MNCs in China Face Rising Challenges

Multinationals (MNCs) in China are facing more and more challenges in the Chinese market while they are seeking to gain a foothold and expand their footprint in the world’s second largest economy， according to a recent report by KPMG.

“MNCs will continue to play an important role but China has evolved quickly， as have Chinese homegrown businesses. Opportunities abound， however， MNCs should be flexible in this market and prepared to adapt，”said Stephen Yiu， Chairman of KPMG China.

“For the most part， the world’s MNCs remain optimistic towards the country’s outlook. There is recognition that China still offers plenty of untapped opportunities and an entrepreneurial spirit，” said Ben Simpfendorfer， Managing Director of Silk Road Associates.

MNCs’ strong interest in China

The fates of China and the world’s MNCs are bound tightly together. In the past two decades， both benefited from the spectacular growth in global trade and investment， said the report.

With the global crisis continuing and the benefits of globalization being reconsidered， the relationship between China and MNCs is set to not only grow， but also grow in complexity.

The report shows that China’s inland economy naturally ranks high on any multinational’s wish-list， both as a place to source product or build retail stores. It is no wonder， given that the inland regions have a combined GDP of USD3，150 billion and population of 720 million， competitive in size to Africa， Latin America， or the Middle East. There is a belief that China’s success (or not) in developing its inland economy will be one of the biggest drivers of global growth over the coming decades. Some hold the view however， that only the largest MNCs will succeed.

MNCs certainly have alternatives to China’s inland regions (or even China itself). UNCTAD’s latest World Investment Prospects survey， for example， shows China as the top priority for MNCs in 2011-13， India and Brazil rank third and fourth， while Russia， Indonesia， and Mexico all make the top ten (with Vietnam and Thailand close behind). Together， those countries account for 16 percent of the global economy， or a similar share to China.

Indeed， some MNCs are becoming increasingly aware of their dependence on China. The country’s huge fiscal stimulus was a source of growth in the early stages of the global crisis. But growth is now slowing and even those manufacturing in China are looking to diversify whether because of worries about rising costs or concerns over potential trade disagreements. “As a result， it is common for MNCs to talk of a China + 1 (and often more) strategy or ‘nearsourcing’，” said the report.

MNCs are interested in China for that the market size is important and so is the pace of change. New markets can emerge seemingly overnight.

MNCs are finding the operating environment tougher than ever and it is a popularly held view that China is no longer a cheap destination to manufacture goods and outsource services. Therefore， a shift in the world’s production chain may be seen.

It used to be that MNCs viewed China as a lowcost export platform， manufacturing goods in Dongguan or Wenzhou for export to the United States and Europe， and so helping to grow market share and even margins. But it is not the case any more: costs are soaring across China making the country an increasingly expensive place for business.

Almost all the MNCs interviewed by the KPMG deem the biggest challenges for them are labor shortages and wage inflation， especially for the consumer goods sector where China’s once cheap-labor offered a major cost advantage. But the country’s ageing population has changed the cost equation abruptly.

The phenomenon of “nearsourcing” is that MNCs are looking to manufacture closer to their home markets and shorten their delivery times and， thus， costs.

However， that does not mean the end of China as the world’s manufacturer. For a start， there is no simple alternative to China: the country exports almost as much as the rest of emerging Asia combined (USD1，900 billion versus USD2，000 billion annually) and twelve times that of North Africa. Further underscoring the point， some of China’s largest container ports also have vastly more capacity than entire countries， such as India or Vietnam.

China’s urban middle-class is burgeoning with increasing income. Still， selling to China’s middle-class isn’t always easy. For instance， consumption patterns can change overnight to create new markets and that requires either investing in new sectors speculatively or responding late to market changes.

The report indicated that it is the end of “cheap China” that has partly triggered the rise of “consuming China”. China’s government is rightly trying to boost incomes and， ultimately， consumption. Tougher labor laws and higher minimum wages are a part of this effort. So long as reform is sustained， the result should be a better balanced economy more reliant on consumption， not investment. In turn， MNCs are viewing China as a place to sell to， not just to buy from.

“China continues to rank high on MNCs’ wish lists， both as a place to source products and to build a retail presence. If China continues to maintain a growth rate of seven to eight percent in the next few years， it is expected to account for as much as 30 percent of the world’s growth through to 2017. This indicates that China will remain a large and growing source of revenue for the world’s MNCs，” said Peter Kung， Regional Senior Partner， Southern China， KPMG.

The growing challenges

China remains a strategically important market for MNCs. However， they also face a number of challenges as they expand their footprint in the world’s second largest economy. These include rising inland provinces， strengthening local competition， and an economy not immune to the current global economic malaise， the report said.

The report finds that China might be one of the global economy’s last bright spots， but some MNCs are finding it harder than ever to compete in the country.

“This is a critical report at a time when MNCs face difficult global conditions， not least the ongoing crisis in the Eurozone， but also at a time when China faces its own challenges， including the need to rebalance its economic model，” said Kung.

“The issue is not that China is short in money supply. The general public has a higher saving rate when compared with the Western world. However， the money is not going to the right channels. A lot has gone to the property sector， but not enough is reaching the private companies in order to help them grow. If more money was directed to the country’s high-growth sectors， then the outlook would be far stronger，” he added.

Many of the MNCs interviewed maintain that benefiting from China’s growth story is not easy. For example， it is far harder to capture growth opportunities in the inland provinces compared to the coastal provinces. They describe the inland provinces as higher-cost， lower-yield， and more fragmented places to do business. However， some of the largest MNCs seem to find it possible to invest for the longterm in the inland provinces， whereas the smaller MNCs tend to be contented with staying in the coastal provinces， at least for now.

The outlook for the future

According to Nick Debnam， Partner， KPMG China， there is little doubt that China will remain a large and growing source of revenue for the world’s MNCs. However， the shift from “cheap China” to “consuming China” means firms will be looking to produce less in the country’s factories， and instead sell more to its consumers—ultimately a more challenging business model， but one that offers significant rewards. And MNCs are not simply to manufacture for those overseas markets.

One major change to look out for is a return to jointventures. Such arrangements were popular in the 1990s， largely because legal alternatives were limited. However， that approach changed soon after China’s entry to the WTO in 2001， and many foreign firms took advantage of more liberal investment laws to set up wholly-owned enterprises， believing that such structures gave firms a greater control over their own destiny and allowed for organic growth.

However， the popularity of joint-ventures is rising again， especially as a result of greater local competition and a push into the more challenging third and fourth-tier cities. It has accordingly made more sense for MNCs to team up with local partners as a way to expand their market， rather than through acquisitions or organic growth. Local firms are also increasingly maturing， valuing joint-ventures not just as a source of income， but as a source of strategic strength.

Another change will be the extent to which MNCs invest more in the services sector， as opposed to the manufacturing sector， a development that would be consistent with China’s own move up the value-chain. So far， such investments have been largely limited to the logistics and financial sectors. But were China to open up a wider range of service industries to foreign participation， MNCs would be sure to respond， said the report.

However， it is important to ensure that both China and the world’s MNCs continue to jointly lobby for further growth in global trade and investment flows amid a period of global difficulties and uncertainties. Both parties have benefited so far from globalization， and should expect to continue to do so.

A need to adapt strategies

Facing the challenges in China， MNCs see an increasing need to adapt their strategies in China. “Unlike ten years ago， MNCs are trying to expand， rather than simply enter the market. They are also finding it increasingly challenging as local competitors have become more competitive，” said Honson To， Partner in Charge， MA and Transactions Services， KPMG China.

“Chinese companies used to rely on foreign capital and so were willing to go to the negotiation table. Today， they don’t need money. They either have their own or are well backed. It’s instead the foreign MNCs that are keen to enter a promising market， and so they find it far more difficult at the negotiation table. And unless they have an attractive brand， such as Mercedes Benz or GM， it is difficult to convince a local partner why they should agree to a joint-venture.”

A lot more domestic consolidation and MA is expected across many industries as a result. “MNCs will be part of the consolidation and MA story， and the smaller MNCs may struggle to exist profitably as a result. We already see that directly in the consulting business. The marginal players with thirty to fifty staff can no longer sustain their business and are already pulling the plug through disposals or leaving China，” said Babak Nikzad， Partner in Charge， Consulting Services， KPMG China.

“The challenge is now to make China a profitable story. MNCs previously preferred to go wholly-owned as that was the best way to drive their own destiny. There are also more local players that see a joint-venture as a key part of their own global expansion as they seek to leverage MNCs more widely， not just a way to earn income and leverage the expertise that MNCs have to offer，” said Rupert Chamberlain， Partner， Head of Transaction Services.

Some of the larger MNCs also face challenges. “The local firms are becoming much smarter. Many Chinese nationals are going overseas to be educated， while local firms are also paying good money to poach talented professionals from MNCs. It’s also cheaper to buy software today， unlike before when you had to spend years developing and implementing systems. As a result， many local firms have become very credible and competitive by properly packaging the people and technology infrastructure aspects of their business，” Babak added.

Before China joined the World Trade Organization in 2001， jointventures were a key priority for MNCs in terms of their China entry strategy. However， shortly afterwards， some MNCs felt it would be better to establish their own enterprises and grow either through MA or organic growth.

“Today， they are finding it difficult to compete and are slipping back into joint-ventures. There is an element of， if you can’t beat them， joint them， not only in the inland areas， but also the coastal areas. Joint-ventures are also crucial in any area that requires licensing，” said Honson.

MNCs have historically tended to set up contract manufacturing structures in China， with a view to targeting overseas customers. However， this is set to change. “In the long run， we see greater opportunities for foreign companies to establish full-fledged manufacturing operations in China with a primary focus on the Chinese market. Intangible assets can be moved into the Chinese operations to increase their market competitiveness. The Chinese tax authorities have implemented several regimes to grant favorable tax treatment to foreign invested companies that develop and own technologies in China， conduct local RD activities to maintain such intangible assets， and interface with the Chinese customers directly to tailor goods or services for the domestic markets，” said Khoonming Ho， Partner-in-charge， Tax， KPMG China.

Shared-services is another important area that offers new opportunities for China MNCs. Babak noted that“China’s MOFCOM is expected to announce its plans for the industry next year， including how China will position itself with respect to other major shared services centres in the world such as India and the Philippines. The industry won’t service only the needs of MNCs， but also domestic companies. This is part of the government’s plan to shift the economy from manufacturing to services.”

This is also likely to impact MNCs. “First， they are likely to relocate some of their overseas back-office operations into China， much as they did with India. And second， they will organize their domestic operations with more being done out of shared services centers to create efficiency and to manage risk better.”

In addition， while the costs of MNCs operating in the coastal cities of China have increased significantly， some areas， such as the western region encompassing less developed inland provinces， are still quite competitive in term of local labor and infrastructure costs.

It is used to be that boardrooms spoke of a single “China strategy”. Today， that approach no longer works， and it is common for the world’s largest MNCs to operate multiple strategies， distinguishing between the coastal and inland regions; the first， second， and third-tier cities; and， the large regional clusters in the southern Pearl River Delta， the central Yangtze River Delta， and the northern Bohai Rim， said the report.