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STRATEGY
Working in China's Changing Environment
Originally published in HSBC Guide to Treasury and Cash Management in Asia Pacific 2006 July 30, 2006
Ian Lewis, Johnson Stokes & Masters
China is providing new opportunities as it meets the requirements of World Trade Organization membership. Investors need to be aware of the changing legal environment, the different business practices that are likely to be encountered in various sectors of the economy and the changing objectives of major Chinese companies.
Over the past decade, the People's Republic of China (PRC) has changed in many ways. It has developed from being an emerging market to having the potential to be a key player in the world economy, and is likely to remain the fastest growing economy in the world for some time. China features in international news reports almost every day. Its position in world affairs has changed with China now being a member of the World Trade Organization (WTO), and an observer at G8 summits of world leaders. It is central to the growth strategy of many companies. China appears to have created a momentum of its own and, notwithstanding the difficulties and risks involved, many companies that have yet to establish a presence in China feel they must gain one.
In 2004, a record 43,644 new foreign-invested enterprises were set up, while many international corporations with well-established business interests in China are now looking to expand their operations. In many cases, investors treat China differently to other markets and investment opportunities, in that they are often willing to take a higher level of risk than they would elsewhere. China has established a special importance for itself in the eyes of the business world; one that is likely to see investment continue to flow into the country for the foreseeable future.
A Changing Environment
Part of the reason for this enthusiasm is that China remains a changing environment, and the reasons for investment in China have altered with the development of the Chinese market. A decade ago, many investors saw China as a source of cheap labour and as a manufacturing base for low-quality goods designed mainly for export. Now, more and more investors are interested in the emerging middle class and the domestic market. China's admission to the WTO has also led to significant changes. As a result of commitments given by China, whole areas of the Chinese economy are opening up - again encouraging investment in new sectors of the economy. Membership of the WTO has also resulted in an acceleration of the relocation to China of manufacturing industries from traditional bases elsewhere - particularly in the textile sector, which has been a cause for concern in recent times in Europe and the US.
Need for Caution
Although there are very good reasons for the positive sentiment that currently exists in respect of the China market, investors need to be aware that the business environment in China remains a difficult and complex one. Although areas of business that were once closed are starting to open, there are some areas that continue to be very challenging. First-time investors should still be cautious - this is something that has not changed. Not all areas are experiencing rapid change and many of the problems that existed in the past still need to be taken into account. To illustrate this, it is worth looking at two sectors open to foreign investors.
Commercial Sector
One change of great significance that took place at the end of 2004 concerns the retail and distribution sector. For many years, the distribution of goods (other than self-manufactured goods) was essentially closed, save for those companies in a position that could afford to invest in forming PRC vehicles with very large amounts of capital. Things have changed dramatically, however, since new legislation became effective at the end of 2004, which allowed wholly foreign-invested companies to participate in retail and distribution activities (although it should be noted that some sectors remain subject to separate regulations, e.g. books, oil/petrol and tobacco).
Although during the initial period following the new legislation coming into force, the practicality of establishing such companies often required some patience due to the fact that officials considering such applications were sometimes slow to recognise the new provisions of law and were generally cautious about its implementation, a number of such companies have now been successfully established. The law essentially applies the same standard to such foreign-invested enterprises as it does to domestic companies, and this means that a foreign-invested distribution company can now be established with a total investment or registered capital of only RMB500,000 or around US$60,000.
Power Sector
The position with regard to other sectors of the Chinese economy has been more problematic for foreign investors. The power sector is one such area. During the mid-1990s, the power sector provided numerous opportunities and was the focus of many power companies looking for new opportunities. However, the share of foreign investors in new power projects has halved in recent years from around 14.5 per cent in 1997 to about 7 per cent in 2005. Even though China needs to increase its power capacity dramatically, the outlook of foreign investors in this area remains mixed. During the 1990s, the annual electricity consumption increased by 3-7 per cent. More recently, the annual increase in power demand has been rising much faster and, in 2004, demand rose by more than 16 per cent. At the same time, the Chinese power sector remains very corrupt - something acknowledged by reports published by China's Auditor General in 2004. This made it difficult for foreign investors to take advantage of the obvious opportunities that there should be.
In a report published in June 2004, China's Auditor-General said that as much as RMB21bn-worth of illegal transactions have taken place in recent years. The extent of corruption can be illustrated by the fact that the former State Power Corporation chairman, Gao Yan, fled the country in 2002 in order to escape corruption charges. China has also moved away from the traditional power purchasing agreements of the sort that were concluded in the 1990s with guaranteed returns. Many of these agreements have now been cancelled, and documentation relating to new facilities does not contain guaranteed return arrangements. This obviously requires any foreign power company investing in China to be willing to take a much higher level of risk.
Furthermore, China is experimenting with new tariff arrangements and is moving towards a pooling system whereby power generators bid against each other for the right to supply electricity. At the same time, there have been significant changes in the organisation of relevant government authorities, which have contributed to caution being shown by many investors. While uncertainty remains as to how this policy will develop, many foreign investors feel it is best to delay new investments and focus more on other markets. As a result of the above, a number of new domestic companies have developed and have become financially strong. These companies are now able to compete successfully with their foreign competitors. This fact, combined with China's ability to manufacture power equipment for facilities of more than 300 megawatts, means that there are fewer opportunities in China than were available a decade ago. That said, it should be noted that new opportunities for foreign investors are emerging as China looks to expand both its nuclear and renewable energy capacity in an attempt to move away from coal-fired power facilities.
Other Issues
It should be noted that the business environment in China is changing in other ways. It is not only areas of business that are opening up but the general climate in terms of business culture and corporate practices.
Licences
The new Administrative Licence Law is a major step that has been taken by the Chinese government to reduce red tape and therefore reduce delays in projects and obstacles to development. The new law came into effect in July 2004 and effectively removed the need for many licences. Licensing requirements for some 390 activities now no longer exist. The new law also now requires reasons to be given in the event that an application for one of those licences that are still required is refused. Many ministries and government bodies have also been required to transfer some of their licensing authority to other agencies.
Dispute Resolution
There have also been changes to dispute resolution rules. The China International Economics and Trade Commission (CIETAC), the largest of China's arbitration bodies, has revised a set of rules which came into effect in March 2005. Significant new rules call for the quicker handling of cases. The time limit for issuing counter claims has been shortened from 60 days to 45. It should also be noted that one-third of CIETAC arbitrators are foreigners. To save time, parties can forego an oral hearing and simply ask for decisions to be based on the submitted documents. Documents may be submitted in English or other foreign languages as long as a Chinese translation is also provided. Although progress is being made, foreign investors need to be aware that the larger eastern coastal cities have made more progress down the path of reform. Although in Beijing, for example, the local People's Congress has introduced job performance appraisals for judges - supervision of lower courts generally needs further attention. In March 2005, Xiao Yang, president of the Supreme People's Court, submitted a report to the National People's Congress noting that in 2004 over 16,000 lower court rulings needed to be corrected.
Legislation
Investors should also expect to be ready to adapt to a fast-changing framework of legislation. On 1 January 2005, a total of 88 new laws came into effect - part of a massive revision of the Chinese legal framework, much of which is directly related to China's membership of the WTO. Although foreign investors generally welcome most of these developments, investors should still be aware that new legislation often requires significant changes to the way in which a PRC foreign-invested business is organised (for example, new regulations on foreign exchange issued in 2005 by the State Administration of Foreign Exchange have resulted in some dramatic changes in the ability of companies to borrow and maintain renminbi loans served by offshore deposits).
On the other hand, new legislation does not always mean an instant transformation. The Contract Law of 1999 was a major development (one not related to WTO membership). It replaced three older contract laws and made an attempt to modernise PRC contract law by borrowing aspects of international legal practice. For the first time, the PRC contract law included references to offer and acceptance, anticipatory breach and apparent authority. However, it is taking some time for all of the new concepts to be fully understood and applied by the PRC courts and it would be unrealistic for an investor to expect to receive the same level of analysis of particular disputes in the context of new laws as might be expected elsewhere.
China as Part of the Global Market
The developments in China also need to be considered in the context of the gradual move by PRC corporations into international markets. The government is encouraging Chinese companies to go global. New regulations that came into force in 2004 have assisted Chinese companies in satisfying procedures for overseas investment. As a result, investment by Chinese companies in foreign markets rose by 27 per cent in 2004. At the moment, most of these activities are focused on natural resources although it is expected that other sectors will see similar overseas activity. Recent examples have been the purchase by Shanghai Automotive Industry Corporation of a 48.9 per cent share in South Korea's Ssangyong Motors. Another high profile deal was the Lenovo Acquisition of IBM's personal computer division for almost US$2bn dollars in December 2004. This is likely to accelerate the importance of quality documentation, respect for intellectual property rights and legal development in China.
The emergence of China as a major player in the world economy has been so fast that many observers have been taken by surprise. Many so-called experts who, five years ago, may have doubted China's success would continue, are no longer expressing the same views. Investors who are well prepared and have a good grasp of the risks and nature of the market that they are entering can look forward to many opportunities as China continues to adapt and change in the global business environment in which it is now able to play such an important role.
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