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FOR DEVELOPERS, CHINA ‘WILD EAST’ FRONTIER OF OPPORTUNITY AND RISK

BY ED McKINLEY

For North American developers, finding a safe, prudent way to enter the booming Chinese market may be akin to learning how to leap onto the back of a moving truck.

Sure, China’s development opportunities seem to be infinite — the country includes more than 160 cities of 1 million people or more each, and the economy is growing at twice the rate of the United States. But the risks are immense too. China’s transition from state-controlled economy to free market is bound to be bumpy as the legal, tax and regulatory issues evolve. Thus, for now U.S. developers are focusing their international efforts on Europe and South America, leaving it to architecture firms and to such retailers as Wal-Mart and French hypermarket chain Carrefour to forge ahead in China.

“We’re at the very beginning of trying to understand the Chinese retail market,” said David E. Simon, CEO of Simon Property Group, during a July conference call on second-quarter earnings. “The population itself, of course, is enormous. There is a migration towards the cities and the suburbs of the cities, so there’s a lot that’s going to be happening there. It is an unbelievably dramatic place.” Simon recently acquired its first Asian properties — four successful outlet centers in Japan — through its purchase of Chelsea Property Group earlier this year. Some predict that Simon will eventually use its Japanese operations as a springboard into China.

Power of the people
It’s easy to see the attraction of China for Western developers, as the supply of developable sites in North America and elsewhere dries up. Just look at the statistics: The Chinese middle class numbers about 100 million, even though less than 10 percent of China’s total population earns enough to qualify as middle class, says Merrill Weingrod, CEO of China Strategies, an affiliate of management consulting firm Kurt Salmon Associates. At the higher end of the scale, household income is growing by 12 to 15 percent annually, he adds.

The Chinese government says workers in urban factories earn about $1,000 annually, but Weingrod pegs per capita income at about $2,500 a year in the eastern cities, meaning that households there in which both spouses work can earn about $5,000 per year. The Chinese can buy about five times as much per dollar as Americans, so that gives a two-income couple in Shanghai the purchasing power of a U.S. family earning $25,000 a year.

A population shift to the cities continues. The proportion of urban dwellers in China increased from 19.6 percent in 1980 to 38.6 percent in 1993, and the United Nations Population Division says it expects that to reach about 60 percent by 2030. The organization says further that the country’s total population rose from 999 million in 1980 to 1.3 billion last year, and it anticipates that this will climb to about 1.45 billion by 2030.

China’s gross domestic product grew by 8 percent in 2002, surpassing $1.2 trillion, according to the World Bank. The institution calculates on its Web site that Chinese annual GDP growth will average 7.5 percent between 2002 and 2006.

Little wonder, then, that retail sales have grown — to $50.7 billion in July, up 13.2 percent from a year ago, according to People’s Daily Online — and development opportunities seem likely to follow. This is especially so in the so-called second-tier cities, which have millions of people but began developing later than Beijing and Shanghai.

But despite these positive indicators, some say China and Japan are “too much trouble,” as one executive of a large international retail development firm put it. A handful of big North American developers have been “sniffing around,” but have yet to commit to the market, say sources reluctant to name names so early in the process of exploration.

At the very least, it seems no company should venture there alone.

“The opportunities are huge, but unless they’re able to find very strong joint venture partners, there hasn’t been a comfort level with putting money into the market,” said Phil Kim, senior vice president and managing director in the Hong Kong office of the Venice, Calif.-based Jerde Partnership. This shopping center architectural firm has designed centers in Guangzhou, Hangzhou and Shanghai for Chinese developers. Other North America-based firms, too, have been active in China on mammoth projects for years, blazing the trail for retailers and developers. They often work on towering urban mixed-use projects and sometimes on schemes to remake huge portions of city centers, block by block, mingling old and new in retail, office and residential space.

Development obstacles
One deterrent to Westerners is the fact that the tentacles of government reach into many areas of Chinese commerce, including shopping center development, says Ian F. Thomas, chairman of Vancouver, British Columbia-based Thomas Consultants, which is working with the owners of South China Mall, a massive center scheduled to open late this year (see story, South China Mall, world’s biggest, to open by year-end). Many of the development companies in China are state-owned, and politicians appoint the executives running them.

Private Chinese developers have emerged, however, and some of the government development companies have been privatized, with their shares trading on the Chinese stock exchanges. Many of the remaining government-operated developers show a strong entrepreneurial verve notwithstanding, rather than acting like unconcerned bureaucrats with little stake in a project’s success, says Yan Yang, general manager and an associate principal in the Shanghai office of Seattle-based Callison Architecture. Callison designed Grand Gateway, a mixed-use center completed five years ago in Shanghai, as well as a 30-story office tower with six levels of retail now under construction on Nanjing Road, an important retail destination in Shanghai.

Government developers have not always been so visionary, however. Before they started bringing in architects from abroad 10 years or so ago, they built a number of centers that Thomas says were faulty. The errors included walkways that enticed shoppers to walk from one level to the next only to culminate in dead ends, leaving the flummoxed customers to double back the way they came. Some projects rose around gallerias so broad that shoppers almost needed binoculars to make out the names of the stores across the way, he says.

Then developers arrived from other Asian locales, including Hong Kong, Taiwan and Thailand, with generally good results, according to China-watchers in America. They often wrought multilayer centers, sometimes with as many as seven floors of retail, typically sitting at the base of office and residential towers rising as high as 50 stories.

So far most centers have been built in the busy shopping districts of major cities, and opportunities may open up for Western developers to establish centers “a bit further afield from the town center,” says Daniel Grover, Cushman & Wakefield’s director and head of retail for China. “That’s much more the format that you guys have over there,” he said, referring to malls in the United States.

While Americans eye the possibility of developing in China, Chinese developers are sending large delegations across the Pacific to learn from American centers and to form working relationships with U.S. developers, says Thomas. Dongguan San Yuan Ying Hui Investment and Development Co., the Chinese developer of Dongguan’s South China Mall, is building its gigantic center with ideas gleaned from visits to Las Vegas, Disneyland, Walt Disney World and West Edmonton Mall, he says.

This trans-Pacific exchange comes just as the Chinese government is tightening restrictions on retail real estate, a move that Paul Makowicki, a Callison principal, says will strengthen the more skillful developers by eliminating the weaker ones. Makowicki’s colleague Yang says there are more than 200 shopping centers in development now, adding that “80 percent of those developers don’t know shopping centers.”

Free the market
But the government’s grip appears to be loosening on the retailers themselves, in part because of China’s entry into the World Trade Organization, but also, in the view of many, because the government is seeing the advantages of freer markets. By year-end a requirement that retailers based outside China have to work with local joint venture partners is to be lifted.

Still, some of this apparent newfound liberty may prove to be an illusion, cautions Brenda Sternquist, a professor of retailing at Michigan State University. “As you read the laws, you think everything is open, that you can really have free reign in China,” she said. “It’s not really the case — it’s part of the planned economy. The government is really still deciding what kind of retailers to allow in and where they will allow them.”

To this end, Yang says the government is granting tax concessions intended to protect the Chinese retailers thought to have the best chance of succeeding. Furthermore, it has decided the country needs more convenience stores and specialty stores — either Chinese or foreign. When it comes to hypermarkets and department stores, though, officials believe China already has too many, she says.

Oppressive as this control may seem, things have changed much in a short time. As late as the 1980s, the government condemned retailing as a parasitical drain on the economy, according to Sternquist. In 1992 the country allowed foreign merchants to set up two stores in each province or economic zone, for a total of 22. Illegally, some municipalities began to grant the right for additional stores, and the central government acquiesced after seeing the benefits in action, she says.

But the government retained a large measure of control through the requirement for joint venture partners. The government appointed top managers at the local stores, often because of connections rather than any talent or training in retailing, Sternquist says. Stores in different cities may operate under the same name, but they’re not truly chain stores because they lack central management, buying and distribution.

Over time, Chinese stores are growing to resemble their counterparts in other nations, however, say many observers. While the government still appoints many top managers, some now come from Hong Kong or Taiwan. Shares in some of the stores have been distributed to employees or are offered on the stock exchanges.

Many mainland Chinese store chains have failed to establish clear identities chainwide, partly because of foreign partners and partly because of the parochial influence of political appointees, says Callison’s Makowicki, though he adds that this will not always be so. “That will evolve over time, and I suspect it will evolve very quickly,” he said.

Meanwhile, retailers from throughout Asia fill in the gaps left by the local stores. Parkson, for example, a Malaysian department store chain, runs 36 successful stores in China, according to Sternquist. The company says it will open five to 10 stores annually. Another success on the mainland is Taiwan’s Pacific Sogo Department Stores, which is operating eight big stores, according to The Taipei Times.

Only 14 global retailers, including Bvlgari, Ferragamo, Herm�s, Prada and Tommy Hilfiger, currently operate in upscale Chinese malls. Home Depot is setting up a business unit to consider building and buying stores in China. British retailer The Body Shop paid $20 million to buy 75 percent of Mighty Ocean, the private company that runs 28 Body Shop stores in Hong Kong and Macau. The Body Shop says it will use its new Hong Kong operation as a base for expansion into China. And Italian designer Giorgio Armani just opened its fifth Chinese outpost, a 10,760-square-foot store in Shanghai. It plans 20 to 30 new Chinese stores by 2008.

So far the only Western chains that have succeeded on a large scale in China’s middle market are Wal-Mart and Carrefour. American restaurant chains, including McDonald’s and KFC, have begun making forays.

The government “loves” Wal-Mart, says Sternquist, but not so much for its contributions to the local retail scene as for its proclivity to buy goods in China for stores around the world. The retail powerhouse opened its first Supercenter in China in 1996 and now has 30 there, as well as four Sam’s Clubs and one Wal-Mart Neighborhood Market, according to company reports. Wal-Mart reportedly plans to open 50 more Chinese Supercenters within five years. Costco and Office Depot are pursuing opportunities too.

There’s a lesson in Carrefour’s experience, however. The chain is viewed in government circles as something of a rogue company that entered the country illegally by blatantly ignoring the requirement for local partners, says Sternquist. About two years ago the government cracked down, though, and Carrefour began complying. All to the good, it seems: Carrefour, China’s biggest foreign retailer and its fifth-largest store chain overall, opened its 50th hypermarket there in July, according to published reports.

But not all foreign retailers have fared well. Yaohan, for example, a Japan-based mass merchandiser, failed in its attempt to operate an upscale department store in China. Yaohan ventured into the country in the early 1990s, launching the first of the joint ventures with a Chinese partner, in this case the No. 1 Department Store. It closed the Chinese operations four years later.

“Yaohan entered China as an upscale department store,” said Sternquist. “In Japan they’re a mass merchandiser. It would be like Sears pretending like they’re Saks Fifth Avenue. They went into China in a big way and spent a lot of money. And things went badly in Japan, and they pulled out of China.”

The road ahead
Western retailers and developers attempting to make inroads in China can learn a lot from the experiences of the Western architectural firms. The Chinese government compels foreign architects to work with local firms, which sometimes casts the Westerners in the role of master planner or conceptualizer, with the Chinese architects taking over in the later stages. American architects told SCT they now stay involved until the centers are completed, even though their duties may diminish in later stages of the work.

Jerde’s designs conform to the penchant for pedestrian-friendly communal spaces the firm advocates in the United States, says Kim. That sometimes means dissuading developers who envision a mall built on the American model that has become the standard international configuration, with an anchor at each end of one or two stories of shops. Instead, the firm designs retail space that fits its surroundings.

And Callison’s Makowicki says his firm’s experience in China may benefit others.” If American developers or retailers are looking into going into the market, they need to take an attitude of being very nimble and being very flexible,” he said. “They need to try to embrace China, as opposed to imposing their corporate standard on how they do business. If they try to do it from a corporate standards point of view, I suspect they may not be successful.”