RETAIL SECTOR: FORWARD-LOOKING PERSPECTIVE OF EU-CHINA TRADE & INVESTMENT

RELATIONS

1. Summary of sector developments

China’s retail sector is still in a relatively early phase of development, with full open policies
only in effect from 2005. With the government’s focus on first developing manufacturing, the
Chinese service industry, comprised largely of retail, began to modernize at a fairly late stage
in the reform process, with the first modern supermarket opening in 1990.

However, modernization has occurred rapidly. Since the 2005 reforms, China’s retail sector
has become one of the most liberal sectors of the Chinese economy. After seeing modest
growth in the pre-2005 period, foreign investment is now accelerating and international
retailers have already secured around 3% of the market share. We expect this figure to
increase rapidly as more foreign players enter and as those already in China continue to
expand aggressively. Moreover, the retail industry in China is still highly-fragmented, with the
top 100 retailers in China accounting for only 10.5% of sales. Therefore expansion through
M&A has become an attractive option and we also expect concentration levels to increase
rapidly over the next 5 years.

This report will present a forward-looking perspective on opportunities and threats for
international and particularly Europe-based retailers in China. In particular the focus is on
hyper/supermarkets and superstores, which together account for over 90% of international
retailers’ sales in China. Catering is excluded from the analysis.

Opportunities: The market - China’s retail market presents a tremendous opportunity for
international retailers and producers alike. The market - EUR 672 billion in 2005 1 - is
estimated to be the world’s 7th largest, and is growing faster than any of the leading six at an
average rate of 10.2% for the last 5 years. Europe-based retailers, who accounted for 44% of
sales among the global top 250 retailers, are well-placed to take advantage of the
opportunities. Moreover, as the Chinese retail industry further modernizes and consolidates, it
will provide better opportunities for European producers to find distribution channels for their
goods in China (one can imagine the difficulties associated with having to supply hundreds of
mom-and-pop stores as opposed to one large chain).

Food still accounts for the highest proportion of spending at 36% of urban household
expenditure. However, this has been falling at around a percentage point a year for the last 20
years. Telecommunications and transportation have seen the highest increases in household
spending, in particular, ownership levels of cars, mobile phones and computers have seen
dramatic increases. Nonetheless, rapid urbanization of lower-income consumers will ensure
that food sales remain strong in the years to come.

Wealthy urban centres such as Shanghai, Shenzhen and Beijing were the first to host foreign
retailers. Having established a solid presence, they are now beginning to move to second- and
even third-tier cities as urbanization is contributing to a massive increase in urban
populations. Cities such as Tianjin, Hangzhou, Nanjing and Chongqing have already become
major centres of foreign retail activity.

Thus far, Europe-based retailers have been successful. Of the 17 foreign retailers in China’s
top 100, 6 are Europe-based, contributing to 32.8% of sales of foreign retailers in the top 100.
This is more than any other group of retailers by country of origin.

Recent reforms – Upon entry to the WTO China committed to a complete liberalisation of retail
and distribution by Dec 11 2004, 3 years after accession. Despite a series of delays in
implementation, the reforms were more or less realized by mid-2005 and foreign retailers are
now permitted to open 100% foreign-owned stores and distribution networks.

The new regulations have dramatically lowered entry thresholds such as those on registered
capital, turnover and assets, and geographical restrictions have been lifted. More importantly,
application procedures have been streamlined, with the power of approval of new stores

1
For the purposes of the report, EUR 1 = RMB 10
devolved to local governments producing a notable increase in transparency of approvals with
clearer criteria and timeframes.

Sourcing - Sourcing opportunities play just as, if not more, important a role for multinational
retailers as for the domestic market. In many cases, multinational retailers’ export volumes far
exceed their domestic sales in China, though the gap will likely narrow in the coming years.
While the market shares of foreign retailers in China are far lower than in their home markets,
the sheer volume of goods procured in China for export nonetheless allows foreign retailers to
exercise significant buyer power to negotiate favorable conditions with local suppliers.
Therefore retail is unique in China in the regard that it is one of the only sectors where foreign
players are able to compete on price.

At the same time it should be noted that while sourcing from China has indisputably been
beneficial for multinational retailers and for consumers in home markets, retailers in some
developed countries have been criticized by trade unions and manufacturer groups for
contributing to unemployment in European manufacturing sectors. It is certain that
multinational retailers are catalysts of international trade, which in the short-term leads to
unemployment in uncompetitive sectors, but at the same time has positive disinflationary
effects. However, it goes beyond the remit of the present report to analyze the economic costs
and benefits of increased exports of consumer goods from China to Europe.

Potential Threats: Domestic retailers - Chinese retailers currently pose little, if any threat, to
international operators in overseas markets. China’s comparative advantage lies mainly in its
low-cost workforce, a resource which is difficult to leverage effectively in overseas markets.
Management know-how, and particularly the ability to appeal to an internationally diverse set
of consumer preferences, is lacking. Nonetheless, the Chinese government is determined to
build national champions in the retail industry with the purpose of competing with foreign
retail giants and venturing into overseas markets.

Pilot overseas investment projects have already been implemented, such as in Moscow and
Singapore. The Moscow supermarket venture ended in failure, with managers’ inability to
match local consumer tastes cited as the main reason. It can be expected over the next 5
years that the leading SOE and private retailers will continue to test their abilities in overseas
markets, starting in SE Asia.

Industrial policy – Thus far, foreign retailers have complemented China’s development
strategy of bringing in management expertise. Retail is furthermore a labor-intensive sector
and as such also contributes significantly to local employment. However, one can expect
growing state-backed resistance as foreign market shares increase. Some Chinese officials
have stated that China “will not allow its retail sector to be dominated by multinationals”, and
current regulations still discriminate against larger chains. In order to help domestic firms
withstand the entry of foreign competitors, the state has pledged financial support in the form
of direct subsidies and soft loans from national banks.

However, there are also some encouraging signs that the retail sector will continue to enjoy
it’s relatively liberalized status. For a start, the reform-minded Ministry of Commerce is the
retail sector regulator, rather than the central planning agency, the National Development and
Reform Commission, which is actually the antithesis of what its name might suggest.

Antitrust policy – China’s first comprehensive antitrust law is expected to be approved in 2007
and it will soon be followed by sectoral antitrust regulations. There have been concerns among
foreign investors that the law will primarily be used as a means to curb foreign dominance of
domestic markets. While market shares of retailers in China are too far below the thresholds in
the current draft law to presume dominance, growing consolidation in the industry could
result, in the long-term, in some foreign retailers becoming the subject of discriminatory
antitrust action. For instance, there has been a significant amount of negative publicity in
Chinese media on the exercise of vertical restraints by larger foreign retailers on their
suppliers.

2. Future development scenarios

With the relatively late opening of China’s retail sector and entry of foreign investment, it is
still premature to construct precise forecasts based on the currently available data. However,
the following trends are identifiable and will likely result in the following types of scenarios in
2010.

Scenario 1

Assumptions:

ƒ GDP growth continues at previous rates (9-10%) until 2008

ƒ No dramatic revaluation of the Yuan, although it continues to appreciate gradually

ƒ Government remains supportive of foreign investment in retail

Outcomes:

1) Total retail sales grow at an average rate of 9% until 2010, driven by strong growth in
disposable incomes, urbanization and population growth.

2) FDI in the retail sector accelerates as foreign retailers expand aggressively and more new
entrants appear. Approximately 70% of the global top 50 retailers have entered the
Chinese market. Most of the remaining 30% will likely following in the next 5 years.

3) Market share of foreign retailers increases steadily to about 8%. New entrants and
particularly aggressive M&A by market incumbents will be a key driver in expanding
market share. As a result concentration levels will increase significantly.

4) Domestic sales of foreign retailers exceeds sourcing volumes.

5) Leading domestic retailers, under pressure from foreign competition, begin expansion in
SE Asian countries.

Scenario 2

Assumptions:

ƒ GDP growth slows after 2008 Olympics to around 7%

ƒ Yuan is revalued by 10% or more

ƒ Domestic backlash against foreign investment and regulatory environment deterioriates

Outcomes:

1) Total retail sales grows at 7% until 2010 due to lower consumer confidence and slower
growth in disposable incomes.

2) Due to lower expected future market growth, FDI slows and remains constant while
approvals are more difficult to obtain and revalued yuan increases costs of investment in
China.

3) Due to increased administrative resistance, expansion of foreign retailers slows and

market share grows gradually to about 5%. Revalued yuan makes further investment in
China more expensive vis-à-vis domestic retailers and retailers accelerate acquisitions.

4) Sourcing volumes drop and imports of foreign-produced consumer goods increases due
to revalued yuan.

5) Revalued yuan reduces cost of overseas investment. Domestic retailers gain a solid
foothold in SE Asia and turn to EU and US markets.
3. SWOT analysis of European and Chinese retail sector
Europe
Strengths
- Superior management, business models,
operational processes, after-sales service
and capital
- Ability to leverage global networks
- Localization provides better adaptability to
local business environments
Weaknesses
- Less familiarity with local business
environment, consumer preferences
Opportunities
- Sourcing of made-in-China goods for
global markets
- Sourcing of foreign-made goods for
Chinese market e.g. wine
- Large and growing Chinese consumer
market
- Improving supplier quality
- Improving infrastructure
- Increasing transparency of regulatory
environment
Threats
- Government support for competitors
- Poor supplier efficiency
- Political backlash against foreign
investment
- Economic nationalism, negative publicity
China
Strengths
- Established local brands, suppliers,
trading networks, clients and partners,
government relationships
- SOEs have government backing
(financial support, ability to obtain
good store locations etc.)
- Rapidly modernizing, able to adopt
international best practices through JV
partners
Weaknesses
- No global networks
- Less advanced operational processes,
business models
- SOEs driven by non-commercial goals
i.e. employment
- Poor understanding of foreign
consumer preferences
Opportunities
- Large consumer base from which to
base overseas expansion
- Proximity with and good knowledge of
local manufacturers/suppliers from
which to base overseas expansion
- JV partners good source of
management expertise
- Improving supplier quality
- Improving infrastructure
Threats
- Foreign retailers winning market share
- Gradual abolition of government
support
- Foreign protectionism (for those
Chinese firms expanding overseas)
4. Obstacles to trade and investment

Despite the recent reforms which permit 100% foreign-owned retailers, there still remain
some significant regulatory restrictions which affect larger retailers. Most prominent is the ’30
store rule’, which imposes an ownership limit of 49% on firms with more than 30
stores in China. Most Europe-based retailers in China have already exceeded or are close to
exceeding this limit, which may help to explain why many foreign retailers have opted to
continue business with their local partners. This can however, also be attributed to the
importance of geography and local networks in retail. China is a highly-diverse market; each
province has its own local customer preferences, its own distribution networks, a separate set
of governing regulations and its own local government to be lobbied. Local partners can
sometimes be instrumental in managing these complexities.

In addition, several retailers have said that maintaining a local image –for instance by
retaining a JV partner- has greatly helped to reduce red tape and ease local government
concerns about the ‘invasion’ of foreign enterprises. For instance, one large retailer pointed to
the localization rate of staff, which was crucial in convincing local governments that a new
store would greatly aid employment in the area.

A condition for the approval of new stores in the new regulations stipulates that foreign retail
outlets must conform to local city planning requirements, which cause some alarm
among foreign investors. The conditions grant a high level of discretionary powers to local
authorities and may be abused in the event of a political backlash against foreign retailers as
foreign market share increases.

There also remain some barriers to retailing of certain products and the foreign majority
ownership of stores selling these certain products2. Furthermore, foreign majority ownership is
also prohibited if the store sells “different types and multiple brands from multiple suppliers.”
Moreover, if a foreign retailer opens more than 30 outlets, irrespective of the type of products
sold, central-level approval (not normally required) must be obtained for each additional outlet
opened. Retail by foreign majority-owned stores of printed media is also restricted, though
political reasons, i.e. censorship, may be the main driver for this.

Finally, Customs-related problems also remain a risk. Foreign retailers often complain
about inconsistent valuation practices and delays in the release of goods. Retailers which sell a
large amount of imported goods will be particularly affected by this problem.

5. Policy recommendations by priority

Thus far, EU-China trade and investment in retail has been largely beneficial for Europe-based
retailers. Foreign investment in China’s retail sector is still encouraged by the Chinese
government, and Europe-based retailers have been successful in entering the Chinese market
at a relatively early stage and building a market share. Current obstacles relate mainly to “soft
barriers” such as red tape, rather than hard ones, which are manageable for large retailers but
much more burdensome to SMEs. However, it remains to be seen how policies in retail will
shift as foreign retailers build bigger market shares.

Policy recommendations to DG Trade:

ƒ Negotiate in WTO or lobby Chinese government to lift ’30 store rule’.

ƒ Lobby Chinese government to further clarify or abolish the city planning requirement.

ƒ Negotiate in WTO or lobby Chinese government to lift product restrictions.

ƒ Negotiate in WTO or lobby Chinese government to lift ban on foreign majority owned
enterprises selling products with “multiple brands and multiple suppliers”.

2
Pharmaceuticals, pesticides, mulching film, chemical fertilizer, processed oil, grain, vegetable oils, edible
sugar, or cotton etc. See annex 2A of China’s WTO Accession Protocol for details.
ƒ Negotiate in WTO or lobby Chinese government to fully implement transparent, non-
discriminatory regulations and approval procedures for majority foreign-owned retailers.

ƒ Enhance Customs reform to ensure uniform implementation of the WTO Customs Valuation
Agreement, and reduce Customs formalities. This may be achieved through the Trade
Facilitation negotiations.
ƒ

6. Selection of findings from the industry survey (provisional)

Figure 1: How important is the China market for your business in terms of sales?

67%
70%
60%
% of responses

50%
40% 34%
30% 22% 22% 22%
20%
11% 11% 11%
10%
0% 0%
0%
Today In 5 years

1 little importance 2 some importance 3 moderate importance

4 significant importance 5 utmost importance

Figure 2: How important is China as an investment destination?

50%
44%

40%
% of responses

33% 34% 34%

30%

20%
11% 11% 11% 11% 11%
10%
0%
0%
Today In 5 years

1 little importance 2 some importance 3 moderate importance

4 significant importance 5 utmost importance

* DISCLAIMER

Please note that that the executive summaries of several sectors of the study on the future
opportunities and challenges of EU-China Trade and Investment relations of DG Trade being
carried out for the European Commission are preliminary results. Therefore, the Commission
accepts no responsibility or liability whatsoever with regard to the information in the
summaries or for any losses or damage resulting from the information being quoted or used in
any other manner.