The first half of 2013 has been an unusually turbulent period for companies in China. Amidst an apparent economic slowdown, the new leadership has pursued an anti-corruption drive, a government frugality campaign, and a strengthened Internet crackdown.

More specifically, we have seen the trial of Bo Xilai and the largest political scandal in decades; the purging of China’s most profitable state owned enterprise PetroChina; pharma executives paraded on national television admitting commercial bribery; the collapse of the high-end restaurant sector; infant formula brands paying considerable fines for alleged price fixing and being forced to drop their prices; liquidity in the banking sector dry up for two weeks; and the taming of the ‘Big V’ micro-bloggers on the Internet.

Ahead of the Third Plenum of the 18^th Communist Party Congress, InterChina Consulting foresee continued uncertainty in the near future for businesses operating in China, but say that those that prepare properly and meet the challenges positively can prevail.

The international press was full of negative reports on China’s growth prospects in July until the news suddenly turned positive in August. Meanwhile, many sectors and businesses in China have continued to develop strongly. Automotive companies are having one of their best ever years with strong growth and good margins. Many consumer industries such as packaged goods, e-retail and food service continue to witness double digit growth, and growth also remains robust in healthcare, automation and logistics among others.

No wonder there is some degree of confusion in corporate boardrooms, and even among executives in China, about the direction China’s economy is heading and what this means for their companies; however, we’d better get used to this lack of clarity. Uncertainty and volatility will become the name of the game in China. Much of the turbulence to date has been a consequence of the leadership regime establishing its authority and improving public support and this turbulence will continue as the regime now proceeds with its policy priorities and economic reforms for the coming decade.

For those ready to ride these choppy waters the range of opportunities will broaden. Growth in consumption will remain robust, advanced offerings will find new markets as the economy upgrades, market access and fair competition will improve and acquisition options will arise as consolidation accelerates. However, international companies will need to handle the new environment of uncertainty and volatility in order to take advantage of these opportunities.

So, What Does This Mean For Business?

This profound change of status quo will start to impact business faster and harder than many expect. Business in China will become more complicated and risky, but will also generate new opportunities not currently reflected in most corporate strategic plans. What this means for individual companies in specific sectors is not possible to predict in detail, but there will be a set of common themes.

Growth will slow
As a maturing economy, growth must slow compared to the previous decade. The size of China’s labour force is now contracting, the investment boom has led to declining efficiency of investment, and productivity growth rates have also been falling off. China needs to grow at seven to eight per cent this decade and five to six per cent the next to become the world’s largest economy and escape the ‘middle-income trap’. This trajectory is possible if the new leadership proceeds with productivity boosting reforms, but a significant improvement in the global economy would be needed otherwise. And while the economy becomes more dependent on consumption volatility will increase as the spending behaviour of fickle consumers is less controllable than the investment patterns of credit-fuelled state-owned enterprises (SOEs).

The economy will upgrade
Despite the fast growth of the last decade, Chinese labour productivity is still only similar to that of South Korea in the late 1970s and below that of Japan in the 1960s. International experience shows that labour productivity growth is a prerequisite for sustainable growth. We expect China to pursue reforms that will raise productivity, meaning the movement of resources from low-productivity to high-productivity industries; more investment in machinery and automation; more innovation in new technologies, products and ways of working; and more education and training to upgrade workforce skills.

Consolidation will accelerate
One of the most severe problems facing the Chinese authorities is over-capacity, caused by the excessively fast growth in investment. Thus one of the major consequences of the shift in growth model will be faster consolidation. Inefficient and uncompetitive companies, increasingly starved of cheap financing, will be pressured to sell out or die slowly. This is already evident in sectors with less government interference, such as consumer goods or automotive components, where we are seeing a marked increase in M&A activity.

The direction is harder to predict in sectors with strong government involvement, as this will depend on the degree to which private capital is allowed to participate in restructuring. As the government will not be able to rely on SOEs alone to achieve its new growth model, we are moderately optimistic that private capital, including foreign capital, will have a role to play.

Consumers will pose new challenges
Despite the common wisdom that the Chinese consume too little and save too much, consumption has been growing at a healthy rate of nine per cent per annum for the past two decades. In addition, the consumption rate as a share of GDP is likely underestimated, and is in reality comparable with the East Asian tiger economies at a similar stage of development. Over the next few years we do expect consumption-driven industries to out-pace GDP growth, and investment-driven industries and infrastructure to grow slower. Also, with the consuming class increasing by several hundred million over the coming decade consumer-facing companies will need to meet a more heterogeneous and discerning set of needs, with demand dispersed across hundreds of cities and towns.

Outbound investment will grow slowly but steadily
We expect a shift to a more natural flow of outbound investment, away from the politically mandated investments by large SOEs and towards investments by smaller SOEs and private companies. These acquisitions may be smaller and less eye-catching, but more sustainable given their business rather than political foundations. The implication for international companies is a more rational basis to enter into business partnerships with Chinese companies at a global level.

How Should Business Get Ready?

The new status quo does not mean that the traditional success factors for China have expired: headquarter commitment to China; a capable local team, local decision-making autonomy; a business model and offering adapted to local needs; and alignment with government priorities—all remain critical to success in China, and perhaps even more so under the changing conditions already described. However, given the uncertain and volatile environment ahead, international companies need to consider a further set of initiatives.

Managing headquarters’ view
Headquarter executives will, as usual, react to specific China issues raised in the foreign press without a good understanding of their significance in the broader context. Given the choppy waters ahead this risks over reaction to singular issues, accompanied by gradual mounting of concerns and a weakening of confidence. Now more than ever it will be important to manage headquarter expectations. China country management will need to forewarn their headquarter colleagues about potential future volatility, explain events as and when they happen and keep describing how their strategy fits with the changing business environment.

Optimise sales and distribution
The potential of greater consumption in China also poses the challenge of getting the sales and distribution economics to work. Companies will need to accurately pace the expansion of their sales and distribution platforms, select the most efficient geographies and models, and share good practices between regions while allowing sufficient autonomy to meet local needs. Companies should also consider new route-to-market approaches, fully embracing e-retail as it starts to account for ten, twenty or thirty per cent of category sales, and looking at partnerships between those with strong product portfolios and others with mature sales and distribution platforms.

Go For Consolidation
Given the pending consolidation in many sectors, inorganic growth will become obligatory for either establishing a significant presence or staying competitive, both for Chinese and international companies alike. Few international companies are prepared for this new reality. They will need a reliable view of the consolidation dynamics of their sector, both at the macro (i.e. sector structure) and micro (i.e. available targets) levels. The preferred targets might not be available at present and therefore they will need to establish and cultivate relationships well in advance of acquisition discussions. And they will need to be implementing strategies to defend against intensifying competition and bigger competitors. This will not be easy and will require leadership attention and strong execution capabilities.

Re-aligning with government interests
International companies should pay attention to the Third Plenum of the 18^th Communist Party Congress in November and the subsequent policy announcements and implementation plans. They should be looking for changes relevant to their own businesses, identifying new ways to align with government interests and helping the government make good on its policy goals and reform agendas. This will not be a one-off activity, but ongoing, as the details gradually become clearer. As in the past, the most tangible opportunities will occur at the local level with local governments.

New Challenges, New Opportunities

While China has always been considered a complex and dynamic market the restructuring and upgrading of its economic model will lead to greater uncertainty and volatility over the next five years. In the build up to the Party’s third plenum in November, there will be much speculation over the policy priorities and reform initiatives. Sweeping reforms are unlikely, and many commentators will express disappointment. However, we expect the general direction to be a positive and lasting one and meaningful steps to quickly follow. With a greater emphasis on consumption, efficiency and productivity, there will be new opportunities for international companies. While the choppy waters will be navigable, international companies will need to make sure they are ready for them. What worked in the past will no longer be enough. There will be a shake-out in many sectors, and only the better-prepared companies will flourish.

InterChina Consulting is a leading strategy and M&A advisory firm in China. InterChina’s team of 60 professionals has conducted over 500 strategy projects and closed over 160 transactions. The firm has offices throughout China, the US and Europe, and are members of IMAP, a leading global investment banking organisation. For over 20 years, InterChina has delivered results for clients in the sectors of automotive, machinery and industrial, chemicals and energy, consumer and retail, and healthcare.