China Best Practices for SMEs Still Drooling Over the China Market

Even with the current bilateral unrest in the U.S.-China relationship, the China market is still attractive because of its growing middle class (approximately 400 million) and its relatively easy plug-and-play manufacturing environment. A review of China’s manufacturing production over the past year shows that China hurt in Q1 of 2020 but continued apace starting in Q2 with an increase of 5% over the same months in 2019.

Many small and medium sized enterprises (SMEs) either (1) cannot afford to relocate some or all of their supply chain from China or (2) are taking advantage of a shift in demand to negotiate better terms with their Chinese counterparts. If you are one of these smaller companies, you need to take advantage of and learn from the mistakes made by the larger firms that preceded you. If you cannot get out (see here regarding Samsung, Hasbro, Apple, Nintendo, and GoPro) or have no intention of abandoning the China market or your Chinese partners, then you need to pay attention to some of the best practices as part of your China plan:

  • Perform rigorous due diligence in your partner selection. If you are entering into a joint venture or any type of distribution relationship without proper due diligence, then you need to be aware that many Chinese companies may not be what they seem. These companies can be deficient in their capabilities, hold a surplus of nonperforming assets, and be hiding many off-the-book liabilities. And don’t forget the current (and definitely continuing) hot-button topic of forced labor infecting your supply chain. (See China Products Made With Forced Labor Are now in U.S. Customs’ Crosshairs and China’s Other Supply Chain Infection – Forced Labor.)
  • Base plans on more than just a “snapshot” view of the market. Many early foreign companies in China made their investments based on an inaccurate view of the China market, which changed rapidly, leaving them behind. The pace of change is so rapid in China that their plans were obsolete before they were fully implemented. This can be especially prevalent in a place like China where the CCP is the “market maker,” picking winners and losers and distorting the market. Though some in the CCP advocate for a more market-based economy, we are unlikely to see a convincing market-based economy for many years.
  • Assess the competition and potential for competition realistically. Previous China-focused companies often underestimated the breadth and intensity of competition. Factories appeared seemingly overnight, causing excess supply and price wars. We saw this with the recent “diversification” of factories that previously had no experience making personal protective equipment (PPE) exporting it to the U.S. and the rest of the world, with sometimes wild and scary variations in price, quality, and safety potential.
  • Be prepared for tough times. When China’s economy overheated in the mid- to late 1990s, western companies started to pull back, leaving their local management with few resources to sustain their China operations. Few anticipated the staying power needed to weather the market storms. Even with China’s continued growth, China no doubt will witness additional periods of turbulence as its economy continues to expand, which is likely one reason why the CCP this year for the first time in decades did not provide a concrete GDP growth rate target for the next five years.

SMEs are the lifeblood of most economies, even though larger MNCs (multi-national corporations) tend to get more of the limelight. SMEs often face challenges particular to small companies:

  • Niche market. Successful SMEs often have carved out a space in the market based on patented technology or process expertise developed over many years. These SMEs must be particularly careful to protect their IP rights in China, which is often much easier to do than you may typically think (see How Not to Lose Your IP When Developing a Product with Your China Factory and What to do AFTER You Get Your China Trademark).
  • Thin management. SME management is naturally thinner than that of a large, diversified company. This means that the required investment of senior personnel into a company’s China initiative can result in an extremely high opportunity cost to the company. Ten or fifteen years ago, a deep investment in the China market may have made sense. Now that decision may be more tenuous. But I have known too many companies who put nearly all of their international eggs in the China basket, and many are still reeling as they try to figure out what to do in this current environment.
  • Limited international experience. SMEs typically have limited international experience and infrastructure, resulting in a steeper learning curve and a greater need to rely on third-party organizations, which can be expensive. This lack of experience coupled with the relatively high costs of hiring outside experts often leads SME management to turn to unreliable and unqualified resources that present a friendly and convenient “China face” (for instance, the uncle of an assembly line worker who has great connections with a local vice mayor). You will need your own trusted advisor (preferably employees who are 100% loyal to you) to be on the ground in China, if not constantly then at least regularly.
  • Greater proportional risk. The financial risks of an investment in China can have more calamitous consequences for an SME than for a larger firm that can better absorb a failure or an underperforming operation. This is why the larger corporations and SMEs that could afford to diversify away from China started to do so back when the trade war started rumbling (see China Manufacturing: “Elvis Has Left the Building”). On the other hand, if management waits too long to respond to the need to go to China, it may have already compromised the company’s financial health, heightening risks and limiting strategic options.

Despite SMEs’ special challenges, they some distinct advantages as well. Most importantly, they are usually able to pivot faster than big companies, a trait that can be of great importance in ever-changing China. The family style management of many SMEs often fits well with local Chinese management, making it easier to work together in a partnership. Getting personal and staying personal with your China counterparts are some of the best ways to mitigate your China risk.

As I mentioned initially, the China lure is still very strong, even in the face of potentially crippling sanctions, trade wars, international conflict, and international global health concerns:

  • Attractive new market. China presents an attractive market opportunity to support the development of a market entry or expansion strategy. This opportunity must be thoroughly substantiated to identify market potential where the SME can make money.
  • Customer pull. It appears critical to further explore a foray into China to defend or expand key customer relationships. SMEs in this situation should use direct customer probes to develop a clear and specific understanding of what their customers need from them in terms of localization. This is especially critical when considering the way Chinese e-commerce differs from many Western marketplaces.
  • Competitive threat. The growing competitive threat from China, primarily from local Chinese players that have become adept at penetrating existing customer bases (also a significant factor due to the rise in e-commerce), can often be addressed in country (see How to Stop China Counterfeits: Register Your China IP with China Customs). SMEs facing this situation should carefully measure this threat and identify possible countermeasures both for the China market and for their domestic and other international markets.
  • Cost savings. The SME urgently needs to capture the benefits of lower operating costs in China, which is getting more and more difficult to do. In this case, companies should evaluate the best structural option to achieve these benefits at the lowest risk, which may include a China+ strategy to capture benefits of neighboring countries, especially in Southeast Asia. There are often better and less risky alternatives than setting up a manufacturing facility, especially for SMEs. If you intend to stick with China, then make sure your Chinese partners are using their best creative efforts to diversify away from China as needed.
  • Stakeholder push. Stakeholders continue to press management to consider expansion into China because of the ease of doing business there and the potential for profits. Smart stakeholders will require a clear and substantiated evaluation of the benefits and risks of doing so. Though not a legitimate motivation in itself to invest in China, stakeholder pressure can be a reason to take a serious look and do so in a responsible way.

The drivers to go to China will usually be a mix of the above factors, and management must clearly understand their own company’s drivers and the urgency to address them, along with the consequences if they do not. Though examining these motivations may seem straightforward, companies often perform only a cursory evaluation during this crucial phase of the planning process (see China Manufacturing: Don’t Be Too Eager to Make a Deal). Without the insight that comes from examining the motivations for going to China, management cannot accurately weigh the financial investment, IP exposure, opportunity cost, and other risks of going to China. Now is not the time to be complacent about your China strategy.