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China Business. Which Comes First The Wealth Or The Low End?

By Dan Harris and Steve Dickinson

Had breakfast yesterday with Jack Perkowski, author of the book, Managing the Dragon, and the blog of the same name. Jack recently left as CEO of Asimco Technologies to start JFP Holdings, "a merchant bank for China." Jack has been doing business in China for a long time and he clearly knows whereof he speaks and I found his stories on China business fascinating and enlightening. Much of our discussion was about the still nearly unlimited business opportunities in China, particularly in health care and green tech, and of how it is now pretty much a given that Western companies must go to China for growth. We also talked about how there are essentially two markets for so many products and services in China. There is the high end market, which is pretty much the equivalent of that in the places like the United States, Western Europe, and Japan (which, for simplification purposes only, I am going to call "the West"). And there is the low end market, which essentially has no equivalent in the West. China's high end market is typically way way smaller than the low end market. The high end market seeks out Western made goods at typically Western country prices. Prices in the low end market might be as little as 25% of those in the high end market. A classic example is cars. BMW, Buick, Honda, and Volvo and various other Western manufacturers would be the high end. QQ, Chery, and various other Chinese auto manufacturers would be the low end. Jack told me of an American client that makes a product in the United States that can test for 8 or 9 items. This company sells its product in China and when Jack asked who its China competitors were, the client named General Electric and a few other well known Western brands. Jack then asked if there were any Chinese manufacturers and the client listed about fifteen, but then added that the products from the Chinese manufacturers could test for only two or three items. But the China market for the two to three item testers is bigger than that for the 8 to 9 testers. Jack and I then agreed that, inevitably, within a few years, the Chinese companies would soon be making 8 and 9 item testers at a price lower than that of the foreign companies. Jack then talked about how the American company would need to start making its testers in China and start making two and three item testers to compete with the Chinese companies at the low end. We then talked about how low end products can get companies in the door and build brand loyalty (look at how the Japanese car manufacturers got their start in the United States). I asked Jack if Western companies can really compete in China at the low end and he said "yes." I then asked him if it is worth it to Western companies to compete in China on the low end and Jack answered "yes" to that as well. He then explained how if this is to happen, the foreign companies would have to operate more like Chinese companies and bring in Chinese management (especially in the purchasing department) willing to fight hard over every RMB. I wish I had questioned him further on these points. With very few exceptions, all of my firm's successful China clients that are making money by selling in China are doing so by providing high end goods or services at high end prices. Most of these companies very wisely retain their foreign names in China and they highlight them. They generally make very little effort to compete on price with Chinese companies, figuring that if they do, they will get slaughtered. I recall Bill Russo, former Regional Vice President for Chrysler in China, telling me that everyone in China aspires to own a foreign car, but most end up buying a Chinese car because of the huge price differential. I think Bill is right on this and as China's wealth increases, this has to mean foreign car sales will increase as well. Just a few weeks ago, I had essentially the following conversation with a very successful small, somewhat labor intensive American business in China. This company had just been told by the local authorities that it had to "get legal" because "its Chinese competitors were complaining about the American company that was not operating legally." In very cleaned up and simplified form, here is our conversation:

Company: Local government is telling us that unless we get legal.... and fast ....they are going to shut us down. Me: Okay. What's "get legal" mean. Company: Register our business in China. Get on the grid for taxes, etc. Me: Okay. No problem. We then talked a bit and it very quickly became clear that the first thing this company needed to do was to register as a Wholly Foreign Owned Entity (WFOE). Me: We can register you as a WFOE, no problem, but this is going to mean you are going to have to pay in minimum required capital, probably of around $240,000. Company: That's a lot of money for us, but we can do it if we have to. Me: We will see if we can get it for less and it may be possible as China is certainly more interested in getting foreign businesses now than it was a year ago. How many employees do you have? Company: Sixty. Me: You realize you are going to have to start paying all sorts of taxes for those employees. Company: Yes. All of them? Me: It certainly sounds to me like you are going to have to pay all of them. It sounds to me like you have the local government breathing down your neck right now and it is doing so because your competitors have asked it to. Right? Company: Yes. That is exactly what is going on. Me: Now you realize that typically, these employer taxes mean that for every 100 RMB you are paying your employees, you are going to end up paying an additional 35 RMB or so in various employer type taxes. On top of that, you are going to have to start paying corporate taxes. Company: I've heard that, but if I really have to do that, I am going to get killed. There is no way I can compete with the Chinese companies if I am going to have to pay all those taxes. There is just no way. If I am going to start paying those, I am going to have to raise my prices so high nobody is going to come in here any more. This isn't even fair. I am certain non of my Chinese competitors are paying these taxes, I just know it. Me: Yeah, you could very well be right. Company: So what am I supposed to do? Me: Isn't it pretty much the case that if you don't register as a WFOE and start paying your taxes you will be closed down? Company: Yes. Me: Do you really have a choice? Company: This is ridiculous though. The whole system is set up so that foreign companies cannot compete. Me: (thinking this, but realizing there is no point in saying it). Well actually, the system is now set up so that you and the Chinese companies actually are supposed to pay pretty much the exact same taxes. The problem isn't so much "the system" as the way "the system" actually functions in real life. Company: I am going to have to figure out how I can justify higher prices to my customers....

So a few questions: -- Can foreign companies compete on the low end in China? Obviously this is going to vary by industry and I would love to hear from people in as many different industries as possible. --Should foreign companies even bother trying to compete on the low end in China and, if so, in what industries? -- Is there enough high end business in China now and is that high end growing fast enough such that Western companies can ignore the low end? -- Or, will a failure to garner the low end now preclude garnering any end later?

Full post as published by China Law Blog on April 11, 2009 (boomark / email).