they referred to not whether to be in the market in the first place. their firms’ reassessment of the China market from “totally obsolete and marginal to critical to global strat- Pockets of wealth, with deep pockets egy” or from “an emerging market to one of our top ten The emergence of these consumer markets is a reflection focus countries”. In fact, although 38% of the respon- of the widening income inequality that has accompanied dents to our survey still see China as a prospective market, the recent growth of the economy. For instance, annual a substantial 77% of respondents view it as an actual mar- disposable incomes per head in urban Shanghai grew by ket. After all, there is little question that the world’s top over 75% in 1997-2000, rising from Rmb8,440

Turning to the domestic market

Most of the firms that responded to our sur- has been able to switch sales of domestically in the proportion of sales generated by vey are seeking to sell into China. Just under made goods from exports to the local market, exports over the next five years. one-quarter of companies represented in thanks to growing demand for many of its It is not difficult to find examples of firms the survey indicated that China was “one of core products from China’s rapidly growing planning to increase China’s importance as several export production sites globally” automotive and telecommunications an export base. The proportion of output and nearly 30% said it formed a “critical industries (see case study in the next chapter, exported by Alcatel of France has already part of the global supply chain”. But almost Addressing the market). risen from around 5% at the end of the four-fifths of respondents claimed China Most platitudes or broad perceptions 1990s to 15% today, and the company was an actual market and 38% said it was a about the Chinese market are rife with expects the share to rise further to around prospective one. exceptions. This one is no different. While a 33% by 2006. The US ball-bearing maker, Some global companies, initially number of companies are reassessing their Timken, came to China to manufacture its disappointed in or sceptical of the domestic strategy for tapping the domestic market, products for the domestic market but 70% of market’s potential, scaled down plans or there are also those who are expanding its production in the country is now exported tapped China’s advantage through the their focus on export-generated sales from (see case study later in this chapter). creation of export-oriented manufacturing. China. In the survey conducted for this This does not suggest that companies But these days there are signs of an report, the single largest group of cannot sell into China but rather that they increasing emphasis on the development of respondents (47% of the total) claimed that are gaining a better awareness of which the domestic market. A survey conducted by the ratio of exports to domestic sales in goods will find a domestic market and which the Economist Intelligence Unit in 2003 their business currently stands at 0:100 or are better earmarked for sale to other parts found that the most common reason cited by 25:75. But when asked where the ratio will of the world. In Timken’s case, the firm is Taiwan firms already operating in China for stand in five years’ time, the largest number now addressing local demand for higher- increasing investments further over the next of firms (44%) reported 25:75 or 50:50. In end products (such as those used in steel three years was to take advantage of the other words, and in contrast to the common mills) by importing from its manufacturing opportunities in the mainland’s domestic perception of an increasing focus on the operations in Europe, and retargeting market. Firms from other countries report a domestic market, companies that abroad the China output that was originally similar change of focus. Corning, for example, responded to our survey expect an increase intended for the domestic market.

12 © The Economist Intelligence Unit Coming of age Part 1 A new environment

Richer consumers Income per head, Rmb per year Rural Urban 15000

12000

9000

6000

3000

0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: CEIC

(US$1,015) to Rmb14,870. In the same six-year period, have, for example, fuelled a need for everything from net incomes per head in rural areas in the south-western steel to paint. China is by far the largest consumer of steel province of Yunnan grew by less than 25%, and even then in the world and in 2003 the country overtook Japan to from just Rmb1,375 to Rmb1,695. The poverty in rural become the second-largest consumer of oil, trailing only areas is a serious social problem that is causing increasing the US. Strong demand for mobile phones and other elec- concern for the government. But in urban areas, the dis- tronics products has contributed to surging sales of semi- proportionately strong growth of incomes has generated a conductors. According to the Semiconductor Industry “middle class” that has the financial ability to buy the Association, China is now the fastest-growing chip market more expensive products that foreign companies often in the world, accounting for nearly 11% of global demand want to sell. in 2003, up from just 3% in 1998. The government-backed Chinese Academy of Social Sciences (CASS) claims that 250m people in urban China An export powerhouse belong to the “middle class”, defined as households with As a result of strong growth in external sales, the value of total assets of US$18,000-36,000. According to a New China’s merchandise exports grew by 22% in 2002 (repre- Zealand-based company, Asian Demographics, the middle senting an absolute increase of US$60bn) and by 35% in third of households (approximately 130m in number) in 2003 (jumping by a further US$113bn), propelling China China now earns Rmb12,500-25,000 (US$1,510-3,020) a up the ranks of the world’s largest traders. In ninth posi- year. These are all small figures compared with the assets tion in 1997, China last year overtook France to become and income of even low-income households in developed the world’s fourth-largest exporter. With overseas sales in economies. But the cost of living in China is lower than in the first four months of 2004 growing by a further 34% on the West and it is clear that there are now tens of millions the year-earlier period, it seems unlikely that it will be of people who can afford to buy—and furnish—a small long before China surpasses Japan to become the biggest flat, take one holiday a year (perhaps overseas) and exporter in Asia and the third largest in the world. maybe buy a small car. While the market of one billion Totally isolated from the world economic mainstream consumers might remain nothing more than a twinkle in at the end of the 1970s, China has now become a major the eye of China-virgin executives, foreign businesses can trading power. Its economy is enmeshed in global busi- now legitimately point to a serviceable market of still sub- ness networks to a much greater degree than could have stantial size. been imagined several years ago. Moreover, the country’s domestic market does not end Given China’s emergence as a major exporter, it should with the high street or shopping mall. Perhaps more not be surprising that the country is now the world’s dom- important for foreign firms are the burgeoning business- inant producer of several individual categories of goods. to-business opportunities found further upstream in the For some light manufactured products such as garments production process. This is partly related to surging and toys, as well as for some heavy industrial goods like domestic consumer demand. Rising car and home sales crude steel, China’s global importance is nothing new.

An ugraded business environment World’s leading traders Exports, US$ bn While the change in domestic demand in China and the 1993 2003 ever-expanding appeal of the country as an export base 1US 465 1 Germany 748 are undoubtedly important factors behind the country’s 2 Germany 380 2 US 724 coming of age for multinational companies, they are not 3 Japan 362 3 Japan 472 4 France 222 4 China 438 the only ones. A number of ground-level changes have 5UK 181 5 France 385 also transformed the business environment and the way 6 Italy 169 6 UK 304 foreign companies think about doing business there. In 7 Canada 145 7 Netherlands 293 the last few years several features of the operating envi- 8 Netherlands 140 8 Italy 290 ronment have undergone dramatic change, easing the 9 Hong Kong, China 135 9 Canada 272 way for foreign businesses and opening up new opportu- 10 China 92 10 Belgium 255 nities for well-prepared companies.

Imports, US$ bn Improvements to infrastructure networks 1993 2003 1US 603 1 US 1,306 Thanks to vast state spending, China’s infrastructure, 2 Germany 343 2 Germany 602 both soft and hard, is much improved from a few years 3 Japan 242 3 China 413 ago. The betterment of the IT network has allowed compa- 4 France 217 4 France 388 nies to make operating changes that would have been 5UK 209 5 UK 388 unthinkable a few years ago. Unilever, for example, 6 Italy 148 6 Japan 383 moved out of Shanghai to Hefei in Anhui province in 7 Hong Kong, China 141 7 Italy 289 2003. It can now manage many of its human resources 8 Canada 139 8 Netherlands 261 operations in its ten subsidiaries spread across China, in 9 Netherlands 126 9 Canada 246 Shanghai and Beijing as well as Hefei, using a single cen- 10 Belgium-Luxembourg 118 10 Belgium 234 tralised human resources database that handles payroll 11 China 104 13 Hong Kong, China 233 management and other tasks using just a couple of staff. Source: World Trade Organisation Aside from improving efficiency within Unilever, it also reflects both the coverage and reliability of China’s communications infrastructure stemming from the massive (The country has been the world’s largest steel producer telecoms rollout of the last 10-15 years. This has laid the for several years, although demand remains well above basis for the rise in individual ownership of mobile and domestic supply.) But even for many of these sectors fixed handsets but has also made life much easier for busi- China’s lead has grown in recent years. The phased relax- nesses, with many cities now offering broadband connec- ation of export quotas that have long restricted world tions to the Internet. trade in apparel is, for example, allowing even more gar- In recent years the transport infrastructure, which was ment production to migrate to China. In the early to mid- the target of a government spending programme 1990s China’s steel production, at around 90m metric launched to support domestic GDP growth in the after- tonnes a year, was only slightly above that of the US. In math of the Asian financial crisis of 1997-98, has also the following years, however, US steel production improved significantly. The railway system is now better remained fairly steady whereas Chinese output rose than it was, albeit more because of steady incremental strongly, reaching 220m tonnes in 2003. upgrading than high-profile projects. (Although China is At the same time as output of existing products has the home of the world’s first magnetic levitation line, this grown, China has begun to move into the manufacture of 430-kph service only runs 30 km from Shanghai’s Pudong other goods. Annual domestic output of passenger cars, international airport.) The biggest beneficiary of the gov- for example, jumped from under 500,000 in 1997 to more ernment’s transport spending binge has been the road than 2m last year. China has also emerged as a leading network. Before 1997 China had virtually no expressways. producer of electronics products. According to the Taipei- By 2003 there were 30,000 km of them, although this is based Market Intelligence Centre (MIC), China’s produc- still small compared with the US, which has an arterial tion of information technology (IT) hardware almost network that stretches for 120,000 km. Nonetheless, any- doubled between 2000 and 2003, from US$25.5bn to one who travels frequently within China can attest that US$49.1bn. This allowed the country to overtake both Tai- the transport infrastructure has indeed improved dramati- wan and Japan to become the second-largest producer in cally. This has greatly raised the efficiency of distribution, the world, trailing only the US. particularly in the eastern part of the country, with jour-

14 © The Economist Intelligence Unit Coming of age Part 1 A new environment

An IT hub Production of computer-related products, US$ bn 100

0 2000 2001 2002 2003 Taiwan US Japan China South Korea

Source: Market Intelligence Centre neys between key cities in provinces such as Guangdong ping lines design routes including stop-offs in the coun- shrinking from tens of hours to several hours. try. China’s overseas air links have also been mushroom- It is not just the internal communications and trans- ing: the number of weekly international departures from port networks that have improved in leaps and bounds. Shanghai rose from 41 in 1985 to 554 in 2002, and from China’s connectivity with the rest of the world has also Beijing, from 44 to 405. improved. Just ten years ago, for example, making an overseas phone call from anywhere outside the largest Ongoing moves towards market orientation cities was a complicated procedure. Today, international The improvements in the soft infrastructure and policy direct dialling (IDD) is possible from almost anywhere in environment in the transport sector are part of the gov- the country. In terms of transport, heavy investments ernment’s ongoing effort to make the economy more have been made in the country’s port infrastructure, mak- market-oriented. Large state-owned enterprises (SOEs) ing it easier for companies to import and export goods have been downsized and partly privatised, and a stalled directly from their nearest port. In the past goods made in drive to sell off, close or otherwise restructure the thou- Guangdong, for example, were transported back to the sands of smaller state-owned firms has recently been port in neighbouring Hong Kong for export to the rest of relaunched. The government has aimed to end destruc- the world. However, although Hong Kong’s port remains tive over-competition in some sectors by closing or merg- the busiest in the world, handling an all-time high of over ing smaller firms, whereas in other industries it has tried 20m twenty-foot equivalent unit (TEU) containers in to promote efficiency by breaking up state-owned 2002, its monopoly on shipping in the region is fast disap- monopolies. The private sector has been given more pearing. Guangdong’s largest container port, Yantian, scope, even official encouragement, to grow. Since 1999 started operations only in 1994 but by 2005 it is expected the state constitution has been amended twice to to have the capacity to handle 6.5m TEUs. China’s civil avi- upgrade the status of the private sector. The ideological ation infrastructure has been similarly improved: since dislike of capitalists that was a shared principle of com- the late 1990s a new, modern terminal has been opened munist parties everywhere has in China dissolved to such in Beijing and flashy new airports have been constructed an extent that private-sector entrepreneurs have been in Shanghai and Guangzhou. allowed to seek CCP membership. The state still remains a significant player in the econ- Smoother soft infrastructure omy: in 2002 China still had over 160,000 SOEs, control- The upgrading of the physical transport network has been ling assets of Rmb18trn (US$2.2trn). The structure of the accompanied by improvements in China’s soft infrastruc- economy has nonetheless changed radically. By 2002 the ture. Customs regulations, for example, are being liber- share of state-owned and state-holding enterprises in alised, with the result that larger foreign firms are gaining gross industrial output value had shrunk to 41%, down the unprecedented freedom to consolidate cargo before from 50% in 1998; the share of wholly state-owned firms shipment. The international connectivity of China’s ports fell from over 30% in 1999 to almost 15% in 2002. The has been improving rapidly as more international ship- government has found it difficult to consolidate frag-

Foreign firms are important activities of foreign firms operating in the country, includ- % of total industrial output ing the liberalisation of rules that had previously prevented or restricted the operation of overseas firms in Domestic 70.7 sectors ranging from automotive to financial services. China has by and large kept to the letter of its opening commitments, if not always the spirit. In some of the more sensitive sectors, such as banking, regulators have begun to open up the market, allowing foreign institutions to begin lending local currency to local firms. But overseas banks are still subject to heavy branch capitalisation requirements (see Part 2, Financial and professional serv- Foreign-invested enterprises 29.3 ices) that curb operations and expansion. Nevertheless, China has largely abided by a formal Source: CEIC understanding of its WTO market opening pledges. The government was clearly attracted by the international mented industries but it has been quite successful in pro- kudos to be gained from entry to the WTO, but leading moting competition in previously regulated industries. officials also viewed accession to the trade body as a tool The rapid growth in the telecoms service market, for that could be used to drive through their programme of example, has been triggered in part by the entry of several sometimes painful domestic economic restructuring. It is new firms into the industry. The same is true of the insur- for this reason that the government was for the first time ance sector: whereas just eight years ago China had only since 1978 willing to commit itself to a timetable of one domestic insurance firm, there are now five local com- change, marking a distinct shift from the ad hoc and panies competing in both the life and non-life markets. experimental approach that had characterised the previous passage of reforms. WTO gives reforms a boost The process of reform and liberalisation began long before Foreign investment grows—and grows up China joined the World Trade Organisation (WTO) in 2001. The development of a larger, wealthier and more sophisti- Nevertheless, the country’s entry to the trade body was cated market, together with the emergence of a much- still important. It had a strong symbolic significance, par- improved and more accessible business environment, has ticularly for foreign executives living outside China who led to an associated broadening and upgrading of the saw accession as a signal of the country’s entry to the activities of foreign companies in the country. Annual for- mainstream of the international economic community. eign direct investment (FDI) inflows, for example, have China’s long and detailed WTO accession agreement also risen consistently since 2000, reaching US$52.5bn in 2003 promised tangible changes in the rules governing the according to the Ministry of Commerce. This increase is all

Big players Foreign direct investment in China % of GDP % of investment 20

0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: EIU CountryData

16 © The Economist Intelligence Unit

Coming of age Part 1 A new environment

Putting FDI in perspective

China is the world’s foreign direct invest- traditionally based their lending decisions firms in China have had to pay with equity, ment (FDI) powerhouse. But China has not on government instruction, rather than making this a far more expensive form of sought FDI because it is short of money. The market forces. As a result, banks have financing than ordinary bank loans. country has one of the highest household tended to make loans predominantly to The emerging private sector has not saving rates in the world, with the banks sit- state-owned enterprises (SOEs) and other been the only recipient of foreign ting on personal savings of Rmb10.4trn officially supported projects, with little or investment. During the 1980s and 1990s (US$1.3trn) at the end of 2003. As an econ- no concern as to whether the borrowers foreign firms also invested huge sums to set omist, Yasheng Huang, points out in his would be able to make repayments. up joint ventures with SOEs. Mr Huang study of the role of FDI, Selling China: “The In addition to causing a huge stock of argues that these ventures have been less need for FDI as a source of financing is defi- non-performing loans, this state bias has partnerships than acquisition vehicles, in nitely not present in China.” China, as well made it more difficult for China’s up and which “SOEs have turned over their existing as being the world’s largest FDI recipient, is coming private sector to win loans from the businesses and management controls to also one of the world’s largest exporters of banking sector. The World Bank’s private multinational companies and have become, capital, mainly through its investment in US capital arm, the International Finance in many instances, passive shareholders”— Treasury bonds. Corporation (IFC), in its 2000 report, this was, in other words, a “veritable With so much money sloshing around China’s Emerging Private Enterprises, found privatisation process”. inside China, why has the government been that even when “compared with their Even this process produced a less than so eager to attract FDI inflows? Of course, counterparts in other transition economies optimum aggregate result for the Chinese FDI projects often involve a transfer of Chinese firms appear to depend to a larger economy. SOEs in need of money had little valuable technology and management extent on internal sources of finance and choice but to seek deals with foreign firms expertise, in addition to an inflow of funds. have more limited access to bank loans”. In because ideological issues prevented the But in China, this is not the end of the story. this situation, China’s budding government from adopting an official According to Mr Huang, China’s huge FDI entrepreneurs have been forced to look privatisation policy—one that would have inflows can be interpreted as a signal of either to their own networks—friends and opened up the process to domestic policy failure rather than unadulterated relatives—or overseas for capital. Foreign investors. This reduced competition and, economic success. The US-based academic money, however, is not a perfect substitute. consequently, the sale prices of state- argues that state-owned banks have To gain the backing of foreign firms, private owned assets.

the more impressive when set in the context of global FDI have been joined by their IT-making counterparts. flows, which plummeted by almost 50% in 2001 and then According to the MIC, of the total global computer-related by a further 27% in 2002. In 2002 China overtook the US as production of Taiwan firms, the proportion manufactured the destination for more FDI than any other country in the in factories on the mainland rose from just 31.3% (worth world. China lost the top spot in 2003 when inflows into US$14.7bn) in 2000 to over 60% (totalling US$35.2bn) in the US rebounded by more than US$50bn but remained 2003. Multinational companies from other countries have the second-largest destination for FDI in the world. also been jumping on the China bandwagon by setting up The sources of FDI have diversified dramatically, too. light manufacturing facilities in the country, as have In 1992 Hong Kong, Macau and Taiwan between them smaller foreign firms. Indeed, there is currently a trend of accounted for nearly 80% of all FDI. This share has almost small and medium-sized enterprises (SMEs) from the OECD halved since then, with the proportions of US and EU with no experience of any market outside of their home investment more than doubling to around 22% of the economy seeking to set up shop in China. In many cases total, Japan’s rising a little to around 7-9%, and South these SMEs seek to lower production costs to compete Korea and Singapore now both accounting for around 5% with the wave of cheap, China-made products that are each. appearing in markets in the US and Europe. It is not just the quantity and diversity of FDI that have Capital-intensive firms with huge investment plans increased; manufacturing investments in China have also have also begun to arrive in China. Five years ago, in the steadily moved up the value chain. The toy and garment wake of Asia’s economic crisis and less than a decade after makers from Hong Kong and then Taiwan that were the the 1989 Tiananmen crisis, long-term planning had a pro- pioneers of foreign investment in the 1980s and 1990s visional feel to it. Today, companies are not shying away

18 © The Economist Intelligence Unit Coming of age Part 1 A new environment

Timken’s export niche

How many times does a business need to DaimlerChrysler), to sell it hub units. This market is both attractive in its own change its strategy to get things right in But this also didn’t work. After the Asian right and has long-term potential for after- China? Probably quite a few. Many compa- financial crisis of 1997-98, automotive sales service—especially given China’s tough nies have found their initial assumptions demand in China slowed and volume operating conditions. Just how much were simply wrong, and even if they weren’t, remained too low for Timken to be profitable demand has grown—and how fast—is spelled the market has changed so much and so fast in China. out in the rise in the number of people in that rethinks may well be called for every So once again the company changed Timken’s Shanghai office: from three at the couple of years. strategy, in its third phase going for a “local end of 2002 to 40 by the end of 2003 after it Take the US bearing maker, Timken, for for export” strategy—making goods for opened its own distribution centre in example. Like many companies, it came to China for sales overseas. Shanghai’s Waigaoqiao Free-Trade Zone. China aiming to sell into the local market. It Finally, the company found the right The way Timken’s strategy has evolved began by setting up a joint venture at Yantai, strategy: 70% of its output is now exported, has some advantages. Its operations in on the Shandong peninsula, in 1996 to largely to Europe. And it has set itself a China are insulated from any slowdown in manufacture automotive bearings. 100% export target for its newest plant, a the economy, although its sales to China This didn’t work. The company found joint venture with a Japanese bearing from abroad would be affected. However, large state-owned enterprises difficult to maker, NSK, in Suzhou, which is due to go the company is hurt by the changes in work with. Not only were they not willing to into operation this year. China’s tax rebate rules—lowering its rebate pay for anything which looked like a service, on value-added tax paid on exports from but often they were not willing to pay for Demand now in China, too 17% to 14%—meaning that China will be anything at all. At the same time, however, demand for one of the few countries which taxes This created enormous problems for Timken products in China has grown enor- exports. (It is worth noting that Timken’s Timken, so it switched its initial “local for mously—particularly because of the massive payments, at least for a while, will at least be local” strategy—local production for the rise in capital investment and infrastructure notional: the company is owed US$5m in local market—to “local for transplant”— spending funded by the government over back rebates.) meaning it followed its global customers and the last five years. But most significantly, to get to where it would sell to them if they were in China. This demand is satisfied with imports is now Timken has had to change its thinking This seemed to hold better prospects, from Timken plants elsewhere—for high-cost and strategy three times in just eight years— especially when it teamed up to sell to items made in the US, or in machinery and fair going for a company that has the Beijing Jeep, a joint venture between equipment made elsewhere but which have reputation of being traditional in its Beijing Automotive and Chrysler (since 1998 Timken bearings inside. outlook.

from projects with long time horizons, requiring large have been instrumental in the upgrading of China’s ports. capital investments. BP, Shell, BASF and ExxonMobil, for Service-sector firms that were previously kept out by example, are all involved in large multibillion-dollar government restrictions and lack of a market are also petrochemical projects in China. Between 2001 and 2005 beginning to make their mark. In the last couple of years BASF plans to invest Euro2bn alone and Euro4bn together foreign asset management firms have begun for the first with joint-venture partners. Since 2001 almost all of the time to sell investment funds in China, and international world’s major vehicle manufacturers have announced accountancy firms have been seeking to strengthen their plans to either start plants in China or extend existing presence in cities, including Shanghai. International ones. The investment plans of just three firms, the current banks like HSBC, Citigroup and Standard Chartered are market leader, Volkswagen (VW), together with two still heavily restricted but have established small retail Japanese companies, Nissan and Toyota, total more than networks in China, as have less well-known foreign play- US$10bn. Huge spending by foreign firms has also played ers like Hong Kong’s Bank of East Asia. Retailing giants an important role in the improvements in China’s trans- like Carrefour and Walmart are rolling out nationwide port network that have been achieved in recent years. The store networks, and the British homewares chainstore, German firm, Siemens, hoping to roll out the technology B&Q, which only established its first store in China in on longer routes around the country, built the US$1.2bn 1999, plans to have 75 outlets across the country by 2008. maglev train link in Shanghai, and foreign operators like As with so many firms, B&Q began its China operations in Hong Kong’s Hutchison Port Holdings and the UK’s P&O Shanghai. But it quickly chose to move into the interior,

The foreigners take control FDI by type, US$ bn Equity JVs Contractual JVs Wholly foreign-owned enterprise 50 45 40 35 30 25 20 15 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: OECD; MOFCOM

opening a store in the south-western city of Kunming in ship exceeds 25%) rose from an already high 41% in 1997 2001 and the central city of Wuhan in 2003. It is not only to almost 55% in 2003. It is little exaggeration to say that the retailers that are expanding away from the relatively China’s rise up the table of the world’s largest exporters tried and tested southern and eastern areas of the country has been fuelled by foreign money: FIEs accounted for to investigate opportunities in the centre and west. The almost 66% of the US$256bn absolute increase in the US insurance firm, Liberty Mutual, decided to establish its value of China’s exports recorded in this period. China general-insurance venture in Chongqing, a huge Admittedly, it is in the export sector that foreign firms municipality in the west of the country. have had the clearest impact, but foreign firms have also been establishing themselves in the domestic economy. Growing influence of foreign firms Even excluding enterprises supported by money from Hong This picture of an economy in which foreign firms are Kong, Macau and Taiwan, FIEs still generated 17% of establishing an ever-larger foothold—and having greater China’s total industrial output in 2002. If firms from else- influence on the local economy—is supported by both where in Greater China are defined as foreign, the propor- macroeconomic and sectoral statistics. The proportion of tion of output generated by FIEs rises to almost one-third. China’s exports manufactured by foreign-invested enter- A large amount of this production is exported but nearly prises (FIEs, traditionally any firm where foreign owner- 60% is not, instead being sold in China’s domestic market.

Big for MNCs, and big in China Sales in China 50

20 % global sales % relevant market 10

0 Volkswagen Danone Nokia Coca-cola Procter & Gamble HSBC Novartis (VW) (P&G)

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

20 © The Economist Intelligence Unit Coming of age Part 1 A new environment

Roughly what proportion of your company‘s global revenue is generated in What do you expect the proportion to be in five years‘ time? China? (% responses) (% responses)

1-5% 51.5 6-10% 15.7 1-5% 30.5 6-10% 24.0

11-30% 13.7

11-30% 28.5 Less than 1% 11.3 More than 31% 13.5 More than 31% 7.8 Less than 1% 3.5

Source: Economist Intelligence Unit survey, March/April 2004

Foreign companies have a growing influence on the tors tend to put on a brave face, claiming that their busi- direction of the Chinese economy. Many firms have a big- ness partnerships are sound and their choice of JV partner ger say in the running of their own companies as well, correct. Managers of manufacturing firms are more san- owing to the growing prominence of wholly owned, for- guine and with good reason: not only do they have more eign-invested operations. In the 1990s the joint venture experience dealing with JVs, many of them no longer (JV) was the principal vehicle by which foreign companies need to deal with this bothersome regulation at all. The entered China. In the early to mid-1990s JVs accounted for liberalisation and opening of the economy over the last around 75% of all foreign investment. These arrangements few years has allowed many foreign firms more latitude to allowed multinational companies (MNCs) to establish joint establish wholly owned enterprises in China. Many over- ventures with local firms, giving them the opportunity to seas firms have jumped at this chance, buying out part- access China’s market. But, more often than not, the joint- ners in existing JVs or making new investments on a venture structure denied foreign firms management con- wholly owned basis. trol over their domestic investments. Horror stories abounded and the caricature of Sino-foreign co-operation No longer bound to disappoint became that of famed MNCs watching almost powerless as The experience of foreign businesses in China is no longer the joint venture piled up losses, while the local partner characterised exclusively by failure. One respondent to stole expertise and intellectual property. our survey stated that there is “a much stronger percep- By the early 2000s, however, JVs had been pushed tion of both strategic importance and the possibility to aside by wholly owned operations, which now account for succeed” in China. Over 43% of respondents to our survey more than half of the foreign investment entering each reported that their China operations were either outper- year. The reasons for this change are various but they can forming or outperforming by a wide margin. Also, leading be summarised as a much more relaxed attitude on the MNCs are now well represented in some of China’s fastest- part of China’s authorities to allowing foreign companies growing sectors. According to Beijing-based Norson Tele- to operate in their country, combined with the desire of com Consulting, in 2003 sales by foreign firms accounted almost every locality to attract as much foreign invest- for 56% of all mobile handsets sold in China. Through JVs ment as possible. While the government has made no with domestic firms, foreign brands also dominate China’s secret that it wants to see Chinese companies emerge as car market, with VW alone taking a market share of the eventual winners from the country’s market opening, 30.8%. In the fragmented pharmaceutical market, for- it has also consistently maintained that foreign compa- eign companies are thought to have a market share of 20- nies have a major role in this process. Foreign companies 30%. In the similarly fractured retail market, Ministry of bring capabilities, skills, technologies and expertise Commerce figures show that Carrefour has become the which domestic companies lack and, through competi- fifth-largest player in China. The photographic film indus- tion, can compel Chinese companies to improve and try is more consolidated and is dominated by the US’s strengthen themselves. Eastman Kodak. For many of the recently opened service sectors, such China has also become an important market for some as retailing and parts of the financial services sector, for- leading MNCs. One executive who responded to our survey eign firms are still restricted to investing in China only indicated that “China has grown into one of our most through JVs. Overseas executives operating in these sec- important markets in terms of turnover and sales…China

is now and will remain the main growth market for the less than 1% of the total sales of Novartis and the total near/medium-term future.” These comments were echoed consumer lending of HSBC. This sectoral diversity is by other respondents and are reflected in individual com- reflected in the results of our survey. For 26% of respon- pany results. In 2003, for example, 13.9% of VW’s world- dents, the figures was 1% or less; for 62% of respondents, wide sales were achieved in China, more sales than in any it was 5% or less; and for 78%, it was 10% or less. How- other market except Germany. China in 2003 was Nokia’s ever, for a respectable 15%, the answer was 20% or more. fourth-largest market (trailing the US, UK and Germany), If the companies that earn a high proportion of their rev- generating revenue of Euro2bn, equivalent to almost 7% enue from China are stripped out—on the assumption that of the company’s worldwide sales. China is Motorola’s these companies are essentially “China” companies rather largest market outside of the US, generating sales for the than global ones—nearly one-quarter of respondents company in 2003 of US$4.7bn. In 2003 Siemens made indicated that they derived between 10% and 35% of their sales totalling Euro2.8bn in China, accounting for around global revenue from China. 4% of total global sales. In the same year China generated What is noteworthy, however, is how the respondents sales for the French food group Danone of over Euro1bn, see their revenue changing over the next five years. The equivalent to 8% of the global total. number of respondents seeing China accounting for 5% or There are big sectoral differences in the importance of less of their global revenue drops from 62% to 35%, China as a global market for foreign firms. The China busi- whereas 35% see it accounting for 10-25% and 31% for ness of the world’s leading pharmaceuticals companies more than 20%—double the number today. If current and financial- and professional services firms remains very expectations are borne out, the sectoral disparities that small on a relative basis. For example, China accounts for are currently so evident will not be as obvious in a few

The question of profitability

It is accepted wisdom that the China accounts This aspect of foreign firms’ businesses European customer pays directly to the of almost all foreign firms drip with red ink. in China is often overlooked because it is parent company in the US. In this way, the Executives in multinational companies difficult to record. The financial gains US firm keeps most money offshore. So (MNCs), dazzled by the prospect of selling to generated by cheap sourcing in China are although official records may show the one billion consumers, have failed to notice impossible to document because they show China factory is making a profit on the deal that few of these people actually earn much up not as an item in their own right but of US$10,000, in reality it has generated net money, that selling even to this group is rather in the profits MNCs make in their earnings of ten times that amount. made difficult by the country’s poor infra- traditional markets in the US and Europe. The money multinational companies structure and that any resultant profits would Similarly, that the export operations of make from using China as a sourcing and be siphoned off by corrupt local officials. His- foreign firms often show little or no profit is exporting base might be difficult to trace torically, this perception has not been far less a reflection of reality than of transfer but it is far from negligible. Wal-Mart buys from the truth. It is not difficult to uncover a pricing as foreign firms attempt to avoid more than US$12bn-worth of goods in China number of horror stories detailing the misad- capital controls and taxes in China. every year, Motorola’s sourcing in the ventures of foreign firms that have overesti- It works like this. Imagine that a parent country totalled US$2.8bn in 2003 and GE mated the size of the domestic market and company in the US receives an order from a plans to raise sourcing in China to US$5bn understated the difficulties of accessing it— European customer for 1,000 notebook by 2005. Moreover, more than 50% of and ended up losing lots of money. computers at, say, US$700 each. Assume China’s total exports, equivalent to But China has not been nearly the also that the computers cost US$600 a unit. US$240bn in 2003, are produced in foreign- unmitigated disaster for foreign firms that Typically, the parent company would invested factories. these stories suggest. Many big Western subcontract its factory in China to produce The focus of this report is how companies have found the going tough but this order and pays it US$610 for each unit multinational firms are approaching China’s the China operations of lots of companies (foreign firms know that a factory operating domestic market. But it is important to from Taiwan and Hong Kong have been at a loss would be suspicious and so attract remember that when trying to assess their hugely profitable. Although many MNCs have the unwanted attention of officials). This is overall performance China, it makes less lost money trying to sell to the domestic the value of the export from China, although sense to ask how much money foreign firms market, they have made a great deal by a change of invoice en route means it enters have made in the country than how much using China as a sourcing and export base. the US at US$700, which is the price the they have made from it.

22 © The Economist Intelligence Unit Coming of age Part 1 A new environment

How many times has the global CEO of your company visited years time. For example, managers at one of the world’s China in the last 12 months? leading asset management specialists, Franklin Temple- (% responses) ton, believe that, based on current growth rates, China No visits 21.8 could become one of their most important international More than 5 markets in five years time, and KPMG thinks its Shanghai visits 6.5 office will be one of its biggest in the world within ten 3-5 visits years. 8.8 Importantly, some firms are also now beginning to earn money from their domestic market operations. The degree of success depends to a great extent on the sector. Profitability is most apparent in the industrial sectors that were first opened to foreign investors and that have been 1-2 visits further liberalised over time. In the service sector, by con- 63.0 trast, foreign firms are only just gaining the opportunity to access the market and even then only on a very restricted basis. Nevertheless, in a survey of their members, the American Chambers of Commerce in Beijing and Shanghai found 75% declaring themselves to be either Where does your China CEO fit within your global decision- profitable or very profitable in 2002. VW’s Chinese joint making structure? (% responses) ventures generated net earnings of Euro561m in 2003 compared with total group operating profit of Euro1,780m. At the level As head of the Detailed profit breakdowns of this kind are difficult to of the global China business, board 13.6 reporting into come by but other evidence at least suggests that, for for- the regional eign firms, China’s domestic market is no longer synony- headquarters mous with losses. As explained by an executive in a 34.7 construction firm that responded to our survey, China is As head of the moving “from an emerging market to an important profit Asia-Pacific centre”. Another company stated that the “perception of regional business, Other 9.9 China has changed from a drag on the bottom line to a reporting into major contributor”. Moreover, a recurring theme among the global board As head of the China many respondents was that, having been given time to 16.0 business, reporting establish themselves, China operations were now into the global board 25.8 expected to move towards profitability or, where they were already profitable, to increase their margins. Typical was the comment: “Changing from top line growth to more focus on profitable growth.” From the perspective of your global headquarters, China is... (% responses) Given all the changes that have taken place in the Chi- nese market, it would be surprising if foreign firms had ...critical to not begun to look at China in a different light. More than global strategy ...strategically 50% of respondents to our survey stated that China was 52.5 important, “critical to global strategy”, with another two-fifths of but not critical companies reporting that it was “strategically important”. 40.6 Only 6% of firms thought of China as “a location on a par with other emerging markets”. “The importance of the ...a location China market has been recognised by every key decision- your company ...a location on maker in headquarters, and operation has been re-engi- is still only a par with other exploring emerging neered to accommodate this mindset change,” explained 1.4 markets one respondent. 5.5 In a reflection of the importance attached to their China businesses, big firms have been upgrading management structures in the country. Companies that were pre- Source: Economist Intelligence Unit survey, March/April 2004 viously represented in China by managers of individual

joint ventures have been appointing more senior country dent to our survey explained, “Five years ago, China was heads. In 2000 HSBC relocated its mainland China head- an interesting market possibility. Now it is central to our quarters from Hong Kong to Shanghai. Other large firms success.” have moved regional headquarters to China. Of companies This is partly all a function merely of volume. With lead- that took part in our survey, only around 35% stated that ing companies now spending significant sums sourcing their China management was subordinate to regional goods in China, managing factories that account for large headquarters. The remainder said that their China CEO had proportions of global corporate output and beginning to access to the global board, either through membership or sell more to the domestic market, the country matters in a a direct reporting line. way that just was not the case ten or even five years ago. It Managers of China businesses often find that they have is now of global importance that multinationals get their the ear of senior global executives even more than would China strategies right. be suggested by formal reporting lines—and sometimes At the same time, succeeding in China is no longer more than they would want—simply because many CEOs mainly a case of addressing the operational issues that pre- cannot stay away from China. Almost fourth-fifths of com- occupied multinationals in the 1980s and 1990s—an over- panies that responded to our survey said that their global burdened infrastructure, excessive regulation, shortages of CEO had journeyed to China at least once during the last human capital and intellectual property rights. None of year, with over 15% of firms saying the top boss had vis- these issues have disappeared and indeed form the focus of ited more than three times. Admittedly, our sample does the third chapter of this report. But neither are they the all- include some foreign firms that look more like China busi- consuming problems that they once were. The business nesses than multinationals, but anecdotal evidence con- environment in China has improved. In any case, the bigger firms that the heads of even some of the largest multinationals, now with several years of experience operat- companies in the world find their way to Beijing or Shang- ing in the country, have a good on-the-ground understand- hai from time to time. Despite having been chief executive ing of just how to run operations in China. of Citigroup for only seven months, for example, Charles But merely producing a good and shipping it to market Prince has already visited China three times. is no longer enough for foreign firms wishing to be successful in China. This is because it is not just in terms of A new environment raw spending power that China has begun to resemble a To sceptics, all the enthusiasm over the Chinese market real market in recent years. It is also in the emergence of has worrying echoes of the naivety that fuelled the first competition. Other MNCs, SMEs from the OECD, large com- flood of foreign investment to China in the 1980s and panies from other Asian countries and ambitious local 1990s. Such concerns are not without justification and, as firms all see their future in China’s domestic market. It is we will argue, ensuring expectations remain rooted in no exaggeration to say that China is turning into the most reality is one of the most important challenges facing competitive market in the world. For MNCs wishing to sell multinational companies in China. Nonetheless, for many within China, it is this competitive element that poses leading foreign firms it would be reckless not to devote their biggest challenge. In the next chapter we turn to the more senior management time to China. As one respon- advent of competition.

24 © The Economist Intelligence Unit

Coming of age Part 1 Addressing the market

Part 1 Addressing the market

he very visible growth of demand within China in fight dirty, often stressing investment and market share the last few years has made building a domestic rather than productivity and profit, and using below-cost business not only feasible but also essential for any pricing to achieve their aims. performance-oriented multinational company Fortunately, accompanying the rise of demand and (MNC).T These days, a truly global company would no more competition has been the emergence of strategic options ignore China than it would the UK or France. for foreign firms wishing to fight back. An increasingly Just as demand has emerged, however, so has compe- sophisticated business environment is giving MNCs the tition. The MNCs that first tested the waters of the domes- opportunity to use sophisticated brand-building and mar- tic market in the 1980s and 1990s faced many challenges, keting strategies. Infrastructure improvements have made but a crowded market was generally not one of them. But it possible for foreign firms to move production to the as China moves from being a peripheral to a mainstream cheaper, inland areas of China and thus begin to emulate economy, other foreign firms are joining their pioneering the cost structures of their local counterparts. Finally, and counterparts. MNCs must also now contend with the rise perhaps most critically, the emergence of a local market of local competitors, which have emerged quickly and for mergers and acquisitions (M&A) is allowing big foreign

● Foreign firms in China now face strategic challenges. Compe- ● Multinational companies are now also more able to engage in tition, which in many markets was almost non-existent in the comprehensive localisation and thus bring their costs more 1980s and 1990s, is becoming intense. Big multinational into line with those of domestic firms. Borrowing from companies, smaller firms from Europe and the US, ambitious domestic banks, moving production facilities inland, sourc- companies from the rest of the Asia region and domestic ing inputs from within China and expanding local product players all want a slice of the market. development are all strategies that are being employed to narrow the cost gap. ● The challenge from up and coming domestic companies is the most intense. Competing against these firms is difficult ● Regulatory changes are giving multinationals that entered because they have the advantage of operating on their home China in the 1980s and 1990s the opportunity to consolidate turf and often seem to fight dirty, stressing investment and control of their Chinese ventures. Foreign firms are also market share rather than productivity and profit, and using starting to use mergers and acquisitions in the same way below-cost pricing to achieve their aims. that they do elsewhere, to accelerate growth or buy out competition. ● The development of China’s market has not just generated competition. It has also opened up new ways in which multi- ● Multinational firms do not always manage to bring their nationals can respond to this challenge. Foreign firms are strategic planning strengths to bear in the Chinese market. having more opportunity to bring their sophisticated brand- In particular, while the foreign business community in gen- building capabilities and marketing techniques to play in the eral is becoming less naïve, many companies still seem to China market. This is true even for firms in regulated sectors take leave of their critical faculties when judging the size of like pharmaceuticals. China’s market.

26 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

firms to buy up local competitors. network. Many foreign companies quickly took advantage Not all foreign firms are in a position to exercise these of this rather unnatural market, in which competition was options fully. Ownership restrictions, for example, limit virtually absent. M&A in the automotive and financial services industries and foreign pharmaceutical firms continue to be heavily The current challenge regulated. Nevertheless, for a whole range of multination- How quickly things have changed. Competition in most als in China, the focus of management attention has sectors is now intense. In recent years multinationals that moved. The operational problems that were such a pre- either left or did not try to enter the market in the 1980s occupation in the 1980s and 1990s (see the following and 1990s have joined their now well-established compa- chapter, Persistent headaches) are no longer the only triots. Less well-known regional firms have also piled in. issues taxing the time of executives. Instead, managers For these firms, which come from small home economies are spending more time thinking about the kind of strate- and have found it difficult to penetrate the rich but gic planning and development issues that tend to pre- mature markets of the OECD, China’s large market repre- occupy their counterparts in more developed markets. sents a unique opportunity to establish a brand. Apparel retailers from Hong Kong like Espirit, Baleno, Bossini, Changing competitive landscape Giordano, Jean West and Moiselle are common features of It was the experiences of big multinationals trying to tap shopping districts from Beijing to Chongqing. Taiwan the local market in the 1980s and 1990s that fuelled the companies like Giant (bicycles) and Tony Wear (a men’s widely held perception that foreign firms in China are clothing brand established by Tainan Enterprises) are now prone to losing money. Suffocated by regulations, frus- leading players in China. trated by the weaknesses of the transport network and China’s domestic firms have also moved quickly into disappointed by an apparent lack of spending power, the home market. Initially shell-shocked by the arrival of many of these companies quickly changed tactics, either foreign competition, local companies now seem to be rel- withdrawing from China altogether or refocusing local ishing the fight. The survey conducted for this report production for export. found that nearly two-thirds of respondents identified Not all companies were forced out. But even those that domestic competition as either significant or very signifi- persevered found that basic operational issues, rather cant. According to IFF, the number of shampoo offerings than strong competition, posed the biggest challenge to in China’s domestic market has increased exponentially their business. In many consumer-goods sectors there from the five found in 1984 to over 2,000 in 2003. During was no competition of any kind. Before the early 1980s, the same period the number of toothpastes rose from 100 for example, shampoo did not exist in China; regular soap to almost 800. Twenty years ago China had no fruit juice was used to clean hair. According to International Flavors suppliers, but now there are over 160. & Fragrances (IFF), as late as 1984 there were just five The emergence of this new challenge is partly the shampoo offerings in China’s market. In other sectors, result of government policy. Chinese officials have estab- such as insurance, domestic suppliers did exist but only in lished real companies in markets like insurance which pre- the form of monolithic state-owned enterprises (SOEs), viously operated like extensions of the government institutions that were about as far removed from being bureaucracy. Existing SOEs have been partly or even fully consumer-oriented and profit-seeking firms as it is possi- privatised and, consequently, have begun to judge suc- ble to imagine. cess using financial rather than social criteria. Finally, in In this environment, foreign firms achieved high mar- recent years, China’s official ideology has become increas- ket shares. Leveraging their production technology and ingly less hostile towards the private sector. Private firms marketing skills, foreign firms quickly dominated any mar- still face discrimination when, for example, they seek to ket in which they were given relative freedom to operate. borrow from China’s largely state-owned banking sector. In the 1980s and 1990s MNCs like Procter & Gamble and But a burgeoning capitalist sector has nonetheless begun Unilever virtually controlled China’s detergent and sham- to emerge: government statistics show that the number of poo markets. In the mid-1990s three foreign-invested private firms with annual sales over Rmb5m (US$600,000) joint ventures (JVs), two involving Volkswagen (VW) and rose from under 15,000 in 1999 to almost 50,000 in 2002. one Daihatsu/Toyota, controlled more than two-thirds of The market for foreign firms in China is increasingly China’s car market. The take-off of the mobile-handset challenging. According to Euromonitor, a global market market in the second half of the 1990s was dominated by research company, the domestic Diao brand now domi- foreign firms like Motorola and Nokia. In the mid-1990s nates China’s detergent market with a share of almost Alcatel’s Shanghai Bell joint venture was making more 25%. Unilever’s Ono brand now stands in third place, with than half of the switches for China’s fixed-line telephone a share of just 10%. The reversal of fortunes for foreign

China’s multinationals

The threat posed to multinational compa- other firms has been led by several factors. counterparts as much of a global threat. But nies (MNCs) by Chinese firms no longer ends Not surprisingly for China, government this is beginning to change. Some 16% of at China’s borders because, in recent years, policy has been one, with officials companies that responded to our survey larger Chinese firms have increasingly been encouraging overseas investment both to said they expected Chinese companies to expanding overseas. China’s most promi- secure oil and other resource supplies and, pose a major threat to their international nent multinational has been the conglomer- more recently, to offset the strong capital business in five years, with a further 50.5% ate Haier. In addition to having offices and inflows that have been generating pressure expecting them to pose something of a factories in more than 100 countries, Haier for a revaluation of the exchange rate. threat. MNCs are already beginning to lose claims a sizeable market share in the US for out to Chinese companies in other emerging Going international small fridges (30%) and wine coolers markets. For example, in recent years The overseas expansions of firms like TCL (50%), not to mention a 10% share in Huawei and ZTE have both beaten out and Huawei are also being motivated by the Europe’s airconditioner market. leading European and US equipment same factors that drive the international More recently, Haier has been joined by suppliers to establish a foothold in the strategies of companies everywhere: TCL, another final-goods producer, this Indian market (in an example of the extent crowded markets at home and raw business time of telephones and electronics of the competitive challenge posed by ambition. According to the head of Haier, appliances. TCL’s strategy has been to Chinese firms, one of ZTE’s recent winning Zhang Ruimin, after entry to the World Trade expand by acquisition. In 2002 it purchased bids in India came in at half the price Organisation (WTO), “every multinational the assets of a bankrupt German television offered by Motorola and one-fifth that of set up in China. Margins are low here. If we producer, Schneider Electronics. This was Ericsson). But just as in China itself local don’t go outside, we cannot survive.” followed in late 2003 by an agreement with firms quickly migrated from the low end of Expanding by acquiring the assets of a French firm, Thomson, to establish a joint the market to the middle and high end, so OECD companies, the approach followed by venture to produce televisions and DVD the likes of Huawei and ZTE are beginning to both TCL and Bluestar, demonstrates players. In April 2004 TCL teamed up with challenge European and US firms on their increasing confidence on the part of Chinese yet another European firm, this time home soil. In April 2004 Huawei won a firms. But it is a strategy that is still France’s Alcatel, to form a joint venture to contract to supply equipment to Banverket relatively uncommon. Indeed, the approach manufacture mobile-phone handsets. TCL’s Telenät, a network service supplier in used by many local companies to move international deals in particular have been Sweden. offshore is not dissimilar to that used to quite high-profile. Nevertheless, the global expand within China itself. Just as many Attracting less attention from general competitiveness of Chinese firms should not indigenous firms started out at home by observers has been the overseas expansion be exaggerated. Sectors like telecoms and targeting the less-demanding lower-end of of China’s business-to-business firms. oil where the domestic market is large and the domestic market, so companies Leading the charge has been China’s leading consolidated enough to support the growth expanding overseas have tended to begin in makers of telecommunications equipment, of powerful local conglomerates remain few other developing countries where price is Zhongxing Telecom (ZTE) and Huawei and far between. Even China’s biggest often the single most critical element in any Technologies. Huawei claims its companies tend to trail their foreign purchasing decision. It is no coincidence international revenue rose by 90% in 2003 counterparts in terms of technology that of the ten existing markets highlighted to just over US$1bn. In 2003 a local processes and management. Finally, with by ZTE on its corporate publications, four are conglomerate, China National Bluestar, standards of corporate transparency in in Africa, with a fifth located in Bangladesh. launched a bid (ultimately unsuccessful) to China being generally poor, it is difficult to According to our survey, foreign buy Ssangyong Motors of South Korea. assess how successful the international companies do not yet see their Chinese China’s biggest overseas investors in recent operations of local firms are, and how much years have been the country’s leading this is the result of good management and energy firms, China Petrochemical Corp How much of a threat will domestic companies high levels of corporate efficiency rather (Sinopec), Petrochina (the listed arm of be to your business globally in five years’ time? than the support of the government and China National Petroleum Corp, or CNPC) (% responses) banks at home. Perhaps paradoxically, the and China National Offshore Oil Corporation A serious competitive threat 15.9 true competitiveness of China’s budding (CNOOC). The three companies have Somewhat of a competitive threat 50.5 multinationals will only become clear when invested in 14 countries, including Not a threat 33.2 growth in their home market begins to slow Kazakhstan, Yemen, Sudan and Myanmar. Other 0.5 and the country’s banks apply more The international expansion of these and Source: Economist Intelligence Unit survey, March/April 2004 stringent lending criteria.

28 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

firms in other markets has been just as dramatic. In 2003 inadequate. The overall result? According to business con- the 30 firms that offered more than 700 different kinds of sultants, for many domestic companies in China the cost of mobile phones in China were mainly domestic. According capital is low if not wholly non-existent. to Beijing-based Norson Telecom Consultancy, domestic Local knowledge, access to cheap bank capital that has firms now control around 45% of the market and have allowed the ramping up of capacity, together with a no- pushed the market share of European and North American frills approach to service, give local firms operating costs vendors to below 50%. In the consumer-durables market, that are almost universally lower than those of foreign Haier, a company that started off making refrigerators but companies in China. Worse still, local firms seem willing to has recently entered the mobile-phone market, claims to accept profit margins that are well below those generally have a 30% share in the domestic market for refrigerators, demanded by their overseas counterparts. In general, freezers, airconditioners and washing machines. The abil- success for domestic companies appears not to be meas- ity of local firms to win market share has been so pervasive ured by profit margins at all but by market share. As a that some observers consider it only a matter of time result, local firms are able and willing to price goods at a before foreign domination of the automotive sector is very low level. Of the foreign companies that responded to brought to an end. our survey, almost two-thirds identified lower prices as the main competitive strength of domestic companies. More than a typical home advantage Foreign executives are often full of praise—tinged with a Meeting, and being beaten, in the middle dose of fear—for the entrepreneurial spirit of China’s com- The initial strategy followed by most foreign multination- panies. The rise of the country’s capitalist class is often als was to focus on the middle and top end of the market, portrayed as a natural phenomenon, with regulatory lib- selling high-quality goods at Western-style prices—a eralisation freeing up a cultural propensity to trade that strategy motivated more by a desire to target the richer was so visibly on display in China a century ago, but was consumer than an eagerness to avoid local competition. then stifled by 50 years of communist-style central plan- Up and coming domestic companies, by contrast, started ning. There may be an element of truth to this theory but by developing cheaper goods for low-end segments. Thus, the competitiveness of local firms also owes much to fac- according to Christopher Nailer of Australian National tors that are more easily quantified. University, in 1999 the cheapest microwave sold in China As is the case with indigenous companies everywhere by Japan’s Matsushita cost US$70, way above the US$36 in the world, local firms have a home-turf advantage. They price tag for the cheapest model sold by the largest local know how to do business in China and are much more producer, Guangdong Galanz Enterprise. Procter & Gam- comfortable than foreign firms navigating through the ble priced its Pantene shampoo at 60-70% above the level corruption and regulatory grey areas that remain such an charged by its local peers. Similar examples in other important feature of the country’s business environment. industries, ranging from glue to stock flavouring, abound. Local companies also do not have to support the salaries Since then, however, international companies have of expensive expatriates and are generally in a stronger been looking to broaden their appeal, to establish mass position to know how and where to find talented staff and and thus economies of scale. At the same time, having suppliers. grown in confidence and improved the quality of their Local firms, at least those that are more prominent, also goods, domestic companies have started to push their benefit from easy access to bank capital. That banks are products into the middle and even upper segments. This willing to be more supportive of companies they know well has been a painful development for multinationals. They is hardly a phenomenon unique to China, although the have been losing market share almost overnight to firms underlying importance of guanxi—cultivating personal that have seemingly appeared from nowhere. Even worse, relationships—in the business environment probably profitability has shifted. By selling upwards, domestic makes the relationship element of banking stronger in firms have been able to raise their average selling prices China than elsewhere. Still, guanxi alone does not explain and, consequently, profit margins. Foreign firms, mean- the easier access to, or lower cost of, capital offered to local while, have been forced to move in the other direction, firms. The banking system does not yet function on a fully cutting prices in an attempt to hang onto market share commercial basis. Wanting to raise local economic growth but losing profitability as a result. and thus their own chances of promotion, lower-level officials often pressure banks to lend to local firms. More gen- The international advantage erally, despite the aggressive bank reforms pursued by the When asked about their competitive strengths vis-à-vis central government in recent years, the enforcement of risk domestic companies, most overseas firms tend to empha- management procedures in the banking sector remains sise the characteristics that have made them successful in

Doing it like Danone

The French food group, Danone, first Danone has certainly benefited from duction fell from 4 US cents/litre in 1997 entered the China market in the 1980s rapidly rising demand in China. But the to 2.2 US cents/litre in 2001. through a partnership with a regional dairy company has also made use of the strategic in the southern city of Guangzhou. This options presented by the development of Mergers and acquisitions small venture came to nothing. The com- China’s economy. ● New brands: In the early 1990s Danone’s pany found that “supplies of fresh milk and water brand in China was Evian. But in packaging were lacking, as was refrigeration The international perspective 1996 it purchased 41% of Hangzhou- for reliable production, transport and stor- ● Market segmentation: In the late 1990s based Wahaha, China’s largest domestic age. Most important of all, consumers were Danone focused its attention on 30 brand of bottled water (Danone now simply not accustomed to drinking milk, let cities, accounting for 15% of China’s owns 47.7% of Wahaha but controls alone eating yoghurt.” This didn’t look like population and 30% of its wealth. 51%). In 1998 Danone purchased 60% of an auspicious start. ● Product development: Launching another water producer, Shenzhen In the 1990s, however, the company localised products, such as soda crackers Health Drinks, and in 2000 93% of tried again. Through the 1991 purchase of (sold as helping to make up the lack of Robust, China’s second-largest bottled Amoy, the Hong Kong food-products calcium in local diets) and Maidong, a water brand. company, Danone gained some exposure to vitamin-enriched energy drink that came ● New markets: In 2000 Danone also the market for Chinese food. The following onto the market in April 2003 and sold signed an agreement to buy 50% of year Danone made its first real foray into the 100m litres in eight months. Wahaha, Aquarius, China’s leading company for mainland market, establishing the Shanghai Danone’s leading water brand, has been home and office deliveries of water (the Danone Biscuits Foods joint venture. branching into the tea-drinks and fruit- HOD market). Aquarius operates in the Another joint venture, the Shanghai Danone juice segments. Shanghai area but Danone’s other ven- Yogurt joint venture, was formed in 1994. In tures—Robust and Health—give the firm 1996 Danone purchased 41% of the Localisation exposure to the HOD market in other Hangzhou-based drinks company, Wahaha. ● Local staff: In 2003 Danone had nearly areas of the country. Since then, China has emerged as 23,000 employees in China but just 30 of Danone’s third-largest national market. these were expatriate managers. It has not all been smooth-sailing for Sales reached Rmb9.9bn (US$1.2bn) in ● Diversified production: In 2001 Danone Danone in China. Like other multinationals, 2003, up from Rmb8.1bn (US$980m) in had 38 bottled water factories in 26 dif- the company invested in the brewery busi- 2000. The firm has leading brands in the ferent cities. ness in the 1990s, only to pull out later. But water, dairy-drinks and biscuit markets. Like ● Nationwide sales: Danone’s leading water Danone appears to have been very success- most companies, Danone does not publish brand, Wahaha, is sold in 2m outlets ful in the bottled water sector, and its expe- profit figures for China, but its Asia-Pacific through 10,000 distributors, and the rience does provide a useful case study of division achieved an operating margin of company claims to be increasing sales in the kind of strategy available to foreign 14.4% in 2003, beating the group average medium-sized cities and rural areas. firms wishing to build real businesses in for a second time. With volume increasing, the cost of pro- China.

other markets. “Better product, better brand and know- those of a local rival. Moreover, that foreign firms have how that cannot be matched by domestic firms (as yet)” built up well-known and successful brands outside China was the response of one foreign executive who took part does not necessarily help them when competing inside in our survey. Another manager said the local strength of the country. B&Q, for example, has a very strong retail his firm lay in the introduction of “a service quality that name in the UK and parts of Europe but before it entered does not really exist in China at present”. Other represen- the market it was unknown in China. Franklin Templeton tative responses included “adherence to professional eth- may be one of the world’s leading specialist fund man- ical standards”, adoption of “international best practice”, agers but this is a fact lost on most retail investors in “greater knowledge and experience with international China. Even true global brands such as HSBC, despite its business”, “superior marketing capabilities” and “general origins in Shanghai and Hong Kong, are far from house- quality management”. hold names in China. Of course, the fact that a company practices high ethical standards is of little help to the business when its Brands and marketing products and services are five times more expensive than That said, foreign companies are right to identify brand as

30 © The Economist Intelligence Unit

Coming of age Part 1 Addressing the market

Share of the shampoo market, 2003 Share of the detergent market, 2003 % % Foreign-owned brands Local brands Foreign-owned brands Local brands 15 25

12 20

9 15

6 10

3 5

0 0

Lux Fan Slek Diao Omo Liby Tide Kami Sifoné Dosia Rejoice Pantene Head & Feather Qiqiang Lonkey Hazeline Satinique Whitecat Shoulders Vidal Sassoon

Source: Euromonitor

one of their most important competitive strengths in promotional techniques that multinationals have devel- China. This is because brand-building is something that oped elsewhere. The biggest foreign firms in China are domestic firms in general do not yet do very well. Domestic now devoting considerable resources to ensure their pro- players typically lack the quality and innovative products motional activities are tailored to appeal to the prefer- that form the foundation of any strong brand: by compet- ences of their target markets. Finding out “What Chinese ing on price, many local firms simply do not have the Women Want”, the title of a vivid presentation delivered resources to invest in innovation. In addition, although in 2002 by the Greater China head of J Walter Thompson, some domestic firms are big advertisers, their promotional Tom Doctoroff, is becoming something of a science. efforts tend to be brief affairs—for example, five-second With larger and better-understood client bases, bigger television commercials—that focus more on achieving multinationals are gaining the opportunity to start using immediate sales than building a brand that would position fairly advanced market-segmentation techniques. In more the company to achieve longer-term profitability. restricted industries like pharmaceuticals, firms are far These, of course, are generalisations. Some local play- from reaching this stage, but even here companies have ers are investing in innovation: both Huawei and ZTE claim the ability to use some strategic marketing techniques. to spend more than 10% of revenue on research and This is because there are a whole range of common dis- development (R&D), and Haier gives all of its engineers eases in the country, from hypertension to hepatitis, that the freedom to design and build their own products. A few currently pass either under-diagnosed or completely domestic companies are undertaking quite sophisticated untreated. This is the kind of situation that the interna- advertising campaigns which attempt—in marketing tional pharmaceutical firms, with their existing range of speak—to promote the “values” of a good rather than its drugs and experience of market-shaping in the West, are mere “attributes”. In one example highlighted by well placed to exploit. By focusing their marketing efforts Matthew Rouse of IFF, a local company has been running on grass-roots doctors and consumers, in addition to key television commercials with a plot based around the opinion leaders, pharmaceutical firms have an opportu- plight of China’s unemployed. Far from being the focus, nity to cultivate demand for drugs in these areas. the good being promoted, the Diao detergent brand, does not appear until the very end of the advertisement. Going local But for domestic firms these examples remain the In one way at least, going local is not a new strategic exceptions rather than the rule. By contrast, having an option for foreign firms. Just how fast to localise staff in innovative and high-quality offering is a defining charac- China operations has been a question taxing multination- teristic of MNCs. Moreover, foreign firms understand just als ever since they started to invest in the country in the how to build on their platform of goods and services to 1980s. It is an issue they continue to grapple with today establish a brand. Finally, as the example of Diao shows, it (see next chapter, Persistent headaches). is now possible in China to use the kind of sophisticated Nevertheless, the parameters of the localisation

32 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

debate have shifted. Previously, staff localisation was mainland is listed at home—which indicates a degree of seen only as the most obvious way of cutting costs at accounting transparency—it is willing to provide a line of unprofitable businesses in China. Now replacing expen- credit within a month. Domestic banks give higher-profile sive expatriates is just one of a whole range of localisation MNCs an even easier ride. The overall cost of finance is options foreign firms are exercising in an effort to remain probably still not as low as that enjoyed by local compa- or become competitive. Borrowing from domestic banks, nies because foreign firms will be under more pressure to moving production facilities inland, sourcing inputs from pay loans back. Nevertheless, overseas companies can within China and expanding local product development— now access more competitively priced loans than was the these and other localisation strategies are being case in the past. employed in an effort to narrow the cost gap. Foreign Localisation in other functional areas requires more firms want to better understand and even shape local effort but can still be rewarding. For example, the areas demand. But they also want to match the cost structures first favoured by foreign investors—Shanghai, Beijing and of local firms, allowing them to compete on price without Shenzhen across the boundary from Hong Kong—are wrecking profit margins. becoming richer and thus more expensive. Thanks to improvements in the road network, however, it is possible Credit, production and inputs to find much cheaper locations in which to base opera- China’s banks are willing participants in this localisation tions that are still within relatively easy reach of these drive. Domestic banks are under great pressure to urban hubs. For example, while being just a couple of strengthen balance-sheets and foreign firms are seen as hours’ drive away from Beijing, costs remain relatively low offering safer lending opportunities than domestic firms. in Tianjin. The same is true of the string of cities stretch- According to sources that spoke to the Economist Intelli- ing from Ningbo to Wuxi that lie close to Shanghai and gence Unit, if one of China’s Big Four banks, the Agricul- large swathes of the Pearl River Delta surrounding Shen- tural Bank of China, knows that a Taiwan firm on the zhen. And all of these are only the most obvious choices.

The challenges of localisation

In recent years, foreign firms have become of ensuring the flow of inputs is consistently forms an integral part of any sales package. much more enmeshed in local business net- of a high quality. The pool of domestic In other words, there are similarities works in China than was ever the case suppliers suffers from the same kind of between securing payment and before. This is the result of several develop- weaknesses that afflict their final-product safeguarding intellectual property (see next ments: the desire of overseas companies to counterparts: production quality is often chapter, Persistent headaches)—foreign localise supplies and so reduce the need for sacrificed for the sake of low prices. But this firms should think through systems from more expensive imports; the increasing may not be obvious to potential foreign beginning to end to make payment more confidence with which at least the more buyers because local firms are not above likely. established foreign firms approach the mar- cheating, for example producing sample Foreign firms are also not powerless to ket; and the growth of China’s own corpo- products that are of far higher quality than ensure a flow of quality inputs. Foreign rate sector. the goods that are finally delivered. firms with more experience in China are This localisation process has not, Foreign firms are not defenceless in the likely to have built up some knowledge of however, been without its problems. For face of these challenges. In terms of the reputations of local firms. For greener foreign firms selling to local companies, payment, for example, it may be sensible to firms, inspections of the factories and there is the issue of securing timely demand a down-payment, payment on facilities of potential suppliers might be payment. One telecoms-equipment delivery and, recommends one high-end possible. Also, it has to be remembered that manufacturer told us that accounts video-equipment maker, to be persistent, domestic firms have some incentives to sell receivable are the one thing that has ignoring appeal for delays based on cultural quality inputs to foreign firms. Building a become worse across the board over the last or social norms. The same manufacturer positive and strong relationship with 20 years. In the 1980s a company could be adds that China may not have a long history overseas companies could bring greater certain it would be paid; now that is of litigation but foreign firms should not be business in the future, and not just from the anything but the case, especially when afraid to take a bad payer to court. It should original customer: being able to claim a dealing with private businesses in China. also be remembered that foreign firms are customer-relationship with a prominent Foreign companies sourcing supplies clearly in a stronger position to extract foreign firm will help a local company win from domestic firms also have the problem payment if ongoing support and servicing the trust of others.

The improvement in the transport infrastructure has made exclusively as competitors and stealers of intellectual it possible for foreign firms to cast their nets even further property; sometimes they can also be valuable partners. afield, as demonstrated by Unilever’s decision to move its household and personal-care goods manufacturing oper- Moving away from the coast ations from Shanghai to Hefei, the provincial capital of Foreign firms are also employing a localisation strategy of Anhui. sorts to address the demand side of their businesses. Foreign companies are also seeking to reduce costs by After all, the recent convergence of the target markets of localising input procurement. Of the companies that multinationals and their domestic counterparts is not just responded to our survey, the proportion that expects to the result of local companies seeking to sell up to the buy more than three-fifths of their components from richer cities. Multinationals have also been taking advan- inside China (rather than importing them) rises to over tage of higher incomes and a much-improved infrastruc- 30% in five years’ time, up from just 19% today. But for- ture to move beyond the eastern seaboard to market to eign firms are not just buying more from within China; the less-developed inland areas, and in some cases even they are also purchasing more from domestic rather than to establish a national presence. foreign-invested enterprises (FIEs). According to our sur- As the next chapter, Persistent headaches, will vey, the proportion of firms purchasing more than two- explain, this is no easy task but it does offer the attraction fifths of their components from local companies rises from of greater scale and thus lower per unit costs. For exam- 37% now to 44% in five years. ple, when the French company, Danone, produced 500m This development is not surprising: domestic supplier litres of its Wahaha brand of bottled water in 1997, the firms share all the cost advantages enjoyed by their fin- average production cost was 4 US cents/litre. But over the ished-goods producing counterparts—although they also course of the next five years, output rose to 2.4bn litres, share some of the quality problems as well, which is why an increase in scale that helped to cut the average pro- the proportion does not rise more quickly. This trend illus- duction cost to 2.2 US cents/litre. trates that local companies should not be thought of

What percentage of your inputs on a value basis is sourced from within Where do you expect this percentage to stand in five years‘ time? China (as opposed to being imported)? (% responses) (% responses)

Not applicable 32.7 Not applicable 32.6 0-20% 11.6 0-20% 26.6 20-40% 14.9

40-60% 8.8 20-40% 12.6 80-100% 12.1 40-60% 9.3 80-100% 18.6 60-80% 13.5 60-80% 6.5

Of the inputs that you source from within China, what percentage is sourced Where do you expect this percentage to stand in five years‘ time? from domestic Chinese companies (as opposed to foreign-invested firms)? (% responses) (% responses)

0-20% 10.3 Not applicable 34.6 0-20% 20.6 Not applicable 35.0 20-40% 10.7

20-40% 7.9 40-60% 13.6

40-60% 10.7

80-100% 11.2 80-100% 16.4 60-80% 14.0 60-80% 15.0

Source: Economist Intelligence Unit survey, March/April 2004

34 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

Corning’s China boom

The US technology company, Corning, is an and its auto market had not taken shape. labour costs were not important. But five example—a prime example—of a company All of these industries have seen a major years ago it saw the potential of using the whose China business has been transformed surge in growth since then. China has country as a regional manufacturing hub in the last five years. become the world’s second-biggest market exporting to the rest of Asia with the In 2000 it had a small stake in a joint for personal computers, as well as a major prospect of being able to ride the local venture in Shanghai, employed 100 people source of manufacturing them; its mobile market up if demand rose. and had annual sales of US$80m. and fixed-line telephone network has grown As with any manufacturing business, By the end of 2003, it operated five joint from having tens of millions of subscribers being able to source the right inputs is a ventures (two in Shanghai, one each in to having hundreds of millions; and last year major challenge. The right suppliers, Mr Chengdu, Wuhan and Beijing), another two its auto industry finally began registering MacKinnon says, are “stardust”. The smarter wholly owned plants in Shanghai, plus the sort of sales that foreign auto executives foreign companies—and he singles out another one in Taiwan. Between them, had been promising for years. Hong Kong’s trading and sourcing company, these eight operations had sales of With half of its China operations Li & Fung, as one such business—are US$380m and employed 1,500 people. producing telecoms equipment and the developing deep relationships with a From barely featuring on the company’s other half producing LCD glass, plus sales of network of strategic partners able to radar, its China operations now account for Corning goods imported from other parts of procure the inputs needed. more than 10% of Corning’s US$3bn annual the world, the company has had a China Being involved in telecoms turnover. boom. manufacturing, which is still restricted by For Corning, China matters. So what Mr MacKinnon, who has worked on and the government, has meant entering into happened in the last few years which made off in China since the 1980s, for the UK’s joint ventures for most foreign investors. the country suddenly become important? P&O and Japan’s Mitsui before joining This is likely to change as the industry Simon MacKinnon, its Greater China Corning, suggests the key element in restructures over the next few years. president, says the explanation is simple: making a company successful for China is Another change is likely to be the growth Corning is an “extraordinary barometer for being able to determine whether its in demand for environmentally sound China’s high-technology development.” competitive advantage or ability can be products–hard to envision now but perhaps His company specialises in just a few applied there. not as unlikely as it might appear. Mr areas: optical fibre and cabling, high- “This is the question for CEOs,” he says. MacKinnon suggests China has already put in quality and ultra-pure glasses such as those Corning’s key advantage is its technical place environmental regulations largely in used in LCD screens or in the lenses used for know-how, which makes it a world leader in line with those of North America and Europe, etching semiconductors, and catalytic all its key businesses, combined with its and in some areas pushing beyond them. substrates used to clean vehicle exhausts. manufacturing ability, which gives it a For now, many of these rules are Five years ago, China had little demand for quality edge. unenforced. But when they are, Corning, these products: its telecoms networks still Coming to China was not such an obvious with its range of environmentally advanced largely used copper wiring; its computer move: the company’s business is capital- products, stands to benefit from another market, although growing, was still small; intensive so attractions such as its low wave of new demand.

Research and development in China scientists employed at the firm’s other four global facili- Grand announcements of localisation of R&D need to be ties (see Part 2: Pharmaceuticals). greeted with a degree of scepticism. Big firms know that Still, it would be surprising if foreign firms were not being seen to transfer technology and expertise is one undertaking any R&D in China. Although skilled labour way of winning the favour of powerful government offi- costs are rising quickly (see next chapter, Persistent cials. But the political gains are potential at best, imagi- headaches), they remain lower than in western Europe or nary at worst, and in all cases need to be set against the the US. So, while many firms remain reluctant to transfer very real risk of intellectual property theft in China. As a their more sensitive “research” activities to China, they result, it probably remains true that the R&D facilities are willing to move lower-level “development”. Global being established are not as grand as media relations pharmaceutical firms, for example, are conducting clinical departments would like us to believe. For example, while trials in the country and manufacturing firms are under- the pharmaceutical firm, Roche, is establishing an R&D taking pilot production runs. And, with China buying up centre in China, initially it will employ just 40 chemists, a more mobile handsets than anywhere else in the world, it very small number when set against the more than 5,000 should not be surprising that foreign telecoms companies

are establishing facilities to develop new products, or at recent years both Siemens and Alcatel have been able to least adapt existing ones, for the local market. turn minority holdings into majority stakes with manage- But the on-the-ground R&D presence of some foreign ment control in their respective telecoms equipment-mak- companies goes further than this, in part because China’s ing joint ventures. In February this year Samsung paid massive telecoms market is not just of local but of global US$30m to increase its holding in the Shenzhen Electronic importance. Siemens has established the global headquar- Group from 21% to 35.5% and take management control. ters for R&D of voice-centric phones in Beijing. In May For some firms, the opportunities to consolidate do Nokia announced that it would expand R&D activities in not end here. The restrictions of the last two decades have China, with the result that 40% of handsets produced by its left many MNCs with a whole range of often unrelated mobile-phone business division would be designed and operations spread right across the country. The changed developed in the country. Alcatel has taken the localisa- regulatory environment is clearing the way for this fraction theme even further. Shanghai Bell has become one of tured presence to be converted into a more centralised Alcatel’s global R&D centres, with the French firm giving one. Nokia, for example, has taken four separate joint the joint venture full access to (among other things) its ventures and persuaded the partners in each—Capitel, worldwide technology base, including patented products. Beijing Hangxing, Dongguan Nanxin and Shanghai Alcatel’s goal, according to its Asia-Pacific president, Lianhe—to convert their shares into stakes in one cen- Christian Rainaudo, is to be in a position to capture and tralised company. In so doing, Nokia has sought to con- export new telecoms technology coming from within centrate more of its China activities at Beijing’s Xingwang China, rather than merely importing existing trends from Industrial park. The Finnish company still has to deal with other countries. several different partners but now only one joint venture. This, no doubt, is music to the ears of officials in China. In the future, it would be surprising if this restructur- Feeling its companies spend too much to use the technol- ing trend did not emerge in the service sector. From ogy royalties owned by foreign companies, transforming retailing to financial services, foreign firms wishing to the country from a follower of trends to a setter has been enter the China market are still being required to start a specific aim of China’s government. This drive has incor- joint ventures. As a result, several service multinationals porated data storage systems and wireless land-area net- are ending up with the kind of complicated corporate works (WLAN), but is an effort that has progressed structures their manufacturing counterparts are currently furthest in the telecoms arena with the development of trying to shed. The retailer Carrefour, for example, has China’s own third-generation (3G) telecoms standard, TD- expanded across China by finding different JV partners in SCDMA. While some observers have expressed scepticism each location. In a set-up typical of the continental Euro- that this standard will ever gain a commercial following, pean financial services groups, Fortis has two banking foreign firms have been working to ensure that they will business centres in China, a fund management joint ven- not be left out if it does. Indeed, Siemens, in partnership ture and a minority investment in one of China’s smaller with the China Academy of Telecommunications Technol- but rapidly growing life insurance firms, Taiping Life. ogy and a local telecoms firm, Datang, has played a key Under World Trade Organisation (WTO) rules China is sup- role in developing the standard. The German firm has also posed to allow foreign firms to establish wholly owned teamed up with Huawei to develop TD-SCDMA equipment, retail operations from the end of 2004. Foreign-owner- and similar ventures have been formed by other foreign ship restrictions in the financial services arena are likely firms including Nortel (Canada), Philips (the Netherlands) to remain for longer, but companies like Fortis may still and Samsung (South Korea). gain the opportunity to consolidate their operations in the next few years as China eases prudential rules that Mergers and acquisitions currently restrict the amalgamation of banking, insurance A third choice for foreign firms looking to strengthen their and securities firms. competitive position is mergers and acquisitions (M&A). While a relaxation of restrictions on foreign ownership is The M&A market is developing, but slowly allowing new arrivals to enter China on a wholly owned Buying out and consolidating joint ventures is no longer basis (see previous chapter, A new environment), it is also the only M&A option available to foreign firms. Since late allowing existing firms to buy out local partners. Today, 2002 the government has put into place a regulatory joint ventures formed in the 1980s and 1990s do not tend framework that is aimed at allowing the kind of broad to be short of the kind of resources that the Chinese side is M&A activity that forms such an important component of able to offer (land and people) but rather the ones that the corporate activity in more advanced markets. Foreign foreign side can supply (capital and technology). Many firms have begun to take advantage of these changes. In MNCs have been able to capitalise on this change. In recent years, leading multinationals ranging from BP to

36 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

AIG have taken small stakes in large SOEs such as acquisition by a foreign player of the state shares of a PetroChina and PICC. In 2003 Eastman Kodak of the US listed Chinese company. In a further illustration of the finalised an agreement to buy 20% of Lucky Group, normalisation of the M&A market, the British beer com- China’s largest producer of traditional photographic film. pany, SABMiller, in May launched an attempt to buy con- This appeared to be a breakthrough, marking the largest trol of Harbin Brewery. Harbin was not flattered by the bid

The evolution of M&A regulation

November 2002. “Notice regarding the trans- the acquirer buys more than 30% of the Institutional Investor (QFII) scheme. fer of state shares and legal person shares of shares. Acquisitions of less than 30% of There are limits on the size of the listed companies to foreign parties.” Issued the shares, but which result in de facto position that a qualified foreign investor by the China Securities Regulatory Commis- control of the listed company, are sub- can take in a stock and capital remittances sion (CSRC), Ministry of Finance (MOF) and ject to notification to the CSRC, and a 15- are subject to quotas and mandatory lock-in State Economic and Trade Commission day comment period. periods. Nevertheless, the introduction of (SETC) ● Use of securities to pay for shares in a the QFII scheme did mark a welcome It has traditionally been very difficult for listed company is allowed (previously liberalisation of China’s stockmarket. outside companies to buy control of the only cash offers were permitted). January 1st 2003. “Tentative provisions on more than 1,000 firms, mainly state-owned ● Different offer prices for different classes the use of foreign investment to restructure enterprises (SOEs), that are listed on of shares are permitted (listed and trad- SOEs.” (SETC, MOF, State Administration for China’s stockmarkets. This is because only able shares versus non-listed and non- Industry and Commerce—SAIC—and the around one-third of the shares in listed tradable shares). State Administration of Foreign Exchange— firms are publicly traded. The rest are owned ● The CSRC has the power to issue waivers SAFE) either by state institutions (known as state from the obligation to make a mandatory These provisions laid out a general shares) or other bodies, often other state- offer. framework for the involvement of foreign linked firms (legal person—LP shares). As a ● Takeovers have to be conducted in an capital in the restructuring of SOEs (apart result, only around 33% of China’s total open, fair and just way, with proper dis- from firms in the financial sector, which are market capitalisation is actually tradable. closure of accurate information. subject to special rules). These regulations Foreign firms have generally had a difficult ● All parties involved are required to main- did not make everything clear but, according time buying these non-tradable shares. An tain order in the securities market. to the official publication, the People’s attempt by two Japanese firms to buy LP ● Fiduciary duties are imposed on players Daily, it “clearly drives home the authorities’ shares in 1995 led to a government ban on on both sides of the deal. determination to expedite SOEs’ reform.” all such sales. The November 2002 regulation was aimed at ending this ban, December 1st 2002. “Provisional measures April 12th 2003. “The provisional regula- thereby clearing the way for foreign firms to for administration of domestic securities tions on merger and acquisition of domestic negotiate to buy bigger stakes in listed firms investment by qualified foreign institutional enterprises by foreign investors.” (Ministry by converting non-tradable shares into investors.” (CSRC and People’s Bank of of Commerce, SAIC, SAFE and the State “foreign capital shares”. China) Administration of Taxation) The existence of non-tradable shares is In the past, foreign firms wishing to December 1st 2002. “Takeover provisions for not the only peculiarity of China’s invest in China have almost always had to listed companies.” (CSRC) stockmarket. Another is the division of set up a new firm in order to do so, either a This regulation laid out China’s first tradable shares between local-currency- joint venture with a Chinese partner or a comprehensive takeover code for listed dominated “A shares” and hard-currency- wholly foreign-owned enterprise. Foreign companies. According to Teresa Ko from denominated “B shares”. Traditionally, firms were sometimes allowed to buy equity Freshfields, one of the leading international foreign investors were only allowed to buy interests in local firms but there were no law firms, major features include: shares on the B-market, which consisted of national rules to regulate such investments ● Three methods of acquiring a listed com- only around 100 thinly traded stocks. The and permission was thus granted only on a pany are allowed: acquisition by agree- December measures, however, cleared the case-by-case basis. These new regulations ment; acquisition by offer; and way for overseas firms to buy A shares, as are therefore significant, laying the legal competitive bidding on the stockmarket. well as other financial instruments including basis for foreign firms to invest in China ● Mandatory offers must be made to all Treasury bonds, corporate bonds and through the acquisition of an interest in a shareholders of the target company if convertible bonds, via a Qualified Foreign local firm.

Lucky Eastman Kodak

Eastman Kodak took a major step towards no alternative but to seek an alliance with photo-processing equipment. dominating China’s photographic film mar- Lucky, which had managed to retain about Kodak and Lucky have announced they ket—the world’s second largest after the 20% of the market. will be working together in digital imaging— US—when in October 2003 it reached a Kodak’s victory in this struggle appears possibly taking advantage of Lucky’s US$100m agreement with Lucky Group to linked to its willingness to take a minority partnership with Seiko-Epson to offer digital buy 20% of Lucky Film, the company’s stake in Lucky, contrary to its usual practice imaging in its retail outlets. Shanghai-listed arm, offering a mixture of of requiring majority control when Whether Kodak will be able to make the cash, technology and equipment. launching joint-venture subsidiaries. Fuji leap to digital imaging in China remains as The deal came after years of may not have been willing to take this step. much of an unknown as whether it will be negotiations, stemming not least from Certainly, Lucky should be congratulated able to make that transition elsewhere. divisions within Lucky’s managerial ranks on how well it played the companies off Nonetheless, what is striking about Kodak’s over whether it should tie up with Kodak or against each other. As the only domestic film strategy is how it has constantly Japan’s Fuji. Some in the company favoured maker left after 1998, its position has been concentrated on the big picture—and how Fuji on the grounds that it was weaker than precarious and is one reason that it has been being clear in this respect can help a Kodak, which in turn would allow Lucky to constantly negotiating for an agreement company drive some tough bargains in have more control and to keep its own with a foreign partner since then. China. brand. Others supported Kodak because of Its vulnerability was highlighted by a Its 1998 deal showed just how much its strength in China and its more advanced 37% fall in net profit in the first nine months leverage a company could get if it was technology. of 2003 to Rmb66m (US$8m). Although willing to go to the government for support. Kodak’s stronger position in China stems Lucky blamed fallout from the respiratory It is unlikely such a deal could be struck now. from its US$380m investment in 1998, when disease, Severe Acute Respiratory Syndrome Since the late 1990s, the government’s it bought three money-losing state-owned ( SARS), as the main reason for its earnings direct involvement in business has declined film makers, one based at Xiamen in Fujian, drop, more important was competition from markedly; moreover, now that China is a one at Shantou in northern Guangdong and Kodak, other film makers and counterfeit member of the World Trade Organisation, one at Wuxi in Jiangsu. products. such a discriminatory practice as restricting As part of that deal, which also included a The agreement with Kodak could help entry to another company in the same commitment to invest another US$700m by Lucky fight back. But the question it faces— industry might be harder to pull off. the end of 2003, the central government as does Kodak—is whether it will be able to Now, while the circumstances may be undertook to stop all other foreign film make the transition to digital photography different, it has managed to buy into the one makers from setting up film production and imaging. Kodak is expanding its network big domestic player left. Assuming around facilities in China for three years. of processing outlets with digital five more years of the traditional film market The agreement was principally aimed at capabilities, signing deals with Chinese in China, it has more than a useful platform Fuji which, barred from opening its own banks to allow licensed Kodak store owners from which to build—especially compared facilities in China until the end of 2002, had to take out loans for the purchase of digital with that of its main foreign competitor.

from the UK firm, which it described as “wholly unso- ing business fast. The rapid increase in the total size of licited”, indicating that it was more willing to entertain China’s M&A market in recent years has been fuelled by the advances of another budding suitor, the US’s domestic rather than crossborder deals. Indeed, while for- Anheuser-Busch. eign firms proceed only cautiously, local companies have In reality, these kind of events remain few and far been using M&A aggressively. The Urumqi-based D’Long between. Kodak’s breakthrough with Lucky has not led to a has already completed more than 100 acquisitions, start- flurry of other deals, and SABMiller’s attempt to buy ing with Chinese food and agribusinesses but now also Harbin was the first-ever attempt by a foreign company to including overseas purchases: in 2003 it bought the Ger- launch a hostile takeover of a domestic firm. AIG’s pur- man aircraft maker, Dornier Fairchild. chase of 9.9% of PICC Property & Casualty is just one of a number of similar deals announced by foreign banks and Digging the dirt insurance companies. But these all mark the establishment The main factor discouraging foreign firms from following of a tactical presence in a sector that is still heavily regu- in the footsteps of their domestic counterparts has been lated rather than signalling major forays aimed at develop- poor standards of corporate governance. Foreign profes-

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Coming of age Part 1 Addressing the market

Buying in China

● Basic market access and expansion. taking 9.9% of PICC Property & Casualty them effectively or market the products M&A allows companies to establish ahead of its share flotation in Hong they manufacture. With local govern- themselves or expand an existing pres- Kong. ments seemingly queuing up to privatise ence fast. Given China’s size and complex ● Eliminating local competition. Domes- their SMEs, foreign firms are in a strong business environment, many companies tic companies pose an increasing com- position to negotiate good deals. see M&A as the easiest way to gain petitive threat for foreign firms in China ● Acquiring new abilities. According to growth—much less hassle than starting a and, in some sectors, in overseas mar- one observer we spoke to, “There are a greenfield operation and expanding kets as well. Foreign firms can neutralise lot of Chinese companies that have inter- organically. An example is SABMiller’s this threat and seek to strengthen their esting positions and technologies which current bid for Harbin Brewery. own competitiveness by buying up their foreign companies can use.” An example ● Stealing a march on foreign competi- local counterparts, much as Kodak of one with its own subset of skills was tion. With entry or operational restric- acquired Lucky. search engine business 3721 Network tions remaining in many industries, one ● Buying assets cheaply. In the state- Software, for which Yahoo! is paying way in which foreign companies can out- owned sector, many companies are in US$120m. Managers at other Western manoeuvre other international competi- terrible shape, with antiquated machin- companies, particularly technology and tors is by buying into a domestic firm ery, work practices and management. telecoms firms, also say that they see ahead of any opening of the sector. In But there are also enterprises that have potential targets in software houses, insurance, HSBC acquired 10% of Ping spent heavily on technology and equip- both for their skills and for their ability An Insurance and AIG secured a coup by ment but which lack the soft skills to use to adapt goods for the Chinese market.

sional services firms say due diligence exercises almost ing. Policy is part of the problem: Ministry of Finance rules invariably uncover a mess: companies that have not paid state companies cannot be sold for less than their net their welfare contributions, do not own the land on which asset value. These values are set by government- their factories are standing, have government subsidies appointed teams, which must—among other things— showing up as income in their accounts or—the biggest value fixed assets at their replacement cost not their single problem—have not paid all their taxes. These prob- depreciated value. lems are not restricted to SOEs in China. Standards of All these difficulties are beginning to ease. Standards of transparency remain poor even at the largest firms: wit- financial transparency and corporate governance, particu- ness the disclosure problems at China Life, the leading larly for listed firms, are improving as a result of govern- domestic insurer which recently listed a subsidiary in Hong ment policy (quarterly reporting for listed companies has Kong and the US. One foreign accountant says he starts been introduced, a regulatory requirement that is still out by telling his multinational clients that all domestic missing in Hong Kong) and the activities of an increasingly acquisition targets will fail due diligence tests. The ques- inquisitive financial press. There is now also a growing sup- tion is not whether a domestic acquisition will be risky but ply of companies available for foreign firms to buy, owing how much risk the foreign firm is willing to take on. to a renewed government drive since late 2002 to restruc- Even after a firm decides it is willing to accept the like- ture the SOE sector. This latest reform effort is expected to lihood of nasty post-acquisition surprises, it still has the result in most of China’s more than 150,000 SOEs—many of problem of closing the deal. For one thing, a foreign firm which are small and medium-sized enterprises, SMEs— needs to identify exactly who owns the domestic target. being put up for sale. On the demand side, meanwhile, for- This is more difficult that it might sound: often several dif- eign firms are beginning to realise that M&A in China can ferent government organisations may lay claim to an indi- serve the same functions as it does in other markets. Given vidual SOE. Only when an ultimate owner is eventually all this, it should not be surprising that even though the found does the hard work begin: negotiating a price. It is environment remains far from perfect, many multination- often difficult for Chinese and foreign companies to agree als we spoke to said they were scouting around for possible on what is a fair valuation for a target. Chinese sellers buying opportunities in China. tend to overvalue hard assets and see less value in intan- gibles, although this is changing, particularly as Chinese Keeping their heads companies become more aware of issues such as brand- Multinational firms do not always manage to bring their

40 © The Economist Intelligence Unit Coming of age Part 1 Addressing the market

strategic-planning strengths to bear in the Chinese mar- the market. China is not so unique as to make irrelevant ket. In particular, while the foreign business community all lessons multinationals have learnt from operating in in general is becoming less naïve, many companies still other economies, most notably that it is income, not pure seem to take leave of their critical faculties when judging demographics, that matter. For example, over-investment the size of China’s market. Dazzled by current surging on the scale currently being rolled out in the car industry sales and the thought of an eventual consumer base of looks dangerous. Although it is difficult to measure pre- 1bn people, foreign companies overstate potential cisely, the multibillion-dollar investment plans of local demand and invest too much as a result. Telling them- and foreign firms are likely to add 4m-5m units of capacity selves that China is “important”, foreign firms also fail to in China by 2005 or 2006. As a result, according to Mike apply to the market the same rigorous performance stan- Steventon, the head of the auto practice at KPMG, overca- dards that are used elsewhere. While 66% of respondents pacity in the industry in China is likely to hit 70% before to our survey stated that the yardsticks used to judge suc- too long. cess in China were the same as those applied to operations Our own interviews suggest that it is executives in in other countries, more than one-fifth of companies said headquarters in the US or Europe, rather than managers they were more lenient. Our survey results also show that on the ground in China, that are most guilty of this kind of most foreign firms continue to commit the sins they would irrational exuberance. The China knowledge of these out- like to suggest are limited to their domestic counter- side executives is often very skewed, based on headline parts—assessing performance by revenue growth and rates of GDP growth, the almost saturation coverage “the market share rather than return on capital or equity. rise of China” receives in the international media and per- Some missteps on the part of foreign firms can proba- haps a trip to be wowed by the soaring skyline of Shang- bly be excused simply because judging future demand hai. Visitors would be well advised to remember that trends in China is a difficult task. There are simply no neither the buildings nor average incomes in China’s most precedents from which to gauge the economy’s likely commercial city are anywhere near representative of the direction. China’s size, combined with the gradual evolu- rest of the country. tion of the economy from central planning to some kind of market system, makes it unique. The economy is also Addressing the market prone to cyclical booms and slowdowns. In this context, it In recent years, foreign firms have been facing increas- would not be surprising if car companies were unsure ingly intense domestic competition. This represents a new whether the almost tripling of sales in 2002-03 is the first strategic challenge for multinationals. But the develop- surge in a market that is finally coming alive, or a cyclical ment of China’s economy has also opened up new ways in issue related to the unsustainable rate of overall GDP which they can respond and, as a result, foreign firms are growth recorded last year. in no way being pushed out of all the markets. Domestic It may also not be altogether unreasonable for foreign brands have overtaken multinationals in markets such as firms to apply to China operations more lenient perform- detergents but overseas companies remain dominant in ance criteria than those used elsewhere. Business consult- other sectors, like shampoo and cosmetics. In the market ants characterise China’s market as being in a state of for automatic washing machines, foreign firms increased “chaos”, a phase that will not last forever. A more mature their market share from 15% in 1999 to around 40% in market will eventually emerge, an event that is likely to be 2003. Even in the much-watched telecoms-handset mar- triggered in China when banks start to tighten credit crite- ket, foreign players are beginning to fight back. Norson ria, thereby forcing the consolidation of the domestic cor- Telecom Consulting thinks overseas brands will have a porate sector. In the meantime, normal market rules market share of 57% this year, up slightly from the 56% simply do not apply, making it difficult to judge just what recorded in 2003. success a business is achieving. For example, the China This new level of challenges has created an added operations of a foreign firm may currently be underper- degree of complexity for executives managing businesses forming relative to the global business. In the process, in China. But still sitting below this strategic challenge are however, the firm may be building a brand and working the operational issues that have taxed MNCs ever since towards creating a nationwide distribution network, all of they began entering China in the 1980s: infrastructure which will put the company in a strong position when mar- and distribution, regulation and corruption, shortages of ket consolidation eventually occurs. skilled managers and violation of intellectual property Still, while it might be reasonable to cut China opera- rights. At least for better-established firms these are not tions some slack, good business practices should not be the all-consuming problems they once were. But, as the completely thrown out of the window when firms look to next chapter will show, they remain very real challenges.

Part 1 Persistent headaches

t an operational level, China remains a very chal- firms have an equal amount of international and country- lenging place in which to do business, despite specific experience, but are handicapped in China by the many changes that have taken place over the extremely tight regulatory restrictions. Then there are last few years. In the Economist Intelligence second- and third-tier MNCs and even one-country firms, Unit’sA business environment rankings, China is ranked many of which are just arriving in China and do not have 38th out of 60 economies, putting it below countries such the depth of international experience to fall back on. Even as Brazil and Thailand. This overall score masks consider- for the biggest firms like Deloitte and Procter & Gamble, able regional disparities, with the environment being far shortages of human capital and counterfeiting in particu- more business-friendly in the eastern seaboard than the lar remain huge problems. But unlike their smaller coun- west. But this is of little consolation to the big multina- terparts, these firms are often in a better position to tional companies (MNCs) that are increasingly expanding ensure that these operational issues do not completely out from cities like Shanghai and Beijing to try to tap mar- crowd out strategic planning. kets in other areas of the country. The burden of China’s weak business environment is Infrastructure and distribution not, however, felt evenly by all companies. Best-placed China’s economy is certainly experiencing some growing are the big manufacturing MNCs that have solid experi- pains. Since late 2001 China has experienced a strong ence in difficult operating environments in emerging mar- economic upturn. GDP grew by 8% in 2002 and, despite kets around the world and that have now several years of the economic disruption caused by the outbreak of Severe experience operating in China. Some global service-sector Acute Respiratory Syndrome (SARS) in the second quar-

● At the operational level, China remains a very challenging ● China has an intense shortage of skilled labour, the result place to do business, despite the vast changes that have both of rocketing demand and low supply particularly of peo- taken place in recent years. China’s business environment is ple with the ”soft skills” required by multinationals. Firms are rated worse than almost two-thirds of the other 59 forced to pay high wages to recruit senior staff and must still economies included in the Economist Intelligence Unit’s fight to retain them in the face of poaching by competitors. business environment survey. ● The violation of intellectual property rights in China is rife. ● China’s infrastructure has improved during the last few years Counterfeit goods are easily available. Although some are but has still been overwhelmed by the recent upturn in eco- poor copies, others have been produced with the use of nomic activity. Deficiencies in the transport network and the stolen designs and technology. Enforcement remains inade- regulatory environment impede the ability of companies to quate despite the introduction of new laws and regulations. distribute goods around the country. ● These issues affect all companies, but present the most seri- ● Regulations in the manufacturing sector have been relaxed ous challenge to small foreign firms that are just arriving in but in the services sector they remain oppressive. Multina- China and that lack international and country-specific expe- tionals across the industrial spectrum must still deal with red rience to fall back on. Larger firms are coming up with strate- tape and corruption. gies that at least address these issues, if not resolve them.

42 © The Economist Intelligence Unit Coming of age Part 1 Persistent headaches

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 2004-08 Overall position 5.3 6.2 42 38 11 11 Political environment 4.3 4.5 49 46 14 14 Political stability 5.1 5.1 44 46 13 14 Political effectiveness 3.6 4.0 50 46 13 12 Macroeconomic environment 9.3 9.0 5 3 3 3 Market opportunities 8.4 8.4 2 1 2 1 Policy towards private enterprise & competition 3.3 4.9 55 48 16 15 Policy towards foreign investment 6.1 7.2 41 33 10 9 Foreign trade & exchange controls 4.9 7.8 50 36 13 11 Taxes 5.1 5.2 34 52 12 14 Financing 3.6 5.5 52 44 15 13 The labour market 5.3 6.0 52 42 16 13 Infrastructure 2.6 3.9 57 51 14 10 Source: Economist Intelligence Unit ter, by a further 9.1% in 2003. This growth helped fuel a duction have been hampered by the deficient rail infra- further, sharp rise in incomes, particularly in urban areas. structure, which has prevented adequate supplies of coal But it has also raised overall demand to the point where reaching power stations. elements of China’s infrastructure, despite the very real The government is throwing money at the problem, upgrading that has occurred since the late 1990s, have approving plans to raise China’s total generating capacity simply been overwhelmed. According to some observers, from the current 385m kw to 515m kw within the next few imports have increased to such an extent that bulk cargo years. But even the Chinese government thinks that serious vessels must wait for 18-24 days—at vast expense to electricity shortages will not disappear until 2006. The defi- importers—to unload cargo at China’s ports mainly ciencies in the transport sector are likely to last even longer because of the lack of railway infrastructure to remove because they are not related only to a simple shortage of cargo from docks. China’s newly extended road network is already showing signs of becoming congested—a result of Overall, some way down the more than doubling of the number of cars on the road Business environment rankings, 2004-08 in just the last five years. Score 0246810 The current economic boom is also causing a return of the electricity shortages that dogged China in the 1980s Canada 8.7 1 and first half of the 1990s. Shortfalls started to appear in June 2002 and by 2003 had spread to two-thirds of Hong Kong 8.5 9 China’s 31 provinces. These shortages were at times 18 severe—state media reported that some cities lacked suf- Taiwan 8.1 ficient electricity to power traffic lights—but are set to South Korea 7.3 24 worsen further in 2004: according to the deputy chairman of the State Electricity Regulatory Commission, Song Japan 7.3 26 Mi, the overall electricity shortfall will double this year to 20m kw. The industrial areas around Shanghai and Thailand 6.9 31 Guangzhou, the main drivers of China’s manufacturing juggernaut, are already rationing electricity and short- Brazil 6.3 36 ages are likely to become more severe as the approach of Global 38 summer raises temperatures, and thus demand, for air- China 6.3 rank conditioning. India 6.2 40 These infrastructure bottlenecks, never easy to solve in any country, are particularly tough to tackle in China Vietnam 5.3 52 because they are often interlinked. Local media have reported, for example, that efforts to raise electricity pro- Source: Economist Intelligence Unit

When planning for domestic sales within China, you think in What determines this view of China? terms of... (% responses) (% responses) 0 102030405060 ...distinct regions (north-east, Yangtze Income disparities 54.8 river delta etc) 30.7 Other 6.0 Infrastructure deficiencies 39.6 Central government ...east coast regulation 27.6 and the Local-level informal interior 7.4 17.1 protectionism ...a national market ...1st, 2nd, 3rd- Other 24.0 20.9 tier cities 34.9

Source: Economist Intelligence Unit survey, March/April 2004

physical capacity. The different types of transport infra- required to pay.” Indeed, 17% of respondents to our sur- structure are poorly integrated: train services, for example, vey stated that local protectionism was a further factor generally do not terminate at dockyards, so goods must be contributing to the lack of a national market in China. In trucked from railyards to ports. Computerised inventory many cases the frustrations of foreign firms with these management systems are rarely used, making it impossible local, ad hoc rules are shared by the central government, accurately to track the progress of deliveries. which is well aware of the possible benefits in terms of economic efficiency and a more even distribution of No national market wealth that would result from the creation of a less-frag- In a reflection of the transport network’s continued weak- mented internal market. Still, China’s vast size and the ness, only one-fifth of the respondents to our survey indi- degree of autonomy enjoyed by local governments sug- cated that they thought of China in terms of a national gest that such local protectionism will remain a persistent market. Although regional income disparities are typically challenge. the main reason for this perception, a significant propor- None of these issues should be ignored. They all cause tion of executives—almost 40%—also attributed this view problems for foreign firms, which often translate into real to deficient infrastructure linkages. The distribution prob- expense: according to Amcham, logistics costs account for lems facing foreign firms do not end here. A further 28% up to 16% of product costs in China, compared with just of respondents attributed the lack of a national market to 4% in more advanced economies. But companies are com- central government regulation. Wholly owned foreign ing up with strategies to address these difficulties (see enterprises in China are, for example, currently prevented box: Distribution strategies). Even though the distribu- from conducting international trade, distributing goods tion system requires substantial improvement, it is within the country or establishing warehousing opera- undoubtedly becoming easier to distribute goods around tions. Foreign transportation and logistics companies are China. The transport network, particularly on the east also required to obtain separate licences for each province coast, has improved considerably in the last five years, as in which they operate. has the regulatory environment. The distribution prob- As part of China’s 2001 WTO entry agreement, some of lems faced by foreign consumer-goods makers are also these regulations are to be removed at the end of 2004. easing with the emergence of both local and foreign chain But rules imposed by the central government are not the stores—Carrefour, for example, already has 44 hypermar- only ones that make life difficult for foreign firms wishing kets in different parts of China—and specialised logistics to distribute goods around the country. Multinational providers within the country. companies also face ad hoc regulations imposed by local governments, designed to frustrate imports not just from Regulations and corruption overseas but from other regions within China. For exam- The gradual easing of official restrictions in the distribu- ple, the 2003 white paper of the American Chamber of tion sector is symptomatic of an economy-wide trend. Commerce (Amcham) in China complained that ”in many During the last few years much of the economy has been localities, out-of-province trucks are arbitrarily stopped at deregulated, a process that was well under way well city borders and subjected to tolls that local trucks are not before December 2001, the date of China’s accession to

44 © The Economist Intelligence Unit

Coming of age Part 1 Persistent headaches

the WTO. During the 1990s almost all of the former indus- of the broad regulatory framework and can have some trial ministries and state commissions were abolished, confidence that it will not be subject to sudden or arbi- cutting the number of institutions and officials at the cen- trary change. tre looking to be involved in business affairs. Some old- school planning apparatchiks have no doubt survived but A socialist market economy there are fewer options for them to slake their thirst for While the improvements have been real, managing the control. Many state-owned enterprises have been sold off regulatory environment remains a real issue for foreign and a large proportion of those that remain have lost mar- firms operating in China. Red tape in China is still perva- ket share to private domestic firms and foreign-invested sive. In order to open a new joint-venture private hospital enterprises (FIEs). China’s thicket of regulations has been in Shanghai, the US’s Chindex International had to collect cut back and the rules that remain have gradually become 150 chops (name stamps signalling approval from a par- more institutionalised. The picture that characterised ticular department). Even simple banking procedures in much of the 1980s and 1990s—everyone from multina- China remain bureaucratic. It is still far from rare for new tional managers to Chinese officials groping their way for- regulations to surprise and concern MNCs, as was the case ward, often making things up as they went along—is no with 2001 proposals from the People’s Bank of China longer representative of the business environment. For- (PBC, the central bank) to limit borrowing by individual eign firms in different sectors have greater understanding foreign banks on the interbank market to 40% of their

Distribution strategies

Self-distribution and, as such, is not subject to restrictions on FIEs. But this also Self-distribution is an option for individual foreign ventures that means the joint operation is excluded from the tax breaks allotted manufacture in China, typically larger multinational operations. to FIEs, adding to costs. Furthermore, flirting with restrictions on This is also the model favoured by local firms: according to a study foreign involvement in the service sector can trigger a response published in 2002 by the State Council’s China Development from regulators. Research Centre, 70% of China’s commercial enterprises have their Foreign firms may also seek to identify distributors that meet own fleet of vehicles and 80% own their own warehouse facilities. certain criteria and then work with them to improve their services. There is also disguised self-distribution, practised by foreign Generally, companies start at the end of the chain—retail outlets— companies with multiple ventures. Some companies with multiple and determine the key stores in each city where their product needs ventures have used a holding company to act as a sales agent for to be. It is then a straightforward matter to identify the major subsidiary ventures, assisting them with after-sales service and distributors that supply similar products to those retail outlets. market development, and providing distribution services such as Through direct talks with those distributors, a company can then transportation and warehousing. Other firms have established a determine which ones will fit into its strategy, and target them for ”service company", for example by designating one joint venture as co-operation. the sales agent for all of its ventures. While continuing to issue To upgrade the domestic firm, the foreign manufacturer might invoices for their products, the other ventures sign a contract that guarantee a certain amount of business and support in exchange for hands over all sales and distribution activities to the designated the distributor investing in new vehicles or warehousing. In agent. addition, the staff of the foreign firm may work out of the city-level distributors’ offices to provide sales forecasts that enable the Working with local firms regional distributors to manage their inventory more effectively. It is possible for foreign firms to contract use of warehouse space and Another foreign importer ”gives” employees to each of its four main vehicles from distributors but supply and directly manage all staff. distributors to help increase consumer awareness of its product. The terms of such an agreement might include a small cut, perhaps a 1% margin. The risk is that these management contracts exist in a Using a middleman legal grey area, making it difficult to obtain redress if anything goes Another strategy, frequently employed by Japanese consumer- wrong. products companies, is to include Hong Kong-based trading firms as Another option is to set up a joint venture between a Sino- partners in a productive joint venture. This is not an approach com- foreign joint venture and a Chinese company for distribution. monly adopted by Western companies, which tend to view the elimi- Because both entities are Chinese legal persons, the joint venture is nation of Hong Kong middlemen as one of the main advantages of considered a domestic rather than foreign-invested enterprise (FIE) setting up a domestic production base.

46 © The Economist Intelligence Unit Coming of age Part 1 Persistent headaches

total renminbi liabilities, denying them an important an important, and often positive, role in the economy. source of funding. Foreign firms obviously generate much of China’s indus- Burdensome red tape, surprising and ad hoc rules trial output and a majority of the country’s exports, but imposed by overbearing local officials—these operational they also directly help with the upgrading of the economy. headaches can overwhelm day-to-day operations and dis- The research and development (R&D) investments of tract managers from longer-term planning. Firms in sev- pharmaceutical firms, Siemens’ involvement in the devel- eral industries must also cope with formal regulations opment of an indigenous third-generation (3G) technol- aimed at restricting their access to the market. Foreign ogy in China and the willingness of executives throughout automotive firms in China, for example, can only produce the financial and professional services sectors to give cars by teaming up with local firms and the government advice that help regulators to better understand interna- has made no commitment to allow wholly foreign-owned tional standards are all examples of the direct guidance operations. The car industry is a sensitive one for the gov- and modelling that foreign firms can offer. Cynics might ernment; such a level of regulation in the manufacturing suggest that such apparent pandering to the government sector as a whole is now rare. But the same cannot be said costs foreign companies resources without producing any for the service sector, where many foreign firms have been real gain. Certainly, the government is still more than all but denied access to China’s local market. capable of riding roughshod over the wishes and desires That protectionism remains alive and well in the serv- of multinationals. But just because lobbying does not ice industry is perhaps unsurprising. Until the late 1980s, always succeed does not mean that the effort of foreign domestic companies simply did not exist in sectors such as firms to show their commitment to China does nothing to telecoms or insurance. These industries were run as part raise their influence with the government. of the governing bureaucracy. The government is probably The ability of foreign firms to influence the regulatory rightly concerned that, with easy entry, foreign firms environment in their favour does not just stem from these would quickly displace the fledging locals. The risk of for- corporate-level investments. Cultivating personal rela- eign domination is particularly real in the financial serv- tionships—guanxi—is still very important in China. This ices sector where domestic companies are not only young would be the case even if China was a much more deregu- but also financially weak. Years of bad lending have left lated economy than it is today: guanxi is a basic element China’s state-owned banks with a non-performing loan of Chinese business culture and is therefore something (NPL) ratio of at least 20%. Local insurance companies are that no foreign firm seeking to sell to or buy from local sitting on an equity shortfall of several billion US dollars. companies cannot afford to ignore. Cultivating relation- Domestic banks and insurance companies need time not ships with government officials, joint-venture partners, just to learn the basics of healthy competition but to put suppliers and clients thus remains an important part of their finances in order. the job of senior managers in many foreign financial services firms. This task is not always easy. Domestic firms are Playing the system inevitably in a better position to build guanxi, not only The good news is that foreign firms are gaining new ways because their managers are personally steeped in the to deal with regulation. Lobbying, for example, has local business culture, but also because the corporate become a much more effective tool. In sectors across the structure offers them the necessary degree of flexibility. economy, regulators now tend to listen more to the con- Foreign firms, even those with Chinese managers, often cerns of industry players. Domestic companies obviously have tighter standards of accountability that make com- have the loudest voices, sometimes to the direct detri- pany procedures more rigid. For example, stricter ment of foreign firms. For example, while the activities of accounting procedures result in smaller entertainment foreign lawyers in China were initially restricted because expenses, making it more difficult to wine and dine busi- the government was concerned they would bring to the ness partners in the expected style. The insistence on country such heretical concepts as ”rule of law”, the transparency in expenditure, a requirement that appears retention of the regulations is largely a reflection of the so reasonable in a Western context, is also a disadvantage influence of an expanding domestic legal profession. For- in China: officials will be more wary of accepting hospital- eign firms are, however, not entirely powerless. The PBC’s ity from multinationals if they believe their actual name 2001 regulation on interbank borrowing has yet to be will be documented in corporate records. implemented, a delay that according to Amcham is the Of course, there is a wider issue involved here: at some result of a ”strong and unified reaction by various foreign point the cultivation of guanxi becomes outright corrup- bank associations and chambers of commerce”. tion. In recent years the Chinese Communist Party (CCP) That multinationals are not entirely free of influence is has been taking stronger action against graft, a pro- partly because the government recognises that they play gramme that has involved the execution of some very

Still not enough Newly-enrolled students in higher education, ‘000

4000 3,822 3500

3000 3,205

2500 2,683

2000 2,206

1500 1,597

1000 1,084 966 1,000 924 900 926 754 500 609 620 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: Economist Intelligence Unit

high-ranking officials. Nonetheless, corruption remains tions remains distinctly limited. But even in more open widespread, a point illustrated by our survey: corruption industries, such as manufacturing and consumer goods, was named by more foreign businesses as having a detri- foreign firms are no longer the automatic choice for ambi- mental impact on their business in China than any other tious people. Budding local MNCs like TCL and Legend can factor. also offer positions with attractive opportunities for advancement and foreign travel. Human capital constraints At the same time, the supply of skilled workers is very Finding and retaining human resources remains one of limited. In 2003 the country’s tertiary institutions the most taxing day-to-day issues facing foreign compa- accepted 3.8m new students, up from just under 1m in nies in China—and its associated challenges have bedev- 1996, a tiny number in such a populous country. More- illed foreign companies since the early 1990s. The 2003 over, only a small proportion of graduates will have the Best Employers in Asia survey conducted by a human skills necessary to work at management level in a foreign resources (HR) consultancy, Hewitt Associates, found that firm. For a start, potential senior staff must have foreign- of the top five issues that CEOs believe determine success language skills in addition to their basic training in engi- in China, four relate to human capital. Labour shortages neering or finance. But MNCs also want to find workers in the world’s most populous country may seem counter- with soft skills, such as the ability to make decisions and intuitive. After all, China’s over 750m-strong rural popu- innovate. It is this that forms the crux of the human capi- lation does offer a rich source of low-skill, low-wage tal problems facing foreign companies in China. Overseas migrant workers. The problem for foreign firms is that as executives are almost universal in their praise of the soon as they start to look for people even slightly higher strong core knowledge of local graduates. However, up the value chain, the number of staff available falls and across the spectrum of sectors, from electronics firms to the price goes up. accountants, these same managers are almost equally critical of the inability of young people in China to apply Where are all the people? their skills in the workplace. According to Hewitt Associ- The HR challenge is partly a problem of demand. Existing ates, companies in China report that ”soft skills including MNCs are expanding and new ones set up operations in longer-term thinking, comfort with ambiguity and uncer- the country almost every day. Competing with these for- tainty, and innovative problem solving are not what they eign firms for skilled workers are domestic companies. need to be”. These firms are increasingly able to offer attractive oppor- Another issue that is by no means unique to China is tunities, particularly for mid-career staff who already have the rigidity of ”mind sets” and a lack of openness to the credibility and solid professional skills gained from change—a hangover, perhaps, from several decades of a having first worked for a foreign firm. The ability of local top-down, state-led economic system as well as an educa- firms to poach staff is particularly high in industries like tion system focused on learning rather than thinking. One insurance, where the scope for advancement in foreign financial director at a large Sino-American manufacturing companies that are subject to heavy government restric- joint venture (JV) who spoke to the Economist Intelli-

48 © The Economist Intelligence Unit Coming of age Part 1 Persistent headaches

name their own price. Indeed, wage inflation at the upper Lagging behind end of the labour market has been rapid. According to fig- Tertiary gross enrolment ratio, % of relevant age group ures from Hewitt Associates, salaries for technical and 1980 2000 professional staff in MNCs have increased by more than China 2 7 25% over the last three years, a period during which con- India 5 10 sumer prices rose by just 1%. Cash wages sometimes still appear low relative to other countries but, according to Thailand 15 35 Hewitt Associates’ Vincent Gauthier, this is not entirely South Korea 15 78 accurate. Financing government-mandated and other UK 19 60 benefits can add 60-110% to the basis salary of a worker. Japan 31 48 The result is that hiring such people is no longer as cheap Source: World Bank, World Development Indicators as might first be imagined. According to foreign managers, the fully loaded cost of skilled local engineers in China is around the same as that in Taiwan, and around half as much as in Germany. gence Unit complained of the difficulties in trying to Worse still, even if foreign firms accept these prices, encourage local managers to focus on productivity, still a there is no guarantee that they will be able to retain their relatively new concept in a society that tends to measure employees. Job-hopping is endemic. Again, according to success in terms of sheer investment in infrastructure and Hewitt Associates, attrition rates for local senior and mid- equipment. Many Chinese businesses still hope to advance dle managers working in MNCs in China average around their businesses by investing more and buying new tech- 30-40%, well above the global average of just 5-10%. nology, rather than getting better returns out of existing Addressing the human capital problem is one of the capital assets or even selling them. Another executive major operational challenges facing foreign firms in said that the biggest challenge ”is making people take China. In a market as fast changing as China’s, it is of risks and bear the consequences”. utmost importance that foreign companies have in place skilled and loyal managers. Given the dearth of qualified Labour shortages undermine flexibility, increase costs local staff and the likely, comparable professional experi- Some financial and professional services firms complain ence of foreign staff, expatriates may be the most obvious that shortages of skilled staff pose the biggest obstacle to choice. Yet foreign firms must also localise staff, to avoid expansion in the country, hampering the ability of compa- both the high costs of expatriate executives and the per- nies to keep up with the rapid changes in China’s business ception that there is a glass ceiling limiting the promotion environment and grab opportunities. prospects of local staff. Even if this dilemma can be The shortages also mean that the skilled and experi- resolved, foreign firms face spiralling wage costs for enced local managers who are in the market can almost skilled employees. With competition and overcapacity

Not so cheap anymore Annual change in wages and prices, % 10

0 Top management Management Professional technical and support Clerical Manual Consumer price inflation

-2 53.4 63.8 80.6 104.0 115.6 132.1 138.8 142.4 140.2 165.7 226.1 243.6 295.2 412.8 2001 2002 2003 2004* Source: Hewitt Associates, Economist Intelligence Unit * Projected

continuing to push down the prices of many finished more damaging, costs beyond the expense of recruiting goods, this puts further pressure on profits. replacements: the loss of valuable company-specific ideas and expertise to rivals. This, of course, is but one cause of Education, education, education the piracy and theft of intellectual property that is ram- The human capital challenge is not, however, experienced pant in China. More damaging, perhaps, has been the vul- evenly. In particular, the bigger MNCs that have been in nerabilities of the JV structure itself, which until recently China for several years are in a much stronger position to forced almost all foreign firms entering the country to set deal with HR issues than smaller, less-experienced firms. up partnerships with local companies. The porousness of The large companies have a wealth of HR management the JV arrangement, combined with a notoriously weak expertise to bring to their China operations, gained from legal environment, has allowed the theft of trade secrets their long experience in many different markets around on an almost institutionalised scale. the world. These firms should be in a better position to For even the most casual visitor, it does not take long understand what makes Chinese employees tick—accord- to stumble upon the pervasiveness of intellectual prop- ing to Mr Gauthier, this is opportunities for career devel- erty theft in China. Tourists do not have to stray far from opment and training—and have the resources and their hotels to find shops selling DVDs of the latest Holly- institutional framework to act accordingly. They can, for wood films (often before they are released in cinemas), example, offer potential local employees positions on Louis Vuitton handbags and North Face clothing. The well-established, multi-year executive development pro- quality of these fake products is often impressive. But the grammes. These often include postings overseas but, even story does not end on shop shelves. According to the without this, some multinationals have developed to such Business Software Alliance (BSA), China’s software piracy a size in China that there is considerable room for local rate of 92% is the second highest in the world, trailing employees to advance, even if there are glass ceilings at only Vietnam. BSA figures show that China was responsi- the very top of the organisation. ble for almost 20% of the global counterfeit losses, These programmes help develop local staff and give equivalent to US$2.4bn, suffered by the software indus- foreign firms a supply of skilled and experienced local try in 2002. Perhaps the most remarkable illustration of managers who can run the China business in the future. the depth of the intellectual property rights (IPR) prob- But the training initiatives of foreign firms do not end lem is the emergence of counterfeit cars in China (see here. Companies like General Electric (GE) are establish- box, Counterfeiting cars in China: Eat your hat). The ing in China the sort of training structures that they main- Development Research Centre of China’s State Council tain elsewhere, such as chief learning officers. Several estimates the total value of counterfeit goods in the major corporations, such as Motorola, Nokia, IBM and country at US$19bn-24bn. Even these large figures do General Motors, have established formal on-site training not convey the full extent of IPR violations in China, centres. GE is in the process of building in Shanghai what excluding, for example, the value of stolen technologies will be the company’s largest staff training facility outside and production techniques. New York. Counterfeiting and piracy are clearly major problems Many companies have also started mentor programmes for MNCs operating in China. Our own survey found that under which expatriate managers help develop their local foreign firms think inadequate protection of IPR trails counterparts. HR professionals in China emphasise that only corruption as the factor with the biggest detrimental the ability to mentor local staff should be a key criteria impact on their business in China. More than 50% of used when selecting expatriate managers to work in respondents stated that IPR violations were a problem for China. GE, Intel, Nortel, BASF and Microsoft all require their China operations. senior managers—whether expatriate or local—to desig- Tackling rampant counterfeiting and piracy has simply nate their successors. In some companies, expatriates are not been a priority for the Chinese government. Perhaps specifically evaluated on how well they nurture their local because few local companies own much intellectual prop- successors, a measure that helps prevent the crowding erty, the local business community can be seen as a net out of training by the very real day-to-day demands of beneficiary of the weak protection given to IPR in the managing a rapidly growing business. None of these ini- country, at least in the short term. Arguably so also has tiatives makes even the biggest firms immune from skills China as a whole, since the piracy problems have seem- shortages, wage inflation and staff poaching. But they do ingly done little to cut the queue of foreign firms waiting show that multinationals have ways of addressing them. to enter the country. In any case, the institutional environment in China does not naturally lend itself to protec- Intellectual property theft tion of IPR. The country’s modern political and economic Losing staff to rival firms has secondary, but potentially system was built on an ideological opposition to the very

50 © The Economist Intelligence Unit Coming of age Part 1 Persistent headaches

concept of private property rights. Moreover, at least emergence of a ”domestic Chinese business constituency since 1949, the judiciary in China has not been independ- that is increasingly active in promoting IPR enforcement”. ent but rather subordinate to the authority of the CCP. The legal environment for the protection of IPR has also Officials at all levels of government have thus viewed the improved. Upon entering the WTO, China signed up to the courts and the legal system as a tool to protect their own Agreement on Trade-Related Aspects of IPR (the TRIPS interests and power, including favoured local companies. agreement), which sets minimum standards of protection As a result, legislation protecting IPR has been inade- for intellectual property. According to the USTR, official quate and enforcement of these laws weak. efforts to introduce a legal framework consistent with China’s IPR record is beginning to change. A group of TRIPS had resulted in ”major improvements that move local capitalists with a stake in a more rigorous IPR envi- China generally in line with international norms in most ronment is beginning to appear. A 2003 report by the key areas”. Finally, the independence of the judiciary is Office of the US Trade Representative (USTR), assessing improving as China slowly moves towards institutionalis- China’s compliance with its WTO commitments, notes the ing rule by law, if not quite rule of law.

Counterfeiting cars in China: Eat your hat

Martin Poste, then head of Volkswagen (VW) in fact, to VW’s own levels. And there was Anhui Chery’s QQ is said to be ”99% like the Asia in 1996, just laughed. ”Could they ever good reason. The Spanish carmaker, SEAT, a GM Chevrolet Spark”, a claim the make counterfeits cars in China?” he subsidiary of VW, had sold a car plant to a manufacturer denies. retorted, echoing the question. ”Good grief, Mexican group a few years previously, and no! Cars are not like watches or CDs, you this had been sold on to a company in China: Toying with Toyota know. A car is too complex a product. The the counterfeits were being built in an old Anhui Chery is not alone. A separate com- engineering required to design one and, VW factory. But there was another twist. The plaint revolves around the Zhejiang Jili even more so, to manufacture one is much Chinese company that had bought the plant, (Geely) Group and Japan’s Toyota. Since too difficult to copy.” Anhui Chery, was 20% owned by VW’s joint- 2000 Geely has produced three different That was then. Mr Poste has long-since venture partner in Shanghai, Shanghai Auto- models of cars, each of which look remark- retired. And VW—still the largest carmaker mobile Industry Corp (SAIC). ably similar to models licensed by Toyota’s in the world’s fastest-growing market—has VW demanded a halt to the Chery. Its Daihatsu subsidiary to Tianjin Auto. The run into, well, counterfeits. The first copies partner, SAIC, said it would do everything in Geely cars even use Tianjin Auto engines, began appearing in 2000-01. Today, there its power to help: it then persuaded Anhui bought legitimately, but at as little as half are counterfeit Volkswagens, Toyotas, and Chery to stop using original VW parts and to the price of the Japanese-designed car. Mercedes and General Motors (GM) cars, pay VW ”a substantial sum” in damages. But Arguments between Geely and Toyota among others. Some are made in SAIC, apparently, has been unable to first began over the design of the vehicle. substantial numbers and to quality levels persuade its provincial offshoot to cease But it was similarities in the logo, and the that have shocked the global majors. Worse, production altogether. Chery volumes, fact that Geely mentioned Toyota in its the range of copied vehicles is likely to grow instead, have continued to rise, breaking advertising, which irritated the Japanese further and any recourse to law is proving through the 100,000 mark in March 2003— company most (in a poll, 67% of difficult. almost half the total for VW’s Jetta. respondents thought the offending logo Anhui Chery is not stopping there. In was a Toyota badge, while less than 7% What goes round... May last year it launched the QQ—another knew it to be a Geely Group brand). The first VW counterfeit—a copy of its Jetta counterfeit of a model not yet in production Toyota alleged the Chinese firm model—appeared in late 2001, re-badged but scheduled to be introduced later this infringed on its patented design and took (as a Chery), altered slightly in appearance year by SAIC’s other foreign joint-venture Geely to court, demanding Rmb14m and priced 20% cheaper. A number of com- partner, GM. Executives at the US carmaker (US$1.7m) in compensation. In early ponents were even sourced directly from the told Anhui Chery last year that they would August last year, realising it stood little German company’s own parts’ suppliers (and ”not appreciate” them copying GM’s chance of legal redress, Toyota withdrew its stamped with VW’s logo to prove it). But the products without referring to a specific claim. But given the extent of major surprise was the comparatively high model, and received assurances that no counterfeiting in China, this legal battle is tolerances and quality of the new car—close, such thing would happen. Fast forward: unlikely to be the last.

An unavoidable operational issue the plant and security at the manufacturing site to which Nevertheless, inadequate IPR protection will remain one bits of technology you bring in and what you keep off- of the most vexing problems for foreign firms operating in shore; which employees have access to what in the plant; China. While the balance is changing, the number of local and how you handle the future—what do you do in a year’s Chinese firms with an interest in demanding better IPR time.” protection is still far outweighed by those with none. There are many reasons to operate in China and for- More importantly, despite the improvements that have eign firms will undoubtedly find it useful to tap into the been made during the last few years, enforcement of business networks of their local counterparts. Yet a dose China’s near state-of-the-art legal and regulatory frame- of caution remains a good rule of thumb. The Economist work for the protection of IPR remains extremely weak. Intelligence Unit learned of one case involving a major According to the USTR, neither administrative nor crimi- foreign engineering company and a local firm caught in a nal enforcement of IPR protection provisions have much, protracted set of negotiations. All looked to be going so if any, deterrent effect. Civil action to protect intellectual well that when the Chinese side asked to view some blue- property can be more effective, but to pursue even this prints, the foreign company complied, believing that the angle requires an element of luck and a considerable gesture would increase trust between the two sides. amount of time. Instead, the prospective partner broke off the discussions In these circumstances, foreign investors are not and went its own way, blueprints in hand. entirely powerless. But the hard reality is still that, given With a careful strategy, even very IPR-intense foreign the weak enforcement, some loss of control of intellectual companies can be successful in China. A good example is property is inevitable for all large foreign companies in the US firm, Qualcomm, a company that produces and China. It does not take much imagination or investment, sells intellectual property rather than physical products. for example, for a local businessman to mimic the logo of But Qualcomm’s competitive strength lies in technology one of the best-known global corporates, or even for that works only as a sum of its parts—knowing just one or domestic firms to make good versions of designer hand- even several different individual elements is not much bags and to burn DVDs. It is likely, however, to become use. This approach is well suited to China and Qualcomm more difficult for local companies to learn the detailed recorded revenue of more than US$310m (equivalent to production techniques that form the heart of the propri- around 8% of the firm’s global total) in China in 2003. etary knowledge of many of the world’s leading industrial Other firms have found ways to trade on their non-manu- firms. For example, many foreign manufacturing firms are facturing skills in an effort to keep the outflow of their no longer compelled to form JVs with Chinese companies, technology within sanctioned channels. One foreign closing off one of the main routes of IPR seepage. maker of large-screen projection equipment with a fac- Of course, all foreign firms wishing to build substantial tory in south China has found it better to pitch its equip- businesses in China still have to work closely with domes- ment as a way of generating revenue from tic firms, either as clients, suppliers or even production advertisers—which it could help find—rather than as partners. Even in these circumstances strategies to pro- hardware for buyers to use as they sought fit. Further- tect IPR need not be the stuff of rocket science. Foreign more, by offering to help set up and operate its equip- firms that assume all domestic companies are potential ment, it has also found a way of keeping an eye on its competitors are probably on the right track. For example, goods and helping prevent rivals obtain damaging access a foreign company may ask why the products of a budding to them. local supplier are so cheap? Is it that the firm simply has an admirably low cost base? Or is it that it wants to gain Persistent headaches other advantages, such as the ability to advertise its rela- That China’s operating environment is perceived as being so tionship with a foreign firm or, more dangerously, to pro- difficult is partly a sampling issue. Attracted by the size of cure technology such as the information necessary to the market and the low cost of low-skilled labour, many make a component? companies that would simply not enter other challenging Foreign firms operating in the country would be well markets around the world nonetheless feel prepared to take advised to take a more sophisticated approach to the pro- on China. This is the case even for some big names, such as tection of company secrets than would be necessary else- B&Q, whose parent company, Kingfisher, has a non-Euro- where. Simon McKinnon, the president of Corning Greater pean presence in only three countries (Turkey, Taiwan and China says: ”You have to build concentric moats, you must China). B&Q claims to be making good progress in China. It have multiple layers of protection.” When a company would be surprising, however, if other firms lacking much brings in a manufacturing plant, he adds: ”You have to international experience were not overwhelmed by the think about things all along the chain, from how you build operational challenges presented by the country.

52 © The Economist Intelligence Unit Coming of age Part 1 Persistent headaches

A dose of perspective is also needed to better under- companies have started to put in place mechanisms to stand the challenges to true multinationals posed by address issues such as labour shortages and theft of trade China’s operating environment. Many of these firms have secrets. At an operational level, China will remain a chal- been operating for decades in other emerging markets lenging location for foreign companies for years to come. and thus have accumulated a wealth of expertise and But for the more experienced multinationals, at least, experience that can be bought to bear in China. In build- operational issues now have a much less dominant impact ing businesses in China during the last few years, these on corporate performance in China than they once did.

Part 2 Automotive Good times today, but an uncertain tomorrow

rom certain angles, the prospects for China’s auto- It would be difficult to argue that growth prospects do motive industry could not look better. China is the not remain good. With an estimated 12m cars on the road fastest-growing automotive market in the world. today—just under one car per 100 people—car ownership Sales of trucks and (the focus of this section) pas- rates in China remain very low; the US, by contrast, makes Fsenger cars have been booming for most of the last more cars each year than China has stock—some 16m— decade. Car sales—driven by rising incomes, declining and boasts almost one car for every two people. It is no prices and, more recently, consumer access to finance— secret why car ownership levels in China are still low. have risen sixfold, from around 300,000 units annually in Average annual income per head in China is around the mid-1990s to just over 2m in 2003; sales rose by US$1,000, well below the price of even the cheapest car, almost 80% last year alone, with the majority of cars— and well below the US$4,000 threshold at which car buy- some 70%—purchased by private individuals, compared ing appears to take off. Patently, all China will not soon be with less than 10% in 1995. Similarly, sales of light com- buying cars. But where incomes are higher in the main mercial vehicles have risen fourfold during the same cities and coastal regions, the addressable market is period, to around 1.8m units in 2003. Sales of heavy growing and will continue to do so as the economy trucks and buses have performed slightly less well, but expands. Driven by passenger-car sales, vehicle sales overall vehicle sales leapt from 1.4m units in 1995 to growth for 2004 is forecast to be between 30% and 40% 4.4m in 2003. (it was 34% last year); as an indicator, car sales rose by

● China’s automotive sector continues to expand rapidly. As ● Although there are good growth prospects and profitability is developed-world markets have stagnated, there has been a still healthy by world standards, the huge capacity expansion headlong rush to China by the major foreign automakers— under way is raising concerns about future levels of prof- most of which are now present in the market. itability. Already, end-prices are falling quickly as competition heats up. ● Restricted to 50:50 joint ventures, foreign automakers have helped to bring major state-owned carmakers into the modern ● In the face of these threats, companies are wrestling with age, if not yet to global standards. Market access has been new strategies to sustain margins. given in exchange for transferring technology and management skills. Local firms have built multiple partnerships with ● The government’s explicit longer-term goal of developing a foreign firms, often playing one off against another. strong and independent domestic automotive industry, one predominant in the market, is at odds with the expectations ● The early development of a competitive domestic car industry and plans of foreign investors. has taken many by surprise. Local companies not only compete effectively with multinational companies in the China ● Given the risk over time to profitability, multinational auto market, but their number is growing. Many have ambitions to firms will need to devise long-term strategies that take into compete overseas too. account a potentially diminished role in the market.

54 © The Economist Intelligence Unit Coming of age Part 2 Automotive

44% year on year in the first quarter of 2004. The Econo- ket. Names such as Geely, Chery and Great Wall—some mist Intelligence Unit expects passenger-car sales to attached to established local players, others not—are reach almost 5m in 2008—even as annual car sales growth becoming familiar badges on China’s roads. Even China’s moderates to between 15% and 20% during this period. automotive aristocracy—SAIC, FAW and Dongfeng—have The auto sector is profitable, too. Average margins indicated they will expand their range of own-label vehi- across all vehicle types are about 30%, according to the cles too; SAIC is building a new facility to manufacture its international rating agency, Standard & Poor’s; estimates own cars and others have announced their intent to follow for passenger cars are somewhat less, at between 10% suit. New entrants continue to appear, with some of and 20% (depending on the manufacturer), but contrast them—like AUX, a home-appliance maker which plans to this with a global average of just 5% and the China market invest US$966m to build 450,000 cars annually by 2008— undoubtedly is an attractive proposition. General Motors diversifying from their core businesses to cash in on the (GM), for example, reported earnings of US$437m from its burgeoning auto market. partnerships in China last year, tripling its profit from 2002. On sales of 487,000 cars, this compares very Heavily circumscribed favourably with the performance of GM’s North America China has good reason to see the automotive industry earnings of US$811m on sales of over 4.5m cars. China’s thrive on its own shores. According to the Michigan-based market leader, Volkswagen (VW), with a 30% market share Center for Automotive Research (CAR), auto manufactur- in 2003 (down from more than 50%), reported consoli- ers and their ancillary industries account for 10.5% of the dated operating profits of Euro561m, around 25% of GDP of OECD nations, or one job in nine. Industry leaders group operating profits, on sales of almost 700,000 cars. are giants by almost any measure: in 2003 the turnover of Investment in the sector continues to surge. Global the US automaker, GM, was 50% greater than the GDP of auto manufacturers have turned to China at a time when Thailand and equal to 13% of the GDP of China. There are a the industry in traditional markets is mature and compar- host of other benefits, too: the auto sector is a source of atively static; in the US, car sales have long reached a intelligence in products and manufacturing technology plateau, whereas European and Japanese markets are in that stretches far beyond the vehicles themselves—from slow decline. With little growth elsewhere, the nascent materials innovation to global positioning systems. A China market—with all its apparent potential—is one few healthy market for vehicles also greatly increases personal major players feel they can ignore. This was not always so. Throughout the 1990s, the market was dominated by three main joint ventures (JVs), one between Shanghai Roaring ahead Auto Industry Corporation (SAIC) and Germany’s VW, Sales of passenger cars, ‘000 another between Changchun-based First Auto Works (FAW) and VW, and the third between Tianjin Auto (now 2000

owned by FAW) and Daihatsu/Toyota of Japan. But in the 2,040 last few years there has been a headlong rush of new entrants. Nissan, GM, Ford, BMW, Hyundai, Daimler- Chrysler—most of the industry’s big names are now pres- 1500 ent, each with ambitious plans to build or increase capacity and market share. Among the plans recently announced: ● VW is to invest Euro5.3bn (US$6.4bn) to double capacity to 1.6m cars by 2007; 1000 ● the French carmaker, PSA Peugeot Citroen, is to invest 1,107 Euro600m to double production capacity at its Dongfeng Motor joint venture to 300,000 cars by 716 2006; 500 614 ● Japan’s Toyota has formed a strategic alliance with 571 FAW to produce 400,000 cars in China annually by 509 2010; and ● Kia Motors will invest US$645m to build a second plant in China with its joint-venture partner, 0 1998 1999 2000 2001 2002 2003 Dongfeng Motor. There has also been a influx of local entrants into the mar- Source: CEIC 55 © The Economist Intelligence Unit Coming of age Part 2 Automotive

A serious market, at last Passenger car sales, ‘000 1998 2003 2500

2000 2,579.1 2,378.5 2,247.4 2,236.6

1500 2,040.0

1000 1,380.7 1,211.9 1,192.5 1,118.6 500 980.9 584.4 588.5 568.3 538.4 0 China Brazil Spain Australia South Korea Italy UK

Source: EIU CountryData

mobility—another primary driver of economic growth and agement skills and, worse, violations of trust. The impact development. of foreign carmakers on the industry has been enormous, China has long designated the automotive sector a pil- yet their influence has been heavily circumscribed. lar industry, with all the attendant implications of creat- The arrangements were, and remain, an unpalatable ing a strong and viable domestic automotive sector. This necessity to foreign companies. VW arguably has played national strategy, and its subsequent refinements (see this difficult, and lop-sided, system most successfully. It below), has permeated the entire history and nature of came to China in the early 1980s, setting up two separate foreign involvement in the industry. joint ventures (one with FAW in Changchun, the other Since foreign automakers made their entry in the early with SAIC in Shanghai). In the initial years, at least, it 1980s, they could, and can only still, establish operations managed to control, and limit, the pace of technology through JVs with local partners, and then only with up to transfer, often for good reasons (China could not service 50% equity. The model was quite rigid. Usually the local and maintain more advanced cars until recently). In these partner was designated by the central government (from a very early days of foreign investment, when government small coterie of large state-owned firms), and usually a relations meant all, VW worked slowly and patiently, foreign company would have just one such joint venture building relationships, and gradually building its share of (the maximum permitted was, and remains, two) at a sin- a small market of less than 250,000 cars to 60%. gle plant producing a single model. There were strict VW was helped by the fact that the market was largely requirements for local sourcing of components (usually closed to other entrants; the German carmaker even had a 40% plus) and little operational control (nor control over hand in the appropriate legislation, arguing—rightly— marketing and sales). Although foreign companies now that a free-for-all would not help the country establish have far greater latitude to work within their joint ven- economies of scale. Its only serious rival was Tianjin Auto, tures, on all aspects of their business, the basic entry and producing (not especially well) small cars under licence set-up rules have remained the same. from Daihatsu. Two small French joint ventures proved lit- The regulations circumscribing foreign involvement tle competition: one, Guangzhou Peugeot, ended in disas- were designed quite intentionally. The right to market ter, as did the other, Beijing Jeep, an alliance between access had a clear price—by transferring technology and Beijing Auto and Chrysler which suffered many partner- management skills, foreign automakers were to help bring ship teething problems, some of which reportedly remain China’s major state-owned car companies into the modern to this day (Hyundai has now taken on Beijing Auto as a age, if not yet quite up to international standards. These partner and seems to have made more of a success of the arrangements also permitted the big state-owned firms to relationship, however). build multiple partnerships and to play foreign competi- By the mid-1990s these firms controlled more than tors off against each other, often to great advantage (in two-thirds of the local market, albeit a market with sales securing newer technology, for example) and sometimes of around 400,000, well below what foreign carmakers to ill effect through the leakage of technology and man- had anticipated. Even so, the government was getting

56 © The Economist Intelligence Unit Coming of age Part 2 Automotive

impatient for more technology and more choice. In 1996 firms together are likely to add another 4m-5m units of it decided to offer one more car manufacturing licence, capacity by 2006. According to Mike Steventon, the head which it awarded eventually to GM in 1997, after a fierce of the auto practice at the management consultancy, bidding contest between GM and Ford. It was widely KPMG, overcapacity in the industry in China is likely to hit thought at the time that GM had paid a high price—the US 70% in the next few years. Most analysts agree that over- carmaker had entered a joint venture to build a US$1.5bn capacity is looming—it is just a question of how severe, plant, and to bring in its latest technology and cars. And it and how long-lasting, it will be. Much will depend on how had agreed to work with one of its prospective rival’s main current aggressive capacity-building plans play out. Car- partners, SAIC. The plan proved to be astute, allowing the makers themselves say that new investments will follow state-owned automaker to play GM off against VW, raising the pace of demand and that capacity forecasts tend to the bar for the German firm to bring in its latest technol- overestimate the potential of local carmakers; GM ogy as well. observes that the market has been continually undersized The market was now undergoing a transformation, with by carmakers in recent years. Yet it is worth bearing in sales picking up and, in anticipation of eventual member- mind, too, that the market already carries overcapacity— ship of the World Trade Organisation (WTO), clear commit- among foreign carmakers, estimates automotive consul- ments to open the market and reduce tariffs. A new wave tancy Autopolis, utilisation rates were around 65% in of interest among foreign automakers was gathering. In 2003; purely domestic firms—those whose capacity is June 2001 the government issued a development plan known—could manage only 40% last year. Exceptionally under which smaller domestic firms would eventually be rapid rises in car ownership will be needed if both existing shut down and the remaining ones consolidated around facilities, and the huge new ones currently being built, are three of the largest firms: FAW, China’s largest manufac- to be profitable. This is unlikely. turer based in Changchun in the north-east province of Foreign automakers are entering a period when Liaoning; SAIC, the second-largest producer based in falling prices—and margins—will be their primary con- Shanghai; and Dongfeng, the third largest located in the cern and the focus of their business strategy. The fear is central province of Hubei. that margins—until now quite healthy—will soon drop to Foreign firms, too, have been drawn inexorably into global norms. Falling prices are now a characteristic of this constellation. With a limited number of viable Chi- the market as competitive pressures—exacerbated by nese partners in the market, many new entrants have cheaper imports (under WTO, vehicle tariffs began been forced into alliances with partners that are already falling in 2002)—increase. Domestic car prices fell by affiliated with their global rivals. As with VW and GM shar- around 11% last year and industry analysts forecast a ing SAIC, Toyota and VW share the same partner in FAW, more than 10% drop on average in 2004. Add to this the and Renault, Peugeot and Nissan are all working with rising costs of inputs—steel, rubber—and margins look Dongfeng (Nissan is the only carmaker to have broken quite fragile. the joint-venture mould, by acquiring a 50% stake in The risks to foreign manufacturers are significant. The Dongfeng for US$1bn; the fact that it was unable to dominant manufacturer in China, VW, which has plans to secure a majority stake suggests, however, that its expe- locate almost one-third of its productive capacity in China riences will not be dissimilar from its joint-venture by 2010, is likely to suffer most as pricing power evapo- rivals). Unsurprisingly, these arrangements are creating rates. The days when it was earning a net profit of up to tension. Rmb20,000 (US$2,400) per car, twice its average global margin, have long gone. But equally, all other manufac- Competition and overcapacity turers must now live in a market in which sales are likely to Growing competition among foreign players is one thing rise and margins are likely to fall. The common quest will but few seem to have anticipated the emergence of new be to come up with new strategies to sustain margins or (and surprisingly competent) local rivals or the growing prevent them falling so quickly. strength of established local firms. The market is certainly becoming crowded. China has 100 or so domestic car Among the solutions are: manufacturers. Many of them are small admittedly, and Scale back capacity and expansion plans. For many com- likely to be consolidated or driven out of business, but a panies this is simply not an option. Most have entered significant number are real competitors. China to seize market share and, currently in their build- With every carmaker eager to grab market share, the out phases, have fairly rigid commitments and timelines concern is that collectively they are over-investing, and to achieve capacity and market-share targets. Inevitably building too much capacity too quickly. Although it is dif- they are not in a good position to counteract pricing pres- ficult to measure precisely, the plans of foreign and local sures and sustain margins.

Coming of age Part 2 Automotive

Very sizeable opportunities therefore for financing—and for leveraging Share of global profits, 2003, US$m a lucrative service business on the back of the core product. Car financing is a major and integral component of 2000 the business of global car firms. In the past couple of years, China’s domestic banks have been rushing to pro- 2,136 China vide individual car loans; foreign firms had been excluded Global (despite WTO provisions allowing their participation). That has now changed. In October 2003 long-delayed leg- 1500 islation was finally announced and three major players— VW, GM and Toyota—each received approvals for establishing auto financing companies (AFCs). Car companies certainly have great hopes for AFCs. Ease of consumer 1000 finance should help propel sales, reduce the threat of overcapacity and, in a virtuous circle, feed more financing 1,100 itself. These are big hopes—demand will have to rise very quickly indeed to keep up with new supply. In any case, the wait for foreign AFCs is not yet over. Numerous

500 673 bureaucratic hurdles must be negotiated and car companies expect AFCs to be up and running only in the third or

437 fourth quarter of 2004. Even when AFCs are set up, car companies would be well advised to take a conservative 0 attitude to customer selection. Defaults with banks so far General Motors* Volkswagen** have been high, unsurprisingly perhaps: the average com- * GM figures are solely for automotive operations (not financing) pact car costs 2.3 times the average annual household ** VW China figures are not included in Group figures. Converted at Euro1:US$1.20 Sources: Company reports, EIU income in China, compared with just 20% of average income in Japan.

Imports. Like financing, imports are very much icing on Gear up for exports. Most foreign carmakers in China the cake. Lower import tariffs have not yet had a major have plans to export, yet, with the exception of Honda impact on the proportion of imported cars sold in China; (whose Guangzhou plant is export-only), few seem partic- although numbers have risen, imports account for less ularly serious about doing so—despite growing govern- than 5% of vehicle sales. But they are potentially a rich ment pressure to make China a global production hub. source of added value, particularly given that income does Most set up operations in China to meet local demand and not have to be shared with a partner. have little incentive to export to markets where they have more than enough capacity already—and often labour Local sourcing of components. Perhaps the single most unions to think about, too. Nor is it assured that exports important strategy to combat falling margins is to reduce would fare well abroad in any case. The quality of Chinese- costs (cars are relatively expensive to produce in China; made cars is not up to international standards. The low generally, economies of scale are not especially good). cost of labour in China offers little benefit to potential car Cars are made largely of components sourced from (usu- exporters; being capital-intensive, the average labour ally separate) parts makers. Typically, car companies are content in a US$20,000 vehicle is around US$1,500, required to buy a certain percentage of locally made parts according to Deutsche Bank; the most efficient plants and many have encouraged their traditional parts makers today are in high-cost Japan. Components, which typi- to join them in China in order to be able to secure local cally require greater scale than the vehicles themselves, is sourcing lines able to produce quality parts. But compo- not a fully developed sector, nor yet cost-efficient. nents made in China typically also cost above the global Exporting vehicles from China only really makes sense as a average—usually by around 10-20%, and in some cases by way of repatriating profits or making a show about com- as much as double the price of parts elsewhere; most commitment—the theme, it seems, behind most foreign ponent makers do not yet have the economies of scale to export plans in the sector so far. produce in China cheaply. As demand from carmakers increases, component makers are expanding their capaci- Car financing. Margins on the cars themselves may be ties and investments in China. There are no immediate falling but sales volumes will certainly increase, as will the and quick solutions but companies like GM, for example

(and not untypically), are now working closely with local the market, as these would be the first to come under seri- suppliers to bring down costs over time; GM is extending ous attack from emerging domestic firms. technical help (on quality issues and training on improving scrap rates, for example) and is also extending larger- A road-map for...Chinese companies scale orders to encourage economies of scale. Most The desire to capture the China market, and all that it foreign carmakers are looking to increase local content to promises, has compelled many major foreign carmakers to above 70% in established models (new models take accept rather unpalatable arrangements and, in some longer). cases, violations of trust. But overcapacity in the market and underwhelming partners are, perhaps, only near-term Differentiate, differentiate, differentiate. Technology, complications. A greater concern is the government’s design, brand—all are important distinguishing features blueprint for the future of the local car industry—and in a market where copying remains rampant and lack of determining where foreign carmakers fit into the picture. brand innovation acute. All foreign carmakers, without Since 1994, the government has said that its long-term exception, already pay heed to this mantra but difficulties objective is the establishment of a strong and independ- may come, especially for foreign brands at the bottom of ent domestic automotive industry. Plans have been

A host of challenging issues

Counterfeiting. The idea of counterfeit cars party in the (50:50) joint venture wants the the roads. There is, as yet, no fixed pattern was laughed off when, in 1996, it was put money retained? VW, for example, tries to and no second-hand market to indicate how by the Economist Intelligence Unit to a sen- “export it out” with engines. But still, with the market will evolve. Will the Chinese want ior foreign automotive executive in China. pressure from its partners, VW says it is rein- manageable cars for the family, pick-ups Cars are too complex, he replied. Yet today, vesting much of the profit and expects, (70% of the market in Thailand) or small counterfeits—near-complete copies, in instead, to be able to get the money out at cars and MPVs (the two segments that make some cases, of foreign-designed vehicles— an unspecified point in the future. Only for up the bulk of the market in South Korea)? are now being produced in substantial num- Honda, with its export-only plant in How, indeed, do foreign firms know what to bers across the country. Imitation VW, Guangzhou, can margins be taken where the build when they establish factories to make Toyota, Mercedes and GM cars are crowding vehicles are sold. one model in volume? China’s roads alongside the more expensive originals; and counterfeiting of auto parts Sales and service networks. China is a vast The darker side. China’s car market may, in is also rampant in China—by some esti- place and national distribution and service the medium to long term, be constrained by mates, as much as 90% of aftermarket parts networks hugely complicated to set up. A a number of other factors. The availability of are fakes. Counterfeit cars are being built to car sold to a customer in Beijing might petrol (at affordable prices) is one possible quality levels that have shocked the major need to be fitted with spare parts in Inner concern, as China soaks up increasing vol- companies, and the range of copied vehi- Mongolia, Lanzhou or the far western umes of world oil and questions begin to be cles is expected to grow further. The regions. Many joint-venture firms are raised about the sustainability of global authorities, certainly, are doing a better job forced to sell their cars through provincial supply. China’s urban environment, too, is of enforcing laws against counterfeiting but governments and allied organisations. In suffering markedly as a result of the explo- penalties remain inadequate, according to such uneven circumstances, how can car- sion of cars on the road. Particulate pollu- foreign automakers and suppliers. More- makers build a consistent brand? The tion is increasing dramatically in cities like over, recourse to law is proving difficult biggest carmaker, VW, has just 900 outlets Beijing and Shanghai, and traffic snarls and (several cases have been lost) and litigation after being in the country 20 years. Toyota accidents are increasingly common, and suggests even the more respectable local has just 100; Honda twice that. serious. Both these have significant eco- partners cannot be trusted. (See Part 1, nomic and health implications and costs, Persistent headaches, for a detailed case The right product. What sort of cars will and the risk is that governments at all levels study.) China’s new motorists want? The truth is, no in China may feel obliged to bring in restric- one knows. The market is currently in an tions on car ownership to tackle them; Repatriating profit. There may be profit to experimental stage; most car buyers are already Shanghai limits the number of new be made, but how to get it out when the ren- tasting the different models on offer, hence car registrations each month, and other minbi is not fully convertible and the local the plethora of sizes, models and brands on cities may well follow.

60 © The Economist Intelligence Unit Coming of age Part 2 Automotive

Taking a different road

Glance at the vehicles parked on the streets Instead of getting into bed with a still- business, according to Mr Torok. This means of Beijing, Wuhan or Shanghai and you will state-owned company which is in need of that the motivation to counterfeit—a rarely see a Mitsubishi badge. Yet the com- large-scale restructuring, lay-offs and an phenomenon that has been a bane to others pany has a higher share of the light-vehicle investment overhaul, Mitsubishi’s more in the industry—is much less, especially if market than many other big names in nimble partners have been able to raise the local partners can be helped to maintain China’s auto sector, such as Audi of Ger- capital locally, Mr Torok says. He adds that high margins. “We have never had a lawsuit many, Ford of the US and Japan’s Honda. being linked to smaller partners makes it or a fight,” he adds. “We have a different strategy for China,” easier to avoid having the sorts of overly says Mitsubishi’s Tokyo-based marketing politicised negotiations with the authorities Next, the brand head, Steve Torok, as he explains how his that have dogged many other foreign So far, the company has not insisted on the company grabbed 6% of the light-vehicle investors in the sector. use of its brand: less than 10% of the vehi- market, with revenue of US$300m in 2003. The bulk of Mitsubishi’s sales come from cles sold in China in 2003 carried the three- With sales of more than 145,200 cars and an alliance with South East Motor (SEM), a diamond-shaped Mitsubishi badge. But multi-purpose vehicles (MPVs), it achieved a company formed in 1995. SEM sold close to there are now plans to introduce the Mit- volume almost three times that of Audi, 80,000 Mitsubishi Lancers, Delica vans and subishi brand on all vehicles and bring in a seven times that of Ford and 40% more than Freeca small multi-purpose vehicles in wider range, which the company sees as a Honda. 2003—all under its own brand. The key step in creating a more powerful base for relationship is controlled through China further growth. It recently introduced the More ventures, not less Motor Corporation (CMC) of Taiwan, one of Pajero Sport through an alliance with Beijing Mitsubishi’s approach is certainly different. Mitsubishi’s most enduring and successful Jeep (one of the bigger Chinese names in the For a start, it has pursued several separate Asian partnerships. CMC, which controls sector) and the Outlander. Both carry the ventures, unlike most of its foreign rivals. one-quarter of the Taiwan vehicle market Mitsubishi badge and are sold through Most critically, it has not, for the most part, itself, owns 50% of SEM. (It is still illegal to branded dealerships. Again, however, MMC pursued partnerships with the big names of control more than 50% of a vehicle has no equity stake in the business. the business. Rather, it has operated on the assembly venture in China.) The local Fujian Mitsubishi’s unusual portfolio strategy fringes, seeking partnerships with several government owns the remainder. Although gives the company greater flexibility to smaller firms. Through these arrangements, Mitsubishi has made no direct investment in achieve these goals, claims Mr Torok. It the company has four vehicle-assembly and the venture so far, it has been able to build opens more options and gives it leverage two-engine production alliances—yet it healthy volumes. Moreover, the vehicles over where to put future production. This controls not even half of any of them. This is rely completely on Mitsubishi technology. gives the company a stronger hand in another distinguishing feature of Mit- Because Mitsubishi owns 15% of CMC, it has negotiations, a rare thing in the auto sector subishi's strategy: while it has some equity also been able to draw royalties and earn in China where pressure to “cut a deal” and participation in some of the ventures, most revenue through licensing agreements. the fear of being left out make most hot- are purely licensing arrangements. Even The Japanese company has also taken headed entrants almost dizzy. then, the stakes and licensing agreements minority equity stakes in two engine joint Nothing is ever certain in China’s auto are sometimes held through a third party. ventures, Harbin Dong (in which it has a sector, of course. But with a growing share, According to Mr Torok, Mitsubishi Motors 15% stake) and Shenyang Aerospace (25%). good returns, little investment, seemingly Corporation (MMC), in which Germany’s These companies also have licensing healthy relationships and, it says, no DaimlerChrysler has a controlling stake agreements for Mitsubishi technology. counterfeit problem, taking a different road (though this is now under review), has The strategy specifically encourages certainly seems to have paid dividends for “chosen less visible partners deliberately”. Mitsubishi’s partners to take a stake in the Mitsubishi so far.

steadily updated and refined since. The detailed objec- three dominant carmakers (FAW, SAIC and Dongfeng), the tives spelled out in the Tenth Five-Year Plan, which runs types of vehicles that will be needed and by when, and a until 2006, specify a very precise vision for the sector’s sequenced plan for the development of component tech- development. The Plan outlines the projected pace of nologies. These plans are extremely detailed and part of technology development for the industry, the competitive wider government development objectives. The market so structure (including the numbers of companies in each far has evolved almost exactly as the government decreed. product segment), the consolidation of the sector around Further refinements have followed. In May 2003 the

Under-utilised China’s passenger car capacity and production, 2003 Capacity, Production, Utilisation Foreign joint ventures ‘000s ‘000s rate, % Plans/comments BMW—Brilliance Automotive 30 7.5 25 Investment to treble by 2005 DaimlerChrysler—Beijing Jeep 80 19.4 24 Production 80% lower than in 1995 Mercedes to make 25,000 own-brand cars a year by 2012 Fiat Auto—Yuejin Automotive 100 37.4 37 Ford—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 2010 Ford—Jiangling Motor 100 60.3 60 General Motors (GM)—Jinbei Automotive 30 3.5 12 GM expects to have 750,000 units of capacity in China by 2006 GM—Shanghai Automotive (SAIC)—Wuling 180 0.5 0 GM—SAIC 200 207 104 GM—SAIC—Dongyue 100 na na Honda—Guangzhou Automobile 120 117.2 98 Honda—Dongfeng Motor 30 na na Honda China (export) 50 na na Hyundai—Beijing Automotive 50 55.1 110 Hyundai (which owns Kia) plans to have 300,000 units of capacity by 2006 Hyundai—Dongfeng Yueda Kia 100 52 52 Mitsubishi—Hunan Changfeng 50 29.2 58 Mistubishi plans to have 200,000 units of capacity by 2006 Nissan—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 too Nissan—Zhengzhou Light Automobile 60 10.1 17 PSA Peugeot Citroen—Dongfeng Motor 150 105.5 70 Plans to raise production to 300,000 units within “the next few years” Suzuki—Chongqing Changan 100 102.1 102 Suzuki—Jiangxi Changhe 100 37.3 37 Toyota—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 2010 Toyota—Sichuan 10 0.4 4 New plant. Toyota also plans to make up to 300,000 cars a year in Guangdong VW—First Auto Works (FAW) 300 302.3 101 In all, VW wants to increase capacity to 1.6m units a year by 2007 VW—SAIC 450 405.3 90 Total foreign JVs 2,590 1,686 65

Domestic companies Dongfeng Motor Luizhou 50 10.3 21 With its own production and that of affiliates, DFM says it will produce 630,000 vehicles by 2007 Dongfeng Automobile 100 na na Light commercial vehicals FAW—five locations 420 222.2 53 Anhui Jianghuai n.a 14.8 na Shenyang Brilliance 100 26.8 27 BYD 50 20.1 40 Jianxi Changhe 60 2.7 5 Chery (SIAC part owned) 200 91.2 46 Geely 150 81.3 54 Great Wall 45 28.1 62 Guizhou Skylark 50 1.2 2 Harbin Hafei 150 32.4 22 Hebei Zhongxing 100 28.5 29 Rongcheng Huatai 30 na na Soueast 120 83.5 70 Total domestic firms 1,625 643.1 40 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 as well; AMX, a home-appliance maker, plans to add 450,000 units of capacity by 2008 Source: Autopolis

62 © The Economist Intelligence Unit Coming of age Part 2 Automotive

Bit parts

The titans of China’s automotive industry— The survey also threw up a rather unlikely coming in the form of lower vehicle prices big names like Shanghai Auto Industry Cor- finding over export development, one of the and more inward investment—that is, more poration, First Auto Works and most oft-touted reasons for international competition. By implication, they see a Dongfeng—get most of the attention. But parts makers to be in China. In contrast to sector where cost pressures will rise further car producers, on average, buy parts worth speculation that China will be the and economies of scale will be even harder 75% of the value of each car and so are automotive-parts supply base to the world, to achieve. highly dependent on a vast array of parts the survey found that very few firms are now None of this is the way it was portrayed a suppliers. While much attention has been exporting much at all. According to the few years ago. Foreign parts makers had devoted to the corporate strategies of the survey, 83% of purely domestic Chinese claimed to be in China for three main major car companies, it is worth considering parts makers export less than one-quarter of reasons. They said they had been forced to how part suppliers, China’s automotive foot- their output, while the majority of foreign- be there by their customers, the vehicle soldiers, are faring in the world’s fastest- participant companies also export less than manufacturers. But many investors also growing vehicle market. one-quarter of what they produce. The claimed to their shareholders that they were In the first survey of its kind, the top 300 reason? Cost competitiveness—or rather the setting up shop in China because they automotive-parts makers in China have just lack of it. wanted a share of a fast-expanding market been asked their views. Just over half of Contrary to popular belief, the auto- (in a global sector without any growth). Yet these were purely indigenous firms, the rest parts sector is highly scale- and capital- they seem to have found a market which is mostly foreign-invested joint ventures and a intensive—very few parts actually have increasingly fragmented, where costs are few entirely foreign-owned firms. The much of a labour input. The scale high, prices are likely to fall and where most results of the survey, which was carried out requirements in components are typically believe Chinese firms are favoured by the by the Economist Corporate Network, a much higher than they are for car assembly. authorities and will continue to be. sister company of the Economist In practice, almost every part is stamped, Another reason, they claimed, was to Intelligence Unit which also participated in bashed, extruded and wound by machines in develop an export base. Again though, with the survey for this report, suggest that the massive volumes. The few labour-intensive plenty of capacity elsewhere, few labour- car-components sector is in some confusion components that exist are already made in intensive components in the business (and about what it originally hoped to achieve other low-cost countries such as those that do exist already being made in and what it now believes it really will. Bangladesh, India and the Philippines. other countries), a lack of scale, an The biggest issue for those questioned China cannot compete where labour costs increasingly fragmented supply base, few was growth, although not in the way that really matter. Moreover, many components parts that can be shipped easily across the might be imagined. Obviously enough are too heavy, delicate or integrated with world for the just-in-time needs of their perhaps, the companies thought that other parts to make overseas production end-customers 8,000 miles away, as well as China’s automotive sector would continue and shipment very sensible. Even the an expectation that WTO will not increase to grow rapidly (in fact, none even indigenous Chinese parts makers claimed these opportunities much, the argument is questioned the idea). More than 70% that they have to import more than half of beginning to ring a little hollow. thought that the market would expand by the value of their end products. Sino- On the basis of this survey, it is more than 11% in each of the next five foreign joint-venture firms reported an even beginning to look as if the world’s years. Yet most expected themselves to lower local added value. automotive-parts makers were at best grow even faster—almost half planned to Firms do not expect these prospects to unrealistic about their initial prospects in add capacity by more than 20% a year. This change much as a result of China’s China. As the market grows, the situation suggests that the companies all plan to membership of the World Trade may improve. For now, however, the grand increase their market share (an Organisation (WTO). Only 20% of all the battle plans of the foot-soldiers of the impossibility), so there is likely to be an firms questioned expected to increase world’s automotive industry are looking a even greater level of overcapacity in the exports as a result of WTO membership. little less well thought-out than they once coming years than there is today. Companies saw the greatest impact of WTO claimed.

government published a draft auto-industry policy that Autopolis also sees China mimicking Japan and South alarmed many in the industry and raised fears that the Korea. Both these countries developed their auto sectors ability of foreign carmakers and suppliers to protect their as China is doing now (although neither had a problem proprietary technology and intellectual property would be with counterfeiting): state-supported industries initially further curtailed. There are some familiar features, for forged alliances with global names or signed licensing example on ownership—this would remain at 50%, agreements and built their own skills until indigenous although foreign car companies had been hoping that manufacturers became dominant. Today, both have mar- China would ease rules that limit on foreign investment. ket demand patterns in which imported or foreign brands But the critical feature is a requirement that, by 2010, account for less than 5% of sales. Autopolis’s projections 50% of all sales in China must be in the hands of wholly make China similar in construct to Japan and South Korea, owned domestic firms using their own technology. As the the only other countries in the region with automotive management consultancy, KPMG, has noted, the “provi- industries that now have deeply rooted, indigenous skills sion could force foreign manufacturers to turn over their as well as technological depth, industrial scale and devel- technology and patents to their local partners as a way of oped brands. remaining in business.” Whether these new plans are fully implemented—one Good times today, uncertain tomorrow issue will be whether limiting the sales of foreign compa- With most major car markets in a slump, China is the most nies to 50% violates China’s WTO obligations—it is clear attractive automotive market in the world at present. For- China is trying to put its companies at the centre of the eign carmakers have been falling over themselves to get a industry and develop a more autonomous and free-stand- foothold, or to expand, in a market that, understandably, ing sector, less dependant on foreign firms. Chinese poli- is seen as having good long-term potential. Yet clearly, cymakers have hinted that they may heed calls from the there are reasons for prudence. There is a risk to the long- auto industry to make the controversial automotive policy term profitability of multinational car companies in the less protectionist. The State Development and Planning government’s explicit policy goal of building an inde- Commission has released a new draft which is softer pendent auto industry using JVs with foreign firms as con- around the edges. But there continue to be concerns that venient stepping stones. Foreign companies will certainly the key policies (which remain almost unchanged) will be an important factor in the China market for many years inhibit foreign involvement in the sector. to come, but at the same time they need to develop Determining the future balance of local versus foreign strategies that are cognisant of these realities—and of the is difficult—often such long-term policy documents are possibility of being marginalised. broad in nature and articulate a preferred rather than a More immediately, companies need to think of what singular vision. Yet it is worth contemplating what a more can be achieved now and in the next few years, and how to pessimistic scenario might be. Autopolis forecasts that as develop strategies to cope with the host of difficulties and China’s market for cars and trucks grows to around 13m by disadvantages (particularly of ownership and control) 2020, as much as 80% of total sales will be from wholly that they face. Untrustworthy partners, technology leak- domestic firms. Autopolis argues that the pattern of age, counterfeiting, the rising cost of inputs, burgeoning development in the auto sector already mimics the evolu- competition, falling prices and falling margins are all tion of other key sectors of the economy. The model, it characteristic of working within a rapidly expanding and notes, works something like this: the government sees an maturing market. opportunity; it develops plans; invites foreign partners Equally, China is an emerging market with an over- (but only in minority or equal partnerships with local heating auto sector; a further risk, and one experienced firms); builds domestic capabilities (partly with counter- by almost every emerging automotive market from Mex- feits); and then gradually assumes control of the market. ico to Indonesia, is of a collapse in demand and sales. Car Such a pattern was followed in the development of the companies would be well advised to think about how they telecoms sector, computing and white goods, and in other can limit their exposure. So great is the fear of being left industries where the maturing process took ten years or out in this peculiarly global industry that too many firms less. In the auto sector, the pace of development is likely seem to be rushing in headlong. China calls for less to take 20 years or more, according to Autopolis, but the haste, more focus on building working relationships and initial stages of the industrialisation pattern are already more attention to the evolution of the market and to identical and recognisable. building brands.

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Coming of age Part 2 Financial and professional services

Part 2 Financial and professional services Still dreaming of the future

f all industries in China, the financial and profes- leged access to China’s market. One of the world’s largest sional services sector is the one where the gap accountancy firms, KPMG, admits that China is currently between the current reality and future expecta- very small relative to its global business. A leading inter- C Otions of foreign firms is the greatest. Currently, national law firm, Shearman and Sterling, reports that M China is a minuscule market from a global perspective, China is small relative to its West coast office in the US or even for the most committed of foreign firms. More than its Paris office in France. Y half of the firms in this sector that responded to our sur- Pinning down exactly how important China is to foreign CM vey reported that China currently accounts for 2% or less services companies is tough, not least because few firms MY of global revenue. For the world’s largest financial serv- are willing to reveal detailed revenue data. Instead they

CY ices firm, Citigroup, for example, the mainland China mar- tend to lump their operations in the world’s most populous ket remains small relative to even Hong Kong and Taiwan, nation with those generated by the rest of the Asia and CMY let alone its home market of the US. In 2003 China con- Australasia region. This reticence is perhaps surprising, K tributed just 3% of the foreign first-year life insurance given that most foreign and professional services firms premiums collected by American International Group that responded to our survey indicated that top-line (AIG), a company that in recent years has gained privi- growth was the criteria used internally to judge success.

Of all industries in China, the financial and professional serv- All is not lost for foreign firms. Domestic players tend to be ices sector is the one where the gap between the current real- financially weak and thus open to co-operative and even own- ity and future expectations of multinational companies is the ership arrangements with their overseas counterparts. Also, greatest. From the perspective of the global financial and foreign firms have much higher service standards—a trait professional services industry, China is a minuscule market, increasingly appreciated by China’s growing middle class. even for the most committed of foreign firms. There is no common strategy among foreign services firms. But there is an almost universal belief among big foreign There is the Anglo-Saxon approach (exemplified by the likes financial and professional services firms that within ten years of HSBC and Citibank) that takes advantage of any opportu- China will emerge as one of their biggest global markets. nity to expand corporate presence in China. The continental Recent growth suggests that China has the necessary level of European financial services groups, by contrast, have a lower demand. The question is, will it be foreign or domestic firms profile and more diversified strategy. Then there is the spe- that provide the supply? cialist approach favoured by the likes of Franklin Templeton, Chubb and the legal and accountancy firms. Foreign financial and professional services firms are subject to tighter restrictions than companies in any other sector. Strategies are determined more by the nature of individual Overseas banks and insurance companies also face domestic firms outside China than by conditions inside the country. In competitors that have huge branch networks and very this way, while the market remains difficult, foreign firms are aggressive pricing strategies. playing to their strengths.

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A small market for HSBC Loans and advances, 2003, US$m

12000 96

10000 Profit

8000 198

6000 149 83 4000 39 42 80 94 69 2000 75 54 0 Australia & India Indonesia Japan China Malaysia Singapore South Taiwan Thailand Brazil New Zealand Korea Source: HSBC annual report 2003

M Still, the shyness about revenue is nothing when compared China may be a minor market for foreign financial and with the almost universal caginess with regard to prof- professional services companies at the moment but Y itability. It might be thought that of all sectors, executives among most of these firms there is an almost universal CM in the financial and professional services industry would belief that within ten years the country will emerge as one MY know a thing or two about net earnings and return on capi- of the world’s leading markets for the largest foreign

CY tal. This, however, is far from apparent when bankers, financial and professional services firms. In a reflection of accountants and even management consultants are ques- this, almost half of the companies in these industries that CMY tioned about their own profitability in China. One of the responded to our survey said that, from the perspective of K few organisations that is willing to publish specific earn- their central headquarters, China is ”critical to global ings numbers is HSBC, which claims that in 2003 mainland strategy”. More specifically, according to HSBC, China is a China operations generated profit of US$42m—a figure ”critical long-term growth area”. Citibank has identified that hardly registers when set against the UK-based bank- China, along with India, Brazil and Russia, as one of the ing giant’s global pre-tax net earnings of US$12.8bn. main growth markets of the future. A big European bank The insignificance of China in terms of revenue and we spoke to thinks China could become one of its top profit is not obvious from the amount of corporate atten- five—perhaps even three—global markets within the next tion paid to the country by many of the world’s leading ten years. financial and professional services firms. For example, The excitement is not limited to the banking sector. since becoming chief executive of Citigroup in October last AIG believes that ”with a population of 1.3bn and a high year, Charles Prince has already visited China three times. savings rate, there is enormous opportunity” in China. Foreign insurance companies are restricted in all sorts of According to an executive from another leading insurance ways from accessing China’s domestic market and yet most firm, ”In 15 years China will be the second-largest insur- of the top global firms have set up operations in the coun- ance market in the world.” Managers at one of the world’s try. China was the destination for the first official overseas leading asset management specialists, Franklin Temple- visit made by the global chairman of KPMG, Mike Rake. One ton, believe that, based on current growth rates, China of KPMG’s rivals, Deloitte, chose Shanghai to host its first could become one of their most important international global management committee (GMC) of 2004 and plans to markets in five years. Meanwhile, KPMG believes that its increase its China staff from 1,500 to 4,500 over the next Shanghai office will be one of its biggest in the world five years, an expansion that is claimed will involve the within ten years. The list goes on. Only the law firms tend biggest investment in the organisation’s near 100-year to be a little less effusive but even they expect solid history. Many foreign legal firms in China may be losing growth over the next few years. money but few are passing up the opportunity to establish second offices in the country. Securing premises alone may Optimism without giddiness not cost much but putting partners in them represents a A focus on revenue. Little if no current profitability. Hype considerable investment for these firms. about the future. All this looks disturbingly like the misin-

formed mentality that fuelled the first wave of largely tralian counterparts to take the title of the biggest issuers loss-making manufacturing investment into China in the of equity in Asia ex-Japan. (According to Thomson Finan- 1990s. Certainly, even at current rates of growth it is cial, companies from China accounted for 23.9% of the unlikely that China will fulfil the expectations of all the equity issued by the region’s firms last year.) foreign firms that are currently piling into the country. Some markets are already beginning to look very crowded: Room to grow there are, for example, around 30 foreign insurance com- There is certainly room to grow. The market for financial panies in China and by the end of last year 15 foreign fund and professional services in China is highly underdevel- management JVs had either started operations or were in oped—virgin territory, according to one executive. Pene- the process of entering the market. tration rates for many financial services products remain Nonetheless, the optimism felt by foreign financial and very low on an international basis. For example, it is esti- professional services firms does appear less naïve than the mated that there are only 3m-4m real credit cards in bullishness of earlier investors in China. For example, China, the equivalent of just one card for every 400 or so HSBC could well be disappointed in its effort to boost, in people. When it is considered that many consumers in five years, its presence in cities like Shanghai to a level on more advanced economies have not just one but several par with Hong Kong. But its broader expansion plans credit cards each, it is clear that usage in China remains seem sensible: branches in 20-30 cities in the few years, very low. Similarly, life insurance premiums in China are up from nine currently. In a country of 1.3bn people this is equivalent to just 2% of GDP, compared with 7.3% in Tai- a cherry-picking, rather than mass-market, strategy. wan and more than 10% in the UK. Optimism without giddiness seems to define the per- There is little reason to believe that local individuals spective of many of the foreign services firms that and companies will not eventually find such services as responded to the Economist Intelligence Unit’s survey. necessary as their counterparts do in more advanced Financial and professional services companies are adopt- economies. Indeed, in recent years growth in some finan- ing a cool-headed strategy for the China market but also cial services markets has been very strong. According to finding some inspiration in the rapid evolution of these government statistics, the value of mortgage lending markets in recent years. After all, China has already increased from US$1.6bn in 1997 to US$142bn in 2003, emerged from a tiny to a reasonably sized market for a the value of life insurance premiums more than tripled number of financial services in recent years. Swiss Re fig- between 2000 and 2003, and media reports have sug- ures show that, in 2002, China’s insurance market was gested the amount of assets under management in China larger than that in, say, Taiwan, Switzerland and Belgium, rose from Rmb130bn at the end of 2002 to Rmb227bn at albeit still smaller than that of South Korea and Spain. the end of March 2004. China’s mortgage market, which was virtually non-exis- The demand from China’s growing corporate commu- tent just a few years ago, is likely to have rivalled Italy’s in nity for more sophisticated services is also rising rapidly. 2003. In 2003 Chinese firms again beat out their Aus- The more than doubling of China’s exports over the last five years has created strong demand for services such as trade finance and cargo insurance. The US$70.7bn in funds raised in 1999-2003 by China-linked companies on Virgin territory? Life insurance premiums as % of GDP the Hong Kong stockmarket alone has created much work for investment banks, accountants and lawyers in main- % 024681012land China. More recently, the financial and professional UK 10.2 services sector has benefited from the increasing number of foreign investments made by China’s larger companies. South Korea 7.2 In fact, it is no longer far-fetched to think of China Australia 5.0 becoming an even more important market for financial services in the next few years. For example, even assum- US 4.6 ing that annual premium growth halves in the next few Italy 4.4 years from the 26% recorded in 1999-2003, China’s insurance market in 2008 will still be worth US$90bn, a thresh- Spain 3.6 old which in 2002 had only been passed by the US (where China 2.0 annual premiums have already risen over US$1trn), the UK, Germany, France and Japan. Brazil 1.0 Nevertheless, while thinking business will grow rap-

Source: Swiss Re, Economist Intelligence Unit idly, no executive we spoke to thought foreign institu-

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Coming of age Part 2 Financial and professional services

tions would overrun China’s bank or insurance industries, eign firms is becoming less hostile. For example, in with most executives thinking that a collective 10% mar- December 2003 the government began to allow foreign ket share—up from only around 1% now—is a conceivable banks to undertake renminbi business with, and overseas target for the next 5-10 years. Neither is China expected general insurance firms to write policies for, domestic to begin to dominate global corporate performance: companies, in line with China's commitments to the WTO. almost half of the financial and professional services firms Also in December, in a goodwill gesture not directly that responded to our survey reported that they expected related to WTO entry, the main bank regulator, the China China to account for less than 5% of total corporate rev- Banking Regulatory Commission (CBRC), raised the ceiling enue in five years’ time. for any individual foreign stake in a Chinese bank from 15% to 20%. Barriers to faster growth Despite this gradual liberalisation, market-access For foreign services firms, the challenge is not lack of restrictions for foreign firms remain tighter in the finan- demand but how to capitalise on it. A number of barriers cial and professional services sector than in most other still complicate the ability of financial and professional industries in China. Regulators have found ways of services firms to capitalise on current opportunities and restricting the activities of foreign financial and profes- potential growth. sional services firms even as the market officially opens The financial and professional services sector suffers up. Upon entry to the WTO, China pledged in five years to from an acute shortage of qualified and experienced staff. remove geographical restrictions imposed on banks and Some foreign firms have been investing in education to try insurance companies and allow foreign banks to under- to bridge this gap. For example, two US insurance compa- take local-currency transactions for individual citizens. nies, John Hancock and CIGNA International, have helped However, working capital requirements for bank branches finance insurance-related programmes at universities in in China are high, more than 15 times higher than those China. These kind of investments by foreign firms are not required in the EU according to the European Union uncommon in other markets around the world and have Chamber of Commerce in China. These requirements make the advantage of bolstering a foreign firm’s local brand it very expensive for foreign banks to expand—for exam- image, as well as generating skilled service-sector person- ple, HSBC head office injected Rmb435m (US$52m) into nel. Nevertheless, they add to the cost of doing business its China operations to allow three of its branches to begin and, given that wages in service industries in China are providing renminbi services to foreign enterprises and being bid up quickly, do not necessarily win the loyalty of individuals in 2003—but do not violate clearly the terms the students whose education the firms help to fund. of China’s accession to the trade body. Even those banks that are willing to invest the necessary capital are pre- The regulatory straightjacket vented by the government from opening more than one Even with a better supply of human resources, foreign new branch a year. In the professional services sector, the firms’ ability to access the market would be limited by reg- WTO agreement made no mention of further opening the ulatory measures. There are two angles to this: the gov- legal services market. ernment’s willingness to allow foreign firms greater The reality is that foreign firms will not be given much access to the market; and the wider issue of the structure greater freedom in China until the government is certain and regulation of China’s domestic financial services that domestic companies can withstand the subsequent industry. increase in competition. Even when this condition is met, Restrictions on operations have prevented, for exam- the market is unlikely to become as open as some foreign ple, foreign banks from undertaking local-currency busi- firms would wish because by then new constituents will ness with domestic corporations or individuals, most emerge with an interest in protecting the domestic mar- foreign life insurance firms and all overseas fund manage- ket. The changing motivation for protectionism is already ment firms from starting wholly owned operations, and visible in the legal profession. The activities of foreign international law firms from practising mainland law. For- lawyers in China were initially restricted because the gov- eign banks and insurance companies can only operate in a ernment was concerned they would bring to the country limited number of cities. such heretical concepts as ”rule of law” and ”equality As China begins to fulfil the market-opening commit- before the law”. The government has now realised that ments made in conjunction with its 2001 accession to the foreign law firms are generally more concerned with mak- WTO, these rules are being gradually eased. China is ing money than promoting democracy, but now there is a expected to honour the remaining pledges that fall due in new dynamic: a domestic legal profession that is lobbying 2004-07. According to the views of many executives work- the government for commercial protection. Thus, while it ing in the country, the government’s attitude towards for- can be hoped that domestic reforms will, in the future,

70 © The Economist Intelligence Unit Coming of age Part 2 Financial and professional services

Banking and insurance permitted business for WTO Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Banking Open cities Shanghai, Shenzhen, Guangzhou, Jinan, Fuzhou, Kunming, Shantou, All Tianjin, Dalian Qingdao, Chengdu, Zhuhai, Ningbo, Nanjing, Chongqing Beijing, Shenyang, Wuhan Xiamen Xian,

Permitted business Foreign currency business; renminbi Renminbi business Renminbi business business with foreign-invested with domestic firms with local individuals enterprises

Minority investments Single foreign ownership limited to Ceiling raised to 20% 15% of equity

Insurance Open cities Shanghai, Guangzhou, Dalian, Beijing , Chengdu, All Shenzhen, Foshan Chongqing, Fuzhou, Ningbo, Shenyang, Suzhou, Tianjin, Wuhan, Xiamen

Permitted business Life Individual foreign and local Group foreign and local Non-life ”Master policy” insurance and large commercial risks nationwide; foreign-invested enterprises Domestic enterprises Broking Large-scale commercial risks, for reinsurance and for international marine, aviation and transport insurance Ownership Life Joint venture with 50% ownership Non-life Branch or joint venture with 51% ownership Wholly-owned subsidiaries Broking Joint venture with 50% ownership Joint venture with Wholly-owned 51% ownership subsidiaries Minority investments Total foreign investment to be less than 25% of equity Reinsurance 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- services industry. Officials have already taken some steps ity of the financial services industry, restrictions could in this direction: last December legislative measures remain in place as the government becomes beholden to were approved first to allow banks some leeway to diver- increasingly powerful domestic interest groups. sify into other areas of the financial services industry, It is not all bad news for foreign companies. Even if such as broking, and second to lay the legal basis for a market access rules are not eased further, the position of new committee to supervise and co-ordinate the sepa- foreign firms in China will improve in the next few years. rate bank, insurance and stockmarket regulators. Given This will be the result of changes to the domestic regula- that many foreign companies position themselves glob- tory structure, in particular an expected easing of ally as financial services ”supermarkets”, they will bene- restrictions that China’s government has traditionally fit from any changes that allow such structures to be placed on integration of different aspects of the financial formed in China.

Coming of age Part 2 Financial and professional services

Huge networks and aggressive pricing Even if China reduced the current The competition The Big Four, branch and staff numbers restrictions on foreign firms, it cannot Banks Branches Staff be assumed that multinationals would Agricultural Bank of China 39,286 480,931 suddenly dominate the local market. Bank of China 12,090 174,919 Chinese firms have some notable China Construction Bank 21,616 406,441 strengths vis-à-vis their budding Industrial & Commercial Bank of China 25,960 405,558 foreign competitors in the financial Source: Almanac of China’s Finance and Banking and professional services sectors. Most notably, Chinese companies command huge branch networks that cover the entire professional services firms that responded to our survey country. Whereas many foreign companies operating in cited ”lower prices” as the main competitive advantage of manufacturing sectors face the emergence of new domes- local companies. Foreign insurance firms (particularly in tic competition where little existed before, foreign banks the non-life sector) and banks complain that their domes- and insurers must compete with a massive, existing net- tic competitors simply do not price according to risk. work of competition from the existing Chinese banking The price advantage of local institutions is not just the and insurance sector. One of China’s four largest domestic result of mismanagement; their costs are also lower. Local banks, for example, the state-owned Agricultural Bank of firms, for example, do not have to cover the cost of expen- C China (ABC), had almost 40,000 branches around the sive expatriate staff. Domestic banks also, in general, have

M country at the end of 2002 (latest available data) and the a lower cost of funding, relying on retail deposits which biggest general insurance company, PICC, has 428 currently pay interest rates as low as 0.7%. In a reflection Y branches and sub-branches. By contrast, government sta- both of their critical mass and the rapid business growth of CM tistics show that the 64 foreign banks active in China have their major foreign clients, many of which over the last two MY under 200 offices between them, whereas AIG, which has years have moved from being net borrowers to net deposi-

CY the largest wholly owned foreign insurance business in tors, the larger foreign banks in China are now overfunded. China, operates in just a handful of cities. Moreover, local But smaller foreign banks, denied the right to undertake CMY services companies have long-established relationships renminbi business with local consumers, often have to K with their clients, a particularly useful asset in a country borrow on the interbank market where rates_particularly where guanxi remains important. These factors give those charged overseas institutions—are higher. domestic firms very strong brand recognition and a very deep presence in a very large country. A complex competitive environment In addition, like many of the foreign companies oper- Facing entrenched local players with huge distribution ating in manufacturing sectors, foreign financial services networks and low pricing, China might seem a hopeless companies are faced with very aggressive pricing by local market for foreign financial and professional services firms—pricing strategies that few foreign firms are either firms. But price and distribution are not the whole story. able or willing to match. More than half of the almost 30 While the aggressive pricing of domestic firms has helped

Cheap funding One-year interest rates, year-end, % Loan Deposit 15

0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: CEIC

72 © The Economist Intelligence Unit Coming of age Part 2 Financial and professional services

to generate sales in the short term, it has also contributed deep product-development capabilities of their foreign to the longer-term deterioration in the capital strength of counterparts. many of China’s largest financial services companies. This An illustration of just how far domestic firms trail inter- weakening of balance-sheets has been exacerbated by national standards in these kind of areas is given by the other, more sector-specific factors. Close links between experience of the International Finance Corporation (IFC), banks and the government have, for example, resulted in the private finance arm of the World Bank. In one of sev- loans to loss-making state-owned industrial enterprises. eral investments it has made in recent years in China’s The financial strength of the largest insurance firms has financial services industry, between 2000 and 2002 the been undermined by previous sales of policies that guar- IFC paid US$50m to take a 7% stake in the Bank of Shang- anteed annual returns of 7.5-10%, when interest rates hai. In so doing, the IFC gained a seat on the board of the were falling and premiums were mainly invested in the bank, and one of the first suggestions of its appointee was form of bank deposits. As a result, official figures show the establishment of audit and compensation commit- that at the end of March this year 19.2% of the state- tees. This was no doubt a sensible initiative but one that owned commercial banks’ loan books are non-performing; highlighted that such basic elements of the managerial outside observers estimate the figure to be much higher hierarchy did not exist in the first place. still. The insurance industry, meanwhile, is sitting on an The extent of the gap makes it possible for improve- equity shortfall of several billion US dollars. ments to occur rapidly. According to executives from Chinese firms' balance-sheet weakness makes them across the spectrum of foreign financial and professional keen to work with foreign institutions. China’s banks, services providers, local firms, even those without foreign which have traditionally been dependent on revenue partners, are progressing in leaps and bounds. This is not earned from simple deposit and loan activities, are now just true of management techniques. According to the keen to boost fee income and the influx of foreign players head of the recently launched strategic credit-card co- into the market is giving them an opportunity to do just operation between Citibank and the Shanghai Pudong that. Foreign banks, for example, are paying to utilise the Development Bank, China’s emerging credit-card market huge branch networks of the domestic banks. In this way, already has some of the features of an advanced market, the likes of Citigroup and Standard Chartered are able to such as fee waivers and free gifts. provide nationwide cash management services to their global clients, while domestic institutions earn non-inter- The foreign advantage est related income. Overseas fund management and insur- Still, even in the areas of management expertise and ance firms are also beginning to sell their products product development, foreign companies retain an edge. through the domestic banking network. Local firms, for example, will find it difficult to imitate the capital markets expertise of the world’s leading legal Nascent ownership relations firms. When China’s government eases controls on out- The financial weakness of domestic players also makes ward capital flows, foreign asset management firms will them more willing to accept equity investments from for- be at a huge advantage in selling, say, international eign competitors. Some overseas firms take such stakes mutual fund products. merely as a financial investment. Others, however, lever- Local firms can also hope to learn something of the age their investments to win real business opportunities. client service standards employed by global institutions, For example, in 2002 Citigroup purchased 5% of the although copying service quality is not as easy as produc- Shanghai Pudong Development Bank, with the ”focal ing pirated DVDs. Service standards in China are famously point” of the alliance being a joint credit-card business. In low, a malaise that is just as evident in the financial and October 2003 AIG purchased a 9.9% stake in the People’s professional services sector as in any other industry in the Insurance Company of China (PICC), an investment that country. Expectations of service standards are rising as included an agreement to develop the market for accident incomes increase, a trend highlighted by consumer sur- and health products through PICC’s branch network. veys. Recent research by Millward Brown Firefly (MBF), for While the need for money is important, it is not the example, shows dissatisfaction with local banks in wealth- only reason domestic firms have been co-operating with, ier cities such as Shanghai. (The survey carried out by MBF and courting investments from, foreign institutions. At also shows that consumers in less developed urban areas least some local firms are also keen to learn from the tend to be less demanding of their banks and so more sat- expertise of their overseas counterparts. By working with isfied with local institutions.) foreign firms, particularly by accepting a minority invest- All this puts foreign banks in a potentially strong posi- ment, local institutions can benefit from exposure to tion, as the same surveys suggest that overseas financial international standards of management and draw on the institutions are associated with better standards of serv-

Coming of age Part 2 Financial and professional services

ice quality than their local counterparts. A recent survey been selling to China’s biggest firms, which to undertake carried out by the investment bank, Credit Suisse First initial public offerings (IPOs) on foreign stockmarkets Boston (CSFB), indicates foreign firms may have similar have needed to tap the expertise of international invest- opportunities in the insurance industry. While 56% of the ment banks, law firms and accountants. As firms that sell people surveyed who reported an indication to buy insur- more than 25% of their equity overseas are generally ance said they would do so from a domestic company, the regarded as ”foreign-invested enterprises”, this process main reason for this choice was reliability. Only 18% of has also created potential clients for foreign commercial respondents indicated a preference for buying from banks in China. wholly foreign-owned or Sino-foreign joint-venture insur- The easing in December 2003 of rules that had pre- ance firms. But the survey found that people choosing vented foreign banks from undertaking renminbi services these firms did so because of a perceived ”good reputa- for domestic enterprises has, of course, opened up a tion/credit, overall capability and service”. whole new market for foreign banks. But foreign firms are not quite as excited about this prospect as might be The local challenge expected. Wary of generally weak standards of corporate For foreign firms, the issue of the relative competitive- governance, foreign banks—and for that matter interna- ness of local institutions has become more pressing as tional accountants—are expected to expand into the the crossover between the markets served by overseas purely domestic market only cautiously. (One foreign financial and professional services companies and their bank told us that of every ten domestic companies it sees, domestic counterparts grows larger. It is a similar story only one or two has the quality to qualify them as poten- across many sectors in China. Foreign companies arrived tial clients.) Nonetheless, foreign banks are expected to aiming at the top end of the market—in this case ,serving become more active in the domestic corporate market in foreign companies—where they faced little if any domes- the next few years, an expansion that will lead to more tic competition from domestic firms. However, as foreign head-to-head competition with local banks. companies have looked to sell down into the middle section of markets they have met Chinese companies looking The evolving China strategy to sell up. Foreign financial and professional services companies are The domestic financial services sector, which was pre- operating in an extremely complex environment. On the viously a part of the government bureaucracy, is now one hand, the market is deepening and broadening. An becoming much more like a competitive, commercially increasing number of basic financial services products minded industry, albeit one that both pricing strategies (such as life insurance) can now be sold across the coun- and the testimony of foreign executives suggest is still try, while newer products (such as credit cards and focused on the top rather than the bottom line. China now investment funds) are introduced to the richer cities on has a variety of different-sized banks (although only one the east coast. Demand for more sophisticated legal and nationwide private institution) and, whereas the country accountancy services is also growing as China’s industrial just eight years ago had only one domestic insurance firm, revolution continues. Foreign firms are, in theory, well there are now five local companies competing in both the placed to capitalise on this demand, both because of life and non-life markets. their financial strength, product depth and service stan- The resultant rise in competition, combined in the dards and because many local firms are eager to find banking sector with government pressure to strengthen overseas partners. balance-sheets, has compelled local financial institutions On the other hand, foreign firms face immense diffi- to seek sales to the high-quality global clients that were culties in recruiting and retaining skilled staff, and com- previously the almost exclusive preserve of multinational petition is often cut-throat and irrational, at least from a banks and insurance companies. In an illustration of this pricing point of view. In this context, government policy change, some estimates suggest that local banks now looks designed to ensure foreign firms supply capital and serve as much as 40% of the banking demand of multina- expertise to support the development of the local indus- tional companies in China. Foreign services firms of all try without allowing them to build up significant market types are seeking to break out of their dependence on the positions. China business generated by their global clients and sell Despite this challenging picture, it is clear that some into the domestic market. This partly reflects a recogni- firms are managing to build real businesses. Citigroup’s tion that it will be demand from China’s domestic firms, China revenue grew at a compound annual rate of 43% in rather than from foreign companies, that will be the driver 1999-2003. HSBC’s 2003 profit might be small in a rela- of the country’s financial and professional services market tive sense, but US$42m is not negligible in absolute in the future. The foreign services community has already terms, especially given that, until recently, the bank's

Strait to market

Foreign banks in China should feel some pity mainland’s own Bank of Shanghai). Sinopac Clients introduced by Sinopac do not just for their Taiwan counterparts. Banks from the Financial Holdings, meanwhile, has a provide First Sino with opportunities for island have to put up with the stifling restric- representative office in Beijing through its US lending and trade finance deals, which tions imposed on all foreign institutions by the affiliate, Far East National Bank. More currently form the bulk of its commercial government in Beijing. They also have to deal uniquely still, Sinopac has a ”strategic activities. The referrals also generate with another set of regulations, imposed by partnership” with a licensed Shanghai lender, renminbi deposits, a supply of funds that is Taiwan’s own authorities, which seek to limit First Sino. bolstered by credit lines provided by SPDB. the island’s economic interaction with China. Gaining access to local-currency funds is a Taiwan’s manufacturing companies have Missing links particularly big issue in China, where until employed all kinds of ingenious methods to Officially, there are no shareholding links recently government restrictions have evade their own government’s restrictions on between Sinopac and First Sino. But ties prevented foreign banks from undertaking cross-Strait economic interaction. The between the two institutions are close: most renminbi business with domestic companies. attractions of China for local banks are of First Sino’s senior management are former According to First Sino’s vice-chairman perhaps even stronger than for their Sinopac employees and the Taiwan bank also and CEO, David Kiang, First Sino does not just industrial counterparts. Expanding to the provides information technology (IT) assis- limit itself to clients referred by Sinopac. It mainland certainly gives them the tance. First Sino also has a strategic partner- would be foolish to do so: as the only Taiwan- opportunity to win new clients by tapping ship with the Shanghai Pudong Development linked bank operating in China, First Sino is at into China’s potentially huge domestic Bank (SPDB), which owns a 5% stake of First a considerable advantage in winning business market. But, perhaps more importantly, with Sino’s equity. from the many thousands of Taiwan firms that so many of the island’s manufacturers having These partnerships are immensely now have investments in China. With its already invested in China, moving across the important for First Sino. Sinopac, for management of experienced Taiwan bankers, Strait may be the only way that Taiwan’s example, is keen to refer clients, in an the bank can deal with Taiwan clients more banks can hang on to their existing clients. attempt to keep customers in the Taiwan efficiently than other mainland-based banks. Consequently, despite the island bank’s orbit, and to limit their exposure to That its senior staff speak Taiwanese is also government’s restrictions, some smaller China’s increasingly predatory domestic important in building trust with clients. All private banks in Taiwan have found ways to institutions. The link with First Sino also gives this puts First Sino in a powerful position, establish footholds in China. Taiwan’s Sinopac a source of information on the helping to explain the eightfold increase in Shanghai Commercial and Savings Bank, for activities of its mainland-bound corporate the bank’s client base that has been achieved example, has established a representative clients. Given the enthusiasm with which since 2001. office in China through its Hong Kong-owned Taiwan firms have moved to China, this is Despite its inherent advantages in dealing subsidiary, Shanghai Commercial Bank helpful in Sinopac’s attempts to control its with firms from the island, not all Taiwan (which, helpfully, is co-owned by the own credit risk. firms in China are potential First Sino clients.

activities were limited to servicing mainly the foreign Allianz Fund Management (GJA), between Allianz Dresdner business community. In 2003 the value of first-year life Asset Management and Guotai Jun’an Securities, expects to insurance premiums written by AIG in China was almost break even at the end of its second year. 45% larger than in 2002. According to a report released in As for the professional services industry, accountancy 2003 by Goldman Sachs, AIG’s life insurance operations in firms have been rapidly increasing staff numbers in China China still made a loss of US$10m in 2001, but its general to cope with an expansion in business, while some law insurance business generated profit of US$2m. firms, especially those that are chasing large IPO man- Foreign fund managers also seem to be doing well. The dates, claim already to be profitable. fund management JV between the Belgian financial services group, Fortis, and a domestic securities company, Haitong Choosing an entry Securities, only gained regulatory approval in late 2002 and These days, foreign financial and professional services yet already has US$2bn under management (giving it a mar- firms in China have a large number of entry options and a ket share of around 12%). Fortis claims to be reaching growing array of expansion strategies. In terms of green- breakeven ahead of the schedule laid out in its original busi- field choices, foreign banks and general insurance firms ness plan. Another fund management JV, Guotai Jun’an can start wholly owned branch networks. Banks can also

76 © The Economist Intelligence Unit Coming of age Part 2 Financial and professional services

It is difficult, for example, to imagine IT the far from negligible problem of weak tap a new market that is potentially very hardware manufacturers of the size of, say, standards of corporate governance, which large, but presently very risky. This, then, is a BenQ or Hon Hai having much to do with makes even the most adventurous of foreign win-win-win arrangement. Taiwan firms small bank like First Sino. But in some ways, banks wary of jumping too quickly into the foster new suppliers, emerging domestic such firms are also unattractive clients, domestic corporate market. companies access funds that allow them to driving hard bargains through their size and To gain exposure to the domestic market, grow, and First Sino uses a low-risk method to their relative attractiveness—big, Taiwan- First Sino is considering buying stakes in establish a relationship with local firms. listed firms are targets for other foreign small local institutions and has become the financial services institutions, as well as first foreign bank to pursue a relationship On borrowed time? China’s aggressive domestic banks. with the China Export and Credit Insurance Success for First Sino is not guaranteed. The First Sino’s target market is thus not large Corporation. First Sino is also seeking to gain bank remains small and its links with Sinopac but SMEs. The bank does not limit itself to local customers by leveraging its foreign are truncated by the restrictions on cross- Taiwan-linked clients: around 10% of its client base. It works like this: First Sino has a Strait links. First Sino is also not alone in clients are from Hong Kong, helped by Mr trusted Taiwan client, Firm A. This company identifying the Greater China niche. Speaking Kiang’s own experience as a banker in the sources materials from a local company, Firm in 2003, a senior executive at one of Taiwan’s former UK colony. First Sino has also been B. First Sino has little information about Firm largest state-linked banks became distinctly targeting the retail market, opening, for B and so is unwilling to deal with it animated when discussing the possibilities example, a branch in Shanghai’s Gubei and independently. Instead, First Sino lends to that would arise from a link-up between a Tai- Xujiahui suburbs, where many Taiwan and Firm B but is repaid by Firm A, which routes wan, Hong Kong and mainland China bank. Hong Kong expatriates live. Partly as a result, payments for its supplies from Firm B through The Bank of Shanghai, through its different even though the bank has around 400 an account held by the bank. The bank takes guises, is close to having the framework in corporate clients, it also services more than principal repayments, with the remainder place, and in 2003 one of Sinopac’s Taiwan 2,000 high-net worth individuals. accruing to Firm B. The trusted client, Firm A, competitors, Fubon Financial Holding, took a The combined Taiwan and Hong Kong is in essence the source of the repayments. step in this direction when it purchased a market is big. But Mr Kiang stresses the This scheme benefits all involved. Keen to small Hong Kong-based lender, the Interna- importance of winning business from cut costs, bigger Taiwan firms in China are tional Bank of Asia. domestic firms and individuals, and hopes eager to cultivate a network of domestic Still, competition is not new. First Sino at local companies will soon account for 25-30% suppliers. But domestic banks in China are least has first-mover advantages over other of the bank’s client portfolio. Achieving this famous for discriminating against local SMEs, Taiwan banks. First Sino also illustrates that, will be challenging: foreign banks are only so without the intervention of a bank like First with a focused and innovative approach, it is now obtaining the right to offer renminbi Sino potential suppliers such as Firm B would possible even for small banks to build real services to domestic companies. There is also struggle to survive. First Sino also wants to businesses in China.

invest in joint ventures (JVs) in China, as can life insur- risk of a loss of management control, but could allow an ance firms (limited to 50% ownership) and fund managers overseas firm to leverage the official and client contacts of (currently restricted to 33% ownership, a ceiling that will its local partner. Last but not least, minority investments rise to 49% by the end of 2004). All these firms are also involve an even greater loss of management control. Local able to take minority stakes in existing Chinese firms. firms selling small stakes to overseas companies are not, Even accountants have a choice of entry strategy, being however, reclassified as foreign firms and so continue to allowed to set up joint ventures or establish business be subject to easier local regulations on expansion. This alliances with local firms. final option may thus give foreign firms the fullest oppor- Wholly owned branches, JVs and minority investments tunity to be involved in the rapid growth of China’s finan- all have their advantages and disadvantages for foreign cial services industry. firms. With the former, overseas companies can exercise The nature of the initial investment decision is usually full management control but are subject to severe restric- determined by a firm-level consideration of the pros and tions on expansion and are faced with the task of building cons offered by the different entry vehicles (wholly a business from scratch. Some foreign-invested JVs are owned, JV and minority investment routes). However, also subject to expansion restrictions, and have the added what seems to differentiate the broader China strategies

of foreign services companies is not how they enter China, line that forms the core of the drive into China. They are but what they do once they are there. This, in turn, is also huge companies that can afford to take risks in China determined as much by the nature of the company in the that other firms can not—buying stakes in Ping An and rest of the world as by the challenges encountered in Bank of Shanghai, for example, cost HSBC US$663m, not China’s financial services market. a large amount when set against the US$14bn the firm spent buying the US consumer lender, Household Inter- Different routes to market national, in 2002. All these firms also have long experi- It is possible to identify three broad strategies. The first, ence in emerging markets in general, with strong what might be termed the Anglo-Saxon approach, is exem- corporate links to China in particular: both HSBC and AIG plified by HSBC, Citigroup and AIG. All three firms have were formed in the country and Citigroup boasts it estab- taken any advantage of any opportunity to increase their lished its first branch in China in 1902. (While their presence in the China market. The banks have been rolling Shanghai roots may be especially strong, these three out new branches as quickly as they are allowed, and mov- firms are far from alone in stressing their Chinese history; ing into new product markets as soon as regulations per- it is far from uncommon for managers in foreign financial mit them to do so, most recently credit cards for consumers services to start conversations about China strategy with and renminbi loans for domestic companies. In addition, the comment, ”Well, or course we have been here for a all three firms have been taking stakes in other financial hundred years….”) institutions. Citigroup has a link with SPDB and AIG with This financial and historical background encouraged PICC, but most aggressive has been HSBC. In December all three firms to take an early interest in China as the 2001 the UK-based bank purchased 8% of Bank of Shang- country started to reopen to the world in 1978. As a hai and just ten months later bought a 10% stake in Ping result, in the banking industry HSBC and Citigroup, along An Insurance. Through a Hong Kong subsidiary, Hang Seng with perhaps the UK’s Standard Chartered, ABN Amro of Bank, HSBC also owns 16% of China’s Industrial Bank. In the Netherlands and Hong Kong’s Bank of East Asia (BEA), yet another small acquisition, HSBC in December 2003 have now been able to establish critical mass at the announced it was buying, in partnership with Ping An, expense of other foreign players. The first mover advan- 100% of a small Sino-foreign JV firm, Fujian Asia Bank. tage is even clearer in the insurance industry, where AIG The continental European financial services companies managed to get a licence to sell life and general insurance have taken a slightly lower-profile, and also more diversi- products in China in 1992, two years before the next for- fied, approach to the market. The business interests in eign entrant. It also managed to open wholly owned life China of the German financial services group, Allianz, insurance branches, an entry strategy denied to all other include its wholly owned bank, Dresdner, a general insur- foreign entrants, and has been given more freedom to ance operation in the southern city of Guangzhou, and a expand than its international rivals. JV life insurance company in Shanghai with China’s Dazhong Insurance. In addition to its fund management The continuing importance of relations JV with Haitong Securities, Fortis has a banking presence AIG would not have been able to gain such privileged in three cities in China and a 24.9% stake in one of China’s access to the market had it not assiduously built relations smaller but rapidly growing life insurance firms, Taiping with leading officials in China. This is a lesson that still Life. ABN Amro has a larger retail bank presence than its has relevance today. In other industries, the importance continental European counterparts and in February 2003 of relationships has begun to fade—although not disap- it purchased a 33% stake in an existing fund management pear—as market forces have become more dominant. In company, Xiangcai Hefeng Fund Management. It is also the financial and professional services sector, however, working to sell investment products to China’s domestic guanxi remains as important as ever. This is partly financial institutions. because the sector is heavily regulated, with the result Other firms have a more specialist approach. Franklin that the attitude of government officials can have a signif- Templeton, for example, only has its fund management JV icant bearing on the success or otherwise of a business. in China. General insurers like Chubb of the US and Royal Foreign executives do report that regulatory criteria are Sun Alliance of the UK have wholly owned general insur- being applied more evenly and transparently across dif- ance ventures in Shanghai but not much else. The main ferent firms. Nonetheless, retaining good relations with exposure of the Bermuda-based insurance firm, ACE, is in the regulators—the CBRC in the banking sector, the China the form of its 22% stake in and strategic alliance with Insurance Regulatory Commission (CIRC) for insurers, and Huatai, one of China’s smallest general insurers. the China Securities Regulatory Commission (CSRC) for The exponents of the Anglo-Saxon approach are diver- fund managers—is essential for foreign firms looking to sified firms but with one particularly dominant business build successful businesses in China.

78 © The Economist Intelligence Unit Coming of age Part 2 Financial and professional services

It is not just relationships with officials that are impor- Other banks cannot and should not hope to copy such a tant. With regulations forcing many foreign financial and strategy but this does not mean they should not be in professional services to enter the market only through JVs China. For example, the French bank, Societe Generale, or minority investments, choosing good local partners has a completely different approach, concentrating on and retaining guanxi with them is also essential. Neither providing investment options for domestic financial insti- of these tasks is necessarily easy to achieve, as demon- tutions. In another example of a successful niche strat- strated by the experience of the foreign manufacturing egy, a Taiwan-linked bank, First Sino, has been growing investors who were the first to form JVs in China in the rapidly by leveraging mainland China’s large communities 1990s, only to move to wholly owned structures as soon as of Taiwan and Hong Kong businessmen. regulations allowed. Still dreaming of the future Know thyself China can certainly be a frustrating place for foreign The role of guanxi may be particularly strong in the Chi- financial and professional services firms to operate. Mar- nese market. But China is not so unique as to make lessons kets for the services they are providing are expanding from other markets entirely irrelevant. As crucial as under- strongly but most companies are prevented by regula- standing China’s business environment may be, it is just as tions from fully tapping this demand. Nonetheless, in important for foreign firms to know their strengths, to some ways foreign services firms are in a stronger posi- know what they want to achieve in China and have a clear tion to succeed than their better-entrenched manufac- strategy of how this can be done. Few retail banks, for turing counterparts. There are signs that consumers in example, have successfully established overseas opera- China value the kind of services that foreign players can tions, so aiming to set one up in China would seem risky, if provide and copying service standards is a far more diffi- not foolhardy. It is no surprise that the handful of banks cult proposition for domestic firms than, say, making that do have international branch networks are the ones pirated DVDs. Moreover, despite the regulation that that are leading the pack in China. Despite the apparent exists, there are signs that firms with well-defined strate- scattergun nature of, say, HSBC’s China investment strat- gies are managing to build real businesses in China. The egy, the market approach of the British bank and Citigroup belief of many of the world’s leading financial and profes- has a clear focus: to provide the full range of financial sional services firms that China will be one of their major services they supply elsewhere in the world to the emerg- markets in the future may not be as far fetched as it cur- ing middle class of Chinese consumers. rently sounds.

Part 2 Logistics Not yet connected

y the end of 2004, China is scheduled to open up China has invested vast sums of money in infrastructure in its distribution and logistics markets in line with recent years, the country’s transport system is likewise a the commitments it made upon accession to the regional patchwork that frustrates the ability of logistics World Trade Organisation (WTO). Foreign compa- firms to offer seamless inter-modal services. More niesB are gearing up for the “big bang” of expanded market recently, that transport network has been overburdened access. China’s market for carting goods into and around by the strain of moving goods to keep up with China’s fast the country is huge—estimated at some US$270bn annu- economic growth. ally—and opportunities abound in logistics services such The logistics sector was once dominated by state- as storage and warehousing and wholesale and retail owned enterprises (SOEs) but in recent years foreign and operations. With logistics costs in China currently esti- domestic third-party logistics suppliers (3PLs) and large mated at around 20% of GDP according to World Bank numbers of small-scale providers have emerged in the estimates—compared to just 10-12% in developed mar- industry. There are now some 510,000 logistics companies kets—the potential for both profit and efficiency gains is operating in China, according to official media. Inte- considerable. grated services are best provided by independent special- The China market looks to be fertile ground for selling ists. Although just 3% of China’s distribution market international-quality logistics and supply chain services. currently belongs to 3PLs, the sector is a focus for foreign Foreign investor optimism about the market for logistics service providers and overseas participation is expected to services in China is justified but must be tempered by the expand rapidly as a result of increased levels of foreign on-the-ground reality of the sector’s regulatory, infra- investment in China’s manufacturing industries (espe- structural and operational limitations. Although the dis- cially in the retail and automotive sectors). Dickson Ho, tribution and logistics sector will, in theory, be largely an economist with the Hong Kong Trade Development open to foreign investors by the end of 2004, foreign Council (HKTDC), projects an increase in market penetra- logistics operators will still have to navigate patchy, tion for 3PLs to 6%—or US$35bn—by 2010. As there are locally-enforced regulations. Moreover, even though very few domestic players—the domestic giant Sinotrans

● China’s economic and foreign trade growth has increased ● Despite expanding market access, foreign logistics firms will demand for international-calibre logistics services. continue to face a number of regulatory hurdles in China.

● The logistics sector has developed fast in recent years, from ● The logistics sector is also limited by China’s transportation state-sector dominance to strong competition among foreign infrastructure, which continues to struggle to keep up with and domestic third-party logistics providers. demand.

● Many foreign logistics service providers eagerly await the fur- ● Logistics firms face considerable operational difficulties in ther opening of the sector under China’s World Trade Organi- China, ranging from limited IT systems to pilferage of freight sation commitments. in transit.

80 © The Economist Intelligence Unit Coming of age Part 2 Logistics

Logistics providers in China also face an increasingly The big and the fast in China’s foreign trade competitive environment. The Logistics Institute-Asia Top three trade regions, US$ bn Pacific’s survey of logistics users found that companies Province 2003 were more satisfied with domestic 3PLs than with foreign Guangdong 283.6 and joint-venture (JV) providers, even in the provision of Jiangsu 113.6 technology-intensive logistics services. Based on the Shanghai 112.4 results of the survey, the Logistics Institute-Asia Pacific National total 851.2 concluded that “domestic 3PL providers have closed the perceived gaps with foreign and JV providers in service Three fastest exporting regions, % change, year on year quality and capabilities”. In addition to larger domestic Province 2003 logistics providers, foreign companies have also felt com- Xinjiang 84 petition from small private transportation companies that Qinghai 81 have developed increasingly comprehensive logistics Gansu 60 services at very low costs. National 35 Partnering...or not? Three fastest importing regions, % change, year on year Although large shipping companies such as APL and Province 2003 Maersk benefit from grandfathering provisions that allow Jilin 107 them to operate wholly foreign-owned enterprises Anhui 67 (WFOEs) for some types of distribution services, most for- Xinjiang 61 eign firms have been severely restricted in their scope of National 40 Source: China’s Customs Statistics. operations by domestic regulations, which specify, among other things, that foreign logistics providers can only operate as JVs with domestic partners. This throws up a range of problems. Many foreigners prefer not to work is only beginning to develop significant 3PL capacity— with Chinese players for various reasons. Correspondingly, most of these services are currently offered by foreign many Chinese distributors have their own agendas too— specialists such as Panalpina, Maersk Logistics, DHL, Exel, with ready access to domestic sources of capital, there is SembCorp Logistics and APL Logistics. often no pressing reason for them to find a foreign part- Despite the development of 3PLs in China, many com- ner. This makes finding a suitable match even more companies still prefer to handle their own logistics. Based on plex for foreign companies even if they are open to the the results of its 2002 China Logistics Provider Survey—a idea. survey of 33 leading logistics companies—the Logistics Partnering with Sinotrans has been a common strategy Institute-Asia Pacific concluded that “the biggest chal- for foreign transportation and logistics firms. According lenge facing China’s logistics industry is to generate to Sinotrans’ most recent annual report, the company is demand”. Many companies consider logistics to be a core involved in 25 Sino-foreign JVs. Sinotrans has partnered competency or see it as “too important to outsource”, with some of the biggest global names in the sector, according to the Logistics Institute-Asia Pacific’s 2003 including DHL of Belgium, US-based UPS, Exel of the UK China Logistics User Survey. Companies also cited the dif- and Japan’s OCS. In March 2004 alone, Sinotrans formed a ficulty of shedding existing logistics facilities as another strategic alliance with Rickmers-Linie, a German shipping important reason not to outsource. line, to co-operate in logistics services in China and set up For the international logistics firm Panalpina, by con- a joint venture with Mitsui OSK Lines of Japan to ship fin- trast, the problem is not generating demand but manag- ished cars in China. Partnering with Sinotrans gives for- ing it. Panalpina’s biggest source of revenue in China is eign companies access to the domestic giant’s resources in sea and air export freight-forwarding services, accord- and also helps with government relations. “But our coming to Claus Schmidt, the company’s executive vice presi- petitors are doing the same thing,” notes a manager at dent for marketing and sales in Asia-Pacific. Panalpina one foreign company which has partnered with Sinotrans. handles a larger volume of air- and sea-freight in China "It’s no more advantage for us than for others.” For many than in any other country, according to Mr Schmidt. The companies, however, it is still a strategic necessity. company’s biggest challenge in its export operation in DHL has been one of Sinotrans’ largest foreign partners China is in “capacity management”, Mr Schmidt says; “to since the establishment of their 50:50 JV, DHL Sinotrans, have the right capacity because it is such a volume in 1986, which made DHL the first foreign express carrier increase.” to enter China. DHL claims that the venture now holds

Frontier Foods: Who moves their cheese?

Distributing any product in China can be dif- other supermarket chains. consumer goods. ficult. Frontier Foods, a small Australian- According to Mr Kumar, the biggest issue Aside from the opaque regulatory based food distributor, faces the challenge for Frontier’s imports “has been a environment, Frontier Foods’ distribution of distributing a perishable product that significant increase in non-tariff barriers” also faces particular infrastructure requires strict temperature control: cheese. since China joined the World Trade limitations. Although Chinese roads The company ships cheese from Australia to Organisation (WTO). Most recently, these continue to improve, the shortage of sell to China’s rapidly growing middle class have come in the shape of labelling laws. refrigerated transport capability and the through fast-developing supermarket and Although the rules are not new, local absence of trucking companies with fast-food chains and in bulk to Shanghai customs officials only began enforcing them nationwide reach create supply- chain Bright, a large Shanghai-based dairy com- in March in a strict—and apparently problems. To save costs, perishable goods pany. arbitrary—manner. often share the same vehicle with other Distributing perishable goods to such a The rules require the labels of foreign goods, creating risks of cross- wide range of end-users in China is no mean foods sold in China to comply with local contamination. Also, because goods must feat, and the company’s experiences over standards, such as a provision requiring the be frequently transferred between vehicles the last few years are instructive. Rajiv Chinese lettering on packaging to be larger and are subject to arbitrary delays, they face Kumar, Frontier’s general manager at its than the foreign lettering. In the past, the a high risk of spoilage when, for example, a Hong Kong regional headquarters, explains requirement was not a problem, Mr Kumar driver decides to turn off refrigeration to that the food products are shipped by says, because importers could simply attach save fuel when stuck in a traffic jam. container from Australia to Hong Kong, stickers, a solution also widely accepted in Nonetheless, Frontier remains positive where the company maintains a distribution other markets. Now, however, stickers are about the long-term prospects for its centre. This is convenient for customers in no longer acceptable and products business in China. The company is neighbouring Guangdong, who can be packaging must be specifically tailored to particularly encouraged by the development reached by road directly. High-margin or comply. This has significantly increased of foreign-owned hypermarkets and urgent deliveries are distributed by air, while product costs and detracted from the increasingly competitive domestic players, foods bound for other Chinese destinations product's appeal as local buyers assume it is who have kept supermarket listing fees to a are transhipped directly to a local port, such domestic (or worse, faked) rather than reasonable level. While non-tariff barriers as Tianjin, via an import agent. Once cleared foreign. Worst of all, says Mr Kumar, the therefore continue to create problems—and through customs, the products are rules are impossible to meet because, may even threaten the ability of smaller dispatched by the refrigerated vehicles of a although they must be signed off by Beijing, businesses to ride out periodic storms—in- local trucking company (or possibly by rail) no one knows which department is country, at least, the experience is fast to various regional distribution centres, responsible for compliance. Meanwhile, the improving. For now, as Mr Kumar says, “the which are then responsible for delivery to new interpretation of the regulations has retail channel is the brightest star in the local branches of Wal-Mart, Carrefour or badly disrupted imports of food and other distribution sky”.

almost 40% of China’s express delivery market. According sq metre air- and sea-freight logistics centre in Shanghai’s to DHL, the company’s business in China has registered Waigaoqiao free-trade zone. With an infrastructure invest- annual growth rates of 35-45% in recent years. In May DHL ment of US$12m, DHL plans to expand its logistics pres- announced expansion plans for several of its China opera- ence from 20 to 37 cities by 2007. tions, under which the company will invest US$215m in Another prominent foreign player in the sector, TNT of China over the next few years. The most intrepid of the ini- the Netherlands, broke off its long-standing partnership tiatives was the launch of China Domestic, the first door- with Sinotrans. TNT Express established a joint venture to-door domestic parcel delivery service offered by an with Sinotrans, called TNT Skypak Sinotrans, in 1988 to international carrier. The move was not spurred by regula- offer express services in China. The venture expanded tory changes allowing foreign firms to offer such services from five to 12 branches and reportedly boasted strong but DHL said that nothing in Chinese law expressly forbids revenue growth. The companies decided not to renew the the service. DHL is also expanding its logistics operations, partnership, however, when their contract expired in May with plans to open three express logistics centres and 16 2003. The two companies “have decided to pursue their spare parts centres in China. DHL Solutions, which pro- own plans in China”, TNT said in a press release. After end- vides custom logistics services, is stepping up its presence ing the JV, TNT announced plans to expand its operations in China, and DHL Danzas Air & Ocean opened an 11,500- from 12 to 25 branches by the end of 2003 and to form a

82 © The Economist Intelligence Unit Coming of age Part 2 Logistics

JV with Mach ++ Express Worldwide, a small Beijing-based chain services to importers, regulatory reform is an impor- firm. tant issue. Jeff Bernstein, the managing director of While the major global express delivery companies Emerge Logistics, says foreign companies are focusing on have expanded to offer a wider range of logistics offerings the WTO-mandated “big bang” that will allow WFOEs to in China, other foreign players have built warehousing operate in most areas of the domestic logistics market by facilities and logistics centres to offer integrated services the end of 2004. Since Emerge chooses to operate inde- in industrial parks. Exel, which set up a joint venture with pendently, it is currently restricted to Shanghai’s Waigao- Sinotrans in 1996, offers warehousing space for logistics qiao free-trade zone, which greatly complicates efforts to services in 15 locations in China. The company says it is provide services to companies outside the zone. Although focusing on the retail and automotive sectors, which are a draft regulation relating to market opening began circu- growing fast but require integrated logistics services, lating in late 2003, there is still no indication of what con- before expanding across other sectors. In September ditions may apply to foreign distributors once the market is 2003 Exel’s JV in China was awarded a contract to provide opened. Currently, JV distribution businesses are logistics services to Legend, the domestic personal com- restricted in geographic scope and require US$5m regis- puter manufacturer. tered capital—a hefty amount that only the biggest players SembCorp Logistics is likewise focused on supply-chain can easily afford. Branching limitations under the upcom- logistics services. The company established a wholly owned ing rules will be another closely watched issue. subsidiary in Shanghai’s Waigaoqiao free-trade zone in Hong Kong distributors have a first-mover advantage April 2004 to serve as the company’s regional office for under the terms of the Closer Economic Partnership north Asia. Schenker opened its first office in China in Arrangement (CEPA), which opened up key types of logis- Guangzhou in 1979 but has only recently developed logistics services—land transport, warehousing and storage, tics centres to offer supply-chain management services. and freight forwarding—to WFOEs at the start of 2004, The company is now building two major logistics centres, a almost 12 months ahead of the WTO measures. However, 15,000-sq metre facility in Shanghai that is slated to be many of them realised they would still need to work operational later in 2004 and a 16,500-sq metre facility through local partners, who are more familiar with local close to the Beijing International Airport for Schenker traffic rules and conditions, distribution practices, cus- BITCC Logistics, Schenker’s US$5.7m joint venture with tomer preferences, tolls and fees. Beijing International Technology Co-operation Centre. For Panalpina, which is a registered company in Hong Kong, CEPA offers a chance to accelerate its application Regulatory reform for an ‘A’ licence to offer international freight-forwarding Expanded market access provided under the WTO will open services in China as a WFOE, according to Mr Schmidt; this some new opportunities for foreign logistics providers but would give the company more flexibility to operate inde- firms will still face a host of problems ranging from inade- pendently in China. Even if it is awarded the licence, Mr quate infrastructure to various bureaucratic and regula- Schmidt says, the company will continue to use its local tory obstacles. As a result, the impact of policy changes partners for many operations because they boast the size on foreign business will differ from company to company. and infrastructure that a foreign company could only For small operators such as Shanghai-based Emerge match with a very substantial investment. Logistics, which offers specialist distribution and supply- A relatively low minimum registered capital require-

Taking to the roads Freight carried, bn tonnes

1982 1992 2002

Rail 1.1

Rail 1.6 Rail 2.0

Road 3.8 Road 7.8 Road 11.2

Other 0.6 Other 1.1 Other 1.6

Source: CEIC 83 © The Economist Intelligence Unit Coming of age Part 2 Logistics

Road development takes priority Length, km Expressways Double-tracked railways 30000

25000

20000

15000

10000

5000

0 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: CEIC

ment of US$1m could make Hong Kong distribution busi- some products for long periods (such as last year’s spat with nesses attractive takeover targets for international logis- the US over China’s soybean imports). This can also affect tics companies, however, as the merged companies will purely domestic deliveries, with officials finding ways to dis- qualify for CEPA privileges just one year after takeover. On courage outsiders from muscling in on local markets. The the face of it, therefore, CEPA seems a viable entry strat- lowly clerk at a Chinese checkpoint or approval office can egy for small or specialist foreign players, and the level of still have enormous influence on scheduling; a just-in-time interest has been high. By March 2004, 98 of a total of provider ignores the need to promote relations with this 177 certificates of origin handed out by the Hong Kong contact at his peril. government were granted to companies in the logistics Many cities still impose measures such as “traffic-con- and distribution sectors. Nonetheless, many players trol” regulations that restrict out-of-town trucks from remain dubious of taking this route–most are waiting for entering built-up areas during rush hours. Whether these new WTO-related rules before making up their minds on rules are protectionist or not depends on how they are applying for CEPA eligibility. enforced. While these issues can be devastating for indi- The logistics sector lacks a coherent body of laws and vidual importers or distributors, the fact that they usually logistics firms are forced to rely on trial regulations and occur arbitrarily and at low operational levels makes them general foreign investment laws for guidance. Apparently difficult to combat effectively. aware of the need to structure the sector, the central government established a logistics authority, the National Transport infrastructure Committee for Standardisation of Logistics Information Despite the fast growth in logistics in recent years, the dis- Management, in August 2003. The committee is charged tribution network in China remains seriously fragmented. with formulating, revising and implementing standards in Although thousands of logistics providers exist in China, logistics. There is a perception among managers active in none is in a position to offer a fully integrated seamless the sector that the central government has a high level of package. Besides regulations limiting such comprehensive commitment to market opening and liberalisation. Never- services, the sector is also limited by China’s physical infra- theless, foreign firms should not take it for granted that structure. China suffers from poor connectivity between dif- doors will be opened automatically at every level as soon ferent types of transport, meaning that goods must often as Beijing gives the word. be warehoused while in transit, thereby increasing costs Although national rules and regulations in China have and wastage, especially for perishable goods. This makes it become clearer and more standardised than before, this has extremely difficult for integrated logistics providers to offer not prevented local officials from finding ways to bar certain seamless inter-modal transport services (that is, a combi- types of foreign goods from being imported or delivered. nation of rail, road and water). Train services, for example, Protectionist behaviour comes into play at international generally do not terminate at dockyards so goods must be ports of entry, where strict interpretation of rules relating to trucked from railyards to ports. Computerised inventory arcane subjects such as labelling or health standards can management systems are rarely used, making it impossible create non-tariff barriers that, in effect, close the market to to track accurately the progress of deliveries.

The problem has worsened in recent years as China’s ago, among the first building projects were roads and astonishing growth in foreign trade has put new strain on highways. The country’s first superhighway—initiated by its already over-stretched infrastructure. Despite billions Gordon Wu, the chairman of Hopewell Holdings, a Hong of dollars invested in building roads and highways, ports Kong-listed firm—linking Hong Kong to Guangzhou, the and airports, telecommunication networks and power Guangdong provincial capital, and Zhuhai took ten years plants over the years, new capacity is quickly used up. All to build and became fully serviceable in 1994. By 2002 of China’s transportation networks are in need of China had doubled the length of highways to 1.8m km, improvements. much of it built with foreign investment. However, China still does not have enough highways to meet its needs. Ports According to a report published last summer by Drewry Chinese ports have been more successful in keeping up Shipping, a UK-based consulting and research firm, the with the rapid trade growth than other infrastructure sec- density of land transport systems in China amounts to just tors, thanks to central policy support and foreign invest- 157 km per 1,000 sq km. This compares with equivalent ment. A mere ten years ago China was still building its figures of 720 km in the US and 3,138 km in Japan. Chi- modern container ports and none were significant global nese highways are also notoriously expensive to use. Toll players. Last year, Shanghai elbowed out South Korea’s fees amount to 10% or more of freight costs, much higher Pusan to become the world’s third-busiest port with con- than in developed countries. Much of the toll collection at tainer throughput at 11.28m twenty-foot equivalent units local levels is arbitrary and illegal. (TEUs), while Shenzhen jumped two notches to fourth place at 10.65m TEUs. Despite additional capacity, Chi- Rail nese port facilities are straining at the seams. Bottlenecks Years of neglect have resulted in acute undercapacity in at ports have become especially acute since the beginning China’s railway system. Having invested heavily in road of this year, according to Koay Peng Yen, the president for and port infrastructure over the past decades, the govern- greater China operations at APL, the container-shipping ment has only recently turned its attention to the country’s arm of Singapore’s NOL group. overburdened and underfunded rail network. However, the Although container turnaround at the ports is still focus appears to be on restructuring rather than throwing keeping schedule, bulk freight is choking up docks, delay- money at the system—a wise move. The national railway is ing unloading. Most ports in China handle both container overstaffed, employing over 1m people, compared with the and bulk cargo, with common access to road and rail. The US, for example, where the network is run by a few thou- logjam in bulk-freight handling reflects long-term local sand people. The sector is not directly affected by China’s government neglect in investing in bulk docks. Bulk carri- accession pledges to the WTO as the government has not ers are now subject to delays as long as 30 days at Chinese promised to open up the national rail system to foreign ports, says Mr Koay. Container shipping terminals are sub- investment. Nevertheless, in the interests of efficiency, the ject to hold-ups averaging no more than a day, he adds, government will break up the rail system into three parts: although tight schedules normally kept by the container passenger operation, freight handling and infrastructure lines mean that delays of even a few hours can have a sig- building. Foreign participation will be allowed in cargo nificant impact on operations and profitability. Condi- transport services and railroad construction. tions in southern Chinese ports have deteriorated, Since 1996, the start of the ninth five-year plan (1996- especially at Shenzhen’s Yantian port, already notorious 2000), railways in China have expanded by only 4,000 km for its snarled docks. Mr Koay believes that container ship- compared with 624,000 km of highways—up by 7% and ping facilities in China should be able to keep up with 53%, respectively, by 2003. A major reason for rail’s slow demand as new facilities come on stream but says there is development is tight government control, unlike roads no end in sight for bulk carrier delays. Four new berths are where there is greater official tolerance for foreign owner- under construction in Yantian that would boost the port’s ship and hence foreign investment. The Ministry of Rail- rated capacity to 5m TEUs by 2006, although this would ways is planning to increase the entire network by less still meet only half of the actual throughput in 2003. than 40% to 100,000 km by 2020. Double tracking and Shanghai is building an enormous deepwater port at electrification will rise to 50% from the current 39%. Train nearby Yangshan islands that will take 18 years to com- speeds are also being increased to 160 kmh—so far only plete, with capacity rivalling Hong Kong’s port. The focus 28% of the tracks are capable of taking the increased here is on modern container facilities. speed—and bigger wagons are being added to take heav- ier shipments. Roads The expansion could help overcome some of the rail When China opened its door to foreign investors 25 years network’s structural problems. For instance, much of the

Develop-it-yourself, B&Q

The home improvement retailer, B&Q, first have started to show a profit—despite the getting around these issues by outsourcing entered China in 1998—the first overseas cost of opening new outlets. This success to a third-party logistics provider (3PL), building materials retailer to do so. B&Q’s stems in part from careful planning and although this is an expensive strategy. The parent company, UK-based Kingfisher, had close monitoring of its logistics supply company also plans to invest in IT systems kept watch on China for several years after chain. The company has set up its regional to improve communications with vendors launching the only do-it-yourself (DIY) headquarters in China to help direct the and so control inventory management more chain in Taiwan in 1995. With the increasing development of an effective supply-chain effectively—a move that will pay dividends wealth of Chinese consumers and growth in network, monitoring the management of in the longer term. home ownership, the mainland market local outlets and looking at the best ways to looked promising. Moreover, the universal grow its procurement chain. Like other Challenges for 3PLs practice of selling new apartments in China multinational chain-store operators, B&Q 3PLs are forced to charge high fees because as empty shells—largely unpainted and can call on a low-priced global procurement they themselves must cobble together lacking basic fixtures and fittings—made network to match or beat the prices offered multi-modal transport networks with the personal home renovations commonplace, by local building materials dealers. At the help of numerous smaller, inefficient local but DIY enthusiasts bought solely from same time, it can win over local suppliers to distributors. Basic transport services remain street stalls or small shops. With no organ- its procurement network: B&Q sources the mainstay of even the largest 3PLs in ised competition, B&Q made its move, goods worth at least US$1bn each year— China, and value-added services on offer— designing its stores to provide a full interior including electrical goods, kitchen appli- such as tracking and tracing solutions—are design service for Chinese customers ances and daily-use products for sale at its still rudimentary. attempting to refurbish their empty shells. stores in Europe and elsewhere. 3PLs must also bear the cost of local Today, B&Q has 15 outlets across the Like other national retailers in China, protectionism. Even in China’s largest cities, country, including in Beijing, Hangzhou, B&Q faces an underdeveloped transport non-local logistics firms face Kunming, Shanghai, Shenzhen and Suzhou. network, a lack of sophisticated logistics discrimination. The central government is The company’s Beijing store, which opened systems and the need for countless unable to enforce fair-trade rules in the in 2003, is its largest anywhere in the world. middlemen to make the supply chain work. provinces. Logistics firms operating on a In 2004 B&Q launched an aggressive retail These obstacles have made it difficult to set national level will face higher expenses at expansion strategy with plans to open at up regional distribution networks, let alone best and, at worst, exclusion from markets. least ten stores by the end of the year and national ones. B&Q’s 350 stores in the UK Overall, Mr Zhao is bullish about B&Q’s grow to a total of 75 stores by 2008. Most of are supplied by 600 vendors but the prospects in China. However, he warns that the stores will open in China’s wealthy company has to deal with as many as 1,800 logistics and the supply chain will play a key urban markets along the eastern seaboard, for its 15 outlets in China. role in determining the extent of the although B&Q has also started to locate George Zhao, the vice-president of company’s mainland development. China’s stores further inland in cities such as Wuhan logistics for B&Q China, says the common logistics infrastructure inevitably will in Hubei province. problems facing large retailers are poor improve significantly but Mr Zhao believes it warehousing facilities and the lack of an will take more time to make improvements The importance of logistics integrated logistics network and in the supply-chain system—notably co- After a rocky start, B&Q’s China operations sophisticated IT systems. For now, B&Q is operation with vendors.

rail system is oriented along a north-south axis, leaving tial delays during holiday periods, such as the Chinese New many east-west routes underserved. Service to important Year, booking systems are antiquated, cargo tracking is destinations in China’s interior—cities such as Wuhan, negligible and there is room for improving tariff structures. Chongqing and Nanjing—also remains weak. Moreover, a lack of regularly scheduled freight services prevents effi- Air cient movement of goods and creates a build-up of inven- Although air freight has expanded fairly rapidly in recent tory for shippers. Container block trains are available, years, it still accounts for only 0.1% of total freight although limited: only companies with sufficient cargo throughput in China. Domestic airlines were not allowed can charter entire trains, giving them better control over to operate dedicated air-cargo routes until 1998, giving freight movements. rise to scheduling problems and capacity shortages. Other problems remain. Services are subject to substan- Although these problems have eased somewhat, service

providers are concerned about the lack of inter-modal basic inventory management and security systems, let support, complex customs procedures, and excessive alone offer chilled or refrigerated facilities for perish- clearance delays and restrictions on flight frequency. able goods. ● Damage to goods in transit. For rail shipments, prob- Operational problems lems crop up when goods are off- and on-loaded to In addition to the difficulties of moving goods along trucks—a boxed cargo may look very different by the China’s strained infrastructure networks, supply chain time it arrives at its final destination. For long-haul managers must also overcome operational difficulties trucking, bad roads and poorly maintained vehicles stemming from a lack of professionalism in the distribu- can result in high damage rates. tion chain. The key problems include: ● Pilferage in transit. Companies booking less than ● Slow take-up of IT systems. Although the benefits of one container load on trains and trucks are more sus- information technology (IT) are widely recognised in ceptible to theft, which frequently occurs as goods are China’s logistics sector, the massive investment loaded on or off a container. The problem is worse for required to transform logistics systems remains a key rail cargo than freight transported on trucks. obstacle to development. “Many companies choose to use less expensive solutions for now, not considering Not yet connected the future,” says George Zhao, the vice-president of Despite the regulatory, infrastructure and operational logistics for B&Q China. Nevertheless, the use of ware- problems of conducting logistics services in China, most house management systems is becoming more popu- players are positive about the market’s long-term lar, even though transportation management and prospects. The Chinese government is pushing hard for logistics planning systems—and their integration— reforms to improve train services, while opportunities for still have a long way to go. expansion in integrated services make it a particular focus ● Poor collaboration between logistics partners. The for companies like APL going forward, says Mr Koay. He absence of a nationwide logistics network has forced sees necessary infrastructure upgrades as taking at least companies to build up a patchwork of different local ten years to implement, however. Smaller companies, and regional logistics providers in a bid to operate meanwhile, must await the upcoming regulatory reform to distribution networks across provincial borders. But gauge just how far the market will be opened. Although co-ordination between different logistics providers their expectations for what the new rules will bring are remains poor, creating high inventory and poor cus- generally not very high, there is a consensus that, eventu- tomer service for the industry. ally, they will come good. With such a large prize at stake, ● Obsolete warehousing facilities. Many facilities lack many are prepared to bide their time.

Part 2 Pharmaceuticals Cultivalting demand and biding time

elling drugs is different from selling mobile Given this laundry list of operational and strategic phones, televisions, computers or refrigerators. challenges, it is perhaps unsurprising that foreign phar- Certainly, some of the challenges facing overseas maceutical companies have not achieved huge success in drug companies in China mirror those that compli- the Chinese market, even though it has been open to for- Scate foreign firms’ operations in other sectors: a lack of eign investment since the 1980s and, by the mid-1990s, intellectual property protection; complex and opaque reg- 20 of the world’s top 25 drug firms had established a pres- ulations; complicated and costly distribution networks; a ence in the country. highly fragmented local industry; and an undeveloped pri- Yet there is still room to grow. China’s healthcare sec- vate sector. tor is in the midst of a transformation, one that could cre- Drug companies also face a unique set of structural ate new opportunities for growth. Although it will take challenges. In every country in the world, pharmaceutical years for the sweeping changes to be fully realised, some companies must operate within a highly regulated envi- drug firms are starting to make the strategic changes nec- ronment that imposes many restrictions, rules and regula- essary to tap into this changing market, and are reconsid- tions. China certainly has those in spades. In its ering how to tap into today's opportunities as well. government-run, hospital-based health system, drug registration, pricing and reimbursement are strictly con- The demand picture trolled, complicating the business strategies of even the Drug multinationals were initially attracted to China for most experienced companies. the same reason as other foreign businesses: the possi-

● On an international basis China is a small market for most for- ● The hospital system will be reformed, with the development eign pharmaceutical firms. But it is a market that is growing of health insurance, community-based primary care and the rapidly, a trend that many foreign firms expect to continue. full range of private healthcare services. These changes will take many years to implement but will have important knock- ● In addition to strong demand growth, other aspects of the on effects for the pharmaceuticals market. business environment for pharmaceuticals firms have been improving. The regime for the protection of intellectual prop- ● Even in the current environment, pharmaceutical firms have erty is still far from perfect, but is improving, and tariff barri- options. They can, for example, start to use market-shaping ers and rules on participation are slowing being relaxed. strategies to create new demand for drugs in areas that currently pass either under-diagnosed or completely untreated. ● Structural issues complicate the ability of foreign firms to capitalise on the emerging market. Chief among these is the ● Many foreign pharmaceuticals firms already have manufac- nature of the national healthcare system. In China's govern- turing facilities in China. But recent investment in research ment-run, hospital-based health system, drug registration, and development activities is an indication that drug compa- pricing and reimbursement are strictly controlled. And in an nies are starting to think more broadly about their China ven- effort to control costs, the Chinese government is cutting tures. Most of this investment has been and will continue to prices and favouring generic drugs whenever possible. be focused on drug-development clinical trials.

bility of selling their products to as many of China’s 1.3bn More demand for drugs people as possible. The first foreign pharmaceutical firms China‘s medicine industry, Rmb bn to enter China, which included Bristol Myers Squibb Annual total output value (1982), Janssen (1985) and SmithKline & French (1987), Annual market sales volume 400 found a virtually untapped market. By employing basic marketing and advertising techniques, they easily took 389.1 market share from local state-owned producers, which 350 were lethargic and inexperienced after decades of 323.8 bureaucratic control. Their early success stories con- 300 vinced many other drugmakers that China was the land of plenty and many followed in their footsteps, arriving in 270.0 China with a naïve and wildly unrealistic view of the mar- 250 ket potential for their wares. The over-optimism of those 233.2 early days was dampened in the mid-1990s by disap- 200 pointing sales and a realisation of just how difficult it was 183.5 to do business in the country. That sober mood prevailed 150 for a number of years, during which time corporate head- 150.7 quarters were nervous about their future in China. Invest- 126.0 ment was cautious, expectations were modest and 100 108.5 strategies were mainly geared towards simply maintaining a presence in China. 50 In recent years, growth has been solid but not explosive. The total market for ethical and over-the-counter 0 (OTC) drugs in China in 2002 was US$7.4bn (ex-factory 2000 2001 2002 2003 price) according to IMS, a US-based pharmaceutical Source: China Pharmaceutical Corporation research firm, up from US$5.5bn in 1997 and US$6.2bn in 2000. By some measures, China is still a substantial world market: in 2002 China was the seventh-largest drug mar- than 1% of these firms’ global business, according to a ket in the world, behind the US, Japan, Germany, France, number of executives interviewed for this report. the UK and Italy, and close in size to Brazil, Canada and Disappointment about market share, however, masks Spain. However, to put the overall size of the Chinese mar- the rather satisfying performance of individual compa- ket in perspective, one blockbuster pill generates more nies. The past couple of years have been good for many sales in the US alone than the sales of all foreign compa- foreign drugmakers and many already have, or are consid- nies' products in China combined. The world’s bestselling ering, increasing their investment in China (see box, drug in 2003, Pfizer’s cholesterol-lowering pill Lipitor, had Development, and perhaps even some research). For some global sales of US$10.3bn, more than all the medicines companies, China has become their fastest-growing mar- sold in China that year. A blockbuster drug in China, by ket and many are predicting continued growth. Novartis’ comparison, is any that reaches just US$75m in sales. sales, for example, were up by 30% in 2003 (to about Sales in China by foreign-invested enterprises (FIEs) US$120m from US$92.3m in 2002) and it expects 20-30% total no more than US$2.2bn, equal to about 20-30% of growth each year for the next five years. Roche expects its the Chinese market (although the share is bigger in prescription medicine business to double in the next five Guangzhou, Shanghai and Beijing). But the market is years to US$240m. AstraZeneca and GSK are also opti- highly fragmented. There are about 1,700 Chinese-foreign mistic. joint ventures (JVs) operating in the country, according to IMS, with the top ten global companies controlling less A better outlook for growth than one-fifth of the market. By comparison, the top ten If this rapid growth continues, IMS predicts that the phar- pharmaceutical manufacturers have 50% of the global maceutical market will top US$15bn (at ex-manufacturer market, with the biggest, Pfizer, capturing 9.25%, fol- prices) by 2010. Although this is still a tiny fraction of the lowed by GlaxoSmithKline (GSK) with 7% and US and Japanese markets, it would make China the fifth- Aventis/Sanofi with 6.6%. In Europe, the top ten compa- largest market in the world, on par with Germany, France, nies hold 45% of the market, with the leader, GSK, at the UK and Italy. 7.2%. The weight of the Chinese market on these compa- It is clear, therefore, why many multinationals regard nies' overall portfolio is still quite light, representing less China as an important part of their global strategy: the

country is already one of the world’s top markets and the private sector for services such as eye care, dental care potential for long-term expansion is great. For foreign and cosmetic surgery. As doctors, they are quality health- drug companies, a number of ongoing changes to the care providers who are better able to discern and digest business environment are buttressing their optimism information and make more informed decisions concern- about the market's future growth. ing patient care. One reason the Chinese market has been so difficult to penetrate is simply that, despite the economy's expan- The business environment sion, the majority of the country’s 1.3bn people cannot An improving, but still imperfect, IPR regime afford to buy expensive medicine; they have no access to Another important change in the business environment is what many foreigners would consider a basic level of the ongoing improvement in protection of intellectual healthcare. But preferences play a part, too. Among those property rights (IPR) and patent recognition. In its 2003 who have the ability to pay for drugs, many prefer tradi- white paper the American Chamber of Commerce tional Chinese medicine to Western medicine, especially (Amcham) in China described 2002 as a “milestone year in for chronic conditions that require long-term treatment. China for the promulgation of laws to improve intellectual Drugs such as Celebrex (for arthritis), Lipitor (to lower property protection of pharmaceuticals”. The main cholesterol), Premarin (hormone replacement therapy) change was legislation extending the period of patent and Prozac (for depression) have not been hugely suc- protection to 20 years, but improvements were also made cessful in China, as they have been in the West, primarily in the areas of data protection and patent linkage. because Chinese consumers prefer traditional Chinese Still, inadequate protection of intellectual property medicines for long-term treatments and Western medi- remains one of the biggest bugbears of foreign drugs cines (such as antibiotics) for short-term treatments. firms in China. Despite the changes that have been made Rising income levels, particularly in the bigger Chinese in recent years, in its white paper Amcham still called for cities, will begin to open up new sources of demand. The further progress to be made in the areas of data exclusiv- increasing number of young (25-35 years old), middle- ity, patent linkage and Patent-Term Restoration. Amcham class urban residents is already having a growing influ- also highlighted the problem of counterfeit drugs, which ence on the healthcare market. As consumers, the according to some estimates account for 10-15% of OTC members of this group are quality healthcare seekers who pharmaceuticals sold outside of hospitals in China. Drug are involved in making treatment decisions not just for enforcement authorities at the central government level themselves but also for their parents, grandparents and have devoted significant resources to anti-counterfeiting children. In addition, they will opt to pay for the conven- efforts. But more needs to be done at the local level to ience of private healthcare or be covered by health insur- enforce the law and prosecute offenders. One problem is ance. They are already beginning to dip into the nascent limited criminal sanctions. Currently, only counterfeiters

Big players Revenues of the top global pharmaceuticals manufacturers, US$ bn

38.9 35

30 29.6 25 27.9

20 22.0 19.0 15 16.9 15.6 14.8 14.4 10 11.8

0 Pfizer Glaxo Aventis/ Merck J&J AstraZeneca Novartis Hoffman- Bristol-Myers Wyeth SmithKline Sanofi La Roche Squibb

Source: International Federation of Pharmaceutical Wholesalers

Healthier features that continue to complicate the operating envi- China‘s pharmaceuticals‘ sales, US$m, actual prices* ronment as well as the formulation of the appropriate 12000 strategic response to changing conditions. Chief among them is the structure of the national healthcare system. The promise—and in some cases application—of major health system reforms supports some of the more opti- 9000 mistic forecasts for the market, but deep changes are still a long way off. In China’s government-run, hospital-based health 6000 system, drug registration, pricing and reimbursement are 7,471 8,161 8,947 9,903 11,110 12,511 strictly controlled, complicating the business strategies of even the most experienced companies. Most medical 3000 care is provided in government-controlled hospitals, where 70-80% of drugs (both ethical and OTC medicines) are sold. Reimbursement in the state-controlled hospitals is limited to drugs on provincial and national drug 0 2003 2004 2005 2006 2007 2008 lists that, in turn, largely determine which products a * Ex-manufacturer level pharmaceuticals manufacturer can sell to which hospitals Source: IMS Health and at what price. According to some executives at foreign drug compa- who produce substandard drugs that result in serious nies, the system of pricing and reimbursement greatly injury can face criminal sanctions. complicates, and sometimes threatens, the success of their business in China. In an effort to control costs, the Easing restrictions on participation Chinese government is cutting prices at the central and Market-opening measures may also support growth. For- provincial levels for reimbursed medicines, and aims to eign participation is now permitted in the previously reduce the price of off-patent drugs from multinationals closed drug distribution industry. China’s first pharma- to no more than 30-35% above the price of locally made ceutical distribution JV was announced in 2003 ahead of generics. Moreover, the Chinese government is favouring the date China promised to the WTO. The joint venture, generic drugs whenever possible and is restricting the list called the Zuellig Xinxing Pharmaceutical Co, has a total of drugs sold through hospitals. As with anti-retroviral investment of US$14.5m, with China Xinxing holding a medicines to treat AIDS, there is certainly a case for low- 51% stake and Zuellig Pharma the remaining 49%. ering the price of drugs directed at diseases such as dia- Although based in Switzerland, Zuellig Pharma carries out betes and hepatitis, which are major medical and social its main business as a distributor of pharmaceutical and problems, in order to expand access to treatment. More healthcare products in the Asia and Australasia region. As broadly, it must also be acknowledged that the pharma- with local manufactures, drug distribution has been con- ceutical industry does battle against restrictive pricing trolled by the government for decades and is costly, inef- and reimbursement policies in just about every Western ficient and overcrowded. (There are currently more than country, with the notable exception of the US. 16,000 drug distribution companies in China.) The long-term solution to the enormous challenge the Other developments that have aided, and will continue government faces in trying to provide an adequate level of to aid, the growth of the market include the reduction of healthcare services for the entire population with very import tariffs. As part of China’s WTO obligations, average limited resources lies in hospital reform as well as the import tariffs were lowered to 4.2% in 2003 and compa- development of health insurance, community-based pri- nies were allowed to import into any part of China. The mary care and the full range of private healthcare serv- efficiency and transparency of the regulatory environ- ices. The government also hopes to restructure and ment, particularly with regard to issues such as drug reg- modernise the domestic pharmaceutical industry (makers istration and imports, is also improving. of both Western and traditional Chinese medicine), bring manufacturing up to international quality standards and Enduring systemic barriers maintain the dominance of local companies. But these A growing and more sophisticated market, coupled with changes are likely to take at least ten years to implement, an improved business environment, offer some cause for even though, ever so slowly, progress is being made. Most optimism among the foreign pharmaceutical companies of these changes will have important, knock-on effects on operating in China. But there are a number of offsetting the pharmaceutical market.

The near-term strategies phase involving investment in research and development With the completion of deep, structural reforms a decade (R&D) is emerging and seems all but destined to become a away, many foreign companies are being forced to investi- more important strategic area for drug companies, both in gate how to maximise opportunities in today's market, terms of their business in China and their regional and while keeping an eye on the future. To that end, the idea global operations (see box, Development, and perhaps of applying the same marketing and communications even some research). strategies in China that are used to such great success in other countries is a concept many of the big drugmakers Stressing sales and marketing are now beginning to explore. Patent recognition has The strategic approach taken towards sales and marketing made this possible, as have other changes over the past is likely to separate the winners from the losers in the five years, such as the growth of the market and the Chi- coming years. When foreign drugmakers first came to nese middle class. China, they tended to manufacture and sell their more GlaxoSmithKline (GSK), the world’s second-largest drug- “mature” products, that is medicines that were off-patent maker, still has less than 2% of the Chinese market. The and already facing generic competition in home markets. company is re-evaluating its China strategy to determine Because patents were not recognised and intellectual what, if anything, it can do differently to make a break- property not protected, companies understandably with- through in the market. Will GSK, and other drugmakers, try held their most innovative drugs from the Chinese mar- to find a way to break the mould or continue on a “business ket—these drugs were certainly not manufactured in as usual” approach? Will they be satisfied with organic China and, in many cases, were not even imported. Over growth along conventional lines or take a risk and possibly the last five years, this has begun to change. Pfizer, for jeopardise what has already been achieved? Companies example, offers 40 products in China, including all of its looking to elevate China from an interesting market to a pri- global bestsellers (Lipitor, Norvasc, Celebrex, Viagra, mary one are now wrestling with their next strategic steps. Diflucan, Zithromax and Zoloft). Novartis launched four To make the most of opportunities in the near term and new drugs in China in 2003—a record for the industry. to be as well placed as possible in the longer term when According to a number of company executives, foreign hospital and insurance reform are implemented, Western drug companies are eager to include China in the global drugmakers will have to make some strategic changes to launch of all their new products, although there is still a their business development plans. Mergers and acquisi- lag between the international launch of many drugs and tions (M&As) are not a favoured route for growth in the their Chinese debut. The time delay is not a result of a cor- Chinese market. Local drug companies—rife with ineffi- porate strategy decision but rather because of China’s ciencies, overproduction and losses—offer nothing to complex rules and regulations, which can delay the regis- most foreign firms. Manufacturing strategies are already tration of a new drug in China by two or three years com- well developed, as this was the first wave of investment pared with registration in the US or Europe. after drug multinationals began setting up their commer- On the one hand, introducing the latest patent-pro- cial businesses in China (see box, Making drugs). A new 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 companies Create 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 market manufacturing up to international quality standards Source: Economist Intelligence Unit

Making drugs

Since the late 1980s, after the central gov- As a result of global mergers, some drug AstraZeneca’s largest manufacturing ernment announced the imposition of companies now have complex JV structures investment in Asia. Some 80% of the restrictions on imports and a policy favour- in China with several factories and several products it sells in China are manufactured ing locally manufactured products, foreign partners. In these cases, it is difficult to at the plant; the remaining 20% are drug firms interested in the China market centralise manufacturing operations since imported because the volumes are too small were compelled to set up manufacturing the registration of a drug is tied to the to justify local manufacture. Novartis, joint ventures (JVs). (A local partner was place it is manufactured and not easily another one of the leading players in China, obligatory.) A pharmaceutical JV typically changed. has only a US$30m formulating plant for its involved a US$10m-30m investment in a The global trend in the industry, tablets and creams and imports 50% of its plant engaged in formulating, filling and however, is to rationalise manufacturing, products. packaging low-technology products such as and some firms consider China and India In the future, companies will continue pills and creams. (Formulating, or second- increasingly attractive locations—a change to both manufacture locally and import. ary manufacturing, involves mixing active from just five years ago, when they were still Decisions to expand manufacturing are chemicals with inactive ingredients.) Once considered risky owing to the lack of more likely to be based on demand and the ink was dry on a JV deal, it was easier to intellectual property protection and costs, and not whether the expansion will get drugs on the reimbursement lists and to concerns about quality of supply. Some use win favour with local drug regulators. import finished products into the country. China as a manufacturing base for the local These will be internal decisions, part of a In the latter half of the 1990s companies market as well as for export to other Asian larger global plan, that are unlikely to have began to take greater stakes in their JVs, in markets. Some foreign companies a big impact on a company’s sales in some cases opting to form a wholly owned manufacture locally the majority of the China—at least not to the degree that it foreign enterprise, which also became an products they sell in China. Some will separate winners from losers—but will option for companies willing to manufacture manufacture only high-volume, low-price be reflected in a company’s global higher-technology products. Typical products for the local market. performance. So in terms of investment levels in a plant increased to The merger between Glaxo and manufacturing, at least, China is becoming US$100m or more as companies built more SmithKline Beecham left the new company, more like other developed markets. If this expensive formulating plants and began to GlaxoSmithKline (GSK), with US$400m same trend emerges in other areas, manufacture higher-technology goods such investment spread over five plants and five investment levels could rise further. After as time-released capsules, injectables, different partners. Pfizer has invested the all, manufacturing, which accounts for aerosols and inhalers. (Primary most—US$500m—primarily owing to the most of the official US$2bn in “equity manufacturing or chemical manufacturing large manufacturing presence in China of investment” that foreign drugmakers have plants cost US$200m-400m to set up and Pharmacia, which it acquired in 2003. made in China, is in general not drug drug companies by and large have not opted AstraZeneca, by contrast, has a simple companies’ biggest expense. They spend to locate such plants in China.) Many raw structure with one US$134m formulating much more money on sales and marketing materials are sourced locally but most active plant in Wuxi, which it owns outright. and on research and development—and are ingredients for patented drugs are imported. Inaugurated in 2002, the plant is beginning to do just that in China as well.

direction. Those that continue to satisfy head office even the most “innovative” one, if there is little chance budget figures with sales of “mature products” are going of obtaining a spot on the all-important provincial and to face hard times ahead. This is not a viable long-term national reimbursement lists (because the government strategy, as it will become increasingly difficult to lobby cannot afford it) or if there is little chance of sales in the for placement of these medicines on reimbursement lists private sector because of a lack of demand from doctors when far cheaper alternatives of the same treatment are (who would prescribe it) or consumers (who would pay available. And so it should be; foreign drugmakers could for it). do themselves a collective favour by accepting this simple reality and concentrating on their new drugs, just as they Picking winners do elsewhere in the world. Drugmakers need to try to pick the winners. Sometimes it On the other hand, launching a company’s entire is clear, as was the case with GSK’s Heptodin, a novel treat- global portfolio is not necessarily the best strategy ment for hepatitis that has been a Chinese blockbuster either. There is little point launching a product in China, since it was launched in 1999. It was the tenth bestselling

drug in China in 2003. Novartis’ Glivec, a new treatment Marketing by market shaping for leukaemia, broke records when it was registered after Picking the right drugs and the right cities is only part of only six months and was one of the top ten bestselling new the marketing battle. Companies must also begin to cre- drugs in China in 2003. These were truly novel treatments ate demand where demand did not previously exist. Mar- that met a clear and significant medical need. But matches ket shaping is a strategy employed successfully across like these are few and far between. In general, determin- sectors and around the world, and the time is ripe for its ing which products to launch, and how many should be utilisation in China. included in the China portfolio, is no easy task. The concept of market shaping has been around a long Few foreign companies can make the investment time in the pharmaceutical industry. The marketing his- required to promote a whole slew of drugs effectively. But tory of Lipitor, a drug to lower "bad" cholesterol, is a clas- companies must bear in mind that there are more and sic example. It was a late arrival to the statin field, more people who can afford to use drugs, and more peo- following in the footsteps of Zocor and Pravachol, which ple who want the “best” drug and will pay for it if they both enjoyed considerable success. Pfizer, however, have to. Drug firms also need to consider the launch mar- reshaped the market by changing the approach to the kets, looking beyond Shanghai, Beijing and Guangzhou to clinical management of heart disease and, in so doing, include as many of China’s first- and second-tier cities as made Lipitor the world’s bestselling drug. the budget allows. Another more recent example of market shaping is the

Development, and perhaps even some research

Although foreign drug firms have had a pres- and Beijing on genetic epidemiology studies waters: the new centre will initially be staffed ence in China for more than 20 years, most of about conditions such as diabetes and by 40 chemists—rather few when compared them viewed the world's most populous Alzheimer’s disease. In 2001 AstraZeneca with the more than 5,000 scientists Roche nation as a manufacturing centre and an signed a collaboration agreement with employs in its four other facilities. expanding market, instead of a place to con- Shanghai Jiao Tong University to study the Sceptics say the opening of a research duct innovative research. Recent investment genetic basis of schizophrenia. facility is mostly a token gesture made to in research and development (R&D) is one A few have even set up their own research gain favour with the Chinese government. indication that drug companies are starting facilities, something that was unthinkable The sceptics may be partly correct. Besides to think more broadly about their China ven- five years ago, so great were worries about the possibility, however small, of tures. It is impossible to put a figure on the intellectual property rights (IPR). In contributing to an organisation’s global drug amount that the industry is spending, but it November 2002 AstraZeneca opened its discovery efforts, an investment in an R&D is fair to say that it is minuscule compared regional Clinical Research Unit–East Asia, centre in China will indeed please the with overall spending on R&D worldwide and which is responsible for overseeing clinical authorities, perhaps offering foreign that greater investment in China seems research in China, Hong Kong, Taiwan and companies some leverage in negotiations on almost certain. South Korea. Eli Lilly, NovoNordisk, Pfizer issues such as the new drug application Pharmaceutical R&D comprises two arms: and Roche have also opened R&D centres or review process, drug pricing, reimbursement basic and preclinical research (drug discovery have made announcements that they will be and IPR protection. and all the testing that goes on in laboratories doing so soon. Both GSK and Novartis say before a treatment is tried in human that it is just a matter of time before they, Clinical trials volunteers) and clinical trials (testing drugs in too, invest in an R&D centre in China. Currying favour with the government aside, humans). In China, foreign drug companies In February 2004 Roche announced that it R&D investment is a step towards building a are investing in basic research through various was establishing a wholly owned and stronger presence in the Chinese market. sponsorships and alliances with academic operated R&D centre in Shanghai, which is Given China’s weak IPR track record, it is institutions, research groups and biotech scheduled to be fully operational by the end easy to understand why drug companies are start-ups (local drug manufacturers are absent of the year. It will be the group's fifth R&D only just now beginning to make invest- from the list of close collaborators because facility worldwide (the others are located in ments in R&D centres. They have, however, innovation is not part of their business). the United States, Japan and Europe). Roche been somewhat less cautious about involv- Roche, for example, is collaborating with the has not put a dollar figure on its investment ing China in global drug-development clini- Chinese National Genome Centres in Shanghai but clearly the company is just testing the cal trials, which is where most R&D

erectile dysfunction market. Viagra created the category mote their patent-protected drugs. and the general thinking in the industry was that the new A market-shaping strategy will also entail a jarring entrants like GSK’s Levitra could not grow the market; shift in current marketing techniques. Until recently, for- they could only take market share from each other. But in eign drug companies have focused marketing efforts on some places elsewhere in the world, clever and creative gaining access to hospitals, winning over key opinion sales and marketing departments found a new way to leaders and doing whatever it takes to get their products position their new drug instead of competing head-to- on provincial and national reimbursement drug lists. In head with Viagra. To the surprise of many, not only has other words, the companies have targeted the supply the total market grown but the new entrant has taken a side, with teams of 700-1,200 medical reps playing the leading position. same market share game and competing head-to-head Opportunities abound for market shaping in China and with each other. But perhaps a more effective strategy is there is no inherent reason why it cannot be done just as to create demand with doctors and consumers—a strategy effectively. Diabetes, hypertension, hepatitis, heart dis- that might require, for example, a company to investigate ease, dementia and other diseases related to ageing, strategies for changing the opinions about Western medi- women’s health and men’s health are just some of the cines versus traditional Chinese medicine or building under-diagnosed and untreated health problems waiting brand awareness. to be tapped by foreign drug companies looking to pro- This strategy will begin to pay off when consumers are

investment has been and will continue to be protected by its patent. A second reason is new treatments once they are discovered. focused. that by including Chinese sites, drugs can get The drug company benefits for all the rea- Although drug development is one of the to the China market faster. Chinese sons already explained. The central and local biggest areas of spending for a multinational regulatory authorities require local trials for governments benefit because they bring drug company (costing hundreds of millions of all new drugs, even if a drug has been investment and expertise and help upgrade dollars to test each new drug), such trials do approved elsewhere in the world. If China the standard of the local industry. Govern- not require investment in a research facility. participates in initial stage trials, this speeds ment regulators, ethics board members and They are conducted in hospitals and involve up the drug registration process. This can medical personnel acquire the skills and gain doctors, nurses, patients and many others who translate into millions of dollars in sales. It valuable experience in clinical trials of an serve as administrators, regulators and also helps sales and marketing efforts international standard. Hospitals, doctors overseers. After a new drug candidate passes because it is a way to get top hospitals and and researchers are keen to participate preclinical testing in the laboratory and on influential key opinion leaders on board as because they bring training, money, new animals to assess safety and biological early as possible. drugs and technologies for which they would activity, it moves into three phases of clinical Today, most of the big foreign companies otherwise have to wait years. They also bring trials involving testing on humans. Phase III are conducting such trials in China. GSK says prestige to an institution and the chance for trials generally involve thousands of patient that at any one time it has 4,000 patients an investigator to be published in an inter- volunteers in many hospitals in many enrolled in trials in China. Novartis is testing a national medical journal. Patients benefit countries throughout the world. new treatment for hepatitis, which, if it proves because they get access to a potentially There are many compelling reasons why to be effective and safe, may be launched in effective treatment for free and they receive foreign drug firms are increasing investments China before the rest of the world. care, which is often better than that avail- in drug- development trials in China. For one, able to regular patients. such trials are faster and cheaper to perform Of benefit to all The biggest risk in the strategic decisions in China than in the US and other Western Assuming international ethics and standards to conduct clinical trials in China is a breach countries. It may take longer to obtain are adhered to, it is difficult to find fault with of ethics, which could seriously damage a permission to conduct a trial but patient the strategy. All players stand to benefit. If drug firm’s business in China and recruitment is extremely rapid. This is a big the government’s dream of one day spawn- internationally. The other main concern for draw. The faster a drug can get to market, the ing Chinese versions of Pfizer and GSK is ever foreign companies investing in any form of speedier the return on investment; the faster to be realised, the country will need to have R&D in China remains the protection of IPR, a drug can be developed, the longer it is the infrastructure and skills in place to test and this concern is likely to remain.

Coming of age Part 2 Pharmaceuticals

given more choice over their own pharmaceutical purchases. One ongoing reform—the rapid expansion of retail China’s pharmaceutical sector: market leaders, 2003 pharmacies in China’s larger cities—presents both an Top 10 companies Top 10 products Top 10 new products opportunity and a challenge to the industry. Officially, a YangZiJiang Fty Zuo Ke Rui Pu Xin Nt doctor is allowed to write a prescription for a medicine ZhuHai LiZhu Group Da Li Xin Nobex that is not on the reimbursement list. A patient can take Pfizer Group Kai Shi Seretide Novartis Group Glucobay Ka Bo Ping this prescription to a retail pharmacy where he or she pays GlaxoSmithKline Lu Nan Xin Kang Nexium for it out of pocket. In practice, the need for a prescription AstraZeneca Group Sulbactam/Cefopera Glivec is rarely enforced, with the result that prescription drugs Roche Group Sandostatin Herceptin of all kinds are as easy to purchase as OTC cough medi- L.Y.G. Hengrui Rocephin Femara cines. Moreover, consumers will sometimes self-treat HLJ.Haerbin Pharm. Cefuroxime Simulect rather than go to the doctor, opening up the potential for GuangZhou Tianxin Heptodin Xin Ke misuse. The concern about misuse is perhaps greatest in Source: IMS Quarterly Market Brief the case of medicines for diseases (such as cancer) that are simply too expensive for government reimbursement lists. The trade-off between price and benefits for most chemotherapeutic agents is not favourable—the Chinese ket in the foreseeable future, foreign drugmakers should government, for instance, cannot afford to pay hundreds continue to experience solid, but not explosive, growth. if not thousands of dollars to prolong a patient’s life by Price cuts will contain overall revenue growth despite two or three months. A small but growing portion of the likely increases in sales volume over the next few years. population is, however, willing and able to pay for such But individual firms may experience breakthrough if they treatments. The conundrum for a drugmaker is whether to can launch truly innovative patented drugs that clearly supply the treatment at the retail pharmacy level, well meet an unmet medical need, such as GSK’s Heptodin or aware of the risks involved, or avoid it altogether until the Novartis’ Glivec. Multinational pharmaceuticals compa- government is better able to police the system and nies must continue to seek more effective ways to engage enforce regulations. In the medium term, the develop- doctors and hospitals, and work with local and central ment of the private retail pharmacy network opens up new drug regulators to get their drugs on provincial and potential for foreign firms but current concerns about national drug reimbursement lists. At the same time, the control are slowing the process. ongoing reform of the healthcare system will create more opportunities to tap demand from private pharmacies, Big hopes for a still small sector doctors, consumers and patients. The current market is Even though the cash-strapped, public hospital-based satisfying for some. But there is still real potential to be system will continue to dominate the pharmaceutical mar- unlocked by the right strategy.

Part 2 Retailing and consumer goods Overcoming regulations and building brands

n the early 1990s, fast-moving consumer goods all found market entry relatively easy. Faced with little (FMCG) was one of the first sectors in which multina- domestic competition, most of these companies quickly tional companies (MNCs) established a large pres- found themselves able to sell their goods and even report ence in China. Two main factors helped to advance profits. theI progress of foreign consumer-goods firms. First, by Life has not been so simple since then. For a start, the the mid-1990s around 350m people had an annual rather imbalanced market that opened up in the early income of US$500 or more, helping to create a consumer 1990s, with a mass of foreign companies and little local market that could afford basic consumer goods such as competition, has begun to tilt sharply in the other direc- soap and detergents. Second, the government did not tion. Chinese companies have spent massively on manu- view consumer goods as a strategic sector, unlike steel or facturing equipment and are now making everything from telecommunications which were subject to greater shampoos to batteries. With this sudden tilt toward mar- scrutiny and restriction. As a result, foreign companies ket overcapacity in just about every subsector, local pro- such as Procter & Gamble, Unilever, Colgate and Gillette ducers have slashed prices and claimed sizeable market

● The big international retailers, notably Carrefour and Wal- ● China’s consumer markets remain largely focused on the first Mart have established themselves in key cities in China. They and second tier cities of the coast. The country’s economic are likely to expand their chains fast in the next few years, and growth will bring in growing numbers of inland and third-tier be joined by other retailers with global ambitions. The over- cities over the next few years, but markets will remain cen- crowded domestic retail sector will see huge consolidation tred on Greater Shanghai, the Pearl River Delta and the Bei- over the next few years, especially once restrictions on the jing-Tianjin axis. operations of foreign companies are lifted at the end of 2004. ● Brand building is an area where foreign companies have ● The leading international fast-moving consumer goods com- struggled—but local companies have even more so. With few panies established a strong presence early in the 1990s, but consumer brands yet established strongly, market shares for making money has been hard. Procter & Gamble managed it fast moving consumer goods firms will fluctuate sharply over with a focused strategy starting with shampoo, but Unilever, the next few years until companies have worked out how best which early on launched products across a host of personal to build brand equity. and household sectors, has only succeeded in approaching break-even recently after embarking on a programme of con- ● Human resources, or rather the lack of them, remains a major solidation and cost-cutting at its ventures. challenge for businesses in both sectors. The problem is finding staff able both to overcome pressing and immediate ● Bitter competition from domestic companies emerged in the operational issues but who can also undertake long-term late 1990s. Chinese brands have taken large market shares strategic thinking required to make a company’s products from the international companies at the lower-end of the and services a more permanent fixture of China’s consumer market and are moving up into the middle tier. universe.

shares from foreign companies. The quality of some wealthy hinterland. Some of the lesser cities of, say, the locally produced goods might not match that of interna- Greater Shanghai region, may not be as well off as Dalian tional firms. But with consumers, especially those in the but they have other compensating factors, such as access countryside and lower-tier cities, basing their purchasing to the Shanghai market and better links into China’s decisions largely on price alone, these domestic busi- transport network. nesses have proved a threat to both the early foreign Another tier of cities, the so-called tier-three cities, entrants and other Chinese companies. will come into the reach of foreign companies over the In retailing, the story is not so dissimilar. China next decade. Most of these will be in the vicinity of exist- announced in late 1995 that it would allow the entry of ing markets, or in fact extensions of them, as road net- foreign chain stores. The French retailer, Carrefour, was works reach further. For example, foreign companies are the quickest off the mark and established an early lead. expected to branch into cities in eastern and northern But others have arrived or are on their way—including Guangdong, southern Hunan and Jiangxi, as well as Wal-Mart of the US, Makro from the Netherlands, Metro of deeper into Fujian. Germany and UK-based Tesco—while Chinese companies The survey conducted for this report confirmed that the are looking to organise themselves into groups and have majority of companies tend to think of China as a series of the strong backing of the government. distinct markets. Asked how their businesses conceptu- Both sets of experiences have useful and contrasting alised the China market for domestic sales, two responses lessons for foreign companies in general. Whereas the stood out: first, from companies which see it as a series of experiences of the FMCG companies offer some practical cities belonging to separate tiers (35%); and second, from pointers on operating in a relatively open sector of the those which see it as a series of distinct regions (31%). Chinese economy, retailing has remained restricted, with The principal factor determining both these views of the final barriers on entry and operation only due to be China’s markets is the disparity in incomes between differ- removed at the end of 2004. Nevertheless, companies ent locations, with infrastructure deficiencies and the have managed to establish themselves—none more problems these create in accessing locations. prominently than Carrefour, now China’s fifth-biggest The consumer-goods firms that participated in the sur- retailing operator. In consumer goods, the struggle has vey tend to think of the China market as sets of cities. Of been less to do with getting established than how to oper- the 18 companies that responded, 12 said they thought of ate in a market that is maturing and expanding fast. the country in terms of first-, second- and third-tier cities, whereas three each said they thought of it either as a The consumer market national market or a series of regional markets. Their view Foreign companies have long recognised that China has of the country—either as a collection of cities, regions or a three principal areas of wealth: the Pearl River Delta, just national market—was overwhelmingly determined by across the border from Hong Kong; Greater Shanghai, their perception of income disparities: 15 of the 18 com- encompassing Shanghai proper and the string of cities panies declared this to be the reason underlying their surrounding it in northern Zhejiang and southern Jiangsu conception of China’s markets. The only other factor to provinces; and the Beijing-Tianjin axis. Between them, record a significant response was infrastructure deficien- these three regions embrace around 100m-150m people, cies, cited by five companies, all of which had also depending on how widely the net is thrown. From the declared income disparities to be a factor. In short, and early 1990s onwards, when people talked of China’s con- unsurprisingly, consumer-goods companies go to where sumer market they were generally referring to these three people have money; some—though not a majority—find locations, which are thousands of kilometres apart. Not infrastructure a problem in accessing the markets they only was there no national market but even the submar- want to reach. kets were as far—or further—apart than those between Within a decade, China is likely to look less like an many countries. The transport links between them were association of three separate markets and more like a poor at best, as were the people who lived between them. national market, albeit one with major regional distinc- In the last five years, however, this picture has tions and almost certainly with cities arrayed in a series changed. Today, it makes more sense to think of China’s of tiers. To a certain extent, this can already be seen in consumer market in terms of these three areas, plus the the rise of provinces between the main centres, such as country’s other leading cities, plus a series of tier-two Shandong, whose growing industrial strength and heavy cities. Some of these cities are much richer than others. investment in infrastructure is making it a major market Dalian, for example, tops the league of the leading cities in its own right between Beijing-Tianjin and Great Shang- and could be compared with parts of the Pearl River Delta hai. Fujian similarly is becoming more accessible from or Greater Shanghai. It is, however, isolated from a both Guangdong in the south and Shanghai in the north,

moving away from its history as an isolated province. For owned retailers have been merging to form supposedly the meantime, however, companies must cope with a more powerful groups, while foreign entrants—both those country that is divided into relatively isolated markets already present and others with little or no presence— plus the leading, and tier-two cities, although with the have been announcing massive expansion programmes compensation that the pool of consumers within each involving hundreds of millions of dollars of investment market is rising fast. and nationwide networks of stores. Foreign-funded stores have already had a major impact Retailing takes off on the retailing market. A survey conducted by the State As a result of the growing market, improved business Economic and Trade Commission (now part of the Ministry environment and aggressive strategies, retailing of Commerce) in late 2002 found that foreign retailers expanded quickly throughout the 1990s. After the market accounted for nearly one-quarter of major supermarkets was opened to foreigners in 1992, Malaysia’s Parkson was in China. According to another official report, foreign- one of the first overseas foreign retailers to test the funded retail groups now occupy five of the positions waters. Its initial strategy—offering premium goods at a among China’s top 30 retailers. Two of these stand out: premium price—flopped badly. People came and looked, Carrefour and Wal-Mart. Carrefour has been by far the but did not buy. Only after it changed tack to sell everyday most aggressive entrant: by early 2004 it had more than items at regular prices was it able to spread across the 40 stores open across China, with plans to keep this num- country. Other retailers have had similar experiences, ber growing by 10-12 annually. Wal-Mart began by con- with most later entrants concentrating on offering low- centrating on establishing itself in south China’s richest frills experiences rather than trying to trade on their province, Guangdong, only venturing further afield after names. As the fast-moving consumer-goods makers have opening a string of stores there. It has now opened some found, China remains essentially a price-driven market, 35 stores, including one in Beijing and several across the with little ability to charge a premium for anything out- north-east. Domestic retailers, by contrast, have many side the very thin top layer. times more stores, and have been trying to increase their The market has undergone an additional series of qual- clout by consolidating into big groups. Bailian Group, itative changes over the last five years. Across the coun- formed though a merger of six retailers in 2003 (including try, supermarkets and hypermarkets have been replacing the country’s largest supermarket chain, Lianhua Super- traditional state-owned department stores. According to market) operates more than 5,000 stores. AC Neilsen, an international ratings agency, between 2001 and 2002 the number of supermarkets and hyper- Competing in a crowded market markets doubled. The number of modern trade outlets As with many industries in China, oversupply is raising increased by a further 44% in 2003. By contrast, the tradi- itself as a potential problem. ACNeilsen found that while tional multi-storey outlets of such formerly well-estab- the number of modern stores increased by almost half, lished names as the Beijing and Shanghai number one total sales made rose by a more moderate 18%. It also department stores have seen their sales decline. State- found that this tendency was worse in the major cities.

A market, at last Retail sales, Rmb bn 5000

4000

3000

2000

1000

0 1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 Source: Economist Intelligence Unit

Such rapid and broad expansion has created a very frag- the final moves allowing foreign companies full freedom mented market: even China’s biggest supermarket chain, to operate become effective at the end of 2004. In con- Lianhua, now has only around 5% of the food market. trast, the fast-moving consumer-goods industry has been In the short term, this phenomenon is certain to con- open since the end of the 1980s when a string of leading tinue. Bailian, for example, aims to add more than 1,000 global companies entered the market—Procter & Gamble, stores in 2004, dwarfing even the most ambitious plans of Unilever, Gillette, Colgate-Palmolive, SC Johnson, all the foreign companies. In addition, the government is Henkel, Revlon, Shiseido, Kao, Maybelline, Estee Lauder planning to lift various restrictions on the activities of for- and a host of others. eign retailers, encouraging a further burst of investment Given the lack of restricting regulations and local com- and expansion by overseas companies. petition, FMCG was a relatively straightforward market to But clearly such growth cannot continue indefinitely. enter, if not a normal one. Most of the early entrants are Much of the rapid expansion by domestic companies is an still present in one form or another. Gillette still makes attempt to grab market share before companies are forced razors, even if its early estimates of the size of the shaving to merge; as with many other sectors, the imperative is sur- market proved seriously overblown, and the shelves of vival rather than commercial logic. Given the government’s supermarkets and chemists are lined with international- support for local firms, and its desire to develop a small brand haircare products, makeup, toothpaste and sanitary number of Chinese retailing giants, it is likely to force con- towels. As might have been suspected, FMCG makers, with solidation of the retail market at some point—unless the experience of other developing markets—including overcrowded market kickstarts the process on its own. tougher ones, such as India—fared well in their first few Domestic companies are going to find the competition years, with competition mainly between themselves. even tougher after this year. In December 2004 the gov- Of the first wave of entrants, Procter & Gamble of the ernment will lift geographical restrictions on retailers and US stands out as having both the most focused strategy end the rule requiring all foreign retailing companies to and the biggest success. It began by concentrating on have a local partner. Foreign retailers will find themselves establishing its shampoos, backed up with heavy spend- operating in a more open environment but one that ing on advertising, and only broadened its portfolio of remains crowded and tough. goods once it had firmly established itself. Carrefour’s testing of China’s regulations—both In contrast, its biggest rival of those years, the Anglo- exploring grey areas and sometimes explicitly ignoring Dutch concern, Unilever, launched several different prod- rules—has put it into a strong position ahead of these reg- uct types in rapid succession, including soap, toothpaste, ulatory changes. Its risk-taking does not seem to have detergent and ice cream. But doing so meant it had to endangered its activities. The key to its success, however, spread its energies too broadly and thinly. The outcome would seem to be less its early mover advantage than the was that where Procter & Gamble was able to take lessons experience it has built in negotiating China’s distribution learned in launching its shampoos and apply them to other and supplier chains. goods as it brought them into the market, Unilever failed Wal-Mart, by contrast, looks to be building off the to get a satisfactory handle on its portfolio of business. experience it has gained in sourcing from China. The vol- More recently, however, Unilever has both unified and ume of goods it buys from the country for sale in the US— strengthened its marketing as part of a global strategy US$12bn-15bn annually in recent years—makes it China’s change aimed at moving away from its previous largely single biggest customer. Clearly, this has given it a lot of decentralised model to one with greater control from know-how in buying goods cheaply in the world’s major headquarters, particularly in brand management. Procter cheap manufacturing centre. (Carrefour is also a signifi- & Gamble has found the going harder: its original brand cant buyer of Chinese goods; it sources around US$1.5bn- positionings, particularly for shampoo, have become less 2bn worth from China each year.) distinct over time, while a decision to focus on rural sales Given Carrefour and Wal-Mart’s strong foundations, has proved hard to implement. perhaps the biggest issue for the next round of entrants is Across the sector, other new foreign entrants mishan- whether they will find themselves paying too much to dled a number of issues. One is overpricing. Typically, enter. In early 2004 Tesco was reported to be considering international companies have launched their products in spending US$200m on acquiring a 50% stake in 25 stores China at price points that are way too high. Believing, run by Taiwan’s Ting Hsin International Group. often correctly, that their goods will be of higher quality— and perceived to be of higher quality—the assumption has Consumer goods—battle commences followed that premium prices can be justified. There is Retailing is still very much in its formative stage, with the example after example of this—from glue, where Ger- full form of the market only likely to become visible after many’s Henkel decided to launch its Pritt at Rmb6 com-

Coming of age Part 2 Retailing and consumer goods

Carrefour’s experience: does rule-breaking work?

Carrefour, the world’s second-largest China’s Ministry of Commerce. Moreover, will do what it takes to get there. retailer, made little secret of its bending of Carrefour’s China operations were reportedly Carrefour was determined to develop a China’s retail rules during its first five years profitable before its restructuring, so it has nationwide network ever since it arrived in in China. Willingly aided by local govern- not bled cash over the last couple of years. It China. Its strategy of finding a different ments, the French company opened stores also did not wait for all its previous ventures partner in each location (rather than trying across the country in which it retained way to be untangled before talking with new to find just one to work with across the over the 65% ownership share permitted by partners—since 2002 there have been a country) could have backfired by giving the the government, taking full advantage of its series of reports of agreements to start new company too many different partners to ability to offer a modern shopping environ- ventures across the country. Many of these handle. Instead, it has turned its local ment, plus jobs, rent and taxes. are now being realised but others went into support in each location to its advantage. When the central government called the operation with no great fanfare, hence the Clearly, these partners have preferred company to account in 2001, the consensus jump in store numbers from 28 when its ban supporting Carrefour and its presence in was that it would be fined, asked to mend its on expansion was announced to more than their locality rather than supporting Beijing ways and allowed to continue. Given that 40 now. officials keen to clamp down on the French retailing was certain to be opened to greater As the company is now expanding again, company’s business. A locally based partner foreign participation under the terms of it is possible to argue that the pause may can also help obtain access to good sites China’s WTO accession, the company was have helped its performance. Given its and can aid stores in developing a local widely regarded as doing nothing more continuing growth in turnover—up by 26% flavour—while the company, in theory, has serious than anticipating changes that last year—being forced to take a breather on a central ordering system based in would occur in any case. its expansion schedule allowed it to Shanghai, most purchasing decisions are In the event, the sentence was a bit concentrate on developing business within decided locally. In addition, Carrefour does stiffer: Carrefour was prevented from its existing network. not run its own distribution network, relying opening new stores for more than two The lesson from Carrefour, however, is instead on suppliers to deliver their goods years. The company’s expansion not necessarily that you can skirt rules and to its stores, which further enhances the programme is finally back on track, and in get away with it. Rather, it is that a company level of local support. 2004 plans to open at least a dozen new must have a good idea of what it wants to No other company was able to take stores. achieve and must then determine whether it advantage of the lull in Carrefour’s growth. Did Carrefour’s flaunting of China’s retail Wal-Mart has expanded but not at such a regulations hurt it in any way? Certainly, rate that it is likely to squeeze Carrefour, at during its enforced pause, its ranking Already a big player least for a few years. New entrants have slipped. At the end of 2000, after just five China’s top five retailers, 2003 either only just entered the market (as is the years in operation, it was China’s second- Revenue, Rmb bn Stores, number case with Germany’s Metro) or have yet to biggest supermarket chain by turnover. Bailian 48.5 4,357 arrive (as with the UK’s Tesco). Assuming Now, although it remains the biggest foreign Dalian Plaza 18.2 96 that it has learned from the operational retailer, it has dropped to fifth place. But it Beijing Guomei 17.8 139 experience accumulated in the last few managed to keep its revenue growing, with Beijing Hualian 13.6 62 years, Carrefour would seem to be well sales rising from Rmb8.1bn in 2000 to Carrefour 13.4 41 positioned to continue expanding and Rmb13.4bn 2003, according to reports from Source: Ministry of Commerce remain profitable.

pared with local products priced at around Rmb2, to quence, goods and the ways of selling them are too infre- shampoo, where Procter & Gamble priced Pantene at 60- quently tailored to local tastes. Companies tend to impose 70% above its local peers, to stock flavouring, where Nes- a Western model of consumer dynamics across category tle’s Maggi has been sold at three times the local after category, failing to play to Chinese concerns and equivalent. continuing to sell on the basis of what works elsewhere, Foreign companies have also, in many instances, failed even though hardly any products can be sold on global to appreciate China’s differences. While much business marketing. Examples abound: advertising campaigns success in China can be attributed to getting the universal based on an appeal to individual freedom compared with basics right, too little attention is paid to differences that China’s traditional emphasis on group values; advertising do exist between China and other places. As a conse- for nutritional foods that emphasise physical strength and

robustness instead of protection of the body’s ability to remains little awareness of brand equity or how to build defend against disease; and so on. an enduring series of associations with a good. According Considering how basic some of these problems are, to Tom Doctoroff, the Greater China CEO of J Walter why are they not attended to? Three reasons stand out: Thompson, this explains why Chinese television features a ● China is still a difficult place to do many things. Infra- lot of five-second advertisements. With the high cost of structure may have improved enormously over the last advertising also a feature, the consequence, he points decade but distribution remains a big problem for all out, is that Chinese companies are good at on-the-ground companies—even, or maybe especially, for those promotions and guerrilla marketing. which do it themselves. Petty corruption—endless Further reinforcing this outlook is the corporate out- demands from officials for fees and other charges— look of most domestic companies, which are almost with- eats away at the attention of managers. The result is out exception sales- rather than marketing-driven. This that there remains a tendency for operations to crowd outlook is a product of their business environment—they out much else, including long-term thinking on mar- may be ambitious but not only is China’s experiment with keting and brand-building. market forces new, it is also one that is certain to see a ● Finding enough good people of any kind is hard (one major shake-out in the next several years because of its manager interviewed for this report said one-fifth of over-reliance on credit and short-term financing. When his time was spent interviewing potential job candi- the FMCG sector does finally consolidate and the huge sur- dates), doubly so for marketing staff, while finding plus of productive capacity is destroyed, domestic compa- ones with experience is almost impossible. nies will be more inclined to focus on brand-building and ● Advertising costs are high largely because the media, other long-term strategies. For now, the emphasis has to especially television, remain very undifferentiated— be on immediate realisation of cash. reaching a mass audience is easy but expensive; targeting smaller, specific groups of people is still largely Building a strategy not possible. For foreign companies, the conflicting pressures on Chi- nese companies can only be good news. However, the rise The rise of competition of local firms will also add confusion to an increasingly As with almost every sector in China, what is complicating complex market. Against this background, how should both Procter & Gamble and Unilever’s strategies, and foreign companies think about the market? For makers of those of their other foreign rivals, is the rise of local com- consumer and many other types of goods, perhaps the petition. In the space of just several years, local companies most important challenge of the next few years will be have claimed a sizeable market share back from foreign how to handle a series of markedly different tiers in a mar- products for many types of consumer good. ket that is rapidly broadening and deepening, while If foreign companies were able to establish themselves weathering the short-term competition from local compa- in part because pre-reform China had no consumer-goods nies at all levels. The following issues will have to be industries, local companies have moved very fast into the borne in mind: areas ignored by the international companies during their ● Brand architecture. For a foreign company, this typi- entrance programmes. In particular, taking advantage of cally means coming in at the top with a premium name their lower costs, they have focused on the bottom seg- and then moving down into the middle segments with ments of China’s consumer markets—the second- and lower priced variants. As companies do this, however, third-tier cities and the countryside—initially leaving the they must constantly bear in mind that China is a not a upper segments to foreign companies. Chinese companies one-strategy-fits-all country: strategies have to be have also closed the quality gap for almost every kind of very different, especially in the lower-tier cities and good. They may not be able to manage exactly the same rural markets, where price remains the determining quality levels as foreign companies (though increasingly, factor for almost all purchases. especially in the last two years, they can), but they can ● Local appeal. What are the concerns of Chinese con- offer an excellent value proposition, especially to low- sumers and how can they be addressed? Health is a income consumers. major worry for many people—allowing one successful Chinese companies, with a few exceptions, have yet to local company, Skyworth, to devise a series of adver- move into brand development, however. Two reasons for tisements based around the features which made its this stand out. First, Chinese companies compete almost televisions safe for their users. solely on price; their products are copies or clones, with ● Trend arbitrage. As incomes increase, markets can be few or no innovative or distinguishing features. Second, ridden both upwards to appeal to new tastes and while the concept of branding has taken hold, there demands (fashion) and downwards to new groups

Unilever reasseses

The Anglo-Dutch consumer-goods and food with its own promotion and marketing, creation of narrow and defined goals as well maker, Unilever, arrived in China in the late unable to draw on synergies or even as the fact that it did not have a host of 1980s, at around the same time as the US transfer experiences from one product to joint-venture partners to manage and company, Procter & Gamble. But Unilever another. This, in turn, made teamwork a integrate. (Procter & Gamble started with has found the going much harder than its problem; selling ice cream obviously just one.) rival. Why? Two main tenets of its China calls for different marketing and strategy This is not to say that things always went strategy—its initial attempts to offer a than selling sanitary napkins, lessening Procter & Gamble’s way. Having reached out broad portfolio of products and a decen- the need or motive for working together. to stores across cities to get its goods onto tralised approach to selling its family of ● Staff turnover. Staff retention proved a shelves, it had big problems with accounts goods—are likely to blame. problem for Unilever. While managing receivable in its early days. It also took a Unilever’s plans were ambitious. Within human resources is a persistent prob- financial hit as a result of having granted ten years, it had 12 joint ventures in lem for many companies in China, easy credit terms to a lot of customers. In operation. But its strategy of attempting a Unilever’s record stands in contrast to the last three to four years, it has also faced broad attack on China’s markets might that of Procter & Gamble, which built up competition from low-priced local explain why it struggled—and offer lessons a reputation for being tough but loyal to alternatives. for other, ambitious foreign companies. its staff. At the same time Unilever has made Among its main headaches were: Procter & Gamble, by contrast, began with a several, big changes that have improved its ● Too many partners. For each of its more focused approach, launching and performance. Unilever’s cost-cutting diverse range of products—toothpaste, developing only its shampoos. Only after it measures have allowed it to become more detergent, ice cream, sanitary napkins had successfully established its shampoos in competitive and also more unified. Moving and so on—Unilever teamed up with a the market did it then move on to other its household and personal-care production local company. From the start, therefore, product lines. It spent heavily on advertis- lines to Hefei in Anhui, one of China’s Unilever found itself negotiating simul- ing but was able to focus its spend on a poorer provinces, not only saves money taneously with a stream of partners. small range of products, enabling it to owing to its cheaper location but also Moreover, many partners were not able establish separate identities for each mem- because it can use fewer people. This to deliver what they promised. From the ber of its shampoo range. This, in turn, change, in turn, has helped the company outside, it might look sensible to team allowed it both to claim market share on the address some of its other weaknesses listed up with a Chinese company in order to back of a clearly differentiated range of above: fewer people means a stronger, more gain access to its distribution network, shampoos: Vidal Sassoon for fashion, Head focused team, which in turn allows a but in practice many of these networks & Shoulders to cure dandruff, and so on. stronger concentration on issues such as either barely existed or were highly inef- Procter & Gamble worked hard to get its brand architecture. On the back of all these ficient products of central planning with goods into every available retail outlet: changes (lower costs and a more coherent no information or interest in the cus- taking maps of cities, marking the location strategic outlook), Unilever has been able tomers they served. of stores—small and large—then sending to take the struggle with Chinese companies ● Lack of focus. Because of its broad range people to every one of them. to their ground: a 30% cut in the price of its of products, Unilever was compelled for Internally, it worked to develop team Omo detergent helped double sales volume, the most part to let each venture get on spirit. This task was made easier by the the company says.

with no previous experience of buying anything but of all shampoos have been squeezed close together by the necessities of life. It is unlikely that the same mes- competition. sage can be used to sell a product to all market seg- ● Central versus local balance. Companies may be ments, let alone across a country as broad and diverse tempted to hand over control to its managers on the as China. ground, hoping to trust in their experience and know- ● Constant change. China’s markets are both so raw how. It is important, however, to maintain a balance and, thanks to its rate of economic growth, changing between using local operational expertise and cen- so fast, that brand-building strategies have to be con- trally supported brand-building. Coca-Cola estab- stantly reviewed and renewed. Procter & Gamble’s lished itself well by using bottlers with local shampoo market segmentation worked excellently knowledge while keeping control of marketing; when it started but now appears out of date as prices Unilever relied too much on local fiefdoms for each of

its product categories instead of concentrating on be difficult to retain strategic insights for long. strengthening its brands. The next several years will see market shares rise and ● Market data. Little market information exists in China, fall, particularly for Chinese companies. On the one hand, so a company that can collect its own data will own a doing things “right” in these circumstances should help a valuable knowledge base of everything from where company maintain or increase its market share, but this the stores are it wants to reach to understanding cus- cannot be guaranteed. On the other, managing to imple- tomer taste and needs. ment standard marketing practices should give a company the best chance of succeeding: One strategy does not fit all ● Remember that China is a brand-building market—so Taken together, these points underline the fact that, play by the rules of brand-building. Do not be tempted although the China market is still relatively new, it cer- to go down guerrilla routes—these may bring fast tainly is not simple. This idea has been taken on board in results but they probably will not prove sustainable. terms of operations. But the difficulties still appear to be ● Develop a corporate structure focused on brand-build- underestimated in the more abstract and less immediately ing and long-term marketing, not short-term sales. pressing area of marketing and brand development. Some ● Work on developing consumer insights: what do Chi- companies, such as Unilever, have tried to do too many nese consumers want? How are these different from things too fast. Other companies simply have tried to work other markets? How can you capitalise on them? with a partner that fails to see the importance of long-term ● Accept that China’s media is undeveloped and expen- investment in brand equity. Among carmakers, for exam- sive for now, but will become more refined and differ- ple, Daihatsu and Volkswagen achieved early recognition entiated; build brand strategies around this reality. with their Santana and Xiali cars. But their association As with much in business, most of these observations are with low-end models could prove of little assistance when little more than common sense. But the trick is in the warding off competition from even cheaper local cars while application. There have been enough corporate success lessening their appeal against brands launched later with stories to produce a fair number of useful models. Car- higher-segment marques, most notably GM and its refour and Procter & Gamble in their different ways have entrance with the Buick. proved that China is not an impossible place to build As the example of the supermarkets show, it is unlikely profitable businesses. Wal-Mart, in some regards, is that any one strategy will prove the inevitable winner. going in the same direction as Procter & Gamble, estab- Carrefour and Wal-Mart have entered China in distinctly lishing itself in one region before going nationwide. Car- different ways: the former going nation-wide early and refour has used other means: building alliances in many flaunting regulations, the latter starting in one region locations but preferring to pass the problem of distribu- and playing within the rules. The advantage of Carrefour’s tion to the companies that want to sell through its out- approach is the wealth of experience it has acquired over lets by requiring that they deliver their goods to its the last nine years, experience operating in different stores. And Unilever looks to have learned from its early cities and negotiating the country’s bureaucracy. Wal- errors, emerging as a more focused company, able to Mart, by contrast, looks to be bringing its US strengths to both lower its costs and develop a more coherent market- China, and applying them incrementally, knowing that its ing and brand-building strategy. buying power gives it substantial leverage. Of course, there are many other stories in China, but Over the next decade, retailing and fast-moving con- these experiences point to the importance of getting a sumer goods will come together. As the foreign retail few key things right rather than trying to do everything chains take off and the local ones consolidate, distribu- at once. With some successes in place, others can be tion will become much simpler. Within regions, consump- developed. tion patterns are likely to become more homogenous—the Pearl River Delta and Guangdong converging with Hong Overcoming regulation and building brands Kong, the lower Yangtze area sharing tastes and styles In many ways the retailers, despite entering the market with Shanghai, and Beijing’s influence spreading across later and in a more restricted way—or possibly because of northern China. Knowledge of consumer tastes will this—appear to have developed and applied long-term become more important, especially the degree of varia- strategies in a more rigorous way than the FMCG compa- tion across income bands and regions. It is possible that nies. Both Wal-Mart and Carrefour have had to tread war- the development of communications, particularly mass ily in applying their strategies because of central media, will see different becoming more alike. But varying government concerns over foreign domination of retail- rates of change in different parts of the country will ing. They both, however, have found ways of establishing ensure this will not happen consistently. As a result, it will bases from which they are now expanding—particularly

Coming of age Part 2 Retailing and consumer goods

Ermenegildo Zegna tailors its retailing operations

The fashion houses and luxury-goods arcade hosts 50 top-tier brands. Higuchi calls the “shopping centre” companies that set competing trends Zegna first gauged the market for its for Sichuan province—drawing in design are beating a very similar goods and plotted its expansion customers from outside the city itself. path in their corporate strategies by strategy by tracking the development Outlets in other provincial capitals announcing retail expansions in of similar five-star hotels in Chinese have likewise been supported by China. This year the heads of a number cities and opening its early outlets customers residing outside the cities of such companies have come to China inside them. The company’s profile in themselves. Although the company and Hong Kong for the openings of China has evolved alongside wider directly owns most of its outlets in flagship stores and announcements of developments in the country’s retail China, Zegna has franchised 13 of its ambitious expansion plans to target sector—when high-end shopping outlets, in cities where it was less the growing market. The French lux- malls developed, Zegna opened familiar with the local market, the ury-goods company, Richemont, outlets there. “We have to find a company says. which counts Cartier, Montblanc and suitable location to support the Aside from its retailing operations, Dunhill in its portfolio of 18 luxury brand," Mr Higuchi says. The company Zegna is also involved in production in brands, calls China its “priority mar- is now moving to larger-scale outlets, China. In March 2003 the company ket” this year. The company’s turnover starting with the opening of two bought a 50% stake in SharMoon, a in China increased by 24% year on major outlets in China later this year, Wenzhou-based company that year in 2003, according to Francis a flagship store in Beijing in June and produces men’s suits and jackets. The Gouten, the regional CEO of a 500-sq metre store with a 1,700-sq investment is one of Zegna’s seven Richemont Asia Pacific. metre showroom—its largest in Asia— investments in production units The Italian men’s clothing along the riverfront Bund in Shanghai outside Italy. According to Mr company, Ermenegildo Zegna, in September. Higuchi, Zegna bought into SharMoon entered the China market 13 years ago Although Zegna plans to continue “to try to support SharMoon products and has grown to be one of the largest to expand to new cities, the company for the China market”. SharMoon does luxury-goods outlet chains in China. will focus on consolidation of its not currently produce any clothing or By the end of 2004 the company will product lines in larger stores. In terms components for Zegna-brand have 60 point-of-sales sites in 24 of number of outlets, Zegna has clothing, but Mr Higuchi did not cities there. Zegna is currently “quite enough”, Mr Higuchi says. As foreclose on that possibility for the profitable in China and has been part of the consolidation, the future. Zegna does procure raw profitable since its first outlet opened company now plans to integrate its materials in China for its global line, in China in 1991, according to Itsuro Zegna Sport line into its larger as a large buyer of cashmere in Inner Higuchi, the company’s Asia Pacific outlets. In its smaller outlets, 60% of Mongolia. managing director. According to Mr the merchandise on display was The growing presence of foreign Higuchi, Zegna’s turnover in mainland selected according to guidelines from luxury brands in China brings more China increased by 25% year on year headquarters, while the remaining competition for Zegna but the in 2003, while Greater China— 40% was chosen according to “local company still aims for 20-25% growth including Hong Kong and Taiwan— taste”, Mr Higuchi says. The larger every year in the market. Like its accounts for 11% of the company’s outlets will allow the company to competitors, the company is using global turnover. Mainland customers feature more products through its store openings to raise its public represent 35% of the company’s sales “wardrobe concept” of offering exposure. The company spends 6% of at its seven stores in Hong Kong, clothing for every possible occasion. its turnover in China on advertising, according to Mr Higuchi. The “It’s image,” Mr Higuchi says. “We according to Mr Higuchi—a slightly mainland is Zegna’s fourth-largest have a lot of small-scale shops. We higher proportion than in other market, while Greater China ranks need something to show the whole markets. More than branding, second behind the US, but that gap is range of Zegna.” however, Mr Higuchi says the still quite large, Mr Higuchi says. Although Shanghai and Beijing are company is focusing on fundamentals Zegna entered the China market, major markets for Zegna, the like quality control, customer service, like many foreign luxury brands, in company’s outlets in China are as far- human resources and training—to the shopping arcade of The Palace flung as Changchun, Urumqi and manage outlets in China to the same Hotel in Beijing. Now renamed The Kunming. Zegna has three sales international standards as its Peninsula Palace Beijing, the hotel’s locations in Chengdu, a city which Mr products.

vigorously in Carrefour’s case. tition are to blame for this approach. By contrast, the FMCG companies, including the most As a result, many of the FMCG companies are looking a successful, Procter & Gamble, concentrated more on solv- little vulnerable as Chinese companies confront them ing operational problems such as how to get their goods head on. However, as the market grows more developed, to market, postponing the handling of various longer- and domestic firms also find themselves squeezed, it term issues, such as a greater emphasis on brand-build- would seem unwise to bet against the international firms. ing, or being able to defend themselves against nascent Expect them to call on their corporate expertise outside of competition. Perhaps their early entry, the relatively China to turn their early footholds into long-term posi- unregulated nature of the sector and lack of early compe- tions of strength.

Part 2 Telecommunications A strategic and crowded market

hina today is a telecoms superpower. Never before nearly 7m additions a month in this period this is one has a country added so many telephone sub- market where the otherwise fantastical promise of 1.3bn scribers in so short a time, or raised its teledensity consumers is actually making good. Together, mobile and so rapidly. Contemplating China at the start of the fixed-line subscriptions have grown from one subscription 1990sC one would have confronted a country bereft of com- per ten people to less than one in three in the past five munications: its fixed-line telephone network was pitiful; years alone. From being a nation with virtually no connec- there was no mobile network; fax machines in theory had tivity at all, China is today the world’s largest market for to be licensed, and of course there was no Internet or e- both fixed-line and mobile telephony: a surprisingly large mail. proportion of the population can now talk on the tele- Today, things could not be more different. By the end phone, send text messages, even wile away time in Inter- of 2003, there were 230m fixed-line telephones and well net chat rooms. over 50m Internet users. By the end of the first quarter of If China’s government has any concerns about people 2004 there were about 290m mobile subscribers, and with being able to communicate with each other easily and

● China is a prodigious market for foreign telecommunications ● China operations are increasingly treated as distinct from equipment manufacturers, and lucrative too. The country’s other regional markets. This reflects not only China’s impor- main service operators continue to invest billions annually in tance as a domestic market to foreign manufacturers but also telecoms-infrastructure equipment, a healthy proportion of the fact that it is even more embedded in their global produc- which is used to purchase products made by foreign-invested tion and supply networks. Few other markets contribute as companies. much in terms of revenue, the global supply of components or research and development. ● The price of market access for foreign equipment makers has always been explicit: to demonstrate an extensive commit- ● As domestic competition intensifies, and price pressures rise, ment to local manufacturing and to technology transfer. and as Chinese players move out into the world, foreign equipment makers must focus on remaining cost-competitive ● Through joint ventures and other similar arrangements with and further integrating their China production and research foreign companies, and by offering financing (for mobile and development facilities into global supply chains. networks, in particular), China has been able to roll out its telecoms networks at an unprecedented speed. ● The very factors that have created success for foreign equipment manufacturers—strong state-directed policy and con- ● The access-for-technology contract has been instrumental in trol—have proved equally formidable barriers to foreign the creation of a viable and highly competitive domestic service providers. Despite incremental market liberalisa- equipment industry. Local companies not only now compete tion, China’s telecoms service market remains tightly con- effectively with multinational companies in the China mar- trolled by a small number of large state-controlled ket, but ever more so internationally. operating companies.

cheaply it certainly has not shown them. It may stamp and Ericsson of Sweden, China accounts for between 10% down on dissident websites, prevent access to websites of and 20% of their global revenue; it is currently Nokia’s foreign news organisations and discourage online discus- fourth-largest market. Between them, these companies sion of topics it deems taboo, but it has shown no indica- have invested several billion dollars. Motorola’s total, at tion of wanting to restrict the means by which people US$3.4bn, is the biggest of any foreign investor; Nokia, at contact and communicate with others. Considering the US$2.4bn, is not far behind. micro-control the Chinese Communist Party (CCP) exer- Their success, and that of other major equipment mak- cised over daily life until the end of the 1970s, this too is ers, including Alcatel (France), Siemens (Germany) and astonishing. the US-based Cisco Systems, has stemmed from the phe- How has this transformation been possible? China has nomenal sum China has spent on developing its telecoms driven telecoms-infrastructure investment through state- system. According to a telecoms research company, Pyra- owned monopoly carriers, at the same time throwing open mid Research, in the five years between 1999 and 2003, the doors to foreign direct investment (FDI) in equipment China spent US$70bn on its telecoms infrastructure. manufacturing. Central planners, charged with kick-start- Not to have profited from this would have been an ing what was regarded (in both security and development extraordinary dereliction. Yet it is difficult to assess just terms) as a strategic sector, understood well what China how profitable foreign companies have become; most lacked—technology and capital. Foreign companies could refrain from divulging net earnings figures or margins for provide much of the former and a lot of the latter. China, instead leaving sensitive statistics buried in The deal on offer was explicit: market access in return regional or global totals. Mobile-handset manufacturers for technology. China was able to roll out its telecoms net- claim to be making money but proffer—at best—only works at an extraordinary high speed with the help of glimpses at the numbers: Nokia, for example, claims to joint ventures, notably Alcatel’s in Shanghai for fixed-line have a higher profit margin in China than in western switching supplemented by, among others, Siemens’ in Europe, but does not disclose either. The profitability Beijing and similarly, first Motorola and Ericsson for ana- issue is complicated also by the increasingly global nature logue mobile networks, joined later by Nokia for digital of telecoms investments in China: where and how profits ones. The government also aided the process by offering are taken in the supply chain will depend on individual financing, particularly for mobile networks. By equal company preferences. measure, the telecoms services market has largely been off-limits to FDI, although as a result of World Trade Building a China market Organisation (WTO) commitments, this will gradually In some ways, the experiences of foreign equipment man- change (see box, “Service, please”). ufacturers in China have been atypical. All have benefited China has done remarkably well out of this but so too from being in a sector ascribed high priority by the gov- have foreign companies—all earning billions of dollars in ernment and benefiting from high levels of state invest- revenue annually. For US-based Motorola, Finland’s Nokia ment in foreign equipment and technology. (Indeed, in

A big market Subscriber numbers, m 2000 2003 Mobile Fixed 300 300

250 250

200 200

150 150

100 100

50 50

0 0 China Japan US UK India China Japan US UK India

Getting connected Telecoms subscribers in China, m Mobile Fixed 300

250

200

150

100

0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: CEIC

virtually no other country is the state so intimately of any telecoms network. Siemens’ principal telecoms involved in telecoms, owning all the major companies, venture, Beijing International Switching Systems (BISC), choosing technologies and determining equipment pur- in which it initially took a 40% stake, also thrived in its chasing decisions, among other tasks.) early years, as China’s massive roll out of its fixed-line Interestingly, there has been no single model of suc- network through the mid-1990s created enormous cess. A notable feature of the big five—Motorola, Nokia, demand for switching equipment. Ericsson, Siemens and Alcatel—is the different strategies Nokia, Ericsson and Motorola have maintained a employed to enter and build their positions in China. greater degree of independence and thrived as well. Nokia Two of them, Siemens and Alcatel, sought to become and Ericsson also entered the market through JVs but closely involved with the government very early on. There both have, in general, been more successful in retaining are various possible reasons for this strategy. Siemens greater control over their operations than Siemens and and Alcatel are both familiar operating in “statist” envi- Alcatel. This is partly because they entered the market a ronments because of their respective national back- little later but mainly because the high demand for their grounds; Ericsson, Nokia and Motorola, by contrast, are mobile-infrastructure equipment could not be met by more “free market” in both origin and outlook. Familiarity local companies, thus giving them stronger bargaining in dealing with government officials may have helped positions. For most of the last decade, Ericsson has been Siemens and Alcatel in the early days, as did the fact that the most successful seller of mobile infrastructure; Nokia, they were (and are) less beholden to stockmarket after establishing itself with mobile infrastructure, has investors than Ericsson, Nokia and Motorola, and more moved away from this subsector to concentrate on hand- familiar with joint-venture (JV) arrangements in general. set production both for sale in China (where it is ranked Both Siemens and Alcatel accepted minority stakes in second to Motorola) and for export to other markets. state-owned entities as an entry into the market. In those Motorola, the US chip and handset maker, took a still days, the government was wary of allowing foreign com- different tack. Despite establishing itself early—it set up panies to have majority stakes in JVs in industries deemed its first manufacturing facilities in Tianjin in 1992—it has strategic. Siemens and Alcatel adopted a strategy aimed largely managed to maintain its principal China busi- at establishing themselves by demonstrating a commit- nesses as wholly owned operations from the start. Politi- ment to technology transfer and localisation of manufac- cal astuteness was the key. The company forged strong turing operations, even if this meant accepting less ties at a central government level by promising technol- control than they might have wanted. ogy transfer through the building of a US$1bn semicon- For Alcatel, the strategy worked particularly well in its ductor facility and at a local level by identifying itself first few years: its principal joint venture, Shanghai Bell, closely with the Tianjin Economic-Technological Develop- established with an arm of the then Ministry of Posts and ment Zone (TEDA ). Riding on the back of Motorola’s pres- Telecommunications, quickly became the country’s lead- ence there, TEDA is widely acknowledged as one of the ing supplier of fixed-line switching equipment—the core best-run zones in China.

State-driven

Without the government’s clear vision and networks for all remains a priority; China Unicom. intent, China’s telecoms boom may well growth and access may still be as impor- The effect of creating distinct markets for have been a whimper. The state has played a tant a motivation as profits and return fixed and mobile telecoms services, and of central role in telecoms development and on investment. introducing limited and carefully undoubtedly will continue to do so—and ● China’s face. National prestige undeni- orchestrated competition, has been to certainly the rapid growth of telecoms in ably has played a role. In the 1990s, trigger improvements in all aspects of China has taken more than a set of (admit- telecoms was the flagbearer for advance- telecoms supply in recent years. Most tedly advantageous) technology transfer ment and sophistication: to prove China noticeable have been a proliferation of arrangements with foreign equipment man- was a major power, why not concentrate advanced telecoms services in richer areas, ufacturers. Indeed, since the start of China’s on giving it the world’s biggest, most including the emergence of China as the telecoms age in the early 1990s, a series of modern communications network? world’s largest market for mobile telecoms, other key factors have been at play in this ● Foreign money. Building this world-beat- and the improvement in the speed of extraordinary growth story: ing network has required huge invest- Internet connection—and the current roll ● Strategic mindset. Not unlike the auto- ments in infrastructure. In addition to its out of broadband capacity. But lower- motive industry, China’s leaders have seen own funding, particularly of mobile net- income people have also gained access to communications as strategic to the coun- works, the government has sought at var- telecoms services. Importantly, the try’s broader industrial and economic ious times, and in various ways, to tap introduction of limited competition has development. Technology transfer has foreign funds to finance infrastructure: been a conscious effort to prepare the been a primary, driving goal of state pol- early network roll-outs were often funded services market for eventual foreign icy, the aim of which has been to create a by multilateral and bilateral loans; more participation (see box: “Service, please”). strong domestic manufacturing industry— lately, China has allowed state-owned These changes have been mirrored on as well as real R&D capabilities and spin- telecoms firms to list minority stakes on the regulatory side. The ministry which off IT industries—able to compete with international markets. overseas the development of the industry global players at home and abroad. The changes have not only been quantita- (now the Ministry of Information Industry, ● Eager technocrats. Socialism’s emphasis tive, however. China may have come late to the MII, previously the Ministry of Posts and on “hard” knowledge in areas such as appreciate the software side of telecoms but Telecommunications) has gone through a engineering and infrastructure had cre- in recent years both the regulatory and series of transformations—changes that ated a body of technocrats versed in cen- competitive structures of the country’s tele- highlight the government's gradual tral planning, and eager and able to coms industry have been through several adoption of market forces as the accepted build telecoms networks, especially waves of change. From being a monopoly means for promoting economic growth. advanced ones. operated by a government ministry, the From being an old-school, Stalinist-style ● Telephones for all. There has long been a telecoms network has been divided between central planning agency, overseeing every concern, also stemming from the coun- various corporations. In 1998 the govern- aspect of China’s post and telephone system try’s socialist heritage, to build universal ment broke up the main operator, China (including the manufacture of equipment), telecoms provision. This worthy goal is Telecom, into separate companies for fixed- the MII has shed all of its operational side, complicated now by the fact that most of line (China Telecom) and mobile (China leaving it essentially the role of regulator. China’s telecoms operators are listed Mobile). It again restructured the rump of At some point it is likely to see itself internationally and have shareholder China Telecom in 2002, hiving off the north stripped of its ministry status, probably to concerns to worry about. Yet the fact and east regions to China Netcom, a tele- emerge as a body resembling the US’s that the government continues to inject coms company established in 1999 (and the Federal Communications Commission, the networks of poorer provinces into only one yet to be listed internationally). although less independent of the these companies indicates that building China Mobile was also joined by a rival: government than the US body.

The threat of local competition acknowledged by every company in the sector as the sin- The abiding similarity for all foreign equipment makers gle most significant change of the last half decade. has been the requirement to transfer technology. The Two companies, Huawei Technologies and Zhongxing consequence of this condition is the ascent of domestic Telecom (ZTE), both based in the southern city of Shen- competition. The speed with which local competitors have zhen, set themselves up as manufacturers of telecoms established themselves—in fixed-line telecoms equip- equipment in the 1980s but only began making names for ment, mobile handsets and mobile infrastructure—has themselves from the mid-1990s onwards, selling into the surprised most observers. Local competition is also domestic market and increasingly, especially in Huawei’s

Coming of age Part 2 Telecommunications

The telecoms majors and China Net sales, US$ bn Nokia Motorola 5

0 2000 2001 2002 2003

Source: Economist Intelligence Unit, company reports

case, internationally. Both companies began by develop- undue advantages of a market with no competitors, ing and selling fixed-line equipment. They grew fast and should not in principle fill a global company with fear. took market share (especially from JVs set up by Alcatel Certainly, foreign companies may share important disad- and Siemens) by adopting the universal Chinese practice vantages in China—they are shareholder (not market- of pricing lower—aided by strong government support in share) driven, for example, and they must contend with the form of financing and a preference for buying Chinese. the government’s vision of a strong domestic telecoms Alcatel’s Shanghai Bell joint venture, which in the mid- industry. But they also share important advantages. They 1990s was making more than half of the switches for have far higher spending on technology development, China’s fixed-line telephone network, has seen its market better know-how, better management and production share drop to less than one-third. Huawei’s revenue, processes, products with greater innovation and function- meanwhile has risen quickly, to US$3.8bn in 2003. ZTE ality, better after-sales service, brand appeal and the lit- posted revenue of US$1.9bn in 2003. mus test of global markets to sell into as well. Not all of A host of companies has started making mobile phones these advantages will last; local brands, for one, coupled as well. In 1998 Chinese-made handsets barely existed; in with low prices, have increasing resonance. But they 2003 firms such as Ningbo Bird, TCL, Eastcom and a host can—and are—being leveraged to bring greater competi- of others were making and selling enough handsets to tiveness. claim nearly half the market by volume. Other foreign competitors—notably two South Korean firms, Samsung Taking control and LG—have entered the fray too. In this environment, The principal response by the foreign equipment makers and particularly with prices of locally made handsets to the rise of Chinese companies has been a move to falling (a handset can now be bought for around US$60), increase control over their operations, both to be better maintaining margins has been a special concern. High positioned to meet the threat local competitors pose and inventory levels are also encouraging further price drops to try to restrict one of the principal reasons for their among domestic players, adding to the pressure on for- emergence: the leakage or appropriation of technology. eign makers to reduce prices (although evidence of exten- ● In 2002 Alcatel announced the amalgamation of vari- sive price-cutting is, so far, thin). ous of its China JVs into a new entity, Alcatel Shanghai Foreign equipment makers are perhaps right to be a lit- Bell, in which it held 50% plus one share—and over tle apprehensive about the effect China will have on their which it has management control. The new company, operations. Yet the risks to them of China developing a which was set up shortly after the company relocated competitive market, or at least the chaotic and difficult its Asia-Pacific headquarters from Australia to Shang- beginnings of such a market, should not be overstated. hai in 2000, is also one of Alcatel’s global research Learning to live with competitors (even those “dumping” and development (R&D) centres. equipment onto the market), and no longer having the ● Siemens, in early 2004, similarly bought its way to a

majority stake and management control in its main The other companies appear to be using their greater telecoms-related joint venture, BISC, whose sales of control to keep Chinese competitors at bay. Nokia is work- fixed-line equipment had been faltering in recent ing on strengthening its handset distribution network. It years because of competition from domestic compa- is trying to get closer to provincial rather than national- nies. It also wanted to inject new investment to level distributors in order to increase its penetration in upgrade its product technology. more second- and third-tier cities, to which the bigger ● Nokia, similarly, has united various of its joint ven- distributors were paying less attention, preferring instead tures—spread as far apart as Dongguan, just across to focus on the very biggest markets. Ericsson’s strategy, the border from Hong Kong in Guangdong province, by contrast, is concentrated almost entirely on selling Suzhou, inland from Shanghai and Beijing—into one infrastructure equipment. Its approach focuses on main- company centred on its operations in its own Xing- taining a position in the market by constantly being able wang industrial park, just outside the Chinese capital, to deliver better technology. Its task is helped by its vir- where it has surrounded itself with its suppliers. tual non-involvement in the handset market, which it ● Motorola has taken a different route. Although it has abandoned in the early 2000s, meaning it can concentrate managed to maintain its main facilities in Tianjin as a its efforts on selling mobile infrastructure to a relatively wholly owned operation, it has always sought to nur- small number of buyers—the mobile networks. ture close ties with the government. Notably in this Motorola, which already has a strong lower-level distri- vein, it set up a partnership with a domestic manufac- bution network, is focusing on driving sales of code divi- turer, Eastcom, in Hangzhou in the early 1990s, to sion multiple access (CDMA) phones, in preparation for which it has transferred mobile-handset technology, the move to the next-generation mobile communications. as well as the undertaking to build a semiconductor It sold its underutilised semiconductor plant to China’s facility in Tianjin. Retaining its independence has had leading domestic chipmaker, Shanghai-based Semicon- a high cost, although the return has been that it has ductor Manufacturing International, in early 2004. As the by far the highest revenue of all the foreign telecoms- biggest seller of handsets in China, it has the advantage equipment makers in China. Perhaps the company is of being the best exposed of all companies. However, best seen therefore as a hybrid—it has all along executives admit that price pressure is ferocious, forcing retained the greater freedom to manoeuvre that its them to focus on reducing the cost of making what is, wholly owned status has allowed it, but to do so it has increasingly, a commodity. This is a difficult transition for also shown itself willing to help China with its tech- a company that has traditionally been a producer of technology goals. nologies rather than a seller of consumer goods. While the reasons for foreign companies wanting So far the foreign handset makers have resisted mov- greater control over their various China operations are ing into the manufacture of low-end products or embark- self-evident, there remains a divergence of views on how ing on price-cutting to maintain market share, although best to put this greater control to work. both Motorola and Nokia have licensed technologies to Siemens and Alcatel both look to be continuing their local companies to produce low-cost handsets. The prob- close collaboration with state-owned entities, seeing the lem they are facing—and which will grow worse over the advantages for sales of being identified with the develop- next few years—is how to cope with declining margins in ment of China’s own telecoms industry as outweighing mid-range handsets as margin domestic manufacturers other issues such as technology leakage. Although move up the value chain, and so be able to continue to Siemens has raised its stake in BISC, it continues to col- invest in R&D. That challenge, however, is not unique to laborate with Chinese companies and on the development China, explaining the general nervousness surrounding of domestic technology, in February this year founding a the outlook for Nokia and Motorola worldwide. joint venture with Huawei to develop third-generation (3G) equipment using a Chinese-developed standard. The A global strategy, too two companies have agreed to contribute US$100m to the There is another, broader dimension for foreign equip- venture, in which Siemens will have a 51% stake. Alcatel ment manufacturers to balance in their strategies. In Shanghai Bell, the venture in which the French company addition to the large and lucrative domestic market, their brought together its China operations, is similarly com- China facilities are becoming more embedded in their mitted to helping China develop indigenous technological global production and supply networks. Few other mar- capabilities. The venture is one of Alcatel’s global R&D kets contribute as much revenue-wise, or in terms of the facilities; it has access to all of the worldwide technical global supply of components and, increasingly, R&D. If knowledge base, including proprietary technologies measured on net value, China is arguably the most strate- patented by the company. gic of markets.

Qualcomm: Know-how is king

The US telecoms technology- and equipment Because it produces and sells intellectual 20 handset makers. Pyramid Research, a maker, Qualcomm, is the anomaly among property rather than physical goods, telecoms research company, estimates that suppliers to China’s telecoms markets. It Qualcomm might at first glance appear in 2002 the company earned US$200m in also has perhaps the most interesting strat- highly vulnerable to the theft of its know- profit from revenue of US$500m—an egy. Although originally a telecoms-equip- how. Instead, the opposite seems to be the impressive return. ment maker, the company has long since case: the company's expertise lies in How far it can take its business will concentrated its business on research and bringing together its intellectual property in depend on various factors. One is development of technological know-how, systems that work as the sum of their parts— government policy and which route it opts which it then earns money from through knowing just one bit is not much use, and a to go down for next-generation mobile licences and royalties rather than making whole lot of separate bits is not much better systems. Related to this is China’s things itself. By far its most important intel- if you cannot make them work together. determination to develop its own standards, lectual property is that embodied in code The beauty of this strategy is it can then not least so that its manufacturers do not division multiple access (CDMA) mobile- sell its technology to everyone. In the case have to pay royalties and licence fees to phone technology, a lot of which it can lay of its mobile communications technology, foreign companies such as Qualcomm. claim to, and much of which lies at the heart this means selling to the people who build Another factor is the development of of third-generation (3G) mobile systems. networks and handsets, those who operate China Unicom, the main uptaker of CDMA Through the 1990s Qualcomm lobbied them, and those who develop the technology. If Unicom were to falter in its the Chinese government hard for the applications which run on them—to competition with China Mobile and the adoption of CDMA mobile networks, with Motorola, Nokia and Ericsson, to China mobile services being launched by fixed-line little success. The country adopted the Unicom and China Mobile, to Huawei and operators China Telecom and China European standard, Global System for ZTE, and to software developers (hence its Netcom— both of which are using a rather Mobile Communications (GSM), for almost investment in a JV with China Unicom to different kind of technology—then all of its digital networks. This changed in incubate applications developers, which so Qualcomm would suffer. the early 2000s when China’s second- far has invested in around 150 businesses). But with its technology being used by biggest mobile network, China Unicom, While Qualcomm's strategy was not more or less every maker of mobile under heavy pressure because of the developed specifically for China, it has the equipment, including one of the fastest- government’s dislike of being too beholden potential to work in the country: indeed, it growing handset sellers in China of the last to one technology, announced it would roll could already be working there. The two years, South Korea’s Samsung, it is hard out a CDMA network. Although Unicom has company has signed licence agreements for to envisage Qualcomm not benefiting from struggled to find subscribers, Qualcomm CDMA products with various companies, the continued growth of China’s mobile finally had a presence—and some revenue. including both Huawei and ZTE, and around industry over the next several years.

As domestic competition intensifies, price pressures different a strategy in China than elsewhere for foreign rise and, as Chinese players move out into the world, for- firms. Except that China is now a fulcrum for telecoms eign equipment makers must focus on remaining cost- markets globally—a market in which there is not only a competitive globally, further integrating their China prodigious domestic appetite for telecoms technology (3G production and R&D facilities into global supply chains. phones will undoubtedly give a new and lucrative lease of Companies such as South Korea’s LG are deepening their life to suppliers) but where global products increasingly commitments to handset production in China, not simply have an important, if not their chief, node of efficiency. to break into the domestic market but to lower production This makes the strategy of foreign equipment makers in costs so as to feed their global supply chain competitively. China extremely important for their global success. China Existing suppliers, too, are likely to move more produc- is not simply a large emerging market, it is the globally tion to China. Increasing volume will lower costs, so pre-eminent market. allowing them to be more competitive in both the local The global dimension is important too because the and international markets. They will be helped in this by telecoms market in China—prodigious though it is—may the critical mass of component manufacturers and suppli- not be growing fast enough to sustain itself. China may be ers which have already set up in the country and which will increasing its teledensity by a percentage point every two continue to come. months but there are signs that growth is slowing and Making sure they are cost-competitive is, in itself, no that new users are significantly poorer than those added

over the last decade. Moreover, China’s telecoms-equip- companies, as US support of Qualcomm’s CDMA mobile ment production capacity far exceeds its domestic needs. technology attests. But China certainly crosses a difficult It now has the capacity, for example, to make nearly a line when it tries to impose standards by requiring manu- quarter of a billion mobile phones a year; domestic facturers to produce them and consumers to use them. demand will not exceed a quarter of this amount at best. (The Ministry of Information Industry dictates both the technologies used in China and the products sold.) This is A question of innovation especially of concern in a market the size of China’s where The advantage of the foreign companies—both in China whatever becomes the norm quickly generates economies and overseas—will remain not whether they can produce of scale that could be transferred to markets across the cheaper telecoms products but whether they can produce world. better ones at a competitive cost. While Chinese compa- The issue that will tax foreign companies, however, is nies will always be able to compete on low-end cost, what how closely they wish to work and co-operate with the they are less good at doing—and will continue to struggle government and state-run companies—and what this to do—is to develop innovative products. The trick for for- means in terms of further technology transfer. eign players will be either to stay ahead of local innovation and technology developments, be involved in them, A strategic and crowded market or both. China is now playing a fundamental role in the global China is increasingly a source of technology and design telecommunications industry. Foreign equipment suppli- innovation for foreign suppliers as much as a market into ers were initially attracted to China because of its market which to sell such innovation. As more global production potential and, unlike many other sectors, were richly comes to China, so too does supporting R&D and design. rewarded with access, billions of dollars of business and, Here, one of the most intriguing strategies is that of Qual- at least initially, market domination. Local competition— comm and its technology-licensing approach (see box: the result of the access-for-technology contract struck Qualcomm: Know-how is king). At the heart of its business between government and foreign firms—has taken market is the confidence that it will be able to continue develop- share from foreign companies—and probably lowered ing advances that can only be incorporated into networks margins as well. But the evolution of China’s importance using Qualcomm's own know-how. Other companies that to foreign suppliers as a domestic market, and increas- can conceptualise their activities similarly are likely to ingly as a global production and R&D platform, has given find themselves less vulnerable to local competition than China operations a unique place in their global strategies. those who see themselves principally as manufacturers. The government’s outlook has also evolved over the But, equally, the Qualcomm strategy raises a new and last few years. It is certainly as interested in the industry potentially important regulatory risk for all foreign equip- as ever it was but it appears more confident that its ment makers creating and licensing technology. China’s goals—which include making China a major power in man- growing weight in the telecoms world, and its long-stand- ufacturing and standard setting as well as increasing tele- ing vision to have a globally competitive telecoms sector, phone access and usage—can be achieved without its means it will want—indeed it is determined—to be direct, day-to-day involvement. Its primary means for involved in the development of its own technical stan- achieving these goals is the retention of a major policy dards. role at the centre and the ultimate control over the vari- The risk at present is particularly acute for mobile tech- ous manufacturing and service (see box, “Service, nology, as China attempts to boost home-grown stan- please”) operators through continued majority state- dards at the expense of those offered by foreign ownership. Although the state’s involvement has companies. Repeated delays in the roll out of high-speed retreated to a considerable extent, making telecoms a 3G mobile technology are widely accepted to be the result more “normal” market, the playing field is not entirely of government efforts to back a local standard known as even, as the government remains intent on making the TD-SCDMA. When 3G licences are eventually handed out, it sector as Chinese as possible. is expected that some service providers at least will be What is likely to be seen over the next several years is a required to use the local standard—despite it being series of complicated dances between foreign and local plagued by technical problems. companies. With China now playing such a big role in the On the face of it, there is nothing wrong with Chinese manufacture of telecoms components and equipment, a consortia co-operating to develop new standards. The company such as Huawei can simultaneously be a co-oper- effort may be wasted if the new products cannot compete ative partner, a competitor, a supplier and a buyer of but that is what competition is about. Nor is there any- goods from an overseas equipment maker. The market has thing unusual in governments cheerleading for domestic certainly become more complex and nuanced.

Coming of age Part 2 Telecommunications

Service, please

In stark contrast to the success that foreign little in the way of basic telecommunications Unicom. It then went a step further by equipment makers have enjoyed during law at all; the sole piece of unambiguous breaking up China Telecom’s fixed-line China’s telecommunications boom of the legislation is that which prohibits foreign business into northern and southern past two decades, foreign carriers of tele- ownership of telecoms networks. Potential operating companies. coms services have barely benefited at all. foreign investors are not exactly brimming This deck-stacking—in part preparing The very factors, ironically, that have cre- with confidence. the services landscape for foreign ated success for foreign equipment manu- A few foreign-invested service participation by forcing state-owned facturers—strong state-directed policy and operations have slipped through the cracks, operators to shadow-box each other—has control, and a singular focus on rolling out although their impact has been marginal. Of given rise to a remarkable level of inter- infrastructure—have proved an equally for- the two strategies explored, the first has incumbent competition. Although all have midable barrier to foreign service providers. been for foreign carriers to take equity the same parentage, there has been A closed market with tight state control stakes in state-controlled incumbents. This ferocious rivalry for subscribers between the over carriers and their operational budgets has left foreign operators with small, costly (separated) state-owned operators; if (as is has allowed central planners to build out holdings and little leverage or prospect of believed) each is given its own 3G licence infrastructure in line with their technology- such—witness the more than US$3bn this year or next, that battle for market heavy five-year targets and to do so without Vodafone (UK) spent to acquire a thin 3% of share will carry into the next generation of letting a strategic (and security-sensitive) China Mobile between 2000 and 2001. services. But, because this competition has sector out of the state’s grasp. Contracts for The second strategy has been the many been fiercer and more price-based than world-class switches, fibre optics and cellu- and (often) protracted efforts to build perhaps intended, it has also had the effect lar networks have been plentiful; new services JVs from scratch. Usually—and of sending China’s operating companies licences for foreign operators almost non- perhaps unsurprisingly—these have ended looking abroad for acquisition opportunities existent. China’s services market remains in failure; most were risky circumventions for growth—China Netcom, the northern tightly controlled by a small number of of the ban on foreign participation in half of the bifurcated China Telecom, has large state-controlled operating compa- services. Between 1995 and 1998, most recently completed its acquisition of nies. notably, some 40 foreign carriers and international bandwidth provider Asia This state of affairs is only now investment firms sunk nearly US$1.5bn in Netcom (formerly the beleaguered Asia beginning to clear. Prohibitions against JV operations with China Unicom, the Global Crossing). foreign operators running public telecoms second-largest mobile carrier, only to have With China’s carriers increasingly networks, of course, remain in place, them declared illegal (and subsequently interested in becoming global players (not despite incremental market liberalisation dismantled). The only significant foreign- unlike their manufacturing compatriots), and the introduction of limited competition. invested services joint venture to have they realise the value of deregulated, open- Yet, importantly, there is now a framework survived is that between AT&T, Shanghai access service markets. This, more than and schedule for permitting foreign Telecom and Unisiti, the Shanghai anything, may be the catalyst to finally open participation in telecoms service markets, as Investment Institute. AT&T spent more China’s service markets more fairly for spelt out upon China’s accession to the than a decade of lobbying to get this foreigners. But in the meantime, what World Trade Organisation (WTO) in 2001: by venture running; it remains confined to strategies should foreign service operators 2007, inter alia, up to 49% foreign reselling AT&T’s enterprise services to be adopting? They are probably twofold: ownership is permitted in telecoms service companies in the Shanghai area. ● For the less risk-averse, that see China as networks nationwide. In theory, things may be different after a crucial area of growth, they can seek to On paper, WTO-mandated market- 2007 when WTO commitments begin to take partner and invest in any of the smaller opening is already under way: the “value- hold and foreign carriers are able to own value-added service companies that are added service” (non-voice) sector has been near-equal stakes in telecoms operations cropping up as a result of deregulation. deregulated and the door opened to foreign nationwide. But by that time foreign service This in the hope that they, too, can gain involvement. Yet there have been few takers, providers may have lost some of their a foothold in the broader services sector despite the promise of a slice of China’s competitive advantages: China’s four main once the market is fully deregulated. US$20bn-plus annual service markets. It is telecoms players will be stronger and more ● For the more risk-averse, they can con- not difficult to reason why. Limited licences prepared. The Ministry of Information tinue to cultivate relationships with may now be available but little else in the Industry (MII), the de facto regulator, has China’s incumbents in the hope that, way of a functioning telecoms regulatory been preparing for market liberalisation for over time, the relationship will evolve framework exists. Licensing policy is some years. It began by carving off the into more equitable partnership oppor- arbitrary, nor is there formal legislation on cellular operations of China Telecom, the tunities. such vital issues as interconnection, to name monolithic monopoly operator, into the Both are predicated on a fairly high one requirement critical to a working, separate (yet still state-controlled) China degree of hope. One, simply, is less of a deregulated market. China, in fact, has very Mobile; it then created a competitor, China gamble.

But the threats posed by local companies should nei- sonable growth potential in 3G mobile networks, for ther be underestimated nor exaggerated. The real ones, example, if broadband uptake is rapid. Foreign equipment the threats that will remain for a good many years, are makers should do well, providing they can: more political than business-derived: government pres- ● Offer well-priced alternatives to local equipment and sure to share technology, unpunished intellectual prop- handsets—not necessarily cheaper but with a clear erty theft, preferential treatment (including financing for advantage in terms of functionality, technology or even local firms) and, of course, the relentless pressure from style. local competitors as they make further inroads into the ● Retain or increase control over their operations, both market. The challenge for foreign companies will be how to be able to restrict technology leakage and not to be to maintain their profitability in the face of local manufac- beholden to partners with conflicting agendas. turers commodifying what were high value-added prod- ● Use China’s advantages as a production base to make ucts. Technological leadership will, of course, be essential it a key part of their global production strategies. but, if Chinese companies can either develop or buy their ● Be involved in China’s development of its technical own alternatives, it will also call for a ruthless approach to standards. cost-cutting in manufacturing. On present evidence, ● Have the flexibility to react quickly to changes in the those which focus on aligning themselves with China’s form of China’s market—be it changes in technology needs—Ericsson with its emphasis on network equipment, or the nature of customers, at both an equipment pur- Qualcomm with its ability to sell to all players and Alcatel chasing and consumer level. with its strong government partner—may have the edge The last of these is perhaps the most important. The most over those such as Nokia and Motorola with more seem- characteristic feature of China’s telecoms market has been ingly precarious competitive positions to defend. the rapidity of change—from a small, backward, badly run For all these companies, however, success or failure state monopoly 15 or so years ago to today’s enormous will be a matter of degree. All are well integrated into and modern series of networks operated by competing China’s telecoms industry—indeed, they have played the corporations. The roll out of next-generation mobile net- major role in building it. There may not be another golden works, expansion to the next few hundred million users, age quite like the 1990s, especially now that the big listed increase in competition and further changes to the struc- telecoms operators have to be more careful about their ture of the industry should see changes of a similar mag- capital expenditure. But the domestic market offers rea- nitude over the next decade or so.

Appendix: Survey results

The survey was conducted between late March and early provided by trained telephone surveyors. Results were April 2004 among senior decision-makers of multinational compiled, and conclusions drawn, by analysts at the companies in China. Respondents were drawn from users Economist Intelligence Unit in Hong Kong. of Economist Intelligence Unit and other Economist Group The survey received 217 responses, largely from products and services, in particular members of the executives at large multinational corporations: 38% of Economist Corporate Network who shared both their time respondents were from companies with annual global and experienced insights. revenues of US$8bn or more; almost 70% of respondents respresented companies with revenues of US$1bn plus. Methodology The respondents were almost all senior managers, with The survey was conducted via emails which provided a functions across the entire spectrum of business “click-through” facility to the Internet for respondents to responsibilities. Every major industry was represented. access and fill in the survey itself. Additional follow-up was

What is your primary industry? What are your organisation’s annual global revenues in US (% responses) dollars? (% responses) Professional services 13.4 $250m or less 13.4 Chemicals 10.6 $250m-$500m 8.3 Consumer goods 7.8 $500m-$1bn 8.8 Manufacturing (heavy equipment) 7.8 $1bn-$3bn 18.1 Insurance 6.9 $3bn-$8bn 13.9 Healthcare, pharmaceuticals and biotechnology 6.0 $8bn or more 37.5 Construction and real estate 5.1 Technology 5.1 Automotive 4.1 Which of the following best describes your title? (% responses) Telecoms 3.2 SVP/VP/Senior executive 32.6 Financial services (non-insurance) 2.8 CEO/COO/President/Managing director 31.6 Energy 1.8 Manager 18.6 Government/Public sector 1.4 CFO/Treasurer/Comptroller 9.3 IT services 1.4 Board member 0.5 Retailing 1.4 CIO/Technology director/Chief knowledge officer 0.0 Agriculture and agribusiness 0.9 Other 7.4 Aerospace and defence 0.5 Consumer durables 0.5 Entertainment, media and publishing 0.5 Travel, tourism and transport 0.0 Other 18.9

What is your primary functional role? Roughly what proportion of your company’s global revenue is (% responses) generated in China? (% response) Business development 16.2 Less than 1% 11.3 Customer service 2.3 1–5% 51.5 Finance 11.1 6–10% 15.7 General management 41.2 11–30% 13.7 Human resources 0.9 More than 31% 7.8 IT 0.0 Legal 4.2 Marketing and sales 8.8 What do you expect the proportion to be in five years’ time? (% responses) Operations and production 2.3 Less than 1% 3.5 Risk 0.5 1–5% 30.5 R&D 0.5 6–10% 24.0 Supply-chain management 0.9 11–30% 28.5 Strategy and planning 9.3 More than 31% 13.5 Other 1.9

What is the role of China to your global business? Select all that How many times has the global CEO of your company visited apply China in the last 12 months? (% responses) (% responses) One of several export production sites globally 24.0 No visits 21.8 A critical part of your global supply chain 27.6 1-2 visits 63.0 A prospective market 38.2 3-5 visits 8.8 An actual market 77.0 More than 5 visits 6.5 Other 4.6

Where does your China CEO fit within your global decision- making structure? What yardsticks do you use to measure success in China? Select (% responses) all that apply (% responses) As head of the China business, reporting into the regional headquarters 34.7% Market share 64.5 As head of the China business, reporting into Revenue growth 85.7 the global board 25.8% Return on capital 46.5 As head of the Asia-Pacific regional business, Return on equity 27.6 reporting into the global board 16.0% Geographical coverage 24.4 At the level of the global board 13.6% Other 10.1 Other 9.9%

How do the yardsticks of success in China compare with those From the perspective of your global headquarters, China is... used by your company to judge success in other countries? (% responses) (% responses) ...critical to global strategy 52.5 More lenient 22.3 ...strategically important, but not critical 40.6 The same 66.0 ...a location on a par with other emerging markets 5.5 Stricter 11.6 ...a location your company is still only exploring 1.4 Other 0.0

In the light of these objectives, how has your China business What percentage of your inputs on a value basis is sourced from been performing during the last three years? within China (as opposed to being imported)? (% responses) (% responses) Out-performing by a wide margin 9.2 0-20% 26.6 Out-performing 33.6 20%-40% 12.6 In line with expectations 42.4 40%-60% 9.3 Under-performing 12.4 60%-80% 6.5 Seriously under-performing 2.3 80%-100% 12.1 Not applicable 32.7

Roughly what percentage of your company’s global profits do you expect China to be contributing in five years’ time? Where do you expect this percentage to stand in five years’ time? (% responses) (% responses) Less than 1% 5.8 0-20% 11.6 1–5% 37.4 20%-40% 14.9 6–10% 16.3 40%-60% 8.8 11–30% 29.5 60%-80% 13.5 More than 31% 11.1 80%-100% 18.6 Not applicable 32.6 Approximately what is the ratio of exports to domestic sales in your business? (% responses) Of the inputs that you source from within China, what percentage is sourced from domestic Chinese companies (as opposed to 0:100 23.1 foreign-invested firms)? 25:75 23.6 (% responses) 50:50 5.6 0-20% 20.6 75:25 7.9 20%-40% 7.9 100:0 3.7 40%-60% 10.7 Not applicable 36.1 60%-80% 15.0 80%-100% 11.2 Where do you expect the ratio to stand in five years’ time? Not applicable 34.6 (% responses)

0:100 12.1 Where do you expect this percentage to stand in five years’ time? 25:75 23.3 (% responses) 50:50 20.9 0-20% 10.3 75:25 6.0 20%-40% 10.7 100:0 1.9 40%-60% 13.6 Not applicable 35.8 60%-80% 14.0 80%-100% 16.4 Not applicable 35.0

When planning for domestic sales within China, you think in What are the competitive advantages of domestic (as opposed to terms of... foreign-invested) firms? Please rank in order of significance, (% responses) with 1 being most significant ...a national market 20.9 Rank ...1st, 2nd, 3rd-tier cities 34.9 Lower prices 1 ...East coast and the interior 7.4 Better understanding of domestic market 2 ...Distinct regions (North-east, Yangtze river delta etc) 30.7 Support of local officials 3 Other 6.0 Support of the national government 4 Stronger local brand recognition 5 Access to cheap bank credit 6 What determines this view of China? Select all that apply (% responses) Income disparities 54.8 Has your company changed its China strategy in response to the challenge of domestic competition? Infrastructure deficiencies 39.6 (% responses) Central government regulation 27.6 Yes 47.2% Local-level informal protectionism 17.1 No 52.8% Other 24.0

Are domestic (as opposed to foreign-invested) companies a What kind of companies pose the biggest competitive threat to competitive threat to your business globally? your business in China? Select all that apply (% responses) (% responses) A serious competitive threat 5.6% Large state-owned enterprises 27.2 Somewhat of a competitive threat 28.2% Other state-owned enterprises 9.2 Not a threat 65.7% Collectively owned enterprises 13.8 Other 0.5% Private companies 44.2 Foreign-invested enterprises 67.7 How much of threat do you expect them to be in five years’ time? Other 6.9 (% responses) A serious competitive threat 15.9% How significant is competition from domestic (as opposed to Somewhat of a competitive threat 50.5% foreign-invested) firms to your China business? (% responses) Not a threat 33.2% Very significant 25.3 Other 0.5% Quite significant 38.7 Not significant 32.3 Other 3.7

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 of your 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 Political stability 1.8 12.4 25.8 32.7 27.2 Economic policy environment 5.6 23.6 24.5 30.6 15.7 Uncertainty about the stability of the renminbi 6.5 25.0 52.8 13.0 2.8 Equal official treatment for foreign and domestic firms 12.0 23.6 35.2 14.4 14.8 Corruption 40.3 30.6 19.9 6.0 3.2 Protection of intellectual property rights 29.2 23.1 24.5 10.2 13.0 Restrictions on cross-border capital flows 23.0 30.9 36.4 7.4 2.3

How would you expect to rate these issues in five years’ time? (Percentages) 1 (detrimental) 2 3 (no impact) 4 5 (beneficial) Availability of skilled managers/support staff 7.2 10.6 17.4 30.9 33.8 Availability of English-language skills 0.5 8.7 30.6 37.4 22.8 Availability of professional support services 3.4 6.3 28.2 39.8 22.3 Transport and communications infrastructure 1.0 6.9 36.3 34.3 21.6 Electricity infrastructure and supply 1.5 10.7 48.5 26.7 12.6 Political stability 1.5 6.3 32.5 35.9 23.8 Economic policy environment 2.9 15.6 33.7 31.2 16.6 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