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Why it’s no longer business as usual for Chinese companies

Many Chinese companies will simply not survive over the next decade unless they forego the old formula for growth and competition and transform for the future.
Joe Quoyeser

Managing partner of McKinsey Greater China offices; brings deep knowledge of China’s financial institutions and markets and extensive experience in leading large-scale transformations for both Chinese and multinational organizations

As Chinese companies brace themselves for the potential impact of the brewing trade war with the US, a less widely publicized, but far more profound set of challenges threatens their ability to survive in the next decade.

Until recently, things have been really good for Chinese companies: Extraordinary macroeconomic growth, a raft of pro-business government policies and incentives, and the unleashing of decades of pent-up consumer demand among a newly-confident middle class have fueled record revenues and profits. In Fortune’s most recent ranking of the world’s 500 largest companies by revenues, 111 Chinese companies made the list.

Things are changing, however. While China still has one of the highest GDP growth rates in the world, economic growth has leveled off to just under 7 percent since 2015. China’s A-share market and the Hong Kong stock exchange’s H-share market are both down about 25 percent this year, in a few of the salient indicators of a trend taking shape in the Chinese economy.

Look into some of the key engines of China’s economy and you’ll get a better understanding of the underlying dynamics. Housing sales have experienced an annual growth rate of 26 percent over the past two decades and real estate now accounts for 6.5 percent of China’s GDP. But the sector is facing fresh challenges.

Recent government regulations such as price ceilings and more stringent eligibility requirements for new home buyers have put the brakes on China’s high-flying real estate sector. And with government prohibiting developers from borrowing from China’s enormous shadow banking sector, an important source of funding has been shut-down.

Many real estate developers are shifting their focus toward long-term rental housing; some are acquiring new skills in commercial real estate; while others are dabbling in industrial parks. The old business model of churning out residential blocks on high leverage no longer works.

In the consumer sector, the meteoric rise of the mobile Internet and the emergence of powerful Internet eco-systems have forever changed how Chinese consumers browse, buy, and pay for stuff. However, as the Internet platforms squeeze margins, and as consumers continue to be spoiled with an ever-growing choice of cheap goods, only the deep-pocketed can remain confident about the future.

Even in the widely touted FinTech sector, companies face significant challenges. For example, between 2014 and 2017, 250 billion renminbi in capital backed the formation of 3,500 Internet finance startups, most of which were involved in consumer lending or peer-to-peer (P2P) lending.

The sector has experienced a shake-out recently, with Chinese regulators issuing a slew of new regulations aimed at reining in the industry. In the first quarter of 2018, 721 P2P companies filed for bankruptcy, leaving more than 2,800 players to battle it out.

China’s much vaunted “going abroad” strategy has also encountered some serious, if anticipated, headwinds. The failure of several high profile deals to gain approval, and uncertainties surrounding some Belt and Road projects, have made it clear that Chinese globalization is likely to be a more gradual effort, with lots of learning and experimentation—and failure—along the way.

It’s clear that Chinese companies have an urgent need to transform. But how? While transformation will look different for every company, two common themes stand out: First, firms will need to shift from a capital-heavy, to a much more agile, capital-light business model. Second, companies must undertake a shift from managing for scale to managing for quality.

Business model: From capital-heavy to capital-light

If the last decade in China has been about companies leveraging up to build scale, the next decade will be about how companies rethink how they can sustainably make money. For many firms, this will be a complicated task: Asset size, revenues, and market share have been the sole measures of corporate performance to-date. Expansion fueled by bank debt has been their winning formula. Many companies have never needed to worry about making back their cost of capital.

In a deleveraging context, companies will need to reexamine how they allocate capital. Chinese firms have been excellent at driving growth, but much less experienced at trimming underperforming businesses. For a lot of companies, unprofitable business units will have to be shed, organizations will have to be leaned out, and operations will have to be made more efficient. Highly-leveraged companies may also need to tap into different sources of funding to create more capital-light models.

But old practices die slowly. As companies start the business planning cycle for 2019, many of them will still retain many of the same key performance indicators, which are heavily-indexed on revenue and asset growth. This is extremely dangerous, however. Without establishing a clear vision of their “Business Model 2.0,” Chinese companies risk going down the wrong path. More of the same is not a strategy.

Management practices: From growth to quality

There has never been a more urgent need to professionalize management practices than now. In the land grab mode that most Chinese companies have pursued over the past several years, management was tasked with building scale—and fast. Many companies succeeded not thanks to superior management practices, but by taking bold, one-sided bets, and simply by being “at the right place at the right time.” This was the generation of entrepreneurial managers—the men and women who planted flags and claimed territory throughout China in the race for growth and market share.

This is changing rapidly, though. Managing for quality requires a very different set of management practices. This includes much more precision and deeper insights. For example, Chinese companies generally have a lot of customers, but most do not segment them, nor do they differentiate between them according to their contributions the company’s bottom-line.

Another example is the use of big data and advanced analytics. While many companies have invested heavily in IT, few companies have learned how to fully leverage the power of data analytics to improve how they manage their companies. Many Chinese chairmen give speeches about artificial intelligence, but with the exception of some leaders who are making great strides in this space, most don’t understand the range of applications and the potential impact of this powerful new technology on their business. Perhaps more than in any other economy, the ability to wield data analytics and AI will separate the winners from the also-rans in China.

A big bottleneck in this transition of management practices is managerial talent. In many Chinese companies today, the top layer of management is occupied by the veterans who have built the business. While their hard-won experience and “battlefield scars” are invaluable assets, they may not necessarily be the right people to lead the company through the next decade of disruption and growth. As the need for quality management increases dramatically, how these first-generation Chinese corporate leaders pass the baton to the next generation will dictate their path for many years to come.

The glass half-full view tells us that Chinese companies continue to enjoy some of the best prospects relative to anywhere else in the world. Despite recent challenges, macroeconomic fundamentals in China continue to be strong. Chinese entrepreneurs are resourceful and resilient; their companies should ride on past successes, say the optimists. The glass half-empty view, however, paints a very different picture of the future: Many Chinese companies will simply not survive over the next decade. The old formula for growth and competition will no longer work. The next few years will be their moment of truth—transform now, or risk losing everything.

A condensed version of this article appeared in The South China Morning Post.