With China now in the World Trade Organization (WTO), the wholesaling landscape is changing. Foreign trading companies, retailers, and consumer products companies will find plenty of opportunities to generate larger profits later in this decade, a McKinsey study shows. But these gains will come at the expense of China’s domestic wholesalers, which will be hard-pressed to compete as their industry modernizes.

For China’s wholesalers are small, fragmented, and lacking in national scale, mirroring the country’s thousands of equally small, geographically dispersed retailers, which make direct distribution so unattractive financially. Because of the country’s poor roads and waterways and inadequate warehousing and distribution networks, manufacturers must rely on several layers of local wholesalers to get products to remote locations (Exhibit 1). Domestic wholesalers thus capture 80 percent of the revenues from distributing consumer products and have little incentive to change. By contrast, in the United States the corresponding figure is 20 percent, with the rest going to retailers. The Chinese government has long protected wholesalers—more than half of them are state owned—by blocking the participation of foreign companies.

As a result, wholesaling in China is a cutthroat, low-margin business—in marked contrast to the industry in developed countries, where wholesalers have...