Prospering in the China Market is a Matter of Managing Risk

Steve Vickers (President and chief executive officer of International Risk, formerly PricewaterhouseCoopers Investigations Asia)

This article originally appeared in the March 1, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher.

China recorded another year of remarkable economic growth in 2002, despite a weak global economy. More impressive expansion of 7 to 8 per cent is forecast for this year, propelled by a rising flood of foreign investment and booming domestic demand.

China's growth offers lucrative opportunities to foreign companies, but they come with a complex array of business and political risks that could prove costly in terms of money and reputation. These risks affect all companies regardless of their size and experience in China.

Brand protection and the strategic management of intellectual property rights (IPR) problems remain some of the biggest issues, despite recent moves by China to beef up IPR protection. As much as 30 per cent of revenues of foreign firms are being lost to counterfeiting and well-known Chinese brands are also victims.

Crackdowns have done little to dent piracy. Counterfeit goods now account for a significant market share of many brands.

Multinational carmakers find it difficult to sell authentic parts due to competition from knock-offs. Some of the worst affected areas - where counterfeits dominate the market in many parts of China - are personal hygiene and food products, toys and electronic games, CDs and computers, cigarettes and car parts.

Alarmingly, many of the counterfeit goods are now being exported, with Japan a major market, especially for higher-quality fake luxury brand goods.

Much of the counterfeiting is done by criminal gangs, which make crackdowns difficult and sometimes dangerous.

Another major headache is the unreliability of distribution networks. But foreign firms are gradually being allowed to establish their own logistics and distribution networks as a result of China's entry into the World Trade Organisation.

Firms keen to expand quickly may want to buy up established distribution companies, but some of these may be rife with corruption, such as kickbacks, bribery and company staff acting in collusion with outside parties.

Smuggling is another serious problem, and firms can easily get into trouble with an increasingly assertive Customs authority that regards fines and other penalties as an important means of raising revenue. Several multinationals have been caught up in Customs and tax bureau crackdowns in the past few years and have been ordered to pay significant penalties for years of underpaid or unpaid dues and taxes.

But even foreign firms with their own distribution networks have been hit by serious cases of fraud that have crippled their operations.

One prominent consumer manufacturing company with an extensive logistics network investigated the activities of its distribution staff and found that they had produced fake spare parts and usurped the official distribution channels to sell the shoddy products to customers. As a result, the counterfeit goods had seriously undermined the reputation of the company's products. The firm had paid little attention to its distribution operations, allowing problems to grow until they threatened its activities throughout the country. Management had little choice but to dismantle and rebuild its logistics network, incurring enormous financial losses in the process.

Hidden costs and lack of transparency also remain a major headache. Although WTO membership should create more transparent legal and financial systems that would help foreign businesses operating in China, these changes are likely to take a long time to be institutionalised. In the near term, doing business in China will have many hidden costs that could damage foreign firms. These include administrative charges and red tape, corruption driven by the need to cultivate political and business connections, and the high cost of protecting intellectual assets in a nefarious environment.

Macro-economic and political risks can also be a challenge. China's economic reforms have produced increasingly fierce protectionism among provinces that are seeking to safeguard the development of their local industries. For example, the beer industry is tightly protected at the provincial level, and brewers in one province cannot sell to neighbouring provinces.

A range of other issues poses potentially serious threats to China's economic and social stability, especially the high level of bad debts in the banking sector which many analysts believe rivals the problem plaguing the Japanese banking industry.

Additionally, growing unemployment, especially in cities, has led to rising labour discontent. One foreign-owned manufacturer that had decided to trim its workforce in southern China found itself facing angry workers threatening to stage sit-ins at the factory. Instead of shutting down the factory, the company decided to search for a local buyer. This allowed the foreign investor to pull out without any embarrassing incidents that could have hurt its reputation with the authorities.

As China undergoes a profound economic transition, substantial and confusing changes are expected over the next few years. The regulatory environment, for example, will be especially chaotic as the authorities come to grips with interpreting and implementing the highly complex and voluminous rules of the WTO.

Clarifying the risks from the outset can mean the difference between being profitable or being in the red. Foreign firms must therefore carefully assess the risks and adopt appropriate controls and other risk-mitigation measures before executing any plans to start or expand operations in China. If companies do this, they are likely to find that China indeed bring them rich profits.