China is still the world’s current economic darling, and will be for some time to come. Its GDP has risen from 7.5 per cent in 2001 to an estimated 9.9 per cent in 2008. A recent PricewaterhouseCoopers’ survey found that 55 per cent of UK business leaders plan to invest there at some point in the future. But where there is reward also lies risk, and directors must practice thorough risk management or suffer devastating financial consequences.
Regulatory risk is the risk of the national or local government changing regulations, imposing taxes or duties or even nationalising assets. Since the Chinese government is committed to stable economic growth and the development of a market economy, regulatory risk is relatively low and conditions are favourable for outsourcing and investment projects. Nevertheless the economy is still largely state-controlled, and there are strong political influences at work.
The key to mitigating this risk is understanding China’s legal and political (often local) environment. Chinese law is often simply written but its application by the administration varies and is constantly evolving.
Intellectual property has often been problematic for foreign investors, but much progress has been made. Legal standards are rapidly improving: there are now specialist intellectual property courts in the Shanghai region, and enforcement standards continue to improve.
One area that is likely to remain problematic for foreign investors is investment into strategic industries. The Chinese government is currently unlikely to permit foreign investors to take control of assets of national importance. In 2006, China spent a year holding up an investment by the Carlyle Group in Xugong, the largest machinery manufacturing company in China. Eventually Carlyle’s stake was negotiated down from 85 per cent to 50 per cent, with parent Xuzhou Construction Machinery Group, taking the other half. Restrictions on foreign acquisitions will continue in strategic industries.
Choosing the right strategic partner in a foreign market is often more crucial. Horror stories emerge from time to time: partners operating factories at weekends and selling the production privately at discounted prices or setting up clone operations and “stealing” the foreign partner’s technology.
However, when analysed, these stories usually lead to questions about the behaviour of the foreign investor. Why wasn’t better due diligence undertaken, or why were operations not monitored more closely? Why wasn’t more time spent on risk management and, perhaps most importantly, on building a relationship with the Chinese partner?
Due diligence is absolutely critical, and spending extra time and money on this is an essential investment. Anecdotal evidence also suggests that partnerships created by way of referral, rather than at a formal event (such as a trade show) tend to be more successful. So dig out your contacts and see if you can be introduced personally to potential partners. Those who build successful business relationships report that the Chinese are excellent business partners: trustworthy, pragmatic and focused on generating profit.
Currently, the majority of UK businesses investing directly into China do so to take advantage of low production costs. Supply chain risk management is thus essential as this is likely to form the core of the business. Unlike the risks outlined above, supply chain risk management is an ongoing, daily task. It is essential to research how these risks could potentially affect your business, and plan strategically to limit damage if something goes wrong. Key actions you should take to mitigate the impact of these risks include researching tax rates, which are frequently tweaked, and customs duties.
In addition, when sourcing raw materials, thoroughly research all your suppliers. Provide a clear contractual specification on the quality of materials required, and consider multiple sourcing to reduce dependence on one supplier. You should also set up quality control systems into your contracts and control procedures and regularly visit factories where a product is being produced to ensure quality control. If you will not be based locally, consider having a local quality control manager who can manage this on your behalf.
China is a land of opportunity, but as with any country in which you are an inexperienced investor, there are risks involved. If you are aware of the risks and react intelligently to minimise or eliminate them, a partnership with a thriving Chinese company could be hugely rewarding to your business.
Guy Facey is a corporate partner in the Hong Kong office of international law firm, Withers.
Posted 6 May 2008 : Director.co.uk