Welcome to China’s$ 1 Trillion Club. Now for the Hard Part

Chen Jianhua, the bespectacled owner of a ski-glove factory in the coastal province of Shandong, wants to construct the big jump that typifies China’s industrial change: from contract producer to establishing his own brand.

Companies can die pretty quickly when trying to build their own brands, said Chen, near a showing room of hundreds of multicolored gloves at his Jining Jianhua Zhongxin Ski Product Co. plant. If we arent equipped with sufficient talent or capital, blindly constructing a brand will leave us with no competitiveness.

Chens challengeupgrade or be squeezed by cheaper locatings like Vietnamis playing out across the province of 98 million people, from the refrigerator factories of Qingdao-based Haier Group to the cotton mills of textile giant Shandong Ruyi Technology Group. The low-cost make-for-export model that turned Shandong into Chinas third$ 1 trillion provincial economy after Guangdong and Jiangsu is faltering, adding urgency to the push for quality own-name products with fatter margins.

Moving up the value chain is absolutely key to eastern Chinas futureand thus for the entire economy, said Andrew Polk, Beijing-based director of China research at Medley Global Advisors who previously worked for the U.S. Treasury. The challenge is that growth driven by firm-level innovation is the hardest kind to achieve and are very significantly lumpy, taking years to pay off.

Shandong got a boost in the past from its proximity to Japan and South Korea, the source of much of its early investment. Now, its trying to maintain the high growth rate needed to construct the same leaping they did: from middle- to high-income status, a jump only five economies have managed, including Taiwan, Hong Kong and Singapore, according to Nobel laureate Michael Spence.

Unlike other parts of China that have struggled to establish top brands, Shandong has a solid foundation with three of the nations best-known names: household electrical appliances manufacturers Haier and Hisense Electric Co ., and Tsingtao beer.

Shandong has rich natural resources, oil and coal that spawned a large chemical industry, and a temperate climate in which to grow peanuts, peaches, apples, grapes, cotton and medicinal herbs. Qingdao, once a German concession and renowned for its annual brew festival, is among the worlds busiest container ports and the long history of the provinces coastline make it a magnet for tourists.

Yet much of the growth potential is in the second- and third-tier cities inland, where incomes are lower and services and retail industries lag behind those on the coast. In Jininga city of 8 million people about five hours’ drive west of Qingdao that was the birthplace of Confucius, entrepreneur Eason Gao plans to launch the Mr C coffee shop chain to compete with Starbucks, which had recently a handful of local outlets.

Rising incomes

Gao, 29, worked for six years in coffee shops and eateries in Shanghai before returning home to capitalize on Jinings rising affluence. Hell need some bank finance to help him launch Mr C this year, but says hes confident that wont be a problem.

Peoples incomes are rising here, and they can afford better coffee, Gao said, lounging on a Starbucks sofa. The coffee culture is taking off.

Services held up well in Shandong in the first quarter, with an 8.6 percent expansion from a year earlier. Yet the provincelike the majority of members of Chinaremains reliant on the old playbook of investment-driven growth. Infrastructure investment surged 34 percent in the first quarter, the main driver behind the provinces 7.3 percent expansion.

Near the coastal city of Yantai theres terrible overbuilding, tells Chris Ruffle, co-founder of money management firm Open Door Capital Group, who owns the nearby Treaty Port Vineyards. People got a bit carried away. There was inexpensive land and inexpensive labor but there isnt the underlying demand.

Ruffle, whose vineyard renders about 60,000 bottles of wine a year, is nonetheless impressed by the innovation of Shandong-based companies, including single-use medical products manufacturer Shandong Weigao Group Medical Polymer Co. in Weihai, and Luye Pharma Group, a Yantai-based drugmaker.

These are among the most innovative companies weve found in Shandong, said Shanghai-based Ruffle, whose vineyard is next door to Frances Domaines Barons de Rothschild( Lafite ), which chose Shandong for its first China venture in 2009.

Farm hands treat the grape vines with insect control techniques at the Treaty Port Vineyards north of Yantai, Shandong Province .
Photographer: QIlai Shen/ Bloomberg

China is relying more on local intake and innovation as it cuts excess capability in industries like coal and steel and seeks to rein in debt thats about 2 1/2 hours gross domestic product. The 13 th five-year scheme through 2020 and a Induced in China 2025 blueprint “ve tried to” rev up new drivers of growth and envision global competitiveness in 10 industries from machine tools and robots to advanced railway equipment and medical devices.

That shift is upending the economy across the nation, inflicting layoffs from the coal fields of Shanxi in the north to the once unstoppable factories of Guangdong on the south coast. Wins are emerging, too, many in central provinces like Chongqing, which is using its railways and river links to open up the underdeveloped west.

To read other provincial profiles, click here .

New growth drivers

Thrown together, economic growth in the continent-sized economy of China is grinding down to its slowest pace in a one-quarter of a century.

For Haier, the antidote to the slowdown is innovation. Back in 1985, Chairman Zhang Ruimin dedicated employees sledge hammers and ordered them to smash faulty refrigerators theyd just madesomething unthinkable to workers who needed months to save for one of the appliances they were asked to destroy. More than three decades later, Zhang is exerting an axe as he tries to remake Haier into a platform for startups, slashing staff numbers to about 60,000, from about 110,000 at the peak.

Haier has backed 180 startups since 2013, 23 of which have also received venture-capital fund from third parties. Twelve are valued at more than 100 million yuan each, said Sun Zhongyuan, executive director in charge of the program in Qingdao. They range from Ririshun Lejia, a suppliers of lockers in communities for residents to collect packages, to Xinchu, a refrigerator that connects customers to recipes, music and food suppliers via the web.

Lu Kailin has been at the vanguard of Haiers development since joining as a 22 -year-old in 2004. In his first task in Shandong he worked 15 hours every day, riding a motorbike around remote villages near Pingdu city selling refrigerators. His endeavors doubled sales in the district in six months, helping Haier become the best-selling home appliances brand in the world.

Fast forward to 2016 and Lu is chief executive officer of a startup backed by Haier that made a laptop computer for gamers called ThundeRobot. The company is on course to be valued at about 600 million yuan in the latest round of money raise and plans to list its shares next year, said Lu.

Transforming titans

Textile maker Ruyi is another transforming titan. With sales last year of 40 billion yuan, its employing capital to buy foreign brands as it morphs into a administrator of the fashion labels it used to supply, said spokesman Li Yunpeng in an interview in Jining.

Ruyi in March announced it would buy a controlling stake in Paris-based SMCP SAS, owner of brands like Sandro, whose $1,140 python-patterned women’s cowboy boots and other attire sell in 33 countries.

Workers prepare and construct suits at a factory operated by the Shandong Ruyi Group .
Photographer: Qilai Shen/ Bloomberg

Ruyis sales are expected to rise to 50 billion yuan this year with about half from overseas, said Li. By 2022, the company targets 100 billion yuan in sales with 60 to 70 percent coming from fashion labels and overseas sales, he said.

On branded products we can achieve profit margins of 40 percent, but when we fabricate for other clients the margins are typically merely about 10 percent, Li said.

There are road blocks. Li says getting capital from banks that view textiles as an industry in decline is one problem. Another is determining top decorators in China because of the previous focus on cheaper, mass-market clothes. Thats one reason Ruyi is buying overseas brands and their design expertise, Li said.

It really matters if companies like Haier and Ruyi can get it right, said James Laurenceson, deputy director of the Australia-China Relations Institute at the University of Technology in Sydney. These companies have the resources to put into R& D and manage the risks associated with moving up the value chain. If successful, it will have a powerful demo impact for other local up-and-comers.

Count among them Chen and his ski-glove company, which sold a million pairs of its Kineed-brand gloves in China last year, out of worldwide sales of 3.5 million. Kineed gloves, is targeted at the domestic market, expensed$ 7 to $10 a pair versus the $40 to $100 or more for the European or American brands he makes.

Chen says his medium-term objective is to build up his own brand while maintaining his supplier business. To maintain the competitiveness of the latter, hes begun changing production to Xinjiang province in the west, where two-thirds of his 3,000 staff are now employed.

The textbooks tell us to say goodbye to manufacturing for others and to build brands, tells Chen. But results are more important than hypothesis because they enable us to survive. For us, that means manufacturing and brand build must co-exist for a long time.

In a series of provincial profiles this week, Bloomberg News explores the differing economic challenges confronting different parts of China .


Why Its Impossible to Talk About Just One Chinese Economy

Heres a snapshot of the forces reshaping this continent-sized country


Read more: www.bloomberg.com

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