The pros and cons of doing business in China's center of growth.

Will Shanghai's extraordinary growth continue?

Judging from the influx of business travelers, the sharp increase in foreign trade, and the continued explosive growth in foreign direct investment (FDI), Shanghai is the place to be. A look at the statistics through the third quarter of 2003 shows that Shanghai, with only 1 percent of China's population, plays a central role in the national economy: The city accounted for more than 11 percent of China's exports, more than 15 percent of China's imports, and more than 11 percent of contracted FDI through the third quarter of 2003. Further, Shanghai outpaces the rest of the country's growth by a healthy margin—more than 3 percent in the third quarter of 2003. And Shanghai's exports during this period grew more than 20 percent faster than the national average.

Shanghai seems to be intent on reclaiming its title as the Pearl of the Orient, but is it all it's cracked up to be? The short answer is "yes," but the pearl is showing some scuff marks. The massive influx of investment and rapidly improving standard of living has driven up labor costs in Shanghai, almost high enough to price Shanghai out of the market. A surge in the number of cars on the streets means that traffic during rush hour is increasingly vexing to foreign businesspeople and locals alike. Finally, a high-profile property scandal has led to increased scrutiny of Shanghai's real estate sector, and sky-high rents for Grade A space have people talking about a real estate bubble. The future viability of Shanghai's tremendous growth will depend on the municipal government's ability to address these and a host of other problems.

Problem: Labor costs are high and growing

Shanghai's rising affluence is leading the middle class to expect ever-higher wages. The influx of financial service companies and anticipation of further market opening is driving wages up and leading to frequent poaching of top financial talent among multinational companies. Most university graduates prefer such white-collar jobs to less-prestigious technical positions. Shanghai thus still suffers from a shortage of up to 15,000 skilled technicians, which pushes up the cost of qualified employees.

According to a recent Watson Wyatt survey, total cash paid to PRC employees of foreign companies in Shanghai is second only to Beijing. Compared to secondary cities in the region, Shanghai's labor and pension costs are much higher, and some of these cities advertise factory wages that are 30 percent less than those in Shanghai. A Shanghai Labor and Social Security Bureau survey of total compensation concluded that the average annual salary for a local worker in 2002 was ¥44,512 ($5,363). Foreign companies paid more than that, ponying up, on average, ¥56,931 ($6,886) for each of their employees.

Shanghai's solution: Plan 173

To combat this problem, the Shanghai government has instituted Plan 173 along with experimental preferential policies to promote investment in Shanghai's suburban areas. Plan 173, which has received little or no fanfare since it was drafted in April 2003 because it reportedly runs contrary to central government guidelines and has drawn fire from competitors, promotes investment in the 173 km2 occupied by Jiading, Qingpu, and Songjiang districts.

In essence, Plan 173 refocuses government efforts detailed in a plan released in October 2002. In its Shanghai Model Districts Investment Improvement Experimental Measures, the Shanghai government offered special investment incentives including reducing employers' pension burden from 43.5 percent of wages to 24 percent. In addition, wages in the suburbs are lower than in the city proper or in some of the leading development zones like Waigaoqiao or Jinqiao.

Problem: Traffic is bad and getting worse

According to press reports, Shanghai has 1.2 million cars on its roads today, and with more than 3,000 new license plates for private cars issued every month (the numbers in October and November 2003 topped 4,500), Shanghai's road infrastructure is struggling to keep up with the flow. According to a widely reported speech by Shanghai Mayor Han Zheng in September 2003, over the last 10 years the growth in new vehicles on the road has outstripped new road construction by a large margin. Traffic on Shanghai's elevated expressways and narrow city streets is increasingly congested, and movement on the few tunnels and bridges connecting Puxi and Pudong is often stop-and-go at best. Anecdotal evidence shows that the traffic problems are starting to hurt the productivity of some senior managers, who are unable to schedule as many meetings in a day as they have in the past because it simply takes too long to get from one part of the city to another.

Shanghai's solution: Mass transit and infrastructure development

The bad news appears to be sinking in, and the government is ready to spend a lot of money to remedy the problem. The Shanghai government is pushing forward with a massive infrastructure campaign to construct new highways, build tunnels and bridges across the Huangpu River, and expand the mass transit network. For example, the government plans to more than double the city's highway network to 543 km and build seven new bridges and tunnels across the river, increasing to 84 the total lanes of cross-river traffic. On the mass transit side, Shanghai plans to build nine new subway and light rail lines by 2012, almost quintupling the total length of subway track.

Construction of the projects to date hasn't been entirely smooth. The Number 4 subway line, which will form a loop with the Pearl Line (Line 3), suffered a tunnel collapse near the Nanpu Bridge when workers hit sandy soil, causing massive delays, road closures, and property damage. There were no official reports of casualties, but authorities charged three officials from Beijing China Coal Mine Engineering Co., Shanghai Metro Consultant Technology Co., and Shanghai Tunnel Engineering for their roles in the accident.

Problem: Real estate shows signs of a bubble

Even as the city center is being over-built with skyscrapers, record sales of top-tier properties in Shanghai are making people question how much longer prices will rise. Over the last few years, property prices for all classes of real estate have risen steadily, thanks largely to domestic investors from inside and outside of Shanghai, as well as investors from Taiwan and Hong Kong. (Interestingly, many domestic investors have been bringing money back from overseas recently to mitigate the risk of currency changes.) According to government statistics, average new housing costs have risen more than 30 percent through November 2003 over 2002 to almost ¥6,000 ($722) per m2. Yet new apartment prices (excluding renovated old houses) in the fourth quarter of 2003 appeared to be moderating somewhat. If this drop is the first sign of a popping bubble, it could be bad news for the government since a lot of investment is fueled by hopes for short-term gains, and, as soon as a downward trend appears in the market, investors seeking speedy returns may look elsewhere.

Shanghai's solution: Curbing city-center development...and enthusiasm

Shanghai recently announced a plan to restrict the growth of new skyscrapers in downtown, and is apparently considering revoking the permits of 2,700 approved buildings. Though the policy claims to address environmental concerns and city living standards, the desire to keep prices high by limiting the stock of prime downtown real estate is certainly factoring into the decision.

The central government is using such new rules and policies, as well as hints of new rules, to deter the most speculative investors without triggering a full-blown correction. These efforts have included an increase in down payments and mortgage rates for luxury home purchases, and possible changes to rules on property market trading and an increase in property sales tax.

Other cities in the east include:
Hangzhou
Ningbo

Source: This is an excerpt from an article originally published in the Jan-Feb, 2004 .issue of the China Business Review. Reprinted with the permission of The US-China Business Council, Washington D.C.