China’s Emerging Tier 2 Cities: Opportunities for US Companies

As living standards and the business environment improve, US companies may be able to export more goods and services to China’s second-tier markets.by Richard Craig and Jacqueline QiangChina’s expanding economy is rich with business opportunities for US firms, many of which are small and medium-sized enterprises. In 2008 and 2009, the United States exported more than $69 billion worth of goods annually to China. As China’s wages rise nationwide and interior regions receive greater investment and government support, US exporters may find more opportunities to sell to China’s second-tier markets.

China’s diverse urban and rural markets present challenges for foreign companies, however. To understand domestic market trends and opportunities, companies should study the strengths of various regions—and do their homework.

The importance of Tier 2 cities

Though analysts often categorize China’s Tier 2 cities in different ways because the PRC government does not officially define tiers, this article focuses on 15 key Tier 2 cities, many of which are provincial capitals: Chengdu, Sichuan; Chongqing; Dalian, Liaoning; Hangzhou and Ningbo, Zhejiang; Kunming, Yunnan; Nanjing and Suzhou, Jiangsu; Qingdao, Shandong; Tianjin; Shenzhen and Zhuhai, Guangdong; Wuhan, Hubei; Xiamen, Fujian; and Xi’an, Shaanxi. Though the total population of the 15 cities accounts for only 8 percent of China’s overall population, these markets receive more than 59 percent of total US imports, according to the US Commercial Service. Global Trade Atlas statistics show that the cities with the highest year-on-year growth in US imports as of June 2010 were Hefei, Anhui (164 percent), Ningbo (90 percent), Chengdu (75 percent), and Hangzhou (63 percent)—far outpacing the 19 percent and 21 percent growth rates in Beijing and Guangzhou, Guangdong, respectively.

Recent social and economic reforms have transformed and reshaped the industrial, commercial, and regulatory landscapes of China’s developing Tier 2 cities. As living standards and the business environment improve, these cities have enormous market potential. For example, Suzhou’s population was roughly 6.3 million and its gross domestic product (GDP) was $774 billion in 2009. (In comparison, New York, the largest US city, had a population of about 8.4 million and GDP of nearly $1.5 trillion in 2009.)

Consumer spending is an important factor in Tier 2 cities’ growth. Purchasing power is increasing, as evidenced by major retailers’ expansion into these cities. Wal-Mart Stores, Inc. opened its first supercenter in Shenzhen in 1996 and expanded to 189 stores in 101 cities throughout China by August 2010. Home Depot Inc. operates 12 stores in six Chinese cities, including Qingdao, Tianjin, and Xi’an.

China’s 12th Five-Year Plan (FYP, 2011-15), which lays out national policies in major social and economic areas for the next five years, is currently being drafted and is expected to continue funneling major investments into Tier 2 cities. The plan will likely focus on seven strategic emerging industries: biotechnology, high-end equipment manufacturing, new energy, new-energy vehicles, new materials, and next-generation information technology. According to PRC state media reports, the government is considering a $738 billion 10-year energy plan that will develop clean energy by investing in nuclear, solar, wind, and other non-fossil fuel energy sources. These sectors could provide opportunities for US companies that export components or key technologies to manufacturers.

Based on data available for different sectors, this article primarily focuses on second-tier market opportunities in China’s high-tech, food processing, and clean-tech sectors.

High-tech manufacturing

China’s high-tech manufacturing industry has seen unprecedented growth in the past decade. From 1995 to 2007, the industry grew from $19 billion to $167 billion, ranking third worldwide after the United States ($374 billion) and the European Union ($306 billion). The 12th FYP will continue to provide subsidies, deferred interest and lower tax rates, and other support policies to advance the development of high-tech enterprises. The industry’s rapid growth has created opportunities for US companies that export precision machinery used in high-tech manufacturing.

China is the world’s largest manufacturer of consumer electronics—including electric office appliances, electronic communication equipment, home appliances, and plasma and digital TVs—and accounts for more than 35 percent of the global electronic industry’s total revenue. Suppliers and manufacturers of high-tech portable consumer electronics, market-leading innovative technologies, and smartphones may find opportunities in this sector. For example, as of second quarter 2010, Apple Inc. was China’s fifth-largest smartphone vendor, accounting for more than 7 percent of the country’s smartphone shipments.

Qingdao ranks high as a potential export market because of its numerous industries, including alcohol, auto manufacturing, building materials, cargo handling, chemical fertilizers, consumer electronics, food processing equipment, petrochemicals, shipbuilding, steel, and textiles and apparel. The local government has placed special emphasis on the development of consumer electronics. Qingdao is home to more than 30 research, higher-education, and managerial institutions and has roughly 800,000 scientifically and technically skilled personnel. In 2009, Shandong’s GDP grew 12 percent to nearly $495 billion, ranking third among China’s provinces.

Other key cities with strengths in the consumer electronics industry are Lu’an, Anhui; Luoyang, Henan; and Shenzhen.

Food and agricultural processing

Despite the global economic downturn, China’s food processing industry output reached a record high of $662 billion in 2009. The industry grew nearly 30 percent annually from 2003 to 2008, as more consumers replaced traditional fresh foods purchased at morning and wet markets with packaged foods found in Western-style hypermarkets.

The food processing industry is one of the six pillar industries of Chengdu. Chengdu has companies in 22 divisions in the industry and competitive advantages in beverages, dairy products, feedstock, meat, and tobacco. The city’s total food processing industry output is expected to reach $11.5 billion by the end of 2010. This growth has created opportunities for US exporters, especially those that export high-tech equipment used in food and agricultural processing.

Other cities that have strengths in food and agricultural processing include Nanchang, Jiangxi; Tianjin; and Zhangzhou, Fujian.

Clean tech

In 2009, investment in China’s clean-tech industries reached about $34 billion, overshadowing the $18 billion total investment made in the same industries in the United States. The PRC Ministry of Environmental Protection stated that the total output of enterprises in the environmental protection industry is expected to exceed ¥1 trillion ($149 billion) by the end of 2010. Some PRC sources have predicted that the 12th FYP’s budget for environmental protection, which includes wastewater and solid-waste treatment, will reach roughly $454 billion—more than double the amount allocated in the current FYP. Further investment and development plans are underway as China attempts to derive at least 15 percent of all energy from renewable sources by 2020. Companies that provide innovative solutions and advanced equipment and technologies may find opportunities in China’s clean-tech sector.

Wastewater treatment

China generated 57.2 billion tons of wastewater, composed of 58 percent municipal wastewater and 42 percent industrial wastewater, in 2008. Analysts expect that the country’s total wastewater output will reach 79 billion tons by 2015 because of rapid urbanization and industrialization. China’s current wastewater treatment infrastructure is still inadequate. The PRC government plans to build new facilities and upgrade existing ones, resulting in a large demand for technology and components. Competition for these projects is fierce, however, and ranges from foreign companies that provide advanced technology and management to domestic players that typically offer more competitive prices and in some cases comparable technology.

Wuhan, Hubei, is a key emerging market for wastewater treatment facilities. The city is particularly rich in fresh-water resources and the local government strongly supports the development of wastewater and urban sewage treatment facilities. The city’s industrial zones, which will each have wastewater treatment facilities, may present additional export opportunities for US suppliers.

Other key cities with strengths in the wastewater treatment industry include Tianjin; Wuxi, Jiangsu; and Xiamen.

Solid-waste treatment

China is the world’s largest producer of municipal solid waste (MSW). In 2008, the country produced more than 223 million tons of MSW. With a forecasted annual growth rate of 8-10 percent, production is expected to top 250 million tons in 2010. To reduce the amount of MSW, the PRC government is making investments to improve its solid-waste treatment capabilities.

For example, the primary methods of disposing of solid waste in Ningbo in the past 100 years included uncontrolled burning, terrestrial dumping, and dumping into waters—all of which have polluted the environment and affected citizens’ daily lives. To minimize the negative effects of MSW, Ningbo has made significant improvements to its waste treatment facilities in the past few years. The local government has invested roughly $88 million to develop a comprehensive infrastructure system for MSW.

More than 90 percent of China’s landfills do not meet international standards because of capacity constraints and unsanitary conditions. Alternative MSW treatment methods such as incineration will likely become more widely accepted by local governments and industry players in China. These methods require more advanced technologies and instruments than Chinese companies currently have the capability to produce—including sanitary landfill and incineration equipment, treatment equipment, waste-to-energy technologies, and sampling instruments—and thus open greater export opportunities for US firms.

Other cities with strengths in the solid waste treatment industry include Chongqing, Hangzhou, and Harbin, Heilongjiang.

Other industry opportunities

In addition to the main sectors discussed above, exports of other products to key Tier 2 cities are also growing rapidly. Xi’an’s imports of electrical machinery rose 118 percent in 2009, while Tianjin’s imports of railway equipment jumped 634 percent during the same period. Wuhan’s chemical imports increased 100 percent, and Xiamen recorded 544 percent growth in imports of pharmaceuticals.

Considerations for US companies

Tier 2 cities may present opportunities for US companies that take the time to research and understand China’s domestic market trends and complex business environment. Companies must recognize that the China market is highly fragmented with significant differences between cities and regions. They must also choose an appropriate location with a market environment most suitable to their industry and objectives.

Companies may also face other challenges when entering the China market, such as China’s selective enforcement of World Trade Organization rules, vulnerable intellectual property rights, government restrictions on foreign ownership, local content requirements, and competition from established domestic enterprises. In some cases, markets are either premature (especially in the case of expensive or advanced technologies) or highly saturated with intense competition. US companies must therefore understand the China market and assess all opportunities and challenges when determining their entry strategy.

To help US companies better understand the China market, the US Commercial Service offices in China, together with the China Council for the Promotion of International Trade, provide business counseling and matchmaking services for US exporters in 14 markets. To learn more about the services of the US Commercial Service in China and opportunities in emerging Tier 2 markets, visit www.buyusa.gov/china/en, contact a trade specialist at a US Export Assistance Center in any state, or visit www.export.gov or www.trade.gov to find the nearest office. These websites, and the US Comercial Service, are under the US Department of Commerce International Trade Administration.

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Case One: A Wholly Foreign-Owned Wastewater Treatment Company

A medium-sized North American wastewater treatment company engaged in the design and manufacture of key components for wastewater treatment plants has been active in China for more than five years. The company has been working through agents to sell its design and technology in China and is now in the process of establishing a wholly foreign-owned enterprise (WFOE) in Wuhan, Hubei, to better engage in sales and business development while directly importing key components from North America.

By establishing a sales office capable of importing components directly from its North American factory, the company is able to take advantage of the tremendous opportunities in central China by establishing ties with key project planners. Importing key components also allows the company to cut out middlemen and further increase margins.

Firms considering establishing a WFOE must be aware that it requires a two-month process that can be complicated because of the potential number of government entities involved. In addition, capital requirements vary by industry. (For more information on the pros and cons of WFOEs, see the CBR, September-October 2010, Choosing a China Investment Vehicle.)
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Case Two: A Fruit Juice Company’s Representative Office

A small New England producer of premium fruits and juices is expanding its sales in the China market. The company has had some marginal success in China by using established local distributors and is now looking to improve its distribution and sales channels without making a significant investment. The company is setting up a representative office (RO) to assist its distributors and advertise in cities throughout China.

By establishing an RO, which is easier to set up than a wholly foreign-owned enterprise, the firm can monitor distributors and assist with promotional and consumer education activities as needed without worrying about registering capital. In addition, it can more quickly react to changes in local market conditions with people on the ground in China. The RO structure has limitations, however, such as restrictions on hiring, generating contracts, and receiving revenue (see the CBR, September-October 2010, China Tightens Restrictions on Foreign Representative Offices).
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[author] Richard Craig ([email protected]) is the Business Development Unit team leader at the US Commercial Service office in Beijing. Jacqueline Qiang ([email protected]) is a researcher at the JLJ Group. The US Commercial Service and the JLJ Group jointly conduct market research and webinars to inform US exporters of emerging opportunities in different sectors throughout China. [/author]