China’s Explosive Growth Offers Opportunities, Challenges in Corporate Renewal Industry

(TMA International Headquarters)

China has become the factory of the world as international companies flock to the land of the dragon in pursuit of lower-cost manufacturing, access to an expanding Asian consumer market, and premium returns on investment. This long-term trend presents extraordinary opportunities and challenges for professionals in the corporate renewal industry.

Even those whose current practices are primarily U.S.-based are likely to experience a China component in future engagements. This article presents an overview of opportunities for corporate renewal professionals to expand their practices in China as the result of the country’s future potential reforms.

Since China began its economic reforms in the 1970s under then re-empowered leader Deng Xiaoping, the country has evolved progressively into a modern economic powerhouse and future superpower. The 1979 economic reforms instituted by the Third Plenum of the 11th Central Committee of the Communist Party of China represented a major policy shift from Mao Zedong’s “Great Leap Forward” and “Cultural Revolution” Little Red Book policies. Under a “Four Modernizations Program” targeting agriculture, industry, science, and defense and its acceptance as a member of the World Trade Organization (WTO) in 2001, China has achieved global investment and trade with the capitalistic economies of the West and East.

China’s modernization path has been — and continues to be under President Hu Jintao — both pragmatic and non-ideological. This is true despite challenges such as the 1989 Tiananmen Square protests and subsequent demands for political reforms (the Fifth Modernization – Democracy), and re-unification issues such as the Communist and Kuomintang (KMT) parties’ positioning on the fate of Taiwan and the reversions in 1997 and 1999, respectively, of the Hong Kong and Macau sovereignties back to China under new Basic Laws using Special Administrative Regions (SARs).

Economic Powerhouse

The results of China’s economic reforms over the past 27 years are impressive. More than 300 million Chinese have moved out of poverty, and the average worker’s income has quadrupled. The nation’s current production output approximates $1.6 trillion USD and is projected to grow to $4.8 trillion over the next 15 years. In addition, China:

• Is the world’s fastest-growing large economy, averaging annual growth of more than 9 percent since the inception of its economic reforms.
• Became the world’s third-largest trading nation in 2004.
• Is the world’s largest producer of coal, steel, and cement; the second- largest consumer of energy; and the third-largest importer of oil.
• Is the second-largest holder of foreign-exchange reserves, mainly U.S. dollars ($819 billion as of January 2006).
• Possesses the world’s largest military (2.5 million soldiers) and has the fourth-largest defense budget.
• Launched its first manned spaceflight in 2003 and plans to launch two more manned missions by 2007.

China’s exports to the United States have increased 1,600 percent during the past 15 years, while U.S. exports to China have grown by only 415 percent. Its resulting trade surplus with the United States approximated $162 billion USD in 2004 and is expected to exceed $200 billion in 2005 (it was $166 billion USD as of October 31, 2005). Its material trading surpluses have allowed China to fund deficits of its major trading partners and reduce the swings of economic cycles.

Some economists predict that China will overtake the United States as the first-ranked world economic power before 2050, and by that time, China and India together will account for approximately 50 percent of all global output.

Before China gained WTO membership, its economic achievements resulted from government control over the planning, execution, funding, and management of the country’s development, and enforcement of its commercial and trade policies. China’s 2001 entrance into the WTO (Hong Kong and Macau were original WTO members in 1995, and their respective Basic Laws enable these SARs to function somewhat independently) obligated the country to meet a number of commitments. Foreign investment and trade exploded in China as greater market access, import/ export benefits, and other forms of protection were provided under WTO protocols.

Although the Chinese government still primarily controls direct infrastructure development, it designates zones to promote specific types of foreign investment and trade in certain geographical areas. Special Economic Zones (SEZs), Economic & Technical Development Zones (ETDZs), and High-Tech Development Zones (HTDZs) offer differing legal, tax, and operative incentives. At regional levels, industrial park structures contain Free Trade Zones (FTZs), Export Processing Zones (EPZs), and Hi-Tech Parks (HTPs) that specify business scopes and taxation rates.

As a result, China’s most advanced economic areas are the Bohai Bay Economic Area, which includes Beijing; the Yangtze River Delta Area, which includes Shanghai; and the Pearl River Delta Area, which includes Hong Kong and Shenzhen. These three areas have attracted the majority of foreign investment and trade because they possess world-standard infrastructures, offer favorable zone incentives, contain good educational and cultural institutions, and have economically vibrant commercial and consumer sectors.

Economic policies China adopted after its acceptance into the WTO have enabled it to develop into a dominant world leader in mass manufacturing, and it likely will remain so as it continues to expand capacity in its traditional industries — textiles, toys, and other commodity products — as well as rapidly adding capacity in developing industry sectors. These include digital electronic products; consumer appliances; electronic technology, including semiconductors; chemicals; steel; petrochemicals; automotive; and heavy industrial.

The comprehensive capacity of China’s traditional industries stems from access to inexpensive raw materials, cost-effective technologies, managed low-cost labor, and strong international and domestic demand. Although managed low-cost labor is another key element of China’s traditional industries, recent labor shortages and high employee turnover have increased annual labor costs and eroded margins in some cases.

Textiles exemplify the comparative advantages of a traditional Chinese industry. In 2004, China accounted for about 20 percent of the global textile trade, a figure that is expected to rise to 50 percent for 2005 now that 30-year-old global trade agreement quotas have been lifted.

However, China’s traditional industries continue to face retaliatory tariffs imposed by certain trading partners and to generate heated political discussions, particularly with the European Union and the United States. These traditional industries also are being challenged by other Asian countries, such as Vietnam, Pakistan, Cambodia, and Indonesia, which are developing capacities and workforce skill sets that allow them to compete with China as low-cost producers of commodity-type products.

As such, the Chinese government is placing greater emphasis on developing technological innovation. China is shifting to an economy based on state-of-the-art manufacturing from one of low-cost production centered on cheap labor. This shift is evident in China’s current automobile and light-truck industry, which is located primarily in ETDZs.

In 2005, China produced about 3 million passenger automobiles and ranked third in world vehicle production. Advances in manufacturing and logistics methodologies have enabled Chinese companies, such as GM Shanghai and SAIC — along with key automotive suppliers, such as Delphi Packard and TRW Automotive — to achieve record levels of production and profit.

Technological advances also have resulted in breakthroughs in industries relatively new to China, such as microelectronics, nanotech, and aerospace industries primarily located in HTDZs. The rate of technological contributions currently is constrained by a lack of collaboration among China’s research and development (R&D) institutes and its industries, and the country’s lack of enforceable intellectual property protections. However, multinationals are expected to conduct more serious R&D in China once anticipated reforms to laws and business practices in these areas are realized.

Outside of manufacturing and technology, the Chinese government also is reshaping the nation’s economy by developing service industries, such as telecom, retail, and tourism, which are located primarily in the East Coast Region of the country. China’s continued economic development will materially shape the global economy of the 21st century.

China’s demographics, as well as the growing affluence of its people, play important roles in the country’s economic development and in securing foreign investment. China’s population dwarfs that of the United States — at 1.3 billion, its population is four times that of the U.S. China’s East Coast Region, which includes Hong Kong, Macau, Shenzhen, Fuzhou, Hangzhou, Shanghai, Nanjing, and Beijing, has a population of 376 million and produces an annual gross domestic product of approximately $1.1 trillion.

Many inhabitants of this region are educated and affluent. They also are passionate consumers. China currently has the largest base of cell phone subscribers in the world, estimated at 350 million. It is also one of the world’s largest markets for computer-related products and services. Mandarin is the second-most-used language on the Internet, and China probably will overtake the United States in homes connected to broadband by 2007.

China’s emerging middle class has proven to be a fast-growing market for sophisticated consumer multimedia electronics, from MP3 players to plasma television sets; automobiles, including high-end European, Japanese, and American brands; homes and apartments through real property leases and structural ownership; and durable home products, from furniture to appliances. Some economists predict that China has the potential to become the world’s largest consumer market during the 21st century. For multinationals, these demographics and consumer trends make China an extremely appealing market in which to invest.

China has experienced many obstacles to development under its communist dictatorship. The country lacks well-defined property and civil rights; comprehensive laws for banking, capital markets, and bankruptcy; and judicial processes and systems. In part, the nation’s profound achievements are the result of the Chinese government’s continuing control over the planning and management of development and the commercial entities that comprise China’s economy, the imposition of trade subsidies, and the manipulation of its currency, the Yuan [also known as renminbi (RMB)].

China’s success also lies in part in its acquisition after achieving WTO membership of the intangible assets that come bundled with foreign investment: Western-educated and internationally experienced executives, managers, and engineers represented by professionals providing services in law, tax, operations, logistics, risk, engineering, R&D, and sales and marketing. To date, China has succeeded by balancing the benefits of the government’s direct controls with the financial and intangible contributions made by its foreign investment and trading partners.

But as foreign investment and trade continues to flow to China, more of its citizens benefit from expanding development, and more WTO requirements need to be satisfied, additional reforms are necessary to achieve a fair and sustainable balance among the government’s regulatory efforts, its citizens’ rising expectations, and the demands of the international marketplace. Economic reforms offer increasing potential for corporate renewal professionals to expand their practices into China.

Foreign Investments

The advantages of state ties for state-owned enterprises, Sino-Foreign Joint Ventures (JVs), and Foreign-Invested Joint Stock Limited Companies (FISCs) can be enormous. State-owned enterprises in key industries are chosen by the Communist Party to lead China’s economic development, and these companies receive lucrative contracts, tariff protection, cheap land, easy credit from state-owned banks, and preferential treatment for listing shares to facilitate their charters. The Chinese government also steers foreign partners to these companies to ensure that they have access to critical resources, such as executive management, technology, R&D, and foreign markets.

Each state-owned enterprise, JV, and FISC has a Communist Party organization that acts as a shadow management and approves all major decisions and management appointments. For example, the state-owned holding company of Assets Supervision & Administration Commission has a controlling stake in nearly 200 major companies, monitors management and performance of operations, and actively intervenes whenever it best serves the interests of the Communist Party.

For American multinational companies that are foreign invested enterprises (FIEs) in JVs and FISCs, the long-term benefits generally more than offset the inherent inefficiencies of Chinese businesses. JVs and FISCs benefit from a variety of Chinese policy incentives. In addition to those mentioned earlier, tax breaks and operative incentives are often provided. Controlling state-owned partners in JVs and FISCs also tend to permit the executives provided by their foreign partners to manage these companies consistent with agreed-upon business plans.

The concept of guanxi applies. As long as foreigners understand the expectations of the Communist Party and what and who is important — what is expected of them from whom and when — JVs and FISCs managed under foreign stewardship can be enormously successful and profitable.

Two forms of limited liability JVs currently are available: equity joint ventures (EJVs) and cooperative joint ventures (CJVs). A holding company (HC) is a special-purpose limited liability company that permits foreign partners with multiple investments to coordinate its efforts.

A FISC is a form of FIE that allows issued shares to be traded on China’s stock exchanges. Foreign partners in these types of FIEs tend to be well-capitalized, well-managed multinational corporations that are represented by experienced professionals, including international attorneys, investment bankers, tax advisors, and corporate renewal professionals.

Foreign entities can now operate businesses in China without government involvement by forming Wholly Foreign-Owned Enterprises (WFOEs) and Representative Offices. WFOEs are limited liability FIEs in which one or more foreign entities own 100 percent of the equity. WFOEs permit management to control the company’s business plan and execute it — with no Chinese partners or shadow management — although certain scope restrictions may exist, depending on the industry.

WFOEs are most favored by American middle-market companies comfortable with foreign equity investments requiring optimum control and seeking to engage in direct business operations in China, including the domestic sale of products. Currently, foreign entities are not permitted to set up branch offices in China.

Rep Offices are non-FIEs that are prohibited from engaging in direct business operations in China. Foreign entities that establish Rep Offices are limited to conducting local research and promotional and marketing activities, including assessments of FIEs performing Chinese outsourced operations. They are preferred by smaller American companies that require low-investment entry into China to acquire first-hand market information and that are not averse to being responsible for such an office’s liabilities, such as debt the company assumes and wages and benefits promised to its employees.

WFOEs and Rep Offices offer growing opportunities for corporate renewal professionals providing services in North America and China. U.S. companies utilizing North American production in markets in which lowest landed cost is a decisive factor are increasingly losing market share and realizing operating losses as a result of competitors that already use China outsourcing.

American companies that find themselves at such a competitive disadvantage can set up WFOEs or Rep Offices, establish China-based manufacturing operations, wind down their North American operations, divest themselves of these assets, and settle resulting liabilities. Corporate renewal professionals can provide operational, logistical, and financial services to the China operations and manage or advise the wind down, asset conversion, and legal processes of the discontinued North American operations.

Traditional crisis management and insolvency services can be provided to at-risk American companies that don’t implement successful China outsourcing strategies. Professionals engaged to sell American companies or their assets should consider Chinese companies as potential purchasers for certain assets, especially intellectual property.

China’s Banks

Mismanaged government-owned banks represent one of the greatest risks to China’s continued economic development. China’s banks, especially the “Big Four” — Bank of China, China Construction Bank, Industrial & Commercial Bank of China, and Agricultural Bank of China — haven’t acted as “banks” in the Western sense of the word, but rather as financing arms of the Chinese government to fund centralized planned development. As such, China’s banks lack the credit and risk controls, information technology systems, and management processes typical of Western banks.

The Big Four have provided most of the funding provided to favored state-owned enterprises, and their combined uncollectible loans are estimated at $120 billion, or 10 percent of their portfolios. Although Shareholding Banks, City Commercial Banks, and Rural Banks historically have been more rational in their lending practices, their respective portfolios also contain unacceptably high levels of risk and bad loans.

China’s banking practices have resulted in significant opportunity costs as well. Financial products necessary to facilitate future development, such as consumer and trade financing, are currently materially underrepresented in the portfolios of China’s banks. The banks have received about $100 billion in bailout subsidies from the government and may require an additional $200 billion by the end of this century to remain operational.

China is opening its banks to foreign investment in 2006 not only to comply with WTO requirements to open its bank sector to full competition by 2007, but also to minimize future government-funded bailouts and expand the financial products necessary for continued economic development. After the reform takes effect, China will be obligated to begin permitting foreign-funded banks to provide RMB services to their Chinese clients. Those services likely will be phased in gradually.

The China Banking Regulatory Commission initially capped the maximum amount of foreign investment in a single Chinese bank at 25 percent, although it is widely expected that this cap will be increased soon to something approaching 50 percent.

The Chinese government already has consented to investments by Bank of America and Temasek Holdings Pte. in China Construction Bank; Goldman Sachs, American Express, and Allianz in Industrial & Commercial Bank; Citigroup in the Shanghai Pudong Development Bank; and UBS AG, Temasek Holdings Pte., Royal Bank of Scotland Group, and Asian Development Bank in the Bank of China. In addition, HSBC has been granted a 19.9 percent stake in China’s fifth largest bank, Bank of Communications.

Although it is unlikely that the government will allow its foreign partners to exercise significant control over China’s banks, foreign partners are being allowed to import the senior executives, management processes, information technologies, and financial products (commercial, trade, and consumer) typically found in Western banks. For corporate renewal professionals experienced in bank turnarounds, credit and risk management, portfolio development and securitization, and workouts of high-risk loans, banking reform in China represents significant opportunities.

Bankruptcy Laws

China’s current bankruptcy laws are primarily found in Regulations of the Supreme People’s Court on Several Issues in the Hearing of Cases of Enterprise Bankruptcy (2002), which attempts to clarify The Law of the People’s Republic of China on Enterprise Bankruptcy of 1986 (applicable to government-owned enterprises), the Civil Procedural Law of the People’s Republic of China, the Company Law of the People’s Republic of China, and the Measures on Liquidation Procedures for Foreign Investment Enterprises (these are applicable to all non-state-owned enterprises).

Adding to the complexity, certain local governments, such as Beijing and Shanghai, have their own rules on the liquidation of foreign-owned enterprises. China’s current web of bankruptcy laws is based on traditional Communist Party policies — that is, they focus on domestic stability rather than on the economic ramifications of foreign investment and economic reforms. The impetus for a uniform bankruptcy law also lies in the Chinese government’s desire to discontinue subsidies to state-owned enterprises for overcapacity, uncompetitive methodologies, corruption, and business failure. Given the inadequacies of the current bankruptcy law for both state and foreign investors, ratification of a uniform bankruptcy law is necessary and expected.

The State Council and the Standing Committee of the National People’s Congress have reviewed numerous drafts of the new bankruptcy law as prepared by the Committee of Finance and Economics of the National People’s Congress. Drafts of China’s uniform bankruptcy law incorporate concepts familiar to American bankruptcy and insolvency professionals: uniform bankruptcy criteria; requirements of bankruptcy petitions; venue choices; rules for court-appointed administrators responsible for managing a debtor’s assets; rights of creditors to supervise the bankruptcy case; reclamation rights for creditors; recovery of fraudulent conveyances and preferential transfers; processes for effectuating plans of conciliation (reorganization), liquidation, and dismissal; provisions for cross-border insolvency issues; and processes for the payment of creditor claims.

Although a uniform bankruptcy law is viewed as a critical reform for China, when such a law will be finalized and ratified is unknown. However, corporate renewal professionals specializing in bankruptcy and insolvency services will have an excellent opportunity to expand their practices into China once its uniform bankruptcy law is ratified.

Much to Do

The Communist Party of the People’s Republic of China is to be commended for its stewardship over the successes of its economic reforms, measured rate of change, and cultural stability. However, China still must resolve significant issues that materially threaten the sustainability of its economic development and prosperity. Some of the issues foreign investors, trade partners, and their respective professional advisors are watching include:

• Avoiding one of the Communist Party’s worst fears — domestic social unrest or revolution.
• Resolving international geopolitical and trade issues consensually and avoiding adversarial resolutions, especially war.
• Accomplishing the reunification of Taiwan consensually within the framework of a “One China Policy” or being prepared to compromise.
• Successfully reverting Hong Kong and Macau back to Chinese sovereignty after their respective Basic Laws expire.
• Creating policies with India that create a market-driven “Chindia” or reforming its economic policies faster than India can create infrastructure and effectuate cultural change.
• Facilitating education and job creation for the tens of millions expected to enter the workforce annually and preventing substantial numbers of people from sliding back into poverty.
• Facilitating continuing education and career advancement for the hundreds of million of workers who comprise China’s growing middle class.
• Continuing to implement economic policies that attract multinational investment to China’s vast heartland, and promoting economic development of its second-tier cities and the continuous development of their respective labor forces.
• Remedying ecological problems, such as air and water pollution and ground contamination.
• Implementing energy policies to source and use oil, natural gas, and other energy resources more effectively and efficiently.
• Enacting and enforcing uniform property laws, including intellectual property; contract laws; and other critical business reforms, including uniform bankruptcy laws.
• Creating federal and regional court systems that can equitably resolve domestic disputes involving commercial laws and other business matters that cannot be remedied under the nation’s current system of arbitrage.
• Evolving the People’s Bank of China into an entity that sets market-driven monetary policies and regulates banks and financial institutions.
• Criminalizing corruption and other questionable business practices and enforcing sentences.
• Creating regulatory agencies that enforce reforms, laws, and transparent economic reporting.

Economic and cultural reforms in China present opportunities for corporate renewal professionals and their clients. However, caveat emptor applies. China remains one of the world’s riskiest, most complex markets, and any party contemplating entering it should be advised by qualified professionals.