eu_china trade and investment relations

8/7/2019 EU_China Trade and Investment Relations

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Study on the Futu reOpportunities and

Challenges of EU-ChinaTrade and Investment

Relations

Study 8:Distribution/Retail

Study Experts:

Stephen MichaelAlexander vanKemenadeCasper Jacobsen

A project implemented by:

This report was commissioned and financed by theCommission of the European Communities. The viewsexpressed herein are those of the Consultant, and do

not represent any official view of the Commission.

EU-China Trade and Investment Relations Study 8 of 12: Distribution/ Retail 1


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EXECUTIVE SUMMARY

China represents a great opportunity forinternational retailers, and due to a relativelyliberal investment environment, offers agreater potential than many other servicesectors. The dual attraction of a large and

fast-growing domestic market, together withthe extensive sourcing opportunities, makesChina an indispensable part of anyinternational retailers global strategy.

Competitive Strengths and MarketOpportunitiesFor European retailers, the future potential inthe Chinese market is positive. Chinese retailand wholesale sales of consumer goods areexpected to reach more than EUR 618 billion 1 by the end of 2006. Of this figure,approximately 4% of sales (EUR 24.7 billion)are by foreign retailers. Assuming currentgrowth trends continue, the total value of salesin the Chinese market could increase to aroundEUR 916 billion by 2010. European retailersshould be able to capture a significant portion of these sales. Chinas comparative advantage liesin leveraging its vast pool of surplus unskilledlabour through labour-intensive manufacturing.Competitiveness in retail, however, is gained byfocusing on lean operations, supply chainmanagement, integrated procurement,effective quality controls and managementflexibility as well as the ability to identify withlocal consumer preferences. Due to the

weaknesses of Chinese competitors in theseareas, predictions based on current markettrends suggest that the foreign-owned marketshare could double by 2010.

Recent surveys suggest that a new type of consumer is emerging in China, one that doesnot mind paying up to 20% more to ensureproduct quality, particularly when it comes tofood safety. Foreign retailers are in a primeposition to take advantage of the increasingdisposable incomes of Chinas inhabitants.European companies have been among themost pioneering in ensuring food safety,helping to build consumer trust and boost thecompetitiveness of food retailers as well asincreasing productivity for distributors.

Obstacles to Trade and I nvestmentWhile challenges to European and otherforeign retailers largely remain operational innature (e.g. recruitment and retention of talented staff, streamlining fragmented andold-fashioned distribution networks, etc.)there still remains some regulatory challengeswhich restrain foreign retail expansion. Whilemany of these elements are not strictly

speaking in conflict with Chinas WTOcommitments, they are often not implementedtransparently and involving excessive red tape

for foreign retailers. These include limits ontotal store outlets a foreign majority ownedcompany can open up, limits on store size, andlimits on the sale of certain products. Eventhough local authorities can now authorise theopening of new stores, some provisionsstipulate that central-level approval must still

be sought after certain thresholds have beensurpassed (e.g. number of stores in China). Anumber of other non-regulatory obstacles alsoexist, such as difficulties in obtaining land-userights, and a lack of transparency, particularlyin sub-sectors such as media. Counterfeiting isalso a problem, particularly for brand-reliantproducts.

Policy Recommendations

1. Lobby the Chinese government for equalregulatory treatment of foreign retailersincluding:

a. Removing the conditions on foreignmajority ownership.

b. Removing the conditions forcentral-level approval.

c. Removing the remaining productrestrictions

d. Clarifying or abolishing city planningrequirements.

2. Improve and enhance the use of methodologies to assess impacts of proposed EU anti-dumping measures,which can often hurt European retailers

(and consumers) sourcing goods fromabroad. While there are currentlyinstruments in place such as theCommunity Interest Test, there has beensome criticism of its effectiveness.

3. Support Chinese customs reform to ensureuniform implementation of the WTOCustoms Valuation Agreement, and reduceCustoms formalities. This may be achievedthrough the Trade Facilitation negotiations.Some priority areas for the negotiationsinclude reduction of excessivedocumentation requirements and greater

coordination among local customsauthorities to prevent inconsistencies invaluation procedures. Onerous testing andcertification requirements (and in manycases inconsistent application) also makesthe importation of goods a problem forretailers operating in China.

4. Establish inquiry points for market entry,which can be especially helpful for SMEs asthey navigate the complex administrativeinfrastructure.

Recommendations for CompetitivenessSince European retailers already findthemselves in a competitive position vis--vis



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domestic retailers, few radical changes in thecurrent direction of European retailers arerecommended. Nonetheless, a few importantkey principles are emphasised.

1. Build scale. Currently, no single retailer inChina is large enough to leveragecost-cutting logistics capabilities inprocurement, inventory management anddistribution.

2. Be involved in local/community policies.For an industry where each new storerequires approval, good relations withboth the central and local government arearguably the most important asset for

expansion in China.

3. Be flexible. China houses a kaleidoscopeof different consumer preferences andregulatory environments.

4. Aggressively manage supply chains. Asretailers cut production costs by sourcingfrom China, problems remain with risingcosts from supply chain impediments.

5. Be actively involved in the development of trade policy in Europe and lobby on behalf of consumers.



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TABLE OF CONTENTS

Executive Summary ........................................................................................................................... 2

1. Introduction .................................................................................................................................. 7

2. Over al l Sector ................................................................................................................................ 7

2.1 China in the global context................................................................................................7

2.2 Consumption Patterns .......................................................................................................8

2.3 Recent reforms ...............................................................................................................10

3. Ent ry an d Exp ans ion of Fo rei gn Ret ail ers in Chin a ............................................................ 12

3.1 Race for Market Share .....................................................................................................12

3.2 Forms of Foreign Investment: JV vs. WFOE ........................................................................ 14

3.3 Geographic Expansion .....................................................................................................14

4. Com pe ti tiv en ess I ssu es .................................................................................................... 17

4.1 Concentration.................................................................................................................17

4.2 Expansion Strategies: M&A vs. Organic Growth ..................................................................17

4.3 Productivity and Profitability .............................................................................................17

4.4 Challenges and Opportunities ...........................................................................................18

5. Re ma in in g M arke t A cce ss Obs tacles ................................................................................. 21

5.1 Regulatory Restrictions ....................................................................................................22

5.2 Transparency-Related Issues ............................................................................................24

6. Ou tlo ok an d Sce na rios ...................................................................................................... 25

6.1 Scenario 1 - Baseline.......................................................................................................25

6.2 Scenario 2 - Optimistic scenario........................................................................................ 26

6.3 Economic Impact of Baseline vs. Optimistic Scenario ...........................................................26

7. Re co mm en da ti on s ............................................................................................................ 27

7.1 Policy Recommendations..................................................................................................27

7.2 Recommendations for Competitiveness..............................................................................28

An ne x 1: Dist rib uti on / Ret ail Gove rn men t Stru ctu re ........................................................................ 30

Ann ex 2 : Table o f Ke y La w s an d R egul ation s P ertain ing to th e R etail Sector ................................... 31

Annex 3: Factors Influencing Competitiveness in the Chinese Market ............................................. 32

An ne x 4: I nd us try Sur vey Re su lts ................................................................................................... 33



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LIST OF FIGURES

Figure 1: China Retail & Wholesale Sales of Consumer Goods 1996-2010e....................................................8

Figure 2: Composition of Urban Household Expenditure 2005......................................................................9

Figure 3: Ownership Levels of Selected Household Goods ...........................................................................9

Figure 4: Chinas Population Structure 2004 ..............................................................................................9

Figure 5: Sales by Store Format in 2004 ...................................................................................................9

Figure 6: Composition of Consumer Spending by Income Group ................................................................10

Figure 7: Composition of Retail Sales by Company of Origin in 2004 ..........................................................12

Figure 8: Sales of Foreign Retailers by Store Format ................................................................................13

Figure 9: Number of Selected Foreign Retail Outlets in China by Region by Mid-2005 ................................... 14

Figure 10: Relationship between Provincial GDP per capita and Selected Retailers Hosted .............................15

Figure 11: Concentration Ration of Retail Industry in China.......................................................................17

Figure 12: Main Advantages of European Companies in the China Market ...................................................21

Figure 13: Strength of Chinese Competitors............................................................................................21

Figure 14: Market Access Obstacles for European Companies ....................................................................22

LIST OF TABLES

Table 1: Presence of Top 250 Global Retailers ............................................................................................8

Table 2: Top 25 retailers in China 2005...................................................................................................13

Table 3: Store numbers by region 2004 ..................................................................................................15

Table 4: Key 2005 Provincial Indicators, ranked by GDP per capita.............................................................16

Table 5: Performance Indicators by Company Origin in 2004* ................................................................... 18

Table 6: SWOT Analysis of European and Domestic Retailers .....................................................................20

Table 7: Economic Impact of Market Access Obstacles Industry Survey Results.........................................23

LIST OF BOXES

Box 1: Challenges for European companies to conduct business in the Chinese distribution sector - Voices from

industry..............................................................................................................................................23



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ABBREVIATIONS

CCC China Compulsory Certification

CCFA China Chain store and Franchising Association

DIY Do It Yourself

DOFTEC Department of Foreign Trade and Economic Cooperation

EU European UnionEUCCC European Chamber of Commerce in China

FDI Foreign Direct Investment

FICE Foreign-invested Commercial Enterprise

FIE Foreign-invested Enterprise

FTL Foreign Trade Law

GATS General Agreement on Trade in Services

GDP Gross Domestic Product

GRDI Global Retail Development Index

HS Harmonized System

M&A Mergers and Acquisitions

MNC Multinational CorporationMOFCOM Ministry of Commerce

RFID Radio Frequency Identification

SME Small and Medium-sized Enterprise

SWOT Strengths, Weaknesses, Opportunities, Threats

WFOE Wholly Foreign-Owned Enterprise

WTO World Trade Organization



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1. INTRODUCTION

For the global retail industry, little question of aChina threat, i.e. one that entails a flood of low-price substitute goods from China,currently exists. Unlike in the manufacturing

sector, China still has little competitiveadvantage in the service industries and isunlikely to develop such an advantage withinthe 5-year period covered in this study. WhileChinese retailers still largely dominate theirhome markets, there have been very fewsuccessful attempts to break into overseasmarkets.

On the other hand, European retailers,particularly the larger ones, have madesuccessful inroads into the Chinese market.The Chinese distribution sector is often said tobe one of the most open to foreign investment,particularly after a series of reforms in 2005.In fact, European retailers sometimescomplain that it is not the Chinese competitorsor government which pose a risk to theirbusiness, but protectionist measuresstemming from home governments. This isillustrated by the supply chain disruptionresulting from the 2005 textiles safeguards.

Nonetheless there remain some cross-sectoralchallenges which stem from the complexitiesof doing business in China. Though somediscriminatory and restrictive regulations still

exist, these are officially permitted under theconditions of Chinas WTO accession. There isplenty of red tape and a lack of transparency,usually associated with some form of corruption. Currently, few mechanisms ininternational law exist to address suchobstacles; hence a positive approach thatseeks to highlight the benefits which Europeaninvestors can bring, rather than a stick approach has been suggested by some of thecompanies interviewed for this study.

This study will begin with an overview of Chinas global role as both an investmentdestination and a sourcing opportunity forinternational retailers. It will then briefly touchupon consumption dynamics in China and thedevelopment of the Chinese retail industry.Foreign investment in retail and Europeaninvestment in particular, will then be examinedin more detail. This will be followed by asynopsis of regulatory developments andremaining obstacles.

A broad scope of retail sub-sectors shall becovered in this study. Due to the rise of large-scale retailing and the diversification of

inventories, product-delineated classificationof retail sub-sectors makes little sense, and itis more appropriate to view the sector as

delineated by retail format. Hence, unlessindicated otherwise, the retail sector will coverthe entire spectrum of products sold toend-users, with the exception of catering. Dueto data compilation methodologies in China, itwill sometimes not be possible to separatecatering from the rest, and to distinguishbetween wholesale and retail figures, thoughthis shall be clearly indicated.

This definition, while broad, is a useful one forthe purposes of this study, as the bulk of European retail activities in China is donethrough the hyper/supermarket format(Chinese statistics do not distinguish betweenhypermarkets and supermarkets). These carrya highly diverse assortment of goods rangingfrom food to household appliances and fashion.Some focus will be given to the householdappliances sector, however, this broad

definition will be adopted for the greater partof the study.

2. OVERALL SECTOR

2.1 China in the global contextDespite falling from 4 th to 5 th place o n the 2005Global Retail Development Index 2 (GRDI),China retains its position as one of the worldsmost attractive retail markets with a massiveconsumer base, rising disposable incomes anda high rate of urbanisation. In 2005 retailsales 3 reached RMB 5659bn, making China the7 th largest retail market 4 in the world and theworlds largest emerging retail market.

Hence there has been no shortage of international retailers entering the Chinesemarket in recent years, particularly since the2005 reforms, which in effect threw open thedoors of the domestic retail and distributionsector (see section 2.3 for details). This is seenin the increase of foreign investment projectsapproved by the Ministry of Commerce(MofCom). 1,027 foreign investment projectsin retail and distribution have approved by the

Ministry of Commerce since May 2005,compared to only 314 approved for the 12preceding years 5 .

As a result, competition between internationalretailers in China has intensified. This hasresulted in a drop in the nations ranking on theGRDI index, which includes market saturationas an important factor. By Janu a ry 2006, 31 of the worlds top 250 retailers 6 had alreadyestablished operations in China, ranking it11th (see Table 1 ) in terms of presence of MNC retailers. By comparison India, Asiassecond largest emerging market and No.1 onthe GRDI, hosts only 5 of the top 250 retailersin the world.



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Table 1: Presence of Top 250 Global R etailers

Rank Country No.

1 US 120

2 Japan 62

3 UK 61

4 France 45

5 Canada 44

6 Germany 43

7 Spain 41

8 Italy 36

9 Poland 32

10 Netherlands 32

11 China 31

12 Belgium 30

13 Portugal 29

14 Austria 26

15 Czech Rep. 24

16 Ireland 2417 Switzerland 23

18 Taiwan 23

19 Denmark 22

20 Puerto Rico 21

Source: Deloitte, Emerging Market Group 2006

In addition to the domestic market, Chinaprovides a valuable opportunity tointernational retailers in the form of sourcedgoods. While exhaustive data on sourcing byretailers is not available, some indication of thescale can be given by looking at figures madeavailable by individual retailers. Wal-mart,Carrefour and Metro together exported USD23.8 bn worth of goods from China in 2004,which exceeded total domestic retail sales of FIEs in China for that year. The largestexporter is Wal-mart with USD 18 bn worth of

exports. This has led some commentators toremark that if Wal-mart were a country, itwould be Chinas 7 th largest export market,ahead of Taiwan and Russia.

These observations point to the fact that forinternational retailers, Chinas role as asourcing destination still takes primeimportance when compared with its role as amarket. Due to relatively late liberalisation of the distribution sector, foreign investment hasbeen limited, and international retailers haveas of yet barely scratched the surface of thisvast market. This is due to change however, asforeign retailers increase their presence in thegrowing Chinese economy.

2.2 Consumption PatternsRetail sales of consumer goods have beenfollowing a path of steady growth for the last10 years, averaging 10.1% growth a year,

roughly in line with growth of per capita urbandisposable incomes, which have grown at anaverage clip of 10.9% for the same period toreach RMB 10,493 in 2005. A trend lineforecast suggests that by 2010, retails saleswill reach RMB 9.2 trillion ( Figure 1 ).

In terms of the composition of consumption,food is by far the largest item of urbanhousehold expenditure in China, accountingfor 36% ( Figure 2 ). However, as incomes rise,this figure has gradually declined while relativespending on items such as transport andcommunication has been on the rise. This isparticularly noticeable for automobiles, mobilephones and personal computers. Householdownership levels of these products hasincreased 6.8-, 7- and 4.3-fold respectively forthe period 2000-2005. 7

2.4 2.6 2.83 3.3

3.6 4.14.5 5

5.7 6.26.9

7.68.3

9.2

0

2

4

6

8

10

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

e

2007

e

2008

e

2009

e

2010

e

RMB trln

Source: China Statistical Yearbook 2006, Emerging Markets Group 2006

China Retail & Wholesale Sales of Consumer Goods 1996 2010e

Figure 1: China Retail & W holesale Sales of Consumer Goods 1996-2010e



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Food36%

Clothing10%

Householdappliances andservices 6%

Transport &Communication

13%

Health8%

Recreation,Cultural andEducation

14%

Housing10%

Other3%

Source: China Statistical Year Book 2006

Composition of Urban HouseholdExpenditure 2005

Figure 2: Composition of Urban HouseholdExpenditure 2005

One can expect this trend to continue in thelong run as incomes continue to rise. As arough comparison, food spending accountedfor only 13% of household spending in theEU-25 in 2003. Urban ownership levels of household goods in China, while having risenconsiderably over the past 2 decades, are stillrelatively low. Figure 3 outlines the growth of ownership levels in selected household goods.If the big ticket spending items in the 80s and90s were refrigerators and washing machines,then the current decade is marked by airconditioners, computers and mobile phones.Despite rapid growth, ownership levels stillremain relatively low and there remainsconsiderable room for growth (only 3.4% of urban households own a car and 41.5% ownPCs compared to roughly 46% and 55% in theEU-25 8 ).

0

20

40

60

80

100

120

140

160

2000 2001 2002 2003 2005 2006e

Units per 100 households

Mobile Phones

Microwaves

Air Conditioners

DVD Players

PCs

Source: China Statistical Yearbook 2006

Ownership Levels of Selected Household Goods

Figure 3: Ownership Levels of SelectedHousehold Goods

Population dynamics can also be expected to

have a significant impact on consumptionpatterns in China. Interestingly, China andEurope share remarkably similar population

structures (though for very different reasons),with a constrictive pyramidal shape that peaksin the late 30s ( Figure 4 ) 9 As a consequence,retailers in China will have to adapt theirinventories and retail formats to match anageing population. The rapid rate of Chinasurbanisation will provide retailers withhigher-density clusters of customers in thelong-run. The proportion of Chinas populationresiding in urban areas has risen from 29% in1995 to 43% in 2005, and the government hassignalled its intention to continue encouragingmigration from the under-employedcountryside.

0 20000 40000 60000 80000

0 to 4

10 to 14

20 to 24

30 to 34

40 to 44

50 to 54

60 to 64

70 to 74

80 to 84

90 to 94

Age

Population

Male Female

Source: China Statistical Yearbook 2006

China's Population Structure 2004

Figure 4: Chinas Popu lation Structure 2004

The most popular store formats continue to besuper/hypermarkets, specialty stores, and of course (though these are not documented),wet markets and neighbourhood grocers (seeFigure 5 ).

Department Stores

Specialty Stores

ConvenienceStores

2%

Other1%

* Data for firms with sales exceeding RMB 5 mn

Hyper/ Supermarkets

44%

Source: Statistical Yearbook of ChinaRetail Corporations 2005

Sales by Store Format in 2004*

40%

13%

Figure 5: Sales by Store Format in 2004



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0%

20%

40%

60%

80%

100%

2000 2005

HighMid-HighMidMid-LowLow

Source: China Statistical Yearbook, Emerging Markets Group 2006

Composition of Consumer Spending by Income Group

Figure 6: Composition of Consumer Spendin g by Income Group

However, recent surveys have shown Chineseconsumers to be moving away from traditionalto modern, large-scale formats for food safetyand convenience reasons. It is also interestingto note at this point how store formats in China,particularly hypermarkets, differ from theirEuropean or American counterparts. Thisrequires a look at Chinese consumerpreferences. Compared to a Western consumer,the typical Chinese hypermarket shoppertends to spend less (between RMB 60-70) pertrip, prefers fresh produce and consequentlymakes more frequent trips. They are also likelyto be overtly interested in hyeine and tend notto won a car.

Hence a typical hypermarket in China will belocated in densely populated urban areas, withseveral store levels (due to space constraints).They will stock lots of fresh produce (rows of live fish tanks, for instance), have smallerpushcarts, a considerably higher number of checkout lanes and no parking lots. Chinesefood products also tend to be packaged inmultiple layers of wrapping.

Another observable trend in consumerspending stems from the growing disparities of income distribution in China. While disposableincomes of high income groups have doubledin the 2000-2005 period, those of low incomegroups have seen much slower growth about30%- over the same period (see Figure 6 ).Hence, higher income groups are seeing asurge in consumer spending, contributing toan exploding market for big ticket items suchas cars and luxury goods.

Finally, the composition of GDP growth inChina is worth mentioning briefly in thecontext of consumption patterns. Domesticconsumption for the last few years was ataround 40% of GDP growth, approximately 20percentage points lower than the averagedeveloped economy. Growth has mainly been

driven thus far by investment and exports,despite government efforts to drive down thedisproportionately high savings ratio bysuppressing deposit rates. The main reasoncited for this phenomenon is the inadequatesocial safety net, which leads consumers tosave for a rainy day, as well as theunderdeveloped consumer credit market. AsChina develops its consumer credit, pensionand insurance systems and other aspects of social welfare, one can expect domesticconsumption to increase at a faster pace thangrowth in population and disposable income.

2.3 Recent reforms

Prior to China's WTO accession, foreigninvestment in the distribution sector washeavily restricted. In accordance with Chinasservices schedule and Article V paragraph 1 of Chinas accession protocol, a gradual approachwas taken to open the distribution sector andnow, four years after accession, Chinasdistribution sector has been significantlyliberalised in terms of provision of services andinternational trading rights. Chinas GATScommitments cover the following sub- sectors:

1. Commission Agency services consist of thesales on a fee or contract basis by an agent,broker or auctioneer or other wholesalersof goods/merchandise and relatedsubordinated services.

2. Wholesale Trade services consist of thesale of goods/merchandise to retailers toindustrial, commercial, institutional, orother professional business users, or toother wholesalers and relatedsubordinated services.

3. Retail services consist of the sale of goods/merchandise for personal orhousehold consumption either from a fixedlocation (e.g., store, kiosk, etc.) or awayfrom a fixed location and relatedsubordinated services.



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4. Franchise services consist of the sale of theuse of a product, trade name or particularbusiness format system in exchange forfees or royalties. Product and trade namefranchises involve the use of a trade namein exchange for fees or royalties and mayinclude an obligation for exclusive sale of trade name products. Business formatfranchises involve the use of an entirebusiness concept in exchange for fees androyalties, and may include the use of atrade name, business plan, and trainingmaterials and related subordinatedservices.

The main focus of this report is on retailingservices. Chinas service schedule prescribesthat three years after WTO accession, alllimitations on geographical location, numberof establishments, equity ratio and form of establishment of foreign service suppliers asspecified shall be fully lifted, with a fewexceptions. The following sections highlightthe main legal reforms which wereimplemented.

2.3.1. Foreign Trade Law AmendmentsOn 6 April 2004, amendments were made tothe Foreign Trade Law (1994) grantinginternational trading rights to Foreign InvestedCommercial Enterprises (FICE), anewly-established type of legal entity. Theamendments allowed for free import andexport of goods and technologies and allenterprises (including a FICE established

pursuant to the FICE Regulation) were grantedfull trading rights under these amendments.This provision, coupled with the subsequentgrant of distribution rights discussed below,allowed foreign companies unprecedentedaccess to the Chinese market.

2.3.2. The FICE RegulationWhereas the FTL amendments concern tradingrights, the Regulation on Management of Foreign Investment in the Commercial Sector(FICE Regulation) concerns the distributionrights of FIEs. Distribution rights areunderstood to include the right to engage inthe internal sale, offering for sale, purchase,distribution or use of goods manufactured in orimported into China. In accordance with WTOcommitments, all goods in respect of theirinternal distribution are subject to nationaltreatment.

Prior to the passage of the FICE Regulation,foreign companies were required to distributegoods within China through JVs with a Chinesepartner. The FICE Regulation abolished thisrequirement, and introduced a new type of foreign-invested enterprise, the

Foreign-Invested Commercial Enterprise (FICE)which is permitted to distribute productswithin China. In the past, this type of change

has been implemented gradually by theChinese authorities, with new regulationsintroduced on a trial basis only, or withsignificant restrictions, such as high registeredcapital requirements and strict qualificationrequirements for investors. However, followingDecember 11, 2004 the FICE Regulationintroduced significant changes with relativelyfew restrictions.

2.3.3. Ownership and Entry ThresholdsThe FICE Regulation generally allows WhollyForeign-Owned Enterprises to distribute theirfull portfolio of goods throughout China.Certain quantitative entry barriers were alsoreduced. Entry threshold in terms of registeredcapital, average annual turnover and assetsfor foreign entities were lowered substantiallyfor foreign invested enterprises. Effective from11 th December 2004, foreign retail enterpriseswere required to have a minimum of RMB

300,000 registered capital, and Wholesaleenterprises were required to have a minimumof RMB 500,000. This is a marked departurefrom the previously prohibitive requirements.Requirements were re mo ved on averageannual sales and assets, 10 and geographicalrestrictions on the opening of new stores wereabolished, effectively opening the nationalmarket.

2.3.4. Application Process and Delegation of Approval AuthorityThe application process for obtaining FICEstatus involves two steps. The applicationmust first be submitted to the provincial-levelDepartment of Commerce and ForeignEconomic Cooperation (DOFTEC) approvalcommittee for preliminary review. Thereafter,the application is submitted to thecentral-level of MofCom for approval. The FICEregulation stipulates that the entire approvalprocess should be completed within fourmonths. Guidelines issued by MofCom inAugust 2005 helped clarify the procedure forestablishing a FICE and European enterprisesare now reporting that applications submittedare being dealt with within this four month

period and have generally allowed for asmoother application process.

As of March 2006, local DOFTECs are now in aposition to approve new FICE establishmentswithout central-level approval. This has beenwelcomed by the foreign industry as a positivestep in the liberalisation of Chinas distributionand retail sector, however, at present there areno experiences to verify the smooth operationof the new responsibilities of the local DOFTEC.

In general, the application documents requiredin order to obtain FICE status are identical tothe requirements for other foreign-investedenterprises (FIEs). However, the FICE



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regulation introduces one notable addition tothe requirements for retail FICE operations:foreign companies must now obtain a letter of approval from the local government(s) for thelocation of new outlets, indicating thatproposed new retail stores should adequatelyconform to the urban and commercialdevelopment plans of the local government(s).

Foreign industry has raised concerns on thisissue, as it gives local officials excessivediscretionary power in examining andapproving applications for setting up newstores. This requirement also implies thaturban commercial development differs on aregional basis. The foreign industry has raisedconcerns that this restriction is liable toirregular implementation across the Chineseprovinces and that local officials could abusesuch discretionary power as a market entrybarrier to restrict the number of foreigndistributor/ retailers while favouring Chinesecompetitors 11 . MOFCOM is currently amendingits central guidelines for conducting urbancommercial planning at the regional level,however, these are yet to be finalised.

3. ENTRY AND EXPANSION OF FOREIGNRETAILERS IN CHINA

3.1 Race for Market ShareLiberalisation of the retail sector came at arelatively late stage in Chinas reform process,with comprehensive lifting of investmentrestrictions on December 11, 2004 at least intheory. Effective liberalisation came later in2005 with the promulgation of new regulationsin April and December. While most leadingretailers had already established a presence inChina prior to this period, the relatively latereforms have resulted in a heated race to openor acquire new s tores. FDI in the wholesaleand retail sector 12 accounted for a mere 1.2%of total FDI in China in 2004. Although data for2005 is not yet available, in view of the surgein approved foreign investment projects in theretail sector after the reforms, one would

expect a dramatic increase in FDI.

At an initial glance, it seems that foreignretailers have gained a solid foothold in theChina market, with non-Chinese firms holdingabout 11% (see Figure 7 ) of total retail sales in2004. However, bearing in mind that datacollected in China only accounts for companieswith sales in excess of RMB 5 million, it is clearthat if smaller retail outlets were taken intoaccount the overall retail sales figures would bemuch higher. Estimates vary therefore on thesales share of foreign retailers in China,however, it is likely to be between 3-4%.

Domestic

83%

HK, Macau &Taiwan

6%

Foreign

11%

Data for firms with sales exceeding RMB 5 mn

Source: Statistical Yearbook of China RetailCorporations 2005

Composition of Retail Salesby Company Origin in 2004

Figure 7: Composition of Retail Sales byCompany of Origin in 2004

However, considering that the retail sectorhas only become de facto liberalised in 2005,foreign retailers have already notched upsome initial successes and are still expandingaggressively. Of the 100 leading retailers bysales in China, 17 were foreign (excludingcatering), contributing 20.6% of sales of thetop 100 (see Table 2 ). Among these 17 were6 Europe-based companies, whose combinedactivity accounted for 32.8% of sales byforeign retailers in the top 100, more thanany other single non-domestic group.



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Table 2: Top 25 retailers in China 2005CurrentRanking

2004Ranking Company Name

Sales (RMBmn)

Outlets(No.)

1 1 Shanghai Brilliance Group (Bailian) 72,074 6,3452 2 Beijing Gome Electronic Appliances 49,840 4263 4 Su Ning Electronic Appliances 39,718 3634 15 CR Vanguard (Hua Run Wan Jia) 31,299 2,1335 3 Dalian Dashang Group 30,117 1306 6 Beijing Hualian 20,800 747 10 Wumart Group 19,072 6598 9 Nonggongshang Supermarket Group 17,549 1,5729 5 Carrefour 17,436 7810 n/a Shanghai Da Run Fa 15,700** 6011 7 Shanghai Yongle (China Paradise) 15,166 19912 12 Chongqing General Trading Group 15,054 19113 16 Jiangsu Five-star Electronic Appliances 14,612 19314 11 Shangdong San Lian Group 13,201 27415 13 Trust-Mart 13,200 96

16 17 A. Best 11,801 7917 n/a Parkson Group 11,000** 3618 22 Hefei Department Store 10,500 5419 21 Lotus 10,060** 6120 19 Jiangsu Wen Feng Great World 10,001 61221 20 Wal-mart 9,934** 5622 23 Home World 9,217 8223 30 Li Qun Group 8,229 64324 18 Wuhan Wu Shang Group 8,072 42

25 26 Wuhan Zhong Bai Group 7,994 385Europe-based Retailers in top 100

27 n/a Hymall-Tesco 7,920 7828 24 Metro 7,546 2738 48 B&Q 5,160** 4840 36 Auchan 5,000** 1350 n/a Lufthansa Department Stores 3,559 8*Data excludes catering**Estimates

Source: China Chain Store & Franchising Association

This may not come as a surprise as retailers of European origin typically tend to have a globallymore diverse source of sales. While Wal-mart isby far the worlds largest retailer, only 19% of itssales came from non-US countries in 2002 13 .Sears, Roebuck and Co. likewise made 90% of its sales within the US. Carrefour and RoyalAhold on the other hand, saw 49% and 80% of sales in none-home base countriesrespectively. 14

More non-European foreign retailers, however,are entering the market. While the presentposition of Europe-based retailers remainsdominant, it still constitutes a decline from theposition held by Europe-based retailers in 2003,when they held over 50% of sales by foreignretailers in China. As for store formats, the data

in Figure 8 shows clearly that theHyper/Supermarket format is the preferredchoice for foreign retailers in China, comprising

86% of sales of foreign retailers in 2004. Sales of foreign-invested Hyper/Supermarkets accountedfor 21.5% of sales of all Hyper/Supermarkets inChina for the same year.

Hyper/ Supermarkets

86%

5%

ConvenienceStores

1%

Department Stores

7%

Hyper/ Supermarkets

86%

Specialty Stores

5% ConvenienceStores 1%

Single - BrandBoutiques

1%

Source: Statistical Yearbook of China Retail

Corporations 2005

*Data for companies with sales exceeding RMB 5mn

Sales of Foreign Retailers byStore Format 2004*

Figure 8: Sales of Foreign Retailers by Store Format



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3.2 Forms of Foreign Investment: JV vs.WFOEDue to regulatory restrictions, foreigninvestment vehicles in the pre-2005 periodwere mainly limited to Joint-Venture models.Despite the pitfalls of teaming up with a localcounterpart, local knowledge has provedexceptionally useful in retail due to the strongregional nature of retail operations.

China is often described as a kaleidoscope of diverse markets with each region protecting itsown industries, resulting in fragmentation of supply chains. Each region moreover has itsown opaque set of tax and finance rules anddifferent requirements for approvals. Localpartners are often able to help in managingthese regional complexities through their localnetworks, as well as in building indispensablegood relations with local governments. Hence,there was no rush to buy out JV partners

following the 2005 reforms as one might expect.This is in contrast with other sectors consideringthe degree to which foreign companies havebeen complaining about their partners inindustries such as ICT and automotive. Foreignretailers have adopted a flexible attitude,buying out the more burdensome partnerswhile keeping the useful ones.

In addition, since localisation is encouraged bythe Chinese government, keeping domesticpartners contributes to the projection of astrong local image, which has helped manyretailers minimise red tape and curry favour

with local governments. Some retailers evenconsider this an essential strategy, consideringthe plethora of approvals required to open newstores and restrictions placed on 100%foreign-owned companies. Nonetheless,WFOEs are the preferred type of investmentfor most foreign retailers entering Chinapost-2004. According to the Ministry of Commerce, roughly 61% of applications formarket entry by foreign retailers in 2005 wereunder the WFOE format.

3.3 Geographic ExpansionIn terms of geographic expansion, foreignretailers have already established a solidpresence in first-tier cities and have alreadybegan to move into second- and third-tier cities,the populations of which having soared due tourbanisation. Figure 9 shows, based on aselection of global retailers, the geographicaldistribution of foreign retailers in China. Thewealthier coastal regions, with cities such asShanghai, Beijing and Shenzhen, are notsurprisingly host to the highest density of stores.We can also see that international retailers haveentered most of Chinas provinces, with Tibet,Ningxia, Hainan among the exceptions. Apart

from the coastal provinces, Sichuan provincewith the mega-city Chongqing in central Chinais also heavily targeted.

No. of Selected* Foreign Retail Outlets in Chinaby Region by Mid-2005

None1-5 stores6-10 stores11-20 stores

More than 20 stores*Walmart, Carrefour, Metro, Auchan, B & Q, IKEA, Lotus, ItoYokado, Tesco, Parkson, Leroy Merlin

Source: Ministry of Commerce 2005, Emerging Markets Group 2006

Figure 9: Number of Selected Foreign RetailOutlets in China by Region by Mid-2005

Shanghai, Beijing and Shenzhen are thewealthiest cities in China and consequentlyboast a modern retail sector. These are thefirst targets of foreign retail expansion in China.They are already home to a large number of supermarkets and hypermarkets, owing tohigh population densities and a boom in carownership. While the hypermarket segmentstend to be dominated by foreign retailers,domestic companies hold most of the market

in the supermarket segment, with SOE giantslike Lianhua and Hualian (Bailian Group) andNonggongshang in the lead.

Some cities, notably Shanghai are beginningto see a convenience store boom, filled by therapidly-expanding number of suburbanresidential compounds. Usually ranging from300-1000 square metres in size, these storeshave filled a gap in the markets for formatswhich are larger and cleaner than thetraditional Xiaomaibus 15 moreconveniently located than larger 2000-3000square meter supermarkets. Conveniencestores initially followed a 7-11 modelpossessing in-house processing functions suchas the ability to serve warm, cooked foods, butthis model has seen limited returns on themuch higher investment required outside of the major metropolises.

but

Many of the convenience stores chains such asQuik, Kedi and Alldays, are owned by the SOEgiants like Bailian and Nonggongshang,though Japans Lawsons and Family Mart, aswell as Taiwans C-Stores have alreadyestablished in Shanghai. 7-11, having gained afoothold in southern China, is taking its firststeps in Beijing. While European retailers haveonly made limited inroads, the convenient



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retail format promises to become a strongerfeature of the retail landscape in China, withstore densities in cities such as Shanghaialready reaching European levels. Despitesome efforts from municipal governments tocurb the expansion of convenience stores dueto a desire to preserve the Xiaomaibus, retailsales by convenience stores in China increasedby 65.5% to RMB 13.8 billion in 2004.

3.3.2 Increasing focus on 2nd and 3rd tier citiesFollowing entry into first-tier cities, internationalretailers focused on the surrounding urbanagglomerations, particularly the Pearl River delta(Guangzhou, Shenzhen), the Yangtze River delta(Shanghai, Hangzhou, Nanjing) and the Bohai

rim (Beijing, Tianjin, Dalian, Shenyang), asindicated by the 3 darkest areas in Figure 9 .Due to the lack of scale, nationwide distributionnetworks are not yet feasible; however, thesethree areas will form the basis for regional

distribution networks, which will to some degreebenefit from economies of scale. As foreignretailers build their national presence and reacha critical mass in the geographical distribution of stores, they will be able to take advantage of nationwide logistics platforms. Wal-martexecutives, for instance, have already pointedout that China will be the only other country inthe world where the retailing giant will be able toreplicate its super-efficient logistics capabilities.With coastal markets approaching saturation,attention is shifting towards the inland. In 2004,inland regions saw the highest growth in newstore openings; with the number of stores in

western China growing over twice as fast as inthe central or eastern regions. Moreover,growth in store numbers in 2 nd tier cities(32.6%) outpaced those in 1 st tier cities(15.7%). The move inland is being drivenmainly by smaller specialty and conveniencestores which have less space requirements and

hence are able to be more flexible in choosinglocation, typically around newly-built residentialcommunities. Since inland regions are usuallypoorer, there is lower car ownership, andtherefore consumers tend to do their shoppingat a local, neighbourhood level, thus renderinglarge-scale formats, which tend to be fewer innumber and require more travel to reach, lessattractive. This is reflected in Table 3 . As onemoves west in China, the proportion of stores ina large retail format diminishes.

Table 3: Store numbers b y region 2004

Overall ChangeYoY

Proportionof largestores **

East 38170 14.2% 34.4%

Central 6696 15.1% 32.0%

Western 10025 37.7% 14.3%*Data for stores with annual sales exceeding RMB 5 mn**Large format covers Department stores, Hypermarketsand SupermarketsSource: Statistical Yearbook of China Retail Corporations 2005

GDP per capita has been identified throughcorrelation analysis as the most importantfactor in drawing foreign investment in retail,as suggested by the strong positive correlationin Figure 10 . Other important factors includepopulation and infrastructure development (asmeasured by road density), as well as thedegree of urbanisation. Current householdwealth however, has not been the soleconsideration for international retailers.Despite the emphasis on coastal regions,

investment has reached more remote andimpoverished provinces such as Qinghai,Gansu and Xinjiang, with Carrefour alreadyrunning two stores in Urumqi (which do not sellpork, owing to the large Muslim population inXinjiang).

0

10

20

30

40

50

60

0 5 10 15 20 25 30 35 40 45 50 55

GDP per capita (RMB '000)

No. of stores

Source: PRC Ministry of Commerce, Emerging Markets Group 2006

Relationship between Provincial GDP per capita andSelected Retailers Hosted

Figure 10: Relationship betw een Provincial GDP per capita and Selected Retailers Hosted



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The two Xinjiang Carrefours illustrateCarrefours expansion strategy in China, whichso far has worked well and made theFrance-based firm the leading foreign retailerin China in terms of sales. Xinjiang is one of Chinas most impoverished regions, making itan unattractive destination for mostinternational retailers. Only Carrefour andMalaysia-based Parkson have so far venturedinto the western province. Short-term gainsseem to be less of a concern in the case of theFrench chain. Securing prime locations inmajor cities nationwide is of much morepriority, as shown by Carrefours expansion in2000-2001, where it had ignored central-level

approval and dealt directly with localgovernments in opening new stores. Thecentral government reacted by freezingCarrefours expansion for over a year, but bythen the stores had already been opened andthe best locations were secured.

Carrefour has been commended fordemonstrating the flexibility required to dobusiness in China, while its competitors, suchas Wal-mart, have been criticised for gettingbogged down in negotiations at the expense of valuable expansion time. Table 4 provides anoverview of Chinese provincial indicatorsranked by GDP per capita.

Table 4: Key 2005 Provincial I ndicators, ranked by GDP per capita

Rank Province /Municipality

GDP per capita 2005

(RMB)

GDP per capitaCAGR

2001-2005

Total Retail Sales(RMB bn)

Population(mn)

% of population

living inurban areas

1 Shanghai 51486 10.3% 245 17.8 89.1%2 Beijing 44774 11.6% 219 15.4 83.6%

3 Tianjin 35452 14.6% 105 10.4 75.1%

4 Zhejiang 27435 14.3% 365 49.0 56.0%

5 Jiangsu 24489 15.3% 416 74.8 50.1%

6 Guangdong 24327 9.9% 637 91.9 60.7%

7 Shandong 20023 16.3% 448 92.5 45.0%

8 Liaoning 18974 10.1% 264 42.2 58.7%

9 Fujian 18583 9.9% 200 35.4 47.3%

10 Inner Mongolia 16327 20.4% 89 23.9 47.2%

11 Hebei 14737 13.5% 252 68.5 37.7%12 Heilongjiang 14428 10.8% 156 38.2 53.1%

13 Jilin 13329 12.0% 125 27.2 52.5%

14 Xinjiang 12956 10.9% 48 20.1 37.2%

15 Shanxi 12458 16.9% 88 33.6 42.1%

16 Hubei 11419 13.0% 267 57.1 43.2%

17 Henan 11287 16.0% 281 93.8 30.7%

18 Chongqing 10974 15.6% 96 28.0 45.2%

19 Hainan 10804 9.4% 22 8.3 45.2%

20 Hunan 10293 13.3% 207 63.3 0.0%

21 Ningxia 10169 12.0% 14 6.0 42.3%22 Qinghai 10006 12.8% 12 5.4 39.3%

23 Shaanxi 9881 13.7% 97 37.2 37.2%

24 Jiangxi 9410 13.9% 106 43.1 37.0%

25 Tibet 9069 11.0% 6 2.8 26.7%

26 Sichuan 8993 13.9% 238 82.1 33.0%

27 Anhui 8783 12.3% 150 61.2 35.5%

28 Guangxi 8746 14.3% 97 46.6 33.6%

29 Yunnan 7804 9.8% 88 44.5 29.5%

30 Gansu 7456 12.2% 54 25.9 30.0%

31 Guizhou 5306 13.4% 58 37.3 26.9%Source: China Statistical Yearbook 2006, Emerging Markets Group 2006



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4. COMPETI TIVEN ESS ISSUES

4.1 ConcentrationThe retail industry can generally becharacterised as a highly competitive industrywith low levels of concentration, low-entrybarriers and high-entry and exit rates. Thereare typically a large number of relatively smallcompanies competing with naturallyhighly-differentiated products and withlocation being an important competitive factor(a convenience store located in a residentialarea has obvious advantages over one in anindustrial complex).

The exception is food retail, where, particularlyin developed countries, concentration levelshave seen notable increases in the recentdecade, with the emergence of internationalretailing conglomerates such as Wal-mart,

Carrefour and Metro. In the EU, for instance,the to p 20 food retailers accounted for 40% of sales. 16

Concentration Ratio of Retail Industryin China

0%2%4%

6%8%

10%12%

1999

2000

2001

2002

2003

2004

2005

Market Share

Top 100 firms Top 10 firms

Source: China Chain Store & Franchise Association

Figure 11: Concentration Ration of RetailIndustry in China

Chinas retail industry however, is highlyfragmented, with the top 100 retailersaccounting for 10.5% of total retail sales in2005 (see Figure 11 ). While a wave of

government-backed industry consolidation istaking place, competition remains fierce.Some retailers have pointed out that thedistribution of profit margins across the supplychain are inverted: Where in Europemanufacturers see the lowest margins,followed by distributors, and retailers seeingthe highest, in China it appears to be the otherway around. While it will still take some timebefore concentration levels reach the samelevel as Europe, one can expect these levels toincrease in coming years.

The current degree of industry fragmentationmakes comprehensive data very difficult toobtain. To simplify matters, statistics are only

compiled in China for retailers with sales inexcess of RMB 5 million, thus excluding theomnipresent Xiaomaibu - small-scale,family-run convenience stores. 17

4.2 Expansion Strategies: M& A vs.Organic GrowthDue to increasing levels of market saturationand fragmentation of the industry, expansionthrough mergers and acquisitions (M&A) hasbeen an attractive option for retailers bothforeign and domestic - in China. Most retailersare choosing M&A as a fast-track growthoption - Tesco became a player overnight bychoosing to enter China through theacquisition of a 50% stake in Taiwan-basedTing Hsin Groups Hymall.

M&A also represents a way to eliminatecompetition. B&Qs 2005 acquisition of 13stores from Tengelmanns OBI effectively left it

with one real competitor home improvementmarket leader Orient Home. It also helpedB&Q jump 10 places up the Top 100 list to 38 th place, boosting its sales an estimated 156%over 2004.

Most importantly, however, has been the pushto build scale, which allows retailers to drivedown purchasing costs and create valuethrough high-volume, low mark-uptransactions. At the time of writing, the mediahas been reporting a silent bidding warcurrently underway between giants Carrefour,Wal-mart, Tesco and Lianhua for Taiwan-basedTrust-Mart (15 th place). Such a deal,regardless of which party wins, would be themost significant act of consolidation for Chinasretail industry since the creation of Bailian (seenext section), as offers from all 4 bidders a rereported to have been in excess of USD 1 bn. 18

Domestic companies are participating ingovernment-backed efforts to build scale,none more so than state-owned mammothShanghai Brilliance (Bailian), which has beendesignated a flagship enterprise in line withthe 11th 5-year programme.

Bailian was created in 2003 as the result of amerger between then market leader Lianhua,Shanghai Yi Bai, Hualian and Haomeijia. In2005, Bailian took a 45% stake in DalianDashang (no.5), another SOE, forming part of a government-orchestrated effort not only toresist the emergence of foreign retailers, butalso to create a national champion that will beable to expand into overseas markets.

4.3 Productivity and ProfitabilityForeign companies, with relatively advancedbusiness models, operational processes andmanagement, have on the whole achievedgreater profitability and productivity.



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Table 5: Perform ance Ind icators by Company Origin in 2004*

Store Format Company Origin Return onSalesReturn onAssets

Sales/Employee(RMB '000)

Sales/ m of floor space(RMB)

Domestic 1.46% 4.55% 520 15346

HK, Macau & Taiwan 0.06% 0.18% 529 13984Overall

Foreign1.74%

5.33% 610 23965Domestic 0.81% 2.58% 426 13400

HK, Macau & Taiwan 0.23% 0.64% 579 14000Hyper/Supermarkets

Foreign 1.22% 4.64% 643 27500

Domestic 2.09% 7.06% 698 18800

HK, Macau & Taiwan 0.92% 1.33% 270 30200SpecialtyStores

Foreign 2.43% 3.16% 722 9500*Data for companies with sales exceeding RMB 5 mnSource: Statistical Yearbook for China Retail Corporations 2005, Emerging Markets Group 2005

Margins, returns on assets, sales per employee,and even sales per unit of floor space are all

significantly higher for foreign companies thanfor domestic competitors, as shown in Table5 .

Due to cutthroat competition, margins 19 arerazor-thin. The national average, comprisingforeign and domestic firms across all retailformats, is 1.41%, compared to 5.7% fornon-food and 10.5% for food retail in the EU.While foreign retailers have the highestmargins in China, the gap in profitabilitybetween foreign retailers and domestic ones,particularly SOEs, is not as high as in othersectors. A simple explanation for this fact isthat many SOEs enjoy monopoly status in theirsub-sectors due to restrictions on sales of certain products, for instance in tobacco.Furthermore, SOEs receive the best storelocations from local authorities.

Another explanation for the low margins maylie in the fact that the attention of foreignretailers management has been largelyfocused on expansion. Foreign retailers havebeen expanding their number of stores ataround 20% a year. With so much of themanagements attention on opening or

acquiring new stores, less focus is given tostreamlining operations or on improving salesof existing stores. The productivity gapbetween foreign and domestic retailers is moresignificant. This is not surprising consideringthat state-owned retailers are obliged to retainstaff in order to keep unemployment down. Avisit to most state-owned department stores inChina, with droves of idle blue-shirtedemployees sipping tea and chatting awaybehind the sales counters, will confirm this,though this is starting to change in recentyears.

Looking more closely at different store formats,one sees that the advantage of foreigncompanies is strongest in the

hyper/supermarket segment. As we saw in theprevious section, hyper/supermarkets are the

most important segment for foreign retailers inChina, accounting for 84% of all sales byforeign retailers with sales exceeding RMB 5million in 2004.

The source of revenues for many retailers isalso worthy of mention. Because of the marketpower exercised by many of the larger retailersthey are able to negotiate extremelyfavourable conditions with suppliers. In manycases, suppliers must pay a fee to retailers forstocking their products. Large retailers arealso often able to shift a significant proportionof market risk onto the suppliers bynegotiating free return of unsold products.

4.4 Challeng es and OpportunitiesAs is generally the case with foreign companiesin China, the competitive edge of foreignretailers is maintained through their innovativeproduct formats and streamlined management.For instance, the now popular hypermarketformat was introduced by foreign retailers.Foreign retailers will no doubt continue to playa key role in bringing innovative technologies,such as RFID, to China in the future.

4.4.1. Fostering and keeping talentQualified supply chain managers are in greatshortage in China. The China Chain store andFranchising Association (CCFA) forecasts thatnationwide demand for personnel withuniversity-level logistics training will reach300,000, while there are only 5,000 logisticsgraduates annually. Considering that each newhypermarket requires around 400 new staff,including around 50 managerial staff,recruiting strategies take a high priority forretail executives in China.

Competition among retailers is intense andsalary levels for middle management areamong the highest in the country. Foreign



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retailers are generally able to offer competitivepackages to most managers, and have beenthe most pioneering in training staff. Most of Chinas qualified logistics professionalsreceived their training while working forforeign companies. Carrefour and Wal-mart allhave training centres in China, and use strongincentive schemes to retain their staff. Otherretailers have tried selective hiring practices,such as targeting older workers, since workersyounger than 30 tend to move on quickly.

4.4.2. Managing supply chainsForeign retailers have yet to leverage one of the most crucial competitive instruments inretail lean logistics and efficient supplychains. Foreign retailers currently have littlechoice but to rely on local distributors as theylack the type of scale required to be effectivelyserved by a nationwide distribution platform.

A survey of over 100 fast-moving consumergoods retailers commissioned by the CCFArevealed that overall satisfaction levels withsuppliers was only at 51% in 2005.

Chinas local distribution networks are, asmentioned earlier in this study, highlyfragmented and have very low levels of technological sophistication. Shipments passthrough three, sometimes four distributorsbefore reaching the client. An industryobserver once remarked that a typical Chinesedistribution company consists of a driver and atruck. In some provinces, trucks may evencome as a luxury and the more commonSanlunche, tricycles outfitted to carry goods,are sometimes relied upon.

This results in lost revenues and increasedcosts for retailers. Another CCFA survey of 13fast-moving consumer goods including varioustoiletries and beverages placed the likelihoodof a customer in any given hyper/supermarketfinding at least one of the items to beout-of-stock at 9.9%.

The situation however, is improving. The entry

of foreign 3rd

Party Logistics providers hasheightened competition among distributors,and the growing scale of retailers has putpressure on distributors to consolidate in aneffort to counteract growing buyer power.

4.4.3. Differentiating ProductsThe early phase of Chinas retail modernisationwas marked by intensive price competition inan effort to win over notoriouslyprice-conscious Chinese consumers. A factorwhich made it easier for foreign players to beprice-competitive in retail (a phenomenonalmost unheard of in other sectors) stems fromtheir ability to leverage global sales networksto purchase in bulk from China. This however,only works to a certain extent since manygoods sold on the Chinese market have smalldifferences between those sold on overseasmarkets. (For instance, Chinese mobile phonestypically have small holes on the side so thatthe user can tie a string to it and hang itaround his/her neck, or hang a keychain on it.)

Price wars, however, eat into margins andretailers are exploring ways of differentiatingtheir product. Focus fell on store environments

and service, and some retailers began toradically experiment with different ideas.

Recent surveys suggest that a new type of consumer is emerging in China, one that doesnot mind paying up to 20% more to be assuredof product quality, particularly when it comesto food. A recent CCFA survey raised variousproblems associated with the distribution of food products including the use of unsafestorage materials, the absence of comprehensive cold chains, and generally thelack of compliance with hygiene standardsduring transport. The International Quality andProductivity Centre estimates that around25-30% of fresh vegetables and fruit is lostduring shipment.

Retailers operating in other segments havedifferentiated themselves by offeringafter-sales services. For instance, B&Q havemoved away from the DIY concept to homeimprovements by offering comprehensiveinterior design and installation services. Thishas been particularly effective in China due toincreasing levels of home ownership in recentyears, and the lack of Chinese enthusiasm for

doing it oneself.SWOT Analysis

Table 6 summarises the Strength,Weaknesses, Opportunities, and Threats(SWOT) of European and Chinese retailersdiscussed in this section.



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Table 6: SWOT Ana lysis of European and Domestic Retailers

Europe China

Strength - Superior management, business models,

operational processes, after-sales service andcapital

- Ability to leverage global networks- Innovative product formats

Strength - Established local brands, suppliers, trading

networks, clients and partners, governmentrelationships

- SOEs have government backing (financialsupport, ability to obtain good store locationsetc.)

- Rapidly modernizing, able to adoptinternational best practices through JVpartners

Weakness - Less familiarity with local business

environment, consumer preferences

Weakness - No global networks- Less advanced operational processes/

business models- SOEs driven by non-commercial goals i.e.

employment- Poor understanding of foreign consumer

preferences

Opportunity - Sourcing of made-in-China goods for global

markets- Sourcing of foreign-made goods for Chinese

market e.g. wine- Large and growing Chinese consumer market

Opportunity - Large consumer base from which to base

overseas expansion- Proximity with and good knowledge of local

manufacturers/suppliers from which to baseoverseas expansion

- JV partners good source of managementexpertise

Threats - Government support for competitors- Poor supplier efficiency- Political backlash against foreign investment- Economic nationalism, negative publicity

Threats - Foreign retailers winning market share- Gradual abolition of government support- Foreign protectionism (for those Chinese firms

expanding overseas)



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According to the industry survey conducted bythe consortium implementing this study,European companies believe that productinnovation constitutes the main advantageEuropean companies have over Chinesecompanies (23.3% of times mentioned,Figure 12 ). Here, it is noted that productsproduced by European companies aregenerally more geared towards consumerneeds then those made by their Chinesecounterparts. Strong human resources of experienced and well-trained staff are alsohighlighted as being an important asset inmaintaining a competitive advantage in theChinese marketplace (20% of timesmentioned). International brand namerecognition, and the quality and serviceprovision of European retailers is alsohighlighted by survey respondents as astrength (both received 16.7% timesmentioned) Research and technological

development accounted for a further 13.3% of response while 10% indicated other 20 reasons.

20.0%

16.7%

16.7%

13.3%

10.0%

23.3%InnovativeProducts

HumanResources

Marketing &Branding

Quality &Service

R&D andTech. Dev.

Other

Source: Emerging Markets Groups.DEVELOPMENT Solutions (2006)

Main Advantages of EuropeanCompanies

Times Mentioned

Figure 12: Main Advan tages of EuropeanCompanies in the China Market

Despite these strengths, surveyed companiesexpect the strength of Chinese competition tosteadily increase over the next five years. Thecapabilities of Chinese companies such asquality, design, technology and foreignknow-how are improving, and thus present anincreasing threat to European companies(33.3% of times mentioned, Figure 13 ).Government support and intervention (26.7%)in the industry is expected to further Chinese

companies growth in the sector and with theirlower cost base (20%), Chinese companies willbecome increasingly more competitive. Other

strengths (20%) identified include familiarityand knowledge of local market conditions andthe ability to fully concentrate on their homemarket without the need to consider globaloperations as MNCs do.

33.3%

26.7%

20.0%

20.0%

Upgrading ofCapabilities of

Local Companies

GovernmentSupport &

Intervention

Lower CostBase

Other

Source: Emerging Markets Group;DEVELOPMENT Solutions (2006)

Strength of Chinese Competitors

Times Mentioned

Figure 13: Strength of Chinese Competitors

5. REMAIN IN G MAR KET ACCESSOBSTACLES 21

Section Topic5.1 Regulatory Restrictions5.1.1 Conditions on Majority Ownership5.1.2 Special Approvals5.1.3 Rules Pertaining to Existing Manufacturing

Foreign Invested Enterprises5.2 Transparency Related Issues5.2.1 Customs Problems5.2.2 Media Distribution5.2.3 Real Estate Prices

Despite the 2005 reforms, some restrictionsstill remain, such as the limit on the totalnumber of outlets a foreign majority ownedcompany can open up, limits on store size, and

limits on the sale of certain products. Eventhough local authorities can now authorise theopening of new stores, some provisionsstipulate that central-level approval must stillbe sought after certain thresholds have beensurpassed (e.g. number of stores in China).This suggests that the government is keepinga wary eye on foreign retailers becoming toodominant. A number of other non-regulatoryobstacles also exist, such as difficulties inobtaining land-use rights, and a lack of transparency, particularly in sub-sectors suchas media. Counterfeiting is also a problem,particularly for brand-reliant products such asfashion.



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Although the Chinese distribution sector ispositively regarded as offering significantopportunities for European retailers over thenext 5 years, representatives from theEuropean distribution industry have identifiedthe following market access obstacles, (seeFigure 14 ) which continue to inhibit growthand competitiveness.

25.0%

17.9%

10.7%

17.9%

7.1%

21.4%

Lack ofTransparency in

Operating Practices

ComplexBureaucracy and

GovernmentIntervention

Limited SupplyChannels

Lack of LegalFramework

IPRInfringements

Other

Market Access Obstacles for European Companies

Source: Emerging Markets Groups;DEVELOPMENT Solutions (2006)

Times Mentioned

Figure 14: Market Access Obstacles forEuropean Companies

Chinese operating practices such as a lack of transparency in operating practices (25%) wasconsidered by surveyed companies to besignificant obstacle to expansion in China.Complex bureaucracy and governmentintervention, especially at the provincial levelalso create barriers for European companiesoperating in the Chinese market (17.9%). Inthis regard, registration requirements forforeign invested companies are noted to bemore stringent than for local competitors.The lack of an adequate legal framework and

constantly changing product standards alsohinders European companies (17.9%). Limitedsupply channels prevent European companies further access to the Chinese market (10.7%).Furthermore, the participating foreignrepresentatives mentioned IPR infringements(7.1%), and other obstacles (21.4%) toexpansion including lack of financial resourcesand the language barrier. Box 1 providesselected quotes from industry representativesin relation to challenges to be met in theChinese distribution sector. Annex 3 providesa visual summary of both market drivencompetitive forces as well as those derivedfrom NTBs.

The market access obstacles in China can haveeconomic impacts on European companiesoperating in China. The respondents reportedthat as a foreign company they operate at ahigher cost than Chinese companies due to theabove mentioned barriers. One respondentestimated that operation costs areapproximately 10-15% higher than those of local companies. Obstacles such as import tax,for which Chinese companies receive taxbreaks, results in of revenue constraints of 4-5%. Overhead costs are estimated to be ashigh as 90%. See Table 7 on the followingpage for selected comment from the industrysurvey regarding the economic impact of market access obstacles.

5.1 Regulatory Restrictions

5.1.1 Conditions on Majority OwnershipThe FICE regulation outlined in previoussections still poses some obstacles and isdiscriminatory in nature, imposing restrictionson foreign ownership, store size, number of stores, and merchandise sold. For instance,foreign ownership is limited to 49% ownershipceiling if the retailer should meet all of thefollowing conditions:

1) The retailer has over 30 shops in China2) The retailer sells any product listed as

restricted 22 3) The retailer sells products with multiple

brands from multiple suppliers

The first condition is straightforward.Authorities are keeping a close eye on anyretailer becoming too large and eventuallytaking significant chunks of the domesticmarket from domestic companies. Carrefour,Wal-Mart, Metro and B&Q have alreadyexceeded this threshold.

The second condition is also fairlystraightforward. The restricted products (seefootnote 22 ) form part of Chinas WTOaccession protocol, which is the list of productssubject to state trading. Powerful vestedinterests in Chinas SOEs are naturally keen on

seeing competition kept to a minimum in theirrespective sectors, and none more so thantobacco, regulated by the aptly-named ChinaTobacco Monopoly Administration. Anunconditional ban exists for selling tobaccoproducts, and foreign investment in the sectoris close to non-existent. Liberalisation for someof these products, namely, automobiles andchemical fertilizers, is expected to come by theend of 2006, in line with WTO commitments.

The third condition is perhaps the mostobscure as to its purpose. Selling productsfrom multiple suppliers is usually a practicewhich encourages competition; it is usually thepractice of selling products from a single



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Table 7: Economic Imp act of Market A ccess Obstacles Industry Survey ResultsWhere respondent made estimates

Sub-sector Comment HP SM DP SS B CS O

20% of turnover - Wholesale to project developers and toretailers

4-5% When we import fixed equipment we need to pay an

import tax but if we were a local invested company we would geta tax-break. Business to Business

Our estimated operating costs are approx 10-15% higher thanthose for local businesses

We got only 1% sales turnover and market share in thismarket, as compared with our globally turnover. Oil,petrochemical, and power.

In my business the current market situation results in an extraoverhead cost of about 90% that has to be recuperated from ourcustomers in comparison to other markets.

Where respondents found it difficult to quantify market access obstacles:

Sub-sector Comment HP SM DP SS B CS O

This will be hard to predict since it involve not only currentmarket but also potential new market.

HP: HypermarketSM: SupermarketDP: Department StoreSS: SuperstoreB: Boutique storeCS: Convenience storesO: Other

product which falls under the scrutiny of antitrust regulators, as this may be anindication that the retailer is engaging inexclusionary practices in order to sharemonopoly profits with the supplier. Therefore,

it would seem strange that a practice whichpromotes competition would be scrutinised. Apossible reason for this condition could stemfrom the impact of retailers on their suppliers.Dominant retailers are typically in possession

of enough buying power to negotiatefavourable conditions with their suppliers,thereby forcing them to innovate and increasetheir competitiveness, or risk going out of business. It is likely that the suppliers of

influential SOEs, who would rather keep theircosy relationships with the SOE retailers, arereluctant to allow retailers to gain such aposition.

Box 1: Challenges for European companies to conduct business in the Chinese distribution sector -Voices from industry

The following are a selection of quotations from interviewees and the returned questionnaires:

Q: What are the problems in doing business in China?

After application procedure and requirements have been clarified our company has applied for a distribution

license, however, the application has been ongoing now for nearly a year and bureaucratic hurdles keepdelaying the process.

It is clear from the regulations that the central government does not want big retailers to expand too fast.There are a number of extra approval requirements for larger chains, and restrictions on foreign ownership.

Our domestic rivals get big discounts on land and utilities and they get better store locations from the localgovernments.

Were losing at least 20% of turnover on counterfeits.

When entering new local markets in China we find that local authorities will have preferences for using locallyproduced products.

The land auction system should prevent corruption but really favors only real estate giants and slows downthe process of getting a plot.



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5.1.2 Special ApprovalsWhile, in principle, approval for new stores hasbeen devolved to local-level authorities, therestill remain a number of criteria and thresholds,which, when passed, impose the obligation toobtain central-level approval. If ANY of thefollowing conditions are met, there is anobligation to obtain central-level approval:

1. The retailer engages in direct selling i.e.engages in sales over TV, telephone, mailorder, internet or vending machines;

2. The retailer deals in restricted products(covered in the previous section);

3. In the case of proposed new stores over3,000 square meters, the foreign retaileralready has over 3 stores in that sizecategory in the province OR the foreignretailer already has over 30 stores in thatsize category in China;

4. In the case of proposed new stores over300 square meters, the foreign retaileralready has over 30 stores in that sizecategory in the province OR the foreignretailer already has over 300 stores in thatsize category in China.

Direct selling was banned in China as a resultof the proliferation of pyramid schemes in the90s. Currently, it remains somewhat of aregulatory grey area; there has only been 1licence awarded to a direct seller in China,though in theory the practice is permitted. Thesecond, third and fourth conditions exist forsimilar reasons covered in the previoussection.

5.1.3. Rules Pertaining to Existing ForeignInvested Manufacturing EnterprisesThe FICE regulation allows non FICE FIEs,including those in manufacturing, to engage inwholesaling, agency commissioning, retailingand/or franchising provided they comply withthe FICE regulation and amend the scope of their business accordingly.

Hence, apart from establishing new

Commercial Enterprises to engage indistribution, foreign investors andmultinationals with existing FIEs in China areallowed to apply to expand their businessscopes to include these additional activities.Before the issuing of the abovementionedguidelines by MOFCOM, local DOFTECs wouldnot accept any applications for the expansionof business scope by existing FIEs, this issuenow seems resolved one year behind ChinasWTO schedule.

The delay was not necessarily because of thedesire to protect domestic companies, as hassometimes been the case with delays in WTOimplementation in other sectors. Rather, it

appears to have resulted from the need forMOFCOM to coordinate with other ministriesand departments, such as the GeneralAdministration of Customs and the StateAdministration of Taxation, to resolve varioustechnical issues. For example, the distributionrights applications of bonded-zone companieswere left in limbo in part because MOFCOM andCustoms were still in the process of reachingan agreement on whether to treat goods thatenter China from the bonded zones as importsor as domestically distributed products. Newrules issued are basically in line with theprinciples of WTO Valuation Agreement.Manufacturing companies in China are eligiblefor distribution rights under the condition thatrevenues from distribution are kept below 30percent of total revenue in order to continue toenjoy current preferential tax policies formanufacturing FIEs. Although uncertaintiesstill exist with regard to how authorities willenforce this requirement.

5.2 Transparency-Related Issues

Despite positive developments in theregulatory framework covering the distributionsector, foreign companies still face a number of non-tariff barriers related to transparency anduniformity of implementation.Transparency-related issues are very much partof the daily business environment in China,and all the more so for the retail sector, wheremuch of the business requires the involvementby local authorities. In wealthier provinces,

local governments are perceived as being onpar with the central government in terms of transparency, however in poorer provinces,issues ranging from incompetence tocorruption constitute a obstacle for foreigncompanies.

Typical transparency-related problems includevague regulations which leave a wide scope foradministrative discretion, local protectionism,protracted approval procedures, governmentcollusion with local businesses, administrativepower grabs (attempts to extract revenues orgain business secrets and technologiesthrough new regulations), graft and bribery.

The biggest victims of such problems areusually foreign SMEs. MNC investments areusually high-profile, dealt with by seniorofficials and welcomed because of thestate-of-the-art technologies and prestigethey bring to a province. Furthermore, MNCsusually have dedicated government relationspersonnel to handle administrative frictions.

Retailers who stock imported products alsotypically face more problems than those who

sell locally-produced products. This may nothave so much to do with local protectionism asit has to do with getting the goods into the



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countrys borders. There is a number of inconsistencies between central Customspolicy and local practice at the different portsof entry.

5.2.1. Customs ProblemsThe European Chamber of Commerce in Chi na (EUCCC) has reported a number of cases 23 where official guidelines to companies onimport clearance procedures have not beenfollowed in practice. Import classification rulesare not interpreted at each port in a consistentmanner according to the Harmonised System(HS), and in some cases, decisions areinfluenced by the duty rates. Steps are beingtaken by the General Administration of Customs (GAC) to establish an internalnational tariff classification ruling database butit remains to be seen whether this will resolveissues of consistency in customs ruling.

Valuation problems also persist, as post-WTOrules stipulate that the transaction value shallserve as the primary basis for determining thedutiable value of imported goods. However,European companies are reporting caseswhere Chinese customs officers continue touse minimum or reference price lists or insome cases even another companys importvalues to challenge the import transactionvalues of imported goods. Customs officers arerequired to provide written explanations whenthey challenge the transaction value of imported goods. However, Europeancompanies have reported various cases wherethe Chinese customs are reluctant to providesuch written explanations and if provided,written justifications lack detailedexplanations or objective analysis andreasoning.

5.2.3 Real Estate PricesOne of the major complaints of nearly all theretailers interviewed for this study concernedartificially high real estate prices. Ascompetition intensified over prime commercialreal estate, so have prices, which soared to anextent where one interviewees price was ashigh as Western European levels. In addition,foreign retailers are reporting anon-transparent allocation system for land. Aland auction system put in place to combatcorruption has little effect, and large developersare still being favoured in awarding plots.

6. OUTLOOK AND SCENARI OS

Based on current trends the followingoutcomes are identifiable and could result inthe following types of scenarios by 2010.

6.1 Scenario 1 - BaselineScenario 1 constitutes the baseline scenarioand assumes that the current trends of

European retailers expansion in Chinacontinue, although not quite at the pace thathas previously been the case. Chinas economycontinues to see strong GDP growth, whilegovernment policies toward retail anddomestic consumption in general are notexpected to change. No major changes toChinas current exchange rate policies areassumed and there are no major events whichwould alter the Chinese consumers perceptionor valuation of foreign goods.

Assumptions: GDP continues to grow at a similar rate

experienced over the last five years. No dramatic revaluation of the Yuan, the

government relies on foreign demand tosustain economic growth through exports.

The

eu_china trade and investment relations

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