The Rise of Second Tier Cities in China
By Klaus Koehler, Managing Director, Klako Group

What is the Chinese market? Many companies looking to enter China see the country as a whole - as one distinct market. However, this is a common mistake that foreign investors make when entering China for the first time. China is a patchwork of regional markets at various stages of economic development. These markets are bound together as one nation and yet separated by differences in government, communication challenges, regional rivalries and poor infrastructure. This is the reality of the "Chinese market" and any company entering must be aware and prepared to deal with this reality if they want to be successful.

China can be divided into tiers - there are four first tier cities. Shanghai is the main business centre of the Yangtze River Delta, Shenzhen and Guangzhou are cities of high economic development and well-established infrastructure located in the Pearl River Delta. Beijing is home to the government, China's finest universities and research institutes and is the leader in R&D. Beijing also offers "Zhong guan cun" - the Chinese Silicon Valley.

Second tier cities cover other key regions including cities such as Shenyang, Dalian, Tianjin and Harbin in the Industrial North East. The metropolises of Chongqing, Chengdu and Wuhan, cover the more developed areas of Western China. And Nanjing, Suzhou, Hangzhou and Ningbo cover the western coastal areas.

The third tier cities are numerous and catching up rapidly. Many are key cities in the far West, the South West and Central China. If there is a distinguishing feature of these cities, it is that they serve areas that are economically undeveloped and less well provided for in infrastructure terms.

Advantages of Second Tier Cities

A recent trend by many foreign invested companies is that are they are no longer investing in the first tier cities of Shanghai, Shenzhen, Guangzhou or Beijing, but rather moving to the second tier cities such as Hangzhou, Tianjin, Chengdu, Nanjing, Dalian or Wuhan. These cities are in the middle of constructing five-star hotels to welcome overseas investors into the cities. They are promoting their cities by focusing on developing modern industrial zones, new infrastructure projects, providing enough energy so as to prevent shortages and the best telecommunication networks. Infrastructure developments from the coast to these cities are also under construction in order that shipments are able to arrive and depart with ease. Labor costs are also 20 to 30 percent lower than what local employees are asking in the coastal cities. The salaries are also increasing at a slower rate than in the already established metropoles.

Disadvantages of Second Tier Cities

For many companies it is extremely difficult to find qualified and experienced employees, who speak fluent and comprehensive English. These cities also have no foreign schools for children of the foreign managers. These cities are not ideal destinations for foreign or even local managers coming from the first tier cities. In order to relocate local managers to these cities from the first tier cities requires a relatively higher salary incentive. The central government is of course doing their best to eradicate these disadvantages in order to bring stability and further development into these regions. One such incentive is that the government provides and "pushes" business licenses onto key industries of foreign enterprises. For example, Ford was coerced to establish an entity in Chongqing even though the American company wanted to establish themselves in Shanghai. Citroen is another company that was forced into setting up in Wuhan. Of course this is not a huge disadvantage as Wuhan is now home to many suppliers of Citroen.

Imbalance between First and Second Tier Cities

China is clearly concerned to reduce the economic imbalance opening up between its first and second tier cities. These concerns are likely to drive policy changes which will further impact the preferential policies that the first tier cities have enjoyed and that have assisted them in attracting Foreign Direct Investment (FDI) so effectively.

Investment is now flowing from mid-sized companies as well as the MNC manufacturing giants. Many of the SMEs are often suppliers to big companies that are now based in China, as well as manufacturing companies who can no longer compete by keeping production solely at home. Many SMEs have only recently given serious consideration to the impact that China will have on their business. Despite their size and lack of resources, they have realized that they have no choice but to come to terms with this impact. In many cases that has led to the companies deciding to source and manufacture in China.

As all the big Fortune 500 to 1000 companies have already established their operations in China and more companies are entering the market, this has heavily impacted the availability and pricing of property in the first tier cities, especially Shanghai. Nowadays it is very difficult to get good quality industrial space in Shanghai, either because the industrial parks are full or because prices are too high. This lack of availability and high pricing has forced many companies to look to other locations beyond Shanghai.

It is not just the size of the foreign companies investing in the city that has changed, but also the types of companies. Shanghai is a far more economically advanced city than even five years ago, and the outside world is more attuned to its rising status as a strategic economic centre in the Asia Pacific region. Land, utility, living and labor costs have all risen, but Shanghai has also completely changed regarding the kind of industry for which it is suitable. The Shanghai government is attracting more higher-end manufacturing and large investment projects and recommending that smaller investments be made in the satellites cities around Shanghai, being the second-tier cities.

What is certain is that new companies looking to enter the China market will increasingly have greater investment options than before. Locations will increasingly become focused on serving specific niches and less on trying to offer all things to all customers.

However it is unlikely that companies already established in Shanghai will up and leave what has undoubtedly become China's business hub. It's more than likely that expanding companies are looking to invest elsewhere in new plants, rather than moving their whole operations. There are only a handful of cases where companies have actually moved out.

Another trend is that intensifying competition is forcing retailers to expand to China's second-tier cities which offer more than twice the number of consumers, albeit with a lower per-capital disposable income. First movers are establishing a local foothold. French retailer Carrefour, for example, is planning 22 new stores in these second tier cities. The crowded retail scene in the larger Chinese cities points to a shorter-term nature of the retail opportunity. It also suggests that any new retailer wishing to enter the country needs to identify a distinct sub-segment to serve if it wishes to make headway against existing players.

Although China's large consumer base is alluring, it is not homogenous. Tastes and preferences vary considerably among the 31 provinces. Roughly two-thirds of Chinese people live in rural areas with significantly lower per-capita gross domestic product, (less than USD 700, compared with more than USD 1,100 for urban dwellers). Because rural consumers have less income, they must devote a greater portion of their earnings to necessities. Rural Chinese spend 46 percent of their income on food, while their urban peers spend 37 percent.

Additionally, China's infrastructure, although largely improved since 2000, is still lagging with major problems, such as underdevelopment and fragmentation. China has invested heavily in its transportation infrastructure in the past few years, adding 6,000 kilometers if new rail lines, 200,000 kilometers of roads, and an increase of 2 million TEUs (twenty-foot equivalent units) of port capacity a year. However these networks still do not meet the transportation needs of foreign investors, especially as they try to push northward and westward into the country.

Major Second Tier Cities

Below are some facts regarding the main second tier cities that receive the most foreign direct investment after Shanghai, Shenzhen, Guangzhou and Beijing.

Hangzhou

Hangzhou has a population of 1.9 million people. It has become a magnet for light manufacturing, such as electronics, textiles. Mobile phone giants such as Motorola and Nokia have invested in the city. The Xiaoshan Development Zone has attracted companies such as Coca-Cola, United Biscuits and more than 40 Taiwanese companies.

Tianjin

Tianjin has a population of 9.85 million people. Its traditional industries include iron and steel, construction materials, papermaking and food processing. Today it has moved towards automobile manufacturing, shipbuilding, petrochemicals, metallurgy, telecommunications and the production of electronic goods such as TVs, cameras and computers.

Chengdu

Chengdu has a population of 3.3 million people. Companies are attracted as a result of the low costs that amount to as little as one third of hat investing in cities like Shanghai. Intel invested US 375 million in a semiconductor plant.

Nanjing

Nanjing has a population of 2.8 million people. The city has an integrated iron-steel complex, an oil refinery, food processing establishments and hundreds of plants producing a variety of items including chemicals, textiles, cement, fertilizers, machinery, weapons, electronic equipment, optical instruments, photographic equipment and trucks.

Dalian

Dalian has a population of 3.9 million people. Its main manufactured goods include refined petroleum, chemicals, fertilizer, machinery, iron and steel and transportation equipment.

Wuhan

Wuhan has a population of 6.3 million people. The city attracts companies largely on the basis of cheaper costs - both property and labor costs - and its central location. It has the largest concentration of universities and research institutes after Shanghai and Beijing.

Even though the second-tier cities are still undeveloped in terms of quality of employees and infrastructure, these cities are receiving the overflow of investments from the first tier cities. It is likely that these first tier cities will become more service oriented in the future, moving the manufacturing bases to the second and third tier cities.

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.