• Starting 11 December 2004, China fully opened up its commission agency, wholesale and retail markets to foreign investors. However, this development did not trigger a new wave of foreign investment because many leading wholesalers and retailers had already entered the mainland market prior to this date. At present, 35 of the world's top 50 retailers are operating in China.
  
  
• Against the backdrop of fierce competition in the mainland market, the growing trend for retailers to source directly from manufacturers and sole agents is dampening the business prospect of distributors. McKinsey projects that the share of distributors in total sales will drop from 86% in 2001 to 68% in 2006. Hence, the mainland distribution market has reached a saturation stage for foreign investors.
  
  
• With the lifting of geographical, equity ratio and quantitative restrictions on foreign investment in distribution, foreign-invested retailing enterprises such as supermarkets and hypermarkets are bound to step up their penetration into second- and third-tier cities. As these enterprises have to comply with the market development plan of local governments, they are likely to continue to expand through joint venture (JV) and merger and acquisition (M&A). In the face of foreign competition, mainland retailers have undergone an expansion-consolidation stage. Externally, mainland retailers are increasing their operation scale through M&A and forming alliances while internally, they are exploring new operation models.
  
  
• The expansion of retailers into second- and third-tier cities will benefit Hong Kong companies in that their sales operations and geographic coverage will increase as well. However, under intense competition, distributors and retailers which have over-expanded or are poorly managed could easily be squeezed out of the market. Hong Kong companies should pay more attention to managing the credit risk of their customers.
  
  
• Despite the diminishing market share of department stores, their mid- to high-end market positioning matches the target profile of Hong Kong products. In order to stand out from the pack amid growing product homogeneity in the market, department stores tend to source merchandise that has unique characteristics. Hong Kong companies can consider offering premium quality products with unique styles and innovative designs to win the orders of retailers which adopt the strategy of polarised competition.
  
  
• With the lowering of entry threshold of the wholesale and retail market, small- and medium-sized Hong Kong companies can now operate wholly-owned retail businesses in the mainland market. They can also establish sales networks in the mainland in a fast and cost-effective way through franchising and offer branded products developed by themselves or licensed to them by foreign brand owners.
  
  
• Hong Kong companies can also explore new sales channels such as online sales. Payment and delivery used to be the hurdles for direct sales operators in the mainland in the past. But since China entered the World Trade Organisation (WTO), services such as banking and logistics have developed rapidly to support direct sales operations.

Latest Liberalisation Policies

When China joined the WTO at the end of 2001, it promised to fully liberalise its foreign trade and distribution sectors in three years by allowing domestic private enterprises and foreign-invested enterprises (FIEs) to participate in import and export, wholesale and retail.

Under the Measures for the Administration of Commercial Enterprises with Foreign Investment implemented since June 2004, China has lifted the restrictions on foreign-invested commission agency, wholesale and retail enterprises in keeping with its WTO commitments. These restrictions include geographical, equity ratio and quantitative restrictions, as well as market entry thresholds such as minimum assets and annual sales. The measures also allow foreign-invested wholesalers to engage in import-export agency and franchising operations. Meanwhile, under the Mainland-Hong Kong Closer Economic Partnership Arrangement (CEPA), Hong Kong companies can engage in wholly-owned commission agency, wholesale and retail operations one year ahead of other foreign investors starting from 1 January 2004.

In the past, foreign companies could only team up with mainland enterprises to engage in distribution in designated cities in China. Moreover, only large foreign firms could afford to enter the mainland distribution sector. Under the current policy, all foreign firms regardless of their size can register as wholly-owned wholesale and retail businesses anywhere in the mainland. Besides, both FIEs and domestic enterprises are now subject to the same minimum registered capital requirements, which are Rmb500,000 for wholesale and Rmb300,000 for retail. In terms of product category, all wholesale and retail enterprises in China can deal in the distribution of books, newspapers, magazines and medicines in addition to general consumer goods. This allows industry players a more flexible business scope.

Foreign Players' Expansion Strategy

Wholesale Distribution

According to mainland authorities, the response of foreign wholesalers has been less enthusiastic than that of retailers since China fully liberalised its distribution sector. One of the reasons for this could be that most of the sizeable, specialised wholesalers are already operating in the mainland in different ways. The diminishing prospect for development for wholesalers could be another reason. More retailers are expected to take advantage of the liberalisation of agency distribution and wholesale to apply for wholesale distributorship right to facilitate the import of foreign goods for sale in the mainland.

To cope with market development needs, many foreign firms especially Hong Kong companies were engaged in the wholesale distribution of imported goods in the Chinese mainland through various channels prior to the full liberalisation of foreign trade and distribution. These Hong Kong wholesale distributors include Jardine, Li & Fung, Dah Chong Hong and Sims Trading Co (CITIC Pacific). They deal primarily in international branded food, beverages, daily necessities and personal care items. They usually import direct from manufacturers and sell to large retailers such as department stores, supermarkets and hypermarkets. They also supply to secondary distributors which will resell the products to the smaller retail shops.

According to business consultancy firm McKinsey, 80% of China's retail sales are handled by over 300 primary wholesalers and 1,000-2,000 secondary wholesalers, and are channelled through regional wholesale markets. Many of the wholesale distributors which handle imported goods also deal in domestically made products. They serve as the bridge between manufacturers and retailers. They are responsible for delivering the goods to retailers, and participate in promoting the products to the local community based on their understanding of the local conditions. Distributors also play an important intermediary role for both retailers and manufacturers. For retailers, distributors can offer convenient, one-stop sourcing services thereby reducing the cost of having to deal with a large number of suppliers otherwise. For manufacturers, distributors can offer sales channels and shorten the cash flow cycle thereby allowing them more time to concentrate on product development and production.

However, the development prospects for distributors are diminishing because of the fees charged by retailers and the trend of direct sourcing. As China is currently a buyer's market and the degree of product homogeneity is high, retailers often have to resort to low-price or price-cutting strategy to compete. Price is an extremely important consideration when retailers source their products. Retailers often launch various kinds of promotions that require suppliers to offer price discounts. To maintain their own profit margins, retailers demand hefty entry fee and promotion fee from suppliers. These costs are in turn transferred to distributors and manufacturers undermining their profit margins. Furthermore, an increasing number of large retailers and manufacturers - both foreign-invested and domestic - have turned to direct sourcing bypassing distributors in recent years. This, coupled with the emergence of hypermarkets, has taken away the orders from many small retailers, threatening the survival of traditional distributors. As large manufacturers and retailers have the capability to handle their own logistics, they can benefit from the shortening of distribution chain and streamlining of supply chain. Different estimates have put the cost savings of cutting one tier of distributors in the range of 3%-8%. McKinsey forecasts the share of distributors in total retail sales to drop from 86% in 2001 to 68% in 2006.

Looking ahead, in the face of fierce market competition and slowed growth, foreign investors are not likely to enter China's wholesale distribution sector in a big way, especially in the case of small- and medium-sized dealers. On the other hand, domestic distributors will adopt a more conservative strategy, such as higher geographic concentration and adjustments in product mix in order to raise gross margins, as well as a more prudent approach in managing the credit risk of retailers. If the trend of direct sourcing persists, distributors might have to brace for further transformation.

Retail Distribution

At the end of 2003, the 254 retail enterprises invested by Hong Kong, Macau, Taiwanese and foreign investors operated a total of 881 outlets in the Chinese mainland. Among these are 35 of the world's top 50 retailers. In view of further easing of entry threshold and business scope, many FIEs are planning to speed up their entry into China. The number of foreign-invested retail enterprises is expected to increase further over the next few years. Their operation models will become more diverse, with hypermarket, specialty chain, convenience store and branded specialty store being the mainstream modes. Their expansion into second- and third-tier cities will also be expedited.

Retail giants such as Wal-Mart and Carrefour first established their footholds in a number of developed mainland cities at a time when market entry thresholds for foreign-invested supermarkets were still very high in China. After a period of vigorous expansion, foreign-invested supermarkets with operations in China today also include Metro, Makro, Trust-Mart, Ekchor-Lotus, RT-Mart, Hymart and Park'N Shop. Among these, Carrefour, Trust-Mart, Wal-Mart, Ekchor-Lotus and Jinjiang Metro ranked among China's top 30 commercial chains in 2004. They operate a total of 257 outlets in the mainland posting total annual sales of Rmb34.5 billion.

The competitive advantages and market shares of FIEs are the most outstanding in the supermarket sector. Apart from supermarkets, foreign firms have also speeded up investment in other retail channels in recent years. Examples include OK, 7-11 and Lawson convenience stores; and specialty stores like B&Q, OBI, IKEA, Mannings, Watson's and Sa Sa. Among these, Mannings is the first wholly Hong Kong-owned retail operation which entered the mainland market under CEPA. Foreign investors also had an early start in the department store sector. However, the number of large department stores has been limited because of their positioning at the mid- to high-income market, the large shop space required, and the choice of prime location. Jusco, Seibu, Mitsukoshi, Lane Crawford, Sogo and Pacific are some of the names familiar to Hong Kong consumers.

Whether they operate in the supermarket or general merchandise retail sector, FIEs have advantages in terms of management, capital resources and technology. Before, foreign-invested retailers were unable to capitalise on their own advantages because of geographical, equity ratio and quantitative restrictions. With the lifting of geographical and quantitative restrictions, foreign-invested hypermarkets and supermarkets can now speed up their expansion into second- and third-tier cities that have market potential. As for FIEs dealing in general merchandise retail, although they will continue to compete in prime commercial districts in major cities, they can expect to penetrate the mainland market via a greater variety of more flexible channels following the lowering of entry threshold for foreign-invested wholesale and retail enterprises and the maturing of new retail channels such as franchising and direct sales.

Indeed, many retail FIEs have announced their expansion plans. For example, Wal-Mart plans to open 10 to 15 new stores in China in 2005; Carrefour, 15; B&Q, over 10. Meanwhile, Home Depot of the US has announced that it will enter the China market in 2005.

Expansion Plans of Selected Supermarkets, Hypermarkets and Convenience Stores

In their day-to-day operations, most of the foreign retailers such as Wal-Mart, Carrefour and Jusco hire Chinese as senior managers. In terms of sourcing, 90% of the merchandise is sourced locally. Store decoration has also been localised to suit local taste. However, some hypermarkets and supermarkets which continue to adopt the foreign operation model have yet to fully adapt to the mainland market conditions. In view of this, the operators are making minor adjustments. For instance, the early attempts by Wellcome and Park'N Shop to operate small supermarkets in China were both not very satisfactory. Park'N Shop has now made a comeback in the mainland market in the form of superstores. As for Carrefour, apart from hypermarkets, it also operates supermarkets in residential areas. Where convenience stores are concerned, FIEs are now permitted to handle a wider range of products and are therefore better positioned to compete in the market. Nevertheless, the development prospects of certain types of retailers will continue to be dampened by cumbersome administrative approval procedures. For instance, a convenience store has to apply for up to 11 licences before opening for business. These include licences for industry and commerce administration, fire prevention, and the sale of special products such as newspapers, magazines, patent medicines, salt and condoms. Each individual convenient store has to apply for its own set of licences.

Overall Development Directions of Retail Sector

The influx of foreign players has prompted the reform and restructuring of China's retail sector. At present, the different retail channels in China have reached a rather stable stage of development. On the other hand, due to consumers' pursuit of safety, health and quality guarantees, the trend of shop loyalty and brand loyalty is set to grow. Based on the current situation, competition among individual shops, and adjustments of corporate network and competition strategy will become the future development directions.

McKinsey has earlier forecast that 60% of China's retail market will be dominated by three to five world-class retail giants over the next three to five years, while state-level and regional retailers will control 30% and 10% respectively. However, it is generally believed that no single retailer or retail channel will dominate all of China's retail sector over the short term. China is a huge consumer market consisting of smaller markets of varying sizes, significant disparity remains between urban and rural areas, and different regions have different consumption habits and preferences. Furthermore, as car ownership rate remains relatively low and transport facilities need to be further improved, goods still have to go through various tiers of distributors before reaching the more remote areas. This also contributes to the fact that retailers offering fresh produce and daily goods have to be located near residential areas. The geographical area served by a supermarket or hypermarket is generally smaller in China than in Europe or America. Distributors and small shops continue to play an important role in serving the needs of people living in city suburbs and the rural areas.

Comparison of Foreign and Domestic Retailers

Supermarket, hypermarket and convenience store These types of retail stores have continued their consolidation in recent years towards a larger operation scale. As a result, certain enterprises have expanded rapidly over the past few years. During 2003-2004, many retailers which were poorly managed, without a clear market positioning, or over-expanded resulting in disruption in capital flow, were either taken over by others or closed down. In Guangzhou alone, a number of local supermarkets ceased operation during this period. The situation was similar across the mainland. Hence, even the larger local distributors have held back their ambitious development plans and taken a more cautious approach. For instance, a local supermarket chain with over 70 outlets in Guangzhou has plans to open more than 10 new outlets a year over the next few years. However, the expansion will not include places that are too far away, otherwise logistics support will be a problem. To compete with the large chain enterprises, some smaller retailers form chain operation on a voluntary basis. They negotiate prices with suppliers collectively and share the delivery facilities in order to achieve cost reduction. For example, six supermarkets in Shanghai formed a joint sourcing alliance in 2003. Similar initiatives were later repeated in places like Henan and Guangdong.

Apart from increasing the scale of operation, supermarkets, hypermarkets and convenience stores that are of a relatively large scale are actively exploring ways to further improve their business capability. In view of fierce competition, homogeneity of product and operation model, and low customer loyalty, retailers have come to realise that offering discounts is not a sustainable or effective strategy over the long run. Some of them are therefore paying increasing attention to providing a comfortable shopping environment, identifying the right market positioning, offering quality products with special characteristics and excellent service, as well as building integrity.

Developing own brands is a growing trend among supermarkets, hypermarkets and convenience stores. It brings cost savings to the retailer in terms of sourcing, delivery and sales thereby boosting the profit margin. It also helps highlight the uniqueness of the retailer among its competitors. Many medium- and large-sized local and foreign retailers are therefore keen to develop their own brands. According to different reports, the prices of own brand products are 5%-40% lower than those of similar, branded items. However, retailers wishing to develop their own brands have to identify qualified manufacturers, be ready to place large orders and make cash flow provision, as well as carry out quality control during the production process. Otherwise, product quality problems could cost the retailer dearly, including its goodwill. This is also the reason why the smaller retailers tend not to develop their own brands.

Own Brand Products at Selected Supermarkets and Specialty Stores

Following the elimination of the weaker players from the market, the ones that survive have increased in scale and number of outlets. For instance, Beijing Wangfujing Department Store was running more than 10 stores in 2004 and plans to increase this number to 30 by 2005. Apart from relying on internal resources for expansion, cooperating with other players is a fast track to growth for department stores. For instance, Shanghai Bailian Group, China's largest retailer in 2003, was established by the merger of four of Shanghai's leading retail enterprises during that year. Compared to supermarkets, hypermarkets and convenience stores, few department stores have ambitious expansion plans.

In terms of product offering, as department stores realise that they cannot compete with supermarkets on price, they are mostly targeting the mid- to high-end segment of the market. As such, they focus on introducing famous foreign and domestic brands. Due to growing product homogeneity, department stores are actively seeking products that are unique in order to make themselves stand out in the pack.

Professional/specialty store Professional/specialty store is an emerging retail channel in China which specialises in a certain type or brand of product. It has expanded rapidly over the past few years. In 2003, 11 of the country's top 100 retailers were professional stores. In 2004, five of China's top 30 commercial chain enterprises were professional stores, namely Gome, Suning, Sanlian, Yongle and F&S, all being specialised home electrical appliances chains. Their total annual sales rose by 45% year-on-year to Rmb81.8 billion in 2003, accounting for 21% of the total of the 30 largest commercial chains.

Although leading foreign players such as B&Q, OBI and IKEA have yet to top the league, they are growing rapidly. In 2004, B&Q and OBI posted over 60% growth in sales. As for domestic players, apart from home electrical appliances chains, leading drugstore chains that are fast expanding include Shanghai Pharmaceuticals, Tongjunge and Accord Pharmaceutical, while large building materials supermarket chains include Dongfang Group. Such enterprises are often the M&A target for foreign investors.

Meanwhile, specialty stores have also grown at a rapid pace in recent years under the "branding" drive. Foreign and domestic brandname stores are a common sight in shopping malls and shopping districts across mainland cities of all sizes, among them are Esprit, Baleno, Giordano, G2000, Shanshan, Yishion, Le Saunda, HP, NEC and Lenovo. Total sales of the leading specialty chains topped Rmb8.55 billion and Rmb10.01 billion in 2002 and 2003 respectively. Specialty stores can be direct operations or franchised operations. HKTDC has observed during its mainland promotions that many mainland SMEs and individually-run retailers are eager to become franchisees of famous brands.

Capitalising on New Opportunities

Looking ahead, the wholesale distribution sector is expected to develop and consolidate at a faster pace after full liberalisation is in place. Modern retail channels such as shopping malls, supermarkets, convenience stores, professional stores and specialty stores will also speed up their expansion in first- and second-tier cities as well as establish a presence in third-tier cities that are developing rapidly. These outlets will form satellite commercial centres aimed at satisfying the basic needs of local residents. Hong Kong companies can consider cooperating with large retail chains or adopt the franchise model to speed up geographical expansion and market penetration. However, most companies may still have to work with distributors in view of the ever increasing number of commercial outlets and the different geographical coverage of retailers.

So far, Hong Kong companies have found it difficult to build up a working relationship with mainland distributors and retailers because the latter tend to do sourcing based on experience and instinct. However, in the face of fierce competition and increasing standardisation of business practices, distributors generally agree that they must now make more effort in sales analysis of the products and adjust the product mix in order to boost gross profit margin. Hence, established manufacturers may find more opportunities in the mainland market in future. On the contrary, manufacturers that produce products that are not profitable and with no distinctive competitive advantages will find it increasingly difficult to sell to the China market. Meanwhile, distributors and retailers that are not competitive will be squeezed out of the market. Against this background, Hong Kong companies are advised to act prudently and choose distributors and retailers that are strong and honest to work with in order to minimise possible loss.

Increase market penetration and sales through expansion

China is a buyer's market nowadays. This, coupled with white-hot competition in the retail market, has prompted many supermarkets and hypermarkets to compete on price-cutting. As a result, many retailers have to rely on the levy of entry fees as a source of profit. This has brought about an unhealthy consequence which is that except for best-sellers or indispensable, famous items, all goods have to pay an entry fee in order to make their way to the shelves. It is learned that the entry fee for launching a brand new product could amount to several million yuan. Besides, due to vicious price competition, many retailers solely consider the price factor when they source products. This practice may bring short-term benefits but undermines the long-term development prospects of the retailer. It also denies products with good market potential access to the market and deals a serious blow to the confidence of Hong Kong companies in developing the mainland market.

Still, there are retailers who place more emphasis on strategic positioning in their overall competition strategy and treat manufacturers as their business partners. Product quality and sales potential are the key considerations when they make sourcing decisions. They are also willing to give new products a chance to sell at special counters in the store to test the market. If the target sales figure is achieved, the product can then go on the shelf. They are therefore the preferred business partners for manufacturers. However, these retailers may also be very demanding, especially on sales performance. As there are limited shelf space and product display areas, the retailer would review the space allocation regularly (such as every two weeks) and replace products that are not selling very well by new, qualified items. Hong Kong manufacturers should pay special attention to this practice.

With the full liberalisation of the retail sector, more retailers are expected to place more emphasis on strategic positioning and adjust their sourcing policy in addition to seeking to boost operation scale. Given this new development, Hong Kong manufacturers are advised to enhance their R&D and innovation capability, produce more quality products, build a strong brand image, and meet the business targets and requirements of the retailers. After all, the value of the goods is dictated by their popularity with consumers. Only indispensable products that are most sought-after possess good bargaining power when dealing with retailers that place great emphasis on entry fees. They can also meet the entry criteria of other retailers that place top priority on sales.

Retailer's own brands are still at an early stage of development in China and are far less common than in other countries. However, the strong retailers are likely to develop their own brands in a bigger way. This is also a natural consequence of competition in the retail market. Retailers hope to stand out from their competitors by offering their own label products with unique characteristics. Besides, own brand products ring in bigger profit margins. In terms of product type, due to the difficulty in ensuring quality control, most of the own brand products are highly standardised disposable consumer goods such as tissue paper, paper cups and toothpicks. But there are also other more complicated consumer goods requiring government approval that bear the brands of the retailers. Examples include food, beverage and daily-use chemical goods. For manufacturers, OEM production for retailers is the guarantee for sales. But at the same time, the market shares of manufacturers' own brand products will lose out to low-priced, retailers' own brand products on the market. This is particularly so in a price-sensitive market.

In order to capitalise on the development of own brands, manufacturers should negotiate with large retailers direct. To win retailers' own brand orders, manufacturers must first improve their materials sourcing, production, quality control and inspection. Retailers are very demanding on the various production processes and product quality. On the other hand, manufacturers can consider producing products with special characteristics in keeping with the retailers' strategy of building a unique image.

Building brand image with own retail network

Apart from adjusting production to attract large foreign and domestic retailers, manufacturers of general merchandise can also explore other sales channels.

Under CEPA, Hong Kong residents with Chinese nationality may engage in retail in the mainland in the form of individually-owned businesses. Moreover, Hong Kong companies may set up wholly-owned wholesale and retail enterprises. The minimum registered capital is Rmb500,000 for wholesale, and Rmb300,000 for retail. There is no minimum asset or annual sales requirement. Under this new policy, Hong Kong companies can consider opening retail shops in the mainland to sell branded products that are developed or represented by them which can help to build up the company's brand image. Furthermore, as wholesale enterprises are now granted import-export and distributorship rights, this will facilitate Hong Kong companies' licensing negotiation with overseas brand owners on producing and selling their products in the mainland.

Also, according to the Measures for the Administration of Commercial Licensing, foreign franchise operators are required to provide long-term business guidance and training to franchisees. They are also required to operate at least two stores in China either directly or through subsidiary companies or holding companies. Hong Kong companies that already have their own brands and mature management system can consider adopting the franchise model on this basis.

Franchise operations have mushroomed across the mainland since the 1990s. As at the end of 2003, more than 1,900 franchise systems were operating in China with a total of 82,000 stores employing 2 million workers. Today, China has the largest number of franchising operations in the world thanks to their rapid growth over the past few years. Franchising has been introduced in many sectors especially retail, services and catering. Franchised clothing stores are the most popular. Notable examples include famous domestic brands Shanshan and Yishion which have now become household names.

Exploring new sales channel online

Foreign companies began to flock to China's e-commerce market in 2003. In the B2C market, amazon.com of the US acquired www.joyo.com.cn, NHN Group of South Korea bought Lianzhong, CNET bought Zhongguancun Online and www.fengniao.com, and ebay acquired www.eachnet.com. As e-commerce is developing rapidly in China, Hong Kong companies wishing to break into the mainland market but do not know where to start or are not ready to commit substantial resources can consider this new sales channel.

E-commerce has promising development prospects in China. The number of Internet users in China increased tenfold from 8.9 million in 2000 to 95 million in 2004. At the same time, according to the China Statistical Survey Report on Popular Internet Issues 2004 released by the China Internet Network Information Center, more than 40 million Internet users shopped online at least once in 2004. The figure is almost three times that of 2001 and represents 40.7% of the population of Internet users. Furthermore, 24.6% of the net surfers indicated that they would definitely try online shopping in the coming year; 33.4% said they probably would; and only 5.5% said they definitely would not. The fact that nearly 60% of the Internet users said they would try online shopping reflects that online shopping is fast becoming a widely accepted shopping channel for mainland consumers. Different estimates put online shopping transactions in China in the region of Rmb790 million to Rmb1.92 billion in 2003.

Different direct sales methods have appeared in the China market before but failed to flourish due to operational problems. Today, as specialised logistics, payment mechanism and credit system have developed into a mature stage, they can help to support online sales through a convenient, secure transaction platform. At present, www.alibaba.com and www.hc360.com are two of the most popular e-commerce platforms in China. Leading consumer websites include ebay.com.cn, taobao.com.cn and 1pai.com.cn. Industry experts expect competition to intensify among different service providers of online sales platforms in 2005.

This new report is available at TDC's Retail Outlets. It can also be purchased through the TDC Bookshop section in the TDC's trade portal: info.hktdc.com.