China’s Retail Revolution

At the rate foreign retailers are putting up their stakes in China’s vast retail landscape, the world’s most populous country can rightly put a claim to the title “Retail’s Last Frontier”. China’s food retail market, though, is in a state of flux as the rest of the world awaits the crucial moves that China has to make after its accession to the World Trade Organisation (WTO).

With over one-fifth of the world’s consumers and an economy growing at seven to eight per cent annually, China plays a key role in world food demand. A radical transformation overtook China’s food retail sector in the 1990s with the emergence of supermarkets. Yet, today hypermarkets have proven that they are winning over shoppers. With China’s forthcoming WTO entry, regulatory changes are expected to allow foreign retailers to expand more rapidly than in previous years.  

In Shanghai’s main residential district courtyard-styled houses with peeling paint once stood in leafy shade to remind passers-by of the city’s faded grandeur. Today, that bygone era has given way to a skyline that glitters with glassy high rises, a testament to China’s rapid transformation into one of the world’s key business players. As China has over one-fifth of the world’s consumers and an economy growing at seven to eight per cent annually, China plays a key role in world food demand. With food occupying a central role in Chinese culture, the country’s food sector has also mirrored the country’s journey from an economy characterised by state-driven planning and self-sufficiency to one that is market driven and globally integrated.

Grass to glass
It is therefore not surprising that consumer foods played a vital role behind China’s retail revolution. From the 1950s through the 1970s, when government procured and sold nearly all agricultural commodities, and into the early 1980s there was little valued-added in the country’s food system. Plagued by inefficient food distribution systems and poor service, economic reforms were implemented in the late 1970s, with food marketing among the first sectors to be privatised and directed by markets. With the reforms came small food stores, restaurants and kiosks, and by the late 1980s, once grassy plots of land in suburban areas gave rise to modern department stores displaying large food sections. Figures from the government-run China Food and Agricultural Services showed that food processing output value in China reportedly grew at a 14 per cent annual rate through the 1980s and 1990s. By 2000, away-from-home food spending grew by 15 per cent of urban food expenditures compared to negligible amounts in the 1980s. A radical transformation overtook China’s food retail sector in the 1990s with the emergence of supermarkets such as Lianhua, Hualian and Nong-Gong-Shang. With China opening her doors, a number of foreign operators based in Japan, the Netherlands and Hong Kong entered the market, but only to pull out or reduce their presence due to tough market conditions. With the renowned frugality of Chinese consumers, margins in the fiercely competitive foodretailing sector are very thin. Besides the tough competition, domestic players often benefit from reduced property rents, enjoy the advantages of good personal ties with distributors and receive bank loans. The cutthroat competition also forced out some independent domestic standalone supermarkets or were acquired by larger state-held chains.

Hypermarket rivalry
From the boom years of the late 1980s and early 1990s when department stores flourished and ruled the scene, the cyclical growth by the end of the 1990s gave way to the modern hypermarket format, with Western pioneers such as retail giants Metro (Germany), the Dutch-owned Makro, French retailer Carrefour and the US’s Wal-Mart. These retailers are now leading the latest phase in China’s retail revolution and are challenging the dominance of domestic giants like Lianhua, founded in Shanghai in 1991 and which operates 1,300 stores across China. As the country’s top retailer, Lianhua’s 2001 profits of $12 million on $1.7 billion sales may not daunt international giants Carrefour and Wal- Mart. Increasingly too, Lianhua and other domestic supermarkets are being upstaged by the low-prices and an array of services and goods offered “under one roof” by foreign retailers. Analysts have predicted that hypermarkets would fail since Chinese consumers seldom buy in large quantities. Yet, today hypermarkets have proven that they are winning over shoppers by offering convenience, comfort and professionally managed stores. The success of foreign hypermarkets such as Carrefour has been putting pressure on local supermarket groups to lower prices and enlarge store space to remain competitive. Carrefour’s strategy of a product range that features local goods, format, good partners and efficient management has also boosted the retailer’s chances of resisting fierce competition from local retailers.

Multi-format strategy
However, hypermarkets have captured only a small share of the national market, revenues of which reached $459 billion in 2001 and could run up to as high as $688 billion by 2010 (McKinsey). Analysts say the effect of hypermarkets on the Chinese market may be much wider as domestic chains respond to the success of the hypermarket. Hypermarkets also reduce distribution mark-ups by purchasing goods directly from manufacturers and large distributors, and while most retail procurement in China tends to be localised, hypermarkets have sought to establish national distribution networks. Just as the threat of foreign supermarket chains in the 1990s led to better customer service in domestic chain stores, the challenge from hypermarkets may lead to more choice for consumers. The trend in China toward the hypermarket format is also paralleled by the growth of smaller convenience food stores. Convenience stores had captured the market for sales of small purchase items, such as drinks, snacks and ready-to-eat foods. Though foreign-funded chains popularised the format, well-known domestic chains today operate many convenience stores in China. Convenience stores, mimicking the strategy of hypermarkets, also maintain their own warehouses and truck networks or tap into supermarket distribution networks of parent companies. Today, industry figures show that many of the top 100 food retail companies in China adopt a multi-format developing policy to withstand fierce competition. The China Chain Store & Franchise Association said that of around 69 companies operating supermarkets, hypermarkets, warehouse clubs and convenience stores only 18 engage in one retail format. The association’s statistics also indicate that large chains registered faster growth in 2001 with the top ten’s generating sales of 71.8 billion yuan, accounting for around 44 per cent of sales from the top 100 retail companies. Although hypermarkets may seem to capture consistently large sales volumes and nationwide distribution reach, no market chain, foreign or domestic, has yet reached national penetration or distribution. Hypermarkets also pose a challenge to manufacturers and suppliers since they must negotiate and deliver to each hypermarket outlet individually. Hypermarkets generally buy from manufacturers or large distributors and sourced imported goods, which account for five per cent or less of their stocks, via established agents. Retailers also charge high slotting fees and charge for in-store promotion campaigns. Many retailers also impose heavy credit terms on suppliers, and demand payment in 90 to 180 days.

Logistics: Bad case of Feng Shui?
Unlike the harmonious-giving principles in China’s myriad mystic traditions like Feng Shui, logistics is perhaps one of the biggest headaches that foreign companies need to look at and overcome. In Shanghai, it is common to see workers loading crates of branded imported wine into a non-refrigerated truck, and covered only with a tarpaulin on a sweltering day with temperatures rising above 30 degrees Celsius. Morgan Stanley estimates China’s annual spending on logistics is $200 billion or 20 per cent of GDP and double the percentage dedicated to logistics in the US. Only two per cent of that spending goes in China to specialist firms known as third-party logistics providers or 3PLs. After decades of state-planned development, nearly all major Chinese firms transport their own goods, albeit inefficiently. In comparison, eight per cent of logistics spending in the US goes to 3PLs, while in Europe it is ten per cent. The American Chamber of Commerce in Shanghai estimates that logistics costs are often more than 16 per cent of product costs in China, compared with less than four per cent in many developed economies. The Chinese Academy of Social Sciences has an even bigger estimate with transport and logistics accounting for 20 per cent of the retail prices of goods and even higher for perishable products. Morgan Stanley said the average Chinese manufacturer keeps goods in a warehouse for 51 days and sees over two per cent of them damaged in shipment. China is working on boosting its infrastructure systems, increasing highway mileage by 36 per cent and increasing rail track length by 19 per cent. However, despite the growth in capacity, total freight traffic rose by 39.6 per cent from 1990 to 2000, with most of the increase hauled on highways. Although more food is being transported by truck, the rail system remains the chief transport for grain and other bulk commodities. The lack of temperature-controlled equipment, however, makes it costly to transport frozen and perishable foods. Cold storage capacity is believed to be only 20 per cent to 30 per cent of growing cargo demand, and spoilage losses of up to 33 per cent of perishable freight are common. Today, the most efficient networks are around Shanghai in the east and Guangzhou in the south. Smooth connections have boosted these areas into major manufacturing centres, but in the less prosperous north and west, it is an altogether different story. Pepsi subsidiary Frito- Lay has several farms in the western province of Gansu, about 2,000 kilometres from the nearest crisp-making plant located in Beijing. The company ships the potatoes in bulk via rail wagons rather than in bags for trucks or freight trains since packers toss them around, bruising a large number of the potatoes. Frito-Lay said it spends a much larger percentage of its revenues on logistics in China than in other countries.

The “Big Three”
The question of whether China will continue to evolve toward a unified market with national companies and brands remains of interest to foreign business. In some sectors, food producers in the interior provinces of China compete with producers overseas for markets along China’s coast. Thus, differences in the level and pace of development between China’s regions underscore the need to understand the regional diversity in China. Growth in China’s coastal regions was speeded up due to a combination of 1970s development polices, the natural advantages of coastal locations and the ethnic connections with overseas Chinese investors. Although incomes in other regions also saw rapid growth, incomes in coastal regions surged ahead. By 2000, urban per capita incomes in southern coastal provinces averaged 8,541 yuan, while average incomes in other regions ranged from 5,064 yuan to 5,753 yuan. Around 800 million of China’s 1.3 billion people live in rural villages, where per capita incomes are less than 40 per cent of the urban average (see Chart 1). The gap between regional incomes became more pronounced in the 1990s, with provinces along China’s southern coast accounting for 34 per cent of China’s GDP and 21 per cent of the country’s population. Cities along China’s northern coast, such as Beijing, Tianjin, Dalian and Qingdao, are also geographic centres of consumer demand. New foreign entrants to the market are, therefore, well advised to focus on the so-called “Big Three”, namely, Beijing, Shanghai and Guangzhou, which are China’s most developed markets and the main destination for most imported food products. In Shanghai alone, retail food sales exceeded 60 billion yuan ($7.2 billion) in 1998, up 13.5 per cent over 1997 (Shanghai Commerce Commission). Shanghai also has more than 1,200 supermarkets and approximately 57 hypermarkets, a sector that did not even exist ten years ago. Shanghai is also China’s top market for frozen and chilled food products, with national demand growing at a rapid rate. China’s frozen dumpling market alone had an estimated value of $300 to $400 million in late 1990s (Shanghai Commerce Commission).

Competitive sting
With China’s forthcoming WTO entry, regulatory changes are expected to allow foreign retailers to increase equity and expand more rapidly than in previous years. However, market observers said that government protection of local players has reduced the competitive sting from foreign players, suggesting that it is too premature to predict exactly the outcome of new regulations. Astute observers also point out the political exigency of cushioning China’s rural economy against a flood of competing imports. A fundamental change in the system may not be China’s aim in joining the WTO. Chris Torrens of consultants Access Asia, however, said that some officials, particularly Prime Minister Zhu Rongji, believe the WTO is a weapon against local protectionism, which has delayed reforms. Says Torrens: “Provincial governments especially don’t seem to realise that if China is going to contribute to the world economy and to benefit from it as well, it has to give something, it has to open up.”