Decoding China’s Third Plenum Reforms for MNCs

There has been much talk about China’s Third Plenum, and with good reason because China’s Third Plenum is one of most important meetings for Chinese economic and social policy.  Deng Xiaoping, China’s paramount leader following the death of Mao, inaugurated the meetings in 1978 to implement economic reform within China, which effectively opened up China’s economy to increased foreign direct investment (FDI) and laid the foundation for China’s golden 30 years.

Not only is the Third Plenum considered a crucial moment for China because of its global economic impact, it is also the stage for China’s new 5th generation of leadership, Xi Jinping’s administration to unveil a new agenda for key political, economic, and social policies.  These policies will effectively decide China’s growth trajectory over the next 5–10 years, which not only has an obvious impact on China but also the global economy. The Third Plenum comes as China faces unprecedented economic and social challenges from local government debt, shadow banking, and staggering GPD figures. The Chinese government is expected to take the opportunity to address all of these challenges and to plot the course for the coming years.

China's Third Plenum

How will the Third Plenum affect Multinationals doing business in China?

The Third Plenum will certainly affect the competitive landscape within China.  As part of the plenary process, the Chinese government will identify relationships between SOEs, private owned companies, and multinationals. Private enterprises are to obtain more freedom, but SOEs will still remain dominant players in the market. The Chinese government will also emphasize the role of market forces, albeit a double edged sword for multinationals.  Allowing market forces to direct investment will give private domestic companies in China reduced barriers of entry and easier access to capital.

The Chinese government will also deregulate the price for energy which will affect the cost of doing business. Though this will increase the cost of doing business in short-term, the government will also enact interest rate liberalization leading to the lower borrowing cost for companies in the future.  Any company currently doing business in China knows that government engagement is necessary, even if cumbersome.  This will remain the case for MNCs since purchasing decisions will remain consolidated at the central level, including food, drug, healthcare, and construction. MCNs need to consider crafting a centralized government engagement strategy to navigate the political field.

The Plenum will also affect consumer bases, namely those in the early childhood sector can expect a large increase in the consumer base. After the relaxation of one child policy, urban families are allowed to have two children if one of the parents is an only child, which is expected to lead to 2–3 million new babies born each year. Baby-related consumer products, such as in food, diapers, infant milk powder, automotive, toy and clothing industry, will boom in the short term. However, since newly born babies won’t enter the workforce within the next 20 years and parents need to reduce working hours to care for additional babies, a smaller supply of workers will push up labor prices in the middle term.

Lastly, and certainly not least, foreign investors will see significantly lower regulation barriers.  Mixed ownership structures will be allowed and investors will be encouraged to for private sector partnerships in key strategic industries. MNCs will enjoy the improved regulatory transparency and stability for foreign investments in the Shanghai Free Trade Zone. Unfortunately, China will also continue to intensify indigenous innovation, resulting in a “techno-nationalism” and promulgating China’s IP protection, or lack thereof.  China is typically deemed one of the great economic powers of the 21st century, and it seems the Third Plenum is attempting to continue that trend. For further reading on China’s Third Plenum, Frontier Strategy Group clients can click here to access the full report.

The Time is Now for China R&D

China R&D Banner

The importance of a well-designed China R&D game plan 

As multinational executives consider their China R&D strategy, local companies are already penetrating into their key markets at an astonishing speed.  The time is now for multinationals to take action on their China R&D game plan, whether that means increasing existing R&D capabilities or initiating an entry plan, failure to act now will risk missing out on a tremendous opportunity. Skepticism will always prevail but overcoming that will require thorough and strategic thinking.

Define your R&D strategic goal

Defining a clear goal for your China R&D center is vital for success.  Many MNCs often find their current R&D center is not effective enough to sustain revenue growth, or current operations face challenges related to cost, talent pressure, and regulatory barriers.  This is likely because a clear strategic objective was not properly defined at the very beginning.  FSG proposes four types of objectives that an R&D center can achieve based on your business’ maturity:

  • Market Entry: During market entry, MNCs should consider outsourcing the manufacturing function to China by monetizing cost arbitrage. By establishing a local supplier network, China sites will help MNCs become a cost leader in the global market.
  • Early Stage: As time goes by, headquarters may allocate more responsibilities to China R&D such as developing the full range of project management competencies. R&D centers at this stage will begin to conduct relatively complete modules of the development process rather than just low value added manufacturing.
  • Late Stage: Given that local market is becoming more attractive, China R&D centers may be elevated to develop a local product/brand to cater to the domestic market. Organizations will also evolve from a centralized model to a decentralized model.
  • Established: At the next level, companies can consider expanding their China R&D center to serve similar Asian or even global markets. The benefits are obvious; to improve China R&D centers’ scalability by converting them into global resource integrators.  This upgrade will also help to enhance the bottom line, as revenue is increased by leveraging China R&D center for Asia/global and cost is reduced by consolidating duplicated resources across pan Asia/global wise.

China R and D

Though this framework is not a one-size-fits-all solution it is a great starting point for MNCs needing to enter or ramp-up their R&D efforts in China. FSG has done in-depth research assisting multinational executives to consider deepening their China R&D plans. Eventually, the R&D offices in China can play a larger role, i.e. manage some global product innovations or help in launching products which can be optimally used across Asia.

China’s Shadow Banks Impact Your Global Business

China is the world’s second-largest economy yet many executives ignore it as a source of systemic risk to their global business. The biggest risk in China surrounds its banks, yet we hear little about the problem. Executives in China are often say that the government will simply bail out the system if there were a problem, but that discounts domestic political constraints as well as economic ones. For example, if the Fed, which can print the world’s reserve currency, could barely contain the US banking crisis, what makes us think that China can? Is this time different?

China GPD

A major shock to the Chinese economy would have a ripple-effect across the globe because of China’s massive demand for commodities and deep trade linkages with Western markets. When China sneezes, the world catches a cold.

JPMorgan estimates that loans originated by China’s shadow banks may comprise 69% of GDP.   With small Chinese businesses unable to secure bank loans, the shadow banking system has flourished.  Because of low official deposit rates and restrictions on putting money overseas, savers turn to the shadow banking market to earn higher yields, funding the risky credit cycle, while China’s large banks provide additional leverage via wholesale funding.

China GPD

The real risk is not that shadow banks go bad; in fact the Chinese government is actively trying to curb the industry’s growth. Instead the risk is that bad loans in the shadow system bubble up to the systemically important banks that provided wholesale funding, dramatically slowing China’s growth.  Officially, non-performing loans are only 1% of total bank loans, but credible private estimates put the number closer to 10% The problem became clear this June when the People’s Bank of China (PBOC, China’s Central Bank) engineered a cash-squeeze to pressure the shadow banks, and the banks stopped lending to each other pushing interbank rates to 13.4% overnight (SHIBOR).

China GPD

Before the 2007-2008 crises in Europe and the United States, similar interbank indigestion was a strong leading indicator of the looming credit bust.

While the Chinese government is taking actions to manage this risk, companies should also take action by building scenario plans into their long-range business plans.   Better to build in insurance, even for something perceived as low risk, as economic history has a tendency to repeat itself.

Chinese Challengers: Dealing with Local Competition Inside and Outside the Middle Kingdom

Competition in ChinaThere is no silver bullet to address growing Chinese competition; western executives already perceive Chinese companies as current and potential threats to their business in China. However, it is high time that multinationals are urged to build industry specific plans based on the strengths of Chinese competitors. FSG has developed a competitive framework with tailored tactics and strategies at different maturity levels to help multinationals cope with increasingly sophisticated Chinese competition.

Global Competitiveness Curve of Chinese Companies

Multinationals’ journey in China typically starts with a strong market position in terms of product quality and brand image, relative to less sophisticated Chinese competitors. This “honeymoon” phase doesn’t last long as nimble Chinese companies quickly absorb advanced technologies from multinationals, leveraging bold innovation and deep understanding of the local market.  This is a common result of the Chinese phenomenon called Shan Zhai 山寨, or ‘knock off’ in English. Shan Zhai companies typically start by producing low-end product and eventually evolve into highly competent businesses, thus becoming formidable market disrupters or even market leaders; the latter being dangerous to multinationals looking to legally build brand and IP ownership in China.

To learn more about the next stage of Chinese competitors, check back next week for Part 2 as I continue the discussion on how to best handle local competition in China.

Emerging Markets Opportunity Not Over

Currency-Volatility-Global-Performance-DriversRecent reversals in capital flows caused large and sudden currency devaluations, faster than many emerging markets expected or could manage. As a result, many market commentators have called this end of the emerging markets opportunity. That statement couldn’t be further from the truth. While companies should always expect challenges in emerging markets, the changing environment will also create a new set of opportunities.

FSG identified four ways companies can capture growth in this shifting environment:

  1. Leverage home-currency strength to win share back from emerging markets–based competition
  2. Double down on local production to reduce production costs
  3. Use balance sheet strength to earn financing margins
  4. Reassess customer segmentation to identify local customer “winners”

FSG looks at these strategies and the drivers of the changing global environment in our 2014 Global Performance Drivers report, now available for FSG clients.

What happened?

Capital flows reversed because of push and pull factors.  As the US economy continues to improve, the Federal Reserve is expected to reduce bond purchases, changing the risk-return payoff for portfolio investors, “pulling” capital out of emerging markets.  We also see slowing growth in emerging markets “pushing” capital to developed markets.  The outflow of capital is more concerning for countries like Turkey, Poland, and Ukraine, which have high levels of short-term external debt. Countries fitting this profile may run into short-term funding challenges that could drive up local interest rates, or in the worst case cause temporary liquidity problems. Other countries like India and Indonesia may now struggle with inflation as currencies decrease faster than is manageable, driving up costs for consumers.

Be Aware of the Risk of Sudden Deceleration in China

FSG expects China’s GDP growth rate to be worse than the consensus forecast of 8.1% in 2013. Weaker-than-expected data in Q1 suggests the state of the Chinese economy is even weaker than the official number suggested, prompting concern of a sudden deceleration of the Chinese economy.  One of the red flags is local government debt (see chart below), a problem just started to manifest when some city governments, such as Dongguan’s, cut back on public spending. Free bus service in Dongguan was canceled in April.

Local Government debt has skyrocketed since 2009

Another red flag will be exports. China’s export numbers in the first four months of 2013 have come under scrutiny as concerns have been raised about their accuracy. China’s export growth to developed markets—the US, EU and Japan—remains lukewarm (see graph below).

Chinese exports to Hong Kong surged almost 100 percent in March, while exports to the US and EU declined.png

 

Export growth to developing markets in ASEAN and Africa are strong but start from a lower base. Questions have been raised in particular about the extraordinary growth of China’s export to Hong Kong, which stands at 69% in the first four months based on official numbers indicated in the graph here:

    Spike in export growth to Hong Kong was largely driven by Tax-Free Zone Day Trip activities

    We also believe slower growth at home will drive more Chinese investment overseas. Traditionally, Chinese outward FDI is state-led and resource driven. If we look at the geographical distribution of Chinese FDI overseas in last few years, they were focused on resource rich regions like Africa, Latin America, Oceania and some Asian countries like Indonesia.  But with the economy slowing, we see that trend changing. We expect more participation of private Chinese companies who are investing for pure business purposes rather than national strategic reasons. And these private companies have the potential to pose a real challenge to multinationals, starting in the Chinese market, but increasingly in markets outside of China as well.

    Chinese ODI has shifted focus across Oceania, Latin America, African, and Europe in the last few years

    Riding the Social Media Boom in China

    I’ve been hearing about the challenges my APAC executives face while drafting their go-to-market plan using social media as a medium to target the Chinese consumer. I recently spent around 10 days in China which gave me an opportunity to discuss this with them in detail, and also convey our strong opinion on the matter. I managed to consolidate both FSG’s opinions and our clients’ pain points to provide some frameworks to help companies finalize their social media plan for China.

    I recently noticed that a number of big department stores have been closed or scaled down, primarily due to the increased competition coming from the Internet (as compared to the number of stores which I observed several years ago).  Social media is expanding its penetration of Chinese Internet, which is already the largest in the world. Many companies have started thinking about how to build social media into their business strategies, similar to what many MNCs did for the Internet 10 to 15 years ago.

    Number of Chinese Internet users is bigger than US, India and Japan combined

    Chinese social media platforms are generally more interactive and users can share content in a greater variety of formats to a wider audience, therefore drawing more user contributions. Sina Weibo, a Chinese mircroblogging platform, is more user friendly and contains more features than Twitter to attract new users, retain elite users, and encourage all users to contribute more content, leading the platform to be more interactive.

    Number of Chinese Internet users is bigger than US, India and Japan combined

    Home grown platforms like Sina Weibo, Wechat, Qzone, Renren and Kaixin have dominated the social media space in China. Most were started as imitations of similar platforms in the West but over time have evolved into something quite different with unique product and service offerings specific for Chinese users.

    A company’s social media strategy could be rendered obsolete very quickly as the market is ever-changing, with new companies, business models, and user features continuously mushrooming . FSG has built a simple 5-step process for B2C companies to build an effective social media communication plan.  Social media is also not exclusive to B2C companies.  B2B companies can leverage social media in an indirect way to build positive brand image, enhance internal communication, and even drive recruitment efforts. This is definitely a space where the marketing heads need to zoom-in on now to ensure they capitalize on the opportunity.

    Strengthen Your Leadership Bench in China

    Leadership constraint has been constantly identified as a top business challenge multinationals face in China. Rapid growth over the last twenty years has created a huge imbalance in demand and supply of experienced managers and leaders. Shortage of managerial talent has fueled wage inflation in China, and compensation for senior executives has skyrocketed as many companies compete for a small pool of managerial talent (see charts below).

    Wage Inflation in China*Source: Frontier Strategy Group Analysis, Mercer China Monitor Report, EIU

    To make it worse, multinationals are facing increasing competition from local Chinese companies, which offer attractive financial packages and perceived better career development opportunities to attract seasoned Chinese executives working for multinationals. However, many Chinese executives who have built their careers working for multinationals often found it was difficult to adjust to a local company’s culture and experienced “reverse culture shock.”

    Top 50 Employers in China in Last 10 Years

    *Source: Frontier Strategy Group analysis, 中华英才网 (ChinaHR.com)

    Most leadership challenges in China can be attributed to either a capability gap or talent shortage, or sometimes a combination of both. FSG recently created a comprehensive framework to identify key leadership challenges and develop best practices to strengthen the leadership bench through retaining key individuals, leveraging global scales, strengthening the fundamentals, and adjusting to a new reality.

    Senior Chinese managers are motivated more by symbolic recognition such as enhanced decision making power, rather than material recognition such as financial compensation. So it is important for multinationals to realize that seasoned Chinese leaders want to achieve “self-actualization” by creating a vision for the business and having an impact on other people.

    Local Chinese managers are already commanding an equal if not higher compensation than their peers in developed markets, and yet they are subject to higher attrition risk due to strong demand. One solution is to tap into experienced managers in talent surplus areas, such as Western Europe, who are more willing to relocate to high growth regions like China for an “expat light” package.

    Is China Losing its Competitive Edge?

    This blog entry is the first of a six-part series on China which will cover China’s productivity growth, portfolio management, geographical coverage models, talent management, post-merger integration and sales force effectiveness.

    Is China Losing its Competitive Edge?

    Many multinational companies are re-assessing China’s competitive advantage as a manufacturing base since labor arbitrage is becoming less compelling. Although China’s productivity gains (as measured by TFP growth) outpaced other major economies in the first decade of the 2000s, this rapid growth was interrupted by the financial crisis in 2008 and has been slowing ever since.  This is largely due to overcapacity and a “crowding out effect” caused by the massive fiscal package that Beijing put in place to offset the effects of the global financial crisis.

    "Made in China" Industry Competitiveness Matrix

     

    We believe that China is gaining momentum in higher value-added industries such as heavy machinery, information technology, and medical devices, but losing competitiveness in low value-added manufacturing to other low-cost Asian countries, even when it comes to serving the domestic market. In a workshop that I have run recently, we discussed the possibility that “Made in Bangladesh” apparel will begin to flood the Chinese market in a few years.

    As China continues climbing up the value chain, more and more of its companies are expanding abroad to other emerging markets. This leads to interesting dynamics on talent requirements, intellectual property, and portfolio management.

     

     

    Emerging Market View: What Our Analysts Are Reading – 3/8/2013

    Here’s a look at a few of this week’s global headlines with added commentary by our research team members:

    Market Watch’s Post-Chavez Venezuela: oil’s next Saudi Arabia?:

    “As Associate Vice-President for Latin America Clinton Carter is quoted in this article, oil production is unlikely to experience any increase over the short term, as a necessary shift toward investments in PDVSA are likely to continue to be secondary to the need to fuel social spending and support any post-Chavez government.”
    - Antonio Martinez, Senior Analyst for Latin America Research

    The Financial Times reports new property market cooling measures put doubt on China’s economic recovery:

    “China has launched yet another round of of cooling measures, including a 20% capital gain tax on property sold in the secondary market, higher down payment and mortgages, to contain property prices. This is will impact property and construction related industries, which represent a big chunk of the Chinese economy, adding new pressure to the fragile recovery.”
    - Shijie Chen, Practice Leader of Asia Pacific Research

    Reuters had an article on Brazil’s industrial recovery:

    “Any sustainable economic rebound in Brazil will have to be led by the industrial sector, making this heartening news for multinationals concerned about a seemingly interminable slowdown in Latin America’s largest market.”
    – Ryan Brier, Practice Leader of Latin America Research