When Jeff Bernstein moved to China eight years ago as a consultant for McKinsey, he focused on the retail and distribution industries. In an economy where manufacturing was thriving, he figured, these industries offered promising opportunities. Bernstein soon discovered a gap between the country’s manufacturing and retail sectors and following an entrepreneurial urge to plug it, he launched Emerge Logistics in Shanghai. He recently spoke with Knowledge at Wharton about the challenges that small- and medium-sized companies face in trying to build a business in China.


Knowledge at Wharton: What was your objective in starting Emerge Logistics?

Bernstein: My company has been operating in China for three years. After graduating from Wharton, I was a consultant with McKinsey & Co. in the U.S., Korea, and eventually China. I worked in both Beijing and Shanghai. After five years of consulting I decided to roll up my sleeves to try my hand at “plugging the gap” between China’s burgeoning manufacturing and retail sectors. Distribution and logistics in China are fragmented and beyond the touch of global players. Once I jumped in, I realized that a good chunk of the opportunity was not necessarily with fast-moving consumer goods, but instead with industrial equipment, manufacturing components and spare parts.


My company’s main objective is to facilitate manufacturers’ effective direct sales and service channels in China. Most of our clients are overseas manufacturers or foreign-invested manufacturers who wish to target this market. Emerge lets them focus on manufacturing, marketing and sales, leaving the supply-chain challenges to us.


In the course of developing our business, we realized that the key missing ingredient in the market was effective third-party trade accounting to complement physical distribution. China does not allow overseas companies to sell products directly to Chinese customers in local currency. This restriction forces suppliers to sell products offshore through a Chinese Import Agent intermediary, or to set up or invest in their own Chinese firm in a Bonded Free Trade Zone. We have created a third-party accounting platform, while simultaneously managing a separate general ledger for each trading client. As such, we have set ourselves apart from the global giants by offering a proxy trading service.


Knowledge at Wharton: To what extent have you been able to fulfill your objective?

Bernstein: We are in the process of meeting our objectives. Our hypothesis about the market opportunity has been correct; we have found a ready client base for our services, though certain external challenges make life “interesting”. China’s import bureaucracy and lack of consistency across government jurisdictions are a double-edged sword. Before China cracked down on smuggling, many multinationals smuggled products into the country. This was their only means of keeping the prices of their products competitive. That effectively placed these customers out of Emerge’s reach, since our firm is a law-abiding business support provider. During the past two years, China’s import markets have become increasingly disciplined, and many smugglers have met a cruel fate at the end of an executioner’s pistol. At the same time, average duty rates are dropping after China’s entry into the WTO. Both factors push customers in our direction. More and more small- to medium-sized companies are entering the market, for whom our business proposition of handling their supply chain investment and operations sounds attractive.


Knowledge at Wharton: Who are your customers?

Bernstein: In Emerge’s case, we have found that our services appeal to large companies like Siemens and DaimlerChrysler and also to smaller firms, such as Columbia Machines of Portland, Ore. Companies large and small realize that downstream supply chain is less a core competency than a standard business process that must be executed without a flaw. China’s complex regulatory system and operational challenges — such as handling disparate local trucking suppliers — create the need for specific local market expertise to make the supply chain work smoothly. In the case of a small- to medium-sized company, the risk of investing in a failed supply chain in China can wipe out not only their business profits here, but also sink their overall corporate profitability.


I see a tremendous number of small- to medium-sized businesses, especially in tool and equipment manufacturing, which sell products that China’s booming manufacturing sector is gobbling up. As a matter of fact, more than 70% of China’s $300 billion in purchases from the outside world in 2002 were for mechanical and electrical equipment and components. The key to success in China is getting products to the customers with little hassle and providing reliable spare parts and service support.


Knowledge at Wharton: How can small- or medium-sized firms find business opportunities in China?

Bernstein: For small- to medium-sized businesses, finding opportunities in China is certainly challenging. The good news is that resources are plentiful, though too few people try to seek them out.


My first suggestion for small- or medium-sized firms is that they should explore the resources that governments provide. The U.S. government’s largest Foreign Commercial Service in the world is located in Shanghai. Americans’ tax dollars are at work in a busy office of people tracking opportunities and facilitating introductions for U.S. businesses. The governments of Germany, Britain, France, Japan and Australia all have substantial commercial elements to their consular sections in China. A good place to start would be with embassies in Beijing and consulates in Shanghai. The website www.buyusa.gov might be helpful for U.S. companies.


Second, check out the chambers of commerce. Almost every major trading nation has an active Chamber of Commerce in China. A number of American Chambers of Commerce are now active in cities throughout China — the largest are in Shanghai (more than 2,000 members) and Beijing. Chambers of Commerce can provide a wealth of information and “on the ground” experience from the kind of hard knocks that you’ll want to learn about (and hopefully avoid).


For instance, in Shanghai, the Chamber of Commerce offers a briefing in which a visiting company can sit down with three to five general managers of American companies in Shanghai and ask away! The Chamber also offers a formal FDI (foreign direct investment) presentation, sharing lessons learned in various disciplines, including marketing, HR, logistics, legal, etc. Such programs are available for a nominal fee and are worth their weight in gold.


Third, it might be helpful to work with consultants. One common saying is that U.S. companies will invest more time and resources to research an investment in Des Moines, Iowa, than they will to come halfway around the world to China. While it can be challenging to unearth accurate market information in China, there are definite ways of testing hypotheses and refining your market focus by working with a good consultant. China has a healthy community of consultants, ranging from the global giants to freelance foreigners. Again, chambers of commerce can be an excellent place to get a good view of your choice of consultants. Regardless of the size of your business, it’s advisable to have professional assistance before you drop money into China, even at the behest of a trustworthy Chinese employee. China is a complex place that must be looked at objectively, and getting a second opinion never hurts.


Knowledge at Wharton: What are the main challenges and risks involved in doing business in China?

Bernstein: Companies doing business here are exposed to a whole host of risks. Here are just a few:


First, the shifting sands of regulations constitute a major risk. Much business is still done in a gray area of regulations, as it is China’s practice to first experiment on an informal trial basis with new reforms, and then, if they work well, to adopt them officially as “legal practice.” The question is, when you venture out into a gray area, are you ahead of the tide or running into a potential tidal wave coming from the opposite direction? The answer is that you usually don’t know, and you need to make a best judgment call. Also, as you venture out into that gray area, you may find some regulators more supportive than others. Some regulators may even take advantage of your precarious position for their economic advantage. China’s conversion to a society ruled under a system of laws created by a professional legislative body is moving forward in baby steps. Perhaps the grey areas will shrink and the realm of “legality” will expand. That said, opportunities may be more plentiful in this period of discontinuity.


Second, there are cost pressures. Beijing and Shanghai have been ranked as the 4th and 11th most expensive cities in the world for expats to live. The key factors are the high rates of real estate rentals as well as the high prices of imported accoutrements that foreigners cherish. Don’t let per capita GDP fool you. Beyond the high cost of supporting expat employees ($200,000 to $500,000 per employee), you will find that inefficiencies will create high costs (real estate, transportation, employee benefits, etc.). Many foreign manufacturers coming to China are already skipping their first port of entry (Beijing or Shanghai) and scooting out to outlying cities like Suzhou in order to try to gain more sustainable cost advantages.


Third, cash flow is taxing from the start. Starting a business in China will require an injection of “registered capital” in US dollars cash into a bank account in China. A small- to medium-sized business will need at least $200,000 (in U.S. dollars) to get started as a trading company. A logistics company interested in starting a joint venture may need as much as $5 million. When the company begins operations, other cash flow challenges include a value-added tax (VAT) system that requires month-end payment of a 17% VAT balance even if the customers’ credit terms extend beyond the end of the month. Furthermore, collecting accounts receivable is notoriously difficult in China. Customers demand long credit terms and will typically extend beyond promised payment periods.


Knowledge at Wharton: What are the major HR challenges that companies can expect to face?

Bernstein: The so-called “gray gap” is a major issue. This refers to the lack of educated workers in the 38-50 year age group, which creates a gap in the supply of local managers relative to demand. The two main reasons for this gap are the closure of China’s educational system during the Cultural Revolution (1965-1675) and the nascent growth of foreign invested firms in China employing globally accepted management practices. Companies are often left relying on very bright but untested “30-somethings” for their core management teams. While this group is highly motivated, it is accustomed to rocket-like advancement and is not bashful when courted by headhunters anxious to help them “trade up.”


Another challenge in HR is the tremendous entrepreneurial spirit of the Chinese. There is a saying that the typical Chinese would rather be the head of a chicken than the tail of a phoenix. The zest for individual achievement is incredible, and many young managers gladly underestimate the difficulty of starting out on their own — and taking a few of their employers’ customers and other staff members with them. They dream of being emperors of their own domain, and while that attitude is commendable, it doesn’t mesh well with teamwork and information sharing


A third challenge is the passive nature of many of the middle- and lower-rung employees. They are taught in their schooling and families to do as they are told. People are afraid to take the initiative, as they will automatically assume responsibility, and will likely face difficulties whether or not their initiative bears fruit. It is little wonder that people like being their own bosses. The good news is that if these employees are treated with respect and clearly told what needs to get done, they are among the world’s most savvy and efficient.


Knowledge at Wharton: Many global businesses fear coming to China because of the risks to their intellectual property (IP). What is your view?

Bernstein: It is true that many companies face problems in protecting their IP. The reasons are manifold. There is little understanding of, or respect for, what IP means — it is not tangible and is difficult to conceptualize in a society where “copying” is often a sign of flattery and efficiency. Further complicating the problem is the ease with which IP violations occur, creating quick and easy money for government officials (tax revenues) and hungry entrepreneurs who can exploit China’s efficient production and do not have the patience to develop their own brands. Copying is low risk and smart business in the eyes of many.


Knowledge at Wharton: You have described several risks and challenges. How can these be overcome?

Bernstein: As far as regulatory issues go, little can be done directly, though having close contacts with government officials might let you have sneak previews of new rules coming down the pipeline. The legal profession in China has become very savvy in navigating the shifting sands, though they often are more a rumor mill as opposed to a source of interpretation. In general, it’s best to stay away from aggressive moves that will leave you vulnerable to unhappy government officials. (Making money, especially when employing state assets, is one way to attract such attention.)


As regards cost pressures, the key issue here is to be aware and manage costs closely. Many foreign companies come to China presuming that every employee they recruit must speak English and when he/she arrives at the company will need his/her own PC. Such presumptions should be challenged in China. Such expectations don’t exist in the market, but once a company introduces them, it’s hard to step back. Many companies locate in surrounding cities within a one- or two-hour driving radius of Shanghai to access cheaper land and labor. The golden example is the explosion of manufacturing in the city of Suzhou. In fact, Suzhou’s FDI has even surpassed Shanghai’s in recent years.


Knowledge at Wharton: How can companies tackle their HR challenges?

Bernstein: The cardinal rule is to respect your employees. Give them a chance to learn, because training is highly valued in China. Also, make sure that you engage in benchmarking of benefits and salaries with the appropriate peer group. Some industries will have naturally different market demands. There is no way to stop an enterprising manager from leaving, but it’s best to try to gauge the personality of a person in an interview to assess how low that person’s threshold for leaving the job and starting their own company would be. In the meantime, it’s best to make sure that you keep a database of government contacts with whom your senior employees are in touch. If such employees leave, they will likely take relationships with them. You must manage your risk.


Knowledge at Wharton: And what about IP?
Bernstein: Good luck! Some businesses like the music industry have completely changed their business model to rely more on performance fees, endorsements and MTV than revenues from sales of music. Still, a few basic things can be done. First, make sure you understand
China’s patent and trademark system, and that you register IP you think is necessary based on China’s disclosure rules. If you don’t register your IP, you have absolutely no recourse.


Second, find the bureaus of the government that are interested in protecting IP and partner with them to help stamp out counterfeiting. It is a never-ending battle, but without a government partner, your chances are extremely low. Your possible government partners could be the State Administration of Industry and Commerce, China Customs, as well as the new Ministry of Commerce, all charged with improving China’s intellectual property protection. Your natural opponents will be local governments who earn tax revenues from counterfeiters.


Third, it might make sense to partner with China’s nascent firms that are trying to build their own brands — companies such as Haier, Changhong, Chunlan or Legend/Lenovo — which also suffer from counterfeiting and have relatively more influence with the central government.


Knowledge at Wharton: How has the business environment changed as a result of SARS? Do you see any long-term impact for companies doing business in China?

Bernstein: On the surface, the impact of SARS is temporary. Investment decisions have been delayed, and the tourism industry appears to have vanished for the 2003 year. Though bookings are slowly starting to pick up at premium hotels, the industry is still far from its sizzling performance last year. Manufacturers appear to have cranked along during the SARS crisis, though the question is whether their inventories have piled up to uncomfortably high levels (cheap TV’s and mobile phones can be found these days). In addition, some infrastructure projects have been fast tracked by local governments (months or even years in advance) in order to prime the pump and ensure that China’s GDP does not trail off substantially for 2003.


Longer term, it’s tougher to speculate about the impact of SARS. One key emerging trend is an increasing focus on health care investments in China. Hospitals in developed cities are inadequate, yet the bed/population ratio is around four times better in the city than in rural areas, where the problem is even more acute. A mixture of government investments and relaxation of restrictions on private investment in health care may serve to heat up this sector.


My guess is that China will still be the sourcing haven of choice for European, Japanese, and U.S. companies. While other developing countries would like to take advantage of China’s bad press, the fact is that it is difficult to stack up to China’s manufacturing efficiency plus its abundance of natural resources. If anything, the Chinese are even more together and focused having emerged from the SARS challenge. Over time, they will probably become even more competitive and driven than they were before.


Knowledge at Wharton: Now that China has been a member of the World Trade Organization (WTO) for about a year, do you see any difference in the business environment? What effect has that had on companies doing business in China?

Bernstein: Recent surveys of large Chinese companies show increasing awareness of and concern for changes due to WTO. The fact is that changes were happening even before China began implementing the commitments. Many foreign firms arrived in China in 1999-2001 in anticipation of the country’s joining the WTO, and they are already here, competing in the market. The major impact that many local companies have seen is the rise of domestic price wars. Companies are getting ready to compete globally, ruthlessly cutting costs to raise productivity and then succumbing to temptations to cut prices.


On this account, many dumping cases against Chinese exporters would be found without merit if one were to accept China’s “emerging” market prices as the proxy. In the U.S. and Europe, Singapore or other smaller Asian nations’ product prices are used as a proxy for China’s appropriate market price, which often does not make much sense. You will find that as a result of WTO entry, more Chinese companies will look to vigorously defend themselves against anti-dumping actions and even file actions against neighboring countries, like Korea, for import of some chemical products. The Chinese government appears to have placed defense of anti-dumping as an extremely high priority for its new Ministry of Commerce (which combines the domestic and foreign commerce functions of its predecessor departments).


Another effect of China’s entry into the WTO is that with more foreign companies entering China, more Chinese companies are anxious to grow overseas. Haier (a manufacturer of white goods) is just one example. The government is now openly encouraging such companies to go overseas, as there is less concern over foreign currency reserves than existed a few years ago. Funded with equity offering and bank financing, Chinese companies are backed with enough capital to make waves.


WTO’s direct impact has been to lower import duties on products such as automobiles. As a result, many Chinese feel that now is the right time to buy cars, as prices plummet. Prices in China for automobiles are now starting to come into alignment with world prices. Import of cars, however, is still restricted by a quota system, which limits the degree of price decline. The issue of quotas is not unique to automobiles, as agriculture imports from the U.S. also face challenges. Some say that this is a natural immune response of an economy vulnerable to an onslaught of imports.