With China now in the World Trade Organization (WTO), the wholesaling landscape is changing. Foreign trading companies, retailers, and consumer products companies will find plenty of opportunities to generate larger profits later in this decade, a McKinsey study shows. But these gains will come at the expense of China’s domestic wholesalers, which will be hard-pressed to compete as their industry modernizes.

For China’s wholesalers are small, fragmented, and lacking in national scale, mirroring the country’s thousands of equally small, geographically dispersed retailers, which make direct distribution so unattractive financially. Because of the country’s poor roads and waterways and inadequate warehousing and distribution networks, manufacturers must rely on several layers of local wholesalers to get products to remote locations (Exhibit 1). Domestic wholesalers thus capture 80 percent of the revenues from distributing consumer products and have little incentive to change. By contrast, in the United States the corresponding figure is 20 percent, with the rest going to retailers. The Chinese government has long protected wholesalers—more than half of them are state owned—by blocking the participation of foreign companies.

As a result, wholesaling in China is a cutthroat, low-margin business—in marked contrast to the industry in developed countries, where wholesalers have consolidated, invested heavily in information technology, moved into value-added services such as credit control, and actively promoted consumer products. In the United States, the top four consumer products wholesalers have captured a 14 percent market share, compared with less than 1 percent for their counterparts in China, while gross margins are 17 percent, compared with 5 percent.

Our study highlighted three trends that will significantly alter the landscape of the industry over the next ten years. First, to join the WTO, China agreed to allow foreign companies to enter the wholesaling market, initially in joint ventures. The foreigners can own up to 49 percent of these enterprises immediately and assume full ownership after three years. This change in policy is likely to encourage the entry of experienced foreign trading houses, which will probably take advantage of the liberalization to increase exports to and imports from their home markets. Superior management systems and access to capital should also help foreign wholesalers outperform their Chinese counterparts by achieving national scale within China and efficiencies of scope. Marubeni, a Japanese distribution company, for example, has created a joint venture with the No. 1 Department Store, in Shanghai. Through this partnership, which has already obtained contracts to import several Japanese products into China, Marubeni expects to increase its exports of Chinese products to Japan.

The second trend is the continual modernization of retailing. Modern chained formats such as hypermarkets, which tend to rely more on direct distribution, are taking sales away from traditional retail outlets that have been served by Chinese wholesalers. In addition, more warehouse clubs are targeting small retailers directly and becoming direct competitors of wholesalers.

Third, we expect manufacturers to follow suit, cutting out wholesalers and distributing products through third-party logistics providers. One large beverage company, for example, is thinking about reducing the number of wholesalers it uses and directly distributing its own products in China’s major cities. In addition, it is looking into the idea of using this direct-distribution network to provide a wholesaling service for other packaged-goods companies. We expect this trend to gather force as the Chinese consumer products industry consolidates, thereby creating sufficient scale for direct distribution, and as the national highway system improves. Direct distribution, cutting out wholesalers, will account for 26 percent of the product flow by 2006, up from 14 percent today.

These three trends will pass most incumbent wholesalers by, and we estimate that their annual sales growth will decline to about 2 percent, from 4 percent. Although wholesalers will remain the largest distribution channel, their share of the flow of consumer products will fall from 86 percent in 2001 to 68 percent in 2006 (Exhibit 2). In order to survive in this new environment, domestic wholesalers will have to broaden their product portfolios, provide value-added services such as channel marketing, integrate forwardly into retailing, or expand through acquisitions of other wholesalers.

To be sure, rationalizing China’s wholesale industry will make goods flow more efficiently and boost profit margins for consumer products companies. Furthermore, vertical integration by wholesalers, retailers, and manufacturers will reduce the number of distribution layers and improve the coordination of channels. We estimate that removing a single layer of wholesalers would allow a fast-moving domestic or foreign consumer goods company to go on to capture as much as an additional three percentage points of profit margin—certainly a very significant gain in these competitive markets.