Is China Taking Over the World?: Is China Taking Over the World? Edward E. Lehman Managing Director of LEHMAN, LEE & XU Past Vice Chairman of the ABA China Law Committee April 5 - 8, 2006


What is happening in China?: What is happening in China? Spectacular macroeconomic evolution Economic reforms process market economy but strongly monitored and controlled by gov’t Integration into the world’s economy Deep social changes change in consumption patterns Risks: political instability, regional imbalances, financial systems, concealed deficit...


Macro Environment: Macro Environment Social stability (priority) requires strong growth rate (minimum 7%), to create employment due to: Restructuring State Owned Enterprises Increase of urban population Growth based on foreign trade and investment (public and foreign) Overheating Weak consumption due to uncertainty Lack of welfare system Savings of 40%, but problems with financial system


FDI Forecast in China: FDI Forecast in China For 4th consecutive year China is the most preferred FDI location worldwide Global executives are more eager to commit FDI in China than anytime since 1998 Also, China is seen as source of innovation and attractive R&D location Lower R&D costs Availability and quality of local R&D labour IP protection China FDI destinations (next 3 years): 48% product manufacturing 18% R&D 13% distribution and logistics


China Integration in World’s Economy: China Integration in World’s Economy Exports 2004 → 593 billion USD △ 2004 / 2003 → 35.4% Imports 2004 → 561 billion USD △ 2004 / 2003 → 36% Foreign Direct Investment 2004 → 60.6 billion USD Access to WTO: standardization of regulatory framework


Deep Social Changes: Deep Social Changes Appearance of a young middle class Increasing urbanization Assimilation of Western life Quick development of a private industrial sector Appearance of a service and leisure culture One-child policy


The Risks: The Risks Economic Imbalances: Overheating Soft or hard landing? Geographic Imbalances Financial System Tax Balances? Contingent liabilities: Welfare networks Banking recovery Local government investments Variations in the exchange rate? Political stability?


How does it affect us?: How does it affect us? China will be one of the most dynamic areas in the world during the next 20 years China’s Economy will be the World’s Second-largest by 2030 How it affect us: China as a market China as productive base / provider China as competitor China as partner Not only affects each particular company, also to its competitors, providers and clients.


1. China as a Market:Advantages: 1. China as a Market: Advantages Market with great opportunities 1.3 billion people, myth and reality Dynamic Evolution Opportunities and challenges Foreign presence in the market Successful More than 400,000 FIEs Presence of big multi-nationals Presence of main companies in each sector


Market Advantages: Market Advantages Reputable: good reputation of financing institutions Continued liberalization Political decision WTO commitments More integrated in global economy Good infrastructure Telecommunications Transport A country “which works” A safe country


Difficulties: Difficulties Very demanding market Clients want the best Idea of “middle technology” is rejected Clients know what they want Very competitive Wide foreign presence Chinese client knows foreign markets Compete with Chinese prices Clients with negotiating experience Changing Frequent changes in national and regional legislation Political changes


Difficulties: Difficulties Costly Geographic distance Establishment costs are high Time factor. Lengthy: Project planning process Project approval process Project negotiation process Project implementation process Increasing capacity of Chinese companies Powerful and competitive companies Increasing industrial and technological capacity


Chinese Market in numbers (2004): Chinese Market in numbers (2004)


Chinese Market: Geographic Delimitation: Chinese Market: Geographic Delimitation Continental China (mainland China). Hong Kong: Redistribution Center and service provider. Hong Kong and Taiwan: FDI main origin. “Overseas Chinese”: 60 million, 3rd world economy. 65% of FDI comes from Asia. Development is concentrated in east coastal cities: Priority: Development of the Center-west and Northeast areas. Gulf of Bohai area (Beijing-Tianjin corridor). Yangze delta area (Shanghai, Nanjing, Hangzhou...). Pearl River’s delta area (Guangdong and Fujian provinces).


The Market: The Market Strengths Size Growth and Opening Modernization and dynamism Multiple opportunity areas Liquidity (cash) Human Capital and organization  Weaknesses Fragmentation Competition Immaturity in the distribution channels Logistics Insufficiency Quick changes and volatility of commercial regulations Financial system insufficiencies State owned enterprise reform


China: Business opportunities: China: Business opportunities Process of public investment, concessions and privatizations:  Infrastructure Projects. Roads and Highways Railway  Energy Projects  Hydraulic Projects  Center and west country development Growing environmental demands:  Garbage collection and treatment systems  Water treatment systems  Alternative Energies


China: Business opportunities: China: Business opportunities Fast Urbanization (population in rural areas 66%): Attention to collectives and public services Transport urban infrastructures: subway and railway Strong construction process Increase in living standards: Diversification and increase of consumption Sophistication of distribution channels Increase on vehicle demand Potential in the tourist market


China: Business opportunities: China: Business opportunities Access to WTO: Increase opening to exports: Tariff reduction in more than 150 key products. Average tariff from 17% in 2000 to 10% in 2005 Progressive quota increase (i.e. annual increase of import vehicles by 15%) Service sector opening: Distribution (2004), Banking (2006), Telecommunications, Logistics,... Clarification of the distribution system Standarization of legal system regarding foreign investments: Same rights and liabilities for foreign and national companies


Olympic Games 2008: Olympic Games 2008 Beijing Investment area: 27.5 billion USD


Slide20: 32 Sport facilities (19 new) Property and management Conceptual design Beijing Public services: Transport (subway) Environment Parking and traffic control Opportunities for Olympic Games 2008


But some problems…: But some problems… Technical barriers: the other side of the opening process within WTO Certifications: Industrial Products (CCC) Cosmetics Food Packing Contingent management Capital requirements Banking Distribution Construction Local Competition


But some problems…: But some problems… IPRs. Counterfeiting problems before WTO’s challenge: Not only bags, watches, DVDs or software. Affects everything: from elevators to pastries or wine, books... Notable improvements in legislation and applicable penalties. However, penalty enforcement is still weak. Lack of “social censorship”.


China as a Market:Access Strategies: China as a Market: Access Strategies Export  Advantages: Small investment.  Problems: Market fragmentation and real size Strong foreign and local competition Tariff and non-tariff barriers Lack of distribution networks and few specialized distributors. After-sales service. Continuous trips needed. Language.


China as a Market:Access Strategies: China as a Market: Access Strategies Investment  Advantages: Permanent presence in the market. Huge market (unlimited). Lower competition. Better competitive position. Tariff and non-tariff protection Tax relief In most sectors it is possible to invest in the form of WFOE (80% of investors choose this way)


China as a Market:Access Strategies: China as a Market: Access Strategies  Problems: Search for the right partner, if necessary. Legal framework still under development. Not all sectors are open to FDI IPR problems. Personnel problems Language Investment


FDI Divisions: FDI Divisions Encouraged Agriculture New/high technology Industries which develop Western/Central regions Restricted Technologically-backward industries Resource-intensive/wasteful enterprises Prohibited Industries which cause pollution and ruin natural resources Projects which utilize processes/technologies which are unique to China Permitted All other industries not listed in the Catalogue.


FDI Operating Structures: FDI Operating Structures Representative Office Equity Joint Venture Cooperative Joint Venture Wholly Foreign Owned Enterprise Holding Company


Representative Office: Representative Office Advantages Quick and simple. No minimum registered capital. Allows for collection of market information and preparation for direct market entry. Disadvantages Cannot engage in revenue generation. Taxation regardless of prohibition on profit making activities.


Representative Office: Representative Office Set-up Requirements Application letter signed by Chairman of the Board. Certificate of incorporation. Credit report by bank. CV of foreign representatives and photocopy of passport. Business license in home jurisdiction Signed Power of Attorney, allowing agent to legally act on the company’s behalf. Lease agreement


Equity Joint Venture: Equity Joint Venture Most commonly used among the two types of Joint Ventures Main distinction between EJV and CJV is the requirement that profits must be shared in proportion to capital contributions. Key considerations: Selection of Chinese JV Partner after a full due diligence of partner/assets. Selection of location.


Equity Joint Venture: Equity Joint Venture Advantages Chinese partner will bring connections and an established sales and distribution network; Local partner will bring local and particularized knowledge of both market and bureaucracy. Chinese partner will usually have or can easily obtain an operational site, which aides in efficient start-up Disadvantages JV contract often difficult to negotiate Differing objectives and management styles often result in conflict. Lack of control by foreign party Difficulty in selling shares in venture.


Equity Joint Venture: Equity Joint Venture Setup Requirements Project Proposal Feasibility Study JV Contract Articles of Association Letter of intent Business License Capital investment requirements. Minimum equity investment by Foreign investor is 25%.


Cooperative Joint Venture: Cooperative Joint Venture Similar to Equity Joint Venture in structure but with more flexibility because of the following: Sharing profits is governed entirely by contract Foreign partner can obtain return of investment in priority to Chinese partner. Setup requirements similar to that of Equity Joint Venture.


Wholly Foreign Owned Enterprise (WFOE): Wholly Foreign Owned Enterprise (WFOE) Essentially a wholly owned subsidiary of a foreign enterprise By far, the most commonly used investment vehicle If there is a significant amount of IP held by the corporation then the WFOE would be the primary selection Generally, WFOE approval is more difficult to obtain than JV approval.


Wholly Foreign Owned Enterprise (WFOE): Wholly Foreign Owned Enterprise (WFOE) Advantages Quicker setup as there is no Chinese partner Simpler management structure and objectives which are simply those of the parent organization. Disadvantages Independence is often, in itself, a shortcoming because of lack of connections, established markets, and local knowledge. WFOEs cannot operate in some sensitive areas such as securities.


Wholly Foreign Owned Enterprise (WFOE): Wholly Foreign Owned Enterprise (WFOE) Setup Requirements Application Letter Feasibility study Articles of association Evidence of solvency from bank Business License Name of the legal representative CV and copies of passport


Exit Strategy: Exit Strategy Mauritius holding company for conducting operations in China. Benefits: Cost establishment is US $1,500 (company secretary, nominee shareholders and bank account) Exit Strategy 1) easy transfer of interests in the China operation 2) no approval needed for divestiture of interest in case of direct investment relationship Transfer Pricing


Exit Strategy: Exit Strategy Limiting Liability liabilities incurred by the Chinese entity will be the liability of the holding company rather than the parent Tax Benefits In Mauritius: any money held by the holding company will be tax free In China: impact of China taxation can be managed by licensing the IP from parent company. In Spain: money can be repatriated at a tax advantageous time or reinvested in other international operations. Parent Company Mauritius Company Chinese WFOE IP IP


2. China as a Productive Platform: 2. China as a Productive Platform Competitiveness of China production implies not only potential on producing to supply local market, but also positions: China as a competitor China as a provider China as a platform to third markets


China as a Productive Platform: China as a Productive Platform Competitiveness derived from: Labour costs: Unlimited labour reserves (lower wage preassure). Technology contributions and Western management through FDI. State policies to support foreign sector, critical for its growth (tax relief...).


China as a Competitor: China as a Competitor WTO entry also opens international markets to Chinese products Foreign Trade evolution FDI resounds in technological development: quality products... Development of its own industrial infrastructure Protection instruments (anti-dumping measures...). Market Economy?


China as a Provider: China as a Provider Competitiveness of Chinese products is not only a threat but also an opportunity. Wide and increasing range of products Need to make purchasing process more competitive Another way of investing in China: central purchasing office Cooperation agreements, licensed production. Risks


China and Third Markets: China and Third Markets Production investment in China, not only for Chinese market but also to export As Chinese industrial network improves, the foreign projection will be wider FDI companies in 2004 carried out 57% of the total exports (54.8% in 2003) Foreign companies are already taking profit from Chinese foreign competitiviness.


3. China as a Partner: 3. China as a Partner Official interest for the Internationalization of Chinese companies. Supporting measures: Goal: establish 6,000 multinationals by 2015 Sectoral Priorities: Electrical appliances in developing countries High technology in developed countries Mining, hydrocarbon, raw materials New aspects which can include: Chinese companies investing abroad Chinese companies interested in partnership with foreign companies to make use of their knowledge and experience of international markets.


Some advice...: Some advice... 1- Get rid of the myths 2- Get trustworthy information 3- Identify the oportunities 4- Have a clear strategy 5- Professional assesment 6- Conduct market research and due diligence on partners 8- Long term commitment is necessary 9- Ensure that IP is fully protected 10- Watch for personal relations and local customs 11- Success in China implies dedication and big effort


Challenges for China to Take Over the World : Challenges for China to Take Over the World China must modify its development model to: resolve the new problems created by the actual growth avoid jeopardizing the country’s stability Objective: SUSTAINABLE DEVELOPMENT Social point of view; Minimize social differences Improve welfare services Increase public expenditure in health and education Unemployment Environmental point of view Avoid exhaustion of energy resources Use of new renewable energies Fight against environmental pollution


Challenges for China to Take Over the World: Challenges for China to Take Over the World Change from extensive growth (exports and FDI) to intensive growing (internal demand and local companies) Reduce export participation in its GDP Increase local consumption Increase income in rural areas Increase expenditure on social welfare, health and education Maintain growing stability Soft landing process Reduce growing rates Not affect social and economic stability


THANK YOU: THANK YOU LEHMAN, LEE & XU 10-2 Liangmaqiao Diplomatic Compound No.22 Dongfang East Road Chaoyang District Beijing 100600 China Tel: (86)(10) 8532-1919 Fax: (86)(10) 8532-1999 E-mail: elehman@lehmanlaw.com Web site: http://www.lehmanlaw.com