domestic companies in china (Full pages)graphics.eiu.com/files/ad_pdfs/domcomp1_12WP.pdf · Domestic companies in China Taking on the competition Preface Domestic companies in China:

© The Economist Intelligence Unit 2005 1

Domestic companies in ChinaTaking on the competition

Contents

3 Preface

4 Executive summary

8 Introduction

13 Chapter 1: Are the Chinese coming?

24 Chapter 2: The evolution of China’s companies

37 Chapter 3: A snapshot of domestic companies: survey results

70 Chapter 4: Constraints and challenges

81 Appendix: Survey results

94 Appendix: Survey results/ manufacturing cluster only

107 Appendix: Survey results/ services cluster only

2 © The Economist Intelligence Unit 2005




Preface

Domestic companies in China: Taking on the competition is a new study by the Economist Intelligence Unit written in co-operation with Bank of America, Deloitte Touche Tohmatsu, Dow Chemical and Towers Perrin, with additional support from Grey Global Group and Norton Rose. The report is based on a survey of senior executives of 176 domestic companies in China conducted over May and June 2005, as well as numerous interviews with local enterprises and experts on China.

The findings and views expressed in this report are those of the Economist Intelligence Unit alone.

The authors of the report were Mary Boyd and Paul Cavey. The editors were Bina Jang, Cesar Bacani and Laurel West. Gaddi Tam was responsible for design and layout. Steven Carroll drew the cover illustration.



Executive summary

Recent high-profile acquisitions overseas by mainland Chinese companies have raised expectations and, in some quarters, apprehension that they are embarking on an asset-buying drive like the Japanese did in the 1980s. But are Chinese companies taking on the world? Not quite yet.

Despite some headline-making deals, most Chinese companies aren’t rushing to invest overseas, says Domestic companies in China: Taking on the competition, a new report by the Economist Intelligence Unit, written in co-operation with Bank of America, Deloitte Touche Tohmatsu, Dow Chemical and Towers Perrin, with additional support from Grey Global Group and Norton Rose.

One reason few companies in China plan to expand abroad is because their eyes are turned inwards, not outwards. The China market is the main target for the next three years for fully 91% of 176 mainland Chinese companies surveyed for this report. The immediate regional market dawdled behind, with North-east Asia and South-east Asia as the target for 17% of respondents each. Only 12% select Europe and Russia as a target market, and just 11% choose North America.

The report, which is based on the survey results and numerous interviews with local companies, suggests that mainland Chinese firms, while competing with foreign multinational companies (MNCs), see other domestic enterprises as their main rivals, not the MNCs. Preoccupied as they are with the domestic market and their own internal problems, China’s domestic companies are a long way off from going global.

Other main findings of the report include:

• The Chinese aren’t coming just yet. To match

the Japanese buying spree of the 1980s, much more capital needs to flow out from China. In absolute terms, but particularly on a relative basis, the size of China’s overseas investments

is much smaller than that of Japan in the late 1980s, and it is expected to remain so for the foreseeable future. China’s foreign direct investment outflows are likely to rise to US$30bn by 2009, but these will still equal only 2.4% of the global total.

The handful of Chinese enterprises going global are either looking to secure a steady supply of energy and other resources, or are buying international brands to strengthen their own, and are mostly in oversaturated and competitive sectors in China, such as household appliances and personal computers. Some Chinese companies are buying new technology to springboard into new export markets because provincial protectionism and transport logjams are blocking full national access, or because the domestic consumer market is too geographically dispersed for efficient distribution.

• Chinese companies may be in over their

heads in global bids. Making these cross-border deals work is far from easy, assuming the Chinese can overcome political and other opposition to make the purchase in the first place. There is criticism that Chinese companies are overpaying for their acquisitions, and that the companies they are buying have fallen on hard times and are therefore difficult to turn around.

• Copyright and brand protection is among

their challenges overseas. The new Chinese bosses overseas need to inject new life into damaged brands, deal with personnel issues, clean up the books of acquired companies and solve many other problems. Moreover, they must be more careful with copyright issues as they venture into foreign legal jurisdictions where infringement suits are more acrimonious and expensive than at home. Other challenges have to do with



brand recognition (and protection), and damage control from negative publicity, which require management skills attuned to local sensibilities. Culture clashes could arise from Chinese managers unskilled in running complex global companies under the scrutiny of investment analysts and the media, which the increased politicisation of Chinese companies’ overseas expansion is likely to generate.

• Chinese firms at home keenly recognise the

competitive value of brand and effective leadership. Brand is the major competitive advantage cited by 49% of our surveyed executives from domestic Chinese companies, followed closely by effective leadership (45%). China’s corporate leaders aren’t looking for answers on strategic direction from international management gurus—the latter impress only 5% of respondents. Instead, 67% pick up ideas for strategic initiatives from rivals and 66% from industry leaders. There is an over-reliance on proven formulae, which exacerbates a dependency cycle of copying rather than innovating.

• Strategic alliances are a means to improve

a firm’s standing in the domestic market. Almost half of the Chinese companies surveyed are open to the concept of strategic alliances, with 31% considering joint ventures and 23% looking at mergers and acquisitions (M&As). Respondents that fell into the sector broadly defined as manufacturing (agribusiness, automotive, chemicals, consumer goods, energy and natural resources, pharmaceuticals and biotechnology) think along the same lines—45% plan strategic alliances, and 25% M&As. By contrast, 39% of companies that fell in the services sector state they have no intention of entering into alliances. Manufacturers are especially keen to acquire new technology through tie-ups (38%), or shift to higher-growth business areas (45%) or overseas markets (23%). Companies in the services

cluster are more conscious of “moving up” through tie-ups to access a brand or diversify risk, rather than acquire new hardware.

• New graduates are favoured recruits;

“returnees” from abroad are the least-used talent. As a source of recruitment, new graduates are the most favoured by 78% of surveyed Chinese companies overall. The next way is to hire from state-owned enterprises (SOEs), say 62% of respondents. Although Chinese companies in the services sector follow the overall trend, hiring preferences in the manufacturing cluster are reversed, with SOEs as the first choice, followed by new graduates. Significantly, the least-used talent seems to be returnees from abroad and employees from foreign companies, which represent the smallest and most expensive pools. The lack of recruitment of returnees seems to undermine the government’s purpose in encouraging its citizens to study overseas—that they come home and contribute their skills to the economy.

• A lack of innovation and creativity are the

key weaknesses of employees. Six of ten managers of domestic companies complain about the lack of innovation and creativity among their workers. This may be the result of a rigid education system that focuses on rote learning, and the tendency of companies to overstaff middle-manager ranks to the point of suffocation and to over-standardise training manuals and training requirements. A lack of strategic thinking is seen as the next key weakness of employees (say 53% of overall respondents), followed by poor communication skills. Surprisingly, poor work ethic troubles just 2% of surveyed executives.

• Chinese companies consider themselves

to be innovators. Fully 77% of the survey respondents believe innovation is critical but they are not sure what constitutes innovation. For most, an instinctive description of innovation when applied to their companies is



most likely to comprise technical advancement or upgrading, research and development or the introduction of a new product line. It is less likely to mean the type of creativity and enterprising attitude they expect from their employees. That is probably why 71% of Chinese companies consider themselves to be innovative yet see no contradiction in bemoaning a lack of innovative staff. They also think their Chinese competitors have a slight edge over them in being innovative (73% say so). Foreign companies do not impress them much, it seems, as only 56% of respondents see them as innovators.

• Rapid growth of the China market is seen

as the biggest challenge. China’s domestic companies consider the rapid growth of the domestic market, escalating competition and the intense pricing pressure this brings as the greatest risks to their planned investment projects. The next-biggest headaches are unethical behaviour by managers or employees, and information-technology and logistics failures. Other problems identified are government intervention in the banking system and shortages of working capital.

• The growing number of rivals at home and

abroad are the biggest threat to a company’s brand. Six out of ten surveyed managers believe that the biggest challenge to their brand in the next five years in China will be the growing number of rivals, both domestic and foreign. Fully 40% of respondents also think they will face a problem in continued investment in brand building. Interestingly, companies in the manufacturing sector think that pricing will be a more serious risk than counterfeiting. This may be due to the comparatively low level of proprietary technology in the manufacturing sector.

China’s approach to economic reform has been gradual. To consolidate, the country needs to ensure sustainability and foster innovation. This also means going beyond the “workshop of the world” label, and extending the strategy to the laboratories and boardrooms. The current round of M&A by domestic and foreign investors in China is likely to be the start of another formative stage in this maturation process. At its best, it will inject new capital and new skills to fill gaps in local companies, and also continue the reform in the Chinese economy.

presidents/vice-presidents/directors

(20%), board members (11%) and chief

financial officers/treasurers/comptrollers

(7%). The rest were other C-level

executives and managers.

Manufacturers accounted for 22% of

respondents, followed by construction

and real estate (10%), and logistics,

financial services, energy and consumer

goods (7% each). Other industries

A total of 176 senior executives from

domestic companies in China par-

ticipated in the study, with a fifth of

respondents based in Shanghai (11%)

and Beijing (9%). Less-prosperous inte-

rior provinces were also represented,

including Hubei, Hebei and Heilongjiang.

The respondents were chief executives/

presidents/managing directors (24%),

heads of department (21%), senior vice-

include retailing, technology and

automotive.

In terms of annual revenue, 19% of

respondents were from companies with

Rmb100m (US$12.4m) or less, 29% were

from firms with Rmb100m to Rmb500m, 13%

from firms with Rmb500m to Rmb1bn, 28%

from firms with Rmb1bn to Rmb10bn, 10%

from firms with Rmb10bn to Rmb50bn, and

1% from firms with more than Rmb50bn.

Who took the survey?



Introduction

Curiosity compelled us to write this report. Are China’s companies the asset-gobbling predators that evoke apprehension in the US, Japan and

Europe? Or are they merely paper tigers that survive mainly due to government support, cheap labour and a strategy based on low prices? What is their target market? How equipped are they to deal with competition, within and without?

Domestic companies in China: Taking on the competition aims to find some answers. In a sense, China’s companies are victims of the country’s outward economic success. Foreign observers tend to focus on China’s rapid rise nearly to the top of the list of the world’s largest traders, its emergence as one of the world’s biggest markets for a whole range of goods, and its role as an important engine of global economic growth.

From the outside then, it would seem only natural for China to be producing highly competitive and interesting companies. But the view from the inside is different. The picture facing most companies operating inside China is a developing economy with low average incomes, weak institutions and rule of law, heavy government interference and corrupt officials. Looked at from this angle, it should not be surprising that most firms in China, far from being world-beaters, are in fact modest entities going about their business in a quite unexciting way.

Many of the best global companies today are from developed economies that gave them an opportunity to grow (by virtue of access to financing, sophisticated infrastructure and rich consumers), but at the same time set firm rules for operating in a fair and transparent manner (anti-trust laws, codes of business practice). Of course, incidents like the collapse of Enron and WorldCom in the US show that the corporate environment in advanced economies is not perfect. But these incidents also illustrate the immensity of the task facing Chinese firms. Enron and WorldCom are aberrations in US business, but in China’s

corporate world they are typical of the laxity of constraints facing most companies emerging from the country, or for that matter from any developing economy.

Of course many Chinese—and indeed quite a few foreigners—would argue that China is far from a typical country. And they would not be entirely wrong. When compared either with advanced economies at an earlier stage in their development or other transitional economies that are still emerging, China is different, by virtue of both its size and openness. Neither characteristic automatically offsets the institutional disadvantages that stem from being the product of a developing economy, with a legacy of central planning. But China’s size and openness nonetheless create a unique operating environment that gives local companies an edge over companies from East Asia, for example.

China’s huge population helps domestic enterprises to bolster their brands and develop new products and services—an advantage that does not exist in many other developing economies. However, this market is not captive, because China’s economy is much more open than many other significant economies at a comparable stage of development.

Openness means Chinese firms face heightened competition at home from foreign companies, big and small. This has its upside in that emerging local enterprises can learn from their more experienced international rivals. They can also improve technically because of the greater degree of globalisation in manufacturing (and the weak protection of intellectual property rights in China). It is another matter that emerging Chinese enterprises are not really using these advantages, nor the country’s robust GDP, to the fullest, but instead are relying on government help (and interference) to develop. As such, most of them are not nearly as strong as they should be.

Let’s take the characteristic of size. Compared with China, most other East Asian economies are small, constrained by their populations. Many



firms from economies like Taiwan, Hong Kong and South Korea were therefore forced to look towards external markets for growth, and indeed their policy makers deliberately followed export-led patterns of development. China also followed this trend, creating special economic enclaves and preferential policies for foreign investors involved in processing trade as the initial “kick-start” to economic reform.

However, as reforms proceeded and income levels rose, the domestic market took on new significance. With a population of 1.3bn spread over a continental land mass, China’s domestic market has undeniable bulk, and quantitative indicators are usually equally hefty. For example, every year more mobile phones are sold in China than in any other nation, and China is the world’s fifth-biggest market for cars.

This all adds up to impressive aggregates. In 2004—a quarter century after economic reform began—China’s nationwide private consumption totalled US$662bn (at 1996 prices to exclude the effect of inflation). This was well above the US$193bn recorded at a comparable stage of development in South Korea in 1990, or the US$115bn in Taiwan in 1991.

Of course, China’s very size ensures that any comparison with Taiwan (with a population of just 22m), will always be flattering. But China’s consumer market is not nearly as impressive when compared with those of Japan or the US at

comparable stages in their development. Take Japan: 25 years into its economic takeoff in 1980 (assuming a starting point of 1955), private consumption had already reached US$1.6trn (at 1996 prices once again). To find a consumer market of around US$600bn in real terms in the US it is necessary to go all the way back to the late 1930s, when the economy was still emerging from the Great Depression. China’s consumer market should be a lot bigger, and the similarity in scale of exports and domestic retail sales partly reflects repressed consumption.

This parity in exports and retail sales also signifies the unusual openness of China’s economy. In 2004 exports of goods and services accounted for an estimated 40% of China’s GDP. This is not a particularly high figure when compared with other newly industrialising East Asian economies that also pursued export-led growth. Ever since the late 1970s exports of goods and services have been equivalent to about 50% of GDP in Taiwan; in 2004 in both Malaysia and Hong Kong exports of goods and services accounted for more than 100% of GDP.

However, given the small size of these economies, they do not form a useful benchmark for China. When compared with other large economies, China’s openness to foreign trade stands out, in absolute as well as relative terms. For example, it was only in the early 1990s that the value of the US’s exports of goods and

China’s economy 2000-05

2000a 2001a 2002a 2003a 2004b 2005c

GDP per head (US$ at PPP)* 3,960 4,330 4,720 5,230 5,810 6,450

GDP (% real change) 8 7.5 8 9.3 9.50 a 9.3

Government consumption (% of GDP) 13.1 13.4 13.2 12.6 11.8 11.5

Budget balance (% of GDP) -3.6 -3.1 3.4 -2.6 -2 -1.5

Consumer prices (% change, average) 0.4 0.7 -0.8 1.2 3.90 a 2.1

Public debt (% of GDP) 30.4 30.6 31.4 31.2 29.9 29.8

Labour costs per hour (US$) 0.58 0.67 0.77 0.87 b 0.99 1.13

Recorded unemployment (%)* 8.2 9.3 9.7 10.3 9.9 9

Current-account balance (% of GDP) 1.9 1.5 2.8 3.2 4.1 5.5

Forex reserves (US$ m) 168,278 215,605 291,128 408,151 614,500 a 731,427

a. actual b. estimates c. forecasts * 2000-2004 estimates

Source: EIU’s Country Forecast, Country Data



services rose above US$600bn, and that was equivalent to a moderate 10% of GDP; when corporate America was emerging in the 1920s and 1930s, exports accounted for just 4-5% of GDP. In Japan exports of goods and services did not rise above US$600bn until 2004.

A useful, and possibly more apt, comparison is with India. Both countries have populations of over 1bn, and continental-sized economies, but have pursued different development strategies. China’s export-led manufacturing boom is largely a creation of foreign direct investment (FDI) which effectively serves as a substitute for domestic entrepreneurship. Until very recently, India maintained an import substitution policy, forcing local industry to supply the domestic market. As a result, India has strong private companies, better capital markets and a corporate environment more conducive for their growth. However, while India arguably has a healthier microeconomic situation, the macroeconomic indicators still show China’s superiority.

Export-led growth does seem to have been the crucial ingredient in China’s economic story, but exports are not the only indicator of China’s openness: both FDI and imports tell a similar story. Imports of goods and services are estimated to have accounted for almost 40% of GDP in 2004, up from under 10% in the first half of the 1980s, and, not surprisingly, this growth is intertwined with export surges. Imports such as oil, chemicals, components and machinery are required to serve both the domestic market, and fill export orders. China is already by far the world’s largest consumer of steel, the second-largest consumer of basic chemical products, and in 2004 became the world’s third-largest market for semiconductors.

As for FDI, China has been the largest developing-economy recipient for several years (and when a downturn in global merger-and-acquisition activity in 2003 depressed inflows to the US, China received more FDI than any developed economy as well). After peaking at 6.2% of GDP in 1994, FDI has been declining relative to the size of the economy, but even today remains above 3%, and by 2004 the accumulated stock of FDI was equivalent to 34%

of GDP. These large inflows have reinforced the economy’s openness, because they have financed much of the increase in China’s export capacity.

The size of China’s FDI inflow is unusual. In Japan inwards FDI has traditionally been miniscule, in both absolute terms and relative to the size of the overall economy. The slump in 2003 aside, FDI into the US has been on the rise in recent years, but this marks a break from the past: in only one year in the 1970s and 1980s did inwards FDI to the US account for more than 1% of GDP.

As for other emerging economies, FDI inflows into Brazil have been large in recent years, but the surge only began in the mid-1990s, and by 2004 accumulated FDI was still only equivalent to around 20% of the GDP of South America’s largest economy. The relative size of inflows has been much higher in Hong Kong, Singapore, Malaysia and Vietnam, but in the larger East Asian economies of Taiwan and South Korea the accumulated stock of FDI in 2004 was only equivalent to around 10% of GDP. China, with an accumulated stock of FDI that runs at 34% of GDP, stands out.

The unusual openness of the Chinese economy to foreign investment is a direct consequence of government policy. Ever since the process of reform and opening began in the late 1970s, the government has sought actively to attract inflows of FDI, offering preferential tax policies and export-processing enclaves to foreign firms willing to set up manufacturing facilities in China, in a deliberate avoidance of the import-substitution policies pursued by India and many other developing countries.

Why do these arguments matter? For a start, they illustrate the complexity of the institutional and social context in which the political logic for economic reform must be negotiated. This complexity in turn has implications for the development of China’s own companies, and certain constraints on private enterprise.

As mentioned earlier, domestic companies in China should be sturdier, given the economy’s advantages of a robust GDP, openness and size. That they are not—yet—is one reason why a Chinese investment wave overseas is still a while away.



their average selling prices and profit

margins. Foreign firms have been forced

to cut costs in an attempt to retain market

share, losing profitability.

These intriguing inconsistencies

prompted this second report. Its focus is

squarely on Chinese domestic companies,

and their efforts to adapt to fast-changing

circumstances. Paradoxically, there is

often the sense of a reverse image—both

MNCs and domestic companies bemoan

the lack of independence, strategic

thinking, people management skills and

flexibility among employees. The list

goes on—complaints by local companies

about uneven playing fields, opaque

regulations, labour shortages, local

protectionism and strategic zig-zags by

head office are all eerily familiar to MNCs,

hinting at systemic issues in the China

business environment, as well as all-too-

human organisational misbehaviour.

For all the convergence, however, there

is still a sense of two solitudes existing

between the two business cultures. Local

enterprises exhibit an overwhelming sense

of urgency, resulting in compressions—

of time, and of preparatory steps—and

an over-reliance on technical solutions

as shortcuts to accelerate the pace. Many

Chinese businesses hope to advance

their businesses by investing more and

buying more and newer technology, rather

than get better returns out of existing

capital or their own human resources by

empowering their staff. Taking templates

from assembly lines and applying them

to management processes as a way to

fast-forward modernisation may work for

some skills, but not human capital and

the “soft skills” that are necessary for true

innovation. Domestic companies in China:

Taking on the competition provides a series

of views, from differing angles, into what

forces are shaping the often misleading

perception of China as a uniform

competitive landscape.

A sequel?

In other words, and in contrast to

the common perception of an increasing

focus on the Chinese domestic market,

companies that responded to our survey

expect an increase in the proportion

of sales generated by exports over the

next five years. Why is that? Is it because

of restrictions or weaknesses in the

local market, fragility of the consumer

base, or difficulty in overcoming market

barriers? After all, foreign firms are far

from powerless. World Trade Organisation

accession has brought in a slew of lower

tariffs and market-opening measures,

and the country’s improved regulatory

environment is giving MNCs the

opportunity to use sophisticated brand-

building and marketing strategies.

The problem is that these local

counterparts are far more numerous

and aggressive than before. Moreover,

international competition is also tougher,

with the appearance of even more players.

Costs drive this phenomenon, with

almost two-thirds of MNC respondents

identifying lower prices as the main

competitive strength of domestic

companies, hinting at a lemming-like race

to the bottom. Local firms seem willing

to accept profit margins that are well

below those generally demanded by their

overseas counterparts, to the point that

success for domestic companies appears

not to be measured by profit margins

at all, but by market share. This not

only confounds conventional cash-flow

planning, but also seems to be an ironic

emulation of the “China dream” that has

mesmerised so many expatriate firms in

this market since the 19th century.

Yet while local firms are able and

willing to price goods at a very low level,

domestic companies have also been going

upscale, at the same time that MNCs have

been trying for economies of scale, to

push prices down. By selling upwards,

domestic firms have been able to raise

Domestic companies in China: Taking on

the competition is in some ways a sequel

to a previous study by the Economist

Intelligence Unit titled, Coming of age:

Multinational companies in China, pub-

lished in June 2004. The latter focused

on the perceptions of multinational

companies (MNCs) of the competitive-

ness of Chinese enterprises. In answer

to the question, “How significant is

competition from domestic (as opposed

to foreign-invested firms) to your China

business?” 25% of respondents replied

“very significant”, and 38% stated “quite

significant”.

There was plenty of evidence that

MNCs were keen to fight back against

local competitors. Fully 47% of MNC

respondents acknowledged that their

companies had adapted their China

strategies in response to the challenge of

domestic competition.

Impressions and anecdotal evidence

from MNCs also fed into our analysis:

“Local competitors have emerged

quickly and fight dirty, often stressing

investment and market share rather than

productivity and profit, and using below-

cost pricing to achieve their aims.” To a

certain degree, this is self-evident. Local

firms are much more comfortable than

foreign firms with navigating through

the corruption and regulatory grey areas

that remain such an important feature of

China’s business environment. However,

is it accurate to describe them all as

having a “home-turf advantage”? The

closer we looked, the more ambiguities

appeared. For example, while it is fair

to say that local companies generally

have cheaper payroll and supply costs,

is it true that their cost of capital is

“low, if not wholly non-existent”? We

knew from talking to many local private

entrepreneurs that this was not the case,

and that indeed their quest for working

capital was a lot more complex.

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domestic companies in china (Full pages)graphics.eiu.com/files/ad_pdfs/domcomp1_12WP.pdf · Domestic companies in China Taking on the competition Preface Domestic companies in China: