Wise companies prepare for—and minimize their exposure to—risks when investing in China. On the surface, China appears to be one vast market with a strong central government. But deeper down, China is a conglomerate of disparate markets that vary in their levels of economic and social development—from modern municipalities like Shanghai and Beijing, where officials are used to dealing with foreign investors, to the less-developed “Wild West.” Though the central government has been taking steps to improve overall business operating conditions by instituting a stronger rule of law, building a more modern financial system, and creating a more transparent business environment—especially since China joined the World Trade Organization (WTO) in 2001—development and implementation remain uneven across the country.

As a result of this inconsistent investment environment and China’s rapid economic growth, the country provides foreign companies not only with enormous business opportunities—but also with enormous risks. Companies seeking to make their first investment in the country or expand their existing presence must be fully aware of the risks of doing business in China and prepare to take appropriate measures to mitigate those risks. Though foreign companies in China face legal, financial, political, social, and environmental risks, they can employ strategies to prevent them.

Legal and regulatory risks

Regulatory risk in China is high. Although many sectors of China’s economy have become more market oriented, numerous restrictions and a massive bureaucracy still hinder full implementation of regulations and make the approval process unpredictable. Moreover, the interpretation of PRC regulations tends to vary from place to place, and, in some cases, several authorities or departments are responsible for implementing the same regulations. Because companies must consult all of the relevant authorities—and often incur additional costs for doing so—the cost of doing business in China is frequently higher than companies expect. These issues, coupled with a recent rise in policies aimed at protecting domestic companies from foreign competition— especially in engineering and construction, legal services, and banking—create risks and obstacles that few foreign companies are aware of until too late.

Foreign-invested enterprises (FIEs) that plan to operate or invest in China or partner with a Chinese company need to understand how the regulations apply to them before entering into any agreements. Many FIEs wisely seek legal and regulatory advice from experienced professional firms in China. The Chinese business landscape is littered with unsuccessful ventures that tried to save money by “going it alone.”

Using China’s judicial system also involves risk. Because of China’s WTO membership and growing pressure from foreign investors for greater transparency and rule of law, China increasingly recognizes overseas arbitration awards and rulings. It is, however, still risky for companies to rely solely on the PRC judicial system to protect their interests. Few judges in China understand and have significant experience in handling commercial disputes; many are susceptible to pressure from local interest groups and governments. Even after receiving a favorable ruling, some companies have reported enforcement problems. For example, companies often find that authorities fail to implement judgments in bankruptcy proceedings.

In a relatively opaque environment, careful preparation to avoid legal problems in the first place is the best solution. Companies can minimize legal risk by conducting due diligence on the legal and financial background and reputation of key joint venture (JV) partners, acquisitions, senior managers, vendors, and suppliers before entering a formal relationship. Companies should also conduct pre-employment screening of all employees. Finally, companies may also wish to check the reputation of local government officials before committing to a particular locale.

Social and cultural risks

Business ethics and corporate governance

The concept of business ethics is still fairly new in China. In China’s changing economy, material gain, with little regard for how it is acquired, is often the measuring stick of individual success. Also, in many privately owned Chinese companies, one individual—usually the chair of the company—is still the only person responsible for all corporate governance issues. Rank-and-file employees generally defer to management without question, creating an environment without internal controls or where such controls are routinely overlooked or circumvented. Such environments are breeding grounds for fraud, corruption, nepotism, and other unethical behavior.

The legal system is ill-equipped to keep pace with this tide of misdirected entrepreneurship. Extraterritorial compliance regimes, such as the US Foreign Corrupt Practices Act and the Sarbanes-Oxley Act, exacerbate the risk for foreign companies operating in China. US companies must comply with these laws or face stiff fines from their own government, in addition to any penalties from the PRC government, which also monitors foreign companies.

To prevent ethical breaches, companies should institute ethics training programs and perform due diligence on partners, vendors, and investment targets. New senior-level employees and their immediate family members should undergo a thorough background check to determine their overall reputation, potential for conflicts of interest, and to make sure their lifestyle and wealth position are reasonably in line with their current position. In addition, employees who routinely come into contact with intellectual property (IP) or financial information should receive a summary pre-employment screening to verify their resume details. Pre-employment screening can include several levels of research—including public domain information gathering, employment application verification and character reference checks and more in-depth screening.

Investors should assess the corporate culture of a potential partner during the early due diligence process and, if necessary, make a comprehensive internal control program with division of responsibilities a part of the partnership or investment.

Transparency

Chinese businesses are accustomed to operating behind closed doors, out of view of the justice system, investors, and potential partners. Many financial, human resources, procurement, and subcontracting transactions in China lack transparency and documentation, which makes it difficult to determine what information is accurate and what is exaggerated or even false. Often, knowledge of the financial and market health of a potential Chinese company is connected to one specific individual, such as the company’s founder or CEO. This situation further hinders a full assessment of the company.

Before discussing a deal, foreign investors should verify that the individual’s and company’s history and reputation align with what has been presented by conducting thorough due diligence. Companies should also aim to understand the true nature of a potential partner’s ownership structure, political connections, and hidden power brokers.

Partners and suppliers

Prospective business partners in China will often freely admit that they are looking to the foreign partner to supply capital and technology. Though there are usually legitimate reasons for a foreign investor to supply capital and technology, investors must be cautious in this area. Many foreign investors have reported that, shortly after setting up a JV, competition sprang up: A relative or friend of the local partner’s general manager set up a duplicate factory that competes with the JV. Family connections also often exist between the purchasing manager, general manager, or other local managers and the preferred vendors. It is therefore unsurprising that vendors and suppliers routinely collude in tender-rigging arrangements and other corrupt practices, and purchasing managers have been known to demand kickbacks from suppliers or otherwise steer business to particular companies for personal gain.

Some FIEs hire firms to screen and audit vendors. These firms determine whether suppliers are legitimate and whether they would create a conflict of interest, lead to collusion between a company’s employees and its vendors, or result in other undesirable situations or actions.

Relationships

Relationships or connections (guanxi) were once touted as the secret ingredient to success in China. Over the past five to eight years, the market has become more regulated, making guanxi less important than sound business sense in many areas. But “guanxi vendors” still approach foreign investors, claiming to be well-placed individuals or companies able to help the foreign investors accomplish business goals through their connections. Guanxi often presents a double-edged sword to potential investors, as these connections may not exist, may be used by the vendors themselves to accomplish very different aims, or may actually be a reputational liability for the foreign investor (see the CBR May-June 2004, p.48).

Investors must exercise skepticism with these consultants and determine whether their guanxi is real and what its true value may be through detailed background checks.

Social accountability

Though China has relatively robust laws on labor rights and health and safety, working conditions vary enormously across China, especially between rural and urban areas. The reputations of some FIEs have been damaged in the past when subcontractors operated unsafe facilities or employed child laborers without the FIEs’ knowledge. Many manufacturers that have previously worked with multinational corporations are sensitive to social accountability issues and recognize the potential for increased productivity with improved labor conditions.

To prevent labor problems in the workplace, companies can educate and evaluate potential suppliers and subcontractors through social accountability training and Social Accountability 8000 audits, which assess compliance with international norms of working conditions (see the CBR March-April 2004, p.44). Some companies use risk-control firms that specialize in inspecting, auditing, and investigating facilities to ensure that suppliers enforce corporate codes of ethics and social accountability.

Crime and corruption risks

Corruption

The concept of “conflict of interest” is not widely understood in China. As a result, embezzlement, kickbacks, and other forms of fraud and corruption are widespread. Corruption is not limited to government officials; it is equally pervasive in the private sector. In a 2005 Transparency International study that measures the perceptions of international businesspeople on global corruption, China scored 3.2 on a scale of 0-10, where zero is “highly corrupt” and 10 is “highly clean.”

Internal controls and ethics policies are key methods for reducing the likelihood of corruption. Any company considering operating in China must prepare to invest the resources necessary to ensure that such controls and policies are effective. Foreign investors, however, should understand that it is impossible to avoid such problems completely in China. They must also recognize that investigations of employee, supplier, or partner behavior will be an inevitable cost of doing business in the country.

Intellectual property

Both Chinese and foreign companies suffer as a result of weak IP protection in China. According to US government statistics, about 20 percent of consumer products in China are counterfeit. Despite vocal and policy support from the PRC central government, the concept of IP sovereignty has taken a long time to filter down to the provincial and local levels. Though China’s WTO entry and the WTO Agreement on Trade-Related Aspects of IP Rights have made fighting counterfeiting a priority, the problem is likely to persist in China for some time.

Local and provincial authorities are often best motivated to crack down on counterfeiters when FIEs can demonstrate how counterfeiting of their brands affects their ability to employ local Chinese workers. If the manufacturer relocates to another province or country to avoid counterfeiters, the region will lose jobs. And when FIEs plan to leave a region, even corrupt officials are likely to take steps, if only to minimize the loss of revenue in kickbacks or bribes they receive from counterfeiting syndicates.

Foreign investors are well advised to evaluate the types of manufacturing operations they wish to bring to China. Investors that must bring in technology will need to develop robust IP protection programs and apply information security technology to separate sensitive information that could be used to create competition from other information required to run the business. They must also regularly monitor supply and distribution networks and the marketplace. In some cases, companies may wish to manufacture products that require high levels of proprietary research and development outside of China, in places with better IP protection, until China’s IP protection improves significantly (see the CBR January-February 2006, p.18). A thorough IP risk assessment must be conducted to determine the likelihood of IP leakage and what impact it would have on the company, the brand, and the company’s customers.

Money laundering

Much of the capital fraudulently obtained by individuals in positions of power finds its way out of China via investment vehicles and private bank accounts. Foreign investors should conduct due diligence inquiries on potential Chinese partner companies and their personnel before investing to ensure that they do not become unknowing accomplices to such laundering activities.

Rewards come with risk

Companies that plan to operate or invest in China can expect great opportunities in one of the most rapidly growing economies on the planet. But great risks are also inherent in most China ventures, and an overreliance on trust, opaque risk transfer strategies, and luck have caused the downfall of numerous companies operating or investing in China.

To succeed in capturing opportunities and securing competitive advantage, foreign companies must manage their risk strategically and conduct appropriate due diligence on every aspect of their business. Companies that focus on maintaining the integrity, security, and resilience of their business will experience smoother and more efficient operations, greater transparency, and higher investment returns. These companies will become brand leaders in the Chinese market and the standard bearers of their industry.

Jay Hoenig is president of Hill & Associates China and is based in Shanghai.

Posted by Jay Hoenig