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A tale of two cities: from Shainghai to Moscow.

More than a decade ago, I asked to speak at the World Economic Forum in Davos, Switzerland. My topic was "Franchising as a Technique for Privatization in Emerging Economies". but the panel was broader. It included one of the leading investment bankers specializing in the introduction of capitalism to the former Soviet Union One question from the audience stopped him cold: "If you were told tomorrow that you must invest all of your and your clients' money in one country, but that country, had to be Russia, China or India. what would you do?" After a long pause, he responded. "I think I would slash my wrists."

I recently had occasion to recall that experience when taking an extended trip which included return visits to two of those three countries, China and Russia. (Some travel notes: This is not technically, only "a tale of two cities", since the trip to China included both Shanghai and Beijing. I recognize that it wasn't so neatly designed as to include India as well (although it did include a week in London). Nonetheless, the symmetry of the occasion seemed too good not to take advantage of the recollection.) Among other obligations, here is what triggered the journey, and provides the opportunity to comment on franchising in these two huge marketplaces. As general counsel of the International Franchise Association I traveled to China with the chairman and president of the IFA, to express our concern and our suggestions regarding the proposed franchise legislation in that country. The trip was timed to coincide with the yearly Franchise Exposition and I also used the opportunity to visit a number of franchisors doing business in China to explore their concerns regarding the existing and proposed regulation. In the case of Russia. the occasion was a seminar on franchising sponsored by the DLA Piper Moscow office. In the case of both countries I had the opportunity to meet with a number of franchisors and franchisees, both indigenous and international: representatives of the franchise associations: members of the press, and others. It was an invaluable opportunity to bring myself up to date on what is happening in both countries, and to share those thoughts with clients and others interested in international franchising.

First, a word about the legislative and regulatory climates. That subject will not be dwelt on here because it warrants treatment of its own. And, in the case of China, that treatment is likely to come very soon, in light of the recent and prospective legislative developments. In both countries franchise laws exist. In both, they are little understood, and yet little enforced. Yet in both they hang over the franchising sector like a polluted cloud of uncertainty, causing some franchisors to hesitate, others to flout the law and others to enter into convoluted and sometimes economically counterintuitive structures to escape its reach. In both countries there is a sense that "something must be done," but that is far more urgent in China because of the volatility of the regulatory regime.

China

My impressions continue to be of truly extraordinary growth, heavily concentrated on exports. Some objective evidence supports that subjective observation.

China's exports to the United States have grown by 1,600 percent over the last 15 years. U.S. exports to China have grown by 415 percent. Last year, WalMart, the largest company in the world, imported 18 billion dollars worth of goods from China. Of Wal-Mart's 6,000 suppliers, 5,000 or 80 percent are in one country. (If you guessed that that country is not the United States, you are correct). That growth is not slowing, at least thus far: even after two decades of very strong increases, China is still the world's fastest-growing major economy, expanding more than 9 percent yearly over the last few years. Its gross domestic product has quadrupled since 1978.

The country's principal statistics agency has just released some stunning new information. China has probably passed France, Italy and Britain to become the world's fourth largest economy. There is a pretty clear consensus that China will be the second largest economy in the world in a few years.

The figures provided make it clear that the growth is not simply based on exports, suggesting that the economy is healthier, more diversified and more sustainable than previously believed. The new information indicates that services such as real estate and restaurants constituted much more of gross domestic product than previously reported, and that there are many more small-and medium-sized companies in the country than had been generally assumed. The growth in small businesses shows the economy to be less reliant on manufacturing and exports for growth than previously thought, which should encourage companies seeking to sell products and services there.

So what are the ramifications for franchising in China?

Plenty. Quite simply, China has become a consuming society. It is estimated that spending in China will quintuple over the next 10 years to 3.7 trillion U.S. dollars per year, allowing China to replace the U.S. as the dominant consumer market in the world. That's bound to be good for franchising, and the evidence that it is is beginning to accumulate.

Sales of franchised businesses in China totaled 25 billion U.S. dollars last year. Sales from franchised businesses are expected to make up 30 percent of the country's total retail sales in 2010, up from 1 percent currently. It has more than 2,000 franchise systems and more than 120,000 franchise outlets, with more than 1.8 million people working in franchises.

Since 2000, the average increase in the number of franchise stores has been approximately 54 percent. It is thus the fastest growing franchise market in the world.

Some major franchisors who have been reluctant to franchise in the past are now indicating that they will aggressively pursue it. And Starbucks recently announced that in three years the company will probably have more cafes in China than in the United States.

Russia

What of the economy in that country which Winston Churchill called "a riddle wrapped in a mystery, inside an enigma?" Standing in a cleaned-up Red Square, or strolling through the Western stores, I had difficulty reconciling the impressions from my trips there 17 (or 10 or even five) years ago. The grim and unrelieved bleakness of those days has been banished, at least in this highly rarified corner of Russian society.

And even outside this surely uncharacteristic enclave, there are some encouraging signs. There is continued economic stability, with output increasing in the key economic indicators. The overall balance of trade shows a healthy surplus (heavily influenced by high world oil prices). There has been a multi-year consumer spending boom, with growth now beginning to spread beyond Moscow and St. Petersburg. Inflation has leveled off, although still at higher levels than most Western economists would favor. As a consequence, household real disposable income has increased. And although those figures remain very low by most standards, the estimates of income may understate the real ability of consumers to spend. Remember: Russians expend only about 7 percent of their income on housing, a consequence of the giveaway of property by the government when it extricated itself from the business of owning residential housing.

The state of franchising in Russia

The peculiarities of local legislation cause franchise relationships to be registered under various legal forms, making it impossible to track the number of franchises accurately. The Russian Franchise Association estimates 150 franchise systems; a private firm, Newbridge Group, estimates it at 165; another source claims it's 200. The number of franchisees is estimated by some at 6,000, by others at half that number. An interesting feature of the Russian franchise scene is the composition of franchisors here: Newbridge estimates 68 percent are domestic, and only 12 percent American.

There is no dispute that the numbers are increasing. One estimate is that the number of systems grew 19 percent this year, the number of newly signed deals 20 percent. The exhibitors at Russia's main franchising show went from 67 in 2003 to 138 in 2005. A recent publication suggested that the number of franchisees will rise to 60,000 in a few years. The U.S. Commercial Service says bluntly "it is possible to predict a very bright future...franchising is set to grow very rapidly."

Time for a reality check

In both of these countries there is more than enough happening to give pause to a prospective franchisor.

In China, it is easy to allow the overwhelming impression of growth to obscure some worrisome realities. China still ranks below the top 100 countries in output per capita, and stands at only 134th in income per person. And while there is a near-term appetite for consumer goods, recent studies reveal a considerable wariness. Only 37 percent of those surveyed agreed with the statement, "I feel confident about my financial future." While Chinese save about a quarter of family income--vastly more than in Europe and the United States--the social safety net is thin; most Chinese must pay for health care and any pensions out of their own pockets, with obvious ramifications for the availability of funds to invest in franchises.

Franchising, while clearly on an upward trajectory, has a long way to go. Most of the country's 1.3 billion citizens are not functionally a part of the consumer market, because they are too poor, too old or too young. While that leaves a huge number of potential customers, most companies we identify as "franchisors" have yet to adopt true franchising models for a wide range of reasons.

In Russia, let's put the recent growth and increased stability in perspective. Moody's upgrading of Russia's creditworthiness simply brought the rating of its bonds up to Baa2, the next to lowest category (with, for example, Tunisia). The increased investment has surely not reached social services (health care, education and research and development in total represent only 4 percent of total investment). The problems of crime, corruption and lack of transparency have not evaporated; it is estimated the average company spent $244,000 last year on bribes to officials. Anti-Semitism and xenophobia continue to rise. Most worrisome for franchisors hoping to sell goods and services to Russian consumers: while there are approximately 145 million people in Russia the birth rate is among the lowest in the world, at around half the replacement rate. Life expectancy continues to fall. That does not present an entirely attractive prospect for future franchisors. So comparing these two countries to one another is a difficult, and maybe even foolish, exercise. Before any franchisor gets carried away by the vision of untold riches to be acquired in either country, it is useful to recall that China's economy is still only one-sixth the size of America's, and Russia's much smaller.

"The Best of Times"?

Charles Dickens opened his great novel--the inspiration for the title of this article--"It was the best of times, it was the worst of times...". One can find optimists in both China and Russia who will tell you that we are now entering an era which will epitomize, "the best of times."

It is worth remembering the words of Dickens which followed that famous quote: "It was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity." Some seasoned observers of what is currently happening in each country would also point out that there is more than enough foolishness, and react to some of the expectations with more than a touch of incredulity. Nobody is slashing wrists, and no American franchisor with aspirations to true international scale can afford to ignore either of these two great markets. Just don't expect either to be a day at the beach.

WHAT THE MEDIA IS SAYING

San Diego Union-Tribune

Franchises & freedom

This may be the golden age of franchising, as a growing number of workers are jumping off the 9-to-5 clock in a time of economic uncertainty to open their own branded sandwich and hair care establishments, with the help of established franchise parent companies.

The concept, which generated more than $1.5 trillion last year, is at a record level of popularity, with more than 767,000 home-based and storefront businesses in operation--fully one-third of them in the fast-food and restaurant segment.

Many in the growing franchise market will be in attendance at the franchise association's annual West Coast expo next Friday through Sunday at the Los Angeles Convention Center.

Philip Zeidman is senior partner at the law firm of DLA Piper Rudnick Gray Cary US LLP. He can be reached at philip.zeidman@dlapiper.com.
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Title Annotation:state of franchising
Author:Zeidman, Philip
Publication:Franchising World
Geographic Code:9CHIN
Date:Mar 1, 2006
Words:2112
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