Bright Future for Foreign Retailers

China Economic Quarterly

After years of pain, foreign companies are finally starting to make serious money inChina. Is this the beginning of a long-term boom, or are we just seeing the top of the economic cycle? It is an interesting question. According to detailed research by China Economic Quarterly editor Joe Studwell, to be published later this week, American companies made US$8.2 billion profit from China last year, up 67 per cent on 2002. A little over half that figure is profits reported by American joint ventures and subsidiaries in China. The rest came from royalties and licence fees, and from services such as education and training.

Detailed data is not available for other countries' investments in China, but the US data is consistent with Chinese figures which show that the aggregate profits of all foreign-invested manufacturing companies nearly quadrupled between 1999 and last year, to US$33 billion.

All this is a big improvement since the late 1990s, when foreign companies had virtually nothing to show for their billions of dollars of investment. Now, not only are the profits rolling in, but returns have reached global standards.

It is important to keep these figures in perspective. For American companies, China still lags behind Japan (US$23 billion in profits last year) and Singapore (US$12 billion). Last year, American companies made far more money from Mexico (US$14 billion) than they did in China.

The difference is that China is a huge growth story, while most of those other countries are not. So if profits are solid in China today, they will be spectacular in a decade's time. Or will they?

In a few industries, it is almost certain that the best profit days are already past. The best example is cars. The years 2002-2003 were an extraordinary environment for China's carmakers: annual volume growth in passenger car sales of 75 per cent, prices kept artificially high by tariffs and import quotas, and state-owned banks keeping the market flush with vast sums in consumer car loans on easy terms.

The future is bleak. On current plans, carmakers will more than double China's car capacity over the next four years. Banks have been chased out of the car-loan market by default rates approaching 50 per cent. Import quotas will end next month. All this means that prices in China have only one place to go: way, way down.

Across all manufacturing sectors, the story is more or less the same. China's mantra is: anything you can make, I can make cheaper. Money-making paradises, like mobile-phone handsets, can turn into profitless wastelands overnight when low-cost Chinese producers gallop into the market. Sure, China is a growth story - but most of the growth will be in capacity. Prices will fall continuously, and profit margins will remain wafer-thin.

Services is a different story. Modern service businesses are sophisticated, complex enterprises requiring high-level management skills and "software" such as customer relations and branding. They are virtually immune to the copycatting and price-cutting that plague manufacturing. KFC, for example, has been in China for 15 years, has more than 1,000 outlets, and has never faced a serious local competitor.

Later this month, the draconian regulatory restrictions that have impeded the growth of foreign retail enterprises will end. Liberalisation of other service sectors will follow. The benefit of this liberalisation will go almost exclusively to foreign firms. In 2001, the equity profits reported by American service-sector joint ventures and subsidiaries in China came to just US$6 million, and many business lines generated big losses. By last year, those profits had increased a hundred fold, to nearly US$600 million. Our guess is, that is just the beginning.

(Originally appeared in the December 6, 2004 issue of South China Morning Post in Hong Kong, reproduced here with permission.)