Chemicals offer a compelling example of the way China can drastically alter the competitive dynamics of a global industry. With long-term demand expected to grow by 6 to 8 percent a year—compared with 2 to 3 percent in North America and Western Europe—the country is the world's most attractive market for commodity and specialty chemicals alike. Demand comes from both rising domestic consumption and the country's thriving exporters. Like companies in other industries, the world's biggest chemical makers are focused on exploiting this rich market's potential.

While these companies ponder when and how to engage with China, their biggest customers at home—manufacturers of textiles, electronics, and automotive vehicles—are rapidly moving production capacity there to take advantage of lower costs and the big domestic market. Once established in China, these manufacturers will start to reconsider their chemical providers. Chinese producers are maturing, and many of them can offer the quantity and quality of chemicals needed to serve the domestic market, including the factories of Western companies, in diverse product categories. And in some niche chemical markets, the Chinese already compete globally.

Where does this leave the multinational chemical players? They must not only continue to look for growth opportunities in China but also fight a rearguard action to protect their contracts with important longstanding customers as well as their global market share. Many will find that they have good reasons for building plants in China to serve the domestic or global market—or, eventually, both. What the multinationals do will shape the future of the world chemical industry.

Migrating to China

We estimate that China's share of world factory output will rise to 25 percent within 20 years, from about 7 percent today. Foreign direct investment in China also continues to rise. Companies that buy huge amounts of chemicals for their manufacturing processes are in the vanguard of the migration to China. Volkswagen, for example, plans to spend more than $6 billion on production facilities in the country by 2008, and General Motors intends to invest $3 billion in projects there during roughly the same period. Carmakers and their suppliers around the world spend $55 billion to $60 billion a year on commodity and specialty chemicals—about 5 percent of global turnover.

The pace of the migration will vary by industry. Textile manufacturers—another large chemical market, with annual purchases of $75 billion to $85 billion a year globally—have already set up shop in China. Electronics companies are flocking there to make CD and DVD players, televisions, and many other consumer products; LG Electronics and Samsung of South Korea, for instance, had built 24 plants in China by the end of 2003. The migration will be much slower for other big buyers of chemicals. In industries such as construction and building materials, knowledge of local markets and relationships with decision makers will ensure that established domestic producers continue to dominate local supply.

Meanwhile, the new Chinese subsidiaries of overseas companies exercise growing influence over decision making in areas from product development to procurement. General Motors, Volkswagen, and Xerox, for example, are in the process of giving their Chinese divisions direct control over the specification of products and the selection of suppliers. One result of this trend is that local managers increasingly turn to Chinese suppliers to take advantage of their lower costs if the quality of their products is sufficiently good. In fact, manufacturers switch almost as soon as an adequate local source becomes available. The pace of this shift in the locus of decision making will be faster for inputs that are less critical to the quality of a company's end product and for industries and companies whose culture favors decentralized authority.

Chinese competitors are on the move

The global chemical industry comprises hundreds of segments that make, in all, more than 70,000 products. About two-thirds of global sales come from commodity chemicals. Generally, several multinational players with huge capacities and sales volumes dominate individual commodity segments, whose size makes it hard for new entrants to have an impact on the global market. Specialty chemicals account for the rest of world demand. Although there are more than a hundred specialty-chemical manufacturers, a few generally control each of the segments. Since some of the segments are relatively small, a new competitor with a single plant can have a noticeable effect on prices and market share.

Until recently, Chinese chemical makers haven't posed a competitive threat to global players, either in China itself or in world markets, because the domestic industry was fragmented, mostly state controlled, and inefficient. China met about 40 percent of its domestic demand in 2003 through foreign purchases, particularly from Japan, Singapore, South Korea, and Taiwan. Although the country remains a net importer of chemicals, local producers are starting to make waves. Two Chinese petrochemical giants were founded recently—PetroChina in 1999 and Sinopec¹ in 2000—and they have begun to consolidate the domestic market. Both remain controlled by the state, but they also have overseas listings, which add to the pressure for increased efficiency. Furthermore, many private entrepreneurs are now manufacturing specialty chemicals. From 2000 to 2003, the annual turnover of all domestic chemical makers rose to $113 billion, from $68 billion, with most of the growth coming from sales inside China (Exhibit 1). The increase, however, wasn't enough to meet rising domestic demand, and imports over the period also grew to $64 billion, from $31 billion.

In commodity chemicals, Chinese companies within the PetroChina and Sinopec groups primarily serve domestic demand; for the moment, they have little impact outside China. But these producers increasingly supply the multinational companies that are moving plants there and then dropping their traditional suppliers. As domestic demand increases, local and multinational producers will continue to vie for it, with Chinese companies using their market knowledge and established domestic networks to counter the foreign players' technological advantages and management skills.

By contrast, Chinese producers of many specialty chemicals can have an immediate global impact. In the late 1990s, for example, a Chinese entrepreneur took note of rising imports of a specialty intermediary chemical (used as a processing input in certain industries) and opened a small plant to meet local demand. This company, prompted by its domestic success, rapidly increased capacity and began exporting its products. Low factor costs allowed it to undercut competitors, and its entry into the global market brought down prevailing prices by about 40 percent (Exhibit 2). As of the end of 2003, the company was one of the leading global players in its niche.

It is hardly the only Chinese chemical producer that benefits from low factor costs. Chinese companies can produce nutritional and health supplements about 25 percent more cheaply than US manufacturers do, for instance, even when the cost of shipping to the United States is factored in. As a result, almost three-quarters of such products sold there come from China. Multinationals can match these labor savings by moving production to China, but other local advantages are harder to replicate. We estimate that by following local standards, for example, a Chinese company can build a specialty-chemical plant at a cost 30 to 50 percent lower than that of plants built outside China. Multinational companies—conscious, among other things, of the risks to their reputation posed by skimping on health, safety, and environmental measures—find it difficult to match these savings fully even within China.

Playing the market

Multinational chemical makers see both growth opportunities and competitive threats in China, and sometimes it isn't clear how to tell the one from the other. When chemical customers move production to China and increasingly turn to local suppliers, Chinese chemical makers obviously find a ready market and a chance to hone their production skills in preparation for exporting regionally or globally. But that apparent threat to the multinationals is mitigated by the increase in Chinese domestic demand, which makes the market more attractive for everyone.

The right response to such opportunities and threats will vary by product (Exhibit 3), which complicates matters for global companies active in a variety of segments. In any case, the market is developing so rapidly that the wait-and-see approach some companies have followed is no longer appropriate; companies will have to decide now whether to build plants in China or to fend off attackers in other ways. Since rising imports to meet growing domestic demand will eventually draw Chinese entrepreneurs with low cost bases into the market for just about all chemicals, any decision to serve the country from faraway plants may be risky. In many cases, such issues will force multinationals to produce chemicals in China.

These companies must weigh three considerations when deciding whether to build capacity there. First, they must estimate the potential presented by China's domestic market, including multinational customers. Then they must judge whether the factor-cost advantages of using the country as a production base can help them serve the global market more competitively. But since the Chinese producers will likely benefit from still lower factor costs, this alone shouldn't tip the decision unless a company has superior technology or execution skills. Finally, a company must think about whether such a move would likely preempt multinational or local competitors.

Once a company decides to set up plants in China, the current development stage of its market could indicate how to utilize that capacity. If a market segment in China is still in its infancy, the best strategy might be to build production primarily for export; experience gained working in the country would set the stage for a more comprehensive presence later. As local consumption increased and local customers became more demanding—and particularly as more multinational customers built production capacity in China—multinational chemical companies could think about establishing complete business systems there, from procurement to production to marketing and sales. At that point, local buyers will want close relations with their suppliers, which can offer this kind of support only with a fully loaded presence. But moving to this level of service before the market demands it could be a waste of resources.

Sustainable advantages may help some companies serve China's market from overseas factories

In some instances, companies with unique technology or some other sustainable advantage, such as low costs outside China, may opt to continue serving the Chinese market from factories overseas. Middle Eastern companies, for example, have very low feedstock costs and can therefore produce polyethylene—plastics used in many industries—in local plants and then sell to customers in Asia and other global markets. Other factors can also come into play. The German specialty-chemical maker Degussa, for instance, is following a similar approach for methionine, an amino acid used in animal feed. Although China is the world's fastest-growing market, the company decided in 2003 to invest €350 million to build a new plant in Antwerp, where it already has other methionine plants. The move takes advantage not only of existing infrastructure and supply chains, which keep feedstock costs down, but also of Degussa's technological superiority in the field. With a capacity of 150,000 tons a year, the new plant will be the world's largest methionine facility when it opens in 2005.

Yet even when a decision to serve the Chinese market from abroad makes sense, it is still risky. As Chinese imports of a product rise, it could attract the attention of local entrepreneurs. A multinational that seems to have solid advantages today could lose them as domestic players gain experience and expertise.

As for exports by Chinese chemical companies, the threat generally increases as the supply chain becomes more global. The most important factor is the way transportation costs relate to the final price of a specific product: if they are proportionally small, lower factor costs, such as labor, can offset them. A close look at five major multinational companies shows that over the next three to five years, about half of the products of Chinese manufacturers, shipping competitively from their domestic plants to the rest of the world, could make strong gains on the global chemical market. The threat is much more acute in specialty-chemical segments, since these smaller markets are easier to disrupt.

Some segments, including pharmaceuticals, agrochemical raw materials, and intermediaries, will give established multinationals cause for concern. While the limited size or growth prospects of China's market might argue against investment in production there, lower factor costs could create savings. Moreover, smaller Chinese companies could exploit cost advantages to attack the global market with unbeatable prices. Once Chinese products reach international standards of quality, consistency, and reliability, they are likely to snatch substantial market share quickly. Even if they don't, companies that use these products will exploit the existence of the low-cost Chinese alternative to demand lower prices from others.

Multinational companies in these specialty-chemical markets will feel the pressure soon if they haven't already. They must restructure their global supply chains by closing inefficient sites and sourcing more supplies through local procurement offices or their own production facilities. But even after cutting costs as much as possible, they will probably still see margins shrink in the face of Chinese competition. If the threat comes from a single strong Chinese player, allying with or acquiring it might be the best strategy. Inevitably, some companies will be left with the unpalatable task of managing declining specialty-chemical businesses and slowing down the process as much as possible while also considering exit strategies.

The threat Chinese companies present to global commodity-chemical markets is generally less urgent, for they are so large that new players cannot quickly build enough capacity to have a noticeable global impact. But as customers continue to migrate to China, supply chains will shift considerably. Here too, the situation bears watching.

The global chemical market is changing quickly, and the epicenter is China. Local demand there will have a big effect on production and consumption patterns all by itself, and as overseas companies migrate to China, their chemical suppliers in the developed world may face a dwindling customer base at home. Many chemical companies will become unprofitable and may be forced to close inefficient plants in the United States, Europe, and Japan. The range of options is narrowing, and no single strategy guarantees success. But one point is clear: the risks must be tackled now. Top-executive stewardship is vital in creating the optimal strategies, in allocating financial resources to implement them, and in dispatching the right managers to move them forward.