As the senior managers of many North American, European, and Asian MNCs realize that the forces working to open up China’s economy have become irreversible, they are hastening to expand the scale, scope, and structure of their involvements. To understand these changes in more detail, McKinsey recently carried out a survey of MNCs that have a significant presence in China and that are regarded by their peers as "doing China extremely well." These companies—both industrial- and consumer-focused—are not in China just to take temporary advantage of its low labor costs before hopscotching to another country when faster development inexorably drives those costs up. They are there for the long haul, have already figured out how to make profits and sustain them over time, and are working hard to lock out slower-moving competitors. In particular, they are focusing on managing local partners, keeping their business systems as simple as possible, and laying the organizational foundations for a China-wide presence.

China is—and will long remain—a difficult and uncertain operating environment for MNCs. No economic sage, and certainly no responsible observer of the political scene, would disagree. But the long-term economic opportunities China offers are so remarkable that senior managers will find it prudent to pay attention to what the most active companies have been doing—and learning. In fact, thanks to such learning, many of these pioneers are now moving, purposefully and aggressively, into a distinct second generation of involvement in China.

Recent economic developments are, indeed, extraordinary.¹ In the urban locations where much of the country’s growth is centered—Shanghai and Guangzhou, for example—consumer demand for a wide range of big-ticket items shows the continuing effects of soaring purchasing power (Exhibit 1). For more and more Chinese consumers, the issue is no longer whether they are able to afford, say, a $2 bottle of branded shampoo. They have already established themselves as purchasers of goods that require substantial savings and discretionary income (Exhibit 2).

The changes afoot, however, are not confined to the resources or aspirations of local consumers. Over the past few years, Chinese government officials at all levels have clearly signaled their intention of leading the country toward a market-oriented economy far more open than before to the rest of the world (Exhibit 3). This is not mere rhetoric:

• Price controls on 90 percent of consumer products have been lifted.
• Centralized, volume-based planning for manufactured goods now applies to less than 20 percent of industrial output, compared with 95 percent in 1979.
• Vice-Premier Zhu Rongji’s much-publicized 16-point plan has genuinely begun to curb official corruption, excessive speculation in real estate, and unwarranted expansion of the money supply through uneconomic loans made by state banks. Current estimates are that 60 percent of these loans have been retrieved.
• Efforts to undo the "iron rice bowl" working conditions for employees of state-owned enterprises have begun to pay off. Today, many workers operate under explicit labor contracts that—at least in theory—allow them to be transferred or even fired. Moreover, their salaries have largely been severed from the traditional accompanying package of housing, educational, and medical benefits. Companies are being encouraged to buy these benefits from competing service providers in the open market.
• Industry sectors that had long been closed, de jure or de facto, to extensive foreign participation—banking, insurance, retailing, petroleum refining, and infrastructure development among them—are now beginning to open up. Hopewell Holdings, for example, has joined forces with Guangdong Provincial Highway Company to build and operate a US$1.1 billion toll highway and urban ringroad, and the People’s Bank of China has relaxed restrictions on foreign exchange dealings for the retail branches of foreign banks.
• Estimates for 1993 show a total of "approved" foreign investments in excess of US$100 billion, of which US$20 billion has actually materialized (Exhibit 4). In Guangzhou alone, 1992 capital approvals exceeded the total amount authorized in all previous years combined.

Perhaps most important, almost all regions within China are now open to business with the outside world. As Exhibit 5 shows, the initial establishment during 1979 to 1984 of a few special economic zones in southern coastal areas was followed during 1984 to 1992 by the creation of development zones along the entire eastern seaboard. Since 1992, leading cities in every province, including those far inland, have been opened up in a similar manner. And this—combined with a projected growth rate in GDP during the next few years of 8.5 percent (as compared with 5.6 percent for the rest of Asia-Pacific, 2.4 percent for North America, and 1.9 percent for Western Europe)—is what has, in large measure, fueled the explosion of MNC interest in China.

Stages of involvement

As suggested above, some MNCs have acted on their interest more quickly, more energetically, and more successfully than others. It is still far too early—and their experience too limited—for us to generalize a set of broadly applicable "best practices" for others to follow. But it is definitely not too early to see that MNCs can indeed meet or exceed the usual start-up business objectives for ventures in China—such as building market share and making key contacts—as well as earn solid profits. In fact, more than half the companies we studied are making an ROS of 10 percent or more from their China-based businesses; another third or so have achieved between 6 and 10 percent.

Nor is it too early to note the pattern of development that characterizes China-related activities (Exhibit 6). In virtually every case, the companies in the survey began with one or two small ventures—small both in financial commitment and in scale relative to the MNC’s worldwide lines of business—as a way of putting an opportunistic toe in the water. In two-thirds of these early ventures, invested capital amounted to US$10 million or less.

To some extent, this was a path dictated by a central government in Beijing that, during the 1980s, still closely controlled which firms could enter, in which product categories they might compete, in which geographical areas they might operate, and with which local partners they might do business. At the time, such constraints were more or less acceptable since the MNCs’ reason for entry was not so much to capture specific opportunities as to learn about how to do business in China with the minimum of downside exposure. Over time, however, some ventures proved so troublesome that a few of our survey participants lost their initial enthusiasm. Unreliable partners, low sales volumes, scarcity of local managerial talent, and problems with local business ethics have all contributed to decisions by some MNCs to limit—or at least sharply decelerate—further investment.

Other MNCs took these frustrations in their stride, seeing them as the unavoidable price of learning in a complex and unfamiliar environment. Far from being disheartened, after a few years they made an explicit strategic decision to move beyond the experimental stage. In practice, this "second generation" approach meant rapidly expanding both the number and the size of their ventures in China. If current negotiations succeed, nearly all of the companies we surveyed will soon have a minimum of four separate ventures in China, and several will have over a dozen. Accordingly, they plan to raise their invested capital in the country from an average US$50 million today to more than US$200 million within three years. By contrast, those MNCs that still operate in experimental mode have a current exposure, on average, of only US$10 million, which they plan to raise to US$50 million by 1997.

Multiple ventures

To some extent, creating multiple ventures is a way of dealing with the fragmented, sub-scale, and extremely locally-oriented nature of most of the Chinese economy (Exhibit 7). This is a vestige of the traditional Communist planning system, which for political as well as strategic reasons sought to develop self-sufficient economic "cells" within each province to serve a highly dispersed set of demand centers. A quick glance at the scattering of operations in such industries as automobiles, chemical fibers, and TVs reveals the deliberately fragmented quality of the Chinese industrial base (Exhibit 8).

Multiple ventures are also necessary because of the extremely poor state of transport infrastructure in China. For every thousand square kilometers of land, for example, China has only 108 kilometers of roads (compared to 563 in South Korea and 684 in the US) and 8 kilometers of railroad track (compared with 31 in South Korea and 44 in the US).

"Second generation" MNCs have significantly raised their strategic sights; their new objective is to build and hold a dominant share of the Chinese market

A rapid move to multiple ventures is essential for one further reason. These "second generation" MNCs have significantly raised their strategic sights. "We have an opportunity to be the number one player in the world’s biggest market," they tell themselves. "So it is worth taking risks and upping the ante." No longer is experimentation the goal; the new objective is to build and hold a dominant share of the Chinese market, and to pre-empt, if possible, entry by other MNCs—and, very importantly, to do so while making good money along the way (Exhibit 9). The average break-even target for these second generation ventures is only 2.9 years. The issues to be resolved if this target is to be reached are, not surprisingly, many and demanding (Exhibit 10). The striking new fact is the energy and urgency with which a growing number of MNCs is attacking them.

Managing local partners

In most cases, the conflicting agendas of the MNC and its Chinese partner complicate resolution of these issues. Chinese partners, in general, are much less interested in winning market share and creating entry barriers than in gaining access to technology, knowhow, foreign exchange, and new jobs. Even so, finding and cultivating good local partners—most commonly, government-controlled factories that report to the municipal bureau overseeing their industry—remains vital for business as well as legal reasons.

Implicitly or explicitly, MNCs hope that their local partners can add value to their joint ventures in a variety of ways. Some want assistance in setting up day-to-day operations: for example, in securing plant space, personnel, sources of raw materials, and ready-made sales and/or distribution channels. Others desire access to project opportunities, markets, flexible rulings on the use of foreign exchange or state funds, and sometimes even fiscal concessions. And, of course, MNCs seek guanxi—the informal connections so essential to gaining approval for or access to just about everything in China.

Mothers-in-law

In practice, however, the value added by local operating partners is usually quite low to begin with and steadily declines over time (Exhibit 11). Many of them are simply too far down the chain of command to influence either the setting or the application of government policy. As a result, second generation MNCs have begun to dilute the influence—and the equity holdings—of their initial local partners. It is far more important, they realize, to establish relationships with the decision-making authorities—the industry associations and commissions and bureaus—that sit above these operating partners like protective and powerful "mothers." Indeed, for MNCs, these potential "mothers-in-law" represent the best route to the permissions, tax concessions, "locked in" customers, and central funding they need (Exhibit 12).

Experience to date suggests that choosing the right mother-in-law is as critical a strategic issue as choosing the right initial partner. Good ones not only help with first-round activities; they also open the door to future possibilities. One consumer products company discovered, for example, that the municipal government of the city in which it established its first manufacturing venture has become an influential mother-in-law, helping its protégé set up several additional ventures nearby, obtaining for it significant power supply contracts and import approvals, and assisting on worker management issues. In much the same way, the mother-in-law of an MNC in the chemicals industry is now helping the company expand its activities to nine separate ventures.

Minimizing the role of local entities, some second generation MNCs have also begun to cut new deals directly with their mothers-in-law. Both AT&T and Northern Telecom, for example, have signed agreements directly with the State Planning Commission, China’s second-highest-ranking central organization, to develop a nationwide, multi-venture presence that encompasses all their product lines. Such initiatives are especially appropriate when the industry in question is primarily under central government control and is felt to be of strategic importance by the Chinese leadership, and when the MNC can provide a clear value proposition. In the automotive sector, for instance, Volkswagen helped build its position by being the only major manufacturer to agree not just to import auto kits for local assembly, but to transfer technology and R&D management skills to its local partners. The company now controls nearly half the Chinese market for passenger cars.

The virtues of simplicity

Having gained experience in China’s harsh and often confusing operating environment, successful MNCs have also learned the critical importance of keeping things as simple as possible. The business systems they have established in China contain only those elements that represent an unavoidable "price of admission" (say, some degree of local manufacturing) or that create a distinctive competitive advantage (proprietary distribution channels). Anything that is especially risky or cost-ineffective in the early stages of market development—R&D, for example—is kept to a minimum.

Exhibit 13 illustrates what we believe is a representative MNC perspective on business system management in China. Every company will have its own variation on this, depending on the specific deals it has negotiated and its understanding of the fundamental factors for success in emerging markets.

According to our survey, MNCs that are doing well in China emphasize simplicity in their product/market strategies too:

• They focus on their core global products—those they have successfully manufactured and marketed all over the world—and sell current-generation technology and goods to minimize the risk of being leapfrogged by competitors. While this undoubtedly reflects what Chinese companies want from their Western partners, there also seems to be an underlying strategic rationale at work here.
• Contrary to conventional wisdom about the uniqueness of the China market, the excellent companies we studied do an absolute minimum of product tailoring, and shy away from establishing any real design capability in China. The tailoring that does occur is usually limited to adapting product formulations to accommodate local raw materials, or simply altering labels or instructions. Although a few technology-driven companies in our survey group do plan to set up design centers in China (largely to fulfill promises to the Chinese or to take advantage of qualified local engineers), most do not consider this important for their medium-term business success.
• Despite aspiring to broad market coverage, these MNCs have so far tended to focus on China’s top three urban markets. They have also concentrated their production assets in just one or two locations, partly because of the scarcity of experienced local managers, and partly because of the difficulty of developing good relations with local authorities and learning how to work local sourcing and distribution systems. They view setting up shop in a new part of China—even another of the top three markets—as a major step. More than two-thirds of our survey group already have ventures in Shanghai, Guangzhou, and/or Beijing, and plan further investments there; they are beginning to seek market coverage in all three locations.

Keeping things simple might be the MNCs’ current strategy, but it is not the end game they envisage. As the government eases constraints on foreign participation in distribution, sales, and even retailing, more companies are seizing control of these functions to get closer to Chinese customers and establish a distinctive competitive advantage. Moreover, fragmentation of the previously orderly (if inefficient) government distribution system is creating serious gaps in market coverage for companies confined to that channel. Having found that government networks are fine for taking orders but generally abysmal at actively selling products or meeting strict logistics standards, many of the MNCs we surveyed—particularly the more recent China entrants—are building their own salesforces and distribution networks.

Exhibit 14 features three cases that illustrate some of the characteristics of successful MNCs described above. The business system of a personal care products company that has minimized its local manufacturing and focused on setting up a unique distribution and sales channel is shown in the first example. The second company, a leading consumer products conglomerate, relies on superior product performance to command high prices, and carries out some tailoring to ensure that its products work well in China. It handles logistics via third parties, which are closely supervised, but has its own salespeople building customer relationships in major markets. The third example, an office equipment maker, manufactures extensively in China and is increasing its local sourcing to balance foreign exchange. Consolidating and controlling its sales channels are also current priorities.

Unfurling the umbrella

As second generation MNCs confront the challenges of operating multiple ventures in China, they have become acutely aware of the need to manage their entire span of activities in a cost-efficient, coherent manner. In particular, they seek some sort of "overlay" structure to provide shared or centralized functions like salesforce and distribution management, venture negotiation, government relations, foreign exchange balancing, and market research.

Recognizing this need, the Ministry of Foreign Trade and Enterprise Cooperation (MOFTEC) now allows MNCs that have two or more ventures with a total registered capital of US$10 million (at least a quarter of which is in foreign currency) to establish a new type of corporate entity, the "umbrella enterprise." Even under these new umbrellas, MNCs cannot freely import and sell products that they make outside China, but they can more readily coordinate the full range of their activities, many of which, as discussed above, are viewed as highly strategic in nature. To this end, second generation MNCs are increasingly appointing top-level corporate executives—group and company presidents, worldwide functional leaders, Asia-Pacific marketing chiefs—to head their China activities exclusively.

In recent years, China has achieved remarkable economic progress. Leading MNCs already operating there have radically revised their view of the country’s opportunities and redoubled their efforts to capture its potential. The message in all this is clear: China is a large part of their future, and the future is now. For those MNCs that are not yet second generation players, being left behind has become a real and urgent risk.