To Taiwan native Samuel Su, chairman and CEO of Yum! Restaurants China, the past year has been the proudest stretch of his career. Harvard Business School included Yum! China and its subsidiary KFC China among its case studies in this year's spring semester, and the school sent a group of people to China to visit Su's management team. Speaking at Harvard to an audience of CEOs from around the globe, professor David E. Bell even presented an analysis of how KFC China has become the best restaurant model in the world. What is the reason for all the fanfare?

Simple. KFC China generates half of the chain's worldwide profits, and it exceeded KFC revenue in the United States for the first time in the third quarter of 2010 with sales of US$1.1 billion. Having not only established firm footholds in China's largest Tier 1, 2, and 3 metropolitan areas, but also in Tier 4-6 cities, KFC China now has more than 3,000 stores in nearly 700 Chinese cities, a far larger presence than McDonald's or any other rival in the sector. The chain has become so ubiquitous, Chinese consumers generally believe KFC is a Chinese brand.

The crisply coiffured, chicly dressed Su appreciates that the company's robust growth has resulted from the breakneck pace of China's development and the support and empowerment provided by its expanding middle class. These more upscale consumers have begun to eschew traditional food stalls in favor of fast food outlets, where they can relax in a comfortable environment and have a meal, drink a cup of coffee or indulge their sweet tooth.

The Changing Nature of China's Wealth Distribution

Although China's per capita GDP recently edged above US$4,000, it is still ranked 100th in the world. The developmental gaps between China's cities and countryside and its coastal and inland regions remain enormous, but the country's overall wealth distribution is gradually changing shape. Youchi Kuo, director of the Center of Consumer Insight at the Boston Consulting Group (BCG), says wealth distribution has evolved from a flat triangle into a steep triangle and is now in the process of moving toward a diamond shape. "In the future, it will be a diamond shape with the middle class in the majority," Kuo says.

According to BCG, China had over 11 million middle class and affluent households (defined as those with disposable income of US$9,000 or more) in 2005, roughly the same number as in Australia or Poland. Today, that number has risen to above 50 million households, similar to Japan. By 2020, China will have 130 million households in the category, on a par with the United States.

In terms of cities, BCG predicts that China will have 800 metropolitan areas with average per capita disposable incomes of at least US$12,590, or roughly that found in Shanghai today.

Explosion in Middle-class Purchasing Power

All of these signs point to a rising middle class that will soon unleash explosive purchasing power in China.

James C. Wei, a board member of German personal care products company Beiersdorf AG in charge of Nivea-brand products in China and Asia, says that aside from the end of World War II in Europe, there has rarely been a time in human history when such a sizable middle class has emerged so quickly at once.  

This middle-class explosion, fueled by China's rapid urbanization and the growing convenience of transportation, is likely to set off an unimaginable consumer frenzy that will sweep away China and the world.

A glimpse of the future can already be seen in the Chanel store in Beijing's glitzy Shin Kong Place mall. A Chanel bag costing over 10,000 renminbi sells extremely well without the help of promotions or discounts. Though the prices for Louis Vuitton, Gucci, Chanel and other luxury brand products are 30 percent higher in China than they are in Europe, consumers still flock to them, as reflected by Shin Kong Place's annual sales in excess of 4.6 billion renminbi.

Vendors of luxury products made 68.4 billion renminbi off Chinese consumers in 2010, and, by 2014, China is expected to account for 23 percent of the world's luxury goods market, according to a report by global management consultant Bain and Company.

There has also been explosive growth in sales of food, clothing, real estate, transportation and leisure and entertainment.

May is the peak of China's concert performance season. Pop music superstar Faye Wong performed in Beijing and Shanghai to sellout crowds of mostly white-collar workers over 30 who paid between 2,000 and 8,800 renminbi for tickets. Younger performers, such as Jay Chou, perform even more frequently in China. Chou puts on 12 concerts a year, with ticket prices ranging between 1,680-6,800 renminbi, and tickets are usually gobbled up soon after going on sale.

I Consume, Therefore I Am

Whether they are flaunting their wealth or going through a learning process, the newly affluent Chinese are collectively putting into practice a new version of an old philosophy: "I consume, therefore I am."

They learn quickly, are not afraid to try new things, and spend without reservation. Hu Angang, the director of Tsinghua University's Center for China Studies in Beijing, says China's people have opened their eyes to consumption, and through the Olympic Games and Asian Games and the rise of the Internet and modern communications, migrant workers and those in less developed regions of China are now absorbing the consumption habits of big city residents.

Even in remote Tibet, for example, a mall can be found in the capital Lhasa, and fast food restaurants do business in the northwestern outpost of Urumqi, where 10 renminbi Cokes have become a fashion symbol among the young.

Urbanites, who have already satisfied their basic needs such as food and clothing, are now abandoning mass merchandise in favor of higher quality goods, making the effort, for example, to search for healthful foods, organic produce and a healthy lifestyle.

One of the main strategies of China's 12th five-year plan, launched this year, aims to stimulate consumption to transform the country's economic development model, hoping to move away from the current emphasis on exports and basic infrastructure investment. Over the next five years, the government has targeted domestic demand to expand from 36 percent of GDP today to 42-45 percent and become the most important engine of the economy.

District governments in Beijing have even surveyed consumer groups in different commercial areas and discussed with businesses how to expand middle-class consumption to help achieve the targets of the latest five-year plan.

This drive to stimulate domestic demand has drawn the attention of local and foreign scholars alike. Economist Stephen S. Roach, a veteran observer of China's economy, said recently that China could launch the biggest consumer wave in contemporary history, one that will have a deep impact on the economies of Asia and, more broadly, the world.

Service Businesses Flocking In

Sensing the explosion in China's domestic demand, service companies in the retail, distribution, and wholesale sectors have accelerated their efforts to gain a foothold there.

Domestic and foreign retailers or channel operators that already had a presence in China, such as fashion vendors Zara and H&M, discounter Wal-Mart, fast-food chain McDonald's, China-based retail conglomerate Beijing Hualian Group, and Chinese consumer electronics vendor Suning Corp., have all, without exception, stepped up the pace of store expansion. Manufacturers, such as beverage manufacturer Hangzhou Wahaha Group, are also planning to jump onto the sales channel battlefield to close the final link that separates them from the consumer.

Taiwan-based retailers RT-Mart International Ltd., Gourmet Master Co. (which operates the 85C Café brand) and restaurant chain Din Tai Fung also plan to open new stores at a rapid pace, as do children's apparel vendor Les Enphants Co., eyeglasses retailer Formosa Optical Technology Co., and shoe manufacturer Pou Chen Group, which got its start as a Nike contractor and has built the retail sports brand "YY Sports."

Taiwanese manufacturers are changing their focus to capitalize on the Chinese consumer rush, embracing "Made for China" rather than "Made in China."

Taiwan's biggest company by revenues, the Hon Hai Group (Foxconn Technology Group), invested NT$45 billion in retailer CyberMart International to build a brand of digital product outlets that connects directly with consumers. The Taiwan-based Dachan Great Wall Group, a food group with annual revenues of 10 billion renminbi in China, has typically targeted animal feed and chicken meat markets there. This year, however, it decided to invest heavily in retail, targeting white-collar women with the "Sisters' Kitchen" brand of ready-to-eat processed foods.

The Market's Four Hidden Challenges

China's domestic demand stands to take a major leap forward in the coming year. But while its market appears tempting, the glitter masks many uncertainties. Among them are four challenges in China that carry risk and cannot be ignored.

Challenge No. 1: Soaring Operating Costs

At the same time as the costs of labor and rent continue their sharp rise, foreign and Taiwanese enterprises have also been subject to an education surcharge and urban construction and maintenance tax since the beginning of the year. Some local administrations, such as the Shanghai city government, have also imposed their own education surcharge, which businesspeople estimate will add another 1-1.4 percent in taxes. These many added costs are shrinking the operating and gross margins of companies doing business in China. 

Challenge No. 2: A Capital-plundering Market

Many of Taiwan's enterprises in China, which have maintained their traditional fondness for mid-sized operations, may feel they're surrounded by fierce packs of wolves this year as Chinese companies tap into their deep reserves of capital to expand and open new stores at a breakneck pace, spawning a new era of vicious competition.

Many Taiwanese businesses are already feeling the heat from a number of trends created by the abundance of Chinese capital – the rapid pace of innovation and change, the poaching of talent with promises of high pay, and the expansion of retail networks even if stores lose money. A number of Taiwanese companies bristle at the domineering attitude and killer mentality of Chinese companies, which convey a simple message: "If I open enough stores, I can hold on for long enough even if they lose money so that you will eventually disappear. At that point, the market will be mine."

Deep pockets are also required to gain the name recognition and build the brand needed to capture a slice of China's domestic market. As these many trends converge this year, one can sense the unfolding of ruthless predatory warfare fought with huge reserves of capital.

Challenge No. 3: Choosing between ‘Size' and ‘Strength'

Taiwanese companies have generally focused on developing strong capabilities before expanding in size. But faced with the challenges of their domestic market, Chinese companies prefer to put size before strength.

The longer Les Enphants chairman Eric Lin has been exposed to China, the more he realizes the importance of adjusting Taiwan's time-honored strategy. Initially, his philosophy was to do only as much business as his company was prepared to do, but starting this year, he has a new approach.

"Even if you are not fully prepared to do something, if you wait until you are prepared, the niche may already be occupied to some extent by somebody else. China's market changes so quickly that you only need to be 70 percent prepared and then make adjustments as you go," he says.

Lin has tried to find a happy medium between Taiwan's emphasis on "small is beautiful" and China's focus on "big is strong." And he is realigning his company's DNA to reflect the new strategy.

A majority of Taiwanese companies have not had "China-style market experience." How they handle the challenge of balancing "size" and "strength," expanding quickly on the one hand while developing the necessary talent and logistical network on the other, could decide their fate.

Challenge No. 4: The Chinese Consumer's Acceptance of Innovation

Successful experiences in other countries' markets are not accurate barometers in assessing the needs of China's consumers. "Localized innovation" is a crucial factor that may determine success or failure for enterprises in China's consumer market.

One example is KFC China. At a gathering of food and catering industry CEOs at Harvard at the beginning of the year, professor David Bell explained that the restaurant chain's success was in grasping Chinese consumers' new aspiration for Chinese flavor with Western flair.

In contrast to McDonald's, which has insisted on maintaining its Western menu, KFC began in 2002 to offer Chinese breakfast items. It has also catered to Chinese consumers' preference for new things through rapid innovation, offering 85 to 100 new menu items a year instead of the one to two new items a year averaged in the United States.

Sensing the bright prospects of the China market as it is increasingly empowered by its consumers, corporate armies are plotting deployments and weighing strategies to gain a piece of the action. Awaiting them is a battlefield of domestic demand with explosive consumption and white-hot competition.

Are Taiwanese companies ready for the fray?

Translated from the Chinese by Luke Sabatier