Gaining a Competitive Advantage in China
China is a market of growing importance for companies around the world. And,
in many ways, a market we are increasingly becoming dependent upon. Yet few
foreign companies understand the market and its intrinsic financial and operational
challenges.
Investment as % GDP
Foreign Direct Investment (FDI) has been growing significantly important to
the Chinese Economy. China is now the No.1. global destination for FDI.
Total Factor Productivity (TFP)
However, relative productivity is declining, creating the potential for competitive
disadvantage. This could have a significant effect on the sustained investment
in China.
Regional wage variance
Large direct investment is largely taking place to source cost advantage through
labor. China is now central to the cost leadership strategy of many foreign
multinational corporations.
Nominal wages growing faster than GDP
However, wage growth is outstripping revenue growth. The implication is that
wages is not a source of sustainable competitive advantage for Chinese business.
Chinese businesses will be quickly forced into adapting global best practices
to be able to continue to compete effectively on a cost basis. This will force
local business through a rapid learning curve. Equally, Chinese corporations
expanding into foreign markets will be forced to exert stronger financial discipline
in their operations. These organizational stresses will further challenge companies
already being stretched in managing growth. Companies with poor financial or
change management discipline will face escalating risks.
Revenue Growth
Chinese business is growing rapidly. Growth rates are significantly above world averages. High growth rates are appealing for investors, but they have associated risks. In this example, the Chinese carriers have significantly greater growth than their global peers (Ryanair is an exception).
Cash Conversion
Operationally, Chinese companies are significantly lagging in working capital
reform. In this example, global airlines have managed their cash conversion
cycles with increasing discipline. In high growth, each foreign airline increases
free cashflow. Chinese airlines require more capital. Hence for every $100 million
in revenue growth, China Eastern requires 11 million (11%) in additional capital.
Income is 0.66%.
Bank Debt
The result, a rapidly increasing debt position. Higher leverage leads to poor
interest coverage and then to higher cost of debt. These negative cycle effects
are typical of high growth companies and often, can be fatal! Whilst aviation
can be an extreme example, this same pattern is emerging in China across many
industries and enterprises.
Managing growth is a significant financial challenge for companies. Fiscal
discipline is not only a key to success, but often a key to survival. Shareholder
value is driven by sustainable, profitable growth. Whilst growth is desired,
sustainability and profitability is at risk due to increasing debt and escalating
core risk.
The concept of credit is not well established in China. Its inherent risks
even less understood. Intuitively we understand that China is a ‘cash
market’. Infrastructure supporting payment, liquidity and risk management
is relatively immature. Yet there is significant pressure accelerating the development
of these facilities. Chinese banks and corporations will develop these capabilities
at a pace never seen before in the world. There is no choice.
China is now establishing itself as the manufacturing engine for the world.
As such, it is near the origin of the supply chain. Many foreign multinationals
at the end of the supply chain, actively force credit back down the supply chain.
Why? Cash payment creates an imbalance on the balance sheet. If you pay suppliers
cash before you receive money from buyers, you need capital to fund the gap.
Thus, the demand for credit in the supply chain is strong. If Chinese corporations
are forced to give credit to their foreign buyers, yet pay cash for services
in supply, debt will expand exponentially in a high growth environment.
Chinese corporations do not have to go through the same learning process for
credit management as the rest of the world. However, they must act with urgency.
As competition increases under World Trade Organization market liberalization
local banks will be forced to develop products and services to compete or risk
being marginalized.
Banks and corporations in China have an unparalleled opportunity to partner
and develop a model for managing credit and optimizing the cost of capital in
the supply chain. Rapid transformation without legacy infrastructure or practice
can serve as a source of increasing competitive advantage for Chinese corporations.
Equally, given wage pressure, foreign corporations investing in China should
be seeking to use their strong credit standing to force reform in the supply
chain.
Companies whom adapt fastest to the rapidly changing regulatory and operational
environment will be in a position to gain significant cost advantage over their
key competitors. Companies who lag will face increasing risks.
The challenges are by no means small, nor insurmountable. The supporting regulatory
and operational infrastructure is still evolving. There are numerous cultural,
systemic and regulatory impediments to creating an effective credit and liquidity
model in China. However, market reform is surging forward at an ever increasing
pace.
Education is currently a core and valued focus of Chinese corporations. Students
from universities are inquisitive, entrepreneurial and urgent. These characteristics
are essential catalysts for change and a strong indication of the internal potential
of the Chinese market. China is rapidly moving through the education phase into
implementation and application. The challenge for local and foreign enterprise
is to direct and leverage that spirit to achieve positive results.
As much as there is to learn about the Chinese market, equally there is much
the West can learn from the Chinese. John F Kennedy once said the Chinese characters
for ‘crisis’ represent danger and opportunity. Whilst not strictly
true, respect for the dangers and opportunities may well help avoid a crisis.
