Strategies for Investing in China

Strategies for Investing in China

Mechem, R Mark

Since China’s entry into the World Trade Organization (WTO) foreign investor interest and participation in the country’s economy has grown to unprecedented levels. China now rivals the United States as the world’s number one destination for foreign direct investment (FDI). China’s implementation of its WTO commitments has significantly expanded foreign investors’ ability to participate in the country’s economy.

Moreover, recent years have seen a marked evolution in the way companies view their China-based operations in the context of their global business development strategies. Companies no longer view their China operations as a special case, somewhat removed and isolated from the rest of a company’s international operations. Rather, China-based businesses are increasingly integral parts of global business plans.

Combined with the new opportunities emerging as China’s WTO commitments kick in, this shift in viewpoint is leading foreign investors to approach the question of how to structure operations in the country in a fundamentally new way. Of course, which of the country’s limited (if proliferating) number of investment vehicles to choose is still one of the most crucial decisions a foreign investor must make in China. But where regulatory prohibitions-especially those found in the Catalogue Guiding Foreign Investment in Industry-once all but dictated how foreign companies could structure their China investments, strategic and commercial considerations are rapidly becoming the most salient deciding factors in choosing an investment vehicle. Is your company’s goal to tap into China’s rapidly expanding domestic market or to establish a manufacturing base for exports or some combination of both depending on your investment timeframe? Indeed, the regularization of China’s market for FDI in recent years has now reached a point where such considerations are no longer the exclusive purview of multinational corporations. Many small and medium-sized foreign companies can now reasonably begin to consider a “China play” in their own growth and development plans.

The representative office-traditional first step

Though technically not an investment vehicle, the representative office (daibiaochu) is usually the quickest and least expensive way to establish a presence in China (see p.28). Opening a representative office enables a company to learn about the market through market research, build reputation and brand awareness, and foster important and necessary relationships with actual or potential customers, regulators, and possible partners for future investment. A representative office is an attractive option for a company that wishes to establish a reputation and build capacity while it waits for further market openings, a strategy that has been popular in many service industries including telecom. In other service sectors, such as the law, the representative office remains essentially the only option.

The chief constraint of the representative office is that it cannot engage in “direct profit-making” activities. Nevertheless, many representative offices operate as sales offices and are empowered to negotiate virtually all aspects of a deal. But when it comes to actually signing a contract and taking payment, it is the parent company, not the representative, that must conclude the deal.

Another constraint of the representative office is the fact that it must be sponsored by a Chinese company or organization that is recognized by the Ministry of Commerce (MOFCOM) as having an interest in the proposed business of the office. As representative offices are licensed for only three years, sponsorship must be renewed each time the office reregisters, a situation that can lead to bureaucratic fatigue and headaches when dealing with one’s sponsor.

Similarly, PRC citizens employed by representative offices are technically not employees of the parent company, but of a Chinese labor organization such as the Foreign Enterprise Service Corp. (FESCO). FESCO and its competitors theoretically provide Chinese employees of representative offices with pension, health, and other benefits based on contributions from the representative office itself. Many companies have found that these benefits, though often exceeding standards in most Chinese companies, often fall short of international corporate standards, meaning that companies must provide supplementary coverage to their Chinese employees that they would not have to offer in other structures.

For some industries, representative offices are an attractive way to expand into new geographic markets. Functionally, this might best be thought of as branching. But the Chinese FDI regime treats representative offices and branches quite differently in several important respects that often determine which vehicle a given company decides to pursue. Though the laws and regulations governing the establishment and operation of representative offices are well established, branch offices remain poorly defined in Chinese law, especially outside of financial services. To the extent that branch offices are defined, it is important to note that they do not hold legal person status, as representative offices do. The parent company bears all liability for the actions of a branch office. Taxation is another important consideration. Branch offices are taxed on actual profits, whereas a representative office may be taxed on deemed profits. Consequently, the tax burden associated with a representative office may actually be higher than would otherwise be justified.

Straight to the chase: The WFOE

The wholly foreign-owned enterprise (waishang duzi qiye or WFOE) has become the dominant form of foreign-invested enterprise (FIE) over the past decade, a trend that has only accelerated following China’s 2001 WTO entry. WFOEs constitute nearly 70 percent of new FDI projects approved in the first half of 2004, and 75 percent of investment dollars.

WFOEs have always been popular vehicles for foreign investors. The earlier dominance of the joint venture (JV) was primarily due to the fact that the Catalogue Guiding Foreign Investment in Industry previously forbade WFOEs in many sectors of the Chinese economy.

Simplicity and control are the principal attractions of the WFOE. WFOEs can often be established and begin operations much more quickly than JVs, as there is no need to engage in protracted negotiations with prospective partners. Not only are WFOEs immune to pressure from Chinese partners to transfer sensitive technologies, but they are also better able to protect proprietary industrial processes than most JVs. Similarly, a WFOE’s expansion plans remain subject solely to the foreign investor’s capabilities.

The Chinese government has traditionally offered only lukewarm support to WFOEs. Although China’s WTO entry agreement mandates national treatment, WFOEs may still find it difficult to compete for contracts in sectors where there are strong or influential domestic competitors.

Joint ventures: Holding their own

JVs may have declined in relative terms as a percentage of China’s FDI, but they continue to multiply in absolute terms. This is notable because the number of sectors in which foreign investors may only participate through JVs continues to shrink. The persistence of the JV, then, must be attributed to its unique commercial advantages.

Forming a JV with one or more Chinese partners often enables a foreign investor to tap valuable resources and mitigate exposure to risk. JV partners can help lower start-up costs, especially in capital-intensive industries. Many Chinese JV partners can contribute good site locations and serviceable infrastructure. A properly chosen JV partner may also bring a trained work force and strong sourcing, distribution, marketing, and after-sales networks to the enterprise. It is worth noting that, though some early foreign investors have sought to break away from or buy out their JV partners, others have built such strong and mutually beneficial relationships that they now prefer to expand their businesses in China in concert with their JV partners-even though the law no longer requires them to do so.

Some early investors that initially entered the Chinese market via a JV have reported considerable difficulty in negotiating such issues as technology transfer, human resource allocation, intellectual property rights, and expansion plans with their partners. These difficulties have been exacerbated by the fact that China’s laws and regulations concerning corporate governance often convey disproportionate power to minority partners in a JV (see p.24). Most significant decisions in a JV require unanimous board approval.

Some foreign investors have been frustrated by the unwillingness or inability of JV partners to pursue expansion plans, a situation that has become more pronounced with tightening credit markets. This reluctance is of particular concern to multinationals, which are increasingly making efforts to integrate their China-based operations with the rest of their global supply chains.

* The equity joint venture: Beijing’s favorite

The equity joint venture (hezi qiye or EJV) is the main form of JV in China and was once the country’s most common investment vehicle. EJVs accounted for 27 percent of the new FDI approved in China during the first half of this year and nearly 90 percent of all JVs. PRC leaders traditionally preferred the EJV because they believed that it facilitated greater transfer of needed technologies and know-how.

An EJV is a separate legal person established by one or more foreign and Chinese investors. Ownership and the share of profits and losses incurred by the partners are determined by their respective contributions to the JVs registered capital. To take advantage of tax incentives offered to FIEs, the foreign parties’ investment must exceed 25 percent.

The EJV may represent an attractive option to foreign investors interested in selling to the Chinese domestic market. Although China must open distribution-related services to WFOEs by the end of 2004 under its WTO entry agreement, access to a Chinese partner’s existing channels may offer a quicker, more economical way to learn about the market and establish a presence than would building a new network. A Chinese JV partner may be able and eager to leverage its existing commercial and government relationships to assure the success of the venture, which can also enhance the attractiveness of the EJV over the WFOE for some companies.

* The cooperative joint venture: Special purpose vehicle

The cooperative (or contractual) joint venture (hezuo qiye or CJV) differs from the EJV in two fundamental ways. First, the CJV need not be a distinct legal person. If the CJV is not incorporated as a limited liability company in its own right, the parties to the JV retain their independent legal status. second, and perhaps more important, ownership and profits are shared in a CJV not on the basis of each party’s equity contributions to registered capital but rather on the basis of their contractual agreements. Thus, the establishment of a CJV can prove both time consuming and expensive, as virtually all aspects of the proposed investment structure and business operation must be hammered out in negotiations.

Nevertheless, the CJV offers a unique set of possible commercial advantages. As the regulatory constraints on direct foreign participation in many sectors of the Chinese economy have relaxed in recent years, use of the CJV structure has increasingly converged with international norms. The CJV has become the standard form in certain industries, such as construction, where several contractors join forces to bid on a project. In other industries, the CJV may be preferable to the EJV in situations where parties to the JV wish to contribute difficult-to-value assets, such as property, plant and equipment, or proprietary designs and other intellectual property. CJVs also allow for the variable distribution of profits, which is impossible in an EJV, where profits are apportioned according to equity stake. This can be particularly advantageous when the foreign investor must contribute substantial upfront capital or technology to develop the venture. A CJV can then be structured with an accelerated return schedule enabling the foreign party to recoup its investment more quickly than in an EJV.

New options for demanding investors

The WFOE, JV, and representative office served the needs of both China and its foreign investors for many years. But as the economy and FDI inflows grew, some larger investors found themselves straining against the confines of these investment vehicles. Many larger investors had established numerous business units in China. To respond to the needs of these investors as well as to meet its WTO commitments, the Chinese government is expanding the scope of permitted activities for its older investment vehicles and has introduced newer investment vehicles such as holding companies, the foreign-invested company limited by shares, and research and development centers.

* Pulling it all together: The holding company

The holding company (konggu gongsi) structure offers distinct advantages for foreign investors looking to coordinate and consolidate functions across multiple business units in China. Holding companies may take the form of a WFOE or EJV, but WFOEs dominate. At present, the holding company structure is only open to a limited cross-section of major foreign investors. Although the minimum paid-in registered capital requirement ($30 million) is not excessively restrictive, the additional requirement that the foreign investor have at least 10 FIEs in the country effectively shuts the door to this vehicle for most companies. Nevertheless, holding company approvals continue to rise as more and more investors meet these minimum requirements.

Initially, the chief attraction of the holding company structure was the ability to establish an entity within the holding group to engage in distribution and after-sales services rather than needing to rely on JV partners or third parties on an investment-by-investment basis. These rights extend to providing such services for the holding company’s foreign parent as well.

Holding companies enable foreign investors to integrate other business functions-such as procurement, importation, sales and marketing, and training-to achieve economies of scale. Research and development are often centralized under a holding company as well. Holding companies can also provide support services, such as consulting and equipment leasing, directly to their invested companies.

But the promise of the holding company structure in other areas has yet to be fully realized. This is particularly true of infra-group finances. While holding companies can provide loan guarantees for their invested companies or even extend credit to companies within the group, they cannot distribute profits and losses across business units. Foreign exchange balancing, one of the potential attractions of the holding company structure, remains underutilized as transactions are subject to State Administration of Foreign Exchange (SAFE) approvals individually rather than collectively. Tax and personnel functions remain decentralized for similar reasons.

Though holding companies will still be attractive because they enable economies of scale, the present popularity of this structurethere were more than 300 in early 2003-may fade as trading and distribution rights are extended to all FIEs later this year (see p. 14). The Chinese government, in that case, may either lower the bar for establishing a holding company or extend additional special rights, such as streamlined foreign exchange balancing and centralized tax and human resource functions, to maintain the holding company as a suitably attractive investment vehicle.

* Companies limited by shares

The foreign-invested company limited by shares or foreign-invested share company (FISC) resembles an EJV in many respects. Although considerably more expensive and complex to establish, the FISC offers a number of decided advantages to companies heavily invested in China. The FISC is China’s first investment vehicle to allow for an indefinite lifespan. FISCs are eligible for preferential treatment, such as tax holidays, accorded to foreign-invested enterprises in certain sectors and regions provided that the foreign equity stake is at least 25 percent of the registered capital. At the same time, FISCs also maintain their status as domestic Chinese companies even when the foreign investors hold a controlling stake. A minimum of five promoters are required to form a FISC, one of which must be foreign and at least half of which must be PRC residents.

More important, however, FISCs can integrate many management functions across business units-most notably human resources, marketing, and tax. In contrast to China’s other investment vehicles, FISCs may distribute tax burdens equitably by jurisdiction.

Exercising managerial control and exiting the investment are theoretically easier in a FISC than in a JV. The veto power exercised by minority partners in a traditional JV is greatly reduced in a FISC as only a two-thirds majority is required. FISCs can also sell both A and B shares on China’s domestic stock exchanges. The first FISC to list B shares was a Taiwan-invested appliance-maker, Can Kun, in 1993. The first to list A shares was a Taiwan-invested company called Zhejiang King Refrigeration in December 2003. Investors may exit by transferring shareholdings, even to offshore interests, without the approval of other shareholders, provided that the post-transfer ownership structure does not violate applicable Chinese law.

Research & development: Joining the global mainstream

China had more than 120 foreign-invested research and development (R&D) centers in February 2003, and these R&D centers have undergone considerable repositioning in terms of corporate strategies in recent years. Some early R&D centers were established more as deal-sweeteners to smooth bureaucratic approval of other investment projects-they were a way to demonstrate a company’s commitment to the Chinese market. They also proved useful for some investors as vehicles to identify and recruit highly skilled potential employees from partner institutions. Others were established to focus on issues unique to the Chinese market, such as language and interface localization of software products.

Notably, though many early R&D centers originally appeared as black holes on the balance sheet, they have undergone a marked transformation. Foreign investors have quickly learned how to turn their R&D centers into value-generating operations. Most China-based R&D centers continue to focus on product development for the domestic or regional markets, but basic research appears to be on the rise. Not only does the Chinese government continue to offer investment incentives in this direction, but some companies have also realized cost savings approaching 90 percent by conducting research in China. These savings, combined with growing interest in and increased access to China’s domestic market, are contributing to a closer integration of China-based R&D centers with many companies’ global R&D and manufacturing operations.

Mergers & acquisitions

As China continues to relax its regulatory regime for FDI and as an increasing number of foreign investors begin to integrate China-based operations more closely into the rest of their global supply chains, a shift is taking place in expansion strategies. In many industries, expanding in China used to entail a proliferation of JVs. Nowadays, however, mergers and acquisitions (M&A) are increasingly attractive alternatives, as in other markets. This is not confined to buying out JV partners, as discussed earlier, but extends to the acquisition of entirely different Chinese firms. As elsewhere, expanding via M&A often promises the ability to establish a mature footprint in the domestic market quickly. At the very least, companies can gain ready access to an experienced work force and some potentially valuable assets through MScA.

Here again, the difficulties associated with M&A in China may foreshadow further revisions to the country’s regulatory regime to address the needs and concerns of foreign investors. Valuation of assets, never an easy proposition, remains more difficult in China than elsewhere. Human resource concerns are arguably even more difficult, especially in terms of potential work force reductions and benefit liabilities.

Winds of change

Foreign direct investment in China continues to grow in both volume and complexity. Chinese authorities have demonstrated flexibility and pragmatism in adjusting the country’s investment regime to meet the evolving needs of its foreign investors over the past 20-odd years. Although foreign investors increasingly find themselves straining against the limits of China’s existing FDI structures, change will almost certainly continue to follow established patterns: Progressive regional governments and companies are designated as test cases for proposed liberalizations, and once a pilot program shows promising results, the government extends the newly modified investment rule or structure to the rest of the country and other companies.

Shanghai is the clear nexus for such activity now. The city has encouraged the establishment of new variants on China’s traditional investment vehicles. Export procurement centers (EPCs) serve as a case in point. Before the implementation of China’s amended Foreign Trade Law, which confers trading rights on all FIEs in keeping with the country’s WTO entry commitments, Shanghai extended trading rights to EPCs, a new class of FIE.

Similarly, the Shanghai government has spent considerable effort to entice multinational corporations to move their Greater China or even AsiaPacific regional headquarters to Shanghai. More than 60 regional headquarters have now located in the city. It is worth noting, however, that certain critical functions of these headquarters remain offshore. China’s closed capital market and its restrictive and cumbersome regulatory regime continue to dissuade most foreign investors from centralizing regional financial operations in the country. Most of those financial operations remain in Hong Kong, Singapore, and Japan. This fact has not been lost on Shanghai’s municipal authorities, who are exploring options to accommodate foreign investor needs in such critical areas. Yet their eagerness to accommodate foreign investors’ needs is probably the most promising trend as foreign companies look at China as a long-term destination for their businesses; China’s FDI regulatory regime will continue to converge with established international norms as foreign investors integrate their China operations with the rest of their global operations.

Copyright U.S.-China Business Council Sep/Oct 2004

Provided by ProQuest Information and Learning Company. All rights Reserved.