The numbers would make any merchant or developer take notice: a retail market of nearly $700 billion; an economic growth rate of 9 percent annually; a 64 percent a year average increase in disposable income among urban households, with continued heady growth expected for decades to come.
Welcome to China.
“It would be fair to say the pace of development of all kinds in China has been nothing short of breathtaking in the last 10 years,” says Richard Price, managing director of investment firm ING Clarion in New York.
It's no wonder, then, that many U.S. retailers, shopping mall developers and institutional investors are eyeing the Chinese market hungrily and drawing up plans for entering — that is, if they haven't already arrived. “Virtually everyone in commerce generally and in our sector particularly, is looking at China,” says Morgan Parker, president of Taubman Asia, a unit of Taubman Centers based in Bloomfield Hills, Mich.
In July, Simon Property Group announced the first major foray of a U.S. shopping mall developer into China, when it revealed it had entered into a joint venture with a unit of Morgan Stanley and Shenzhen International Trust & Investment to build as many as 12 shopping centers.
Wal-Mart has 47 stores, with plans to open have 60 up-and-running by year's end. Home Depot and Circuit City will soon land there and food chains, KFC, McDonald's, Starbucks and Pizza Hut have been there for years.
Watch your step
At the same time, however, this isn't a market for the faint of heart. In fact, without the right planning, a move into China can become less a goldmine and more a minefield. Western retailers face stiff competition from local players. Land costs are rising. Furthermore, while Chinese citizens in some parts of the country have more money, the party hasn't reached most of the country — and the middle class is still small. Also, finding and keeping employees is a challenge, as is dealing with local governments. “China is not a slam dunk,” says Parker.
Still, the timing seems perfect. Analysts say China is in a position similar to Japan and Korea in their early growth years. But because much of Chinese commerce has remained at least partially state-owned, industry has been less efficient than it could be. That may be about to change. “As the Chinese government accelerates privatization, it should allow for more efficiency and more rapid growth,” says Ira Kalish, director of global consumer business at Deloitte Touche Tohmatsu's Deloitte Research unit.
One important factor has been the loosening of trade. Last year, the Chinese government liberalized regulations on foreign businesses in China, a move required for the country's entry into the World Trade Organization. Now, foreign retailers can operate in any location, run an unlimited number of stores, have vertically integrated distribution systems and don't have to meet minimum size requirements.
There's lots of room for new entrants. As of 2003, foreign-funded retail accounted for only 9.6 percent of retail sales, according to Deloitte, one-third of that from investments from Hong Kong, Macao and Taiwan. What's more, only about 10 percent to 15 percent of retail is what experts call “modern.” The rest is mostly street market vendors, small mom-and-pop enterprises and state-run department stores, most of which are highly inefficient. In booming cities like Shanghai, where there are more chain stores, hypermarkets and better-run department stores, the number is closer to 30 percent to 40 percent.
The lion's share of China's development has taken place in Shanghai and other eastern coastal cities located around the Pearl River Delta, the Yangtze River and Beijing. It was in those areas, for example, that, two decades ago, the Chinese government started to allow owners of small stores to buy their own shops. Many of them then sold their operations to burgeoning chains.
In second-tier cities in the country's interior, however, modernization is just starting to happen and the economic miracle is considerably less apparent. For example, in 2003, per capita sales were $2.558.18 in Beijing, compared with $541.28 in Changchun.
The disposable income in second-tier cities is nowhere near as high as in the big coastal cities. The ratio of per capita disposable income in Shanghai compared with the national average is 1.8-to-1, according to Deloitte. But, while consumers in the rest of the country don't have the money to support a thriving retail industry for now, many foreign players are betting it's only a matter of time before other areas start to boom. That's highly probable because the Chinese government is trying hard to support the development of industry in the interior.
Foreign intrigue
China's largest foreign retailers, France's Carrefour and Germany's Metro, both operators of hypermarkets in the eastern coastal region, as well as Wal-mart, are positioning themselves to build locations in smaller cities
But, which of these territories will be the ones to take off? While about 160 cities in China have a population of more than 1 million (compared with nine in the U.S.), retailers and other investors don't agree on the top targets for investment. “One investment banker recently told me there are 28 cities to focus on; another said 13,” says Parker. “No one has a good handle on exactly how many consumers there are [in the rest of the country] who can afford discretionary products.” He recommends looking not only at population size, but also at other factors, such as whether industries pay above-market wages.
As for shopping centers, the time may be particularly right for mall developers. A significant number of shopping malls have already been built or are in development — about 250 in the past three years.
“I expect every big city has a shopping center in development,” says Parker. They're also often huge, say, 1 million to 2 million square feet or more, and getting bigger. The South China Mall, at 9.6 million square feet and 7.1 million square feet in shopping space, the world's largest shopping center, is being built in Dongguan, in the Pearl River Delta, complete with a Teletubbies theme park, hotels, a giant windmill and an Imax Theatre. The Mall of America, at 4.2 million square feet in total and 2.5 million square feet in retail space, pales in comparison.
But most malls have been built by local Chinese developers and, according to many industry experts, are extremely poorly designed and managed — ungainly Goliaths with low occupancy rates and sales per foot. “They thought all they needed to do was pour a lot of concrete, without any planning,” says David Watt, chairman, international of DTZ Debenham Tie Leung, a real estate advisory firm in Hong Kong.
That spells a huge opportunity for U.S. developers with a sophisticated knowledge of the industry. That's why Taubman, for example, set up an office in China six months ago, to focus on development there, as well as in Japan, Korea and Indonesia, and is evaluating a handful of deals seriously. The office has been deluged with queries from local Chinese developers and landowners. Taubman's plan is to join forces with local developers who know about construction, but not about planning, design and management. “They want our skills,” says Parker.
What's more, the Chinese, apparently, love shopping centers, especially in the south where they can take advantage of the air conditioning. Because entertainment options are limited in cities, with few parks and movie theaters, malls also serve as a source of diversion.
Not every shopping mall developer is taking the same approach, however. At one end of the spectrum, Westfield says it's not interested in Asia at all. On the other is Simon, which owns about 32.5 percent of its newly formed partnership, as does Morgan Stanley. The venture will use Wal-Mart as the anchor in all its malls, most of which will also have movie theaters run by Warner Theaters. The first mall will be a 500,000-square-foot center in Hangzhou.
Shopping mall developers are also getting a boost from a torrent of foreign institutional investors, about 20 in all, according to Price. That should help raise standards and increase the attractiveness of the market. “As yields come down and prices rise, the developer can feel that the investment he's making in the short-term will have someone to take it over in the long-term,” says Watt.
Still, mall developers can't assume they'll prosper. They have to determine the right mix of retailers that can draw enough traffic, the appropriate mall size, the best location and format — all considerations with uncertain answers. “I've been to 20 provinces and none jumped out and made me say, ‘that's the model you should replicate,’” says Parker. At the same time, land costs are on the increase, especially in the eastern coastal region. The result: “Deals are very thin,” says Parker.
For retailers, the market is filled with even more concerns. In fact, despite the loosening of restrictions, few U.S. retailers have taken the plunge. “We thought there would be the opening of floodgates, but it hasn't panned out that way,” says Parker.
Retail expansion into China for Western companies is risky. Indigenous competition has a big head start. “The real strength of the retail market is in national retailers that are building chains,” says Parker. The state, fearful of too much foreign competition, has also pinpointed about 20 retailers, which it plans to support.
It's difficult for Western firms to ramp up their operations when local competitors can operate at a much lower cost structure. Plus, consumers are used to street vendors, who remain the dominant retailers. In fact, some hypermarkets replicate the ambiance of street markets, allowing merchants to lease space and haggle with customers.
Finding fakes
Counterfeiting is a major problem in China, where consumers are extremely brand conscious. (For example, it is estimated that 90 percent of Microsoft products sold in China are pirated.) Worse, there are significant over-runs, where factory workers gather as many goods as they can and sell them on the side. “That is more of a concern because they are the genuine article,” says Watt. While the Chinese government is supposed to be trying to clamp down on counterfeiting, Watt says, there's not a lot that can be done.
Another obstacle lies in the intricacies of translating a particular business to the needs of the Chinese market. For example, in many cases, a retailer's usual competitive edge doesn't work and, as a result, has to be rethought. That's even been true for mighty Wal-Mart. While its primary attraction here is its low prices, in China, that's not enough. “They can't match the prices of street markets, so they have to compete on the basis of quality, product mix and convenience,” says Kalish. Still, store managers visit nearby markets to check prices as often as three times a day, according to Kalish, so they can “quickly respond to changing demand patterns.”
Another case in point is KFC. The menu consists mostly of sandwiches with a Chinese twist. “They realized their competitive edge was their skill in managing a national restaurant organization, not selling fried chicken,” says Kalish. Similarly, Pizza Hut does much of its business in relatively upscale white-tablecloth restaurants. “The kind where a man might ask a woman to marry him,” says Kalish.
Retailers and mall developers face a few common obstacles. Transportation is a problem for suburban locations because, while car ownership is increasing, it's still small. For the top 10 percent of the urban population, there are just 6.6 cars per 100 households, according to Deloitte. Plus, there aren't even that many cars available. Even with a reduction on import tariffs following China's entry into the WTO, the stock of cars increased from 2.3 per 1,000 people in 1998 to just 5.4 in 2003.
Personnel issues are even more troublesome. Demand tends to exceed supply, in a big way. And with companies competing to woo workers, “they often find they train people, only to have them leave soon after,” says Kalish. That goes for employees at all levels of the organization. Kalish recalls one retailer who hired an independent trucking company to transport goods from the supplier to the distribution center. During the course of the trip, the trucker found a better paying job, however. So, he dumped the products on the side of the road. Two weeks later, someone else picked up the goods and delivered them.
Foreign companies also face a maze of rules and political maneuvering with local governments, which often maintain ownership of utilities and other companies. So, getting approval for such things as zoning, road repair or site procurement can be an impossible sleight of hand for the Western business. What's more, even when you win approval, you can't be sure that the terms of the deal will stick. Because Chinese local government officials have been rewarded for encouraging economic growth, rather than smart design, they haven't paid much attention to matters of management and planning.
“You can get permission to build a shopping center, only to find six months later there's another one being built down the road,” says Parker. Recently, the state restricted bank lending, partly to curb such growth.
The difficulty with political navigation is one reason why many companies are entering China through joint ventures with local enterprises. “You need a partner to be a sherpa,” says Kalish. Taubman, for example, plans to do deals only if they involve working with a local partner.
On the other hand, not everyone agrees with that approach. In the long-term, say some experts, foreign companies will benefit by going in alone, because they'll have greater control over the business.
That, of course, is only true if the company has engaged in careful planning. In fact, no matter what approach companies take, they all have to operate with caution, and with slow and painstaking research and preparation. Says Parker, “You have to take a long-term view.”
CHINA'S TOP RETAILERS
| Rank | Company | Jan-Jun 2005 Sales (in dollars) | % gain year over year |
|---|---|---|---|
| 1 | Shanghai Bailian | $4.51 billion | 20% |
| 2 | Beijing Gome Electronics Co. | 2.42 billion | 32% |
| 3 | Suning Appliance Chains | 2.20 billion | 68% |
| 4 | Dalian Dashang | 1.61 billion | 43% |
| 5 | Carrefour (France) | 1.26 billion | 31% |
| 6 | Suguo Supermarket | 1.17 billion | 36% |
| 7 | Shanghai Yongle Electronics | 1.15 billion | 43% |
| 8 | Beijing Hualian Group | 1.14 billion | 26% |
| 9 | Nonggongshang Supermarkets | 1.05 billion | N/A |
| 10 | Sanlian Commercial | 1.00 billion | 27% |
| 19 | Wal-Mart (US) | 581 million | 27% |
| 26 | Metro (Germany) | 470 million | 15% |
| Source: China Ministry of Commerce | |||
RETAIL SALES PER CAPITA BY CITY (2003)
| City | Population | Sales Per Capita |
|---|---|---|
| Shenzen | 2.06 M | $3,035.16 |
| Beijing | 12.37 M | $2,558.18 |
| Shanghai | 13.78 M | $2,248.19 |
| Guangzou | 6.91 M | $2,238.55 |
| Xiamen | 1.44 M | $1,767.75 |
| Haikou | 0.63 M | $1,678.26 |
| Tainjin | 10.16 M | $1,454.54 |
| Dalian | 5.78 M | $1,198.68 |
| Shenyang | 6.91 M | $1,182.49 |
| Wuhan | 7.74 M | $1,160.00 |
| Cities | 188.26 M | $1,596.81 |
| National | 1312.75M | $1,511.03 |
| Source: Access Asia, Deloitte Research | ||