Doing Business in China

Doing Business in China By Timothy Michael Grenon November 10, 2010

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There is an old Chinese saying that says, “Everything is possible, but nothing is easy.” (Shengjun) This statement becomes evident as one looks behind the capitalistic fronts of Beijing, Shanghai and Guangzhou. In fact, The World Bank’s Doing Business 2011 Rank shows China is 79th out of 183 economies when it comes to the “Ease of doing business.” (World Bank) The rankings provide nine more descriptors of how difficult it is to set up and conduct business in China. (See Table 1 in Appendix A) Fortunately, there are many opportunities to make a profit in the world’s second largest economy. However, one must be cautious when moving into the Chinese market. There are many steps to follow and decisions to be made. Suitable Industries for the Chinese Market Many companies in the developed world are anxious to set up business in China; however, not all businesses are appropriate for the Chinese market. The most obvious example of a poor fit would be companies whose products easily imitated. For example, clothing, footwear, media distribution (music, movies and software) and luggage companies may want to reconsider a move into China because their products have the potential to be copied and resold on the “black market.” This is evident by the multitude of street vendors and back alley stores that sell “knock off” Louis Vuitton purses, Armani ties and Ralph Lauren suitcases. Further evidence of this is in Appendix B, which shows a picture of students negotiating for fake purses and watches in a “store” near a back alley off the famous Nanking Market in Shanghai. Therefore, companies whose products are not easily copied have the best opportunity to succeed in China. According to the 2010 Country Commercial Guide for U.S. Companies: Doing Business in China, there are many industries that can provide products and services to

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the Chinese with less risk of having their products and services copied. (U.S. Commercial Service) First, in 2009, there were 13.8 million autos built and 13.6 million autos sold in China, making it the largest automotive market in the world. The market is ripe for companies who manufacture: engines smaller than 1.6 liters; technology and products related to hybrid and electrical cars; machinery, tools, testing equipment for OEM; Auto and motorcycle casting blanks; build auto parts and components; fuel cell technology and auto accessories. (U.S. Commercial Service) Second, 65 to 70% of China’s annual energy supply comes from coal, and experts expect the use of coal to grow at an annualized rate of 3.2% until 2030. Unfortunately, China’s abnormally high dependence on coal contributes to its record as the highest emitter of greenhouse gases. (Energy Information Administration) However, the government is taking steps to lower greenhouse gas emissions. This is an opportunity for multinational companies to provide: pre-combustion products and services such as energy efficient coal mining equipment, coal screening and scrubbing; combustion products and services such as coal liquification, gas turbine technology, Integrated Gasification Combined Cycle, Ultra Supercritical Power Generation and Underground Coal Gasification Combined Cycle. Finally, China also needs assistance with post-combustion products and services such as carbon capture and sequestration, flue gas denitration, flue gas desulfurization and particulate matter removal. Despite these growing needs for development, companies looking to move into this space should be aware that the market is fragmented, which makes it difficult for regulators to monitor all polluters. Environmental companies should be patient when entering this market and collaborate with Chinese regulators. (U.S. 3

Commercial Service) Third, the U.S. Commercial Service recommends companies in the construction equipment market consider selling products and services in China. China’s 11th Five Year Plan calls for rapid development of cities. Specifically, it calls for total construction to be 2 billion square meter during each year of the plan. (U.S. Commercial Service) This provides a fertile investment field for manufacturers of concrete machines, excavators, lifts, bulldozers, graders, scrapers and levelers. Other industries suitable growth in China are: machine tools, marine industries, healthcare, water and wastewater treatment, rail equipment, renewable energy and green building. Other industries suitable to entering the Chinese market are subscription-based services and “value-added services” that cannot be reproduced or stolen. (Billard) These services include professional services where one company has expertise in an area. For example, CBRE China has significant pricing power for its real estate services because there is very little competition in their market. (Yon Jin) In summation, the common theme among these industries is that they all have high barriers to entry. Business Structure After deciding on whether or not a business is suitable for China, one must focus on how to structure the business. The most common business structures are as a representative office, a joint venture or a wholly owned foreign enterprise. Representative offices are an inexpensive way set up in China, but businesses can only perform “liaison” services. The cost ranges from USD$100,000 to $500,000 annually, with office space and expatriate packages consuming the lion share of the cost. The disadvantage to this set up is that the office cannot sign sales contracts, directly bill

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customers or supply parts. A joint venture is an alternative to the representative office. It allows a company to partner with an already established firm in China to take advantage of connections, cut through red tape and become culturally familiar with the country. Many companies have entered China using the joint venture model but have since terminated their partnership due to the loss of control of investments, violations of confidentiality, and the potential for the partner to steal technology to set up a competing business. The relationship also requires constant monitoring of finance, personnel and operations. This become time-consuming and demands too many resources. The more popular route is to set up a wholly owned foreign enterprise (WOFE). The advantages to this structure are that manufacturers avoid import restrictions and high tariffs. They also have greater control over intellectual property and marketing. The disadvantages are that it is slow to set up and the rules to set up this type of business are fluid. Despite these drawbacks, 75% of new investments in China use the WOFE structure. After setting up in China, a business can turn itself into a franchise. This is a new concept for many Chinese, but it is a good way to grow a business. There are some important factors to consider. First, because the franchising concept is so new, experts recommend a company set up its own store to prove the business will work. Second, the government has implemented the “Two plus One Requirement” which requires franchisors to own at least two outlets outside China, prior to opening a franchise in China. (U.S. Commercial Service) Although building a franchise is a great way to grow a business, entrepreneurs claim it is difficult to find qualified franchisors. It is also difficult to collect royalty payments and maintain the

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integrity of the brand. Therefore, business owners should weigh the pros and cons to the franchise model before initiating a business. Steps to Open a Business When it comes time to open the business, owners should be patient and expect setbacks along the way. Assuming nothing goes wrong, it typically takes 38 days to open a business in China. (World Bank) This requires companies have connections within all levels of government to ensure a smooth process. Some steps to open a business in China maybe unusual to foreign companies. For example, step five requires a company to obtain approval from the police department to create a company seal. Step 8 requires the business to register with the local statistics bureau, and step 11 requires the approval to print or purchase financial invoices/receipts. Despite these unusual requirements, companies should follow through on each step to avoid conflicting with the rules.

Table 2 in the appendix shows

the appropriate steps to open a typical business. Pitfalls to Starting a Business in China When moving into a new market, businesses do well to adhere to certain “rules of the road.” Sam Goodman, a successful entrepreneur in China and prominent negotiator on the U.S. – China nuclear power plant bid for Westinghouse, has created a list of pitfalls to avoid when doing business in China. First, “Doing business the same way you did back home” is a recipe for disaster. Fastfood drive-thrus in China are a great example of this. According to Andrew Billard, Commercial Officer for the U.S. Commercial Service, the Chinese are less likely to 6

utilize drive-thrus because auto ownership is new to the Chinese, and they do not want to run the risk of dropping food in their cars. Hence, drive-thrus are not as popular in China as they are in America. Second, “Not respecting the other side of the business relationship, even when you really don’t” is also a major pitfall. Third, do not underestimate the value of “face,” meaning do not “lose face” to customers or suppliers. One should make sure he gains a good reputation in the industry and never make someone lose face. Fourth, do not view China as a homogenous market. The country has over 1.3 Billion people, so “one size does not fit all.” Be sure to adhere to local customs. However, this makes nationwide sales/logistics problematic. Fifth, miscommunication can be a huge problem. A foreigner may think he is being clear, but the Chinese are “interpreting” the meaning. Therefore, they may have said they understand, but they really did not. Sixth, do not believe that signing a contract is always final. A contract is just the beginning of an ever-changing relationship. Seventh, do not go for perfection, the Chinese go with what works. Eighth, most Chinese will go for the cheaper option if the product is not related to “face”. In addition, one should not believe all the statistics that come out of China. Paul Cheung, Director of the statistics division of the UN Department of Economic and Social Affairs, believes the statistic methodology in China is not transparent nor in context. For example, the National Bureau of Statistics (NBS) of China said housing was up 1.5% for 2009, but expectations and observers feel it was much higher. (Xiaotian) “The housing market is not a homogenous market…,” said Cheung. “I would produce as many housing statistics for different type of houses as possible…” According an article from the China Daily newspaper, the NBS is taking steps to improve the accuracy and 7

credibility of the data. The Harvard Business Review article Inside the Mind of the Chinese Consumer, says one should not believe Chinese workers are highly dedicated to their jobs. A 2004 survey found that “68% of employees don’t feel engaged; they don’t approach their work with passion or feel a personal connection to their jobs. And a further 20% of employees hate their jobs to the point of active disengagement.” (McEwen, Fang and Zhang) This is important to consider when hiring Chinese nationals. The same article continues with another myth about how the Chinese have become rich. Evidence from the World Bank shows Gross National Income per household was at USD$3,620. (World Bank) Although, household income has risen rapidly, the people of China are not rich. Therefore, do not assume everyone can afford the product. (Cheung) There is a multitude of pitfalls to avoid in China, and it can be difficult to remember all of them. However, the most severe pitfall is thinking the business model “back home” will automatically work in China. Logistics For companies whose business includes the transportation of products, China will offer substantial logistical challenges. Logisticstoday.com, a website dedicated to the logistics industry lists several “roadblocks” to hurdle when transporting goods in China. First, the integration of transport networks (e.g. highways), information technology, and warehousing and distribution facilities are of low quality. (Penton Media) Workers outside the major economic zones, exacerbate the problem due their lack of technological skills. Second, transport companies have difficulty following all the rules because national, regional and local authorities regulate the transportation of goods across provinces. Furthermore, the transportation rules change from city to city. These 8

operating methods inhibit the movement of goods. Third, the transportation industry is fraught with bureaucracy. Those businesses who can build infrastructure projects to make transportation more efficient are handicapped because of this. These builders of infrastructure need to have contacts at every level of government in order to get projects moving. Fourth, transporters suffer from inefficient equipment that makes the cost of transporting and warehousing goods more expensive. All of these inefficiencies and the exorbitant tolls can make the transportation of goods cost 50% higher than developed regions. Finally, goods can be “charged” unofficial border tolls when crossing into provinces. This is very similar to Mexico, where officials charge the illegal “la mordida,” or “the bite” to truck drivers when crossing into the country and at checkpoints. All of these problems make conducting business difficult for manufacturers and others who need to ship goods throughout China. Culture To be a successful business owner in China, one must understand the history of the country and its culture. It is no secret that the Chinese have a long and proud history. However, in the 19th Century there was an explosion in population, which the economy could not support. (Naughton) During this same period, Britain found a substitute “currency” for trading with the Chinese: opium. By the 1830s, China had an imbalanced trade deficit and worse, a large portion of the population addicted to opium. In addition, China did not like Britain’s incursion into China. In 1839, China attacked the problem by going to war with England, but the British were too strong. Three years later, the Chinese signed the Treaty of Nanking, which forced China to open itself up to more foreign intrusion. Finally, in 1901, an allied invasion (six European countries, Japan and 9

the United States) forced the Qing Dynasty to open all of China to foreign investment. (Naughton) This long period of humiliation from the 1830’s to the early 20 th century jaded the Chinese people against foreign intrusion. This could explain why China is slow to open itself to foreign investment. Business owners should understand China’s history and keep it in mind when conducting business in China. Foreign business owners working in China should also understand the meaning of the Chinese word “guanxi” which means “connections” and “relationships.” Some describe “guanxi” as a necessary tool to “get business” and a “way of getting things done.” It is not uncommon for these relationships to take months or years to establish. Furthermore, they should be built at every level of the organization. While in Shanghai, this student asked a Chinese national what he thought the difference was between the Chinese and American way of conducting business. His response was intriguing. “Americans try to cure the symptoms while the Chinese try to cure the cause.” While this statement is debatable, what is more important is that this particular Chinese national believed it. Although this man may not speak for all Chinese, a lesson for Americans wanting to do business in China would be to get to the heart of the problem not merely the symptoms. In conclusion, there are many pitfalls to doing business in China and there are many “rules” to remember. Remembering these “rules” can be a daunting task. However, one should not forget two major points to conducting business in China. First, remember the value of “guanxi.” Both relationships and reputation are one’s most

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valuable assets. Second, the Chinese do everything for a purpose. (Cheung) By remembering these points, one would be well suited to start a business in China.

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Appendix A Table 1 Activity Starting a Business Dealing with Construction Permits Registering Property Getting Credit Protecting Investors Paying Taxes Trading Across Borders Enforcing Contracts Closing a Business Source: World Bank

Rank 151 181 38 65 93 114 50 15 68

Table 2 Steps to Open a Business Obtain a notice of pre-approval of the company name Open a preliminary bank account; deposit funds in the account and obtain the certificate of deposit Obtain capital verification report form an auditing firm Obtain registration certification “business license of enterprise legal person” with SAIC or local equivalent Obtain the approval from to make a company seal from the police department Make a company seal Obtain the organization code certificate issued by the Quality and Technology Supervision Bureau Register with the local statistics bureau Register for both state and local tax with the tax bureau Open a formal bank account of the company and transfer the registered capital to the account Apply for the authorization to print or purchase financial invoices/receipts Purchase uniform invoices File for recruitment registration with local career service center Register with Social Welfare Insurance Center Source: World Bank

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Time to Complete 1 day 1 day 2 days 5 days 1 day 1 day 5 days 1 day 7 days 1 day 10 days 1 day 1 day 1 day

Appendix B Below is a photo of the back alley store in Shanghai with fake Louis Vuitton purses and Rolex watches.

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Bibliography Billard, Andrew. "China Breifing." Shanghai: U.S. Commercial Service, 2010. Cheung, Edward. "Marketing Strategies and Intro to China's Food & Beverage Industry." Beijing, 15 October 2010. Energy Information Administration. Environment Frequently Asked Questions. 1 January 2008. 10 November 2010 . Goodman, Sam. Goodman's Top 10 China Business Mistakes. 10 November 2010 . McEwen, William, et al. "Inside the Mind of the Chinese Consumer." Harvard Business Review March 2006: 68-76. Naughton, Barry. The Chinese Economy: Transitions and Growth. Cambridge: The MIT Press, 2006. Penton Media. LogisticsToday.com. 7 December 2004. 10 November 2010 . Shengjun, Liu. Harvard Business Review Blog. 5 April 2010. 10 November 2010 . U.S. Commercial Service. "Country Commerical Guide." 20 October 2010. U.S. Commercial Service: Your Global Business Partner. 10 November 2010 . World Bank. Doing Business - Measuring Business Regulation. 1 January 2010. 10 November 2010 . Xiaotian, Wang. "Chinese stats need to 'catch up'." China Daily 21 October 2010: 13. Yon Jin, COO CBRE China. Beijing, 18 October 2010.

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