Localisation in China and the risk of inaction

Analysis 16 May 2023

Kent D. Kedl

Asia Pacific China Political and Country Risk

The past few years have put a strain on corporate globalisation strategies: trade wars, a global pandemic and geopolitical tensions are leading companies to consider “decoupling” their operations and supply chains in order to protect themselves against any future global challenges. In China, one of the strategies companies are considering, ironically, is at the opposite end of the spectrum: localisation or “China-for-China” – putting more resources into this market to make it more insulated from the rest of their global operation. Companies are considering a number of strategic moves to become more local: acquiring or doing a joint venture (JV) with a local company; sourcing more from China to reduce imports; or bringing more IP in or developing more IP locally to create products and solutions for the local market more effectively (and efficiently).

The days of domestic companies chasing MNCs and copycatting foreign designs are beginning to be a rear-view-mirror issue. A mix of smart marketing and flexible sales and pricing, robust investment in R&D, playing to nationalistic sentiment to buy local, and aggressive talent acquisition mean that competition from the local market and the need to be integrated locally are fiercer than ever.

It is common these days for companies to do a risk assessment before they decide on a major strategic move to localise their China businesses. Financial, legal, commercial and reputation risks are considered and factored in to assess the value of the localisation strategy to the company. If major “red flags” come up – a threat to IP localisation, an acquisition target with a questionable background – then often the decision is, rightly, made to not proceed with the localisation, and the company continues to operate as it always has, as a distinctly foreign company in China.

This is the proper way to assess the risk of a localisation. However, what is not often considered is an assessment of the risk of not localising further. What if we don’t partner with this (or another) company… will we still be viewed as a foreign player (or too much of a foreign player)? What if we don’t localise our intellectual property… are we going to be constantly late to market with solutions that do not quite meet the needs of the local market? When considering a localisation strategy in China, it is critical to do a more holistic assessment by looking at the risks of both action and inaction.

An assessment of whether not to localise has to consider three critical questions: how are our customers’ needs shifting; what are our competitors doing; and what are the Chinese regulatory and policy trends that favour a more localised company?

Customers

Good companies are constantly talking with – and listening to – their customers: what are they buying now; what features/functions are most important to them; how are demands on T&Cs changing? These are all good questions and should be continually explored. However, when considering a localisation, companies need to ask different questions of their clients:

What pressures are you getting to “buy local”? Are your foreign customers in China wanting to localise their own supply chains so if you can localise, you stand a good chance of getting more business from them? Are your Chinese companies getting pressure to localise (more on that below)? Are your Chinese competitors winning more business because they are already local?
What is driving your localisation strategy? Are your customers trying to cut costs by reducing imports? Are they trying to insulate their own supply chain against future global risks such as a pandemic or a trade war?
More specifically, are geopolitical tensions causing you to want to buy local? This might be a newly emerging constraint for your Chinese customers, particularly SOEs and those in strategic sectors. Some of them are already feeling the pressure to buy locally made products – and inevitably will be pressured – but they may not be telling you about it yet. Ask them about it and get their advice on how you can remain a leading supplier to them.

The decision whether or not to further localise in China requires a deeper and more nuanced understanding of your customers’ business drivers. You need to know how their businesses may be changing – beyond just the solutions you provide – in order for you to know how to serve them in the future.

Competitors

Like customers, most companies have very good intelligence on their competitors – their products, positioning, pricing, go-to-market strategy, etc. This is a fundamental requirement for working in any market. However, to accurately assess the risk of not localising, you need to have a deep understanding of how your competitors are localising (or are already fully localised) in order to know where the standard is being set:

How localised are your biggest competitors? How dependent are they on imported sub-assemblies and finished goods? Have they localised IP and if so, why (and how are they protecting it)? How localised are your business and core products compared with your foreign competitors?
How capable are your local competitors to make a jump in technology? Most foreign companies underestimate how rapidly Chinese companies are improving their technology, quickly moving from “good enough” to “near equals”. How well do you understand how close they are to competing with – and therefore replacing – you on the technology side? What gaps do they have to close and how soon might they close them?
How good are your competitors’ local connections and how do they benefit from them? How strong are their government and industry connections (everyone says they have good relationships, but how good are they, really)? What kind of government funding are they receiving (particularly “innovation” grants) and how are they using these funds? Is the above question on technology jumping supported by government connections and funding?
How are they positioning themselves with customers against you? Go beyond their marketing material and get at how they are selling, particularly whether or not they make claims of being more localised (and therefore cheaper, more appropriate for the local market, more responsive, etc.). What is their localised “pitch” and how compelling is it for your customers?

Like with your customers, in order for you to assess the risk of not localising, you are going to need a much more complex understanding of your competitors. Despite the risks to them, are your competitors in a better position to serve a rapidly localising market because they have already made the decision (and the moves) to localise? What lessons can you learn from the mistakes they made?

China policy and regulations

Any company doing business in China needs to have a good baseline understanding of the industrial policies and regulations around their company and sector. This is an even greater requirement under the Xi Jinping administration, where regulatory enforcement has been very active: anti-corruption, anti-competition, environment, food safety and (particularly) data security have all been robustly enforced on both local and multinational companies.

But in assessing localisation risk, companies need to understand not just the policies themselves (which are often vague and “aspirational”); rather, you need to have a good feeling for where enforcement is going and how exposed you may be in your current state and in your future (localised) state. Questions to ask include:

What does it mean to be “local” according to China policy and regulations? In some sectors and geographies, just having manufacturing in China (even with imported inputs) qualifies you as “local”, while in others, a company needs to be majority-owned (or even fully owned) Chinese to be considered as “local”. This is also a good question to ask of your customers who are under pressure – they will have a feeling for what might qualify as “local”.
What are trends in standard-setting in your business? In many sectors, China-specific standards – data localisation, product safety, food safety, and environmental protection among the biggest – are increasing localisation requirements (albeit indirectly) for MNCs. Are regulators increasingly requiring your products to adhere to local standards and would it be easier to follow these standards if your business was more local?
What is the trend of regulatory enforcement in your sector? For example, if you are in medical technologies, you are likely to run into the increasing anti-competition enforcement going through that sector. If you localised, would you avoid scrutiny that other, more “foreign” companies might face? Would localising your supply chain as a food company provide any more protection in food safety inspections?

Assessing regulatory enforcement risks – in effect “war-gaming” your China future – is a very good way to identify ways that you might be able to reduce risk by localising.

Strategy before structure

When China first opened up to foreign investment, there were strict requirements on the structures foreign companies were required to use for their investments: JVs, limited business license scope, local sourcing requirements, etc. Except for strategic or sensitive sectors, most of these structural requirements have now been lifted and companies have a broad range of structural options for their China strategies. However, it is critical to place strategic questions before structural options. For example, some might say that their strategy is to acquire a Chinese company, but this is not a strategy, it is a way to realise a strategy (becoming more local, gaining access to distribution, etc.).

When companies consider their localisation strategies, they must consider all the various ways they could realise such strategies. For example, because of all the messy deals in the ‘90s and ‘00s, many foreign companies feel quite negatively about JVs and blame the structure of the JV for its problems. This is like saying that, because of high divorce rates, all marriages are bad. If any relationship, JV or marriage, starts off with unaligned motivations – what the Chinese call “sleeping in the same bed but dreaming different dreams” – then that relationship is likely doomed. But if both parties come together with a mutual understanding of what makes them better together than apart, there is a much greater chance of success. JVs are often a viable option to realise greater localisation in China.

Another, less explored, option is sharing your IP with the right partner in China. Much has been made in the past few years about “forced transfer” of IP in China; however, we have seen foreign companies find great success investing their IP in the China market and with the right partners. Managing the risk of localisation requires companies to think very creatively about their options and not disqualify any option without a rigorous assessment of risk.

Conclusion

While some firms are weighed down by inaction and the idea that further investing in China may bring greater exposure to nebulous catastrophic events, other firms understand that there is an opportunity cost being paid. Indecision over time equates to giving away or falling behind on larger segments of the ever-changing China market.

The decision to further localise your business in China is not to be made lightly and companies are absolutely correct to assess the risks of localising. However, unless a parallel effort is made to assess the risks of not localising, management will be missing some important information to feed into their decision-making. Getting a holistic view on your China market – customers’ attitudes on localisation, competitor strategies, and where the regulatory environment may be headed – is critical to making the right decision, choices that may determine whether or not your business has a future in China.