The challenges facing foreign middle market businesses doing business in China
Foreign middle market businesses surveying the Chinese market in 2016 will encounter a more challenging environment than the one multinational corporations faced during the early years of China’s global economic opening:
- From double digit rates, annual GDP growth in China has slowed to 6.0–7.0 per cent–still strong compared to developed market economies, but a far cry from the breakneck growth rates China registered in previous years.
- Fixed capital investment in China has also slowed under the impact of unsustainable corporate debt and excess capacity in key sectors of the national economy, narrowing the range of commercial opportunities for foreign suppliers of fixed capital goods.
- Business conditions that once favoured foreign businesses have become less friendly for new foreign entrants into China, as state regulators have restricted market access to strengthen the competitive positions of domestic companies.
Notwithstanding these challenges, foreign middle market businesses enjoy important growth opportunities in particular niches of the Chinese economy.
From 7.3 per cent in 2014, real GDP growth in China declined to 6.6 per cent in 2016. The IMF projects further deceleration in 2017 to 6.2 per cent. Some analysts believe that even these modest GDP growth numbers overstate the actual rate of growth of the Chinese economy.
However, these headline GDP growth rates obscure sectoral variations within the Chinese economy. Growth has markedly slowed in China’s industrial sector, especially mining and manufacturing. But other parts of the Chinese economy display more robust growth rates, notably e-commerce and advanced technology sectors that play to the strengths of foreign middle market businesses.
Furthermore, recent data signal an incipient rebound of the Chinese economy from its weak performance in 2015 and early 2016. The September 2016 report of the China Federation of Logistics and Purchasing (CFLP) announced the highest PMI in 22 months, reflecting an expansion of output, new orders, and purchases of inputs.
Long term, China’s era of decelerated growth presages structural changes that create commercial opportunities for strategically nimble foreign middle businesses. The Five Year Plan approved at the National People’s Congress in March 2016 foresees China’s transition from an export-led, resource-intensive growth model into a service-oriented, consumer-centric model. Economists anticipate a recalibration of the ratio of investment and consumption in the Chinese economy, with the latter reaching 43 per cent of GDP by 2020. China’s services sector, which accounted for 31 per cent of GDP in 1990, is projected to attain 55 per cent in 2021.
The forthcoming expansion of consumer spending in China augurs favourably for mid-sized foreign companies with strong brands, high quality products, and capable channel partners that facilitate access to the country’s rising middle class of households with discretionary purchasing power. The increased role of China’s services sector is also a positive development for foreign middle market businesses able to exploit their competitive advantages in service-related trade.
Trends in foreign trade
Recent data on Chinese foreign trade echo these observations drawn from GDP growth numbers. In 2015, China imported $1.6 trillion of products and services. Manufactured products accounted for the largest share of Chinese imports (51 per cent), followed by services (22 per cent), fuels (9 per cent), and ores/metals (8 per cent). The leading sources of these imports were South Korea (10.9 per cent of total imports), United States (9.0 per cent), Japan (8.9 per cent), Germany (5.5 per cent), and Australia (4.1 per cent).
Most of these categories of foreign imports incurred declines in 2014-15. The steepest fall in imports occurred in fuels and ores/metals, illustrating the combined effects of weakening global commodity prices and ebbing import demand by resource-intensive Chinese companies. But food imports (a category that offers major opportunities for foreign middle market businesses with strong consumer brands) held steady during the economic slowdown.
Even China’s beleaguered manufacturing sector displayed areas of resilience amid the downturn in foreign imports: e.g., aircraft equipment, electronic components, musical instruments, nuclear reactor components, optical and medical equipment, watches and clocks. As China pivots from a resource-based to technology-intensive growth model, foreign middle market businesses will enjoy opportunities in specialised manufactured products that cannot be readily sourced domestically.
Current data provide additional grounds for optimism about China’s foreign trade sector. Imports (both RMB- and USD-denominated) increased in August 2016, the first signs of import growth since October 2014.
Foreign direct investment
Recent trends in foreign direct investment (FDI) also hold substantial promise for foreign middle market businesses.
China received USD $136 billion FDI inflows in 2015, surpassing the level of 2014. Adding inbound FDI in Hong Kong (much of which is destined for the mainland), the PRC has surpassed the U.S. as the world’s leading recipient of FDI inflows. This development signals the foreign investor community’s continued confidence in China as an FDI host despite growing anxieties about the country’s politico-economic trajectory. Manufacturing represents the foremost destination of inbound FDI in China (approximately one-third of total inflows), followed by real estate, leasing and business services, and wholesale/retail trade.
The bulk of foreign direct investment in China is undertaken by multinational corporations. Most foreign-based middle market businesses lack the scale, experience, and operational capabilities to engage directly in FDI in China. However, the installed base of foreign multinationals in China creates growth opportunities for middle market businesses pursuing “follow the leader” strategies. By hooking onto the global supply chains of large multinationals already present in the country, foreign middle market businesses can realise their commercial objectives in China while avoiding the costs and risks of full-fledged FDI.
Execution of a follow the leader strategy depends on demonstration by foreign middle market businesses of a superior value proposition over local suppliers of products and services demanded by the multinationals. Such a strategy has proven difficult in previous years, as domestic suppliers in China enjoyed labour cost and locational advantages that foreign-based companies could not surmount.
However, China’s migration to a technology-based development model creates points of insertion for foreign middle market businesses seeking to enter multinational supply chains. In this scenario, multinationals would no longer assign primary weight to the cost/locational advantages of indigenous Chinese suppliers, looking instead to foreign companies (including middle market businesses based in the home country) for specialised products with high technology content.
Renewable energy and sustainable development
At the September 2016 G20 summit in Hangzou, President Barack Obama and President Xi Jinping ratified the Paris Agreement committing China and U.S. to reducing greenhouse gas emissions to mitigate global climate change.
This agreement by the world’s largest emitters of CO2 signals expanded trade and investment opportunities in renewable energy. China is already the world leader in installed renewable energy capacity and renewable energy investment, followed by the United States. As a result, Chinese companies have established commanding positions in key segments of the renewable energy market, such as photovoltaic solar.
However, foreign middle market businesses still enjoy growth opportunities in specialised niches of the Chinese renewable energy market that local incumbents do not yet dominate (e.g., next generation clean technologies). Foreign-based middle market businesses are also poised to exploit commercial opportunities in environmental management, resource conservation, and related areas to support the Xi government’s embrace of sustainable development.
In this connection, foreign middle market businesses should take note of the Chinese government’s launch of a $30 billion venture fund (modelled on Singapore’s Temasek) to support the development and commercialisation of advanced technologies. Prospective foreign entrants into China’s technology sector should also avail themselves of the Bank of China’s cross-border matchmaking events to promote partnerships between Chinese and foreign-based small and medium enterprises.
Conclusion: Challenges facing foreign middle market businesses
Against these growth opportunities, foreign middle market businesses confront several challenges in China:
Standard and Poors (S&P) reports that China’s total outstanding corporate debt reached $17.8 trillion in 2015. At 171 per cent of GDP, this is the world’s biggest corporate debt, double that of the U.S. and far surpassing that of other emerging markets.
A substantial share of China’s corporate debt is USD-denominated, exposing many Chinese corporate borrowers to both exchange rate risk (devaluation of the RMB against the U.S. dollar) and interest rate risk (higher debt servicing costs stemming from the anticipated increase in interest rates by the U.S. Federal Reserve). The eroding profit margins of large state owned enterprises situated in industries with excess capacity (automotive, cement, coal, iron/steel, non-ferrous metals, shipbuilding) heightens pressure on those companies to accumulate additional debt.
For foreign middle market businesses, the high level of corporate debt in China raises the danger of financial illiquidity of Chinese importers and a deterioration of commercial conditions in over-leveraged sectors of the Chinese economy.
In October 2016, the International Monetary Fund will formally add the renminbi to the Special Drawing Rights (SDR), signifying recognition of the Chinese currency as an international reserve asset in transition to full convertibility. This development will provide some measure of confidence to foreign companies undertaking RMB-denominated transactions.
However, short-term fluctuations in the RMB exchange rate create uncertainties for foreign companies active in China. Foreign middle market businesses whose Chinese operations are limited to exports are vulnerable to the recent devaluation of the RMB. While the magnitude of these recent exchange rate shifts has been modest (5 per cent devaluation of the RMB against the U.S. dollar between September 2015-September 2016), foreign middle market businesses will face weakening price competitiveness should this trend continue.
Barriers to foreign trade and investment
A number of the Chinese industries of special interest to foreign middle market businesses exhibit comparatively low tariffs. For instance, the average WTO bound tariff on electrical machinery entering China is 9.0 per cent. 25.3 per cent of imported products in that category enter China duty-free.
However, foreign middle market businesses confront a number of non-tariff barriers to entry in China. Incumbent foreign companies in China report increasing regulatory favouritism toward local firms (e.g., faster approval of licenses). Local regulators (emboldened by China’s emergence as a global leader in trade, investment, and finance) are also imposing technology transfer requirements on foreign companies and heightening enforcement of anti-trust laws to shield domestic companies from foreign competition.
This article was written by David Bartlett
Executive in Residence
Director of Global and Strategic Projects
Kogod School of Business
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