The mysteryof the Chinese consumer

Source: Economist July 9th, 2011

LILY LI wears a lanyard with a little plastic card around her neck, evenat weekends. It is a badge of honour: it shows that she has a white-collar job.(She is a secretary at Access Asia, a retail-research company in Shanghai.) Sheuses Apple earphones for the cheap Chinese mobile phone in her pocket, so itlooks as if she owns an iPhone. And she drives to work, though it takes fourtimes longer than public transport, just to show off her little car.

After decades of deprivation and conformism, Chinese consumers regardexpensive consumer goods as trophies of success. In public, they show off. Inprivate, they pinch pennies. The owner of a gleaming new BMW will drive aroundfor half an hour to avoid a 50 cent parking fee. And she will hesitate to spendmuch on interior decoration, because only her family sees the inside of herflat.

By some forecasts China will be the second-largest consumer market in theworld by 2015, not far behind America. Chinese people already buy more carsthan people in any other country: 13.5m last year to Americans’ 11.6m. China ison its way to becoming the biggest luxury-goods market. The central governmentmade an increase in domestic consumption one of the priorities of its latestfive-year plan.

Small wonder that Western firms are piling in. On July 4th Nestlé, theworld’s largest food maker, confirmed that it is in talks with Hsu Fu Chi, oneof China’s biggest makers of confectionery and baked goodies, with a view tobuying the firm.

If a deal is sealed, it would be one of the largest foreign takeovers yetseen in China: Hsu Fu Chi is valued at $2.6 billion on the Singapore stockexchange. China is currently Nestlé’s ninth-biggest market, with sales ofSFr2.8 billion ($2.7 billion) last year. That is less than half what Nestlésells in Brazil, although China has seven times Brazil’s population. HenceNestlé’s hunger for Hsu Fu Chi’s distribution network, and for its knowledge ofwhat tickles Chinese taste buds.

“Understanding the consumer is the most important thing for us,” says PaulBulcke, the boss of Nestlé. The food business is more local than almost anyother—trying to sell cheese in China is like trying to sell stinky tofu inSwitzerland. Nestlé has been sniffing around for takeover targets in China forthe past two years. Hsu Fu Chi is not its first bite. In April it took acontrolling stake in Yinlu Foods Group, a family-owned maker of peanut milk andcanned rice porridge.

Multinational firms trying to woo Chinese consumers have so farconcentrated on the country’s thriving coastal regions. P&G, an Americanmaker of shampoo, toothpaste and other sundries, has its Chinese headquartersin Guangzhou. Its Anglo-Dutch rival Unilever’s home is in Shanghai. Yet bothfirms are preparing for a “second consumer revolution” among the 665m Chinesewho live in rural areas. The income gap between China’s coastal cities andrustic interior is still six-to-one, but rural incomes are rising and 665mheads could use a whole lot of shampoo.

The Chinese government presents its own unique challenges. “Everything ispolitical,” says James McGregor, a former head of the American Chamber ofCommerce in China. “This is a government that lets foreign companies buildmarket share when it needs them.” Its longer-term goal is to learn enough fromforeigners so it can build its own national champions. To this end, it pushesforeign carmakers, among others, into unhappy partnerships with Chinesestate-owned firms.

Almost all Western consumer-goods makers have felt Beijing’s heavy hand.Bernard Arnault, the boss of Moët Hennessy Louis Vuitton (LVMH), a luxury-goodsfirm, was summoned by the Chinese ambassador in Paris in 2008 for ahigh-decibel dressing down after Nicolas Sarkozy, France’s president, said hewould meet the Dalai Lama. In the following weeks scores of women marched intoLouis Vuitton shops in China with fake Louis Vuitton handbags and brazenlydemanded their money back.

Unilever got into trouble recently for hinting that the price of some ofits products would rise. The Chinese government is terrified of inflation,which it fears might spark unrest. It accused Unilever of inciting shoppers tohoard its products, and slapped it with a hefty fine. Yet Harish Manwani,Unilever’s chief operating officer, is undeterred. He is planning to increaseUnilever’s business in China four- or fivefold in the next few years.

Buttering up local party bosses

The central government is not the only problem. Companies need tocultivate cordial relations with local potentates, too. Often the provincialgovernor’s say-so is needed to obtain land, employment licences and a stack ofother bits of paper a firm needs to operate. Local party bosses tend to favourlocal Chinese firms—another reason why tie-ups can be helpful.

Another big challenge for Western multinationals is that their Chineserivals are catching up fast. “Domestic players will be ferocious competitors,”predicts Derek Sulger at Lunar Capital, a private-equity firm in Shanghai.

For now, Western firms enjoy a lucrative reputation for quality andsafety. Lead pollution from local tinfoil-making workshops in Zhejiang provincerecently injured 103 children and scores of adults. Chinese consumers are asaverse as anyone else to being poisoned, so such incidents persuade many to buyWestern brands. But domestic companies can make things much more cheaply, andtheir quality is improving.

Some Western consumer-goods firms that are also-rans at home dosurprisingly well in China. Back in America, Kentucky Fried Chicken (KFC, partof Yum! Brands) is dwarfed by McDonald’s. In China it has 3,300restaurants—more than three times as many as its rival—and opens a new one eachday. The secret of its popularity is local managers with the freedom to adaptKFC’s offerings to the Chinese palate. That means fewer bargain buckets of wingsand more congee, a rice porridge with pork, pickles or mushrooms.

Other Western firms can’t cope. Home Depot, an American DIY chain, isretreating from China after trying for years to persuade middle-class Chinesepeople to decorate their own homes.

Home Depot “didn’t understand the market for home decoration,” says BenCavender at China Market Research in Shanghai. Chinese people typically have nogarages in which to store tools. And there are legions of poor people who willpaint and decorate for low wages. The middle classes tend to hire decorationcompanies, which subcontract to whichever construction firm pays the bestkickbacks. At the beginning of this year Home Depot closed its last shop inBeijing. It now has only seven stores on the Chinese mainland.

In a recent report on market dynamics and a profile of the Chineseconsumer, Bernstein Research offers several tips to help Western consumer-goodsfirms profit from the “second consumer revolution”. Don’t offer too manybrands: offer only a few, but produce in quantity to exploit economies ofscale. Keep improving your products and (crucially) the packaging; otherwiseyou won’t keep pace with such a fast-changing market. Build an efficientdistribution network early on—delivering goods to inland shelves is hard. Andcourt talent tenaciously. Few employees are loyal, and few want to work in thecountryside, even if they were born there. Finally, be patient. It may be yearsbefore your Chinese operations make money.

Bernstein could have added: beware. The rules in China are still beingwritten. Different arms of government may interpret them differently (see nextarticle). And if someone in power changes his mind, there is not much you cando about it.

Will the Chinese government allow Nestlé to buy Hsu Fu Chi? In 2009 itrejected a $2.4 billion bid by Coca-Cola to buy Huiyan Juice Group, a drinksfirm, for no apparent reason. Analysts say that this is unlikely to happenagain, however. “The company is not strategically important and together Nestléand Hsu Fu Chi would control only about 5% of the market,” says Jon Cox atKepler Capital Markets in Zurich. As the world’s largest chocolate-maker Nestléhas high hopes for a market of more than a billion people who currently eatshamefully little chocolate.

Much could go wrong. Many economists think Chinese households save toomuch. Some fear a property bubble or a banking crisis. The risks of sellingconsumer goods in China are immense. But so is the opportunity cost of stayingaway.