Riding the Chinese Dragon
How East Asian Companies Sidestep Direct Competition and Seek Instead to Profit from China’s Rapid Growth.
January 18 2011 by William J. Holstein
Eizo Kobayashi, chairman of the sprawling Tokyo-based trading company Itochu, is beginning to feel some heat from Chinese competitors. In vying for energy and natural resource projects in South America and elsewhere, China’s state-owned enterprises are making aggressive bids to win deals. And in building a major highway project across northern Africa, Itochu’s Chinese competitors can dispatch 10,000 Chinese workers. Because Japan has only a tenth of China’s population and labor is scarce, Kobayashi and his Japanese joint venture partners reckon they would have to find and then train 10,000 Bangladeshis to compete. They are at a distinct disadvantage.
So it is perhaps surprising that Kobayashi does not see the emergence of China as a dire threat to his trading company, or sogo shosha, which invests in joint ventures in textiles, machinery, food, energy, raw materials and other industries, and then trades those products around the world. Itochu has invested in 75 companies in China—particularly in textiles, machinery and food—and 85 percent of those ventures are making money. In the food sector, for example, Itochu is introducing ways to improve food safety and reduce the calorie count in some foods, which is increasingly an issue as China improves the quality of its diet. “They need those ideas,” Kobayashi explains, sitting in a reception room in his company’s headquarters high above Tokyo.
Because these ventures are doing well as China’s economy grows at about 9 percent a year, Kobayashi says that 10 percent of the entire Itochu group profit is now coming from the mainland—as opposed to virtually no profit in 2009 from the U.S., with an economy still struggling despite its emergence from recession. And none of its joint venture partners are competing outside the Chinese market. “We don’t face serious pressure from China at this moment,” he says.
In the opinion of some economists and Asia-watchers, the emergence of the Chinese Dragon is destined to overwhelm manufacturing companies in East Asia. China has just, in fact, displaced Japan to become the world’s second largest economy and it is clearly brandishing geopolitical power, as seen in its decision to halt shipments of certain rare earths that have important uses in Japan and elsewhere.
But companies in Japan, as well as in South Korea and Taiwan, have adapted their business models and do not foresee genuine head-to-head competition from China in international markets within the next three to five years. Korean companies like Hyundai, Samsung and LG suffer from having a small home market and run the risk of getting caught in a squeeze play, as Chinese companies take advantage of their cheaper labor at the same time that the Japanese dominate high-technology sectors. So far, however, they see more opportunity than peril in China.
Taiwanese companies face a very different set of challenges, partly because their island state is still technically at war with the Chinese Communists. But as the result of a new Economic Framework Cooperation Agreement (ECFA) between Taiwan and China, the Taiwanese are dramatically expanding the size of their investments on the mainland and are pushing much further inland to less expensive areas.
What all these companies are doing—American CEOs take note—is dropping product lines where labor costs mean they cannot compete against the Chinese and moving up to high-end technologies, plant equipment and components. Japan is feeling some pressure coming from the mainland in semiconductors, for example, so it has retreated to the manufacturing tools and components needed to make those chips. “In those areas, we are very strong,” says Kobayashi. Japanese companies also are holding on to their No. 1 global positions in key industries such as cameras (Canon), industrial robots (Yaskawa), hard-drive motors (Nidec) and motorcycle batteries (Yuasa.)
At the same time, these companies are either engaged in huge expansions of their own Chinese plants or in joint ventures so that they can sell aggressively into the Chinese market. “Instead of fighting them, we are trying to work with them,” says Shin Horie, managing director of Japan investment research for Goldman Sachs Japan Co. Although China’s state-owned enterprises and private companies both have moved up the ladder of sophistication in recent years, they are still weak on technology- based innovation, Horie says. They can make cheap products that sell in China or emerging markets, but they have not yet mastered the quality and safety levels demanded by the U.S., Europe and Japan. Moreover, East Asian companies possess huge advantages with their brand names and global distribution systems built up over two or more decades.
Only a handful of Chinese manufacturing companies are making serious international pushes: Haier, a maker of appliances, is competing in the U.S. against Whirlpool. Huawei Technologies, despite bitter intellectual property disputes with Cisco and Motorola, is also competing for telecommunications projects around the world, even though security concerns appear to be blocking its expansion in the U.S. And Mindray Medical International is going up against General Electric and Royal Philips Electronics in medical equipment.
But others seem stuck in the home market. Lenovo bought IBM’s personal computer division and briefly sought to portray itself as the first Chinese multinational, but it has since largely retreated to the home market, Southeast Asia, India and Latin America with low-cost products. Zhejiang Geely Holding Group just bought Volvo from Ford, but intends to use the acquisition to expand Volvo’s sales in China, not as a launching platform for an assault on global markets. China’s state-owned enterprises possess huge capital, but are even less sophisticated in operating multinational-style businesses.
One issue, says Horie, is that the Chinese market, with 1.3 billion people, is so large and is growing so fast that most Chinese companies do not yet have a compelling incentive to compete in tougher, lower-margin markets in the advanced industrial world. “It’s the best market in the world—why would you bother to go abroad?” he asks. Unless the market suddenly becomes saturated—a highly unlikely occurrence—Horie’s prediction is that “a very small number of their companies will go global.”
Improbable as it may seem in a globalized economy, Japanese companies are being guided by the Ministry of Economy, Trade and Industry, or METI (which used to be known as MITI) as they formulate their China strategies. Tomofumi Hiraku, director-general of METI’s manufacturing industries bureau, says his ministry has helped Japanese companies focus on making parts and components for Chinese factories to avoid head-to-head competition with them. “If China exports to other markets, they will be importing parts from Japan,” Hiraku explains.
The automobile industry is the one that METI is watching most closely, because it is so important to Japan’s economy. So far, no alarm bells are ringing. “The competition in the auto sector from Chinese companies is very low,” Hiraku argues. “It will be very difficult for them to export [to the advanced economies], not only because of quality and safety reasons, but also because they have not invested in dealerships. “Japanese companies have global distribution networks and very famous brands,” says Hiraku. The fact that China has at least 40 government-owned automakers suggests that none of them may be able to achieve global scale, some industry analysts argue.
In South Korea, Hyundai Motors has been eking out some gains against Toyota, but still faces a tough battle against the Japanese industry as a whole. To avoid getting caught in a competitive vise as the Chinese push up from the bottom, the Koreans have concluded that they need to be even more aggressive than the Japanese in expanding in China. Hyundai, for example, will assemble 1 million vehicles in China in 2010 and has rolled out a supplier base of some 200 Korean component makers, says Lee Hyun-Soon, its vice chairman of research and development. Hyundai suppliers such as Mando are selling parts to Chinese automakers as well. Experts use the term “production networks” to describe these large-scale industrial alignments.
At the same time, Hyundai is racing to stay ahead of Chinese auto rivals by spending 4.5 percent of sales on R&D and maintaining 11 R&D centers around the world, far outstripping the abilities of any Chinese automaker. The Chinese have some interesting technologies, such as lithium ion batteries, but they do not have as much as experience as the Koreans in “how to link technology to the mass market,” Lee argues. Hyundai has invested massively in its branding and distribution network, which Lee says is a commanding advantage. In distribution, the Chinese “are still at zero,” he says.
Samsung and LG have similar strategies in electronics and mobile phones, investing massively in lower- end manufacturing on the mainland, while seeking to dominate new emerging niches such as organic light-emitting diodes (OLEDs), widely thought to represent the next generation of display technology.
Taiwan companies are racing to stay ahead of their Chinese competitors by expanding their already considerable presence. Some 1 million Taiwanese live on the mainland, where they manage many factories, and some 60,000 Taiwan companies have invested in China, according to the Chung-Hua Institution for Economic Research, a think tank in Taipei. This is highly ironic because the two governments do not officially recognize each other and the Chinese military has at least 1,500 missiles pointed toward Taiwan. But the two sides are greatly expanding economic ties, even if their governmental and military relations remain frozen. Under ECFA, tariffs will be reduced or eliminated for 539 Taiwanese exports to China worth about $14 billion and 269 Chinese exports to Taiwan worth about $3 billion. The industries involved include petrochemicals, textiles, automobile components and machinery.
Taiwanese companies are already exploiting the eased economic barriers by moving more deeply into the interior of China, where labor costs are cheaper than in coastal areas. Foxconn Technology Group, the world’s largest contract manufacturer and the largest exporter from China, already employs 920,000 workers on the mainland—as much as a whole city in Taiwan. It makes most of Apple’s gear, including iPads and iPhones, and also manufactures for Dell and HP.
Now one of its units, Hon Hai Precision Industry, has announced it will build two new plants in second-tier cities, such as Chengdu and Wuhan, that will employ half a million more Chinese. Estimates of the new investment start at $3.5 billion.
In effect, Taiwan’s companies are exploiting their linguistic and cultural know-how, combining Japanese and Korean core technologies into low-cost products and distributing those products through top American companies to the world. Taiwanese companies are No. 1 in the world in making laptops, personal computers, notebook computers and liquid crystal display panels. HTC, for example, is making Sprint Nextel’s Evo 4G phone and Verizon Wireless’s Droid Incredible, using Google’s Android operating system. It is also making the Nexus One, the Google-branded phone. Most of Taiwan’s snazzy devices are assembled in China, and Taiwanese CEOs are convinced they can use the mainland as a platform for conquering global markets, without risking being overtaken by Chinese competitors. One reason for their confidence is the considerable difference between capitalism on Taiwan and the Chinese version of capitalism, which still maintains a heavy Communist Party and central government role. “In Taiwan, CEOs own their own companies and they have to make very tough decisions and make them quickly,” says Luis Ko, president of I-Mei Foods, a maker of foodstuffs. “In China, that’s almost impossible. In the long run, we’ll be able to compete.”
To be sure, many East Asian companies are feeling keen competition inside the Chinese market. In handsets, for example, Beijing Tianyu Communication Equipment, also known as K-Touch, is gaining share against Nokia and Samsung. Lenovo, Huawei and ZTE also are expected to become increasingly competitive in the Chinese market. In their home market, the Chinese have the advantage of government influence, which often includes subsidies or other behind-the-curtain forms of help. Chinese consumers also often prefer products made by Chinese companies, as opposed to those from Japan, and are willing to forgive poorer quality. (There is much historical animosity between the Japanese and Chinese.)
Further, no one can predict whether Chinese competitors will pour out of the mainland in 10 or 15 years. One fear is that the Chinese will leapfrog existing technologies by, for example, coming up with an all-electric vehicle that represents an overwhelming advantage over Japanese or Western designs. Another threatening scenario is that the Chinese might develop enough skill and momentum by operating in Latin America, Africa and other markets at the bottom of the heap as they build scale and then surprise the world with new-found power and sophistication.
But for the time being at least, Japanese, Korean and Taiwanese companies are winning. These companies operate very differently, possess different levels of technology, and work in different geopolitical climates, but they share similar strategies in responding to the emergence of China. The key is learning how to ride the dragon, not to remain standing in its path.