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FICE and the Liberalization of Distribution in ChinaJuly/August 2006ChinaBusinessReview.com

China's long-awaited liberalization of the distribution industry has finally become a reality in recent months. Indeed, China's regulatory environment has shifted to accommodate much broader business scopes and more efficient operating structures for wholesalers, resellers, distributors, and other companies by removing layers of bureaucracy. As a result, companies operating across various industries in China will face new opportunities and uncertainties.

Driving this loosened business environment is the regulation that recently delegated the foreign-invested commercial enterprise (FICE) license approval process to local authorities and lowered registered capital requirements. Many foreign-invested companies are now receiving approvals to use FICEs for retail, wholesale, franchising, and commission-based agency services. Using this new operating structure, firms will be able to trim the fat from current distribution channels, reorganize the existing scope of business, and provide better products and services to customers.

Many companies already use FICEs to make their operations more efficient. For instance, companies that both source and sell in China use FICEs as operational centers to coordinate local and overseas suppliers, customers, and manufacturers (see Figure 1). By integrating a FICE into existing
operations, companies will be better able to manage the buying and selling of goods that are either sourced locally or manufactured elsewhere in the world (see Figure 2).

Though the FICE structure can certainly bring benefits, companies would do well to consider potential drawbacks. These may include higher taxes as a result of losing preferential tax status when converting from a manufacturing enterprise to a FICE and higher costs as a result of setting up a new entity.

The long road to liberalization

Under China’s World Trade Organization (WTO) commitments, wholly foreign-owned distribution and retail businesses should have received business licenses that allow unfettered access to its distribution sector by December 11, 2004. Despite April 2004 rules that ostensibly opened the sector, officials at the PRC Ministry of Commerce (MOFCOM) did not begin publicly espousing a “speed-up” in the approval process of foreign-invested distribution businesses until April 2005 (see Table).

Regulations Governing the FICE Approval Process
Regulation	Content	Issued by	Effective date
Regulations on Management of Foreign Investment in the Commercial Sector	Opened up distribution rights and eliminated or lowered entry barriers for foreign-invested commercial enterprises (FICE).	Ministry of Commerce MOFCOM	1-Jun-04
Notice on Relevant Issues Concerning Expanding Distribution Business Scope of Foreign-Invested Noncommercial Enterprises	Clarified various fiscal and procedural issues for noncommercial enterprises and investment companies to expand their business scopes to include trading and/or distribution rights.	MOFCOM	2-Apr-05
Notice on Certain Issues Regarding Trade Management in Bonded Zones and Bonded Logistics Parks	Clarified distribution regulations for foreign-invested enterprises (FIEs) that only have operations in bonded zones or bonded logistics parks, granted them trading rights, and allowed them to apply for distribution rights.	MOFCOM, General Administration of Customs	13-Jul-05
Notice Regarding the Delegation of Approval Authority for FICEs to Local Authorities	Transferred approval authority to provincial-level commerce authorities and national-level economic and technological development zones and allowed existing manufacturing FIEs, free-trade zone FIEs, and investment companies to expand business scopes.	MOFCOM	1-Mar-06
Source: Francis Bassolino and Sean Leow

In March 2006, MOFCOM took the important step of giving provincial-level governments and national-level economic and technological development zones the authority to approve FICE licenses, except when the proposed FICE is involved in a restricted industry or in the distribution of strategic raw materials. This change has allowed most wholesale and retail FICEs to obtain direct approval from local authorities, circumventing the bureaucracy in Beijing.

China has also drastically lowered minimum capital requirements for establishing a FICE, from the pre-2004 requirements of ¥80 million ($10 million) for a wholesale license and ¥50 million ($6.25 million) for a retail license. In line with the new PRC Company Law that took effect on January 1, 2006, the minimum capital requirement for setting up a FICE is now ¥30,000 ($3,750), 20 percent of which must be paid within three months and the rest within two years. The current requirement—a boon for small and medium-sized distributors that want to enter China’s logistics and distribution industries—is so low that even individuals are obtaining approvals for FICE licenses. Requirements for minimum assets ($300 million for wholesalers and $200 million for retailers) and annual business revenues ($2.5 billion for wholesalers and $2 billion for retailers) were eliminated in June 2004.

As local governments compete against each other for new FICE applicants and their tax revenues, they have an incentive to promote an efficient and painless approval process. For instance, in the two months after local governments gained the authority to approve most FICE applications, the Shanghai Foreign Investment Commission approved more than 110 FICE licenses, the majority of which were for wholesalers. More applications and approvals are expected as small and medium-sized enterprises flood into the China market.

Recent changes will have far-reaching implications for the competitive landscape of retailers, manufacturers, and industrial goods distributors. Though the supply chain dynamics will play out differently in the consumer and industrial goods sectors, ultimately the FICE structure will help improve China’s inefficient distribution industry and provide new opportunities for value-added distributors.

A maturing industry

Between the start of economic reforms in 1978 and China’s WTO entry in 2001, the Chinese distribution system was crude and inefficient. Damage to goods, pilferage, overstocked warehouses, and delays were common, and an inventory management system was nonexistent. Chinese distributors provided only basic transportation and warehousing services, and because state-designated distributors monopolized the distribution and logistics industries, foreign distributors on the mainland had to use fragmented, tiered, and rigid top-down state distribution networks. As the central government gradually delegated more approval power to regional authorities, local protectionism emerged and is still a major barrier to the efficient flow of goods.

In recent years, however, China’s distribution industry has matured rapidly. WTO-mandated openings have sparked fierce competition among foreign, state-owned, and private Chinese firms, which have had to provide better services to survive. Improvements in China’s infrastructure, especially roads and highways, are also making it easier for manufacturers to provide direct wholesaling and for retailers to set up direct sourcing. From 2003 to 2005, 630,000 km of roads were paved in rural areas, twice as much as the total length built between 1949 and 2002. State investments in these enormous projects are beginning to provide the necessary infrastructure for companies to access untapped secondand third-tier urban markets.

The squeeze on distributors

As a result of globalization and advances in supply chain management, distributors are being squeezed from both sides. Manufacturers and customers are expanding their business scopes to integrate along parts of the supply chain and eliminate costly distribution layers (see Figure 3).

In China, where homogeneous products and production overcapacity have led manufacturers and retailers to compete by cutting prices, eliminating one distribution tier can lower costs by 3 to 8 percent. In addition, in the absence of true value-added distributors, many local buyers view domestic distributors as parasites—firms that add no value, just cost.

The FICE license allows retailers to expand their business scopes to include wholesale and agency distribution, in addition to importing from abroad, which many retail business scopes already include. Similarly, manufacturers can expand their business scopes to provide direct wholesaling to retailers. In fact, many manufacturers already operate as virtual distributors as a result of China’s regulatory environment and the lack of qualified value-added distributors. These manufacturers—which traditionally offered only direct sales or manufacturing services—have developed such efficient and profitable distribution networks that many are now considering expanding their distribution services to other regions of the world.

Competition resulting from the expected wave of new FICE licenses will catalyze the drive to increase efficiency in distribution channels, particularly in the consumer goods sector, which is renowned for excess layers. For instance, FICE structures will likely create platforms that can offer more complete product offerings (in part, because companies will be able to sell goods they do not manufacture), which will in turn push them to incorporate robust platforms that permit more direct control over critical supply chain functions such as sourcing, warehousing, point-ofsale data, and logistics. Consolidation of these functions will lower costs, improve productivity, and provide better products to the market because sellers will have more access to real-time data about the characteristics of demand.

To thrive, distributors in the middle must strive to reduce transaction costs for suppliers and customers and offer value-added services such as systems engineering, component integration, sophisticated inventory management, just-in-time (JIT) and just-in-sequence delivery, after-sales service, and reverse logistics. In China’s hypercompetitive environment, product lifecycles are short, making rapid delivery and after-sales service critical advantages, especially in resolving supply shortages and equipment breakdowns. For example, when a breakdown occurs and a specific part is unavailable, the opportunity cost of downtime can, and often does, dwarf the component price.

Shanghai Leads the Way

A total of 22 foreign-invested commercial enterprise (FICE) licenses were approved for the Shanghai municipality in 2004, the first year of FICE implementation. Most licenses were given to Hong Kong-based companies, which had a head start on other World Trade Organization members under the Closer Economic Partnership Arrangement. In 2005, Shanghai authorities approved 431 licenses. Of these, 92 were retail licenses, and 339 were wholesale or mixed wholesale/retail licenses. In addition, more than 100 Shanghai FICE licenses issued in 2005 were for noncommercial foreign-invested enterprises that expanded their business scopes to include trading and/or distribution rights. Between March 1, 2006, when the circular that delegated approval authority to local governments took effect, and early May, Shanghai authorities alone approved more than 110 FICE licenses. The speed and efficiency of the approval process in Shanghai—which takes only about 10 working days—are even more remarkable considering that only one person is processing all the applications.

—Francis Bassolino and Sean Leow

Specialized industrial goods distribution

Because many manufacturers and retailers can now handle their own logistics and distribution, FICE liberalization will foster direct product sourcing. In the highly engineered and highly specialized goods markets, especially industrial goods markets, however, the new rules will give rise to another trend: the emergence of specialized distributors.

Far from being eliminated, specialized industrial goods distributors are using the FICE license in China to insert themselves into the supply chain and roll out value-added services and business models that have been effective in more open markets (see Figure 4). While this trend is not as prevalent as the corporate consolidation described above, it is steadily gaining steam and will undoubtedly play a prominent role in the future.

The FICE structure allows industrial goods distributors to create organizations that can source, design, assemble, invoice in domestic currency, and provide after-sales support. Previously, foreign distributors in China, with the exception of the largest companies, which use convoluted structures, were unable to supply these services. In more developed markets, increasing specialization in the supply chain and use of distributors as a conduit of information for a specialized good improve efficiency and add value. Over the next few years, industrial goods suppliers and other specialized distributors will increasingly apply this global business model to China.

There are several reasons why specialized goods distributors may thrive under the new FICE structure. First, specialized, value-added distributors provide “one-stop” or “shopping list” sourcing services for many industrial consumers. By allowing customers to purchase different components or brands in a single transaction, distributors reduce their clients’ transaction costs. In addition, aftersales service and parts are often big concerns for customers. For example, China’s construction machinery industry often requires the sourcing of components through specialized distributors because low-volume, customized equipment orders are common and after-sales service is crucial.

Second, industrial distributors shorten the cash-flow cycle for manufacturers that specialize in product innovation and development. By bearing the financial risk of owning and managing the manufacturers’ inventory, distributors bridge the time gap between the manufacturers’ production and the customers’ purchase of the products.

Third, industrial distributors cater to geographic and industry-specific segments of the market. In China, where markets and customers are often highly fragmented and widely dispersed, geographically oriented distributors can provide valuable services such as design collaboration, JIT delivery, and after-sales service that manufacturers are either unwilling or unable to provide because of geographic constraints. When industry expertise and technical guidance are needed, specialized industrial goods distributors can design, engineer, and procure the best product at the lowest cost for an enduser.

For highly engineered products, industrial goods distributors allow each segment in the supply chain to focus on its competitive advantage and, ultimately, on product improvement. These are huge improvements over traditional Chinese distributors, who offered only the most basic warehousing and transportation services.

Room to grow

The evolution of China’s distribution industry will likely be similar to that of other markets, though it will move faster because companies will implement the proven models that value-added distributors use in developed markets, particularly in industrial goods distribution, over the next one to two years. Because China’s distribution sector is entering a period of intense competition, the firms that forge strong bonds with their customers, offer quality value-added services at reasonable prices, and build a complete and competitive supply chain will emerge as winners.

By Francis Bassolino and Sean Leow