What are the risks attached to investing from abroad into China? What are the best ways to minimise these risks?
Risks are high in doing business in China because anything can happen, including political revolution, financial crisis, labour uproar, etc. However, the general return is high too – China is one of the fastest-growing markets with an annual growth rate approaching 10% in the past 10 consecutive quarters.
The key to success in China is to fully realise the risks and have a flexible action plan to minimise them. The following are, in my opinion, the most critical risks that may have a direct impact on foreign investment in China.
Undeveloped credit infrastructure
A common complaint of foreign companies doing business in China, or with Chinese companies, is about the difficulty of collecting full payment on time. China does not have a credit infrastructure that provides systematic and reliable resources to the credit history of companies and individuals.
Foreign companies should do good due diligence to minimise exposure to the risk of default on payment. It is worth investing time and money on extensive research and retaining a reliable third-party expert to find reputable partners and confirm the creditworthiness of partners or primary customers.
In addition, companies should pay close attention to the terms of payments and performance standards in contracts and verify the authority of Chinese people involved in negotiating and concluding these contracts. Make sure that contracts do not include provisions that violate Chinese law, even though the Chinese parties may promise not to enforce laws or regulations, and do not accept provisions that are beyond your control, such as visas for visits to your company in Europe or the US.
Poor legal environment
The existing Chinese legal system does not provide adequate and effective protection. The application of laws is inconsistent in different provinces and cities, and court verdicts are difficult to enforce. Cost of litigation is high, and penalties are low. Contracts are not fully respected and difficult to enforce. Bear in mind that the conclusion of a contract is just the beginning of real negotiation.
Verify the authority of the people you negotiate with and the ownership, permits, permissions, license and qualifications they claim that they have through independent sources. Find your own legal counsel and draft contracts in clear terms.
Do not rely on oral promises of business partners and government officials on local subsidies, incentives or special considerations that are not based on solid legal ground. Even if you have them in writing, you should treat these incentives as ways to augment profit (instead of counting on them to create profit) because they may be taken away at any time.
Lack of electric power supply
In recent years, more than two-thirds of China’s provinces and municipalities have experienced chronic power shortages, with the most serious in the high-density industrial areas along the east coast.
In response, the Chinese government has approved several dozen new power plant projects, which are expected to add fresh capacity of about 35 million kilowatts, to come online in 2006 and 2007. However, there are concerns about the viability and sufficiency of such projects, because most of the approved new facilities are located in central China and it is in doubt whether the poor regional grid infrastructure can adequately transfer the added power to high-demand areas long the east coast.
Furthermore, it is expected that China’s energy sector will have to be reformed from a controlled to a market pricing system, which calls for price deregulation. This means that prices of electric power may eventually be adjusted to meet the market demand.
Many foreign companies have started to shift manufacturing investment to smaller cities in central and west China, where power capacity for industrial use is more stable and adequate, and labour and land cost are lower than in large cities along the east coast. In addition, many companies have purchased diesel generators as a back-up to maintain production during peak power times.
As a result, foreign companies may want to include the expense of diesel generators as a fixed cost of investing in China and raise their estimate of costs to account for power supply uncertainties in east and south China.
Diverse and rapidly changing market
China is a very diverse market. With 1.3 billion in population, the consumer culture, cuisine and local languages are dramatically different in provinces from north to south and from east to west. The overall market has been growing rapidly but regional economy has developed at very different paces.
In addition, China has a long history of strong regional protectionism where provincial and municipal governments impose barriers to the inward trade of goods and services from other regions to protect local businesses and tax revenue. It is challenging for foreign companies to penetrate regional markets because products that are well received in one city are not necessarily welcome in other areas in China.
Foreign companies need to be very sensitive to, and make marketing strategies taking into consideration, the regional differences and barriers. It is a mistake to assume that products popular in large cities or the east coast region will eventually find their ways into second-tier cities and the mid-west region.
Before jumping into these markets or launching a new product, it is critical that foreign companies do substantial and in-depth market research and keep close track of regional developments.
Difference in culture and management styles
The cultural differences between China and the West are striking. For example, in China telling a guest that he or she has gained weight recently is a compliment, and the honoured guests at a dinner party can expect to be given the head and tail of the fish to eat. To share and ask about personal matters is an expression by management of caring and respect for employees in Chinese companies, where the same questions may be seen as an invasion of privacy in the West.
Foreign companies doing business in China need to become familiar with basic Chinese culture and critical differences in business etiquette. Hiring managers who grew up in China and were trained overseas may help to smooth the potential conflicts in cultural and management styles.
What particular guidance can be given to smaller-sized to mid-market businesses looking to invest in China?
Find the right partner and make investments step by step
Small firms usually need a local Chinese business partner to make sales, deliver products and develop local markets. Companies may start by working with potential partners on low-cost products or under the consignment manufacturing arrangement to test their quality, capacity, efficiency and reliability before making substantial investment on forming joint ventures with a local partner or investing in factories and other capital expenditures.
Another approach is to set up liaison offices and hire a few Chinese employees to obtain first-hand market information and build customer relationships. Alternatively, foreign companies may form joint ventures with Chinese partners with small amounts of investment and gradually increase the investment and eventually buy out these Chinese partners after they obtain a more solid market foothold.
Hire good local managers and advisors
Smaller firms tend to be cost sensitive. However, firms that are willing to pay for the best managers and advisors usually get significant return in the long run.
Advisors who have substantial experience in advising foreign companies doing business in China and in-depth familiarity with Western management and business models may help foreign companies identify the most cost-efficient market entry strategy and sustainable operating model for their Chinese investment. Smaller firms should invest in hiring and training the best local managers, instead of sending expatriates to work in China. Usually, periodic overseas training opportunities are very attractive to offer and an effective way of retaining and rewarding the best Chinese employees.
Be realistic and patient
Do not rely on the promises of subsidies and incentives of local government officials and partners to project your profitability. Use independent sources to verify your partners’ claims of ownership, permits, permissions, licenses, and professional qualifications. Do a thorough risk analysis and have solutions for the worst situations in every phase of developments. Do not compromise on risk assessment standards just because the trend is to go to China. Be patient in waiting for acceptable terms and return on investment.
In which business sectors are there the most/least risks, and why? In which sectors are the Chinese most /least receptive to investment?
It is difficult to a draw a general line between the highest and lowest risk industries in China because foreign investments are prohibited or restricted in some industries.
The State Council issued the Guidelines for Industries with Foreign Investment as a primary basis for foreign companies to find out whether foreign investment in a particular industry is encouraged, permitted, restricted or prohibited. The next step is to check the local government’s industry policy in a particular province or city where you plan to make the investment.
In general, consumer and consumption-related companies benefit the most from China’s 1.3 billion population and fast growth. We have seen companies that reported double or triple digit growth in annual revenue in their operations that manufacture and sell furniture, construction and interior decoration materials, cleaning and sanitising products, and auto parts in China.
What incentives are offered?
China offers tremendous incentives. The basic tax incentive is the so-called ‘five-year tax holiday’, including a two-year income tax exemption followed by a three-year 50% income tax rate reduction starting from the first profit-making year to manufacturing-oriented foreign investment enterprises with a minimum 10-year business operation.
In addition, the regular corporate income tax rate is reduced from 33% to 24%, 15% or even 10% in various economic, technology or special development zones. There are incentives offered based on industries and transactions, incentives on business tax, value added tax, customs duty and other transactions tax. Local governments usually offer fiscal subsidies and tax refunds. The key is to identify what is on the table and verify incentives with independent advisors.