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China growth paths, Team Finland Future Watch Report 2014


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China growth paths, Team Finland Future Watch Report 2014

  1. 1. “Overall, R&D and manufacturing expansion are growing fast in inland regions of China. ABB’s customer industries, such as oil and gas, electric machinery and equipment manufacturing, and power equipment will grow much faster than average in the Western World. Inland regions, especially some key inland cities with top science and engineering universities, also provide a large talent pool.” Claudio Facchin, Senior Vice-President, ABB Group, Head of ABB North Asia Region, Chairman President, ABB China Ltd. By 2020 there will be nearly 800 urban locations (cities and the urban portions of counties) with real disposable income per capita greater than Shanghai’s today. Boston Consulting Group There are over 800 companies waiting for IPO during the last 15 months. Now first 50 will go public and some of them will be cash-rich and good match with Finnish companies to grow international or make M&A. Rami Vehmas, Ilmarinen; Mikko Puhakka, Lion Partners; Jari Makkonen, Finpro China Team Finland Future Watch China Growth Paths – Understanding Future Business Trends in China
  2. 2. Authors of report: Jari Makkonen, Head of Finpro China +86 1381 667 8981 Email: Tony Yao, Senior Consultant, Finpro Shanghai +86 1592 105 5305 Email: Contact information dfasdf
  3. 3. Contents 1. Summary.................................................................................................................................................................. 1 2. Scope and project background................................................................................................................................ 4 2.1 General project scope............................................................................................................................................. 4 2.2 Geographical focus of project............................................................................................................................... 10 2.3 Finland and its position in the global value chain ................................................................................................. 11 2.4 Policies for main drivers of Chinese growth ......................................................................................................... 16 3. Competition and segmentation –related implications.......................................................................................... 22 3.1 Business and segmentation –related considerations in China............................................................................. 22 3.2 Emerging Market MNCs ....................................................................................................................................... 29 4. More detailed look at Shanghai, Wuhan, Sichuan and Guangdong...................................................................... 33 4.1 Regions in general................................................................................................................................................ 33 4.2 Shanghai as a window to world trade................................................................................................................... 35 4.3 Wuhan (Hubei province) as node of logistics ....................................................................................................... 38 4.4 Sichuan as powerhouse of future ICT cluster and automotive industry............................................................... 39 4.5 Guangdong as a platform for adapting products for mainland China................................................................... 41 4.6 Logistics –related on the regions.......................................................................................................................... 43 5. Market entry –related view for companies preparing entry to mainland China and for those already present in East China ...................................................................................................................................................................... 48 5.1 Aspects on managing talents in China ................................................................................................................. 48 5.2 Basic view to Mergers & Acquisitions in China .................................................................................................... 50 5.3 Finnish newcomers to China ................................................................................................................................ 52 5.4 Established Finnish companies in China.............................................................................................................. 53 6. Conclusion and recommendations........................................................................................................................ 55 6.1 Future challenges of China................................................................................................................................... 55 6.2 Challenges to Finnish industry in mainland China ............................................................................................... 59 7. List of sources and interviewees............................................................................................................................ 64 8. Appendices ............................................................................................................................................................ 70
  4. 4. 1 1.Summary The aim of Team Finland Future Watch is to identify business trends and phenomena relevant to Finnish companies during the next 2-5 years. The present report focuses on raising business opportunities in mainland China and there is a special focus on West China and its importance to Finnish companies. Research for this report was carried out via interaction with four companies that made up the steering group. Several Finnish, Chinese and international companies and stakeholders in Shanghai, Wuhan, Sichuan, Guangdong and Hong Kong were also interviewed, and a number of publications, articles and web pages were carefully studied. The growth of China and other emerging markets was the focus of the Team Finland Future Watch report “Sino-Finnish Paths to International Competitive Advantage”, which emphasized how important emerging markets would become by 2050 and stated that at that time China would represent 28% of global GDP. According to official Chinese statistics, the country's GDP grew by 7.7% in 2013. However, this data and other data used for this study were subjected to critical and careful observation, since Chinese statistics sometimes seem to suffer from systematic governance problems. Substantial changes are occurring in China's population and its urbanization process. Private consumption, in particular, will rise when the challenges of social security have been dealt with. Large numbers of people do not enjoy equal access to services reserved for the urban population such as education, unemployment benefits and health care. It has been argued that China will need at least 10 years to build a social welfare system. Easing the One Child Policy will not reverse the problem of China's aging population. The country's workforce is shrinking – especially with regard to blue collar workers – and its dependency ratio is rapidly worsening. Meanwhile, more than 7 million university students begin their studies each year and will have problems finding their first job. Middle-income and affluent consumers (MACs) in smaller cities make up the core of new unknown markets in West China and areas outside known urban centers. They will soon consume more than their equivalents in larger cities because they enjoy lower living costs and have suffered less during the recent economic downturn. The Boston Consulting Group claims that by 2020 there will be nearly 800 urban locations with a real per capita disposable income greater than that of Shanghai today. However, in segments such as the luxury market it will be difficult to make money. 2013 saw a 15% downturn in sales of high-end products as a result of government anti-corruption policies and wealthy Chinese moving abroad. A further challenge in selling to MACs will be the rapidly-developing e-commerce industry and its role in the future (“Taobao” –internet platform owned by Alibaba Company, others). Restructuring of state-owned enterprises (SOEs) between 1993-2003 saw jobs in this sector cut from 76 million to 28 million. However, the privileged access to credit still enjoyed by the remaining SOEs has led to a collapse in capital efficiency (regulated consumer deposit interest rates, shadow banking thanks to unfair competition for credit). The consequence of this has been overcapacity in various industry sectors (steel, glass, shipbuilding, and others), since the primary focus of their operations has been the creation of jobs. SOEs have also paid only a fraction of profits as dividends. The steel industry and shipbuilding industry are typical examples of sectors with
  5. 5. 2 significant overcapacity. Restructuring efforts planned for the near future will probably result in bigger companies, but companies that have the same headcount and productive capacity. One further driver incentive for restructuring is the possibility of access the U.S. driven Transpacific-Partnership, which forbids SOE from its deals. It is likely that the central government is aware of what needs to be done, but has yet to acquire the political muscle required for imposing changes on the powerful SOEs. When it comes to opening capital accounts and having a freely convertible RMB, the China (Shanghai) Pilot Free Trade Zone is the pilot for making cross-border capital movements possible in the future. It is possible that the pilot FTZ will come into effect from 2014. An exact timetable and method of proceeding are in preparation and will hopefully be experimented with soon. Recently there has been news about the further 10-12 new Free Trade Zones to be opened in mainland China very soon. This might imply a faster opening of capital account and freely changeable Renminbi with related risks. Intellectual property rights (IPR) remain a very hot topic in mainland China. Different levels of IPR infringement are happening every day, and this will continue in the future. Competition is extremely fierce in Asia and especially in mainland China. Leading companies like Samsung are proof that you have to innovate in certain sectors (such as electronics) every six months and bring something new to the market if you want to be the leader in your sector. Companies that are not prepared to do so may be better off staying out of China or focusing on another industry sector. For the last 15 months, 800 companies have been waiting for their Initial Public Offering (IPO), because the government does not want them to compete over funds with companies that are currently listed in Shanghai. The first 50 companies will go public at the beginning of 2014. Some of them could become important potential partners for Finnish companies and their growth in China and the world over the next 1-5 years. They could also carry out M&As in Finland. The location of current and future APAC headquarters has been evaluated, and some Finnish and international companies are considering moving theirs out of mainland China for three reasons: availability and cost of Chinese talent capable of working internationally; air pollution; and concerns relating to the rule of law (internet, etc.). These challenges, then, do not only relate to West China but to the whole territory. Business opportunities for Finns in West China often relate to investment in infrastructure. Infrastructure construction technology business is set to increase in West China from 2014-2017, despite the sentiment that tier-1 and tier-2 –cities in this region are becoming saturated by roads, blocks of flats etc. Finnish companies already established in East China might be in the best position for seizing the opportunities of West China because they possess Chinese-speaking personnel and technology already adapted to the China marketplace. West China has more space for Base-of-the-Pyramid technologies, but on the other hand mid-market solutions by Finnish newcomers to China could also work well in tier-1 and 2 cities in West China. Finnish companies normally have to adapt their high-end offerings to China, if they wish to become an important and long-term player in their industry field. It seems that there are two cases related to adaptation of offerings to the local market place. For investment goods (B2B), the mid-market and upper end of the low-mid market are set
  6. 6. 3 to grow bigger in the future because many Chinese companies are increasingly interested in the export market and must improve the standard of their technology and quality of their products. Additional pressure towards industry automation is given by lack of blue-collar workers in the future. This applies both to the production technology used and to end products made by the same companies. Instead, there is another type of development regarding consumer goods (B2C). There seems to be a trend of the low-low segment and high segment selling well, but mid-market and low- mid market brands are under pressure and often lose money on the China market place. Adapting Finnish offerings to the China marketplace, however, will take time, and 10 years is considered normal by some Finnish experts. Chinese end-consumers are increasing their market share of global consumption. The statement of several Finnish companies that “we work only with Western end customers” does not appear to be a sustainable one in the long-run; we must learn to work with Chinese qualified customers very soon. The fight for “Western” business will become increasingly intense as emerging-market multinationals (EMNC), particularly those from China and India, enter to compete for these customers, and hence Finnish companies will have more and more local (Chinese) competition for this type of customers, too.
  7. 7. 4 2.Scope and project background 2.1 General project scope About this project The aim of Team Finland Future Watch is to identify business trends and phenomena relevant to Finnish companies and society in general during the next 2-5 years. This project is part of Future Watch, which is organized by the Tekes (Team Finland Future Watch). An important part of the work carried out by Team Finland is collecting signals from important markets, making sense of them with companies and anticipating major phenomena that can be turned into business opportunities. We also expect this work to increase the basic know-how of Finnish companies and their stakeholders (Board of Directors, industry associations, trade guilds, other) regarding important markets. Tekes organized a tender for Future Watch-related work and this tender was won by Finpro ry. As a result, Finpro is creating the mainland China project. Some other work related to Future Watch was also recently carried out by Booz & Company and the Economist Intelligence Unit. For example, the “Sino-Finnish Paths to International Competitive Advantage” 1 Tekes Report is one of the most recent outputs of the Future Watch. The report explores growth and co-operation opportunities for Sino- Finnish companies with complementary capabilities. Interestingly, opportunities are identified for serving markets in both developing countries (“Breakthrough”, “Latent Demand”) and emerging countries (“Leapfrog”, “Good Enough”). In addition, Team Finland Foresight has provided an understanding of Common Value networks in East Asia, Case maritime 2 . Both these reports are reflected in, and contribute to, the current project. Team and Steering Group The team working on this project consists of Jari Makkonen, Head of Finpro China and Tony Yao, Senior Consultant at Finpro Shanghai. The steering group is made up of management and experts from the following organizations: Tekes (financier), Evac, Glaston, Ilmarinen and MPS China. From October 2013 – January 2014 the research team (Jari Makkonen, Tony Yao – Finpro Shanghai) held confidential discussions with several Finnish and international companies in China in order to gain further insight into relevant issues. The exact content of these discussions is not quoted within this document, since many of the companies interviewed are listed on the stock market and have a strict policy on releasing business information outside normal quarterly or yearly reporting. 1 Jullens J, Suonio S, Tang T (2013) Sino-Finnish Paths to International Competitive Advantage. Booz & company Inc., Tekes. 2 FinNode China (2012) East Asia Value Networks – Case Maritime Cluster; Cluster.pdf
  8. 8. 5 Finpro ry accepts responsibility for the opinions expressed in this report and its content. The Finnish side The Finnish economy was placed under particular strain in 2013 as a result of falling export figures as well as some major – and for Finns rather shocking – restructuring, including the sale of Nokia's mobile phone business to Microsoft. Clearly, one of the major tasks of the Finnish government is to improve economic conditions for Finnish companies in order to encourage current and future shareholders to maintain Finland as the base of their HQ operations, development of R&D, ownership of IPR, branding and other aspects of company operations that capture value for Finnish society. This is especially important in light of the following statement from the ETLA 3 : “Also the share of distribution and both whole- and retail trade can be a surprise to many; hence, out of the total value chain added value a significant part of the value remains always in the country, where the end customer and – user are”. China, then, with over 1.3 billion consumers, should be in a good position to capture value in the future world economy; at the same time, this makes our position pretty challenging considering Finland only has 5.3 million consumers. This report is not about encouraging Finnish companies to outsource abroad. The authors believe that there is a need to maintain and develop industrial operations in Finland, a sentiment shared by several internationally-renowned consultancies that have argued in favor of on-shoring 4 . However, Finland's home market is small, and the same type of on-shoring projects carried out by American companies in order to repatriate production may not be feasible in exactly the same way in Finland. When it comes to Finnish industries, the main areas of interest for China and Chinese companies and other organizations is Finland's arctic know-how, shipbuilding and offshore oil & gas, the paper and pulp industry, energy-saving concepts and clean tech, mobile ICT and gaming. These industry sectors may offer us the most opportunities for developing business in mainland China, since our image in these fields is relatively positive. However, this obviously doesn't preclude us from opportunities in other sectors, too. In relation to these sectors it must be stated that the future Initial Public Offerings (IPO) of approximately 800 companies could bring cash-rich companies to the China marketplace, of which some companies are in sectors for which Finland is known (paper and pulp technology, shipbuilding, offshore oil & gas, paper, other) and could be considered as partners in China or companies interested in M&As in Finland. Finnish companies in the above-mentioned sectors will be particularly attractive to Chinese companies, since we have a track record of good technology levels and existing sales channels globally in these industries that are likely to be bottlenecks for most Chinese companies. 3 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247). 4 McKinsey & Company: Finnemore, Kim & Pande, 2010
  9. 9. 6 The Chinese side China's integration into the world economy began in 1978 in South China and has included several milestones, one of which was China's entry into the World Trade Organization (WTO) in December 2001. This integration is still ongoing: China, for example, is currently drafting a new Government Procurement Agreement with the WTO that could lead to the opening up of the vast Chinese government market to foreign companies 5 . The Chinese government launched its “Go West Policy” in 2000 in order to guarantee more equal development across the whole of China. This, and its implications for Finnish companies and their success in China, is the focus of this project. For the sake of simplicity, Central and Western China will be referred to as “West China”, and comprise all regions except South China and East Coast including Beijing and North-East China. There are several possible growth opportunities for Finnish companies in West China: - Growth in turnover; new geographical markets and segments, better “share of wallet” (higher market share of client’s total purchases) with current products and services (“zero distance to the customer approach”) 6 - Growth in turnover through commercializing new products and innovations and adapting products and services to new target markets. Same products can be possibly commercialized in other emerging markets (BRICS, etc.), once adapted to mid-, low-mid and/or low-low markets - Better sourcing (new partners or new sourcing locations of the current partners) - New solutions for distributing products or delivering services in a more economical way - Possibly finding a better environment for Greenfield operations and joint ventures (JV) active in China, other emerging markets and towards the developed countries, too - Interesting possibilities for Mergers and Acquisitions (M&As’) - Finding new investors to place their stakes and make Overseas Direct Investment (ODI) in Finland. China's improvement of industry, agriculture and value chains in general has been the driver behind phenomenal economic development. The number of Chinese nationals living below the 1.25 dollar-a-day poverty line set by the World Bank has decreased from 446 million in 1999 to 160 million in 2009 7 . Urbanization has 5 Yao Jing (2014) China aims to open up procurement market. China Business Weekly. Jan 13 th 2014. 6 China Development Research Foundation (2013) China Development Forum survey report. Choosing China: Insights from multinationals on the investment environment. 7 People’s Daily Online, Oct 21 st 2013.
  10. 10. 7 supported the country's growth 8 and appears set to continue at a significant pace: 681 million urban citizens in 2010 will become 798 million by 2020 9 . Basically, it is generally said in China that there are some 13-14 million very wealthy Chinese, some 125 million middle-class consumers, and over 1 billion relatively or very poor people. The middle-class is expected to grow to 356 million people by 2020 10 . Much of China's growth has led to inequality among cities and regions, as vividly illustrated by the following chart: China: provincial growth rates (Annual average, in percent) 11 The incomes of China's rich have been growing comparatively faster than those of relatively poor people, and the Gini coefficient for China increased to over 0.47 in 2012 12 . This has been recognized by the Chinese government, and the role of the public sector has been enforced through initiatives such as the Go West policy. However, the results of efforts to create more even distribution of wealth have been modest. There has been much public discussion abroad over how to encourage China to develop its economy in a more consumption-driven direction. This will be no easy task considering the following: 53 % of the Chinese population lived in cities in 2012, but only 27% of them had an urban “hukou”, or household registration 13 . This means that large numbers of people do not enjoy equal access to services reserved for the urban population such as education, unemployment benefits and health care. This affects people's attitude to the security and predictability of the future, and makes 8 Economist Intelligence Unit report, 2013. 9 Mary Boyd at EIU breakfast seminar, Oct 31 st 2013. 10 China Daily (2013) Middle class sitting in the driver’s seat for consumption. Nov 14th 2013. 11 Il Houng Lee, Murtaza Syed, Xhin Wang (2013) Two Sides of the Same Coin? Rebalancing and Inclusive Growth in China. International Monetary Fund. 12 International Monetary Fund (2013) People’s Republic of China. 2013 Article IV Consultation. Washington, D.C. 13 China Daily, Nov 7 th , 2013.
  11. 11. 8 them less willing to spend money instead of saving it. Thanks to the latest decisions of the Third Plenum, the government seems to have begun allowing more provincial sovereignty over budget, which would create a basis for financing social security for migrants 14 . However, it has been argued that in Europe it took approximately 50 years to create a welfare state, and emerging markets will need a minimum of 10 years to build something at least remotely similar 15 . China's government appears to be debating the next steps related to urbanization and the development of the economy in general. One of the questions is how and when to solve the problem of household registration, and whether to encourage more people to move to big cities. The Third Plenum of the P.R. C. Communist Party in November 2013 contributed to this discussion, even though the initial reaction to its outcome was mixed; the European Chamber of Commerce in China (EUCCC), for example, expressed disappointment. According to public opinion, the expectation of a clear direction seems not to have been met. On the other hand, organizations such as the American Chamber of Commerce and PwC seem more positive about the outcome of this meeting 161718 . Public opinion also seems to be that it is clear to the State Council what to do with SOE restructuring, but that the government needs more time to get the balance of power on the side of this restructuring. One recent development, however, could encourage SOE restructuring: the United States is building a Trans-Pacific-Partnership (TPP) and it has a rule that forbids SOEs in its free-trade zone 19 . This could also act a driver for the privatization of China's SOEs. Finpro's view of the Third Plenum is that there is basic understanding about the problems to be tackled, but that there is not yet enough consensus on some measures to be taken. There are also groups of stakeholders who are not prepared to give up the favorable position they currently enjoy in the name of a holistic approach to developing Chinese society. In other words, the current way of working and living with certain problems (e.g. overcapacity) will be sustained during the next two to five years at least. So, the whole topic of SOE restructuring will be an important part of the government agenda in the coming years. However, it seems that the current top party leaders must still build up some political muscle before tackling the strong interest groups associated with the SOEs. It will be especially interesting to see if the restructuring will start from 117 State –owned Assets Supervision and Administration Commission (SASAC)-owned SOEs, and what the method and timetable will be for other publicly-owned entities. Relatively recently, the IMF released a report on the economic challenges faced by China 20 . According to the IMF forecast, GDP growth could slip to 4% per annum from 2013-2030 if the proposed reforms are not implemented. In the event that 14 Mattlin M (2013) FIIA Comment 17/2013. The Finnish Institute of International Affairs. 15 Dr. Xizhe Peng, EIU Breakfast seminar, Jan 15 th 2014. Shanghai. 16 Keith Jarrett, Chairman of AmCham at FBCS meeting, Shanghai, Dec 6 th 2013. 17 PwC (2013) China Desk Newsletter October/November 2013. Nordic & Chinese Company Highlights. 18 PwC (2013) New Roadmap for Achieving the China Dream – Business and economic implications of the Third Plenary Session of the CPC’s 18 th Central Committee. 19 Yang Yi (2014) Diverse ownership to boost SOE reforms. Xinhua, Jan 5 th 2014. 20 International Monetary Fund (2013) People’s Republic of China. 2013 Article IV Consultation. Washington, D.C.
  12. 12. 9 these reforms are implemented, the IMF would expect China to grow 6% per annum during the same period, which would clearly put the whole country in a very different position. Nevertheless, both growth figures will be challenging considering that China's population is aging and needs to transfer its industrial base from low value manufacturing to high value high skill high tech industries at a time when the working population is diminishing 21 . In the global economy the role of mainland China has been the assembly of products that are then exported globally through the distribution channels of traditional multinational companies. In 2012, multinational companies still accounted for over 50% of Chinese exports. Chinese-owned companies are frequently involved in the export of non-branded, low value added products (textiles, shoes, etc.), and large SOEs have been exporting their technology–related products to BRICS, Southeast Asia and countries where China has been an important financier of development, typically Africa and some Latin American countries. Two banks especially active in this field have been China Development Bank and China Exim Bank. The production of low-value added goods has been sustainable between 1978 and today thanks to large reserves of cheap labor and the relatively cheap RMB. However, China's currency has been re-evaluated and this will continue in the future. At the same time, the One Child Policy has resulted in an aging population and will exhaust spare resources of cheap labor over the years to come. In this context, the so-called risk of the Chinese “middle-income trap” must be mentioned 22,23 . In China productivity should improve and the position of Chinese companies in the value chain should be enhanced so that they can excel in at least one of the following areas: R&D, marketing & branding or operational excellence. This will be especially challenging for Chinese SMEs, which have relatively small resources and export capabilities. China could try to overcome the middle-income trap by going beyond mass-produced goods, exporting capital and aggressively pursuing ODIs and M&As as it progresses from 'assembled in China' to 'owned by China' and 'created by China.' 24 21 Lemos G (2012) The End of the Chinese Dream – Why Chinese People Fear the Future. Yale University Press. 22 Stan Shih, 2012. 23 Roland Berger Strategy Consultants (2011) The End of the China Cycle? How to successfully navigate the evolution of low cost manufacturing. 24 Zhang Zhouxiang & Zheng Yangpeng (2014) Overseas investment leads growth prospects. China Daily. Jan 12 th 2014.
  13. 13. 10 2.2 Geographical focus of project Finnish maritime companies 25 have identified the Yangtze River and Pearl River as waterways that contain possible business opportunities. In addition, consultant John Hoffman 26 has indicated the high-speed rail network 27 as a possible enabler for business growth, and hence this has also been considered in the scope of this project. The mobility of its population will be crucial to the future of China, and as such we will briefly address matters relating to airports and their development. The steering group of this project (consisting of four Finnish companies and Tekes) has asked the project team to focus on the following geographical regions: 1. Primary focus: Shanghai Yangtze River delta (as a link to global trade and the main hub of Finnish business in mainland China) and Sichuan, with its capital city Chengdu (Sichuan being, according to several Finnish companies, the most interesting site right now for infrastructure construction– related companies) 2. Secondary focus: Wuhan (node of high-speed train and Yangtze River) and Guangdong province, with its capital city Guangzhou (as a whole entity looking for new direction for its success in the future). The regional scope of this project is already rather huge; however, we would also like to point out the recently-organized EU-China partnership on urbanization 28 which will increase contact between new Chinese cities (cities new to international contact) and cities in Europe. 25 future session of Finnode Common Value Networks in East Asia, Apr 23 rd 2013 26 XRG Company, Team Finland Day, May 7 th 2013 27 The Economist (2013) Faster than a speeding bullet. Nov 9 th 2013. 28 Project Fact Sheet: Sustainable Urbanisation – Europe-China Eco-Cities Link (EC-LINK) Project – a project funded by the European Union. 2013.
  14. 14. 11 This will increase business opportunities between the EU and China, but will also increase the complexity of the Chinese marketplace and number of future competitors. In fact, in an astonishing statement regarding “rising pockets of important consumers”, Boston Consulting Group has claimed there will be 800 urban locations by 2020 with higher real disposable income per capita than that of Shanghai’s today 29 . At the same time, these smaller urban locations are less competitive and there are more first time buyers 30 . 2.3 Finland and its position in the global value chain Studies have already been carried out by the Research Institute of the Finnish Economy (Elinkeinoelämän tutkimuslaitos or ETLA) into Finland's position in the global value chain. 31 In this context, it must be stated that the current method of measuring Finland's economic performance is probably a poor reflection of the overall situation, since it does not measure added value -based exports and statistics are instead based on the gross value of goods exported 32 . This same statistical bias is seen in Asia. China is currently acting as the world's workshop for assembly, but is only capturing a very small amount of the value of the goods it assembles. At the same time, Japan, Taiwan and South-Korea in Asia are producing the most value-added components. These components are then shipped to China for assembly and China has been blamed for the trade imbalance -a problem which is in fact created elsewhere in Asia. However, China's role in assembly may not be permanent. It is aggressively investing in R&D, and has already achieved an important position in international rankings: 29 The Boston Consulting Group (2010) Big Prizes in Small Places – China’s Rapidly Multiplying Pockets of Growth. 30 Chinaskinny (2012) 6 Reasons Why China’s Smaller City Consumers are a Pot of Gold. Dec 13 th 2012. 31 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247). 32 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247).
  15. 15. 12 The biggest countries in terms of R&D expenses (% of the world’s R&D expenses, 2005) 33 Changes of the shares of R&D investments, %-points 34 The ETLA points out that the share of developing countries, despite constituting approximately 25% of R&D costs, is still lower than it should be in the context of these countries' share of the world's volume of production. However, China’s share of R&D work (in person-years) is already higher than that of the USA due to the relatively low cost of R&D personnel in mainland China 35 : 33 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247). 34 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247). 35 National Science Board 2010
  16. 16. 13 The number of researchers in countries and areas (thousand person-years) 36 The ETLA argues that there have been in our Western world three (3) stages of development of productivity 37 : a) Industrialization and people moving away from agriculture. In Finland this trend was especially prominent after the Second World War until 1970. b) People moving from less value-added work towards jobs to higher value added (leading to industrial clusters mostly within one country). In Finland this took place from 1970 until around 2000. c) Change of task structures globally (ongoing). For policy-makers, but also for Finnish industry, it is of the utmost importance to no longer make future decisions based on past industrial clusters and know-how, but instead according to the new realities of the world economy. In this context it is also beneficial to consider the following quote: “Our society is tuned to the needs of large / traditional enterprises; there is still relatively little enterprise activities urging for rapid growth” 38 . The authors, however, believe this is already changing and that Finland now appreciates the value of its small and medium-sized enterprises. The following ETLA chart illustrates the future movement of value chains and industry clusters towards sharing functions and tasks: 36 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247). 37 see also Jyrki Ala-Yrkkö, 2012 38 Pajarinen M, Rouvinen P, Yläanttila P (2010) Missä Arvo syntyy? Suomi globaalissa kilpailussa. Helsinki: Taloustieto Oy (ETLA B 247).
  17. 17. 14 What, then, will be the future role of Finland and Finnish companies in the European and global economy? There seems to be a common understanding that the Finnish companies should move towards the service business. This will require increased understanding about the business of end-customer and how he makes money. Whatever we do, we should always be capable of articulating why the end-customer should work with us instead of our competitors, and how much more money they will make with us 39 : Once we understand how to make more money with our end customer – and this must be more than what our competitors can offer – then we can start designing distribution channels. This is very different from the all-too familiar Finnish approach of 'going to some trade fair without any plan and waiting for somebody to come'. There are lots of opportunities relating to products and services in emerging markets, some of which have been discovered and described in the Tekes report on Sino- Finnish Paths to International Growth. Making the most of these opportunities now and better integrating ourselves with emerging market economies is particularly important since West Europe will constitute just 7% of the world economy in 39 Kaj Storbacka, Vectia Consulting
  18. 18. 15 2050 40 . Currently, the EU represents 20% of the global GDP; China represents 16% and the United States 19% 41 . In this context we must mention the term “creative destruction” proposed by Joseph Schumpeter. According to the ETLA, “creative destruction” can be more useful when it takes place during an upturn. Currently, it is difficult for us to take advantage of this phenomenon during the Finnish and European downturn. In fact, Finland now finds itself in a situation where debts are in the West and funds are in Asia. Especially important according to the ETLA is that there is no further dismantling of Finland's industrial base, although this need not preclude development of the service sector and its capability of creating international business, and, as a result, national wealth. In its research, the ETLA argued that in the past the assembly location of ICT technology did not have a significant impact on the location of value created. 42 However, this seems set to change in the future. In addition, there may be bigger challenges to Finland in terms of value creation and its location with regard to investment goods. In fact, it seems like there are potentially huge differences depending on the location of sourcing, assembly and the end-customer (the ETLA cases for investment goods, value created in Finland 15-64 %), as follows: At first, the transfer of assembly work to abroad can also mean the transfer of sourcing of parts and components together with the assembly. In this case the negative effects of the transfer of assembly for the national economy will multiply themselves. Secondly, the transfer of assembly has smaller effect in cases where the value of the product consists of non-material property. This non-material property is for example brand, patents, software and other similar. Thirdly, the effect of transfer also depends on, which business entities carry the business risks of the group and own its non-material property. These business units should receive the biggest share of the company profit. Fourth, effects of transfer of production also depends on the transfer pricing policies of the company group. The prices with which business units of the group deal with is reflected directly to the place where value is created. 43 The Finnish government is further addressing this topic of the future direction of Finland through such works as Pekka Himanen's “Blue Book / Kestävän kasvun malli, Globaali näkökulma” 44 . Above all, the Blue Book confirms technology as the driver of innovation, as well as the importance of information technology as a facilitator of future value-added products and services. 40 Jullens J, Suonio S, Tang T (2013) Sino-Finnish Paths to International Competitive Advantage. Booz & company Inc., Tekes. 41 The Conference Board (2013) Global Economic Outlook 2014 42 Ali-Yrkkö J (2013) Mysteeri avautuu – Suomi globaaleissa arvoverkostoissa. Helsinki: Taloustieto Oy (ETLA B257). 43 Ali-Yrkkö J (2013) Mysteeri avautuu – Suomi globaaleissa arvoverkostoissa. Helsinki: Taloustieto Oy (ETLA B257). 44 see also
  19. 19. 16 However, it seems to the authors of this report that Finland lacks a master plan and future direction; or, if these do exist, they have yet to be implemented. 2.4 Policies for main drivers of Chinese growth The main bulk of the Chinese banking sector is made up of four major state-owned banks that are also listed on the stock exchange 45 . These four banks are ranked among the ten biggest banks globally. The state sector is also present as a minority owner of other major Chinese banks. This ownership structure has implications for the development of public and private enterprises in China. The role of large banks in shadow banking should probably be better understood and regulated. However, in the course of interviews with an important shadow banking industry expert, he confirmed that the problems of this sector are equal and valid across the whole territory of mainland China. The more problematic part of shadow banking might be to understand and regulate the role of local government and local- level SOEs. An interesting point is that the Chinese government classifies companies as “public” and “non-public”, which reflects the leading position of the Communist Party in the country and confirms the leading role of the state in the market. In January 2014 news emerged regarding the banking sector being opened up more towards the private sector. For example, Alibaba (owner of the Taobao e-commerce site) has begun some banking activity through its Alipay platform (limited banking rights, but tremendous know-how and data bank of buying habits of individuals and organizations). The relatively “easy life” of the Chinese SOEs in terms of -relatively cheap and unlimited finance from SOE banks -low share of profits paid as dividends to the State -focus on job creation instead of high profitability has permitted them to build overcapacity in various industry fields. This remains a persistent problem even today. 46 Many SOEs are controlled by provincial and municipal governments and inefficiently managed. A further consequence of this is that they are not producing dividends, but instead have been contributing to ever decreasing cash flow vs. CAPEX (Capital Expenditure). This mechanism has been well-documented in recent research 47 . In 2014 there have been signs that the banking sector is opening up, but it is too early to identify an exact direction and timetable for these changes. 45 Korhonen I (2013) Kiina vapauttaa rahoitusmarkkinoitaan – Mitkä ovat riskit? Kansantaloudellinen aikakauskirja. Suomen Pankki. Siirtymätalouksien tutkimuslaitos. 46 Zheng Yangpeng (2013) New warning on overcapacity. China Daily. Nov 5 th 2013. 47 IIAA report, Oct 2013
  20. 20. 17 Chinese Prime Minister Li Keqiang recently called attention to this issue and said that provinces must be forbidden from entering into business with their provincial industrial operations 48 . Should this be respected by the provinces, it could change the competitive landscape of some industrial fields. Below is one example of overcapacity in China. With regard to shipbuilding, Chinese shipyards, which are spread over the whole of the East Coast, clearly suffer from overcapacity. Officially there have traditionally been over 1500 shipyards in China, but the state has expressed a desire to consolidate them into 10 strong shipbuilding groups. However, it is not clear when and how this will take place, even though organizations such as the DNV have predicted that it will occur between 2013 and 2015. Finpro is less convinced by the DNV's forecast, and believes that the restructuring may take some 2-3 years more; this is because the government will be worried about exacerbating unemployment. Future difficulties in finding an adequate supply of young and cheap blue collar labor will change this, but that is more likely to happen in around 2017-2020. With regard to river systems, there seems to be high shipbuilding activity in Wuhan (in Hubei province), but otherwise the inland locations are not significant at all, as is logical. Also, the sentiment is that there will be no significant relocation of shipbuilding inland. When interviewing Finnish, Chinese and international companies it became obvious that they were not optimistic towards China's ability to cut overcapacity in several industry fields. Even highly polluting factories have been allowed to continue operating, provided they are located in a fairly remote location and not next to tier-1 or tier-2 cities. The Asian tradition of not wanting to “lose face” and the need to close down certain operations do not seem to go well together. This was also understood during the Finnode project on Factory automation (2011-2012), which noted that Finnish companies' integration with Chinese machine manufacturers failed to result in greater efficiency and profitability: …mergers of local machine tool enterprise turned out less successful than what had been expected. Most of the mergers conducted in China lacked clear objectives and consisted mainly of scale expansion and asset increases, without any clear synergies gained 49 . For the purpose of this study and future development of China's economy, the big question will be whether growth in West China will produce - Even more excess capacity in some industry sectors - New excess capacity for which some capacity in the East Coast has to be closed, or - New value-added tasks or other, which can renew part of the Chinese economy For the time being, it appears that business development in West-China will be once again be driven by investment in infrastructure, such as high-speed rail, airports and roads in Sichuan, rather than the massive building up of further overcapacity. 48 China Daily, Nov 7 th 2013 49 Long Nanyao (2011) Inter China Insight: Chinese Machine Tool Producers – A long and Slow March Ahead. Inter China Consulting.
  21. 21. 18 This was discussed with David Frey of KPMG 50 . However, it must be stated for the record that Chengdu, for example, has managed to attract a large share of the automotive, pharmaceuticals and ICT–related industries, which can be considered very healthy and a positive contribution to national growth. A recent study of FDI in China in 2013 confirms the positive development of FDI as such (growth 5.48% year on year for the first 11 months), but especially good development in FDI in the service sector. This is an encouraging sign and shows that there is room to transfer people from sectors suffering from overcapacity to jobs in the service sector. 51 . The boom in investment in developing infrastructure in West China clearly presents numerous business opportunities for Finnish companies involved in infrastructure construction. There have been, and continue to be, doubts about China's public debt and the eventual “burst of the bubble” in the real estate market. David Frey, however, commented that all the debt in practice is public and we are currently at 25% of GDP in China, whereas in the US this figure is 75%. So, for the time being we must state that there are risks of this type on the market, but any imminent default of the public sector seems to be very remote if the comparison to the US is accurate. That said, local government debt remains a concern and this has also been confirmed by The Annual Central Economic Work Conference in Beijing 52 . Chinese public statistics present certain difficulties to understanding China's economic future. Public statistics seem to have systemic governance problems, thanks partly to the fact that China is the only country amongst G20 countries to not accept all the common practices of keeping statistics. In addition, individual companies also seek to circumvent regulatory restrictions and boost their profits, even when being surveyed by world-class accountancy firms 53 . It is possible that problems of systematic governance may have been exacerbated by the 2008 financial crisis, following which the government promoted growth through various stimulus packages that may not have always worked out as it would have wished. Whatever the difficulties involved in surveying China's current and future economic development, it must be stated that the country has achieved stunning growth over the last three decades since 1978, and China's growth seems set to remain strong until 2017 54 . In early 2014 there has been frequent mention of the risks of doing business in China, one of the most prominent of which has been saturation of the market in tier-1 and tier-2 cities in mainland China. The chart below shows economic growth worldwide up to 2017 and provides a clear indication of regions with the most dynamic growth. Based on this, China's growth seems set to continue; whilst 50 Economic Intelligence Unit, Strategic Forecast September 2013 51 Song Shengxia (2013) FDI sees moderate rise. Global Times. Dec 19 th 2013. 52 China Daily (2014) Tuning up for 2014 reform. Jan 6 th 2014 53 The Economist Intelligence Unit (2013) Flawed data, flawed decisions 54 The Economist Corporate Network Asia (2013) Regional Strategic forecast
  22. 22. 19 forecasts of growth in Latin America and Brazil appear to have been overly optimistic, nonetheless they are still faster than the EU, Japan and the US. There is little need, then, to be worried about the durability of China's growth and the concerns raised by the Economist Intelligence Unit (EIU) in its report “Flawed data, flawed decisions” (2013). It seems that the slowing economic growth is accompanied by the stressed financial situation of (especially privately-owned) companies, who already have steadily falling returns in investment e.g. on the basis of excess capacity built in several industrial sectors. This has made companies in China reluctant to invest in R&D and other long-term projects, and they have instead been seeking quicker returns by diversifying into non-core businesses. The consequence of this has been the creation of business empires whose constituent parts are only very loosely or not at all related to each other. Companies' hesitance to invest in R & D and other long-term projects may have something to do in the Chinese method of building up national companies, and this will be discussed in greater detail in the paragraph about segmentation and competition. When looking at the big picture of China’s future direction in innovation and economic growth, the book “Why Nations Fail” offers an interesting view on the topic 55 : “…Chinese economic growth today has several commonalities with both the Soviet and South Korean experience. While the early stages of Chinese growth were spearheaded by radical market reforms in the agricultural sector, reforms in the industrial sectors have been more muted. … As in the Soviet Union in its heyday, China is growing rapidly, but 55 Daron Acemoglu, James A. Robinson (2012) Why Nations fail
  23. 23. 20 this is still growth under extractive institutions, under the control of state …” The authors of “Why Nations Fail” claim that the Chinese government has to turn towards so-called 'inclusive institutions' and a political system for guaranteeing “constructive destruction” (terminus technical from Joseph Schumpeter, 1942), and must create incentives for people to innovate and compete under certain wider rights than they have today. In China it is difficult to evaluate whether certain investments in fixed assets are reasonable or not. For example, a municipality may be motivated to develop a new metro line not to generate cash through selling tickets at commercial prices, but to create access to new locations in the city. The land in these locations is often owned by the very same municipality, and hence the objective is to earn money through its increased value. In this way money is made from valuation of the land property instead of cash earned from ticket sales. In the past, some investment was carried out in municipal buildings and other similar structures in remote locations, and such investment was not reasonable. The current Party leadership is working hard to avoid such investments in the future. To mitigate the risks associated with a slowdown in China's economy and the resultant problems that this would cause for local companies, China has been promoting the aggressive expansion of its companies abroad, partly through enforcing the “Go Out” -Policy during the Party Congress of November 2012. This could contribute to sustaining the utilization rates of factories higher than would otherwise be the case had these companies restricted their operations to within China's borders. The slowdown in the global economy has led to reduced valuations of companies in the developed world, thus making them attractive targets for acquisition by Chinese companies looking to carry out mergers and acquisitions in Europe and elsewhere. This is likely to contribute to higher Overseas Direct Investment (ODI) by Chinese companies in the years to come. 56 . The recent interviews amongst stakeholders near to the Shanghai Government have revealed that there is a genuine Chinese concern about the future quality of M&A and their success. So, there clearly exists the intention of having more M&A in sight than has been the case up till now. Possibly this also represents an opportunity for the sale of Finnish companies in instances where the owner is approaching retirement age and there is no family member to take over – a widespread phenomenon amongst Finland's post-WWII generation. In this way these companies would benefit from new, active entrepreneurs who might be interested in serving North European markets from Finland whilst also making inroads into the Northwest markets of Russia. In 2012, mainland China’s Overseas Direct Investment (ODI) was USD 84.22 billion 57 , the third highest worldwide after the US and Japan and ahead of United Kingdom, Hong Kong and Germany. The ODI share probably reflects the location of 56 South China Morning Post, Nov 23 rd 2013 57 Antwerp Management School (2013) Euro-China Investment Report 2013-2014.
  24. 24. 21 company headquarters, but also the sophistication of companies and their international exposure. For the purpose of comparison, we would like to confirm that in 2012 Hong Kong’s FDI was US$75 billion 58 and its ODI was US$83.9 billion 59 . FDI in mainland China was USD 243.1 billion. At the provincial level, FDI was as follows: Guangdong 9.6%, Shanghai 6.2%, Hubei 2.3% and Sichuan 4.3%. The figures for Sichuan are likely a reflection of massive investment in the automotive industry, ICT industry and pharmaceutical industry, especially in Chengdu. Direct Domestic Investment figures were not available for mainland China. 58 59
  25. 25. 22 3.Competition and segmentation –related implications 3.1 Business and segmentation –related considerations in China 'We study the mid-market to enter into a new and growing segment' is a statement commonly heard in discussions with Finnish companies listed on the stock market. When talking with Finnish mid-size companies, however, this is unfortunately rarely heard and even less frequently truly implemented. This mid-end performance segment is, though, growing the fastest, and will also become also highly competitive in terms of pricing 60 . In many cases Finnish SMEs have no choice but to stay with their usual high end solutions - but they should also design the so called “good enough” products which are very often in the mid segment 61 . Challenges of segmentation often have a lot to do with local regulations, which may not support energy-efficient buildings, low-carbon and emission burning technology and so on. For example the current building code is from the Soviet era and hence does not address the need for resource-efficiency or energy-efficiency. This obviously might make the mid- and especially high-end solutions totally obsolete for the local market, for the time being. Things could of course change, but not in the short-term. It is also worth mentioning that the so-called 'China speed' sometimes causes strange outcomes. For example, residential buildings built 20 years ago are considered “old”, meaning that both developers and end customers somehow feel that the life span of a residential high rise is only 30 years - after which it must be rebuilt! Let us take a look at market segmentation challenges from the point of entering the China market. It is the opinion of Finpro and the companies we interviewed that there is a strong argument for companies entering China to first focus on developing sales before considering manufacturing operations. Only when they have achieved a genuine presence and significant sales volume in the country should they turn their attention to production and Supply Chain Management (SCM). Doing so, however, represents a major challenge: companies will want to establish a sound network of operations across the whole of China, but it would be impossible for any company to have the resources to be 'everywhere' in a country that is essentially a continent. Companies should not be under the illusion that it is possible to have one office or partner in Shanghai and be truly present in the whole of mainland China. In the following chapter we will discuss the growing number of purely national producers in China that often produce mid-market or low-market products with extremely low prices. Some of them will eventually fail and go out of business, but others will begin looking towards international markets, as argued in the materials on EMNCs. There are several methods of segmenting the B2B -end-user market, but one good approach used by the companies focusing on sales development is to divide Chinese cities into tiers (from 1-5) and then serve each of the tiers with its 60 Roland Berger Strategy Consultants (2011) Production Systems 2020 – Global challenges and winning strategies for the mechanical engineering industry. 61 Jullens J (2013) China’s Mid-Market: Where “Good Enough” Just Isn’t. Booz&co.
  26. 26. 23 own set of technology and partners. China only has four tier-1 cities: Beijing, Shanghai, Guangzhou and Chengdu. Tier-2 cities are the second most important cities and are often municipalities or provincial capitals. Hence it is clear that important cities can be found basically anywhere in China even though there is only one tier-1 city in West China. When debating in this chapter some aspects about how to organize business in China from the point of view of competition and market segmentation, we presume that any Finnish company – when entering China and when developing its business here – is ready to adapt its business model and way of working to the local conditions. A relevant statement on this is from Chesbrough (2010) 62 : “a mediocre technology pursued with a great business model may be more valuable than a great technology exploited via a mediocre business model”. It is clear to everybody that China is not a country, but a continent and that particular attention is required when addressing its business opportunities. This is especially true for Finnish companies, which are often very small (including Finnish companies listed on the stock market) when compared to the size of the Chinese market, competitors, and potential partners. It could well be that we need several business models when working in mainland China depending on our resources and the sophistication of our market segmentation. All efforts in oversimplifying the above situation will most probably result into an unprofessional approach to the market. As a matter of fact, out of four types of innovation (business model, process, market, product or service) 63 Finnish companies mostly seem to focus on product innovation. In case of mainland China more creativity on other forms of innovation would be definitely required. This also implies that, due to the size of several Chinese competitors, Finnish companies will not enjoy a level playing field in terms of resources and low-cost manufacturing facilities, etc. At the same time, Chinese companies' model of competing with their international equivalents is unprecedented. This will be discussed in more detail in a separate chapter. In this context we should point out that competitors in China are generally very numerous and they are fast to learn from us. In some interviews with companies in Finland they stated that they had 3-4 international competitors; in China this figure is at least 400 competitors or more. Another example is the Chinese car market, which contains 375 brands 64 . This number is probably unsustainable in the long run and this field will see a large amount of mergers. Despite these numerous competitors, Finnish companies should follow the most relevant ones (at least those relevant in our segment) to understand how the competition will evolve over time. Several concepts are important to understand when working in China and Asia in general. One of them is that there is increasing local competition, which may become truly international very soon. There has been some international research on this and 62 Chesbrough H (2010) Business Model Innovation: Opportunities and Barriers. Long Range Planning. 63 Trias de Bes F & Kotler P (2011) Winning at innovation – The A-to-F Model. 64 The Wall Street Journal (2013) Chinese Car Buyers Will Wait for Deals. Nov 28 th 2013.
  27. 27. 24 we have enclosed one of the latest reports regarding so-called Emerging Markets Multinational Companies (EMNC). In this context, end customer segmentation also has to be addressed and Finnish companies have to become better at this. Unfortunately, the Finnish market is so small that true market segmentation is not possible, and hence we have not acquired substantial know-how in market segmentation from our domestic market. In this section about segmentation we use the type of segmentation mostly discussed and used with Finpro China and its Finnish clients’ operative business development work in the field. Each company, of course, might use its own vocabulary with regard to segmentation, but what's important is that the segmentation is carried out and implemented in daily work. The following example is based on concrete segmentation cases of some Finnish companies. In the brackets we use typology often used by Roland Berger Strategy Consultants (later: RBSC). - Imported product (high according RBSC) / mid-market (mid and low-mid according RBSC) / national level (low-low according RBSC) - International leading level (high according RBSC ) / local leading level (mid according RBSC) / mid-market (low-mid according RBSC) / national segment (low-low according RBSC) - And several other ways; important is that this directs our implementation efforts of selling aggressively on the mainland China market place. Later in this report we discuss segmentation based on Finpro's experiences, and we can characterize the segments as follows: High segment: end customer has his/her set of tender parameters, which not only include price range (budget) for the product or service to be sourced, but also lots of parameters and attention to resource efficiency, long product life, reasonable life time cost and similar (Total Cost of Ownership, or “TCO”). Opportunities for service business after having sold machinery or similar are relatively high and the business model for service business might be relatively “Western”. For the purposes of this exercise let us suppose that this segment has a price level of 100 RMB per unit and that the size of this segment could be 1-5 % of the total size of the market. It is clear that this segment is small, in addition to which it is very often already occupied by multinational companies with strong brands. Hence, entering this market as an unknown Finnish company with an expensive product will not be easy at all. NB: A company with an expensive product is not automatically part of the high- segment market. The end-customer decides the set of comparison parameters, not the manufacturer! Mid-segment: end customer has his/her set of tender parameters, which not only include price range (budget) for the product or service to be sourced, but also some parameters and particular attention to operating costs, relatively long product life, life time cost and similar (Operating Expenditure, or “OPEX”). Opportunities for service business after having sold machinery or similar exist and the business model for service business might be relatively “Western”. For the purposes of this exercise let us suppose that this segment has a price level of 70 RMB per unit and that the size of this segment could be 10-15 % of the total size of the market. There could be significant growth in this segment in the future, and all Finnish companies should study it carefully and implement competitive products on this segment.
  28. 28. 25 Low-mid segment: end customer has his/her set of tender parameters, which not only include price range (budget) for the product or service to be sourced, but also some parameters and attention especially towards operating cost and somewhat long product life but rather little attention towards life time cost and similar (Capital Expenditure, or “CAPEX”). Opportunities for service business after having sold machinery or similar might be relatively small and the business model for service business might be very different from the “Western” one. For the purposes of this exercise let us suppose that this segment has a price level of 50 RMB per unit and that the size of this segment could be 30-40 % of the total size of the market. Some good Finnish companies have already designed and launched products into this segment, which will open to them markets not only in mainland China but in all emerging markets. Chinese national champions are about to begin exporting to Europe and will create a lot of competition in 2014/2015. What will happen to our market share in Europe if these companies offer their products 30-50% cheaper to our customers than we do ourselves currently? Low-low segment: end customer has his/her set of tender parameters, which very much focus on price for the product or service to be sourced (Capital Expenditure, or “CAPEX”). The end customer very probably believes that everything produced in the Western countries is automatically “expensive”. Opportunities for service business after having sold machinery or similar might be extremely small and the business model for service business might be totally different from the “Western” one. The after-sales market exists, but most probably in the format of using the machinery without or very little service, breaking it up and then having one retrofit repair before abandoning it or similar. For the purposes of this exercise let us suppose that this segment has a price level of 30-40 RMB per unit and that the size of this segment could be 40-50 % of the total size of the market. Chinese companies in this segment will most probably be not capable of exporting their products, but they will certainly get their share of business in mainland China in the coming 2-5 years when this segment will exist and flourish. In discussions of product life, one thing must be taken into consideration: In many cases the Chinese end users may have much less sophisticated ways of using or servicing products. Hence, a product that might normally be used for 10 years in Finland may only last for 3-4 years in China. This is commonly seen in Russia, too (construction machines, etc.).In this context the following chart illustrates the situation and segmentation described above 65 : 65 Finpro, Professor Kristian Möller of Helsinki Business School, other
  29. 29. 26 To elaborate, what the chart shows is that low-low and low-mid segments focus on Capital Expenditure (CAPEX) - i.e. what it costs to buy the product - and are less concerned with the products’ life-cycle cost and length. In the mid-segment, customers are more interested in Operating Expenditure (OPEX) - i.e. what it costs to operate the product, and how long it will remain in operation, etc. In the high-segment the customer may be interested in the Total Cost of Ownership (TCO), green values, and sustainability, etc. This segment is probably extremely small in China. At the same time, the service business is bigger in TCO and OPEX –businesses, whereas in the lower segments it may exist but is out of our reach. However, it was expressed by some companies that despite the difficulties involved in offering industrial services to Chinese customers, it was still worthwhile since copying products is easy, but copying services is more difficult and not possible for local companies that do not have their capabilities geared to the levels of Finnish MNCs and other similar companies. According to interviews and meetings with people working in the machinery sector, in China the mid-segment and low-mid segment may increase in value and volume during the coming years. The low-low segment will probably continue to be an important presence from 2014-2020, but will suffer from a lack of blue-collar workers later on, and will have to give away to more automated and higher segment solutions from around 2020. Basically, the companies interviewed can and must vary the intensity of their commercial focus on the different tiers of cities in terms of their method of sales funnel management (that is, how to qualify potential customers into further phases of sales process in some understandable and efficient way) and type and quality of partners used as distribution channel. Furthermore, there will be a need to adapt products and technology to the various geographical segments (tiers of cities in this example) and type of distribution channel used. In fact, one of the interviewees has two product lines (one for mid-segment, one for low-mid segment, each of them with its own marketing department, brand image and level of technology) and is typically more aggressive in its offering of mid-segment products to tier 1 and 2 –cities, low-mid segment products to tier 4-5 cities and then a combination of both to tier 3 cities. Another interviewee in the Small and Medium- Sized Enterprise (SME) category focused their efforts on the level of provinces of major interest, working with their own personnel on system integrators and important end customers. In other – for them “secondary” provinces - they build either agents or
  30. 30. 27 distributors, and some of the provinces are only dealt with through OEMs during the times when they happen to have business there. The combinations are of course infinite and must be the result of good strategy and consideration of the resources available. As stated previously, few Finnish SMEs seem to be evaluating the possibility of launching two separate product lines of differing technology content and quality. This is understandable, but where companies are only able to support one product line it should be aimed at a growing market segment and positioned in a way that allows it to be defended from the competition. This project's steering group also proposed the idea that Finnish SMEs could and should more easily experiment with segmentation and various production lines and or productive units in regions such as Southern Europe or Central Eastern Europe, when recent years have seen increasing investment from Chinese SMEs. The following is an excellent example of a company adapting its product to local market conditions. GE Medical Appliances is specially mentioned in the context of EMNCs and TMNCs (traditional multinational companies) responding to their competition 66 . In fact, during research for this project the GE Customer Innovation Center in Chengdu was visited and it was very clear to us how effective their approach to adaptation is: the product, usage of it, training for it and other aspects are all very strongly tied to the end user and the benefits they can gain from using GE's specially engineered products. Products developed in Chengdu specifically for the conditions in West China are sold in China, other emerging markets, but also partially in developed countries. In this way, GE's work in developing West China can serve new segments poorly served in developed countries, too. This permits GE to be present in the customer's life during the whole life cycle of their medical product, opening possibilities to serve the end customers with other products and further services (education, etc.). Lately Finnish infrastructure related industry seems to have lot of work especially in Sichuan, which has traditionally been a rather poor and backward province. Basically, according to theory we should be offering more low-low or low- mid segment products (Base-of-Pyramid, or BOP products) when operating in the relatively poor West China. On the other hand, Finnish companies with factories in East China but whose market are in West China should theoretically focus on higher segments to compensate for the cost of transport to West China. So, to summarize, Finnish companies that wish to maximize their profits should theoretically locate themselves in West China and sell BOP products to West China and high-segment products to the East Coast. Obviously, tier 1-2 cities also exist in West China and there would be some space for higher-positioned goods locally, too. However, where Finnish factories are already located in East China they will probably have very little economic opportunity to move them to the West China unless for some specific reasons that we can truly calculate at the level of P&L. The impression we gained from interviews was that, whilst they may be planning to strengthen their 66 Chattopadhay A, Batra R, Ozsomer A (2012) The New Emerging Market Multinationals – Four Strategies for Disrupting Markets and Building Brands. The McGraw-Hill Companies.
  31. 31. 28 distribution operations in West China and possibly source local components, etc. from there, in general they were not seriously considering relocating the whole of their operations to this region. In other words, though some part of the supplier base may be transferred to West China, the factories themselves and possibly system integrators used by companies will remain where they are, which is probably in the East Coast or South China. Lately there has been a spectacular decision of relocating Baosteel from Shanghai leaving only R&D unit of 1000 people in Shanghai. However, we believe that this is no major short- or medium-term trend for industry in general. Should we consider serving West China from Shanghai and the surrounding area, we would probably have to reconsider our current logic of production. Several locations in West China may be difficult to serve with the usual “manufacture to order” philosophy, and would require us to produce goods for stock and have them available in various types of distribution centers or similar venues in West China. China is also a continent with a variety of regional markets, as confirmed by McKinsey. This may require the use of local sourcing partners, business model(s) and other parameters to become locally successful. A big question for newcomers to China is: where should I locate my productive operations? The only valid answer to this is to just make your business plan and draft a P&L, and then you will know where to be. Most probably it will also be useful to build up some possible scenarios in order to evaluate the raw materials, markets, competencies and capabilities present in certain locations. At the end of the day, each Finnish company must select the location of its main factory and eventual logistics centers based on its own circumstances: location of component and system suppliers, location of end customer segments to be served, logistic cost serving said customers and possible other topics, if any. Based on our interviews, China's river systems would appear to offer almost no potential for machinery products, but play an important role for bulk products (chemical products, construction material industry raw materials, coal to some extent, etc.). Railways appear to be used occasionally, but most machinery-related products travel on trucks. The large number of corruption scandals involving China’s railways during winter 2012-2013 has limited the possibility of innovation and development of the country's railway network. Possibly this problem will improve once it becomes clear that administrative changes in this industry have been effective, which could then result in more substantial development of the railway network in relation to goods traveling between the East Coast and West China. As previously stated, the consensus appears to be that, in the machinery sector, the mid segment is growing the fastest. At the same time, we know that Chinese and international companies are striving to produce suitable products and services for this segment. Another trend in B2C business also seems to be occurring, especially with regard to luxury goods. It appears that only a limited number of high-end segment brands have been able to break even, and many mid segment brands are losing money or exiting the Chinese market; the low-low segment, meanwhile, is very large and important. In fact, the owner of one luxury brand that we interviewed said that they only expected to start making money in China after investing in the market and
  32. 32. 29 educating Chinese consumers up to 2020. In this context, it is instructive to analyze the way Chinese consumers adopt new products and technologies. The following example comes mainly from the B2C sector. Diffusion of a new luxury product in an Asian context 67 Chinese consumers seem slower to adopt new concepts and brands in the B2C market. However, this may not be the case in B2B markets, especially for those companies which are capable of convincing customers of their ability to improve customer P&L. However, this slow capability in adopting new technology might be compensated for by the new e-commerce industry in China, which offers great convenience and extremely low prices (Alibaba being owner of Taobao, other e-commerce players). 3.2 Emerging Market MNCs An interesting question is where Finnish companies will face the most competition from in the future. Will it be in China's East Coast, or will it be in West China, or elsewhere? Who are our competitors – will they be our Finnish or international counterparts, or will there be increasingly tough Chinese and Indian competition for the very same markets in mainland China? Or, will these competitors from emerging markets soon be found in Europe? Chinese SOEs have traditionally devoted most of their attention to the national market. In addition, they have normally been very active in Southeast Asia and Africa, where China has been a very important source of financing for infrastructure projects and projects producing raw-materials to be imported to China. In fact, China's importance as a financier has outweighed that of the World Bank Group in some African countries, and China has also financed much of the infrastructure for offshore oil and gas in countries such as Venezuela. In these cases, when financing these countries China is actually paying up to 60% of the financing funds directly to the Chinese technology suppliers, which are very often large SOEs or big private 67 Chevalier R, Lu P (2010) Luxury China - Market opportunities and potential. John Wiley & Sons (Asia) Pte. Ltd. Singapore.
  33. 33. 30 companies. Oil is frequently used as a bartering tool and it makes the overall Chinese offering very interesting to the countries, which otherwise might not have the opportunity to develop usage of their national resources. Chinese SOEs can be found all over China (including West China). Often they were moved to places such as Sichuan right after the Second World War and following China's disputes with the Soviet Union, thanks to Mao Zedong's fears that both the Soviets and the USA might attack these nationally important companies. In various fields there might be several of these national champions, with each of them competing against each other but servicing mostly their own region (e.g. SOEs in Sichuan for West China, in Dalian for North-East China and Shanghai for Central and South China). Private Chinese companies seems to prefer staying in regions in which they are familiar with making new productive operations, possibly not too far away from their home regions. One further thing has also become clear during this study: private Chinese SMEs have not been aggressive in exporting their products, but will now start to do so following encouragement from the central government's 2012 Go Out policy. An interesting study was recently carried out of EMNCs 68 . It was based on the notion that in 2005 there were 44 EMNCs amongst the world's top 500 firms; in 2010 this figure had risen to 113. The enclosed chart describes them well and how they can be classified: Some companies headquartered in West China will eventually become EMNCs in the future. The current growth in West China seems, however, to have come from infrastructure investment (construction), whilst the outlook of private SMEs remains very local. This may mean that in the near future we will see some Sichuan-based SOEs becoming EMNCs (and being possibly privatized), rather than seeing the local private sector go international. 68 Chattopadhay A, Batra R, Ozsomer A (2012) The New Emerging Market Multinationals – Four Strategies for Disrupting Markets and Building Brands. The McGraw-Hill Companies.
  34. 34. 31 Before they eventually becomes EMNCs, there is currently an ever-growing group of Chinese companies that are not (for the time being) growing internationally, but which nonetheless offer huge competition for us in mainland China. As above and in a separate project we have roughly classified them as a) high-end product, b) mid- end product and c) national low-end product companies. High-end products are mainly introduced to the market by international (also Finnish) companies that have established a commercial – and as is increasingly the case, industrial – presence in China. Mid-end products are very often introduced by Chinese competitors copying some Western products (or rather one product of the whole range) and introducing it to the national market priced at 30-50% of the Western equivalent. The problem is that these copies are sometimes even better, technically-speaking, than the Western ones 69 ! National products are those made with a simple design, solutions and drawings currently nationally used by many companies, low quality short product life and extremely low pricing. We would expect that the companies currently producing low-low segment products in mainland China have little chance of being able to export them, and it is highly dubious that the companies of the low-mid segment will also be able to export elsewhere, apart from to some poorly-developed African countries and possibly to the least-developed Latin American countries. Instead, local manufacturers entering the lower end of the mid-end market can strive to become a Knowledge Leverager or Niche Customizer 70 in some emerging markets, or alternatively to make the jump into developed markets with Cost Leader or Global Brand builder strategies. Whatever the market position of the new Chinese EMNCs might be, they will have to face the difficulties of the slowing mainland China economy in a very particular way. This could present them with some huge commercial and productive challenges, of which there has lately been a lot of evidence 71 . EMNCs, however, have proven to be very resourceful in finding solutions to their 'growing pains', and have been able to effectively move from one category to another. Below is one concrete real world case of an Indian company that evolved into a truly international player 72 : 69 Interview with Jyrki Poikkimäki, VTT Shanghai, Nov 18 th 2013 70 Chattopadhay A, Batra R, Ozsomer A (2012) The New Emerging Market Multinationals – Four Strategies for Disrupting Markets and Building Brands. The McGraw-Hill Companies. 71 Jullens J (2013) Harvard Business Review: How Emerging Giants Can Take on the World. 72 Chattopadhay A, Batra R, Ozsomer A (2012) The New Emerging Market Multinationals – Four Strategies for Disrupting Markets and Building Brands. The McGraw-Hill Companies.
  35. 35. 32 Chinese SOEs have a plentiful supply of financial resources for the above-mentioned evolution, but Chinese SMEs very often have to rely on the gray financing market 73 or on an Initial Public Offering (IPO). It would be interesting to better understand how Chinese private equity companies evaluate the originality of a business idea and business plan, but this is beyond the scope of this study. Considering Chinese companies' current approach of imitating Western technology, they sometimes seem to operate with concepts and a work approach generally not acceptable or used by Western companies. However, those imitating Western products seem to have one big moment of truth in their growth, since they cannot carry out an IPO if they have IPR-related disputes or similar. Companies from mainland China today list themselves either in Shanghai, Shenzhen or in Hong Kong. Several have also been listed even on the New York Stock Exchange. IPOs and the infringement of Intellectual Property Rights (IPR) do not go well together. This delicate moment of transition also might offer good opportunities for Finnish companies to defend their IPR and get paid for know-how, which has been “transferred” in a not-so-traditional way. There are around 800 companies waiting for the authorities’ permission to launch their IPO. This backlog of IPOs is due to concerns by the authorities that this number of public listings would make shares in companies that are already listed soar. However, the ban was removed this year and the first 50 companies are set to go public in the first half of 2014. There is going to be lot of regulation from the China Securities Regulatory Commission (CSRC) 74 . One must bear in mind that Chinese companies not launching an IPO still may still find surprising resources for building new companies. This has long been the case not only in China but historically also in regions such as Southeast Asia, where Chinese shopkeepers have been able to develop their commercial operations thanks to 'clan financing' of initial capital as well as their deep understanding of the cash economy 75 . 73 Joe Zhang (2013) Inside China’s Shadow banking: The next subprime crisis. Enrich Professional Publishing. Honolulu. 74 (2014) China says to strengthen supervision of IPOs. Jan 13 th 2014. 75 Osborne M (2013) South East Asia – An Introductory History. 11 th Edition. Allen & Unwin.
  36. 36. 33 4.More detailed look at Shanghai, Wuhan, Sichuan and Guangdong 4.1 Regions in general Historically, China's modern growth started from South China, where opening of the market has been going on since 1978. From South China the growth has expanded towards the East Coast (Shanghai, other) and obviously to the capital Beijing. One important milestone of this opening was China's entry into the WTO in December 2001 76 . China has achieved phenomenal growth since 1978 and there have been huge changes in the availability of labor resources inland (with workers migrating to better jobs in South China and East Coast), as well as in the cost of labor in East Coast and South China, which has been increasing rapidly. However, China's One Child Policy seems set to bring an end to this supply of cheap labor, possibly by as early as 2020. At the same time the Chinese RMB has and will strongly appreciate. Hence, the problem of the “middle-income trap” is further accentuated by these issues. However, when evaluating the development of China, it is important to bear in mind that China will be a superpower, but also a country (or rather a continent) with some underdeveloped Western regions, a situation that will persist until 2050 or so 77, 78 . The Third Plenum seemed to confirm that the Go West Policy remains one of the key components of governmental policy, even though there was nothing explicit or new in the working documents of the Plenum for November 2013 79 . The Go West Policy is generally known throughout the whole of China but it is lived in a very different way in various parts of the country. When conducting interviews in Guangdong province it became relatively evident that Guangdong province (following the crisis of 2008) is focusing on re-launching its economy and the development of an economy with the neighboring western provinces, rather than looking to central or west China in a way that might be the case for companies in areas such as Jiangsu province and Shanghai. Economic growth in West China, as in the whole national economy, is a combination of growth caused by increases in input volume and growth caused by increases in productivity. We can hypothesize that there is more capacity for growth in West China based on increases in productivity (a relative increase of workers from agriculture to industry), whereas there will be much less room for growth in input volume, since there are several fields of industry in China suffering from heavy overcapacity (shipbuilding, steel production, etc.). The commercial and productive operations of Finnish businesses, on the other hand, are predominantly located in Shanghai and Jiangsu. A certain number of companies 76 Korhonen I (2013) Kiina vapauttaa rahoitusmarkkinoitaan – Mitkä ovat riskit? Kansantaloudellinen aikakauskirja. Suomen Pankki. Siirtymätalouksien tutkimuslaitos. 77 Jacques M (2009) When China rules the world. Penguin books. 78 International Monetary Fund (2013) People’s Republic of China. 2013 Article IV Consultation. Washington, D.C. 79 Keith Jarrett, Chairman of AmCham at FBCS meeting, Shanghai, Dec 6 th 2013.
  37. 37. 34 are also based in Beijing and South China. Companies involved in infrastructure construction frequently claim that a lot of their contracts now come from West China. However, research into the current situation of Finnish and Swedish businesses revealed that most of their end customers came from very traditional regions (Shanghai, Beijing, Guangdong and Jiangsu) 80, 81 . When addressing business growth expectations, Chinese and multinational companies follow different Key Performance Indicators (KPIs) in their business in order to forecast the market and its evolution on the level of national economy, provinces and important cities. One of the typical indicators is the Purchasing Manager Index (PMI) by the China Federation of Logistics & Purchasing (CFLP) and it could be also relevant to understanding West China’s speed and direction of growth. However, there is no provincial data available for the time being and hence we cannot refer to the KPI. Part of the future potential of productivity growth is the availability of talent. Below is some information about the top universities in China and their locations. Chinese top universities 82 Innovation is supposed to be one of the main drivers of economic growth. 2012 patent statistics from China's State Intellectual Property Office (SIPO) for Sichuan, Hubei (Wuhan), Shanghai and Guangdong are as follows (share of patents from all national patents granted): Guangdong: 11.28%; Hubei (incl. Wuhan): 2.21%; Shanghai: 6.62%; Sichuan: 2.27 % Guangdong constitutes approximately 11% of China's national GDP; Hubei 4.3%; Shanghai 3.9% and Sichuan 4.6%. So, the number of patents granted compared to the region's share of GDP appears to be especially strong with regard to Shanghai. As a matter of fact, companies like GE conduct basic R&D in Shanghai and already innovate in several businesses in mainland China. At GE Healthcare, the applied R&D is done in Chengdu, innovating with end customers to find new ways to work in 80 Embassy of Sweden, Swedish Chamber of Commerce, Business Sweden (2013) Swedish Business in China – Trends and Challenges. 81 Finnish Business Council Shanghai (2013) FBCS China Business Climate Survey. 82 China Education Center Ltd. (2013)
  38. 38. 35 remote regions of West China. The same experience and solutions could easily be applied to regions such as India, Africa and Latin America. More Finnish companies should adopt this way of working - which sometimes requires a more aggressive attitude to adapting our products to real end customer needs - if they plan to expand and become a bigger player in their own industry. 4.2 Shanghai as a window to world trade Shanghai is a provincial-level city and currently has some 23 million inhabitants. This figure is expected to grow to 30 million by 2030 83 . Shanghai’s gross domestic product grew 7.7 percent year on year to exceed 2 trillion RMB (321.2 billion USD) in 2012 84 . To put this in context, Finland's GDP was 248 billion USD in 2012 85 . Shanghai has also profited from the Communist Party's decision in 1991 to relaunch of China's development in Pudong following the Tiananmen Square incident in 1989. Shanghai was declared the world’s busiest container port in 2013, an achievement that accorded with the city's goal of becoming a leading shipping center 86 . Shanghai is not encouraging much manufacturing industry to build more capacity in its territory, and hence companies from Shanghai often build new manufacturing operations in the surrounding provinces, typically in Jiangsu province. Finpro interviewed several Finnish companies in Shanghai and Jiangsu, and visited some of the Chinese and international companies operating or building new manufacturing operations in Taicang, which lies close to Shanghai. The impression we gained from these interviews was that Shanghainese and international companies already established in Shanghai or Jiangsu do not have any serious intention relocating their manufacturing operations towards west China; rather, they see the value of continuing to manufacture in their current locations, in an environment that is familiar to them and in locations where they have already built up talent and technical capability. Shanghai was ranked world number 1 in the latest PISA study. This reflects the level of education, appreciation of hard work and possibly some “local measures” to achieve good results in the said competition. In a relative recent study Shanghai was ranked as one of the top cities for regional headquarters in the Asian Pacific Region (APAC). Two other highly-ranked cities were Singapore and Hong Kong. 87 Shanghai scored highest overall, but the more traditional Singapore and Hong Kong also scored highly in certain fields. Beijing is a good number 4. In this comparison also Guangzhou and Shenzhen are mentioned and hence Guangdong is also very well in the picture. 83 EIU breakfast Seminar, October 2013 84 (2013) Shanghai GDP tops 2 trln yuan in 2012. Jan 22 nd 2013. 85 86 Richard Fu (2014) Shanghai still container port leader. Xinhua, Jan 5 th 2014. 87 European Chamber (2011) European Business in China: Asia-Pacific Headquarters Study. In partnership with Roland Berger Strategy Consultants.