Business in China

In a changing investment climate, foreign investors may want to take a second look at the joint venture.
Why would a company that has operated several successful wholly owned units in China for more than 15 years defy conventional wisdom by setting up a new and potentially risky joint venture (JV). The CEO of a foreign foods manufacturer explains: “It is not possible to compete with Chinese players under the same rules as in the USA and Europe. We need to change our structure in this volatile market to be flexible and competitive…. The problem is that we do not know how to do this alone.”

PRC regulatory restrictions in the 1980s and early 1990s limited the role foreign investors could play in many sectors of the economy. For instance, wholly foreign‐owned enterprises (WFOEs) were not permitted in many sectors, so foreign investors had to form JVs with local partners. China’s business and cultural environment during this period also differed drastically from those of more developed markets.

To overcome these hurdles and gain a foothold in China, many foreign companies chose to invest through JVs.
The same business and cultural differences that compelled foreign investors to adopt a JV model, however, often caused major operational difficulties, ending in the dissolution of many partnerships.
Nearly 30 years of experience has taught foreign investors that, when possible, it is better to go it alone. The lifting of restrictions on foreign investment, especially after China’s World Trade
Organization entry in 2001, facilitated this trend. In addition, foreign companies’ success in finding suitable local partners has been uneven, contributing to the continued decline in the number
of overall JVs.
But the winds are beginning to change direction again. Rising government protectionism, a more domestically driven economy, and the difficulties of organic growth (company growth excluding mergers and acquisitions) are making the JV model more attractive and useful to many foreign investors.
Based on recent experience with clients and changing market realities, it is anticipated that the number of new JVs in China to increase this year and in the years ahead. This could mark a reversal of the five‐year decline in the number of JVs approved each year.
It has, however, become more difficult to actually establish a JV. Foreign investors that choose this route now face stronger, more business‐savvy Chinese counterparts, and the relative bargaining power of foreign suitors has weakened considerably.
Some potential Chinese partners are less likely to want to form JVs because they already have strong market position, knowledge, distribution networks and cost leadership – generally Chinese enterprises have a lower cost structure; and faster speed to market. Regulations also restrict foreign investment
in JVs and restrict the formation of WFOEs in certain sectors.

China’s Changing Investment Landscape
Recent PRC government policies and regulations signal a dramatic shift in the country’s attitude toward foreign investment.
Changes in the corporate income tax law, strengthened land management policies, and revisions to the Catalogue Guiding Foreign Investment in Industry signal Beijing’s preference for “quality” over “quantity” in foreign investment.
For nearly 30 years, all government levels supported foreign investment. That support now comes with, substantial qualifications. As part of PRC President Hu Jintao’s goal of building a “harmonious society,” the PRC leadership has turned inward, focusing on Chinese companies. Local officials no longer score points or win promotions merely by attracting foreign investment. Instead, officials are evaluated on issues such as success in introducing advanced technology and environmentally friendly investment China’s efforts to rebalance the economy and provide a more sustainable growth model rely on the increasingly prosperous Chinese consumer. PRC leaders expect higher government spending on healthcare, education, and social security to boost consumer confidence and reduce China’s savings rate. If the government succeeds in stimulating domestic demand, and most measures indicate it will, the Chinese economy will change drastically in the next five years.
Equally important, China’s business environment is becoming inexorably tougher because of the evolution of China’s domestic champions, increased technical competency of Chinese producers, a greater emphasis on local sourcing, and shortages of qualified labour. In short, competition has intensified.
China’s domestic market is already one of the most competitive in the world, and competition from
global and local players is only getting fiercer.
Foreign investors no longer have room to make mistakes, and with each passing day, market entry
becomes more difficult.

Reevaluating the Case for JVs
This new environment calls for a re‐evaluation of the JV’s potential value. The shift in the government’s attitude toward foreign investment, increased focus on the domestic market, and vague references to national economic security in both the new mergers and acquisitions and antimonopoly laws indicate the potential for increased economic nationalism. Direct government protection of strategic sectors such as auto and steel through regulation and legislation, and indirect protection in the form of local government preferential treatment for key companies, suggests that outright acquisition of domestic companies will not always be possible.
Nevertheless, in markets driven by domestic demand rather than investment and exports, a JV partner can provide local business and cultural insights, established workforces, distribution channels, brand recognition, and a strong existing client base. Because local knowledge is so important in this market, only firms with localized management are likely to succeed in the future. WFOEs are an increasingly untenable option in many sectors given the above trends. In sectors facing overcapacity, such as dairy and steel, it makes little sense for a foreign investor to build a new factory. In the banking sector, where WFOEs are allowed, vast and well‐established Chinese retail networks preclude the formation of WFOEs. Foreign investors in the chemical sector will likely find that Chinese control over raw material supplies enables local companies to dominate markets for many downstream products. In many cases, a foreign company will need to find a strong Chinese partner to access those materials. As a result, even in sectors where no government restrictions on investment exist, JVs are becoming the only feasible investment vehicles for many foreign investors.

The Paradigm Shift among Chinese Companies
Unfortunately for foreign companies hoping to set up JVs, finding suitable Chinese partners has not become easier over the years. In general, Chinese businesses are not as interested in forming JVs as they once were and have become more demanding. Chinese companies are stronger now, thus the need to team up with a foreign partner for management, technology, finance, personnel, marketing, and distribution channels has been greatly reduced. Chinese companies are optimistic about their prospects and less willing to share future profits with others. Thanks to higher profitability, private equity investments, and stock listings, they have ready access to capital. Local companies thus no longer blindly pursue foreign cooperation but evaluate cases objectively. Foreign parties are generally perceived as slow, inflexible, and lacking an understanding of local realities.
As a result of this paradigm shift, foreign investors that once relied on a Chinese partner only to provide land, fixed assets, and labor‐‐and consequently had many partners to choose from‐‐will discover that finding a Chinese partner can be extremely difficult now. Though plenty of successful Chinese companies exist, few are willing and able to establish successful JVs.
Further complicating the situation, the motivations of Chinese partners in forming JVs have changed and often contradict the interests and intentions of Western partners. For example, the Chinese side may want technology and overseas market access, while the foreign side may wish to protect its intellectual property and existing markets.

Keys to Success
Clearly, forming a successful JV is not easy. In many cases, however, foreign investors will have no choice but to seek local partners. These investors should take into account the lessons learned by foreign‐invested enterprises over the past 30 years. Most important, they must view a JV as a tool, rather than a strategy in itself.

First, foreign investors pursuing a JV need a clear and realistic idea about why they want such an alliance.
They should understand the bigger picture‐‐including China’s political climate and investment trends. They should also understand the current and potential future motivations of the partner and what the partner can contribute in the short and long run. To do this, foreign investors must conduct thorough due diligence on the potential partner; analysis will require more expertise, time, and effort than is common in more developed markets.

Second, foreign investors must determine what they intend to contribute to the JV, what must be protected (for example, overseas market access and intellectual property), and what they want to get out of the JV (for example, short‐term learning or long‐term market positioning). Though a JV contract is essential, legal agreements do not offer full guarantees in China. Successful cooperation, therefore, depends on other leverage points, such as controlling technology, access to markets, and committing to large purchasing volumes from the JV Foreign companies should also understand that if the partner really wants to end a JV, it can always find a way to do so in spite of the legal agreement.

Third, in terms of operations, investors should try to strike the right balance between Chinese and Western ways of doing things. Foreign investors should keep in mind that Chinese shareholders will expect to make more money by cooperating with a foreign partner than they would on their own for the venture to be worth their while. Sometimes this implies compromises and the acceptance of processes and procedures uncommon in the West.
Though unethical practices obviously must be avoided, it might be necessary, for instance, to adjust to fast decision making cycles without going through the lengthy due process common back home.

Finally, once a foreign company sets up a JV, it must assess the operation regularly to determine whether the JV requires restructuring or whether the foreign company should acquire the Chinese partner. Since a JV is primarily a tool used to reach a specific goal, companies should establish exit and contingency plans from the beginning.
Whether to establish a JV and how a complex is question that requires analysis at the individual
company level. Though the issues discussed above are fairly common, each company is unique and thus may face different challenges. Contrary to conventional wisdom, JV operations in China are not
inherently deficient. When structured correctly and given appropriate attention by the foreign investor,
a JV can be an effective way to begin or expand one’s China operations.