Foreign companies are re-thinking strategies to compete and partner with China’s state-owned enterprises in China and abroad.

As China’s state-owned enterprises (SOEs) develop rapidly with assistance from the PRC government, some foreign businesses are considering new partnership opportunities, while others look to improve strategies to compete with SOEs. US-China Business Council (USCBC) staff recently conducted interviews with 20 member company representatives to learn more about how they are interacting with SOEs in China and abroad.

Respondents indicated that foreign companies that partner with SOEs may be able to work in industries that would otherwise be restricted, apply for special projects, and receive preferential policy incentives. Companies that chose to partner with SOEs can take steps to minimize risks and operational conflicts, such as protecting intellectual property rights (IPR), while companies that compete with SOEs can adjust their strategy to be more competitive.

Foreign company and SOE partnerships

As foreign firms have sought to expand in China, companies have increasingly considered partnering with Chinese enterprises—especially SOEs—for sales, acquisitions, projects, and joint ventures. Several PRC central government policies released in 2010—including the State Council opinions promoting mergers and acquisitions between enterprises and the opinions on improving the utilization of foreign investment—have raised foreign investors’ interest in understanding partnership options, especially if the Chinese partner is state-owned.

The USCBC interview results show that firms should consider the following factors before deciding to partner with an SOE:

  • Foreign companies should identify whether PRC laws and regulations require a Chinese partnership to conduct business in a specific sector. For example, strategic and pillar industries—such as aerospace, auto, nuclear power, and telecom—require foreign investors to find a domestic partner to conduct business in China. Because SOEs dominate these industries, the partner will likely be an SOE.
  • Companies should consider whether they are willing to give up some decision-making control. Interviewees said SOEs often have a hierarchical structure, while the SOE leadership sometimes focuses more on political goals rather than long-term company development or profits. According to USCBC interviews, foreign companies fear they will have to compromise some of their goals or concede some of their decision-making power by working with an SOE.
  • Companies should consider whether cooperating with SOEs can help achieve a specific goal. For example, company representatives interviewed said that some SOEs do not worry about market share because PRC authorities encourage other companies to purchase from SOEs and may assign designated customers for their products. SOE partners can thus give foreign companies a direct channel to sell products.

Evaluating a potential SOE partner

Interview respondents stressed that it was important to choose an SOE partner with care. More than one interviewee said that it is easier to partner with local SOEs than central SOEs because local SOEs may have fewer political ties or motivations. Local SOEs in eastern China tend to be more market-oriented than SOEs in other parts of China because their leadership often has more managerial experience.

When evaluating a potential SOE partner, interviewees said foreign companies should consider whether anything in the SOE’s financial, commercial, or production history could be a liability in the new partnership. Interviewees cautioned that foreign companies may need to perform more due diligence on a potential SOE partner than on a private Chinese company partner. Foreign companies should pay attention to several issues.

  • Recommended partners Though regulations seldom mandate SOE partnerships, the PRC government often steers foreign companies toward a specific SOE partner. According to interviews, SOE leaders often believe that a foreign company needs the SOE more than the SOE needs the foreign company. This leads to a greater risk that the potential Chinese partner will approach the cooperative activity from a position of strength or even indifference.
  • Priorities Foreign companies should try to understand the priorities of the potential SOE partner before cooperating on any business activities. Some interviewees stressed that foreign companies should evaluate whether an SOE’s priorities might be overly linked to a particular PRC central or local government agency. Government connections can be an asset for potential foreign partners, but such connections can also impose political objectives that could constrain a company.
  • Prior experience Foreign companies should evaluate their past experiences with SOEs as well as their potential partner’s experience working with foreign companies. Companies can review past Foreign Corrupt Practices Act (FPCA) cases to find out if the SOE has been involved in such a case or hire an outside firm to conduct due diligence research. Interviewees cautioned that foreign companies that have avoided partnerships in the past may have difficulty cooperating with an SOE. Likewise, an SOE partner with limited international business exposure may make the relationship more challenging.
  • Network reach Interviewees recommended that foreign companies pay close attention to the SOE’s network, which will vary with the size, location, and type of enterprise. For example, a company that is looking to expand distribution in northeastern China may be better off partnering with a provincial SOE based in Liaoning than with a centrally controlled SOE with branches in the Northeast. But in highly controlled sectors, such as electricity transmission or telecom, a centrally controlled SOE may be an effective way to raise a foreign company’s profile in that industry. SOEs in these sectors tend to have nationwide networks and many branches.

Interviewees said foreign companies should not base their decision to partner with a Chinese enterprise on the enterprise’s ownership structure. Both SOEs and private Chinese companies could be well-positioned to help a foreign company meet its goals. For example, most interviewees believe that SOEs often have greater access to resources such as capital, land, and other natural resources than private Chinese companies. If the foreign partner’s primary need is access to capital or different kinds of resources, the SOE might be a stronger candidate. If a foreign company is looking for a partner with a shared commitment to maximizing profits, however, the company may find it easier to partner with a private Chinese enterprise.

Minimizing risk in SOE partnerships

Partnerships between foreign companies and SOEs in China are not always smooth, but companies can take steps to minimize risk and ensure productive relationships. While cooperating with SOEs, foreign companies should pay close attention to three issues: IPR protection, compliance with the FCPA, and implementation of transparent management and conflict prevention practices.

IPR protection

Many foreign company representatives report that one of their biggest fears in partnering with an SOE is intellectual property theft. SOEs and private Chinese companies often lack awareness of IPR infringement. Interviewees shared their best practices in protecting a company’s IPR when cooperating with an SOE partner.

  • Tech transfer and research and development (R&D) activities Foreign companies often aim to limit core technology transfer in China and keep their main R&D activities in developed markets because of fears of intellectual property theft. But withholding essential intellectual property from an SOE partner is more challenging now than it was 10-15 years ago. SOEs no longer rely on foreign capital and are more likely to request technology transfers when negotiating a partnership with a foreign company. Central government policies often encourage technology transfer from foreign to Chinese companies (see Transferring Technology to Transform China—Is It Worth It?). As potential instruments of state policy, SOEs are more likely to press for intellectual property to show government owners they are working toward national development goals.
  • China-specific technologies Many foreign companies are developing new products for China or using China as an incubator for technologies to deploy to other emerging markets. Interviewees suggested that foreign companies manage intellectual property based on where it is used most as opposed to managing it based on tax and royalty considerations. For example, if a company develops intellectual property to meet demands in China, the company should file for IPR protection in China. This practice can help foreign companies offer something concrete to their potential SOE partner. Moreover, SOE partners are often willing to develop China-specific technologies because such actions demonstrate to the government that the SOE is supporting national goals. At the same time, Chinese companies, including SOEs, generally understand the needs of the China market better than foreign companies. Foreign companies must understand PRC rules that govern how Chinese-created intellectual property can be used or licensed overseas. These rules will affect how the foreign company and its Chinese partner are able to use what they create.
  • Accountability Interviewees suggested that companies should encourage SOE partners to take responsibility for protecting intellectual property. According to interviewees, foreign companies will need to educate SOEs continually about why intellectual property protection is in the partner’s interest. Commercial and political arguments—such as the PRC government’s recent IPR protection campaign or senior leaders’ statements about the importance of IPR protection—help persuade SOE partners about the value of protecting intellectual property.
  • Cooperative agreements Interviewees stressed that foreign companies should take customary precautions such as registering patents, trademarks, and copyrights in China, and creating intellectual property protection clauses for the original and supplemental agreements of the planned cooperation. Potential SOE or private partners that are unwilling to discuss intellectual property protection should be avoided.
  • Standard protection mechanisms Companies should consider limiting employee access to certain parts of the intellectual property, using technology and other internal security measures to monitor intellectual property use, and designating one employee or team of employees to track IPR protection.

FCPA compliance

Foreign companies often believe that SOEs generally have excellent relationships with government agencies and officials. But SOE employees may violate FCPA rules through their interaction with PRC government officials. Interviewees said foreign companies should err on the side of caution and pursue a strict course of compliance with the FCPA.

  • Train local partners Companies must train local partners in FCPA compliance, which should not be overlooked for cultural considerations such as the gifts Chinese businesspeople traditionally give government officials. Though PRC antibribery regulations increasingly detail prohibited behaviors and prescribe serious penalties, FCPA rules are stricter. Interviewees recommended using Chinese rules and regulations as a starting point for conversations and training on FCPA compliance.
  • Appoint a staff specialist Companies should appoint one person as an FCPA monitor within the joint venture to help maintain awareness and promote compliance.
  • Create compliance structures Interviewees also recommended designing internal audit procedures for FCPA compliance within the joint venture and organizing regular and ongoing FCPA training programs for SOE partners.

Transparent management systems and conflict-prevention practices

According to interviewees, foreign companies believe many SOEs lack professional business management—especially at SOEs where the leadership is appointed by the government. Companies can strengthen transparent management systems and minimize cultural and operating conflicts using the following strategies.

  • Information sharing Many SOEs frequently disclose less information than their foreign partners expect—practices that reflect their state ownership and lack of exposure to international business norms. Foreign partners need to set aside assumptions of what information might normally be shared and be prepared to ask questions.
  • Due diligence Companies will need to perform due diligence on an ongoing basis, rather than only in preparation for establishing the initial partnership. This will help companies understand the SOE’s perspective on the partnership, help identify areas of divergence, and prevent potential conflicts.
  • Long-term strategy Companies should integrate their long-term strategies in the original cooperation agreements so that both sides understand and accept the partnership’s direction and goals. SOEs may have different opinions on the goals and length of the partnership, as well as how to terminate it. These matters should be agreed upon at the beginning and regularly reviewed during the course of the cooperation to help both parties avoid conflicts relating to culture, values, operation, and management.

Companies should develop new strategies to compete with Chinese state-owned enterprises in China and abroad.

Strategies for competing with SOEs

Regardless of whether a foreign company’s plans include partnering with an SOE at some point, many US companies operating in China find themselves competing with SOEs. Understanding how SOEs operate can be important, as the competition can be intense, particularly for companies that sell products targeted at the middle to low end of the market, or those that operate in monopoly industries. Foreign companies that are technologically advanced, position their products and services on the high end of their market segment, or do not operate in monopoly industries may not face as much competition from SOEs. Moreover, companies find they may need new strategies to compete with SOEs outside of China as these companies move to emerging markets.

Domestic competition

Chinese enterprises, especially SOEs, dominate in strategic, pillar, and certain non-technology-intensive industries reserved by the PRC government for domestic leadership. Such sectors include aerospace, banking, energy, grain, petroleum, postal services, public utilities, railway, and telecom. The PRC government often restricts foreign investment in these industries by requiring foreign companies to partner with domestic companies or limiting the foreign ownership share. Meanwhile, the PRC government offers SOEs and private Chinese enterprises access to tax incentives, subsidies, and special funds, and gives them preference in government procurement.

In technology-intensive industries, such as electronics and information technology, Chinese enterprises usually dominate low- and mid-range products and services while foreign companies focus on mid- and high-end products and services. In the future, however, technological developments and strong government support may make SOEs more competitive in mid- to high-end products and services. Most interviewees agreed that these SOEs will still need some time to catch up with foreign companies in these market segments. At the same time, some US companies are considering how to form partnerships with SOEs that dominate the low- to mid-end product and services markets. Interviewees said that companies competing with SOEs should consider

  • Developing new products or localizing products for use in China;
  • Diversifying current products and technologies to expand business into down-stream industries;
  • Advancing R&D and upgrading products to widen the technology gap between foreign companies and SOEs;
  • Selling business units that have low profits due to severe competition in China or moving the business units to other emerging markets;
  • Focusing on underserved niche segments; and
  • Lobbying government agencies for equal treatment.

Because many SOEs lack strong customer service capabilities, foreign companies can distinguish themselves by paying close attention to customer needs and improving service and support. Company executives could also aggressively market and educate prospective customers about their products. Many SOEs are usually satisfied with their designated customers and do not emphasize marketing and customer development.

Overseas competition
While competition with SOEs in China is increasing, the PRC government is encouraging Chinese enterprises to invest overseas. Most of the $68 billion China invested abroad in 2010 came from SOEs. Though few interviewees—all of which are based in China—expressed strong concern about competition in other markets, they and their counterparts at headquarters are watching China’s investments abroad more closely.

Interviewees said competition with private Chinese companies and SOEs in emerging markets such as Africa, India, and South America is more robust than expected and stronger than competition from these companies in developed markets. Most competition with Chinese companies has focused on low-tech, low-price market segments where Chinese products and services might be more compatible with emerging market demand. According to interviewees, some US companies have been slightly behind their Chinese counterparts in cultivating business in emerging markets, and now these companies must scramble to catch up.

Some interviewees noted that existing partnerships in China could serve as platforms for foreign companies to access emerging markets. One interviewee said his company had established a cooperative relationship with a Chinese SOE so both could take advantage of the SOE’s early access to a specific developing market.

Interviewees noted that many Chinese companies still lack the technological sophistication and customer support necessary to compete in mature markets such as the United States and Europe. Nevertheless, interviewees suggested that competition with Chinese companies would likely be higher in price-sensitive commodity products, and that they expected future competition with Chinese companies in mature markets to increase across all product segments.

Following SOE developments

Trends indicate that SOEs will only become stronger in the future. Foreign companies should consider how they interact with SOEs not only as competitors, but also as partners. Foreign companies should be prudent in selecting a potential SOE partner and take steps to minimize risks—such as conducting due diligence and keeping communication channels open—to ensure a productive relationship. Companies should also adjust their China and global strategies to keep a close eye on the SOE competition.

[author] Joie Ma ([email protected]) is programs manager at the US-China Business Council (USCBC) in Shanghai. USCBC is the publisher of CBR. [/author]

Posted by Joseph Luk