Small-medium sized enterprises (SMEs) contribute 60% of China’s industrial output and create 80% of China’s jobs.
But for the year just past, Chinese SMEs have been experiencing hardships: some have been at risk of collapse. Shortages of electricity, capital and labour have led them to this predicament, and soaring costs have made things worse.
Faced with this indictment of faltering growth, the Chinese government’s 12th Five-Year Plan contains a key strategy specifically in support of SMEs. According to the plan, the total number of China’s SMEs will grow steadily over the next five years and achieve an average annual growth rate of 8%.
Five primary missions underpin the plan: to improve the capacity of establishing business and creating jobs; to optimise the structure of SMEs; to boost the development of “new, distinctive, specialised and sophisticated” industries and industrial clusters; to upgrade enterprise management; and to refine SME support systems.
So what opportunities could this prospective economic about-turn hold for investors and foreign businesses looking to penetrate the Chinese SME market?
Key sectors for investment success
Some opportunities relate to China’s ongoing need to modernise and upgrade its technology base; others relate to rapidly growing consumer markets in the country; while others relate to the ongoing processes of structural change within the Chinese economy.
The most commonly mentioned sectors of business opportunity for foreign SMEs include:
- Machine tools — as Chinese companies continue to upgrade technology, reflecting China’s ongoing strength in manufacturing
- Business services — as the Chinese economy continues to develop. Examples are public relations, advertising and specialist financial services, such as factoring, private equity and specialist management consultancy
- Consumer and personal services — such as healthcare and medical services, and education
- Optical fibre manufacturing technology
- Luxury products — such as high specification cars for the growing consumer market, but also niche opportunities, such as ultra-light aeroplanes, yachts and ski equipment
- Low-carbon technologies — environmental products and services, as the Chinese government increases priorities given to environmental protection.
Energy, particularly renewable energy, has great market potential in China, according to economic analysts. The government is taking aggressive measures to steer the country towards lower-carbon energy use. Yet China’s energy use is vast — it is the world’s largest consumer of energy — and it relies on coal for two-thirds of its energy needs.
The Economist Intelligence Unit forecasts that China’s use of solar power, wind energy and hydropower is destined to grow rapidly — though, not so fast that ascendant Chinese renewables firms can feel secure. It projects that the combined share of renewable energy and nuclear power will rise from 13% in 2010 to over 16% at the end of the decade. As a result of this, and a growing appetite for natural gas, coal will satisfy a lower proportion of China’s energy needs. Yet, in 2020 it still expects coal to provide well over half of China’s energy needs — which by then will have swollen greatly. As a result, 35% more coal will be burnt in 2020 than in 2010.
Other sectors identified by economic analysts include services and supplies to the plastics industry; lifestyle products; life sciences (medical supplies, pharmaceuticals, healthcare, biotechnology); automotive and aeroplane technologies; high value brand products; and building products and services.
Key locations for investment success
Investors and exporters study China’s Five-Year Plans to identify sectors that will be supported by the Chinese government. But they also study regional differences in the Chinese market: both regional market conditions and differences in how rules and regulations at local and provincial levels are interpreted. Variation is plentiful — China has 23 provinces, five autonomous regions, four municipalities directly under the central government, and two special administrative regions.
As China’s growth has shifted into lower gear, the larger eastern provincial economies have been bearing the brunt of the slowdown. Expansion in trade, investment and industrial production has slowed to (by national standards) a crawl. Inland provinces continue to outperform their coastal counterparts, much as they did in the aftermath of the 2008-09 downturn.
Even though many western provinces are seeing a deceleration from their previously heady growth rates, they continue to maintain year-on-year GDP expansion of over 12%. They are also recording faster growth in disposable income and household consumption than the coastal provinces.
Although investors might expect that the poorest would be most adversely affected in periods of economic duress, this has not been the case in China. Beijing, Shanghai, Guangdong and Zhejiang — the country’s political, financial and entrepreneurial capitals — are continuing to record the slowest GDP growth rates in the country, at under 8% year on year.
The eastern provinces have been hit hardest because they are much more highly exposed to the property downturn and weakened external environment than the rest of the country. Property investment accounts for roughly one-half of total fixed asset investment in Beijing and Shanghai, for example, compared with less than 20% for poorer provinces, such as Hubei. The eastern seaboard is also more highly exposed to fluctuations in external demand, as many of its manufacturing facilities operate in export-processing.
Falling exports in the eastern provinces have been accompanied by accelerated export growth in central and western provinces, to where a significant amount of manufacturing capacity has since relocated.
Chongqing, Henan and Sichuan, for example, have all recorded a breakneck pace of export expansion, helping to soften the impact of the recent downturn on China’s labour market, as migrant labourers forced out of work in the eastern provinces have instead been able to find employment inland.
Sweetened policy incentives and improved infrastructure to support inland trade, such as dredged rivers, expanded river ports and improved highways, have encouraged manufacturers to move inland. In July, Chongqing and Henan saw export growth of 160% and more than 60% respectively.
Among the fastest-growing provinces are Shaanxi and Chongqing, which are at the centre of the national western development policy, and Guizhou, which has the lowest average GDP per head in the country. All three have maintained annual growth rates above 13%.
Guizhou, for example, is now seeing huge outlays of industrial investment, as well as a massive government drive to develop tourism infrastructure. Property-related investment in July 2012 rose by a massive 90% year on year.
A further notable development is that growth in disposable incomes and consumption expenditure has picked up considerably in many inland provinces. For example, the south-western province of Yunnan has seen expansion in disposable income per head and consumption expenditure of 14.3% and 18.3% respectively, outpacing real GDP growth of 12.6%.
By contrast, the eastern port municipality of Tianjin recorded expansion of just 10.8% in consumption expenditure and 10.1% in disposable incomes. Narrowing the income gap between coastal and inland provinces has long been a priority for the government; the fact that incomes and expenditure in inland provinces are now growing more quickly than on the coast will be welcomed by the government.
Meanwhile, developing the services sector offers a sustainable means of generating long-term growth in China’s eastern provinces. Such a transition is under way slowly; for example, Shanghai is piloting tax reforms that should encourage the growth of smaller services enterprises.
Overcoming barriers to success
Some SMEs enter China with a naïve approach (‘it’s a huge market, I should be there’) without studying whether or not their business proposition is likely to be successful in China. The market is indeed large, but so is the competition in Chinese markets both from local and international suppliers. A second issue is that some SMEs are too optimistic about the extent to which quick gains are possible. Experience shows that businesses need several years to build relations with business partners and government agencies before business will really take off and become profitable.
It is important to invest in the initial years in obtaining an understanding of the business culture in China – and of the specific province in which the SME investor plans to become established. This approach does not only refer to issues such as language, personal attitudes and relations, how business relations are established and developed and how to organise communication with local staff in China, but also to more structural issues.
Foreign SMEs tend to believe, for example, that knowing and understanding the rules and regulations are the key to understanding the local business environment (investment laws, financial and fiscal arrangements, employment laws, etc.), but many tend to overlook that in China power and relationship are much more important than most assume.
Investors need to not just find good local staff and build up relations with local business partners but also to invest in building good relations with local governments and government agencies, such as customs, environmental inspectors and tax offices.
‘First to file’ principle
One specific problem is the so-called ‘first to file’ principle, which means companies need to register trademarks before entering the Chinese market. One foreign embassy in China reportedly advises companies looking to enter China that they should register their trademarks two years before entering. Another embassy reports that 90% of the intellectual property rights (IPR) cases it deals with are trademark related. Issues also relate to production technologies protected by patents.
Although some economic commentators believe IPR issues are often exaggerated, it is widely agreed that they do add to the cost of doing business in China, particularly in the case of smaller enterprises. IPR problems can present more of a challenge to SMEs than larger enterprises, because typically they do not have in-house lawyers, making it necessary for them to outsource legal services.
SMEs entering new markets always need information about, for example, market opportunities, potential distributors, laws and regulations, and the availability of business services. However, for SMEs seeking to enter China, access to good quality information is reported to represent a higher cost than in other markets.
Similarly, when entering new markets businesses need to understand the regulations governing those markets, in order to identify the implications for their planned activities. However, achieving this in China requires more than just information about the relevant regulations; it also requires knowledge of how these regulations are likely to be applied. This is a particular challenge because of frequently changing laws and uncertainties about how laws and regulations will be interpreted and implemented, not least because some laws can be conflicting.
Non-tariff barriers exist in several industries, as part of the government’s attempt to protect Chinese enterprises. One example is the banking sector, which not only makes it difficult for financial service providers, but also for enterprises in other sectors to deal with investment issues in China. Another issue is China’s Indigenous Innovation Policy which makes it difficult for non-Chinese owned companies to access public procurement contracts. Chinese companies are favoured because the government believes innovation needs to come from within China.
Recruiting the right local employees can be a major issue. Training is one of the possible solutions to this and several Chambers of Trade and support organisations are involved in cooperating with the Chinese government to set-up advanced technical training.
Fear can also be a key bottleneck (fuelled by reports of bad experiences in China): Chinese partners who keep raising the level of investment required; cases of business partners disappearing; problems with Chinese suppliers, including orders placed but not delivered; and some quality issues.
As a result, one of the messages promoted to SMEs is: ‘Don’t go to China without a reliable Chinese partner.’ China represents a bigger challenge for SMEs than entering many other markets. But SME investors who seek out expert advice and support from organisations with practical experience of the Chinese market are well placed to overcome the barriers. UHY has firms based in key Chinese locations and with local knowledge.
UHY has local firms in China.
Contact: Wilson Lu
With offices in: Anhui, Beijing, Jiangsu, Shandong, Shanghai, Shenzhen
Tai Kong CPA Limited
Contact: Robert Kong
UHY Vocation HK CPA Limited
Contact: Mica Pang
Investors looking for advice may also wish to contact the UHY China desk in their region. For details, contact the UHY international office at: firstname.lastname@example.org
Further details of doing business in China are available on the UHY website under the publications section:www.uhy.com.