SHANGHAI – When you think about centres of technological innovation, Silicon Valley, Seattle, and Seoul are probably the first places that come to mind. After all, they are the homes of Amazon, Apple, Facebook, Google, Intel, Microsoft, and Samsung – companies whose innovations transform the way other sectors, from financial services to telecoms and media, do business.

Now, however, the rise of "e-tail” (consumer-facing e-commerce) in China is enabling Hangzhou – the base of Alibaba, China’s largest online retailer – to join their ranks. 

Indeed, on April 29, Alibaba signalled its ambitions by buying an 18% stake in Sina Weibo, China’s version of Twitter. And, as with technology hubs elsewhere, innovations born in Hangzhou are determining the development path of related industries.

China’s e-tail market is the world’s second largest (after that of the United States), with an estimated $210 billion in revenue last year. Since 2003, the market has posted a compound annual growth rate of over 110%. By 2020, China’s e-tail market could be as large as today’s markets in the US, Japan, the United Kingdom, Germany, and France combined.

Despite a broadband penetration rate of only 30%, e-tail commanded 5-6% of total retail sales in China in 2012, on par with the US. And the sector is already profitable: Chinese e-tailers are logging margins of 8-10% of earnings before interest, taxes, and amortization, which is slightly larger than the average margin for physical retailers.

Two features of Chinese e-commerce stand out. First, roughly 90% of Chinese e-tail is conducted on ad-funded virtual marketplaces. 

On these platforms – which resemble eBay and Amazon Marketplace – manufacturers, retailers, and individuals offer products and services to consumers through online storefronts. By contrast, in the US, Europe, and Japan, roughly 70% of the market is composed of e-tailers running their own Web sites, whether online-only merchants like Amazon or traditional brick-and-mortar retailers such as Carrefour, Dixons, and Walmart.

Moreover, according to a study by the McKinsey Global Institute, online purchases in China do not simply replace offline purchases. Rather, e-tail supports incremental consumption: $1 of online consumption seems to generate roughly $0.40 of additional sales. 

And incremental spending as a share of total spending is even higher in China’s less-developed cities, where a shortage of brick-and-mortar retailers means that online shopping provides access to otherwise unavailable products and brands.

Mass consumption in China and other emerging economies is coming of age in the Internet era. Given that industry structures are still developing in many of these countries, e-tail is set to shape not only the retail landscape, but also the manufacturing and financial-services industries – and even the urban landscape itself.

In most countries, the retail sector has typically developed in three stages: first, local or regional players dominate, before a smaller number of national companies takes over, with e-tailers ultimately challenging traditional businesses. 

But China lacks national leaders, with the top five Chinese retailers in different product categories commanding less than 20% of the market, compared to up to 60% in the US. And establishing a strong physical presence throughout the country will be time-consuming and expensive.

By contrast, Alibaba (which owns marketplaces such as Taobao) and 360buy.com (which focuses on electronics) rank among China’s top ten retailers, and already provide national coverage through the reach of express delivery companies. As a result, China’s retail sector seems more likely to follow a two-stage development path, with e-tailers emerging as the major national players.

The ability afforded by online marketplaces to new players to attain national – and international – prominence without massive upfront investment will profoundly affect how both retailers and manufacturers approach new consumer markets. The Japanese retailer Uniqlo, for example, used such marketplaces to expand into China in 2009.

Likewise, by removing some of the benefits of scale and specialization that characterize the consumer-goods industry elsewhere, e-tail enables new manufacturers to join the market, selling goods like apparel and cosmetics directly from workshops and factories to consumers. Such businesses are also leveraging their broad access and widely recognized brands to expand their role in the financial-services sector.

Richard Dobbs is Director of the McKinsey Global Institute, while Richard Cooper is Professor of International Economics at Harvard University.

Copyright: Project Syndicate