Retailing in China has entered a period of turmoil following an attempted crackdown on locally approved foreign ventures. The outcome of last year's unprecedented 'name and shame' campaign ordering the restructuring of nearly 200 foreign-invested stores remains in doubt. Local governments, aware of the inability of many Chinese firms to increase their stakes in foreign joint ventures, appear to have deflected central government demands to enforce Chinese majority equity control.
The situation is further confused by a radical programme of mergers and consolidations among domestic retailers and a slowdown in the retail sector forcing many firms into liquidation regardless of regulatory edicts. Many foreign firms have so far weathered the storm, but they continue to play a waiting game monitoring the likely effect of the crackdown on competitors. While they fear a renewed wave of enforcement from Beijing, they are also hopeful of new, more liberal retail legislation.
ShoGoing in the dark
Eleven cities – Beijing, Shanghai, Dalian, Qingdao, Guangzhou, Tianjin and the five special economic zones – have been open to foreign-invested retailers since 1992. But retail regulations are tight even in these test site cities. State Council approval is required for retail joint ventures in which the Chinese party must hold a majority stake.
No city is permitted more than two 'experimental' retail joint ventures and the proportion of imported goods sold in these ventures is capped at 30 percent of turnover. Retail ventures are also prohibited from engaging in the wholesale business and must not act as a foreign trade agent on behalf of third parties. Fewer than 20 foreign retail joint ventures have so far received central government approval.
That is the theory, but the practice is quite different. Shanghai and Guangdong, in particular, have made a mockery of Beijing's policy by approving nearly 300 retail outlets since the early 1990s. Local governments have adopted' a mixture of open defiance of Beijing and the use of regulatory loopholes, such as arrangements where the Chinesepartner's retail licence is used rather than the joint venture applying for a retail licence in its own right. Other foreign retailers have ridden in on the back of real estate projects or become involved in arm's-length management contract relationships.
Defiance on this scale was bound to attract the attention of the central government sooner or later. A warning shot was fired in 1997 when Beijing placed a moratorium on the issuing of new retail licences pending a full investigation of existing approvals.
In August 1998 central bodies including the Ministry of Foreign Trade and Economic Cooperation (Moftec), the Bureau of Internal Trade and the State Administration of Indus-try and Commerce sent out instructions to their local subsidiary bodies with orders to report back by the end of the year.
Enforcing majority stakes
While Beijing's August missive ordered the closure of 36 foreign-funded retail enterprises, there have been few reports of shutdowns being implemented. Industry sources cited in Business China reported, for instance, that one or more stores operated by Trust-mart had been axed by Beijing. The Taiwanese retailer, which operates eight retail outlets in the Mainland, nevertheless denies that any have actually been shut down or encountered licensing problems.
Most of the 199 locally approved retailing operations were, however, given a chance to continue operations contingent upon restructuring. The brunt of Beijing's attention was focused on stores where the foreign investor had taken a majority equity stake. These stores were ordered to con-form to regulations stipulating a Chinese majority stake.
The move has perplexed many foreign retailers relying on local approvals. One European retailer ordered to restructure a majority stake joint venture expressed bewilderment: "This is unbelievable…If you can't trust that the local authorities have the right to approve things when they give you a licence, what are you supposed to do? Go all the way to Beijing to check on them?"
Beijing's power to exert pressure on local authorities to increase the equity stake of Chinese partners appears to have varied from city to city. "Isetan reports that its Tianjin venture was brought under extreme pressure last year to increase the equity ratio of the Chinese party, but the pressure has since eased," says Mr. Peter Come of the Shanghai office of law firm Simmons & Simmons. "In contrast, [Isetan] reports that its Shanghai stores have not come under strong pressure to restructure." He notes that Isetan has an 80 percent interest in one of its stores on Shanghai's Nanjing Road.
Pressure on Shanghai stores reached a peak during the visit of Beijing officials sent to oversee the restructuring process "but this has eased as the Shanghai government has not itself at any point pushed very hard", notes Mr TK Chang of the Hong Kong office of law firm Coudert Brothers.
Mr. Matthew Cosans of the law firm Freshfields concurs. "There has been a big crackdown in Shanghai. Are the Shanghai authorities not aware of the regulations? Of course they are! What I think has happened is that [the Shanghai authorities] have given Beijing all the dross, including operations where the investment has not materialised. When Beijing demands that one-third of Shanghai operations close, Shanghai tries to restrict the proportion to one-sixth and so effectively the status quo is maintained."
Underlying the reluctance of local governments to force equity restructurings is an awareness of the difficulty faced by cash-strapped Chinese partners. The trend in some cases has indeed been for Chinese partners to reduce their stakes in retail ventures. One European retailer's Chinese partner, for instance, was forced to sell part of its shares two years ago because of cash shortages.
"Where Chinese partners lack the ability to fund any increase in the equity shareholding, it has been virtually impossible for the government to force foreign investors to lend money to the Chinese parties for the purpose of funding an increase in their equity investment," notes Come.
But he believes the full impact of the Chinese partners' funding difficulties may only become apparent in future retailing ventures. "Even if foreign investors are happy to be placed in the position of minority partner in a new venture, will they be prepared to enter into a joint venture whereby the Chinese contribution is funded entirely of assets with no cash injection?"
The observation can be extended to situations where foreign retailers seek to expand existing joint ventures into chains. "Traditionally one way to boost the Chinese stake has been by inflating land values," says Cosans. "This may be OK for phase one of a project but when a project is to be expanded, hard cash is usually required. Many Chinese partners at this stage say, 'sorry we don't have any cash'."
"Many of these retail operations are not yet profitable, so it is likely that the Chinese partner has better investment options, not to mention the fact that they might prefer their foreign partner to have management control," comments Coopers & Lybrand's Rivet.
The fact that Beijing is aware of these problems is reflected in less stringent demands placed on stores based in interior provinces. Here, Chinese partners are only required to raise their stake to a minimum of 40 percent.
But foreign investment in retailing does not always take the form of a joint venture. In many cases a Chinese store will merely con-tract out the management of its business to a foreign partner. The latter will usually be paid a profit-related management fee. Simmons & Simmons' Come believes that the impact of the current crackdown on these types of relationships will be limited by the relative invisibility of such contractual relationships, most of which have not been registered with Moftec. Abuses here "would require great expenditure of resources on the part of the authorities in order to eradicate", he adds.
Freshfields' Cosans believes that management contracts may be being used as a cosmetic exercise to raise the Chinese partner's stakes in some ventures. The strategy here is to "restructure the equity and add-on a management contract which just happens to match the missing dividend."
Another approach to the problem of lack of capital is to encourage mergers between state-owned retail operators. Shanghai has taken a lead here. City authorities announced in 1997 that they would halve the number of chain stores operating in the city from 40 to 20 in order to 'form efficient groups through merger and optimisation of assets.' On paper, at least, the rationalisation has already exceeded this target, with the number of chain stores in the city falling to 14 by March 1998. Plans were also announced to further reduce the number of chain stores to 10 by the end of last year.
A hint of the importance of these changes to foreign firms lies in the fact that Dutch retailer Ahold's takeover of 22 Shanghai stores formerly owned by the Japanese firm Yaohan was included in the municipal plan. One of the dominant domestic retailers in the Shanghai market is Hualian Group which has in recent years absorbed Sanjiaodi, Shanghai Friendship & Overseas Chinese Group, No 10 Department Store and Tianjin-based Zhongyuan. Japanese retailing firm Daiei, Thailand's Charoen Pokphand and Hong Kong-based Li Dong Emporium all have ventures with Hualian – originally a commercial offshoot of the former Ministry of Internal Trade. Shanghai Hualian Super-stores had sales of Yn1.9bn in the first 10 months of last year.
In a few cases Beijing has also raised the alarm over breaches of the rules on wholesaling, which is still in theory off-limits to foreign investors. The duration of retail joint venture contracts which are not supposed to exceed 30 years in coastal areas and 40 years in inland cities has also aroused the criticism of certain officials. Some ventures were also ordered to stop engaging in mail order business. This follows a tightening of the rules governing multi-level marketing earlier in the year. As a result of this, Avon was forced to modify its direct sales operations in China to incorporate a network of 68 branch retail out-lets. The restructured company received a new Moftec licence last October.
Waiting for collapse
One factor which makes the true impact of the crackdown difficult to assess is the slow-down in the growth of retail sales. This has led to the closure of many retail enterprises for purely commercial reasons.
"It's a very competitive market in retail and to some extent the government didn't have to do too much on the regulatory front – they could just wait for the market to collapse," says TK Chang of Coudert Brothers. It also seems likely that the retail sales slow-down has discouraged some potential investors. Marks & Spencer closed its Shanghai representative office in December 1998 – an office which was investigating the possibility of the UK-based retailer entering the China market. "We decided that the timing was not right yet but the decision was made mainly on commercial grounds and is not to do with the regulations," says Ms Louisa So, marketing controller in Marks & Spencer's Hong Kong office.
In Beijing the December 1998 closure of the Qiancun store owned by Zhengzhou based Asia Group was just one of a dozen large shopping malls which have closed since 1996. In China as a whole nearly 30 percent of large retailing firms posted losses in the first 10 months of last year when total profits of the top 200 retailers declined 16.7 percent.
Another symptom of the retail slump is the development of a widespread glut in retail space. In Shanghai there are now more than 1.5m sq metres of vacant retailing space. Retail rents on Huaihai Road have already fallen from a high of US$7 per sq metre per day in 1996 to around US$5 by last summer. Despite this, observers report that Shanghai city authorities have continued to encourage retail real estate projects by offering fast-track building permits and tax breaks.
The rapid changes taking place in the retail scene in China may be making it difficult for Beijing to enforce its will upon the wayward provinces. This applies even where central government bureaucrats are aware that local governments are sidestepping their best attempts at enforcement.
New open cities
Cosans believes Beijing may be aware of the sort of accommodations being reached between local governments and retail ventures. Part of the explanation behind the crackdown, he believes, may be last year's reshuffle among the central ministries. For example the Ministry of Internal Trade, in charge of administering the retail sector, has now become the Bureau of Internal Trade. "Some people [in central government] were shed, and those that remained want to justify their position," he adds.
"At the moment, a lot of the retail stores seem to be playing a waiting game," notes Coyne. "Rather than combining forces to lobby the central government, they are waiting to see whether or not their competitors will be affected more than they are by the new policy." Cosans feels that this approach is understandable: "My guess is that the fuss will die down. Will there be a follow-up from Beijing? I have my doubts."
The attempt to enforce existing retail regulation may have been compromised by persistent rumours of retail restrictions being eased. The most widely expected change is an increase in the number of cities open to foreign investment. In mid-December Meng Yang, a division chief of the State Economic and Trade Commission, hinted that China would soon permit foreign retailing operations in most provincial capitals, allowing each city to approve up to three 'trial' ventures. Some officials had earlier suggested that as many as 300 cities could be opened up to foreign retailers.
There have for some time been anomalies. Wuhan, which was not on the original Ministry of Internal Trade list of cities cleared for foreign-invested retail enterprises, now boasts a centrally approved retail venture. Holmsgreen Holdings of Taiwan has joined Wuhan Zhongbai to set up the Lailai Centre department store in the city.
"Retail ventures have already been set up in cities not included on the approved list," comments Cosans. "So opening up further cities to retail investment is in part a recognition of what has already happened."
Wal-Mart, the world's largest retailer, was reported by Business Weekly to be negotiating the opening of a new store in Kunming, the provincial capital of Yunnan province. Wal-Mart's first store in Shenzhen generated a daily sales volume of Yn2m during the first three days of its opening turnover which was reported to have caused a 5-10 percent drop in the custom of other local stores. French retailer Carrefour, which has an estimated turnover in China of US$250m, also plans to open stores in secondary cities such as Wuhan and Shenyang.
"I expect some devolution of approval power from the centre to the provinces and municipalities, although I doubt very much whether approval power will be delegated to the local levels – such as 'quite big' city, as opposed to municipality level," says Come.
Higher entry thresholds
Another reform in the offing may be the raising of the entry threshold for investors. Sources cited by China Economic News suggest that in future foreign firms investing in the retail sector may need a global turnover of at least US$5bn as well as having well-established retail technology and management systems. The aim of such a requirement would be to block the entry of smaller, mainly Asian-owned investors some of which have entered the China retail market with very limited previous retail experience.
Another widely tipped change is the approval of a few 'experimental' wholesale and distribution joint ventures. While investment in this type of enterprise has officially been prohibited, this reform will in effect only recognise that several of these types of ventures exist already.
How the regions fared
Many well-known foreign retailers have been ordered to restructure their China ventures. For instance Park 'n Shop and Watsons were both ordered to restructure at least two stores in Guangdong province as well as outlets based in Sichuan and Shanghai. Yaohan, Wing On, 7-Eleven and Concord were also all named in the crackdown.
The focus of the crackdown appears to mirror the pattern of foreign investment in retail, with Shanghai (65) and Guangdong (55) heading the list in terms of the number of enterprises that have been ordered to restructure (see map).
"Many are Asian, but this is really only a reflection of where most of the investment into the retail sector has come from," notes Mr. Laureen Rivet, retail specialist at Coopers & Lybrand (Shanghai). Two-thirds of the 277 ventures examined by Beijing involved investment from Taiwan, Hong Kong or Macau.
Beijing appears to have escaped relatively lightly. Only six retail enterprises have been ordered to restructure in the capital – less than one-tenth of the number targeted in Shanghai.
By contrast, Chongqing came in for special criticism, says Mr. TK Chang of the law firm Coudert Brothers. The municipality, which continued to approve new foreign-invested retail enterprises even after the moratorium of mid-1997, has been ordered to restructure no less than seven of its foreign-invested supermarkets. Other cities singled out for criticism include Chengdu, Xian and Nanchang.