Ever since Deng Xiaoping launched the opening of China in 1979 there have been two markets for every product and service offered in China. The first is where all of the foreign companies, with no exceptions, live. It is a market driven by brand cache, quality, and, to a lesser extent, price. (In some luxury markets the price must actually be high enough to compete.)
The second market is populated exclusively by Chinese owned and operated companies. The foreign companies simply can’t participate in these markets and make money. Price is everything. And the prices, in general, are one-half or less of what they are in the market that the foreigners participate in.
Until recently, everyone was happy. The pie was big enough and growing fast enough to satisfy everyone, consumers included. For a price, Chinese consumers could buy the best brand names in the world, and since many of the products carrying those monikers were now manufactured in China, albeit in a foreign-run plant, the price premium was not as great as it would be if the products were strictly imported.
Those once distinct markets, however, are now blurring, and blurring fast, creating a boon for many Chinese manufacturers and a potential bust for many foreign-invested companies operating here
- Economic growth is slowing. The government recently set the minimum growth rate at 7%, 1/3 less than it has averaged for the last decade.
- The world has opened its doors to China on many levels and Chinese companies are making the most of it. They’re now employing the best manufacturing technology in the world, much of it developed in the West.
- There is substantial excess capacity in many industries that is pushing market prices down at an alarming rate. (Success breeds imitation in China. If someone opens a new hair salon that appears to meet with some success, there will be six new hair salons on the same block within a year. The same appears to be true at every level of the economy.)
- Chinese manufacturers, often with the help of foreign technology and/or workers trained in foreign-owned plants, are greatly improving their quality, not to mention reducing their labor content.
And that’s just on the supply side of the equation. On the demand side:
- Price consciousness is getting a boost from the slowing growth of the economy. The Chinese consume by the bell weather of confidence. If their confidence falls the Chinese save – even more. So in an environment of slowing growth it is no surprise that there is a greater emphasis on price in their buying behavior.
- The Chinese are responding favorably to the quality inroads made by their manufacturers.
- The collective confidence of the Chinese people is surging. They are no longer the emerging country to watch. They are it. And proud of it. They no longer need foreign brands to legitimize themselves to the extent they did a few years ago.
Consider, for example, the plight of Apple, whose iPhones were once considered a must-have for rising middle class Chinese consumers.
In the second quarter of 2013 Apple’s market share was halved, much of it lost to Chinese brands such as Xiaomi and Yulong, both little known outside of China. Writing in China Daily, Mike Bastin, a visiting professor at the University of International Business and Economics in Beijing, reports that Apple has fallen to seventh place in the world’s largest mobile market and suggests that Apple should now drop its sub-brands, such as “5S” and “5C”, in favor of purely Chinese monikers.
Perhaps bowing to the pressure it currently feels in China, Apple recently launched its two latest iPhone products in China at the same time they were launched in the United States, a first for Apple. Unfortunately, these recent launches have already been declared a dismal failure by many here in China, in part because of the inexplicably high price Apple put on them. The opening price for a 5C in China is $728, well above the $99 advertised in the U.S. (Recognize, however, that the price of mobile phones is heavily subsidized by the mobile carriers in the U.S., with whom you have to sign a contract to get that price.) Still, Apple is advertising the unlocked 5C, which you could bring to China and use with a Chinese SIM card, for $549 (16 GB) on its U.S. website, still 25% below the price charged in the country where it is actually made.
Apple is not alone. In a July 19, 2013 article on the topic of foreign companies in China, Reuters’ Angela Moon noted, “Among 18 S&P companies with large exposure to China, 12 of them were underperforming the broader S&P 500 .INX index year-to-date…” And in a 2012 survey of members conducted by the American Chamber of Commerce in Shanghai, the percentage of companies reporting profitability or an increase in revenue fell to their lowest levels in three years, and less than ½ of the companies surveyed reported an improvement in operating margins.
Much of this, of course, is being blamed on macro-economic issues – slowing growth, tight credit markets, asset bubbles, etc. I believe that much of this emerging bad news for foreign companies, however, is in fact due to the rise of more intense and capable local competition and changing consumer attitudes.
There are many implications of these trends, not the least of which is that foreign companies are sure to increasingly question their commitment to future investment here. Already one of the most competitive markets in the world, the competition is sure to get even more intense and what is now admittedly a trickle of foreign companies repositioning their China strategies or outright withdrawing from China is sure to gain momentum.
And cost will be at the heart of much of the intensifying battle, an area where foreign companies are currently disadvantaged.
To their credit most foreign companies who come to China sincerely want to be responsible corporate citizens. They want to pay competitive wages, provide good fringe benefits, meet all regulatory requirements, and pay their fair taxes.
And it’s true that not all domestic companies share that perspective. It is, as I have noted in other posts, largely a Western perspective that doesn’t always come into focus through the Chinese cultural lens.
And the fact that local officials are given wide berth to interpret and enforce national and provincial regulations as they see fit opens the door to local favoritism, whatever its root cause.
Those advantages are being lost to the local companies, however, and, I believe, will ultimately lose any material relevance as the national government seeks to ensure a level playing field for all. It won’t happen overnight, perhaps, but it will, in my opinion, happen, if for no other reason than China has irrevocably committed to become a world leader and that won’t happen if it doesn’t adopt impartial rules of competition, a reality that the government is well aware of.
Much of the cost dis-advantage that weighs upon foreign companies operating here, however, is, in fact, self-inflicted, and it gets little attention in the general media or business press.
There are many foreign companies with wholly or jointly owned subsidiaries in China. Few, if any, however, are really Chinese subsidiaries. Nearly all are, in fact, Western subsidiaries operating on Chinese soil.
And there’s a huge difference between the two that goes well beyond the desire to be responsible corporate citizens whose presence is welcomed in China.
Some of these incremental costs, of course, are mandated by the government of the parent company, such as the incremental administrative costs incurred by U.S. companies in complying with the Foreign Corrupt Practices Act (Companies in Europe, in should be noted, face similar requirements.) or Sarbanes-Oxley, or any of the regulatory requirements that apply to a U.S. company’s global operations.
Other cost premiums, however, are truly self-inflicted. It is my educated guess, for example, that most U.S. companies operating in China use the Chinese branches of U.S. accounting, tax advisory, and legal firms in China, even though the latter, foreign legal firms, are not licensed to practice in Chinese court rooms, requiring U.S. companies to incur the additional cost of a second layer of legal representation should an actual dispute spill over to the courts. While the fees charged by these foreign subsidiaries might be marginally less than the fees charged back in the U.S., they are substantially higher than those charged by a comparable Chinese service firm whose expertise and talent is arguably equal to, or even greater than, given that this is China, their foreign counterparts.
And the practice is not limited to the service industries. Chinese subsidiaries of foreign machine-tool, construction, and maintenance companies are often given preference in bidding on key maintenance and expansion projects. Foreign engineering groups, understandably, have a defensible preference to work with companies they are familiar with, who have proven their ability to perform, who communicate in their native language, and whose approach to managing projects is similar to their own. There is, nonetheless, a price premium incurred, often material, for such confidence and familiarity.
Many multi-national companies, moreover, centralize critical services such as IT, engineering, and financial reporting, the former of which may yield benefits and the latter of which is mandatory. The issue is not whether or not this adds net value to the company, but the simple fact that these services, and all of the trans-Pacific travel needed to support them, ultimately becomes, through cross-charges or performance expectations, the burden of the Chinese subsidiary.
That is not to disparage any of these practices. They are both understandable and, at one level, easily defensible. The game, however, is changing, and once defensible tactics may no longer work.
I predict, therefore, a mad dash by foreign companies to ‘China-tize’ their cost structures in the years ahead. They will go beyond localizing their management teams and minimizing the number of ex-patriates they have stationed here. That trend is old news. They will now start to localize everything from policy-setting to technical, IT, legal, auditing, and financial services.
There will, of course, be risks, risks that are sure to be noted by the headquarter organizations most directly effected. And there will be regulatory limits to how far foreign public companies in particular can go.
There will, however, be little option if foreign companies want to survive here. If Apple, perhaps the most powerful brand on the planet, can be so quickly dethroned by heretofore-unknown local manufacturers, how can any foreign company consider itself immune to a similar fate?
Copyright © 2013 Glassmaker in China
Notice: The views expressed in this post are strictly those of the writer acting in a personal capacity. They are not in any way endorsed or sanctioned by his employer or any other individual with which he may be personally or professionally affiliated.