CKGSB Professor Jack Chen on why the government should level the playing field in the Chinese retail industry.

China’s economic growth might be at a 24-year low, but the country’s e-commerce sector continues to boom. Online retail sales in China grew by 49.7% to RMB 2.8 trillion in 2014, which accounted for 10.6% of total retail sales of consumer goods (RSCG), according to the National Bureau of Statistics.*[i]

And the market leader is undoubtedly Alibaba. According to estimates released by Morgan Stanley, the total gross merchandise value (GMV) of the company’s platforms (mainly Taobao and Tmall) is expected to reach RMB 759 billion during the September to December period, making its annual GMV in 2014 RMB 2.2 trillion, or 78.6% of China’s total online sales.

For international investors, Alibaba’s formidable dominance in the Chinese market is one of the biggest lures. However, for the traditional retail industry in China, the disruption it brings is fatal, says Xinlei (Jack) Chen, Professor of Marketing at Cheung Kong Graduate School of Business. Chen says that despite the benefits Alibaba brings to small businesses and consumers, platforms like Taobao do not make supply chains more efficient or increase profitability for manufacturers. To build a robust retail sector that can support China’s shift towards a more consumption-driven economy, he says, e-commerce companies alone are not enough.

In addition, Chen also believes that Alibaba’s market share is going to dwindle as other players like JD.com and Amazon China grow their own fan base. The two accounted for about 20.6% of the business-to-consumer (B2C) market in China, where Alibaba’s Tmall controlled a 57.6% share, a report by iResearch showed last year.

In this interview, Chen explained the limitations of Alibaba’s Taobao and how policy makers could nurture a strong retail industry.

Q. Led by Taobao, e-commerce in China has been growing very fast in the past few years, which has, in turn, impacted offline retail businesses. What effect does that have on the economy?

A. One important reason of the rise of Taobao is that it fulfills the need of millions of small manufacturers to directly face consumers. Another reason is that there were no players like WalMart or Target in China’s traditional retail industry. Till today, China still lacks retailers who can integrate industrial resources effectively on a national level. It’s a hurdle that the industry must overcome.

Traditional retailers must get back on their feet because Taobao alone is not enough to support a healthy retail industry, which is crucial to China’s economic transformation towards a demand-driven economy. The country needs a system that combines both online and offline players as well as an equal environment for all competitors.

Q. Why isn’t Taobao enough? What does it lack?

A. Taobao’s business model means that it depends too heavily on consumer traffic. Taobao makes money because merchants selling on the platform need to buy ads or promotions from it to get a share of the traffic.

But except for traffic, Taobao doesn’t provide merchants with other value. Some are saying that big data will make the platform more valuable for merchants, but so far it remains unclear if big data is going to become Taobao’s core competence in the future.

As for the consumers, the main value that Taobao gives them is low price. But as Chinese consumers mature, their needs are going to go beyond cheap goods; they’ll need a better shopping experience and after-sales service. If Taobao’s competitors, either online or offline, can fulfill those needs better, they can easily grab a share of Taobao’s traffic.

In the online space, for example, more people might choose JD.com for expensive products like home appliances and electronics, because it controls its own logistics and customer service so that people do not have to worry about individual sellers’ credibility. People who want to shop globally might prefer Amazon China because it provides authentic products in foreign markets at reasonable prices. These values can help them build brand loyalty among consumers, which is more reliable than traffic.

Q. So we need various types of e-commerce players to meet consumers’ needs. But why do we still need strong offline, or multi-channel retailers?

A. In theory, for products that consumers don’t need to touch or feel physically before buying, there’s no need to sell them offline. But I think we need the offline experience with most of the products, especially those new and innovative ones.

Compared with pure e-commerce players, the key disadvantage of traditional retailers is price. Even though they can make it up a little by providing unique customer service, they still need to lower prices as much as possible. And that’s when size matters—the bigger you are, the more effective you can be on reducing costs.

So what we see in the US is that traditional retailers like WalMart are not dying because of Amazon. Instead they launched their own online selling platforms, which was relatively easy to do given their existing supply chains. In the US, retailers who have both online and offline channels have had higher compound growth than pure e-commerce players in the past couple of years.

Q. If a multi-channel approach is so important in retail, will the market correct itself and allow such retailers to thrive?

A. The market force alone is not enough in China. One reason is that e-commerce flourished in China before any strong national retailers had emerged. Another is that there’s a lot of capital supporting pure e-commerce players. They can afford to lose money during the competition because investors are betting heavily on them to wipe out others and dominate the market. So I think the government should step in and level the playing field.

Q. So what can the government do?

A. There was a lot of discussion about enforcing sales tax on small online merchants (B2C retailers already pay taxes). I think it might still be a little early to do this because those small businesses still need more time to grow. But in the long run, taxation is evitable. And once that happens, prices on e-commerce platforms will very likely go up.

Another possible measure is cracking down on fakes. There are still a lot of fake products online today, and I believe they are more harmful than offline fakes because they are concentrated on big platforms that are in front of consumers all over the country. As a result, a lot of consumers have lost faith in product quality and become extremely sensitive to prices.

The government should also encourage mergers and acquisitions in the retail sector so that strong players can emerge to compete. They can do this by announcing tax breaks or favorable bank loans.

Q. Wanda, which is in the traditional retail sector, is teaming up Baidu and Tencent to build a new e-commerce company. Is this going to be a model that others can learn from?

A. It sounds like a very good idea—Baidu and Tencent can bring traffic to Wanda’s online or offline merchants. But I’m not quite sure if they are going to work together smoothly—these are three very big companies and each of them has its own interests to look out for. Given their sizes, the joint investment doesn’t seem very significant (RMB 5 billion, or about $805 million). And that’s why I’m a little skeptical at this stage about how serious their cooperation is.

[i] Not all online sales are counted as RSCG by NBS

(Images courtesy: Flickr user Chuck Coker’s photostream)