Bulls in a China shop
Mar 18th 2004
From The Economist print edition

Foreign companies are pouring money into China. But is the investment paying off?

WELDING torches glow orange through the smog. A tangle of silver pipes and concrete structures cover the rutted ground from which the central naphtha cracker is starting to rise. Workers clamber everywhere. Here, near Nanjing in Jiangsu province, BASF is building China's most modern integrated petrochemical complex, the first to be partly funded by foreign money and kitted out with foreign technology. If the plant starts on schedule in 2005, says Bernd Blumenberg, president of BASF-YPC (the German chemical group's joint venture with a subsidiary of China's oil giant, Sinopec), 12,000 workers will have spent 72m hours using 150,000 tonnes of steel in one of the largest industrial construction projects in the world.

Yet this $3.7 billion monster is only the first—and not even the biggest—of six being planned in China. It seems that every multinational in the world is either in China already or declaring that it “cannot afford not to be”. Last year, despite SARS and the Iraq war, China attracted a record $57 billion of foreign direct investment. Contracted FDI, an indicator of future investment, soared 39% to $115 billion.

Unfortunately, few foreign companies have had much to show for their enthusiasm since Deng Xiaoping re-opened the country to the world in 1992 after the Tiananmen Square clampdown. In China, first-mover advantage has often turned into first-mover curse. Early entrants, seduced by quick successes among affluent consumers in one or two cities, decided to tackle the mass market, only to encounter lower prices, fragmented customer bases, haphazard distribution and vicious domestic competition. Most responded by pouring in more resources, becoming ensnared in what Hubert Hsu and Jim Hemerling of the Boston Consulting Group call the “value trap”—the more they invested, the more money they lost.

The world's top brewers squandered hundreds of millions of dollars in China in the 1990s. The average net profit margin of China's 400 brewers (including foreign ventures) now is just 0.5%. Losses are common for companies in packaged food, food retailing, household goods and personal care. The only foreigners to have consistently done well have ignored the domestic market and concentrated on China as a cheap base for manufacturing and export processing.

Most of these are ethnic Chinese, mainly from Taiwan, whose companies have invested more than $100 billion on the mainland, and from Hong Kong. A 2002 study by the Federation of Hong Kong Industries found 59,000 Hong Kong-owned factories in China, mainly just across the border in Guangdong province, making everything from toys to clothes and employing 11m people. These small exporters are probably the most profitable outside investors in China. One reason, notes Gordon Redding, professor of Asian business at INSEAD, a business school near Paris, is that Chinese business people understand better than western ones how to manage uncertainty and line up long-term political support.

Connections have certainly worked for Vincent Lo, a Hong Kong property developer whose Shui On group is now one of the largest cement makers in China. Dubbed the “king of guanxi” (connections), Mr Lo made his first big splash redeveloping Shanghai's run-down Xintiandi district, to the delight of city officials. He then took his cue from the government's “Go west” policy, moving from coastal cities to backward inland ones such as Chongqing in central China. There he won permission to buy dilapidated cement plants by promising local bureaucrats not to lay off a single worker. Mr Lo's flexibility and patience have allowed him to cash in on an infrastructure boom around Chongqing. He laughs at “Americans [who] always want to bring in whole teams of lawyers and negotiate contracts—they will be there forever.”

Even the Americans, however, seem to have learned a thing or two. In a survey of its members by the American Chamber of Commerce in China in 2002, three-quarters claimed to be profitable, and nearly 40% said their margins in China were higher than their global margins (see chart 3). “There is no doubt that companies are doing better than they were,” says the chamber's then chairman, Chris Murck.

Do it yourself

Rapid economic growth has lifted the China operations of most foreign companies. But the multinationals have also learned a lot. Flexibility, as Mr Lo found, is critical. Danone, a French food group, has won plaudits in China by switching from an organic-growth strategy for its dairy products to buying up local rivals in the late 1990s. By contrast, Procter & Gamble failed to adapt, according to A.T. Kearney, a management consultancy. Its focus on shampoo worked well initially, but it confused customers with too many brands and found itself undercut by local rivals, which meant that its market share dropped from over 50% in 1998 to 30% in 2002. Now it plans to attack rural markets, a tough call.

At least P&G chose a weak joint-venture partner it could control. By contrast, Unilever invested in a host of categories it failed to dominate and chose a strong partner, leading to a string of disagreements. Unilever's Mr Gunning admits: “A Chinese joint venture is incredibly difficult.” Even Kevin McCann, the former boss of Audi China, says: “No joint venture is ever good,” although VW's partnership with Shanghai Automotive (SAIC) has been one of the most profitable.

Examples abound. An American businessman in north-eastern Shenyang tells of boxes of car parts piled outside a warehouse run by Jinbei GM, GM's joint-venture partner there. The warehouse manager had apparently been stealing the equivalent of five cars a night for years, “with the implicit approval of GM's partner”. Confronted with the tale, GM's Mr Murtaugh concedes that: “We've had some problems with that joint venture.” Such stories explain why multinationals are opting for wholly foreign-owned enterprises, or “Woofies”, wherever possible.

The foreigners with the best chance of success in the difficult domestic market are those selling goods and services that local firms need, such as iron, cement and steel, or that will take years to develop. The international investment banks make around $500m a year in underwriting, equity sales and advisory fees. Lawyers, advertising agencies and accountants have strategic expertise to offer, and educational services, especially English-language materials, are a booming niche.

Similarly, as demand for air travel soars, China's airlines need more planes, and with domestic firms decades away from being able to make big aircraft, the two global suppliers, Airbus and Boeing, are in a sweet spot. Though a late entrant, Airbus is winning orders for relatively little investment. Laurence Barron, president of Airbus China, says it will be “politically correct” for the company to quadruple the $15m of manufacturing contracts it currently awards to Chinese firms by 2007. But that should also lower its costs.

The product does not even have to be sophisticated. With 1,000 outlets on the mainland, Kentucky Fried Chicken is China's leading fast-food chain. Samuel Su, China president for its American parent, Yum! Brands, says it has been successful because it offers the Chinese a rare combination of safe, tasty food in clean surroundings with American cachet, all at a reasonable price.

For those who have to battle against local, often unfairly subsidised competition, success usually requires a dash of unorthodoxy. Honda entered China late but cheaply, snapping up Peugeot's Guangzhou plant for $250m in 1998 when the French retreated. Counter-intuitively, Honda then sold its Accord as a luxury sedan to businessmen, rather than betting on a cheap family car like its rivals. Production and profits have soared ever since.

Carrefour, a French hypermarket retailer, has built up China's second-largest chain of stores by ignoring the requirement for central-government approval of retail joint ventures. Instead, it signed deals with local city governments, in the expectation that once the stores were open, the central government would not shut them down. It worked.

But in absolute terms the earnings of foreign firms in China are almost certainly still small. A study of American Commerce Department data conducted by a research publication, China Economic Quarterly, showed that direct and indirect profits made by American affiliates in China amounted to $2.8 billion in 2001—less than the $4.4 billion made in Mexico, with a population of just 100m.

Although profitability has undoubtedly improved, many companies are not even covering their cost of capital, much less getting a proper return on their investment. Norman Villamin at Morgan Stanley says that some multinationals deliberately lower the required rates of return for their China operations to wave through projects that would not usually qualify, and charge costs to head office to make the China arm seem more profitable than it is.

Foreign investors that concentrate on exports or use China as a source of goods, such as Wal-Mart, will definitely benefit from the mainland's cheap labour. “Businessmen should take the low-hanging fruit and limit their investment,” argues Kenneth Lieberthal, a China expert at the University of Michigan Business School. A few large multinationals, notably General Electric, are planning to go much further, moving advanced production lines and research facilities there in order to transform their entire corporate cost base. But many of those lured to China for the domestic market will struggle to generate sustainable profits. And all foreign companies have to face the fact that China is still not a rational place to do business.

A disorderly heaven
Mar 18th 2004
From The Economist print edition

Most foreigners underestimate the eccentric nature of China's business environment

“THERE is great disorder under heaven. The situation is excellent.” Chairman Mao's aphorism encapsulates a lesson all foreign businesspeople should take to heart: the Chinese scent profit in chaos. When it comes to doing business in China, the first rule is to throw away the rulebook, along with the business-school texts and western management theory.

Of far more use would be a new book by a man who spent ten years actually trying to run companies on the ground. In “Mr China”, to be published next month, Tim Clissold tells the thinly disguised story of Asimco, one of the largest foreign investors in the country at the time. Started in the early 1990s by Jack Perkowski, a Wall Street banker, and run by Mr Clissold, a British accountant, Asimco raised $434m, invested it in a series of car-component factories and breweries—and watched almost all of it drain away within a decade.

It made no difference that Asimco screened hundreds of factories before making its first investment; that it always insisted on majority control and put in its own managers and accountants; that Mr Clissold spoke fluent Mandarin and spent much time and effort courting officials at every level. The Chinese, it seems, were always one step ahead.

Mr Sha, the company's best manager, who ran a rubber-parts factory in the mountains of Anhui province in central China, secretly set up a rival plant down the valley which he financed by siphoning money from the Asimco joint venture. When he was eventually found out and fired, he told his workers to package defective products from his own production line in Asimco crates and sent them to its customers so they would cancel orders. “There were pitched battles on the street with knives and broken bottles, and the army was called out,” says Mr Clissold. In Zhuhai, near the border with Macau, the director of Asimco's brake-pads factory absconded to America with $10m-worth of letters of credit, leaving behind his entire family. Asimco sued the bank for validating the certificates, but ended up liable for the lot. A local anti-corruption official promised Mr Clissold he would investigate, but only if he got a car and working capital. In 1998, after eight years of frustration and back-breaking work, Mr Clissold, at the age of 38, suffered a total collapse.

His book is at its most telling in describing the attitude of Asimco's New York board members and investors, which included some of America's top mutual funds and banks. They had a stock answer for every problem—fire the manager, cut costs, find new customers—in blissful ignorance of local conditions.

Asimco's story is unusual only in its detail. Many other companies have similar tales to tell. America's PepsiCo has spent more than a year trying to undo its tie-up with a joint-venture bottler in Sichuan after its manager secretly sold the venture to a local-government bureau to buy himself expensive holidays and cars. James Bryant, who runs Subway's Beijing sandwich franchise from a grim office, describes how his Chinese joint-venture partner (now in jail) swindled the company out of $200,000. “People leave their heads at home when they come here,” Mr Bryant says. “They forget all about due diligence. They meet a guy on the street, give him a ton of money to run something and six months later he absconds with it.” After nine years in China, Subway operates just 30 restaurants, rather than the 2,000 it once envisaged.

Many of the problems foreigners encounter reflect the fundamentally non-rational nature of China's business environment. This can be summed up under three headings. The first is bureaucratic. Donald Lewis, a law professor at the University of Hong Kong, argues that if the great invention of European civilisation was a legal system, China's was bureaucracy. The communists simply took over the imperial civil service and added a further layer of complexity by superimposing a party organisation on the government one.

McDonnell Douglas for one fell foul of the system. After an early entry into China in the 1970s, the (then independent) aircraft maker thought it had outwitted Boeing when it signed a $6 billion deal in 1991 to build 150 airliners for China locally in partnership with Avic, China's state aerospace group. With such gold-plated backing, the Americans assumed that China's government-owned national and regional airlines would buy their planes.

But the airlines, represented by a rival ministry, preferred to buy their aircraft direct from Airbus and Boeing, which were cheaper and offered the bureaucrats “factory tours”, mostly to Disneyland. Only two McDonnell planes were ever built in China, and the company lost a packet on the contract, which was cancelled in 1997. As Mr Studwell writes in “The China Dream”, “Douglas's returns from more than two decades in China were 40 Sino-US marriages among its staff and untold embarrassment.”

Another bureaucratic complication is the power struggle between the centre and the provinces. “The mightiest dragon cannot crush the local snake,” goes a favourite 16th-century saying in a country traditionally run on decentralised lines. The central government in Beijing may appear all-powerful to outsiders, but in practice its reach is limited. Local officials and party bosses hold sway not only in individual provinces and cities but even in the smallest villages. “The centre has no control over the provinces,” says Michael Enright, a professor at the University of Hong Kong School of Business. “When it sends people to investigate illegal pirating of CDs, local governors block access to the factories.”

Currently, this problem shows up most clearly in China's foot-dragging compliance with the requirements of the WTO. Whereas the central government is keen to lower trade barriers and increase competition, local barons, afraid of unemployment and instability in their own backyards, are withholding their co-operation.

Chinese bureaucracy also gets in the way in sensitive industries such as cars and technology, where a centrally directed industrial policy appears to be allocating a share of the market to domestic companies. From this summer, foreign makers of wireless technology must rejig their software to a Chinese standard “in the interests of national security”. This new rule will force companies such as Sony and Intel to work with officially designated Chinese partners, exposing their intellectual property to the risk of piracy.

All too frequently, a short-sighted central government seems to regard foreign companies as cash cows to be milked. For example, plans are afoot to fund a rural postal service by slapping a tax on the (largely foreign) logistics industry, which could cost 800,000 new jobs, according to the US-China Business Council. David Cunningham, Asia Pacific president for Federal Express, fumes: “Why should we fund a Chinese postal service any more than a Chinese steel plant?”

A law unto itself

The second problem for foreigners is a direct consequence of the bureaucratic system of government: China is subject to the “rule of man” rather than the “rule of law”. Rights derive from political power, generally the power of an individual, which explains the importance of personal connections, or guanxi.

Granted, China has come a long way since 1978, when it had no formal legal system at all. In the past 20 years it has seen one of the greatest floods of legislation in history. But although China may have laws for most things, enforcement is weak. China needs far more than the 100,000 lawyers it currently has, most of them poorly trained and badly paid.

There is no comprehensive bankruptcy law to protect businesses. A long-awaited draft is still in the works, and even that is more about closing down enterprises than about looking after creditors' interests. Nor is there an effective way to resolve contract disputes. Some foreigners, such as Sumitomo Chemical, have sued their local partner in the Chinese courts, only to destroy their business relationships. Others, such as Newbridge Capital, an American venture-capital firm, have turned to international arbitration.

“Chinese legislation is chock full of ambiguities”, says Lester Ross, a Beijing-based lawyer. He thinks this will take 10-15 years to resolve. Donald Clarke, a law professor and China specialist at the University of Washington, is more pessimistic: “Look at the US legal system in the 1920s. It took over 80 years to modernise.”

The transition from a power-based planned economy to a rule-based market economy has opened the door to endemic corruption. Most foreign companies must deal with constant bribe-taking and the theft of property. They cannot trust the corporate governance or the accounts of Chinese joint-venture partners, and sometimes find it hard even to establish clear title to land and physical equipment. Not surprisingly, many foreign companies (especially struggling ones) lose sight of their own ethical standards: “I have a hard time believing foreigners can succeed in China and keep their hands clean,” says one senior American consular official.

The name of the game

The third distinct challenge of operating in China is cultural. It is not just that the language is difficult and frustratingly imprecise at times, that the country is huge and the working conditions are often appalling, from freezing offices to constant traffic jams and a permanent pall of pollution. Most foreign businessmen who have been there for any length of time say they are baffled by the attitude of their local counterparts. “Often it is not about doing the best deal, but about scoring points,” says one. The Chinese often seem to be driven by emotions more than business logic. Some westerners accuse them of racism.

The concept of “face”—gaining it, preserving it—matters above all, and deception to wrong-foot an “opponent” is an accepted form of negotiation. Bill Young, an American who has worked in China since 1985, originally for McDonnell Douglas and now running a boiler business in Shenyang, recalls that in one round of talks with a customer, “the stenographer in the corner turned out to be the CEO.” An almost ritual test of face for foreigners is the official banquet, where the Chinese host will delight in serving up exotically revolting dishes (Mr Clissold has eaten everything from scorpions to deer's penis) and try to get his guests drunk on bai jiu, a liquor that tastes rather like diesel oil.

The way Mr Clissold tells it, “I was dealing with a society that had no rules; or more accurately, plenty of rules but they were seldom enforced. China appeared to be run by masterful showmen: appearances mattered more than substance, rules were there to be distorted and success came through outfacing an opponent.” The best way to prosper, therefore, is to play China by Chinese rules, a lesson that too few companies have learned. BAT, a tobacco company that has been in China since before 1949, proved more adaptable than most. One of its more aggressive marketing tactics was to buy up stocks of rival cigarettes, hold them until they were mouldy and then sell them on.

Despite all these problems, foreign investors continue to pour money into China (even Mr Clissold is still there, now working for Goldman Sachs). Whether the country will ever become a more rational and more profitable place in which to do business will depend largely on whether it can reform its state corporations, allow its private companies their head and salvage its financial system—the subjects of the remainder of this survey.