By GEORGE F. BROWN, JR. & DAVID G. HARTMAN, Blue Canyon Partners Inc.
Over the past decade, many western firms have identified and targeted China's exciting, fast-growing markets. Most of these firms had already established manufacturing and sourcing operations in China, lured there by the low labor cost environment and its potential for delivering significant cost savings. Soon, a network of western firms emerged, with many traditional supplier-customer relationships transported into China. Over time, those firms turned their attention to selling to Chinese businesses and consumers, joined by other first-time participants in that country's markets. Many of the western companies that established a presence in China were among the "early birds" of western markets, leaders in technology and design, with product offerings far beyond anything previously available to China's customers.
Most of these companies found success in China. From a base of nearly zero, China became their company's "growth story," expanding year-after-year at significant double digit rates and within a short time achieving enough scale to move the needle in terms of both the top and bottom lines of their income statements. "Our continuing success in China was a major factor driving the past quarter's results" remains a common statement in the earnings releases of many western companies.
The customers reached by these western firms with their leading-edge products were the elite of China, a combination of western firms operating there that needed ingredients for their export-oriented manufacturing and the highest-end of China's own society. Western firms operating in China carried their standards and expectations with them, as for the most part, their operations in China were oriented towards production to serve western customers. They expected their suppliers in China to be no different than their suppliers in developed country markets -- and in fact in many instances, these suppliers were the exact same firms. The elite consumers in China quickly gained awareness of the best that western firms had to offer, and had the income levels necessary to buy those products. And for these elite Chinese consumers, buying products that represented the best that the west had to offer was a statement of their stature in a country where that matters considerably. The number of these elite customers grew very rapidly, from a miniscule fraction of the population, to a tiny fraction of the population, to a usually-still-small fraction of the population today. As the bell-shaped income curve shifted to the right at China's growth rate, with its 1.3 billion people, even small shifts generated huge numbers of consumers at the higher-income levels. For the western firms, doing business in China was thus a natural extension of their activities elsewhere, as customers were either familiar western firms or elite Chinese with preferences much like those of western consumers.
As western firms enjoyed the growth described above over the past couple of decades, a new group of Chinese firms emerged, many from the state-run or local enterprises of prior years. These firms had access to the lowest cost labor pools that were available throughout China, and in fact practiced "China economics" in a way that enabled them to achieve price points almost unimaginable to western firms . Many of these Chinese firms sold to their own customers at prices that were dismissed by western companies as either the result of government subsidies or a cultural belief that they could "lose money on every unit, but make it up on volume." Their products lacked the sophistication and refinement of the western brands, often characterized as low-quality knock-offs of similar products manufactured by western companies.
In many instances, these Chinese firms also developed solid manufacturing competencies, and began to be "hired" on some basis by western firms to make products for them, creating a cycle in which they strengthened their manufacturing skills under the tutelage of the western firms for which they were working. Furthermore, through these relationships, they were also exposed to western technology and design on an ongoing basis. Haier, for example, got its start manufacturing refrigerators for Germany's Liebherr Group (and eventually borrowed its present name from the 'herr' portion of that firm's name in Chinese). In other instances, western firms were delighted to license technology and design to Chinese startups, often that of past-generation products. Geely entered the automotive industry in such a manner, with its first car based upon the design of the Daihatsu Charade seen all over Asia with local brand names.
Most western firms dismissed these new Chinese firms as in any way representing a threat to their business. Their products, especially in the early years, were viewed as primitive and often laughable, only interesting to the low-income Chinese that couldn't in any way afford the quality embedded in western products. And such western companies comforted themselves with the knowledge that those Chinese consumers who had risen in the income distribution were clearly signaling their preference for the offerings of western firms, even though these low-cost imitations were widely available. In terms of western markets, it was widely believed that it would be many generations before a Chinese firm could meet the standards, regulations, and expectations of western consumers. And furthermore, in many industries, it was argued that even the primitive offerings of these Chinese firms were the product of stolen western intellectual property, a practice that might work in China, but which couldn't be exported elsewhere.
Tune in tomorrow to see the second part of this article.
George F. Brown, Jr. is CEO of Blue Canyon Partners, Inc., a strategy consulting firm, and is co-author with Atlee Valentine Pope of CoDestiny: Overcome Your Growth Challenges by Helping Your Customers Overcome Theirs, published by Greenleaf Book Group Press.
David G. Hartman is Blue Canyon Partners' China Practice Director and has been an active participant in China's markets for over twenty years. He has previously served on the faculty of Harvard University and as executive director of the National Bureau of Economic Research.
 See David G. Hartman, China Economics: Unraveling the Mystery of China's Low Cost, Blue Canyon Partners, Inc., © 2007
For more information, please visit www.bluecanyonpartners.com.