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China Is The Risk. I See Clouds.

Posted in China Business, Legal News

One of my main duties as a lawyer is to minimize risk. Properly forming/registering a Chinese entity minimizes risk. A great contract minimizes risk. Registering a company’s intellectual property minimizes risk. Written employment contracts and a written employer manual minimize risk.  An FCPA compliance manual (usually part of the employer manual) minimizes risk. The list of how we help our clients reduce their risks goes on and on.

But there is only so much we lawyers can do.

There are certain risks on which we have little to no impact. We can write the world’s best contract, but if your Chinese counter-party is a crook without any real assets, he can breach the contract with impunity. Our registering your IP greatly reduces the likelihood of someone stealing it and makes it easier for you to sue them if they do, but it does not preclude anything. An FCPA compliance manual is not guaranteed to stop your employees from countermanding it.

Then there are the really big risks. We can tell you that doing something is legal today in China, but what is legal today may not be legal tomorrow. We had a client who purchased a relatively expensive building for a particular business and then within months, the local government made it illegal for foreigners to operate that particular business from a building they own. 

And then there is the biggest risk of all: China itself.  

Joseph Sternberg, the dead-bang brilliant and far too young (not sure he’s even 30 yet) Editor of the Business Asia column at The Wall Street Journal just came out with an article discussing China’s too-quick willingness to retaliate against whole countries or to act against their “own economic interests.”  

The article is entitled, “Nobel Sentiments, Business Risks,” and its thesis is, essentially, that businesses should be taking lessons from China’s recent reactions to the way it has dealt with businesses from countries China perceives as having slighted it. These reactions give rise to “new questions . . . about policy risk in China.”  They sure do. 

The article makes note of how China this week canceled a meeting with Noway’s fisheries minister in apparent retaliation for a tiny committee of private citizens. Sternberg then comments on how this sort of thing is taken too much in stride by businesses in China:  

Exporters are optimistic that political disagreements won’t dent trade in the end. But it’s worth asking how they can possibly know. Conspicuously, the only basis for this conclusion is surmise. Norway is a big oil exporter, and China is a big oil consumer. Ergo, Beijing will understand that its self-interest lies in not antagonizing Norway.

No senior officials in Beijing have made any clear statements about whether they will retaliate against Norway. Beijing hasn’t formally said why it canceled that meeting with the minister. There has been no public debate on the matter, so there is no way of knowing how divided the leadership is on whether to pursue a more vigorous response or to let the whole thing blow over.

Everyone simply assumes Beijing will act “in its own best interest.” But absent democratic institutions like a parliament and a free media, there’s no way to know what Beijing thinks its self-interest is.

I could not agree more. Far too often I have had clients just assume the major goal of China and its provinces and its local officials is to bring in foreign business that can provide good jobs for the Chinese people, but that is just one of many goals. I am convinced the main goal is actually to keep the Chinese people happy in a political sense and though that goal can and often does include jobs, it can and does oftentimes include much more than that, sometimes even to the exclusion of that.  

Sternberg goes on to describe the capriciousness of it all:

At heart this is a question of risk versus uncertainty. Policy risk is the ability to estimate with some degree of precision (the risk) the probability that government will do something stupid (the policy). Uncertainty is far more capricious, involving the completely unknown or unknowable. China may be more uncertain in this sense than some have realized.

The question is not whether China’s government will do foolish things. All governments do, as American businesses staring down the barrel of ObamaCare will attest. In the democratic world, however, businesses can see bad policies rolling in their direction like thunder clouds on the horizon. As a result, they enjoy ample time to estimate how bad the hit to the bottom line would be. Policy making in a democracy follows a certain logic of poll numbers, votes, media spin and the like. Because so much of it happens in the open, it is possible to make educated guesses about the outcome. As a corollary, understanding the logic—how congressmen think, say, or where the campaign money comes from—makes it easier to lobby effectively.

Not so in China. This comes up repeatedly as China increasingly asserts its political and economic might. Japanese companies have found themselves deprived of Chinese rare-earth minerals owing to a political spat over maritime sovereignty. Foreign executives like Rio Tinto’s Stern Hu have found themselves arrested, tried and convicted on corruption charges seemingly as a result of commercial disputes.

According to Sternberg, China is so random and the events that trigger China are themselves so random, that there is pretty much no way to know the odds of your company getting caught in a maelstrom.  

So how could a Japanese executive relying on rare-earth minerals from China have estimated his risk from a politically motivated cut-off in supply? How could a Norwegian handicap the odds that a Nobel Peace Prize might adversely affect his business?

Already there are signs companies are realizing they’ve made mistakes. Google withdrew when it concluded it had wrongly estimated the upside policy risk of censoring search results in exchange for doing business in China. The company discovered Beijing’s internal logic evidently rules out allowing a foreign Internet search company to succeed no matter how accommodative it is.

Like it or not, China no longer feels terribly inclined to care much about the foreign companies in its midst and it will not hesitate to place big picture politics over economics. Those who believe otherwise are neglecting real risk. And sometimes, the impact of these things is so small and so subtle that I have suspected something is happening, but I cannot be sure. For example, in the last couple of months, as tensions between the United States and China have been rising on the economic and military fronts, I have gotten the strong sense that China is cracking down on Americans in China without work visas. I can tell you that the number of calls we have gotten on those has greatly increased. Is this random? Is this due to something else? Might this be happening to people from countries other than the United States? I don’t know, but I think there is something going on and this is not the first time.  

What then is a foreign company to do? I am not a business expert, but if it were me, I would at least take note of the potential risks and at least be thinking of contingencies to try to alleviate it. If my product costs $1.00 to make in China and $1.20 in the United States, I would NOT shut down my entire U.S. operations and move it all to China. And I know it is not good form not to be all rah rah on China, but I will note that in my own portfolio right now, I own country funds for three countries: Vietnam, Brazil, and Turkey. I sold my China country fund a year ago. If I had to pick one country that is going to grow the most during the next ten years and do so in the best way possible for American companies, I would pick Vietnam. 

Who’s with me?  

  • Twofish

    Business people think about risks all the time. That’s what managers are paid to do. One problem is that it’s often not clear what is a stupid thing. Sternberg thinks that ObamaCare is a stupid thing. A lot of people disagree. The big risks come when you think the world works in a certain way, and it doesn’t, and those risks are hard to deal with since you don’t know what you don’t know. How does Sternberg estimate the risks that he is basically wrong, and that ObamaCare is a wonderful thing?
    Sometimes trying to estimate a risk using probabilities is useless and self-defeating. The two questions that you have to ask are “can this happen? And are we dead if it does?” And also, “are we making money?” I don’t see how Google’s efforts in China are a “failure.” They tried something new. It didn’t work out quite the way that they thought, but they ended up making money, and they are still in the handset business.
    Having said that. Chinese politics may be many things, but it’s rather predictable. You can often figure out well ahead of time what the government is going to do by reading the stuff that the government writes. Off hand, I can’t think of too much that the Chinese government has done that is surprising. If the Chinese government suddenly reacted to the Nobel Prize but deciding that it was wrong all about creating a one party state and releases Liu Xiaobo, *that* would be surprising.
    And there may be a bit of an over-reaction here. The Chinese government cancels a meeting with a Norwegian minister, and you’d think that it bombed Oslo. As far as the China-Japan dust-up, I don’t know of anyone that has lost money because of it.
    Harris: . If my product costs $1.00 to make in China and $1.20 in the United States, I would NOT shut down my entire U.S. operations and move it all to China.
    Except that you may not have a choice. Having two production lines is extremely expensive, and you may not be able to support both of them. Having two production lines means that your costs of shipping and logistics increase enormously. Then again, you may have a good reason to have two production lines. You have to run the numbers, think about strategy, and the answer you get will depend on your specific business and specific situation.
    If you were born and raised in the US and all your employees are Americans, then you may have a sentimental attachment to the US, and that *should* be a factor in your decision making. However, if you are German, you won’t. Something that I find that Americans have a difficult time coping with is that the idea that people that are not American have no particular reason to act in the interests of the United States, and most people in the world are not Americans.
    Harris: If I had to pick one country that is going to grow the most during the next ten years and do so in the best way possible for American companies, I would pick Vietnam.
    Except this is not how large multinationals think.
    If you are a multinational, you are thinking globally and strategically. The world is this giant chessboard and you aren’t thinking about one square, but rather thinking how all of the pieces interact. It’s not whether or not to go into one country or another, but rather what do we do in the US, in China, in India, in Vietnam, in Turkey?
    Curiously this is something that the United States is pretty good at, because your typical multinational has the problem of having people from a large number of assorted countries, and trying to get everyone to work toward a common goal. This is something that the US has more experience in than other countries.

  • HI

    The Chinese themselves grasp very well the increasingly zero-sum nature of the U.S.-Chinese relationship in a world of diminishing environmental and natural resources. If the U.S. and developed world continue on the current path of capital, technology, and trade openness with China, the end result will inevitably be that Americans will spend half their earnings on food and energy. In other words, they will become poor. And we will fry Earth, to boot. Long term, either China is screwed, or we are screwed. We can’t both win, unless we’re willing to live like the Chinese. Because our standards of living won’t equalize at the current American level.
    As Americans slowly realize this truth, government policy will change. American policy turns slowly, like a supertanker, but it has started to turn when it comes to China. It’s only a matter of time.

  • Jim

    “I have gotten the strong sense that China is cracking down on Americans in China without work visas.”
    I found that statement odd. Is this bad thing? It means that China is enforcing the immigrant law. I thought a lot of Americans want to enforce immigrants laws against Hispanic or is the OP open border advocate?

  • B. Chaudery

    I agree. It’s the massive shutdown out of nowhere that still makes China so risky. India too. But I don’t see the risk being any less in Vietnam or Cambodia, etc., I just see the advantage to spreading the risk around.

  • Twofish

    HI: Long term, either China is screwed, or we are screwed. We can’t both win, unless we’re willing to live like the Chinese. Because our standards of living won’t equalize at the current American level.
    I’m personally more optimistic that we’ll find a way to support everyone at US standards of living, but if we can’t then it really isn’t a US-China issue, it’s a US versus China+India+Russia+Africa+Middle East issue. Personally, I don’t think that it’s a good idea for the US to conduct US versus the rest of the world, because the US will lose and lose badly if it does that.

  • Orange King

    I was reading the WSJ mobile edition this morning and without a subscription I only got to read the first paragraphs of that opinion. But in general I do not agree with that article and this post.
    Look through the history since China’s opening up and would you point me a SINGLE incident in which China retaliate in trade that produced significant aftershocks? I can think of none in all these 30 years.
    Yes, time is different and, it is said that, China is becoming some kind of superpower. But what can it do if it wants to flash its muscle in commerce? What arms does China have in its arsenal? Nationalizing foreign companies like Chaves did in Venezuela? The significance of rare earth material imports have been exaggerated. For one, China is still exporting it. And Japan has stockpiled them, U.S. sits on a vast reserve and companies in Japan have started-successfully-recycling that stuff from used electronics. This thing will be over in less than a year. A most important background has been neglected somehow-China has implemented the import quota system for quite some time and the reason behind it was just to make more money, to help domestic companies compete in world market: not in the intention of sabotaging world supply.
    And it’s also ridiculous to suggest the Nobel prize would affect trade. See the China-Japan showdown? The prime ministers began talking. And the arm sales to Taiwan affecting China-U.S. military ties? Defense ministers met just now. All I’m saying it’s all just short-term effects. You wouldn’t even remember the Sino-Norway thing by Christmas. And so far what has China done? Cancel some meetings with fishery officials. Come on, is that even serious?
    This argument also underestimates the power of globalisation. The truth is that China has been integrated into global trade so deep that it can’t get out by some unilateral ban without hurting itself equally, if not more, hard. I expected the WSJ to have better judgment on this.
    And, don’t underestimate the Communist authorities. They are the most CAPITALIST officials in the world and trust me, they know better than sacrifice money-making for some vague emotions,
    and only God knows how much money exactly those officials’ sons, daughters, nephews, wifes, in-laws are making from those trades?

  • Nate

    Jim,
    The situation is not quite analogous to the American immigration problem. In China many people are looking to work on tourist or business visas, not imigrate. The question then becomes why aren’t they getting a proper working visa? They don’t get the proper visa’s because their employers can’t make the necessary arrangements due to various governement barriers which can range from lack of capital, to the employee being too young / old or any number of other requirements. At the same time there is a huge demand for foreign teachers, especially Americans, Canadians, Brits, New Zelanders, Australians and Irish, in the education market and on the whole enforcement tends to be lax. So many companies opt to leave their foriegn employees on fairly cheap non-working visas rather then fork out the cash for the expensive agency fees needed to buy one indirectly from a corrupt offical.

  • Bruce S.

    Of course China has risks. Every place has risks. But you are right to point out the really random out of nowhere type risk that is not going to be the case in the United States. I think you are right to say Vietnam is less risky and that is because it is still so dependent on foreign investment that it is going to be more cautious about doing something to rile things up.

  • Note you have no idea

    Nate, you have no idea how much it costs to get a proper working visa in the U.S. and how difficult it is. For China to match the U.S. practice to approve a non-immigrate working visa, China would have to charge 35000RMB on various fees and same amount on subsequent renewals, and put people working illegally on tourist visas in jails,

  • Dan (a different Dan)

    I lived in China for six years but returned to Australia a few months ago. China is getting so full of itself it is no longer a fun and exciting place to be as a foreigner.

  • outcast

    “I sold my China country fund a year ago. If I had to pick one country that is going to grow the most during the next ten years and do so in the best way possible for American companies, I would pick Vietnam. ”
    So we should bail out of China? There’s still plenty more growth opportunities that dont really exist on the same scale anywhere else. China will be an attractive market for quite some time.
    “Long term, either China is screwed, or we are screwed. We can’t both win, unless we’re willing to live like the Chinese. Because our standards of living won’t equalize at the current American level.”
    Thanks to technological advance and improvements in efficiency it is possible.

  • Gunda

    There are two forces driving Chinese politics. One is pragmatic, open, willing to talk and learn. Still very Chinese and proud of being so, and wanting to forward Chinese interests. Relational and basically friendly. But clearly pragmatic. The people who represent that force are easy to deal with and can become great friends, once we understand the culture and know how to navigate and negotiate. The other force is dogmatic, with an extreme desire for control and absolute power, terribly suspicious, with minimal concern for individual concerns and values. Expats find them nasty, Chinese nationals have to live with them.
    The second, dogmatic force is not rational in our usual rendering of the word. Its totally supreme goal and concern is that the Party will stay in control, no matter what it takes. The ideological base and rationale for it is Marxism, even if its practise is blatant capitalism of the most brutal kind.
    These two forces have waxed and waned since the death of Chairman Mao. The previous government was more pragmatic, the current one has taken a definite swing to the dogmatic side. Now, they may not want it that way. But the whole Party network has solidified a web of control where they carefully watch each other. The ones at the top may have the least freedom to move. Any change within the scope of this controlling web has to very slow and incremental. If the initiator makes a too bold move he is quickly enclosed in a cocoon and thrown out. They know it very well, and therefore they move very, very slowly – and stay perfectly still for long periods.
    It may in reality be few who really want the second, dogmatic force to rule – but all the others do not dare or cannot do much.
    The movement between these forces of course represent a risk on the macro level.
    A comment to the above – it is correct that the Norwegian fisheries minister was not welcome in Beijing. But Chinese and Norwegian ministry officials on sub-minister level had a very long, very good and very productive meeting – plus a dinner. The Nobel peace price was not mentioned with one word. That was the pragmatic side that came out. Other events in the areas of culture and others were cancelled, but the fisheries business meeting was too important – it was about business, man! So they just did it quietly….

  • Michiel V

    Dump which country fund? Everybody should make up their own mind, but my money is still for a large part in China, based on the simple economic theory of “just look out of the window”. For the next twenty odd years, maybe more, give or take a temporary dip like 2008/2009, China investments will give you a good return, depending of course on whether or not you apply other economics 101 like spreading risk and being contrarian, so think funds of funds rather than “golden opportunities” and get out when you start to get stock tips from your housekeeper. Other places to be are Brazil (via a Latin-America fund of funds), India, Australia (yes!) and assorted South-East Asia funds. USA is still good, regardless of all the hooha, because it is the USA. Europe is…. well, go to Europe and look out of the window. Note, just IMHO: Don’t sue me if you loose your shirt:)

  • Niroth

    Policy risk is higher in China than it is in many countries. As Sternberg suggests, this is compounded by lack of transparency in the policy-making process. I would add that there is also risk from the discretion that local officials have in the interpretation and implementation of policy.
    But there is nothing new in saying this. How is this different from 5, 10 or 15 years ago?
    There is plenty to criticise in China, but it’s far from clear that there is some sort of sinister trend going on. The problem with the lack of transparency is that we tend theorise about intentions, especially when we see China becoming stronger politically and economically.
    Was Stern Hu a victim of politics, guilty of committing a crime, or both? Very few people know the answer, but we probably don’t gain much by speculating.
    Is China becoming less friendly to foreign business? It depends who you ask. In some sectors, the policy environment has become more difficult, but elsewhere foreign businesses continue to forge ahead. The outcomes of policy decision on foreign businesses are mixed and can be debated. There is no simple answer, so it would be foolish to speculate too much about intentions.
    Does China take childish reprisals against countries (and nationals of countries) that have fallen out of favour? Sometimes. But again, probably no more and no less than in the past.
    Will the Chinese economic juggernaut continue to surge forward? I am becoming increasingly worried. But this is a simple question of economics and has little to do with policy risk. If I were going to take what little money I have elsewhere, policy risk and lack of transparency would not be new factors in the decision.