Doing business in and with China: the risks are great, but so are the rewards.
Risk assessment (Usage)
Atkinson, William
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Name: Risk Management Publisher: Risk Management Society Publishing, Inc. Audience: Trade Format: Magazine/Journal Subject: Business; Human resources and labor relations; Insurance Copyright: COPYRIGHT 2004 Risk Management Society Publishing, Inc. ISSN: 0035-5593
Date: March, 2004 Source Volume: 51 Source Issue: 3
Event Code: 640 Foreign trade; 010 Forecasts, trends, outlooks Computer Subject: Market trend/market analysis
Product Code: 9912200 Venture Analysis
Geographic Scope: China; United States Geographic Name: China; China; China; United States; United States Geographic Code: 1USA United States; 9CHIN China

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Despite the popular notion that American jobs are being lost to China, the fact of the matter is that the Chinese economy is a reality, and it is a powerhouse. In addition, the economies of the United States and China continue to find themselves more and more entwined, which Chinese imports expected to reach $ 150 billion in 2003.

Conversely, China is the fastest growing market for U.S. products, with U.S. exports to China expected to reach about $24 billion in 2003, up over 35 percent since 2001. Besides buying from and selling to China, more and more U.S. companies find themselves setting up joint ventures with Chinese companies, not only to take advantage of cheap labor, parts and land, but to gain a direct foothold in the exploding East Asian consumer and commercial marketplaces. All of these initiatives have significant implications for U.S. risk managers.

"For some businesses, problems with doing business in China may crop up once of twice a year, but in our business, we see the problems of doing business in China every day," reports Sam Porteous, China country manager for Kroll Worldwide, in 5hanghai, China. Some of the challenges include understanding the various natural catastrophe exposures that exist, the levels of infrastructure, and the availability of fire and security protection. "The greatest risk of doing business in China is ignoring the risks, of putting people in positions who ignore the risks," says Porteous. These may either be expatriates of Chinese nationals who say things like, "Oh well, it's China. That's the way things happen here, and there is nothing we can do about it."

Not true. Porteous adds that it is important to remember that, from 1949 to about 1980, there was no commercial law or private enterprise in China. "As such, we are in the midst of a transitional communist system and a legal system that is still unformed," he says. In other words, the idea of what is and what is not appropriate business behavior is not yet solidly formed, so, in large part, "anything goes." Tha alone presents multi national organizations with special opportunities ... and perils.

In-Country Risks

When actually doing business in China, there are several risks foreign businesspeople need to understand. The first is the importance of going in with open eyes. "Recently, a U.S. company decided to make an investment in the People's Republic of China by setting up a joint company through its Hong Kong manufacturing agent," recalls Stephen Nelson, partner and co-head of the China practice group for the Hong Kong-based law firm Baker & McKenzie. "The U.S. company sent over $3 million worth of equipment, then came to us with documentation written in Chinese and asked, 'Can you look at this and tell us whether we really own 50 percent of this company?" The moral of the story is that foreigners simply cannot enter a venture in China with only a cursory understanding of its terms and conditions.

From an investment perspective, when acquiring businesses in China, ii is important to realize that there are perceived cultural differences, according to Nelson. "I have seen more companies make mistakes in negotiating commercial transactions in China in an attempt to bend over backwards to accommodate cultural differences, than I have seen companies make mistakes by failing to take cultural differences into account," he says. In other words, you are better off approaching a business transaction primarily as a business transaction rather than a commercial endeavor in a strange culture. "For example, when negotiating an acquisition in China, don't be too wary of offending the Chinese people and thus failing to engage in the due diligences one might do in other jurisdictions," he says.

Until recently, a lot of foreign companies only maintained "representational offices" in China. "They 'planted a flag' in China simply to gain access to the market," says Porteous. "It is only when they start production in China or start to get a significant volume of business that they begin to get serious." However, by then, it can be too late if an anchor staff has already been established and subsequently ignored for four or five years.

When starting business in China, the first step is to decide if you are operating as a wholly owned situation or a joint venture. "You have different objectives with each," says Bernard Fung, chairman and CEO of Hong Kong-based Aon Asia. Aon-COFCO is the first international broker with the right to carry out insurance and reinsurance broking and risk management consulting in the People's Republic of China. "For example, the goal of a joint venture is to learn the technology transfer and then explore market opportunities together with the foreign party." As such, you want to create risk management programs under the standards of the U.S. corporation. However, this can be a challenge if your joint venture partner is less interested in risk management initiatives, which may be the case for a number of reasons. For example, the partner may assume that the totality of risk management is in insurance, which is the way things are typically done in China. "Companies tend to retain very little risk, preferring to cover everything with insurance," he says. There are also different perceptions on the risks associated with liabilities. "The legal system in China is evolving, and there is not a lot of precedent yet with regard to liability exposures," says Fung.

In China, distribution and supplier fraud is common. Corrupt networks, which are often red and sustained by kickbacks, can quickly destroy an entire supply chain and cost structure, according to Porteous. "For example, one company was paying on average 30 percent more for its inputs than it should have," he states. "In this inquiry, we found an accountant who had quit working for the company because, during the budget exercise, he was threatened with bodily harm if he actually put in the budget what these inputs should have cost."

In terms of environmental regulations and other laws in China, the law may say one thing, but the application of the law will some times differ based on local conditions. "At any point in time, however, local conditions may change, and you may be held accountable to the letter of the law," says Fung. As such, companies that do anything less than what the law says should always beware, even if the situation is currently one of leniency and looking the other way. "Furthermore, Chinese laws are not written as airtight as U.S. law, so even if you feel you are complying with the laws, they may be interpreted more broadly in such a way that you are considered not to be in compliance," he adds.

In-Country Strategies

In facing the inherent risks of doing business in China, there area number of steps you should take. "Companies need to work around the inherent nationalism that exists with much of the workforce in China," suggests Porteous. It is important to find a way to blend this with your own corporate culture. In many instances, companies coming into China don't put the effort into implanting their own corporate culture. "If they don't, the Chinese culture will come in and fill the vacuum, which is not always a good thing," he adds.

A lot of companies come in and put a layer of expatriates on top of the Chinese company, but then never bother to monitor what is really happening in the company. "You need to implement business controls and then monitor them to make sure they are not al risk for internal fraud, counterfeiting or other problems," says Porteous. "The companies that are really succeeding in China are those that are constantly monitoring what is taking place. They bring in outside auditors and third-party companies to conduct inquiries."

Kroll, for example, has three types of business services in China. One provides due diligence to companies looking for investments in China, for investment partners, or for employees to hire. This is an analysis of the in. vestment, company, or individual before they make a commitment. A second is internal fraud investigations, which are usually upped off by an anonymous letter of e-mail. "We have found situations where everyone in an office has been involved in an illicit or fraudulent operation, because one person hired everyone, and this person is involved in this activity," says Porteous. This is called a "hiring tribe." As such, Kroll encourages employers to mix up their employees to make sure they are from different regions.

Third is intellectual property investigations (counterfeit issues). This used to be a problem just internally, where the counterfeits were being sold solely in China. "Now, these counterfeits are being exported out of China and are showing up in markets around the world," says Porteous. "This is a growing problem, because China has become the 'workshop of the world." These can be counterfeit electronics, auto parts, pharmaceuticals, food products, handbags or almost any other retail of wholesale good imaginable.

Specific Challenges

There are three other specific risk is sues related to China: maintaining local partnerships, fraud and corruption, and natural hazards.

Local partnerships. One area of concern is assessing the integrity and capability of in-country individual with whom you may consider doing business. "In trying to find partners in China, it is easy to be misled by consultants claiming to have all sorts of connections in China, such as a relative who is a high level party official," says Nelson. Even if they do have these connections, which aren't always the case, it does not mean that they can utilize them. In fact, paying a consultant to help you with your endeavor will not necessarily put you in a better position than if you did the work on your own. "You can end up paying a fair bit of money and not getting much in return," he says. "You may be better off hiring a full-time employee with the requisite experience in your field."

Internal Fraud and Corruption. Also known as "parallel operations" internal fraud and corruption remains a massive problem in China, says Porteous. There have been some times, he recalls, when he has conducted up to three simultaneous inquiries into the general managers of foreign subsidiaries all suspected of running parallel operations. These are other companies that compete directly with the company that is paying their check. In many instances, these individuals have diverted resources from the foreign company to support their parallel company. "In other words, a senior employee in your company may also have another company on the side, and this fact is not disclosed to you," he says.

This company often competes directly with your company or has an other relationship with your company, such as being a supplier to, or distributor for, your company. "We see instances where these parallel operations use the logistics channels of our client companies," he continues. In some cases, they also use the company's technical specifications to counterfeit the company's products.

Natural Hazard Risks. A third specific risk relates to natural hazards, such as earthquake, windstorms, floods and hail, which occur throughout the country. Detailed investigation of these hazards is a critical component of any decision to establish operations in China. "In the absence of readily available material to map these exposures, some foreign insurance companies licensed in China have undertaken their own research efforts to understand these exposures and be better prepared to advise customers," according to Brendon Allen, senior vice president and Asia/Pacific underwriting officer for the Chubb Group, based in Warren, New Jersey.

Recent Developments

The economy has grown in the last decade at compound rates, and the ability for the infrastructure to keep pace with the economic growth has created significant challenges for local authorities. "Levels of available water supply, public fire fighting equipment and the experience of fire fighting personnel vary dramatically from location to location," says Allen. The authorities have established numerous standards. However, due to resource constraints, many areas struggle to meet these standards. Chinese design codes have been established, and these codes adopt the latest fire protection technologies, for example. "These standards, however, which are updated every five years, are all written in Chinese with no English version avail able," Allen notes.

There area small number of private engineering consultants and construction supervision firms that are licensed to advise companies on private protection requirements. In addition, there are some state owned firms that have been accredited to internationally held safety engineering standards.

"Testing laboratories have been established to certify the protection equipment and apparatus manufactured in China as well as equipment imported from other countries," says Allen.

Security in major cities, in particular in state-level industrial parks and development zones, is generally very good. Central Station security alarm monitoring, however, is not readily available, and companies generally rely on security contractors that provide 24-hour watchman services manned by retired military and police.

"Overall, risk managers should work closely with insurance carriers that have trained and experienced loss control services available on the ground to advise them on exposures in China and to help them develop contingency plans to minimize their exposure to loss," adds Allen.

Selling to China

Even for organizations that do not purchase products from China of have operations in the country, there is still some risk to be faced, such as that stemming from selling products to China.

"The biggest risk for foreign companies selling into China is pretty clear: payment risk," says Nelson. "In Fact, this is a greater risk in China than it might be in many other countries, because it is more difficult to enforce a judgment debt in the People's Republic of China than it is in more developed jurisdictions, such as Western European countries."

In addition, you may find out, too late, that the person with whom you are dealing does not have the authority to bind the company from a legal standpoint, of the company may not have the authority to enter into the transaction.

It is a good idea to do company searches in China, according to Nelson. "These are possible to do in order to identify the company's general credit rating. They are not as reliable as a Dun & Bradstreet, but they can still be useful."

The Future

The current Chinese leadership is very focused on developing the economy and is becoming less politicized, according to Fung. "As such, the economy should continue to grow steadily, at least over the next 12 to 18 months." This only proves the continuing nature of China's dynamic economy, one where more Western businesses are bound to set up shop, and manage the risks--and rewards--that come with it.

William Atkinson is a freelance writer with more than 20 years of experience with risk management-related topics. He is a recurring contributor to Risk Management Magazine.
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