China is famous for being the world’s factory floor but it’s also fast becoming the world’s biggest virtual shopping mall. Whichever way you look at them, its e-commerce sector’s growth figures are staggering. Turnover from online shopping reached RMB461bn (€54bn) last year, up 75.3% from 2009 according to Shanghai-based market researchers iResearch. That means that about a third of everyone in China who went online, or 148 million people, bought something on the web in 2010 – not bad for an industry that started just eight years ago when credit card users were scarce.

The largest player in customer-to customer (C2C) online sales – Taobao, which has an 80% share of the market – says that last year an average of 48,000 items were sold every minute of every day on its platform. Taobao is owned by the giant Alibaba Group, founded in 1999 by former English teacher Jack Ma. It’s so powerful that when Ma was asked about Yahoo! recently, he told an audience at Stanford University that he would be “very interested” in acquring the ailing US firm and revealed that he had spoken to other potential buyers. When asked which part of Yahoo! he’d like to buy, he replied, “The whole piece,” adding: “China is already ours, right? It's already in my pocket.”

For their part, analysts are buoyant about the Chinese market’s prospects. Although growth is likely to slow somewhat over the next few years, China should still end up with around half a billion online shoppers by 2015, according to Ben Cavender, senior analyst with the China Market.

Research Group. “We are seeing close to 60%-80% growth within the consumer e-commerce segment this year, and 30%-50% growth annually (conservatively) over the next five years,” he says. “By 2015 the number of online shoppers should be more than 500 million and we are looking at a market with a size of RMB2trn-RMB3trn (€235bn-€350bn).”

With such enticing prospects, overseas players are naturally looking to join in, but as the recent failure of Groupon highlights, China is not easy to crack. To find out why, it’s worth taking a closer look at who’s shopping, how they’re shopping and why.

China’s e-commerce sector is dominated by C2C transactions. According to iResearch, C2C still commanded 86.3% of online sales in 2010. However, says Cavender, that’s changing as the C2C sector matures, B2C grows faster and the number of online retailers continues to expand. Many new B2C players are C2C sellers who grew so successful that they started their own company. There are also many online-only stores (such as clothing retailer VANCL), and existing bricks-and-mortar stores that have jumped on the e-commerce bandwagon. Those in the last category includes high-street chains such as electronics giants Gome and Suning, big supermarkets and even state-owned companies such as the telecom corporations.

This transformation is also manifesting itself in changes to what people are buying online. “In terms of product categories, we’ve seen a shift from small-ticket purchases to much larger purchases,” says Cavender. “Consumer electronics, even home appliances, have become popular.”

E-commerce growth is clearly riding on top of the background growth in the general economy and the growth of the internet both in terms of infrastructure and number of users (485 million by June 2011, according to the China Internet Network Information Centre). However, another driver is that buying online is cheaper, easier and faster. “Online items are less expensive, there is more choice online, and it is more convenient,” says Will Tao, director of analysis at iResearch. “Chinese people are very price-sensitive and show less brand loyalty.”

Access Asia, a market research company in the region, estimates, for example, that prices of electrical appliances and 3C (that's computers/communications/ consumer) products are generally 10% 15% cheaper online than in physical stores. Ask anyone here why they shop online and they’ll probably cite cost as the key factor.

Zhong Yu, a 38-year-old NGO worker in Beijing, says she buys online for just this reason. “Take this tobacco for example,” she says as she rolls a cigarette from a soft pouch of Mac Baren’s Original Choice. “It costs HK$180 (€17) in Hong Kong, but I can buy it off Taobao for RMB25 (€3).”

E-commerce’s explosive growth has prompted many new companies to skip the bricks-and-mortar stage altogether and dive straight into online retail.

VANCL is China’s biggest online clothing store. According to Access Asia, the company made RMB2bn (€235m) in revenue last year and controls roughly 30% of the B2C apparel retail segment. Its success can in part be attributed to an aggressive online and offline marketing campaign. Last summer a video ad with bad-boy novelist and social commentator Han Han went viral and helped make VANCL a household name.

But it wasn’t just Han Han’s good looks that drove sales, it was the fact that VANCL’s products are incredibly cheap. Han Han was modelling a T-shirt at RMB29, at least half the price of any high street shopping mall branded T-shirt.

Joel Backaler – a director at consulting firm Frontier Strategy Group who also blogs on Chinese consumption trends – says: “Regardless of whether the site is a store on Taobao, Dangdang (China’s first online bookshop), VANCL or others, the reason why online storefronts are so successful is because they meet the needs of Chinese netizens for a relatively lower-priced good.” And selling from their website means that they have instant access to millions of customers across the country.

“Beijing, Shanghai and Guangzhou are large markets, and usually where most traditional retailers first establish their presence, but there is tremendous opportunity beyond first-tier cities,” explains Backaler. “For many retailers it’s nearly impossible to scale at the speed of the market demand, therefore going straight to an e-tailing model offers the advantage of being everywhere at once. While distribution logistics will be challenging in more remote areas, the e-tailers’ ability to market their products across the country 24 hours a day is certainly advantageous.”

But in a country where fakes are rampant, the real secret behind China’s e-commerce growth is that customers began trusting online retailers whose payment options gave them the power to control the sale. What customers want to know is that their payment is secure, delivery will be prompt, and goods can be returned if they are not up to scratch or simply counterfeit.

“The biggest boon to online shopping was the development of payment processes that consumers trusted,” says Cavender. “Due to the high number of scandals involving dangerous, substandard or misrepresented products, Chinese consumers are extremely cautious. There is a very real fear not just of being ripped off and sold a fake, but of buying something hazardous.”

Online payments are not released until the customer signs off, which could be in the form of cash on delivery, a credit card payment or through an intermediary escrow system such as Alipay (also owned by e-commerce monster Alibaba). Alipay, Cavender says, “has to be credited with easing consumer fears over shopping online”. Furthermore, look at any Chinese e-commerce site and you'll see it’s crawling with phone lines and QQ contacts (an instant-messenger service that's wildly popular here), so that the customer has plenty of access to the company’s staff to ask about the goods and complain if necessary.

This trust has now spread to users of bank cards, Cavender adds, with Chinese people now increasingly willing to link their credit and debit cards to an online shopping account. As analysts are quick to point out, however, the biggest stumbling block has been distribution services, which, while expanding to keep pace with rising orders, are not quite up to scratch. Says Access Asia’s Matthew Crabbe: “Most sites in China still hinge on crappy warehouses full of cheap labour packing goods to dispatch by courier.”

At the beginning of this year, a video showing packers kicking and throwing parcels around for fun at courier company Pudong Jinqiao ShenTong Express ended up doing the rounds on the internet. As a result, the company was slapped with a RMB60,000 (€7,000) fine and a one-month suspension of business.

“Right now in China, e-commerce is almost a victim of its own success,” says Cavender. “Because the market has grown so quickly over the last two years, companies have run into a distribution and logistics bottleneck. Consumers have become used to demanding same-day or next-day delivery of products but there are not enough warehouses or competition shipping providers to actually move goods across the country efficiently.”

Things are changing, though, with many of the bigger stores investing in their own distribution networks. Taobao, reportedly, will have delivery centres in 52 Chinese cities by the end of next year. “This year and next, we’re likely to see a big push by e-commerce entities to develop this infrastructure,” says Cavender.

Can Western counterparts hope to take advantage? Many analysts are sceptical, pointing out that the e-commerce market is much more localised than the general internet business model.

“There is tremendous opportunity here but it is not simple to enter the market and be an immediate success,” says Cavender. “Consumers gravitate heavily towards the major e-commerce platforms because they know they have recourse if there are any problems. Right now almost 80% of B2C transactions are running through Taobao, so the market is very centralised.”

Western firms, he advises would do well to copy that model. “We are seeing more and more foreign firms like, say, Uniqlo developing successful e-commerce storefronts to augment their bricks-and mortar sales, but in many cases they work with a company like Taobao to actually run their e-commerce platform for them.”

Historically, overseas companies haven’t bothered to try to understand the Chinese market first and that’s what throws them, says Backaler. “China’s e-commerce market is not as mature as its counterparts in the US and Europe, thus when a Western firm adopts the typical approach of ‘transplant and translate’ [i.e. take their existing portal, translate it into Chinese and then expect success], it often fails.”

Western companies, Backaler argues, charge into China and fail largely because they are arrogant. He points to Groupon as the most recent example. The Chicago based online group-buying site teamed up with China’s largest internet service portal, Tencent, this year to launch a Chinese version – gaopeng.com – into what was admittedly an overcrowded market. By the summer, Groupon was closing down offices and laying off hundreds of staff.

“Groupon’s arrogance made many enemies in China,” says Backaler. “Before Groupon even entered China, the US firm proclaimed that it would become China’s largest shopping site. It tried to copy its European strategy, which was to use high salaries to poach competitors’ top employees, but was stumped when a group of Chinese group-buying sites joined forces to warn staff that they would never be hired again if they worked for Groupon.”

The company also employed expats to run its operations around the country with little understanding of the local culture. “You had a situation in which foreign managers were managing Chinese employees with a Western style, and seeing very low efficiency, because employees did not respect or feel loyal to their managers. As a result Groupon experienced tremendous employee turnover.”

Similarly, eBay lost out to Taobao a few years ago because it simply copied its US model, which took a cut of transactions to make money. Taobao made its services free to users and made money from advertisers instead. Naturally enough, Chinese customers went for the cheaper option.

Backaler does not expect this to change in the next five years or so. China’s “online consumers have preferences and tastes that simply cannot be effectively targeted by foreign firms”, he says. “The biggest trend that will continue to develop over the next three to five years is the number of small scale e-tailers who scale their operations and register as formal corporations.”

But if the temptation of half a billion online shoppers is too much to resist, Access Asia’s Crabbe says that overseas firms should consider buying their way in rather than simply muscling in.

“Foreign companies will do best to watch strong local competitors emerge, buy them just as they are getting interesting, and use investment to grow on that interest,” he says.

‘TRUST HAS BEEN A BIG CHALLENGE’

One foreigner who has won over the Chinese online shopper is French born Aline Conus (pictured above). She set up Yangjiu.com (the word means 'Western alcohol' in Chinese) in 2007 after realising that there was an untapped market for selling high-grade imported wines and spirits to China’s nouveaux riches over the internet. She launched it as a one-woman show and has nurtured it into one of the top online foreign wine e-tailers in China, with a staff of 15. Last year, Conus says, the company made a profit of around $2m. Here she talks to CNBC Business about modesty, mistakes and millionaires.

WHO ARE YOUR CUSTOMERS?
We have three main groups. Firstly, the white collars, the younger generation of Chinese who have just started working and doing well for themselves. They want to try new things, new brands and imported products. They are very curious and they need a lot of information. The second group is the VIP client. These are successful entrepreneurs. They really want the best. They find it really cool to buy online, and they can afford to buy everything. The last group is made up of corporate clients who buy our products as a gift.

WHAT WAS THE MAIN PROBLEM IN SETTING UP THIS COMPANY AS A FOREIGNER?
Having learned business abroad, I tried to design a company tree and it was a big challenge. But my Chinese counterparts didn’t do that because they knew it would be impossible, it’s not part of the Chinese culture. They just hired people, gave them each a desk and said: 'OK, you do this today.'

WHAT KIND OF MISTAKES HAVE YOU MADE?
One of the biggest was trying to sell our famous brands based on their history. For example, wines from Bordeaux are the most famous wines from all over the world and we tried to sell them on where they were from, why this one is good, and it tastes like this... and this was a big mistake. The way we do it now is to sell Bordeaux as a brand. It’s a luxury brand as much as LV or Gucci is a luxury brand. It is a very famous, very glamorous luxury brand. So Bordeaux is a brand, cognac is a brand, XO is a brand.

HOW DO YOU INSPIRE TRUST AMONG YOUR CUSTOMERS?
Trust has been one of the biggest challenges that we faced in the first two years and that’s true for pretty much any e-commerce player in the market. We spend a lot of our resources on this, publishing documents from the customs bureau to show that our products are genuine. We only sell imported goods.

We put them on the website, we emailed and faxed them to clients. Our customer teams are pretty much full time talking to customers on the phone about how our products are imported and so on.

WHAT ADVICE DO YOU HAVE FOR OTHER ONLINE SHOPPING SITES HOPING TO BREAK INTO THE CHINESE MARKET?
You should listen to the consumer more than you would do in the West, and have a lot of modesty, because even if you are very, very successful in the West or in Japan or other markets, you will need to twist and change a number of things to appeal to the Chinese consumer in your marketing, in your customer service, in the way you serve your customer. You will need a lot of modesty when approaching the market because you will need to change a lot of things that work elsewhere. And you will need a lot of luck.

‘WE WANT THE SITE TO LAST 100 YEARS’

Online shopping has grown so popular over the past five or six years that many individual C2C sellers in China have moved on to running their own fully fledged B2C companies. One of the most successful is Shanghai-based Lemon Green Tea (nmlch.com), founded by Wang Weidong, 37, and his wife Zhang Dinghua, 32 (pictured). The couple started selling cosmetics on Taobao from their home in 2003. Today they run an operation with more than 100 staff and have expanded their merchandise to include clothes, foodstuff s and jewellery.

WHY DID YOU START LEMON GREEN TEA?
In 2003, my wife and I quit our jobs and started selling cosmetics on Taobao. We did it because both of us knew a lot about the internet and we liked the cosmetics business. In the beginning it was just the two of us and it grew steadily from there, bit by bit. In 2007 we won best Taobao shop with 200,000 positive ratings. The next in line got 85,000.

WHY DO YOU THINK YOU HAVE BEEN SO SUCCESSFUL?
We think like buyers first, and then like retailers. We chose cosmetics because that’s what we’re interested in, so we can also understand what our customers want. Whenever we make a decision or try to solve a problem, we put ourselves in the role of a customer. And that’s how we’ve always done it. Sometimes we even buy stuff off our own site to see how it’s working. That it’s what you want as a customer.

TRUST IS A KEY ISSUE WHEN SELLING OVER THE INTERNET. HOW DO YOU WIN YOUR CUSTOMERS’ TRUST?
We are willing to take responsibility. If we are in the wrong, we always compensate the customer. If there’s any problem with our service, we will always take the initiative to make a public apology.

WHAT’S THE BIGGEST HURDLE YOU’VE HAD TO DEAL WITH?
We want Lemon Green Tea to be around for many years to come. It’s not just a vehicle for us to make a quick buck. In 2008, some venture capitalists offered to invest in us but we refused them because most of these companies work on a get-rich-quick model. They act like they are fattening up a pig to sell, even to sell for slaughter. We want to work hard and make Lemon Green Tea into a company that will be around for another 100 years and more. In 2009, after two years looking fruitlessly for an investor who thinks about the long term, we gave up and now we’ve decided we won’t look for investment. Instead we’ll just use our own funds.