By William Merkle
China has grown to the second largest economy in the world and the seventh largest retail market.[1] With brisk economic development and an expanding middle class eager to spend its newfound wealth, Wal-Mart and other retailers perceive great potential in expanding their companies into China.
Makes sense, right?
Wrong.
Behind “the wall” of China’s 1.3 billion potential consumers, a disturbing reality awaits foreign investors seeking access to the Middle Kingdom. To understand China’s economy, we must look to its recent past. In 1978, under Deng Xiaoping, fiscal policy was decentralized, empowering local governments and initiating Chinese private enterprise. In 1992, China began to allow foreign direct investment (FDI) in the form of joint ventures with Chinese companies. This scheme allowed Chinese companies to retain majority ownership. Only in 2007 were foreign companies such as Wal-Mart permitted to assume sole ownership of their stores in China (See Exhibit A).[2]
Within this context, there are two significant considerations. First, Chinese companies had an almost 30 year head start on marketing their brand, gaining customer loyalty, and establishing prime locations without foreign competition from 1978 to 2007. For example, in commercial sectors such as Shanghai, the Chinese Bailian Group dominated sales as the incumbent retailer and political favorite. These disadvantages prove difficult to overcome for companies such as Wal-Mart, which have historically relied on markets with little to no competition.
Second and less transparent, the transfer of fiscal policymaking to local governments created a breeding ground for corruption in China’s economy. As it evolved from communism to state capitalism, China suddenly demanded that its provinces become economically self-sufficient. In order to fill the void created by an underdeveloped national market, inexperienced provincial leaders enacted strict economic policies, which required businesses to pay local taxes on all goods as well as highway tolls exceeding 10% of the value of all shipments. Following Beijing’s model, local governments controlled market participation in paranoia of a second “century of humiliation.” This market control resulted in grossly inefficient resource allocation and disregard for the basic laws of supply and demand.[3]
By bending such policies, France’s retailer, Carrefour, realized great success in urban sectors. In exchange for majority equity and prime store locations, Carrefour offered jobs and rents to Chinese employees and agreed to pay local taxes if locals were allowed to supply their stores. Before China entered the World Trade Organization in 2001 and lifted restrictions on FDI in 2007, Carrefour had already snatched locations in urban Chinese sectors without consulting the central government. Unlike Carrefour, which delegated its finances to each location and used local suppliers for their stores, Wal-Mart supplied its locations using their prototypical hub-and-spoke distribution method, their pioneering method originally developed in the U.S. This proved to be a mistake in China. Unreliable highway systems, arbitrary and often illegal tolls, and taxes on both distribution centers and store locations all weighed heavily on Wal-Mart’s finances. To the chagrin of aspiring multinational corporations (MNCs), local regulation is not the only obstacle to selling in China.
Wal-Mart thrived in the 1970s and 80s by targeting small-market regions in the U.S. that could only support one major retailer, creating a de facto retail monopoly. But Wal-Mart did not only attract customers because of location. “Everyday low prices (EDLP)”—the business mantra that built Wal-Mart into the number one Fortune 500 Company and 25th largest economy in the world—became a beacon for saving to the American people. Former Wal-Mart CEO, Lee Scott, stated, “I’ve yet to meet a customer who came to a store because we’re Number One: If they come it’s because of the value we give them.”[4] But what if these small-market customers could not afford even Wal-Mart’s “value”? That is precisely the case in China.
China’s transition into a global economic superpower over the past 30 years left many assuming that its accumulation of wealth and assets would have a trickle-down effect to its destitute populations. But the reality diverges from this projection. Rural provinces in China, such as Anhui and Guizhou, have an annual per capita gross domestic product (GDP) roughly equal to that of Somalia in East Africa (See Exhibit B). Even worse, it is estimated that at least half of the population in China lives day-to-day at this rate. In other words, Wal-Mart’s “everyday low prices” are not low enough. As Craig Allen, Deputy Assistant Secretary for Asia, U.S. Department of Commerce, stated in his September 2014 address at the Utah Global Forum, “China is not your backyard.”[5] According to the World Bank, China has a Gini Index of 0.47 out of 1.0, which is .07 over the threshold for dangerous levels of income distribution as determined by the World Bank.[6]
China’s income distribution leaves FDI companies such as Wal-Mart with a number of dilemmas. First, it creates multiple markets. Rural Chinese often cannot afford commodities outside of food and clothing, while urban Chinese tend not to be as price-conscious as Americans and are willing to pay a premium for foreign brands.[7] Wal-Mart now has the difficult task of reinventing itself for the urban consumer as well as the rural. Additionally, rural consumers cannot afford to buy food in bulk, which drives up inventory costs. Unlike in America where the customer shops about once per week, the rural Chinese make small, daily purchases. Second, rural poverty forces Wal-Mart to compete in urban sectors—markets in which it is not best suited. In commercial sectors such as Shanghai, Wal-Mart must compete with the aforementioned Bailian Group Inc. and the culturally savvy Carrefour.
Nevertheless, Wal-Mart has more recently closed the gap with its competitors. According to Forbes, Wal-Mart has grown from the 20th largest retailer in China to ninth while Carrefour has dropped from fifth to seventh in 2014.[8] This is due in large part to Wal-Mart’s adjustment to China’s multiple markets. Through deliberate price discrimination and selling more high-end brands, Wal-Mart has, in part, turned China’s income disparity into a strength. Still, Wal-Mart’s sales in China account for only 2% of its total worldwide sales. Wal-Mart must continue to adapt to China’s myriad markets and local regulations by selling brands that the growing middle-class will buy and by hiring negotiators with the cultural savvy to coordinate with local leaders.
[1] Tobin, Damian. World Development Indicators: Distribution of income or consumption. School of Oriental and African Studies, UK: 2011.
[2] Farhoomand, Ali. Wal-Mart Stores: “Everyday Low Prices” in China. Asia Case Research Center, University of Hong Kong: 2006.
[3] Gorrie, James. The China Crisis. John Wiley and Sons, New York: 2013.
[4] Farhoomand, Ali. Wal-Mart Stores: “Everyday Low Prices” in China. Asia Case Research Center, University of Hong Kong: 2006.
[5] Allen, Craig. China is Not Your Backyard. Utah Global Forum. 9/24/14.
[6] World Bank. World Development Indicators: Distribution of income or consumption. http://wdi.worldbank.org/table/2.9 10/5/14.
[7] Allen, Craig. China is Not Your Backyard. Utah Global Forum. 9/24/14
[8] Flanery, Russell. Bailian Group Tops Ranking Of China's Biggest Chain Stores (Top 30 List) http://www.forbes.com/sites/russellflannery/2012/05/21/bailian-group-tops-ranking-of-chinas-biggest-chain-stores-top-30-list/ 10/5/14
