Retail in the wild east

Since 2004, when China met the criteria for joining the World Trade Organisation (WTO), modern retail formats have developed quickly. Foreign retailers already present in China welcomed the improvements in the Chinese business climate. Less government interference, less red tape and a distribution sector fully opened to foreign direct investment, finally gave them the opportunity to tap into the opportunities of the promising Chinese market.
Most modern retailers – of both foreign and local origin – flocked to the major cities along China’s coast, where they established state-of-the-art retail networks. Competition is fierce in China’s commercially most sophisticated cities on the east coast (Shanghai, Beijing, Shenzhen and Guangzhou). Due to market saturation in these cities, retailers are moving towards other – less developed – cities in mainland China. It is there where China’s new middle class is emerging, but where is there? What cities to target first? China has some 160 cities with a population of over one million. Combined with the still underdeveloped distribution infrastructure and strong regional differences in consumer preferences and behaviour, this is a huge challenge.

Middle class to quadruple
China’s National Bureau of Statistics defines a middle class household as having an annual household income between RMB60,000 (US$7,322) and RMB500,000 (US$61,016). At this moment five per cent of Chinese households fall within this range, but the bureau forecasts that by 2020 this percentage will increase to 45(!) per cent of total households.
“In an emerging market such as China, defining the middle class is typically not just about sufficient disposable income – though that is important. It is also about education levels and evolving purchasing habits and attitudes,” writes Carol Wingard, managing director of L.E.K. Consulting’s China office, in a recent article with the appropriate title ‘The world’s largest middle class’. Wingard says that there are some 60 million urban residents in China with household incomes exceeding US$5,000. “The majority of these urbanites have adopted ‘modern’ purchasing habits and have real purchasing power more than twice their nominal incomes,” states Wingard. She also mentions estimates of China’s modern middle class to quadruple to more than 200 million people in the next decade. “Eventually comprising 15 per cent of the population and becoming a critical factor in retailing globally,” she writes. “The question facing many global retailers today is not if to address the Chinese market, but how.”

A rush to China’s cities
Retail development in China is entering a new stage, with retailers rushing to build store networks in tier-two and tier-three cities. According to A.T. Kearney, 75 per cent of the Chinese middle market will be in tier-two and tier-three cities by 2017, so that explains the retailer’s rush into these cities. Tier-two cities – some twenty cities where roughly twelve per cent of the Chinese population lives – are now the main targets for foreign retailers, writes Wingard. “Tier-three cities – typically smaller provincial capitals with limited chains – are today predominantly in the sights of the more aggressive domestic retail chains […]. The approximately 60 per cent of the population living in smaller tier-four urban or rural locations is largely out of reach of most modern retailers.”
Following the development of rising economic prosperity in lower-tier cities, Carrefour aims to develop its network in China’s western region and set up a regional headquarters for central and western China in the town of Chengdu. The French retailer is interested in building hypermarkets in Zhengzhou (Henan province), Urumiqi (Xinjiang province in the northwest) and Kuming in South China.
Wal-Mart is said to be negotiating store opening with local authorities in some ten second-tier cities, like Jinhua (Zhjiang province) and Wuhu (Anhui province). Other cities Wal-Mart is interested in are Foshan, Mianyang, Yuxi and Nanhai. Wal-Mart avoided a very competitive market like Guangzhou but it is investing in retail development in cities like Guiyang and Taiyuan – the capitals of the mountainous inland provinces of Guizhou and Shanxi – and it has a successful venture in Nanchang (Jiangxhi province). The acquisition of the Taiwanese retailer Trust Mart will add over 100 stores across 20 Chinese provinces to Wal-Mart’s network.
German Metro Group intends to open up to ten new cash & carry stores per year in China. It is focusing on cities like Dalian, Harbin, Shenyang and Changchun in China’s northeast. Tesco is also active in this region, following its acquisition of the Chinese hypermarket operator Hymall. In January 2004 Tesco acquired 50 per cent in a joint venture and since December 2006 it owns 90 per cent of the shares. Tesco’s current operations are in Shanghai, Dalian, Hangzhou, Ningbo, Shenyang and Tianjin.

Pitfalls
In Tianjin, French retailer Auchan opened a hypermarket in 2005. Two years later, however, Auchan Tianjin was closed due to ongoing losses. Auchan has 17 hypermarkets in China and announced last July to be adding eight more stores by the end of 2007 and ten new stores in 2008. These stores are planned in Beijing and affluent urban regions around Shanghai. The retailer’s experience in tier-2 city Tianjin underlines that there are significant challenges in opening stores in lower-tier cities, compared to China’s tier-one cities.
A.T. Kearney’s 2007 Global Retail Development Index (GRDI) points out three factors that, combined, can mean the difference for a retailer’s success or failure in a new market:
• gauging the window of opportunity for entering key cities;
• understanding consumer readiness;
• knowing when and how to move into second- and third-tier cities.

A.T. Kearney points out that given the saturation of China’s first-tier cities, these cities’ windows of opportunities are closing. But the consultancy stresses that there is a world of difference between opening a store in Yuxi, Tianjin, or any other lower-tier city and opening a store in Beijing or Shanghai. A retailer should not go into a second-tier city armed with a first-tier city strategy. Products, services and the strategy at large should be tailored to consumer readiness – assessing real consumer needs and requirements – and the available infrastructure. Another drawback to two-tier cities A.T. Kearney distinguishes is limited availability of talented, qualified people.
The still underdeveloped distribution infrastructure (not only poor road networks but also lack of cold storage warehousing and limited availability of refrigerator carriers) and the highly diverse consumer preferences and buying habits, should also be taken into account. “Southern Cantonese-speaking consumers have tastes for product colours, food flavours and apparel sizes very different from their Mandarin-speaking northern counterparts,” writes Wingard. “Those retailers that emerge as leaders in their category – whether domestic or foreign – will be distinguished by their deep understanding of China’s multi-tiered socioeconomic landscape, their agility in adapting to its highly diverse consumer base, an aggressive and intelligent approach to competing within cities and across city tiers and their skill in managing the practicalities of doing business in China.”

Brilliance
Before the liberalisation of China’s foreign ownership regulations in 2004, foreign retailers were obliged to team up with local companies if they wanted to build a business in China. Quite often this led to foreign retailers having local joint venture partners they may not have wanted, now ownership regulations are liberalised. Yesterday’s partners are often today’s competitors.
China complying with WTO regulations and liberalisation of foreign ownership since 2004 does not, however, mean that the impact of the Chinese government is limited. Most local retailers are state owned and benefit from favourable policies like allocation of the most wanted store locations.
In 2003, the local government in Shanghai decided to merge several retailers – including the local operations of Lianhua and Hualian – into a single entity named Brilliance Group (or Bailian Group, as the retail entity is also referred to). With the creation of Brilliance Group, the Shanghai government intended to put Shanghai’s distribution industry in a favourable position to compete – or collaborate – with multinational retailers, now the distribution sector was opened to foreign global retailers.
The new entity was to become – as the China Daily called it – the ‘Great Wal-Mart of China’. According to PlanetRetail, however, the merger to form Brilliance was rushed and all retailers involved remain independently operating units. This Shanghai giant is therefore yet to demonstrate its power.
Lianhua is China’s largest retailer, but government interference in its retail strategy and operations frustrates its ability to compete. “Rather than to operate at the whim of the government, a better solution may be for the government to retain control of the board while handling over operational decisions to professionals,” comments PlanetRetail.

Consolidation rumours
Despite this, last August Lianhua reported a 64 per cent increase in half year earnings. It explained this huge increase by its focus on the east China region and expanding its franchise business. Earlier this year there were rumours that Lianhua might be acquiring the underperforming Hualian supermarket operation. Both subsidiaries of the Brilliance Group, however, retained independent operations. Lianhua has also been rumoured to be interested in acquiring Jiangsu Times Supermarket. This local retailer operates 45 Times supermarkets in Jiangsu province.
In July 2007, Wal-Mart’s vice president of Chinese operations Terence Cullen said Wal-Mart expects to double its stores in China over the next five years and it targets a 20 per cent market share. Here again rumours were heard as it was said that the Americans eyed all or a part of the 70-store chain Beijing Hualian Hypermarket. Like the other rumours that can be heard through China’s consolidation grapevine, this one has not become a reality yet.
So did the alleged discussions between Carrefour and Shanghai Brilliance Group. Carrefour denies the contact but fact is that Brilliance’s subsidiary Lianhua is Carrefour’s joint venture partner in Shanghai. PlanetRetail quoted Carrefour’s chief executive Juan Luis Duran who said during a press conference on 31 August 2007 that “organic growth remains our priority in China,” and that Carrefour intends to open 20 to 25 hypermarkets in China each year.
Carrefour is aiming to counter Wal-Mart’s expansion into metropolitan areas of cities like Beijing or Tianjin. Last summer, Carrefour’s president in China Eric Legros was quoted as saying that in this competition, acquisition cannot be ruled out. “We will look at acquisitions, but it would have to be a plus and not put the quality of Carrefour China into question.”
Since its market entry in 1995, Carrefour has built a network of over 100 stores in China, which it sees as one of the important reservoirs for future growth. Duran attributes the success of Carrefour to its local strategy which implies a 95 per cent local procurement rate of the products on the shelves of Carrefour’s Chinese hypermarkets. Chinese nationals account for 80 per cent of store managers and hold half of the posts of regional managers.

Corporate image
Carrefour is geared towards bypassing wholesalers and agents for the procurement of fresh foods in order to reduce costs and benefit farmers who directly supply the company. A challenging task in a country where corruption and counterfeit practices are to be dealt with. Late August, eight of Carrefour’s purchasing managers of fresh foods were arrested for receiving bribes from suppliers. Carrefour itself initiated the police investigation in an effort to drive out corruption and raise – as the retailer calls it – the ‘professional level’ of its staff.
Wal-Mart also has a keen eye on the quality of its sourcing practices in China. The US retailer denied allegations that it decided to cut its sourcing from China due to the appreciation of the Chinese currency. A decision which would hurt local suppliers. Wal-Mart did, however, warn some of its suppliers who it suspected of improper labour practices.
Both examples underline these retailers’ concerns of protecting their corporate image, as such multinationals are being scrutinised by retail watchers in all the markets where they operate. Wal-Mart is said to be planning a restructuring of its local operations by granting more rights to each store to reshuffle posts for employees who can then manage their own careers with the retailer. And Carrefour went as far as allowing the creation of a trade union for five outlets in the city of Guangzhou. “Carrefour is witnessing a rapid expansion in China and we will step up efforts to set up trade unions in all of our outlets across the nation,” said Carrefour China’s HR director Joanna Meng. But the only unions allowed in China are branches of the ‘All-China Federation of Trade Unions’ (ACFTU), which is an offspring of the Chinese communist party. Yet ACFTU is often criticised by international labour rights groups for favouring business interests over workers’ rights. Therefore, good intentions should be seen in the light of the reality of retailing in China’s promising yet capricious market.