The risks of the Middle Kingdom - Phil Taylor

IBA Global Insight assesses the issues facing foreign investors venturing outside Beijing or Shanghai.

We’ve all heard the China Miracle hyperbole: unstoppable growth, huge untapped potential, an incubator for millionaires. Most of us have probably heard the doom and gloom about the country’s hinterland, too – the stories of stolen IP, tales of rampant corruption, and predictions of impending burst-bubbles. It can be hard to know what to believe, and on closer inspection it seems there is truth in both sides of the story. There’s no denying that there are still plenty of opportunities to make money in China. But it’s also clear that China’s investment landscape is changing.

Although they still have further to go, China’s first-tier cities (Beijing, Shanghai, Guangzhou and Shenzhen) are now well-developed bastions of capitalism – albeit with a very strong socialist flavour. For those cities, to quote Churchill, ‘it is, perhaps, the end of the beginning’. Foreign money is increasingly flowing further inland as smart investors follow the lead of the Chinese Government’s Go West programme. (Although it was originally intended to last ten years, the plan, which was launched in 2000, appears to have been given a new lease of life with a new injection of capital into the country’s western areas in July 2010.)

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China’s so-called second- and third-tier cities (see sidebar Life in the provinces, p39) offer many benefits when compared with Beijing and Shanghai. The most obvious is financial: there is a arge potential market and labour, rent and essential services are cheaper. Rail and air transport links to the financial and political capitals have improved vastly in recent years, and some cities offer international direct flights (Hangzhou, for instance). Shanghai-based Freshfields Bruckhaus Deringer partner Alan Wang says that although lots of tax advantages have been removed since 2008, there are still plenty of incentives available to foreign investors, including cheaper land and government grants and subsidies. This is particularly true in so-called encouraged sectors (such as healthcare, biotech, renewable energy and agriculture technology).

Another apparent advantage to China’s smaller cities is competition, or, more accurately, a relative lack of it.

‘Depending on your industry, second- or third-tier cities are much less crowded markets and can be easier to penetrate,’ says Ronan Diot, chair of the legal working group of the European Union Chamber of Commerce in China.

Horror stories

In the real world, of course, every silver lining has a cloud. As in any country, investing in a less-developed area has its drawbacks and risks, and China can sometimes yield up stories that are hard to believe. On the popular China Law Blog Harris & Moure partner Dan Harris writes that he has, like all lawyers who work with China, ‘a ready set of horror stories, which I rotate depending on the occasion’. He goes on to mention gems including, ‘The guy who “invested” US$500,000 into a China business because the owner of the Chinese business was allegedly the son of a five-star general’ and ‘The guy who bought a million-dollar condo in Shanghai in the name of his girlfriend because he believed foreigners were not allowed to own real property in China’.

Or take a more sensational example given by Violet Ho, a managing director at Kroll and head of the global risk consultancy’s Beijing office.

‘We were asked to do some seller’s diligence for a US client who was approached by a Chinese entrepreneur who said he was interested in buying a lot of shares and holding a board position,’ she tells IBA Global Insight. ‘Our initial mandate was to find out whether this person really had money. Yes, he had a lot of money, but where he got it was a different story. We found out that the person was one of the kingpins of an organised crime syndicate in a third-tier city. There were reports of how he chased after people who owed him debts by cutting off people’s fingers.’

Further investigations by Kroll revealed that the potential buyer’s brother was on a most wanted fugitive list for a violent crime. And he was still an active board member of one of the potential buyer’s companies.

What seems to amaze Ho more than the story itself is the client’s reaction.

‘It felt like we were having parallel conversations; their consideration was, “are we going to get paid?” They felt that because their operation was in the US, they would have control of the management and this person would always rely on them to run the business,’ she says.

Ho makes it clear that this is an extraordinary case: ‘We don’t deal with criminals every day,’ she says. But the story neatly illustrates that one of the real risks of doing business in China is the suspension of disbelief. Many experienced advisers will tell of how foreign investors seem to leave their common sense at the front door when looking to build their China portfolios: a modern-day Gold Rush mentality.

‘The problem is there’s so much information about China, it can be hard to work out what you really need to know. Also, it’s such a huge potential market – executives get very excited and maybe then forget some basics,’ says Neal Beatty, regional director of global client services for Greater China at Control Risks.

One of these ‘basics’ is following the local law; there are some foreign investors who have, so far, managed to gain prosperity in China without doing even that, building a false sense of security for those who come later.

‘Too many foreign companies have run afoul of the local rules and it is a really bad idea to think that it’s OK because “most companies are doing it” or “there is no other way”. This is simply not true,’ says Diot.

Getting away with it

Outside Beijing and Shanghai, there is a complex network of provincial and city-level regulations overlaid on the national law. These are often quite opaque, with little information available in English. A lack of strict filing requirements means it is difficult to get up-to-date information on private companies. It is also more common to encounter unscrupulous auditors and local officials who will turn a blind eye. Here we see another real risk coming to the surface: it can often be much easier to get away with things in smaller cities that would be impossible in somewhere like Shanghai, and this can lead to a false sense of security.

‘Oftentimes, the smaller cities will allow foreign companies to bypass certain laws in an effort to get the foreign company into their town as quickly as possible’

Dan Harris
Harris & Moure

‘Oftentimes, the smaller cities will allow foreign companies to bypass certain laws in an effort to get the foreign company into their town as quickly as possible,’ explains Harris, speaking by phone from Beijing. ‘The foreign company goes along with the shortcut, figuring it must be OK if the city itself is signing off on it. This can be a big mistake as it is exactly these sorts of cities that tend to be subject to audits at the provincial or maybe even the national level.’

Harris mentions by way of example two foreign companies that were formed in very small cities, even though they had not satisfied all the requirements for forming a wholly foreign-owned enterprise (WFOE). They ended up being shut down within a year due to audits that came down from the central government.

‘This is a very real risk that businesses are simply missing,’ says Harris.

Don't get carried away

Another risk arises from a misinterpretation of one of the key concepts in Chinese society: ‘guanxi’. The word essentially describes the key ingredient in personal relationships of influence in Chinese society – a kind of who-you-know networking concept – and there is no denying that creating and maintaining good relationships with regulators and local officials can be a very important element of business success.

‘Guanxi is absolutely a good thing. Government endorsement and support is very good to have and can ensure the long-term prosperity of a company,’ Ho says. ‘But people don’t pay enough attention to dissecting it. Not all guanxi is created equal.’

She divides guanxi into several types. Inherited guanxi is exemplified by the influence of government officials’ offspring (known as princelings). This type is often very dangerous as it is susceptible to political volatility. Personal guanxi – where a company relies on one person for its success – can be very risky, particularly where little is known about that person. A foreign business that falsely believes a connection with a single influential political figure will keep it out of trouble can quickly find itself operating in a legal grey area.

‘One of the real risks of doing business in China is the suspension of disbelief’

Violet Ho
Kroll

‘Many people can tell you of their formerly rich and successful friend who is now serving 16 years for bribery and embezzling company property,’ says Diot. ‘Generally speaking, it is often a strategic mistake to rely on one well-connected individual for the development of one’s business in China.’

A powerful local figure can also become a liability when they start to use their connections to override a contract or exert influence on a local judge. For these reasons, a foreign company may go too far in its attempts to nurture what it perceives as an important relationship. Lavish gifts or extra cash payments make a company easy prey for extraterritorial anti-corruption laws such as the US Foreign Corrupt Practices Act, the OECD Anti-bribery Convention, or the UK’s new Bribery Act.

‘In addition to purely legal aspects, our advice to clients is to take their home jurisdiction as guidance: if you would not feel comfortable doing what you plan to do in China back home, then do not do it,’ says Diot.

Harris is more direct: ‘Making good connections makes sense but running afoul of anti-bribery legislation does not. Know what the laws are and do not violate them, no matter what.’

A more positive type of guanxi is what Ho calls institutional guanxi – support from a particular government agency – which she says should be carefully developed. She also describes ‘a new generation of guanxi’ whereby a company receives strong government support because it is considered a leading enterprise in the local area.

‘An enterprise that has contributed to local development, paid a lot of taxes, and employed a lot of local people can find itself in a win-win situation where it is being recognised and supported by the government for its contribution,’ says Ho.

The conclusion is straightforward: guanxi should be about networking and making connections, and not much more. It should be used as it would in the West – to get to know the right people. This might in turn improve the chances of winning some business. It should never be seen as a long-term solution because it is by nature about personal relationships. It can never be permanent and is always susceptible to political or institutional change. Furthermore, many foreign companies (and Chinese businesspeople) probably do not possess the amount of guanxi that they claim to have. And even if they have enough to push through a deal, such as the formation of a WFOE, by bypassing the law, the gains will only be short term and the potential for disaster is high.

‘I’ve had two grown men break down in tears in front of me, because they spent five years setting up their company but they didn’t take the time to do it properly, and once they started making money they got booted out by their Chinese partner,’ says Harris.

Reasons and motives

As we saw earlier, the main reasons behind moving to a smaller Chinese city are, broadly, low cost, high market potential and lack of competition. But these three factors are not always present, or can be over-stated. For example, some foreign companies may nowadays find the retail sector in Shanghai and Beijing too intensely competitive and so make a move to a city such as Qingdao, only to find there is no market there at all. Or company bosses can sometimes become so intoxicated with what they see as the cost benefits of relocating inland that they fail to think through all the implications. Kent Kedl, Control Risks’ managing director for Greater China and North Asia, says that this mirrors what happened 20 years ago: then, American companies became very excited by the fact that Chinese factory workers were about 30 per cent cheaper than those in the US, and failed to take into account the efficiency and infrastructure issues that would also have to be overcome.

‘I think we’re in danger of making the same mistake this time; we didn’t learn the lessons, and people are just blindly looking West,’ he says.

‘There are lots of times where second- and third-tier cities are definitely the way to go; but don’t just jump in because there are also many things about those cities that can make them more difficult,’ adds Harris.

Some provincial Chinese cities are grappling with infrastructure issues, low water quality and power brownouts and blackouts. According to China’s Xinhua news agency, the government of Zhejiang province (home to Hangzhou city, a manufacturing centre and logistics hub) is predicting a power shortfall of between 3.5 million and 5 million kilowatts this summer. Beatty says one of Control Risks’ clients in the southwest of China has experienced big issues with its gas supply despite operating its manufacturing facility in a relatively new industrial zone.

Intellectual property is another area of potential difficulty. Although the risk of IP theft itself may not be any higher in the provinces, the difficulty of dealing with the aftermath is usually greater. Take the case of a foreign company that agrees to license its IP to a Chinese company for a year. If the Chinese company keeps on using the IP, the chances of being able to stop the company will be greater in Shanghai than in a smaller city like Chengdu. A risk factor like this, although hard to quantify, should influence a foreign company’s decision regarding where to locate. Harris talks of a software company that wanted to set up in Chengdu and employ five people to write software there. It turned out that this would only have saved the company about US$25,000 a year.

‘If they were making widgets, then I wouldn’t have raised the issue with them, but is it worth it for the IP risk?’ asks Harris.

Local know-how

If, after carefully considering the pros and cons, a foreign investor should decide to go into one of China’s smaller cities, it will be important to have local expertise alongside to help navigate the complex web of existing local interests and relationships.

‘It is said in the US that all politics is local – well, in China, all business is local and much of business is political,’ says Kedl.

Finding good local legal expertise may be easier said than done, however. The quality of advice and the depth of understanding of a foreign investor’s perspective can be variable in the provinces, to say the least. (Even the label ‘law firm’ can sometimes be misleading. A former journalist who spent time travelling around several smaller Chinese cities while carrying out research for a legal directory tells of her surprise when visiting some law firms. Although describing themselves as firms offering a range of services, at least one turned out to be nothing more than a one-man shop operating from a smoky room above a supermarket.)

The difficult question of guanxi appears again here. Some investors may be tempted to rely on a local Chinese lawyer who claims he or she has important connections. This may yield results in the short term but will not provide a stable, long-term base on which to build a business. Harris cites the example of a company that took advice from a local lawyer and rented a property in a small city from a landlord who was not legal. Things went well until the Beijing tax authorities said the company would not be able to claim its rent as a tax deduction because of its illegal landlord.

‘I said if you want to feel really bad, the tax authorities might tell Mofcom [the Ministry of Commerce, which regulates foreign companies’ operations in China] that you’re not operating legally there and you may be shut down.’

Most specialists recommend using a large, national Chinese law firm, preferably one with an office in the same country as the foreign investor, paired with local counsel for certain areas in which local knowledge and connections would really come in useful: filing important paperwork, meeting with local officials, or fighting a case in a local court.

Be open but wary

In conclusion, specialists warn foreign investors against automatically assuming they must invest in Beijing or Shanghai, and say it is wise to be open to other options. But those options should be weighed carefully. Consider your business needs, and the risks involved, and carry out good, thorough due diligence to reduce the chance of creating your own risk.

‘Don’t be scared off – you just need to pay more attention and do more in-depth work to find out who you’re dealing with,’ says Ho.

‘The foreign investor will have to move cautiously since the contemplated investment will be taken in a web of existing local interests and relationships’.

‘First off, think. That’s right, think,’ writes Harris in one of his blog entries. ‘Secondly, do not do anything you would not do in any other country. Just because your Chinese partner and/or your Chinese partner’s lawyer tell you this is how things are in China does not mean you have to believe them and it certainly does not mean you have to abandon your common sense.’

Life in the provinces Key facts on China’s so-called second- and third-tier cities:
	Chengdu, Sichuan province Population: 11 million A national electronics and IT hub; host to many foreign hi-tech companies including Intel, Cisco, Sony, Toyota, Motorola, Ericsson, Microsoft and IBM; and an important financial hub for western China.
	Chongqing Population: 31.4 million One of four directly-controlled municipalities in China. A largely industrial city, one of the country’s largest motor vehicle production centres, and a key Yangtze River port. There was a significant clampdown on organised crime in the city in 2009, following several years of notoriety.
	Nanjing, Jiangsu province Population: 8 million A former capital city and known as a business centre; economy built on five pillars of electronics, cars, petrochemical, iron and steel, and power. Home to several large state-owned firms as well as foreign corporations including Volkswagen Group, Iveco and Sharp.
	Qingdao, Shandong province Population: 7.5 million Known for its brewery; also home to large Chinese companies such as Haier and Hisense. The city has a reputation for its good quality of life, which makes it relatively popular with expats.
	Wuhan, Hebei province Population: 9.1 million Home to a large number of French companies, and an important economic, trade, finance, IT and education centre.