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As Manufacturing Exits China, Retailers Enter; H&M Targets Smaller Cities

As China gradually shifts from a manufacturing economy to one based on domestic consumption, retailers are scouring its minor cities for new sales opportunities.

Hennes & Mauritz (H&M), the Stockholm-based retailer, is leading the pack of major Western retailers moving its manufacturing out of China while moving its stores into it. As a response to the rapidly rising costs of production in China, H&M is relocating to factories in Ethiopia, Kenya and newly liberalized Myanmar, but plans to open between eighty and ninety new outlets within China, well beyond the bustling streets of Bejing, Shanghai or Guangzhou, typical destinations for Western brands.

For example, H&M is exploring smaller cities like Meishan, Daqing, Weifang, Baicheng, Zhuhai and Zhangjiajie. Matthew Crabbe, head Asia expert for the Mintel Group, said, “It’s a reflection of the strong competition in bigger cities and also a reflection of the opportunity to be had in the smaller cities. More companies are coming in and the pie is getting sliced more thinly.”

H&M isn’t the only retailer investigating less heralded cities in China. Fast Retailing Co. and Inditex SA are looking to follow suit, sending teams to these smaller outposts to assess the potential for physical retail stores. H&M CEO Karl-Johan Persson said, “The whole country is definitely getting more competitive. We’ve tested second tier-cities and third-tier cities in China and found the concept is working well.”

For some time now, the potential for e-commerce in China has been enticing Western retailers. Inditex’s Zara,Coach, Neiman Marcus all established websites in China last year. And Hugo Boss, Cherokee and Kering (the maker of Puma athletic wear) weren’t far behind, looking for cyber-access to the Chinese consumer. Now Gap Inc. has announced plans to follow suit and offer its Old Navy apparel in China sometime in late 2014.

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One thing everyone does know about Chinese shoppers is their expectation of deep discounts, always shopping for high-recognition brands marketed within special promotions. According to a study conducted by Bain this year,more than half of Chinese shoppers listed the hunt for bargains as the principal reason they shop online at all.

And there are powerful signs that manufacturing is exiting China. According to a recent survey issued by the Boston Consulting Group, U.S. companies are planning to relocate much of the manufacturing they outsource to China back to their own shores. The study interviewed 200 executives at of large manufacturing companies headquartered in the U.S. and discovered that 21 percent of them had already committed to returning manufacturing work done in China back to the U.S. or were planning to do so in the near future. Another 33 percent revealed that they were open to the prospect. The Boston Consulting Group conducted the same survey last year, interviewing the same respondents, and registered 10 percent and 27 percent respectively.

By a wide margin, the most common reason cited for “reshoring” plans is the rapidly rising costs of doing business in China, largely driven by escalating labor costs. Once a prime destination for those apparel companies looking for big production capacity and small costs, China’s swelling middle class is forcing it to reinvent itself in the global marketplace. While the average hourly earnings in the U.S. has increased approximately 1.6% each year, China  has experienced breakneck growth of 15 percent to 20 percent per year.

Persson said that shoppers in the smaller Chinese cities are enthusiastic about the retailer’s combination of cutting-edge fashion and competitive prices. He said the rising strength of China’s middle-class in these outlying cities “opens up a lot of expansion opportunities.”