One of the most interesting parts of doing market research in China is learning about the innovative ways of doing business. A few weekends ago the fracas over the China launch of the iPhone 4S at the Apple store in Beijing got me thinking. If you haven’t followed the story, basically, the store was meant to open in the morning and people had queued all night for a chance to buy one of the new phones. The store eventually never opened that day with Apple citing staff safety concerns much to the ire of the people who had braved the cold.

If you look at pictures and reports of the event, it’s clear that many of the people who were queuing and waiting were not necessarily the typical iPhone user. Many of them are in fact what are called huangnius (yellow cows) who are the scalpers who buy the iPhone 4S at retail for about US$790 (as compared to US$650 in the US for a 4S 16GB unlocked) and then sell it on the gray market for a 20%+ markup.

Huangnius are not just limited to electronics though. Actually the first that I had heard about them was when I arrived to shanghai a number of years ago and wanted to exchange RMB for USD. You can go through the banks, but as the currency is capital controlled, you are limited to how much you can convert. No limits to the amount of RMB the huangniu will buy though, of course you’ll have to take his rates, but if you need the USD, you need the USD. The award for best business model though, has to go to the huangniu that are involved in the pre-paid card industry.

As we discussed in previous commentaries, pre-paid cards in China are very popular and are often given by companies as part of an annual bonus to their employees. A key part of that equation are the ‘fapiao’ or official invoices that they receive for the cards. In order to account costs in China, you need to have an official fapiao that is submitted to the tax authorities to show that you actually did incur an expense and aren’t just faking invoices. There are of course ways that companies counterfeit fapiao or buy actual fapiao, but that is a whole separate subject.

Back to the prepaid cards and the huangniu, so in the west, there are of course a number of companies that will give you money today for your money tomorrow. Similarly, the huangniu openly purchase pre-paid cards. So let’s go through how this whole process works:

A large company, let’s call it ACME, will purchase a number of prepaid cards from a prepaid card issuer such as a large retail store chain for typically what is the actual face value of the card, let’s say 1000 rmb (renminbi or rmb for short is another name for Chinese Yuan; 1000rmb is about US$150). ACME will pay the issuer and receive the official receipts (fa piao) from the issuer and be able to claim either as a business or salary expense depending on ACME’s accounting and then will give the cards to their employees as part of their annual bonus or just as part of their regular compensation.

Now, say the prepaid card is only good at the issuer’s store and the ACME employee who received the card rarely shops at that store, or just really needs the money right away. They can then contact a huangniu who, if it is a popular kind of prepaid card, will buy it off the ACME employee for a certain percentage of the original value, let’s say 800 rmb in this case. The huangniu at that point has a number of options including reselling it to an individual consumer who might be interested in the card for say 900rmb, thus making a 100rmb profit. This makes a lot of sense, and when it was explained to me, wasn’t surprising.

What was surprising to me in this case is that the huangniu will sometimes sell it back to the issuer themselves. So think about this, the issuer has sold the card for 1000 rmb and immediately that becomes a liability for the company (similar to a loan for a bank) as the user can then use that card to purchase goods. Not trying to make things overly simple here, but what the issuer would love is that the users never in fact use the cards and they expire along with their complete value. That 1000rmb suddenly moves from being a liability to a cash asset. If that isn’t possible, the issuer would want to get the most value back from the card as possible.

So to do that, the issuer will actually buy the unused card from the huangniu at a slight discount. In this case, say it was 900rmb. So the issuer has cleared off 1000rmb of liabilities for 900rmb and everyone in the ‘value chain’ is happy. The issuer is happy as they make a tidy profit and are then able to reissue the card at the same 1000rmb value which accelerates the velocity of the card in the market so that it appears more popular. ACME is happy because they have compensated their employees and have received official receipts which they can then deduct from their tax bill. Employees are happy because they have 800rmb in cash. Huangniu are happy because typically the sellers are buyers of these cards are fixed which means steady regular and predictable profits.

The values used here are just examples. From others in the industry it seems that these arrangements happen for as little as a 1rmb discount on each card. So the huangniu will buy the card for 99rmb instead of 100rmb and then sell it for 99.5 rmb or similar. Even with such a small discount, they still manage to make huge profits through volume.

The key takeaway from all of this is that China is developing rapidly and many of the regulations in and around the finanancial services industry are somewhat vague and often allow for loopholes similar to the model I laid out above. These inevitably will be sorted out in the future, but for now, it is another example of the inventiveness of the market players and the lack of specific regulations preventing what is essentially a huge tax dodge and license to print money.