Strategies for Competing in a Changed China

The night before China’s entry into the World Trade Organization in December 2001, Motorola Inc. held its global board meeting in Beijing for the second time and announced an ambitious plan to increase investment, revenue and sourcing by $10 billion each in China over the next five years. Other companies have had similarly grand visions. Telefon AB L.M. Ericsson announced that it would more than double its investment in China to $5.1 billion, also over a five-year period. General Motors Corp.’s plans call for Chinese operations to generate more than $3 billion of revenue by 2008. By that same year, Bayer AG intends to have the second phase of its $3.1 billion production facility up and running to meet forecasted growth in its China sales. These represent just a handful of the thousands of multinationals that have ambitious growth in revenues from China etched into their strategic plans. As China’s accession to the WTO gradually opens new markets and as its growth continues at better than 9% per year, even those that have long resisted China’s temptations are jumping in.

Experienced multinationals are aware of the many challenges they must overcome, summed up by the old adage that in China “everything is possible, but nothing is easy.” Learning from the experience of pioneering companies, savvy investors know they have to contend with a minefield of competing local interests, overloaded infrastructure, difficulties in retaining skilled people, tortuous supply chains, unfamiliar local HR practices and communication barriers.1 But few predicted what is fast becoming the most formidable obstacle to success: the emergence of tough competition from local Chinese players.

A decade ago, the possibility that Chinese companies would pose a serious competitive challenge to multinationals looked improbable. It wasn’t surprising, therefore, that, in 1995, just a few years after China’s personal-computer market opened up to foreigners, The Economist predicted that by 2000, multinationals would have captured an 80% market share from their hapless Chinese competitors. And it appeared that this prediction would be on target, as multinationals like IBM, Hewlett-Packard and Compaq quickly won more than 50% of the market.

But the 80% figure was never reached — in fact, the numbers went in the opposite direction. Just one year after The Economist’s confident pronouncement, the Chinese company Legend Group Ltd. (known as Lenovo Group Ltd. outside China) became the No. 1 PC supplier in China. By 2000, Legend had 29% of the desktop PC market, and two other local players were at No. 2 and No. 3 with a combined 14% of the market. Legend maintains that lead today, with a market share of around 30%, and the combined market share of multinationals has dropped to only 20%. Instead of multinationals coming to dominate the China market, the local champions are prevailing.

Our research over the past five years into the battles between multinationals and local Chinese companies reveals that while market dominance by local champions is far from universal, it’s becoming ever more frequent. In industries as different as beer brewing, mobile-phone manufacturing and laundry-detergent production, Chinese companies — often seeming to appear from nowhere — are forcing multinationals to rethink their strategies and their hopes for explosive growth in the China market.

The message is clear: Multinationals must factor in the existence of robust local competition, while considering the new opportunities that have opened up as a result of China’s WTO membership. To understand the way competition between multinationals and local champions is evolving and to pinpoint the keys to success, we traced the evolution of competition in China in 10 industries over the last 10 years.2 We conducted more than 100 interviews with dozens of leading companies operating in China, both multinationals and locals, and reviewed thousands of pages of secondary data. The picture of competition that emerged from our research can best be described not in terms of traditional market positioning, but as a battle of competencies between multinationals and local players.

Constraints on Multinationals

Multinationals generally start off with clear advantages in two areas: They have better industry-specific technology, know-how and innovation capabilities; and they have a higher level of managerial competence in such functions as marketing and brand building, financial management and IT that can be used to underpin a strong, well-integrated value chain. But multinationals also face four fundamental handicaps in the race to build competitive advantage in China.

First, poor supporting infrastructure often prevents them from exploiting their advantages. Many multinational companies are equipped with sophisticated marketing and brand-building skills, for example, that are far ahead of most of their local counterparts — many of which are still struggling to master elementary distinctions such as the difference between marketing and sales. But in order to deploy their expertise, multinationals need specialized inputs like detailed market research that are often unavailable or poorly supplied in China. Good market-research companies, for example, are scarce outside a few major cities. So the multinationals either have to make do with inadequate inputs or perform these functions in-house, even when they lack the requisite skills.

Likewise, many multinationals rely on strong distribution channels to deliver their products reliably and also to educate customers about the more subtle advantages of their offering. But efficient logistics and distribution are new concepts in China, and there are almost no national distributors. In a Chinese distribution system, the superior attributes of a multinational’s offering might never be communicated to potential customers, and the product’s advantages for those that do buy may be compromised by late delivery or damage. Multinationals’ potential advantages in supply-chain management, meanwhile, are often rendered ineffective by the lack of competent local suppliers. Toshiba Corp., for example, spent more than five years developing a local supplier for a component it needed for laptop PC production. During that period, the performance of its supply chain as a whole was constrained by this weakest link.

A second handicap for multinationals is the lack of flexibility and higher costs imposed by the need to integrate operations in China with global organizations. Multinationals also have to implement international corporate standards that can put them at a competitive disadvantage in comparison with local rivals that are content to match Chinese norms. And the slower decision making that can result from having to involve a corporate headquarters and sister subsidiaries can be a fatal handicap in a fast-moving market. At one Japanese firm in our study, it usually takes almost two years to approve a project. Executives at headquarters are powerless to speed up the process even though it means that by the time a project is approved, it is probably no longer relevant. Not surprisingly, of more than 20 projects launched by the company in China, only a couple are making money.

Third, multinationals’ ability to reap economies of scale and spread high fixed costs is checked by the fragmentation of the market, provincial trade barriers and the protection of local enterprises. In the beer market, for example, several global companies spent money on national or regional advertising campaigns only to find that it was impractical to supply large volumes of beer outside the province in which it was brewed. And Otis Elevator Co. discovered it needed to maintain production facilities in several regions of China in order to respond to the buying preferences of local authorities. Government regulations have also aggravated the problem. Until recently, multinationals wishing to build their coverage across China had little option but to enter joint ventures with different partners, sometimes in tens of provinces. The resulting fragmentation of their operations makes seamless integration virtually impossible. These difficulties in exploiting scale economies reduce the gap between multinationals operating in China and Chinese enterprises that typically start from a strong base in a geographically limited provincial or local market.

A fourth handicap is the fact that many markets in China are in an early stage of development. Despite the impression given by sophisticated consumers in central Shanghai or Beijing, more than one billion of China’s consumers can still only afford products that serve their basic needs. Thus the superior quality, functionality or service offered by multinationals cannot be translated into premium prices or higher market share. The same is true for business and industrial buyers that are struggling to finance ever increasing demands for new investment. Consider a company that sells power transformers, including one for installation in underground sites and one for installation on outdoor platforms. In the underground segment, the multinational is thriving because high repair costs mean buyers are willing to pay for superior reliability. But in the outdoor segment, where most buyers are content with a cheaper, less reliable product that can be easily repaired, its market share is less than 5%.

None of these four drawbacks would matter much if Chinese competitors lacked advantages of their own. After all, Chinese companies also have to deal with insufficient market research, inefficient distribution and inadequate supply chains. The problem is that Chinese companies do have unique competencies that need to be set against the multinationals’ muffled strengths.

Chinese Advantages

The advantages Chinese competitors enjoy fall into three categories. First, they have a better understanding of what will work in the local environment. For example, detergent producer Nice has a deep understanding of Chinese consumers. In one of Nice’s widely acclaimed advertisements, a young girl is shown helping her mother, who has just been laid off from her job, wash the family’s laundry. The advertisement succeeds because it connects with the emotional thread of dongshi in Chinese society, a term that refers to the transition that happens when a child starts to understand his or her responsibilities to the family and society — a critical part of growing up. Promoting this transition is one of the most important and satisfying achievements of a Chinese parent, but it’s not a concept with a direct counterpart in Western cultures and thus would not likely be part of an ad campaign by a company based in the West.

Another example of such subtleties can be seen in the home-appliance market. While multinationals like Whirlpool Corp. introduced large, impressive-looking machines, Haier Group Co., the leading Chinese company, pushed a machine dubbed “Little Prince” that is capable of handling small loads with very low consumption of electricity. Chinese parents prefer cotton diapers over disposables for their “little princes” (a label that taps into emotions associated with China’s “one child” policy), and the small machines make it easy and inexpensive to do many loads. This is also important for the entire family during hot Chinese summers when clothes are washed daily. Little Prince became an instant hit, and millions of units have been sold.

Not surprisingly, local knowledge also helps companies manage the complex web of relationships that are necessary for operating in China. Such relationships — with state and local governments, buyers, suppliers and those that control access to infrastructure — are seldom transparent. Even ensuring continuity of power supply, for example, isn’t always as simple as paying utility bills on time; it takes the right relationship to make sure that when power is rationed, your plant is among the priority users. Multinationals that now have 15 or 20 years of Chinese operational experience under their belts are very competent networkers, but those that have entered more recently generally lag behind their Chinese competitors in the subtle arts of managing relationships.3

A second key advantage often enjoyed by Chinese competitors is that they are leaner, more flexible and have lower costs. This may seem paradoxical, given the straightjacket effect of a planned economy. But after 20 years of reform, state-owned enterprises now account for only about one-third of China’s gross domestic product, and they are mostly concentrated in heavily regulated industries such as telecommunications and financial services. Many of the most powerful Chinese competitors are run by highly entrepreneurial people who have either built their businesses from the seed of a flexible “township enterprise” (a collective set up by a local government outside the centrally controlled state sector), transformed a state-owned enterprise into a joint-stock company with strong managerial autonomy or launched a new private business that continues to be flexible and cost-conscious despite rapid growth.

A third advantage comes from the existence of open global markets — the same force that multinationals hope to take advantage of by their presence in China. Open markets allow Chinese companies in many industries to simply buy much of the technology and expertise they need to catch up. Cola marketer Wahaha Group, for example, was able to build the most modern production lines in the world using imported machinery that it purchased in volume at a very competitive cost. And in white goods, it is easy to buy a production line that incorporates technology capable of matching what multinationals can produce. In the PC market, the latest tools and technologies developed in Silicon Valley now arrive in China within months. This allows Dongguan, a small city in Guangdong province that has the world’s highest concentration of component manufacturers, to provide Chinese PC makers with a ready supply of world-class technology.

A Battle of Competencies

This reassessment of the strengths and weaknesses of multinationals in China compared with their local competitors points to a developing race between the two sides. Each faces the same task: to build new competencies that can help complement and exploit their existing capabilities before the other group establishes an unassailable lead.

Time is not on the side of multinational companies. The reason is simple: The competencies that they need to master, such as gaining a subtle understanding of Chinese consumers, can’t easily be bought. Instead, they have to painstakingly learn through experience. Conversely, Chinese competitors can fill some of the holes in their portfolio of competencies by purchasing technology and systems on the open market. The wild cards in this contest are functional management skills. Just how fast can Chinese companies build or acquire access to world-class competence in areas like marketing, service, product design, R&D and financial management?

Multinationals can’t count on it taking the Chinese a long time. They need to rethink many of their assumptions if they are to compete effectively against the local competition. Setting realistic expectations would be a good place to start. China seems likely to maintain the 7% to 9% growth rates it has achieved over the past decade for the foreseeable future. But all too often, the forecasts that companies put into their strategic plans for China are unduly influenced by the need to meet corporate growth targets in the face of stagnant demand in the West and a mind-set that casts the Chinese market in the role of the last frontier. Growth plans need to be realistic about fierce competition from local companies, as well as from other multinationals, for a share of China’s growth.

To be competitive, many multinationals in China also should get their existing houses in order. A mix of government regulation and opportunism has often resulted in China operations composed of an unwieldy collage of joint ventures, representative offices (whose function is to explore opportunities and build relationships), partnerships and wholly owned subsidiaries —sometimes numbering 40 or 50 individual units. Such structures make it impossible to achieve economies of scale and to start to build national brands or unified and consistent distribution and service. As China implements its WTO commitments, a window of opportunity is opening up to rationalize these anachronistic structures. Multinationals can now form foreign-owned limited companies that fall under China’s new Company Law rather than the tangle of regulations generated by China’s Ministry of Foreign Trade and Economic Cooperation.4

Path breakers like Eastman Kodak, Alcatel and Unilever have already completed this kind of restructuring. In March 2003, Nokia Corp. announced that it would fold its four manufacturing joint ventures (each with different partners) into a single company in which Nokia would hold a 60% share of the equity. The Michelin Group is consolidating all its joint ventures in China into a single production network while moving marketing and sales to a centralized function located in Beijing. Many Japanese firms are making similar moves. Nissan Motor Co., for example, is folding Dong Feng Motor Co., the third largest auto producer in China, into its global network. Multinationals that emulate these examples and establish a solid base in China can then begin to devise effective strategies to address the threats posed by local rivals.

Five Strategies for Multinationals

To win the battle of competencies that will characterize the next round of competition for Chinese markets, companies should consider acting on some combination of these five strategies:

Expand market coverage.

Seeking to exploit their superior technology and brands, most multinationals entered China through the high end of the market. American and European beer companies, for example, positioned their brands at between three and five times the price of low-end Chinese brews, and electronics companies such as Toshiba and Hitachi Ltd. sought to compete by continuously introducing new, leading-edge products at premium prices. But for two reasons, such a strategy is unlikely to succeed in the future. First, unless multinationals break out of high-end niche markets that generally exist only in major cities, they have little hope of building the localization competencies they need to succeed in the long term. Second, unless they expand into the mass market, they will be dangerously exposed as local Chinese firms use their expanding competence base to move aggressively upmarket, financed by massive sales volume in the low end.

Many multinational firms are now starting to move into lower price, mainstream market segments and into areas beyond China’s more developed coastal strip to win back the market share they lost to Chinese competitors. A year ago, Hitachi launched a new mini washing machine directly targeted at the Chinese mass of midmarket consumers. Kodak, meanwhile, has a major campaign called “Marching West” in which it is extending its coverage into the western provinces of China. And Procter & Gamble Co. has cut the prices of some of its leading products by more than 40%, introduced low-priced small packages for rural consumers and signed up new distributors to cover even the most remote areas. The result: Its market share is increasing again after declining for three years in a row.

Focus on dramatically lowering costs.

With the integrity of their reputations to protect, multinationals have some valid reasons for having higher costs than their local competitors — such as their need to maintain international standards of environmental and worker safety. But they no longer have the luxury of sustaining the magnitude of cost differentials that often existed in the past. The technology and quality gap is narrowing, and global players will have to reach customers unable to pay premiums for multinationals’ products. After all, despite China’s economic miracle, annual income per capita only passed the $1,000 mark for the first time last year.

Consider how the scope for maintaining premium pricing has diminished in the market for television sets. Five years ago, Japanese brands could charge a premium of about 20% over local products. Today the viable price premium is only 5%. The cost reductions required to respond to this kind of shift in pricing won’t come from incremental changes. Multinationals will need to look at wholesale reengineering of their business processes in China. And there is no time to lose, because the Chinese aren’t standing still. BYD Battery Co. Ltd., for example, developed its own proprietary process for manufacturing rechargeable batteries. It now has close to a 40% price advantage in the end-product market. See sidebar

Streamline distribution channels.

Until recently, multinationals have been handicapped by regulations that effectively prohibit their direct involvement in distribution and retailing activities. Canon Inc., for example, has historically had to use its Hong Kong office as the primary sales arm in servicing China because of regulatory constraints on mainland sales and distribution. But the removal of these restrictions as part of China’s deal to join the WTO is opening up new opportunities for multinationals to streamline their channels. One option is to emulate the Chinese practice of building dedicated distribution networks that can be used to smooth the supply chain, get closer to customers and gain better control of marketing and communications through to the point of sale.

A second option is to take advantage of the fact that China’s excessively fragmented retailing sector is consolidating fast —driven by the aggressive expansion of retailers like France’s Carrefour SA, America’s Wal-Mart Stores Inc. and Britain’s Tesco Corp., along with emerging local chains such as Nmart International Trading Co. Ltd. By working closely with the rapidly emerging retail chains, multinationals can expand their market coverage, improve distribution efficiency and make sure superior product quality and performance are communicated effectively to end customers. This will enable them to avoid the problem in which poorly performing distributors destroy much of the differentiation a multinational has to offer.

Chinese firms are active in this area, too, equipping themselves with dedicated sales channels and networks of distributors that extend well beyond China’s major cities. PC supplier Legend, for example, has built a network of more than 4,000 distributors in addition to its 1,000 “Legend one+one” stores and has accumulated a great deal of experience in how distribution can best be managed.

Localize R&D.

In the past, most multinationals have viewed their China operations as importers of the results of their R&D elsewhere. But there are good reasons for localizing more R&D in China. For one thing, it would improve the chances of meeting local customer needs and increasing speed to market. In addition, given China’s vast supply of cheap and talented scientists and engineers, localizing R&D could substantially reduce its costs. Lastly, transferring R&D to China would do a lot to help sweeten relations with government at every level and could provide a powerful bargaining chip for soliciting official support for other parts of a company’s China business.

Of course, the questions of intellectual property rights (IPR) that are associated with local R&D need to be carefully managed, especially in joint ventures where Chinese partners may look to apply new technologies to related businesses outside the venture. And there are risks of IPR leakage if turnover of personnel cannot be contained. But leading multinationals in China are recognizing the potential of China as an important R&D base. Over the last few years, more than 100 global R&D centers have been established by such companies as HP, Microsoft and Motorola.

Drive industry consolidation.

Many Chinese industries are highly fragmented by world standards. While fragmentation persists, economies of scale will be undermined, excess capacity and cutthroat price competition will remain endemic, and even fundamentally sound companies will struggle to make adequate returns. Until recently it has been difficult for companies to do much about this problem, given China’s regulatory restrictions on takeovers. Only 5% of foreign direct investment takes place through acquisitions in China, while for the rest of the world the figure is 80%.

Opportunities to drive industry consolidation, however, are opening up. Kodak has been a pioneer. In 1998, it negotiated a deal with the Chinese government to take over three large state-owned enterprises in the photographic industry and integrate them with Kodak’s existing operations into a holding company. The aim was to assemble the future leading player in the Chinese market. In return, the Beijing government also agreed to close two other domestic film plants.5

Kodak continued to drive consolidation in the industry, a strategy that led it to acquire five of the seven largest state-owned film companies.6 Its objective was twofold: to turn the market into a three-way game (with Japan’s Fuji Photo Film Co. Ltd. and the largest remaining Chinese player, Lucky Film Corp.) in which the bases of competition would be quality, brand strength and convenience; and to use its first-mover advantage to improve its chances of becoming the dominant player. By 2003 it appeared to be largely succeeding in both objectives.

Other multinationals are following Kodak’s lead. The French-based food and beverage company Groupe Danone, for example, has acquired large shareholdings in the major companies in China’s drinking-water market, driving consolidation and becoming the leading supplier.

To implement some combination of these five strategies successfully, multinationals’ China organizations will have to become more-flexible and faster learners. A dialogue is necessary between corporate headquarters and management in China about the realities of the discrepancy in competencies between foreign and local firms — and also about the need for operations in China to have sufficient autonomy and elbow room to respond to nimble Chinese competitors. To make such dialogue feasible, the head of China operations in many companies, such as P&G, Microsoft and Motorola, now report directly to the global CEOs. The seniority of China heads has also risen dramatically. For example, the president of Samsung Group’s China operation is one of the three key decision makers back at headquarters in Korea.

Multinationals must squarely face the fact that the competitive edge that is potentially available to them from superior technologies, products and systems will be severely blunted unless they build much stronger local competencies. In many cases, that will require a new willingness and determination to master the complexities of distribution, sales and service in China’s secondary cities and rural heartland and to learn how to more sensitively adapt everything from products and processes to marketing messages to the peculiarities of the Chinese market — competencies in which their local competitors are currently far ahead.