ADAPTING TO SUCCEED IN CHINA

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1 INTERNATIONAL SERVICES WHITE PAPER ADAPTING TO SUCCEED IN CHINA KEYS TO OVERCOMING CHINA S BIGGEST CHALLENGES By Daniel Joseph, PNC s International Treasury Management group Emerging markets aren t easy, least of all China. While there is no shortage of minor obstacles in China, the major issues that can really knock a company off track are having the wrong strategy, the wrong partner or poor management. This paper examines China s local conditions, primarily as they relate to its economic structure, business environment and culture, and how those conditions can impact a company s strategy and management in China. This paper also provides some general guidelines for navigating your way through China s operating environment. INTRODUCTION Conversations about doing business in China tend to focus on what we could call the basic How-to s, i.e., how do I establish a company, how do I find an agent, how do I open a bank account, etc. These kinds of tactical execution issues are important. Often, without completing such tasks, a company cannot move forward in China. So, by all means, pursue the answers to these questions and feel free to contact PNC as we often help clients address such issues. But also bear in mind that these are not the issues that can stunt your growth, bleed your cash or cause you to travel to China once a month as opposed to twice per year as originally planned. The issues that can have the greatest negative impact on your business in China are having the wrong strategy, the wrong partner or poor management. In most cases, challenges in these areas occur because companies have failed to adequately account for differences in the local conditions between China and the U.S. We can basically divide the local conditions as presented herein into three categories as follows: Economic structure: The most important facet of China s economic structure is that it is in transition from a centrally-planned, communist economy to a free market, capitalist economy and the fact that this transition is being done gradually and unevenly. Business environment: There are many important aspects to the business environment, the most important of which would have to be inconsistent legal systems and the role of the government both quite different from what we are used to at home. Culture: Lastly, relative to local conditions would be the culture, a topic which also covers a lot of territory and can impact everything from management to consumer preferences. In the pages that follow, we will first describe important aspects of China s economic structure, business environment and culture. Following that are some thoughts as to how to steer your way through the differences in China. THIS ISSUE Economic Structure 2 Business Environment 3 Culture 4 Suggestions 4

2 ADAPTING TO SUCCEED IN CHINA 2 ECONOMIC STRUCTURE Deng Xiaoping, China s paramount leader from and chief architect of China s liberalization program, used the idiom Crossing the river by feeling the stones (muo zhi shi tou) to describe the gradual, step-by-step, trial-anderror approach to liberalizing China s economic system that he employed. The point of this idiom is that, when striving to meet a goal or destination, you don t have to know every step of the way. You simply have to know the direction in which to travel and then take one step, make sure you are on solid ground, then take another step, and another, and another, until you eventually reach your destination. Many, indeed most, aspects of China s economy, from Special Economic Zones to price controls to agriculture to currency regulations, have undergone transitions in this similar fashion. It is important to identify the main risks when entering a market like China. Strategy, partnerships and management tend to present the biggest risks. The result is that many aspects of China s economy are somewhere in between communism and capitalism still partially one and partially the other. The fact that China s communism-tocapitalism transition has not been even across all sectors or regions means that different parts of the economy are at different points along the spectrum which has a significant impact on China s economic structure. To avoid mistakes you have to understand the local environment and possibly make some adjustments to how you do business. Specific examples of differences in China s economic structure are provided below. Industrialization/Modernization There are so many big numbers relative to China it is easy to lose sight of the fact that China remains a relatively impoverished country. Half of the population still works on largely non-mechanized farms and earns no more than a subsistence income. China has made great progress but has a long way to go relative to developing its economy. Regional Development Over the first 30 years of China s liberalization program, roughly 75% of the foreign direct investment into China went into three major economic centers built around Beijing, Shanghai, and Shenzhen. As a result, per capita disposable income in Western China is one half that of cities on the East Coast and one third that of the Big Three cities (Bejing, Shanghai and Shenzhen). It is expected that over the next few decades the rest of China will catch up to the cities that started down the path of development earlier. Sectoral Market Freedom Different sectors within China have been liberalized at different rates. The result is that, if you are in some industries in China, you might feel that China is the most laissez-faire economy in the world. Yet in other sectors you will feel like you can t breathe without asking the government for permission. COMPANIES STRUGGLE TO ADAPT There is no shortage of companies who feel the impact that comes from struggling to adapt to the local conditions in China. preferences: There was a multibillion dollar consumer oriented company that entered China in the mid-2000 s and exited abruptly 3 years later having misunderstood the cultural issues that lead Chinese buyers in their space to make buying decisions based on very different factors from back home. Cost vs. efficiency: An industrial service provider who completely misjudged China s appetite for outsourcing, did not understand that cost consciousness tends to outweigh everything else with many Chinese companies. The revolving door: Four general managers in six years. Three in three years. Two in three years. There is virtually no end to the examples of companies struggling with turnover, particularly among managers.

3 ADAPTING TO SUCCEED IN CHINA 3 Crossing the river by feeling the stones Companies The background and ownership structure of a company in China often translates into widely different levels of sophistication and approaches to management and business. Some state-owned enterprises (SOEs) are actually financially successful, usually because they receive considerable subsidies and/or are protected from competition. Most struggle to survive. All are more motivated by politics, as opposed to profits, than any company you would find in the U.S. Privately-owned enterprises (POEs) are the drivers of China s growth and the source of most new jobs in the economy. They are very profit-oriented and vary widely in terms of their level of sophistication. Foreign invested enterprises (FIE s) play a major role in China s economy including accounting for the majority of China s value-added and technology-related exports and being major taxpayers. China is transitioning from communism to capitalism and is doing so in a gradual, step-by-step manner, which has a significant impact on its economic structure. BUSINESS ENVIRONMENT Though not the only aspect of China s business environment that differs from the U.S., the weak rule of law is certainly the most important. Rule of Law All developing countries struggle to establish the rule of law, just as the U.S. did back in the days of the Wild, Wild West. From a business point of view the problem is that, relative to all rules, regulations, standards and laws, there is a general lack of transparency, consistency and fair enforcement. Despite reports of its success, China is still very poor and its development is unevenly distributed throughout the country. Fixing the problem is not just a matter of passing a few new laws. Improvement requires laws, courts, lawyers, judges and most importantly, a change in culture permeating not just government but society as a whole. There are positive signs. For example, whenever China has lost a WTO case, it has abided by the WTO decision. The number of intellectual property cases has risen from roughly 5,000 per year to more than 30,000 per year, and 90+% of the cases are Chinese vs. Chinese (i.e., do not involve a foreigner). We can expect that, as the Chinese continue to produce and want to protect their own intellectual property (IP), IP protection enforcement will continue to strengthen. Like many things in China, the rule of law is improving, but still has a long way to go and foreign companies have to make the effort to understand the environment and protect themselves.

4 ADAPTING TO SUCCEED IN CHINA 4 Energy Banking & Natural Finance Resources Construction Media Telecomm Real Estate Heavy Mfg Medical Agriculture durables Retail Transportation Wholesale Education non-durables IT Light Mfg Leisure & Hotels Business Services Services Different sectors within China have been liberalized at different rates and in different ways. This chart is meant to capture the relative degree of market freedom that exists within various sectors. State controlled: Sector has low degree of market freedom. Free market: Sector has high degree of market freedom. Not an exact measurement. Based on analysis of China s trade policies and WTO commitments, China s foreign investment catalogue, the presence of Chinese state-owned enterprises and private enterprises within various sectors, and experience. CULTURE Without direct contact, it is difficult for foreigners to sense how China s culture might differ from America s. But if you spend time in China, it is easier to see the patterns that emerge. Above, under the Business Environment Section, the rule of law was discussed. At its roots, this is actually a cultural issue and is an example of how China s culture differs from our own at this point in history. Other examples are as follows: Hierarchical: In China, position is everything. Those below don t get to move up. Those in the right positions hold all cards. Authoritarian: Since position is everything and subordinates have to know their place, leaders have all the power and leadership tends to be more heavy-handed and authoritarian than in America s more egalitarian culture. Different sectors have been liberalized at different rates. There is much variation in management among China s different types of companies. It is important to know if you are dealing with an SOE, POE, or FIE. Cooperation: In a culture in which formal hierarchy is so important, people are accustomed to formal lines of authority. As such, they tend to be uneasy with informal arrangements and like to know who is the boss. SUGGESTIONS: HOW TO ENSURE YOU ADAPT TO THE LOCAL CONDITIONS Below are some brief suggestions as to the approach you should take to ensure that the local conditions in China and the extent to which they differ from those back home will not negatively impact your business in China. Walk the process: Whatever you are doing in China (buying, selling, building a plant, etc.) don t assume you understand the process. Walk your way through it ahead of time, understanding each step, to make sure you haven t missed anything. Like many things in China, the rule of law is improving but still has a long way to go. Foreign companies have to adapt. Good advisors: Develop relationships with organizations (accounting firms, law firms, banks, freight forwarders, the U.S. Commercial Service, etc.) that can give you reliable advice relative to regulations, local practices, etc. Advisors should include other companies active in China. Partner carefully: Only use formal partnerships if absolutely necessary. Take the time to really understand your partner, who has authority, how decisions are made, what are their goals, etc. Understand your leverage. How do you protect yourself (not just legally) if things sour? Invest time in the relationship.

5 ADAPTING TO SUCCEED IN CHINA 5 Stay close, watch everything: Don t hire a GM and delegate everything to China. Manage your managers closely. Implement your system and your corporate culture (possibly with some modifications that suit your China operation). Get as many people from the home office involved as you can. Take your time, do your homework: Don t move too quickly. Wade into the shallow end and then work your way to the deep end. You can t learn everything before you begin, so learn as you go, but don t undertake more risk than your knowledge can support. ABOUT THE AUTHOR Dan Joseph is an international cash consultant within PNC s International Treasury Management group. Prior to joining PNC, Dan lived in China for 12 years and has been doing business there for almost two decades. He has direct experience in sourcing, market development, FDI, manufacturing, and banking in China and is fluent in Mandarin Chinese. Bring enough to the party: Underestimating the amount of resources (mostly time and effort) required to climb the learning curve and succeed in China is probably the single most common cause of failure in China. Be sure you have the people and time to do it right. Worth it in the end: Surveys consistently show that 80+% of foreign companies in China are profitable and optimistic about the future of their business in China. 8+% GDP growth and 1.3 billion people leads to tremendous upside, if you do it right. You won t do everything right, but if you avoid the killer mistakes, you will do well and reap the rewards. (Please keep in mind that an exhaustive treatment of this topic would amount to an entire book. This white paper is designed to introduce summary ideas and provide basic guidance.) For more information please contact your Relationship Manager or Dan Joseph at daniel.joseph@pnc.com or visit. The materials or video that you are going to view were prepared for general information purposes only and are not intended as legal, tax or accounting advice or as recommendations to engage in any specific transaction, including with respect to any securities of PNC, and do not purport to be comprehensive. Under no circumstances should any information contained in those materials or video be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon any such information is solely and exclusively at your own risk. Please consult your own counsel, accountant or other advisor regarding your specific situation. Any opinions expressed in those materials or videos are subject to change without notice The PNC Financial Services Group, Inc. All rights reserved