A fter thirty years of opening and liberalizing its economy, nowhere else, not even among the mature markets of Japan, Europe, and the United States, offers the same extraordinary range of brands and products as China. If you doubt this, step into a convenience store in, say, Shanghai, Dalian, or Shenzhen. Accompanying the Western products Coke, Pepsi, and Schweppes there are Japanese soft drinks made by Suntory, Kirin, and Sapporo, Taiwanese flavors under the Uni-President label, and Hong Kong brands such as Vitasoy. Alongside the bottled waters, colas, and beers are teas, coffees, and soya milk drinks, plus ones made from fruits unfamiliar to most foreigners. Chinese companies make their own versions of every international flavor—and many flavors that are not produced elsewhere.
Outside, on the newsstands, are Chinese magazines—and Chinese editions of such familiar global titles as Cosmopolitan , Vogue , and Elle. Driving on the streets are locally manufactured vehicles from almost every global carmaker—General Motors (GM) and Ford, Toyota and Honda, Volkswagen (VW) and its subsidiary Audi, BMW and Mercedes, Citroen and Hyundai—plus a host of local auto brands, including Chery, Geely, Brilliance, and Great Wall. Step inside a department store and there’s a proliferation of labels and choices: from sportswear
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to electronic goods, handbags to massage equipment, foreign to local, high end to low end, and everything in between. Even someone accustomed to American or European superstores might find it a bit daunting; but for most of the local patrons in cities such as Shenyang, Wuhan, and Changsha, it’s a remarkable change from the sparsely stocked, perfunctorily managed shops they patronized just a decade ago.
At first glance, for global consumer-oriented companies, this would seem to be the realization of a dream. For years, they have looked forward to the rise of the mythical “land of one billion-plus consumers”— new to the middle class, eager for new products, ready to be sold to. And indeed, for some companies the last decade has been an extraordinary and exciting time, and in many cases a prosperous one. Executives who argued in the 1990s that China’s markets for their goods would rise exponentially were vindicated. The old perception of China as a poor country with a closed economy has become obsolete.
To be sure, the ability of many Chinese to join the consumer economy is still restricted by the country’s overall low per capita income, especially away from the largest and wealthiest metropolitan centers. But now that China’s consumer market has been unlocked, it cannot be reversed. Since the start of the 1990s, annual retail sales have increased more than fifteenfold, from around $100 billion to more than $1.6 trillion by the end of 2008. This represented about one- third of sales in the United States during this period. 1 That is not a one-time phenomenon; it is here to stay.
Yet the Chinese consumer market is more complex than people expect, and the challenges to achieving profitability are growing. For new openness is bringing with it phenomenal competition, abrupt rises and falls in market share for both new and established products, and almost zero brand loyalty. The experience of companies like KFC suggests that the new Chinese consumers are rapidly becoming as diverse in their tastes and needs, and as demanding and fickle, as their Western counterparts. They cannot be taken for granted.
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The big winners in open China are the consumers themselves. They are now choosing from a cornucopia of goods in almost every product category, from every corner of the world, all competing for their attention, and many of them sold at rock-bottom prices.
For companies trying to reach these consumers, the prospects vary by industry. Although the markets for certain types of goods rival and sometimes surpass other of the world’s largest consumer markets, this has not been true in every sector. The size of the market for mobile phones and television sets may be comparable among China, the United States, and Europe, but for products that call for additional discretionary spending, such as DVD players, Chinese sales levels remain below those in developed-country markets (see exhibit 2-1). In some sectors, sales are rapidly rising. In 2009, auto unit sales in China exceeded those in the United States for the first time.
exhibit 2-1 Sales of consumer goods, millions of units, 2007
Mobile Handsets | Televisions | DVD Players | Cars | |
China | 190 | 38 | 11 | 5 |
US | 146 | 35 | 37 | 16 |
EU | 100 | 43 | 38 | 20 |
Table captionSource: Booz & Company
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Since the early 1990s, and especially since the early 2000s, the markets for various types of goods have experienced S-curve-shaped periods of growth. Three representative examples, from three very different industries, are the increase in mobile-phone subscriptions, the value of home mortgage loans, and sedan sales (see exhibit 2-2).
Toward the end of the 1990s, China had 43 million mobile-phone subscribers, up from just a million six years earlier. 2 At the time, that seemed to be an impressive achievement, but what came next was unprecedented. The government reorganized the telecommunications industry, pitting China Mobile directly against the country’s other mobile operator, China Unicom. Both companies slashed their tariffs and, helped by a liberal issuance of handset manufacturing licenses and heavy competition among foreign equipment suppliers, consumers found themselves presented with an irresistible combination of cheap phones, ultralow tariffs, and a state-of-the-art nationwide network. Better still, after years of having to endure long waiting lists, drawn-out bureaucratic procedures, and big up-front fees to get fixed lines, now all anyone had to do to get a phone was walk into a shop and sign up. Total subscribers increased more than tenfold to pass 500 million in 2007; by mid-2009, the number was up to 687 million.
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The mortgage-loan market took off at the same time. In 1998, China’s government reformed its urban housing policy. Until then, almost everyone’s apartment was owned by the enterprise or organization that employed them; households were allocated a home for which they paid a token rent. The government, looking to free enterprises of their welfare burden, liberalized the housing market, jump-starting the process by offering city dwellers the option of buying their homes from their employers at giveaway prices. Overnight, the mortgage-loan industry was born. During the next decade, sales of residential floor space increased nearly tenfold, from around 80 million square meters to 700 million square meters. 3 In 2008, as the economy slowed in the wake of the global financial crisis, sales dropped. But the overall trend for the next decade remains strong growth: by 2020, China’s urban population is expected to grow from 600 million to 800 million and all of its new urban residents will need somewhere to live.
As with mobile phones and mortgages, China’s car-sales surge was driven by regulatory change and a corresponding surge in supply. In the early 2000s, as a succession of Sino-foreign joint ventures and independent Chinese auto firms invested in production capacity, the government allowed banks to offer auto loans and the carmakers to set up auto finance companies. Annual motor vehicle sales rose from around half a million in the late 1990s to more than 9 million by 2008. In January 2009, for the first time in history, monthly automobile sales in China surpassed those in the United States. And just after midyear, the China Association of Automobile Manufacturers increased its forecast for total vehicle sales for the year from 10 million to 12 million. Moreover, with manufacturers lowering prices, expanding their model ranges, and continuing to expand production capacity, prospective buyers will have both more lower-cost cars and more cars overall to choose from through the next decade.
In other sectors, profitability remains elusive. While survey after survey has found revenues and profits gradually rising, many businesses continue to struggle to reach the margins they would like. This
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includes sellers of inexpensive goods that almost every consumer can afford, and those that have operated in China for a long time.
Take Coca-Cola. It first entered China in 1927, then retreated during the early Communist years. It re-entered in 1979, just months after Deng ascended to power and launched his program of economic reforms, and ahead of its global rival, Pepsi. Since then, Coke has invested more than $1.3 billion, mostly on bottling infrastructure (through its joint ventures with bottlers, it has thirty-six bottling plants) and other facilities, including an $80 million headquarters and R&D center in Shanghai—one of six worldwide. Between 2009 and 2012, Coca-Cola is planning to invest an additional $2 billion in China. These investments will involve factory sites, production facilities, route-to-market supply-chain channels, product development, and marketing.
Over the years, Coke’s sales have risen continuously, giving it almost one-third of China’s market for nonalcoholic beverages. Like the sellers of cars and mobile phones, the company has recorded particularly strong growth in the last five years, with annual volume doubling to more than 1 billion unit cases—5.7 billion liters—making China its third-largest market by volume worldwide, after the United States and Mexico.
But although profitable, Coke’s margins are thinner than its margins in the United States. Coca-Cola’s Chinese business is being squeezed on all sides. A fragmented retail market—it estimates the number of outlets at somewhere between 7 million and 12 million— combined with a state monopoly over television advertising means that marketing and distribution costs are high. Competition from international and domestic rivals is ferocious and the competitive landscape is complicated. While it competes with Pepsi in the carbonated drink segment, Coca-Cola also faces off in the noncarbonated categories against local and Taiwanese brands, such as Kangshifu (Tinghsin), Wahaha Uni-President, and Wanglaoji. As a result, Coke needs to sell its drinks in China for among the lowest prices anywhere in the world. And with every competitor investing in capacity and clawing for market share,
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price competition will probably become even more intense. (Coca-Cola, as we’ll see in later chapters, has also responded to this challenge by trying to acquire local Chinese brands.)
In other sectors companies face similarly fierce competition and dynamic markets. Their fortunes can rise and fall with astonishing speed. Take the car market: VW, after dominating throughout the 1990s, with a market share of more than 50 percent, saw its share drop rapidly and its performance slump into the red in the early 2000s. It was initially displaced as the market leader by GM, whose market share rose as it built a highly profitable joint venture with one of the country’s largest automakers, Shanghai Automotive Industry Corp.— a company that also has a joint venture with VW. By 2008, GM was in turn finding itself eclipsed by Toyota, long regarded as a struggling latecomer, after the Japanese company brought a second plant into operation in the southern city of Guangzhou. Within a year, however, Toyota was also struggling, with reports suggesting it had lost half its market share in the first half of 2009 after failing to upgrade its models quickly enough to satisfy the demands of Chinese buyers. 4 A senior executive from a large Chinese automobile maker told me later that year that “the huge profit era of the Chinese automotive industry is now gone, because of intense competition.”
Breathing down the necks of all the big international motor vehicle companies are China’s own independent carmakers, whose share of the market rose from 20 percent in 2004 to about 29 percent in mid-2009. The largest of these companies, with 7 to 8 percent of the market, is Chery Auto—a relative newcomer, founded in 1997, which has already established itself as China’s top car exporter. Potentially even more threatening to the established automakers is Shenzhen- based BYD. (Its initials stand for “build your dream.”) Primarily a maker of mobile-phone batteries—and a successful one, with 130,000 employees and revenues of $3.1 billion—BYD decided to take on the automotive market with an electric car. It launched its first model in late 2008, two years ahead of the expected launch of
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GM’s Volt, with a car priced at just over half of the Volt’s targeted price, and with a greater range. That same year, BYD received a major boost when a company owned by Warren Buffett bought a 10 percent stake for $230 million. (BYD’s story is examined in more detail in chapter 8.)
As upstart entrants, BYD, Chery, and other Chinese carmakers face major challenges. BYD only sold its first car, a gasoline-fueled model, in 2005, and Chery only exports about 100,000 units a year, all to developing countries. But they have the potential to reshape China’s automotive market, and beyond that, international markets—especially given the global restructuring of the industry that has to occur over the next decade. They will start by building scale at home, producing low-priced vehicles, then by leveraging domestic volume as the jumping-off point for international expansion. The Chinese government is likely to support these companies.
Given this combination of official goals and a consumer market that cannot support all of the companies now present, China’s auto industry will inevitably undergo a major restructuring. When that will be is impossible to know. Car sales resumed after a brief slump in the latter half of 2008 and China has now become the world’s largest automobile market. Sales are certain to continue growing through the 2010s, and automakers will continue to invest as long as they believe they can emerge as one of the eventual winners. At the same time, Chinese competition and the global financial crisis could accelerate consolidation in this industry, especially if foreign carmakers, particularly the American ones, find themselves distracted or put out of business by events in their home markets.
One major but often unnoticed factor in the growth of China’s consumer markets—and its instability and ferocious competitiveness as
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well—is the country’s openness to foreign business. The government has allowed non-Chinese companies to set up manufacturing operations and sell freely in many sectors, and growing numbers of consumers not only welcome this variety of goods regardless of the country of origin of their makers, but consider it a symbol of their own increasing prosperity.
This openness has created ripe conditions for entry into many of China’s industry sectors, both for foreign companies and new Chinese companies. Investment has surged into almost every industry, coming from both established players and total newcomers. Different sectors have different stories to tell, but for a high proportion of those making or selling consumer goods, the big picture remains the same: delayed returns on investment; strong downward price pressure; far higher costs than expected for many functions, especially marketing and distribution; and, a result of all of these, lower margins.
We’ve just seen how the world’s most established automakers are finding themselves confronted by previously unknown Chinese competitors. In sportswear, Li Ning, Dongxiang, and Anta are credible threats to Adidas and Nike. Huawei and ZTE, both telecom equipment makers based in Shenzhen, used the growth of China’s communications infrastructure to build the domestic volume necessary to launch their own equipment businesses worldwide. Their aggressive pricing, which accelerated a commoditization of many elements of the telecommunications industry, played a major role in driving a global consolidation that led to Alcatel’s acquisition of Lucent and the merger of Nokia’s and Siemens’s equipment-making divisions. Over the next decade or two, the presence of Chinese companies can be expected to make restructuring more likely in a wide range of other industries— among them automotive, shipbuilding, chemicals, energy, information technology and, possibly, aerospace.
To understand the potential and the complexity of China’s markets, one must therefore understand the nature of this openness and how it affects the trajectory of business development. Only those who see it
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THE CHINA STRATEGY
clearly can formulate a China strategy that uses these markets to create organizational capabilities that can be applied globally. There are four ever-changing dimensions of openness to consider:
1. Openness to outsiders: the arrival and role of overseas investment in China.
2. Regional markets: the growth trajectories of geographic market development within China.
3. Improved distribution: developing more and better retail channels and the infrastructure necessary to support them.
4. Consumer culture: the evolution of a demanding and fickle population of purchasers.
These four dimensions can guide companies as to what to expect upon entering China, where to target their efforts, how to plan their distribution, and what sort of consumer markets may emerge.
When Deng Xiaoping launched his economic reforms in the late 1970s and early 1980s, he had no grand vision of making the country join the global economy. Indeed, what happened next was one of the great ironies in recent commercial history. Deng and his fellow officials wanted the opposite of globalization. They wanted to acquire technology and know-how from abroad, while minimizing China’s exposure to outside influence. Hence the decision to try and concentrate foreign investment in a handful of “special economic zones” that were open to the world, but largely closed to the rest of China. Access to these zones was limited to those who worked within them.
The great liftoff in foreign investment only came in the 1990s. Its ignition point can be traced precisely to 1992—when Deng Xiaoping undertook what Chinese call his “southern tour.” Traveling to Shenzhen
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and then Shanghai, he urged officials to relaunch and expand China’s economic reforms that had faltered after the suppression of the student- led democracy movement of 1989. His call was taken up across the country, especially by Zhu Rongji, the senior Party official who was China’s single most influential voice on the economy during the past twenty years. On Zhu’s watch, first as vice premier and then as premier, China undertook or began all of the most significant reforms that have created the economy we see today. Zhu took China into the World Trade Organization (WTO); he privatized the country’s housing stock; he launched the overhaul of the country’s financial system; and most astonishingly of all, he oversaw the biggest single example of “creative destruction” the world has seen: the wholesale closure of much of China’s state-owned sector in the late 1990s and early 2000s, and the creation in its place of a private sector. 5
This latter change, in which tens of thousands of state-owned companies were closed and some 30 million workers lost their jobs, laid the foundations for today’s more productive economy. Those parts of the state sector that survived are strongly profitable—among them earning more than $200 billion in 2007, the equivalent of well over 6 percent of GDP. (Before the change, their earnings had been about 0.5 percent.) Still more significant was the boost this removal of deadwood gave to the private sector. Forced to find work wherever they could, most of the workers who lost their jobs ended up in private enterprises. In 1997, the urban private sector employed 24 million people; a decade later, that had risen to nearly 80 million. 6
Zhu focused on allowing market forces to determine the direction of development rather than using government intervention. This explains why, from the early 1990s onward, he attached such importance to WTO entry: the best way to improve the performance of Chinese companies, he reasoned, was to expose them to the best practices and competitive challenge of foreign companies. It also helps explain why foreign investment started arriving in China in large volumes in the mid-1990s. Although China had first opened its doors to foreign companies at the end
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exhibit 2-3 Foreign direct investment into China, 1985-2008, $ billions
$100 80
60
40
20
1990 2000 ’08
1985 | 2.0 | 1991 | 4.4 | 1997 | 45.3 | 2003 | 53.5 |
1986 | 2.2 | 1992 | 11.0 | 1998 | 45.5 | 2004 | 60.6 |
1987 | 2.3 | 1993 | 27.5 | 1999 | 40.3 | 2005 | 60.3 |
1988 | 3.2 | 1994 | 33.8 | 2000 | 40.7 | 2006 | 63.0 |
1989 | 3.4 | 1995 | 37.5 | 2001 | 46.9 | 2007 | 74.8 |
1990 | 3.5 | 1996 | 41.7 | 2002 | 52.7 | 2008 | 92.4 |
Table captionSource: National Bureau of Statistics, Ministry of Commerce 7
of the 1970s, the true influx of foreign capital only began in 1992, rising to a record high in 2008 of more than $90 billion (see exhibit 2-3).
For cities and towns along China’s southern and eastern coasts, often with little more to offer than land and unskilled labor, attracting foreign investment became the quickest and easiest way to develop. In these regions, especially in the 1990s, keeping this money arriving became a major imperative—to spearhead growth, create jobs, help upgrade infrastructure, boost exports, earn hard currency, obtain technology, and introduce new managerial practices. As growth surged, more sectors were opened and more economic development zones were built. Foreign companies were offered more tax breaks and granted more freedom, to entice them to operate wholly owned businesses instead of the joint ventures the government had first required.
For foreign manufacturers in particular, the freedom to operate on their own terms was a major plus. The benefits of China’s low-cost
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exhibit 2-4 Exports from foreign enterprises in China, 1995-2008, $ billions
$ 1,500
1,000
500
ftiissii
Exports by:
H Chinese-invested enterprises Foreign-funded enterprises
hi . mm
.
2000
gj|§jj Mgl 1 I
^111
’07
Exports by Foreign-Funded
Foreign-Funded China’s Total Enterprises’ Share of
Enterprises, $ Billion Exports, $ Billion Total Exports, %
1995 | 46.9 | 148.8 | 32 |
1996 | 61.5 | 151.0 | 41 |
1997 | 74.9 | 182.7 | 41 |
1998 | 81.0 | 183.7 | 44 |
1999 | 88.6 | 194.9 | 45 |
2000 | 119.4 | 249.2 | 48 |
2001 | 133.2 | 266.1 | 50 |
2002 | 170.0 | 325.6 | 52 |
2003 | 240.3 | 438.2 | 55 |
2004 | 338.6 | 593.3 | 57 |
2005 | 444.2 | 762.0 | 58 |
2006 | 563.8 | 968.9 | 58 |
2007 | 695.4 | 1,217.8 | 57 |
2008 | 790.6 | 1,428.5 | 55 |
Table captionSource: National Bureau of Statistics 8
manufacturing base more than compensated for their frustrations in trying to sell into China’s fragmented and hard-to-penetrate markets. As foreign investment poured in, China was transformed into one of the world’s leading exporters. Foreign-owned companies displaced domestic ones as the main source of Chinese exports, with their share of exports rising to nearly 60 percent (see exhibit 2-4).
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Such figures are a tribute to Chinese openness—and a rebuke to those around the world, who criticize China for resorting to unfair trade practices. Chinese companies certainly play a substantial role in producing the country’s trade surplus, but foreign companies have played a larger role, taking advantage of China’s openness and low costs to improve their competitiveness. Along the way, China has created an economy that although still closed in many respects, is far more open than those of its neighbors, Japan and South Korea, and many other developed countries. For example, China has allowed several foreign auto brands, including BMW and Mercedes-Benz, onto procurement lists for government vehicles; other countries, including Korea and Japan, have been much more restrictive at times.
As for China’s government leaders, the liberalization of China’s economy and the opening of its borders to foreign companies generated unforeseen consequences. Arguably the most significant of these was the degree to which foreign companies and their ideas and practices penetrated the Chinese economy. Gradually, the Chinese leaders have come to accept the fact that this has benefited China. In the short term, it has brought investment, created jobs and demand, boosted trade, and generally stimulated the economy; in the long term, it exposed Chinese companies to competition and the best practices of global businesses. The best Chinese managers may go and work for multinational companies, but many will also return and work for Chinese companies, or establish their own start-ups, using the skills they have acquired and passing them on to others in the process. Openness has also brought foreign goods to China, which in turn has encouraged Chinese companies to produce their own versions.
And yet, the Chinese economy may be at a new point of transition, becoming more challenging. Foreign companies expecting a similar welcome to that of the previous fifteen years will find some major changes—and could be disappointed. It is not that China will close its economy; along with the United States, it has been, and will continue to be, one of the greatest beneficiaries of the tide of globalization that
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swept across the world in the past twenty years. Foreign investment will remain lucrative in China in the years to come, perhaps more so than ever, and global capital will continue to be drawn there. In their book Merge Ahead, Booz & Company partners Gerald Adolph and Justin Pettit say that China is “indispensable for multinationals to enter,” 9 and it remains one of the most attractive investment markets in the world.
But foreign capital will no longer play the same kind of key enabling role to China's transformation. The big changes, which outside investment helped facilitate, have now taken place. China has most of the resources that it lacked at the start of the 1990s, including money and know-how, necessary to develop its economy. Of course, there remain elements in short supply, such as certain technologies and areas of expertise. But with the economy largely transformed, and its two weakest areas—state-owned enterprise and the banking system—utterly unrecognizable from just fifteen years ago, the greatest era of foreign investment's impact is at an end. Foreign companies arriving now (or looking to expand their existing investments) will do so in a crowded, competitive environment, where they can expect fewer incentives, such as tax and land breaks, than they received in the past.