Patrick Powers
Cover by Benjamin Hurd
China's WTO accession will mark a turning point in the development of China's distribution channels, but change will be more evolutionary than revolutionary Although state trading companies will fight hard to keep the status quo intact, WTO entry will almost certainly force them to become value-added service providers instead of the middlemen who make easy commissions today. They will have to upgrade their capabilities significantly in order to be attractive outsourcing candidates.
Patrick Powers is director of China Operations at the US-China Business Council in Beijing.
With China's accession to the World Trade Organization (WTO) imminent, the Holy Grail of distribution and trading rights is almost within reach for foreign firms in China. Getting to this point has been neither easy nor inexpensive. Since the opening of China's markets in 1979, the history of distribution in China has been fraught with infrastructure problems and difficult legal issues, and many firms have been forced by those circumstances to use highly creative methods to bypass anachronistic and restrictive regulations in order to distribute their products.
Now that greater market access beckons, it is important for businesses to look back at the history of distribution in China to keep a sense of perspective about what changes new market-access opportunities will bring under the WTO regime. The underlying trend of the past 20 years is one of centrifugal force--as trading volume and opportunities have expanded, local and foreign firms have pushed the limits of existing trading regulations outward. This, in turn, has forced the government, directly or otherwise, gradually to liberalize the trade regime to reflect market conditions. From that perspective, accession to the WTO is simply the next evolutionary step in the reform and development of China's economy.
Distribution's Stone Age...
In the earliest days of China trade, professional distribution options were scarce. Maoist doctrine encouraged each province and city to be self-reliant, resulting in considerable industrial overcapacity, few logistical synergies, and a vast bureaucracy. Foreign firms had little choice but to use state distribution networks, which were organized along rigid, vertical command-and-control lines. First-tier distributors were located in Beijing, Shanghai, and Tianjin municipalities, and Guangzhou, Guangdong Province; the second tier consisted of distributors in provincial capitals and medium-sized cities; and the third tier of distributors operated in smaller cities and towns. With no market forces at work, each level of the network passed products to state retailers and enterprises at their own level or to wholesalers at the next level, as instructed from above. Distributors essentially provided basic logistics services (transportation and warehousing) but no marketing support or sales reporting. Distributors were not allowed to import products; that right was reserved for foreign trade corporations (FTCs) in the major cities. Once an import entered the country, it was handed over to the appropriate distributor, as FTCs were forbidden to sell the goods downstream.
...and Middle Ages
As China's trade with the outside world grew, leaders recognized the need to liberalize this system. When the central government wants to liberalize or reform a particular policy, the most common practice is to implement the policy in measured, calculated steps--in order to evaluate what elements of the policy are and are not working at each step. As control during the 1980s continued to shift away from the center to the provinces and municipalities, which gained the right to establish their own trading companies, Beijing was satisfied enough with their progress to relax restrictions further.
By the late 1980s, domestic enterprises that met specified trade volumes were permitted to import and export directly. At roughly the same time, Beijing began to allow manufacturers to sell their own products directly to retailers, bypassing wholesalers entirely. Competition among state and provincial firms began to intensify, and as a consequence direct state control of imports began to break down. Legally ambiguous ("gray") import channels sprang up, in many cases involving non-civilian work units, and an entire industry of these so-called "converters" began to emerge along a Hong Kong-Guangdong axis.
Further north, the central government decided to develop the Pudong area of Shanghai, beginning with a high-intensity propaganda blitz (similar to the current "Develop the West" campaign). Unfortunately the government's hopes of obtaining 70 percent of the development funding from foreign firms were quickly dashed, as Pudong had virtually no infrastructure and was an unattractive investment destination. Following the normal practice of using pilot programs to test policy options, the government's next attempt to attract investment was to allow local firms special trading privileges in Pudong. This was initially successful in attracting larger state firms, but still failed to generate significant actual foreign investment in the zone. The government's only logical option at that point was to try to create an export-processing area in what became the Waigaoqiao Free Trade Zone of Pudong. Foreign firms gained the right, under certain conditions, to transact business in domestic currency. This step, when combined with other incentives for professional services providers, kicked off a drive to develop Pudong into what it is today. Pudong's success is somewhat accidental; the government never intended it to be a center of renminbi-denominated sales into China. But as in many other instances, the central government was forced to accept commercial reality.
In the mid-1990s, as business volumes grew, foreign-invested enterprises (FIEs) increasingly despaired over prohibitions on sales of goods not manufactured in China and the problems involved in selling their products nationwide. Some of the key issues then (and now) included the inadequate state of transport infrastructure (despite progress in the past few years) made worse by monopolistic practices; a fragmented and chaotic distribution system; and local protectionism. Compounding these difficulties were (and still are) a general lack of professional third-party distribution channels; pricing issues; cash flow and accounts receivable problems; the high cost of building and maintaining distribution networks; and the usual petty bureaucratic interference frequently encountered in the PRC commercial environment.
Distribution's Enlightenment?
In spite of the difficulties of conducting one's own logistics and distribution activities in China, companies can still earn a profit. In fact, contrary to popular belief, a majority of the foreign companies operating in the PRC are in the black, although perhaps not to the degree they would be if they were able to reduce costs by fully integrating their operations. In fact, many foreign firms have managed to set up national distribution channels and are well positioned to compete in a post-WTO China. Yet most of those same firms have to use a complex array of channels to fulfill their distribution needs and find it difficult to consolidate to take advantage of economies of scale. Nonetheless, the reality of the marketplace has been the greatest driver of change in distribution. A close look at what goods are available in the marketplace today both on the coast and inland reveals enormous changes compared to even five years ago. Regardless of the infrastructure and logistics problems, goods always seem to find their way to market.
One of the best examples of the change that has occurred in the distribution of goods in China over the past few years is the development of the hypermarket/big-box retail format since 1996, as exemplified by Wal-Mart Stores, Inc. of the United States, Metro AG of Germany, Carrefour SA of France, and China's own Shanghai Hualian Supermarket Co. and Lianhua Supermarket Co. Ltd. By virtue of their buying power, these local and foreign retailers have forced alteration of traditional distribution practices.
For example, the typical large foreign retailer will buy in one of two ways, often using sophisticated automatic order replenishment software: either through a third party that usually must provide a high level of service at low margins in exchange for high sales volume; or directly from the manufacturer, which will be pressured to offer the cheapest wholesale prices in the market. Given the high volumes involved, the retailers demand--and usually get--highly favorable payment terms, timely delivery, bar coding, and priority service, all of which were generally nonexistent just a few years ago. These demands have forced local manufacturers and distributors to upgrade their internal capabilities, especially in major urban areas, to the benefit of the distribution and logistics industry as a whole. It does not mean, however, that the old problems have disappeared; they still exist. The improvements to date are just from a relatively low base.
Aside from this trend, which benefits the consumer-goods sector, the different value-chain alternatives available to investors are fairly well established: local or foreign third-party distributors, representative sales/liaison offices, joint-venture (JV) trading companies (on a very limited scale), and Waigaoqiao "exports" to the domestic market. One of the key questions for investors in China is how to consolidate sales, marketing, distribution, and back-office functions across the breadth of their multiple operations. In many cases these ventures range from traditional JVs to wholly foreign-owned enterprises (WFOEs). Thus, larger firms have used one or more of the following structures: centralized sales organizations under a holding company; "service companies," in which an entity under an existing JV manages sales and marketing for all of the other group operations; or "sales-service JVs" (SSJVs), similar to "service companies," in which the SSJV acts as the agent and/or distributor of the FIE's other JVs.
Other options, although less conventional, are contractual (chengbao) and joint-operation (lianying) entities which enable the foreign party to act as a local company. Full details of these distribution alternatives can be found in the June 1998 US-China Business Council report, Distribution of Goods in China: Regulatory Framework and Business Options.
The future: WTO's limits
The question on every foreign investor's mind is, "What does the future hold under WTO?" First of all, it is important to remember that the full terms of the WTO services agreement are phased in over three years in most cases. Given the specific market-access commitments China has made regarding trading rights and distribution, foreign firms will immediately be able to distribute all products made in China as of the date of China's accession and will be able to distribute imported products a year later. For after-sales maintenance and repair, foreign service suppliers may establish themselves in China as joint ventures upon accession, hold a majority equity share in one year, and be free of restrictions in three years.
Just because China will be a WTO member does not mean that foreign firms will immediately set up their own exclusive distribution channels en masse. One major change that will occur soon after accession, though, is in the way state import-export corporations are used. Established firms will be able to bypass third parties in the value chain, generating significant savings in transaction expenses and related overheads. Therefore it is very likely that this will be an issue of primary importance in the short to medium term. Although state trading companies will fight hard to keep the status quo intact, WTO entry will almost certainly force them to become value-added service providers instead of the middlemen who make easy commissions today. They will have to upgrade their capabilities significantly in order to be attractive outsourcing candidates.
For the distribution industry as a whole, the more likely outcome will resemble the historical pattern of evolutionary opening rather than immediate, revolutionary, change. Since both Chinese and foreign firms have the same logistics and distribution problems, they will exert significant competitive pressure on local distributors and service providers to improve their existing business models and force increased integration in the value chain. The result will probably be industry consolidation and introduction of more, and more-professional, service providers--the majority of which will likely be located in the provinces and may partner with others in neighboring regions. Nationwide, the larger foreign operators will also play a greater role, but they will only be able to benefit fully from WTO terms after three to four years.
The Chinese logistics industry is underdeveloped and historically prone to local protectionism, unfair competition, and an excessive number of government-related operators who enjoy the privileges of monopolistic regulations at either the national or provincial level. None of the ministries involved in different parts of the transport value chain, such as the Ministry of Railways or the Ministry of Communications, is renowned for its efforts to develop true intermodal capabilities within its own provincial networks, let alone nationwide. But as China enters the WTO, there will be a more pressing need to rectify that situation for the benefit of all concerned.
Leaders in the Chinese logistics industry believe that they have a three- to four-year window in which to restructure their firms and the industry before foreign operators become significant competitors. On the other hand, their customers would rather see the industry opened up as soon as possible, because history has shown that the earlier an industry opens up in China, the more it prospers; witness, for example, the strength of the consumer goods and household appliance markets in China today. These were the first markets opened significantly to foreign competition in the 1980s.
The caveat
Although the WTO will open up many markets in China, distribution and logistics, like other sectors, will no doubt experience implementation difficulties and delays. Foreign firms would do well to remember this fact as they attempt to broaden their distribution networks.
But anyone who visited China before 1990 will remember what China didn't have--which was just about everything in terms of business infrastructure and products. Today China has brought itself to the point (in many cases using foreign funds or technology) where, the usual litany of problems aside, the country has a strong foundation from which to develop into a modern economy. And this development will occur at an ever-increasing pace.
|
Distribution and the WTO: Some Historical Context World Trade Organization (WTO) accession marks what may be remembered by historians as the end of modern China's economic beginning. For the leadership, giving foreign firms the right to operate freely in China is a very serious and sensitive matter that it discusses in a historical framework, specifically with reference to the preliberation period when foreign companies were dominant players in distribution (among other commercial sectors). Since 1979 China's leaders have dealt with this subject very cautiously and have now decided, perhaps reluctantly, that it is in China's best interests to allow significant foreign access to distribution and many other sectors. That is what the WTO is really all about from the PRC perspective--it is not so much about free trade as it is about the need to develop a professional financial and managerial culture based on internationally accepted commercial practices and rule of law so that the country can prosper in the years ahead. -- Patrick Powers |
|
The US-China Market Access Agreement: Distribution Services According to the November 1999 US-China Market-Access Agreement, as detailed in the White House Fact Sheet (www.uschina.org/public/wto/factsheets/distribution.html), China agreed to phase out current restrictions on access to distribution services within three years of accession. China made the following specific commitments in the area of distribution-related services:
|
All Rights Reserved.