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How Foreign Companies Will Be Impacted By China’s “Rebalancing”

Posted in China Business, Legal News

Received the following email this morning from a China businessperson I have known and greatly respected for many years.

This is a good article on what is coming down the road for manufacturing and large service WFOEs in China. The basic goal of the CCP is to drive all private enterprise away, to be replaced by SOEs.

This reinforces what we were saying about how foreign companies are crazy not to consider doing their China business from outside China.

As we discussed, Apple is ahead of the curve by doing its manufacturing through third parties. The fate of Foxconn remains unclear. The fate of all the large-scale assembly WFOEs remains unclear: Dell, HP, Nike: they all operate as WFOEs. They are the targets of the program in the forwarded article.  Not to mention KFC.

It is not clear what will happen.

The view that China will not continue with this because it will be bad for business and will harm them economically is untenable. The Chinese government does not really care about this. China is driving out Japanese companies right now even though doing so has negative economic impact. They don’t care. This is also another reason not to do big WFOEs in China. Why do a large amount of fix asset investing in a country that behaves like China? It makes little sense. The idea was that China would move more towards the EU model. The opposite is happening. Investors/companies should take that into account.

The article referred to in the email was a recent Wall Street Journal article by two Baker & McKenzie employment lawyers, Andreas Lauffs and Jonathan Isaacs, entitled, “Rebalancing the Workplace: In its drive for domestic consumption and social harmony, Beijing steps up labor interventions.”  The thesis of that article is that China’s efforts to rebalance its economy by increasing household income are related to “increasing labor unrest throughout the country.” According to the article, these two things “are related in a way, and add up to a new concern for foreign companies operating in China.”

The article then cites various CCP actions highlighting its intentions to democratize the workplace:

In February, new national regulations required that employee representative councils be established in enterprises to carry out democratic management of the enterprise. The councils are bodies directly elected by the employees at large, that are distinct from and have different powers than unions; for example, while a union would negotiate a collective bargaining agreement, councils would vote to approve or reject the negotiated agreement.

Such councils have long been mandatory at state-owned enterprises, but this is the first time national regulations have expanded this requirement to all enterprises. Although the text of the rules is vague on this point, it is generally believed that the regulation also applies to foreign-invested companies.

Meanwhile, in May, the Central Committee of the CCP circulated a notice urging lower-level CCP party committees and local governments to strengthen and improve the CCP’s work in private companies. All private companies with at least 50 staff should have at least some CCP members, the notice said, and if a company employs at least three CCP members, then a Party organization should be established within that company.

The writers see all of this as pointing “to an overall goal of asserting more CCP oversight over labor relations at private companies” and they conclude their article by calling this “the latest example of Beijing’s rebalancing process in action, and one foreign companies can’t afford to ignore.”

I agree with the Wall Street Journal article and I sort of agree with the email writer.  I agree with the email that Chinese government decisions (like those of every other government I know) are based on more than just economics.  I also agree with the email writer that foreign companies too often unthinkingly conclude that they must go into China as a WFOE, without analyzing the real life pros and cons of doing so.  And though I think that it is rough sledding for foreign businesses going into China and I do not see all that many signs of it getting any easier, I do not think for a moment that the Chinese government has the goal of shutting down or shutting out all foreign or other private companies. WFOEs do make sense much of the time for foreign companies looking to profit from China, but definitely not as often as consultants and accountants and lawyers who stand to profit from another company being formed make it out to be.

But what are the alternatives for foreign companies looking to “get into China”?  If you are looking to sell your product or service into China, doing so via a licensing or distribution or franchising arrangement might make better sense. For more on this, check out the following:

What are you seeing out there?

  • http://twitter.com/theeastasiaco East Asia Co.

    This sounds like yet another China doomsday scenario that is being foisted upon us.

    The idea that China is going to start showing foreign companies the door is one I have trouble with. It is not going to happen simply because China’s
    big export machine quells more unrest than it creates. In other words when the
    orders come in from abroad, factories have jobs to give to workers. When
    workers have jobs they do not riot. It is no coincidence that there has been so much unrest in the last several years because in the wake of the global economic crisis many factories had to close or streamline their operations as the orders from abroad dried up. And this has been the cause of many demonstrations, riots, unrest, for back pay, for higher pay etc. A couple of researchers at the Wharton School
    did a study a couple of years ago on labor unrest in China and they found that strikes now are about “bread and butter” issues, whereas prior to 2008 they were about rights issues. Well, as long as foreign companies provide Chinese workers with bread and butter they will be welcome in China. And many foreign companies, including many Japanese companies, do this in China now. To say that China
    is “driving out Japanese companies now” is hyperbole. ManyJapanese companies
    are struggling in China now because of the dispute over the Diaoyu
    Islands.” But many other Japanese companies are doing very well and expanding. I know because I live in Japan and read the papers here.

    I would also mention that what the Chinese govt. implements is not necessarily what it gets. In his seminal book on China, China Shakes the World, James Kynge shows how so much of China’s change in the post Mao era was owing to the fact that local govts. just ignored Beijing’s and Deng’s reforms, because they saw them as a threat to their local economies. And this is why China has grown so fast over the past 30 years. The fact that there are new regulations does not mean they will be implemented with full force. In many cases I am sure they will not.

    • http://www.chinalawblog.com/ Dan Harris

      Nobody said that foreign companies would be “shown the door.” What was said was that China is a tough place for foreign companies and that foreign companies should at least consider options other than going into China as a WFOE.

      • http://twitter.com/theeastasiaco East Asia Co.

        Dan: Isn’t “driving Japanese companies out of China ” as your contact wrote, pretty much the same as “showing companies the door” as I responded ?

        • http://www.chinalawblog.com/ Dan Harris

          No. “Driving them out” mplies making it tough on them. “Showing them the door” implies literally forcing them to leave.

          • http://twitter.com/theeastasiaco East Asia Co.

            From Burton’s Legal Thesarus: Drive out means, banish, deport , expel, oust remove. These are legal definitions of drive out.

  • Mark

    Wow, after reading this post, I wasn’t sure if I was living
    in the same country that you are writing about. There are several points in
    your post that are just not true.

    1.
    Your “friend” is highly misinformed. The government cares a great
    deal about what is “bad” for business and that includes Japan. The
    problem that Japanese companies have now in China is driven by
    nationalistic consumers that on one level or another boycott Japanese
    goods (particularly autos). The two economies are too closely entwined.
    Can you provide an example whereby China is forcing out a Japanese
    company? Here is one of many interesting articles on the subject.
    http://www.thefinancialist.com/territorial-dispute-disrupts-sino-japanese-trade/

    2. There is absolutely no evidence whatsoever that any
    regulations
    imposed upon SOE’s regarding employee representative councils be
    established in enterprises (SOE’s) will apply to WFOE’s.

    3. I
    totally disagree with your statement that companies that are looking to
    “get into China” should consider selling their product or service via a
    licensing or distribution or franchising arrangement. In most market
    segments there is rarely one single partner that has coverage in all for
    Chinese geographic selling regions. Additionally, in many market
    segments, distribution partners do not create product demand and expect
    the vendor to “hold their hand.”. Unless a company has strong brand
    recognition, the responsibility lies with the market entrant. To do this
    effectively requires an in-country presence. In most instances, being
    successful in China by “remote control” just doesn’t work most of the
    time.

    • http://www.chinalawblog.com/ Dan Harris

      How can you argue with some companies considering selling their products in China via licensing or distribution or franchising? You are absolutely right about how in most market segments there is rarely one single partner that has coverage in all Chinese geographic selling regions. But how does that argue for a small company US company coming in and doing the selling itself? Doesn’t it argue for that small US company licensing its product or entering into a distrubtion agreement with a company in Shanghai, a company in Beijing, etc. All I am saying here is that not all companies must go into China to profit from China and that not going in should at least be a consideration. What you propose no doubt makes sense for some companies and also no doubt makes no sense for others. I really cannot understand your arguments otherwise.

      • Mark

        Perhaps I didn’t articulate this as well as I should have. We would never recommend to our clients they should consider entering China via a 3rd party partnership agreement without creating a business entity in China. Why? Simply because this solution in the market we serve has historically, a very low probability of success. A couple of weeks ago, we got a call from the CEO of an up and coming U.S. technology company that wanted their product sold in China. They wanted to know if we could help them secure a partnership network that would make an investment in the sales, support and marketing of the company’s product without much (or any) effort on the company’s part. We already knew the answer to that but since they had a product that could be a good fit in China, we talked to some potential Tier 1 partners. They laughed and basically said that unless the company wasn’t prepared to create a presence in China and fund the market development, they weren’t interested. Furthermore, they said they weren’t in the business of financially supporting their vendors. We heard the same thing from our Tier 2 partner contacts. Again, this information only confirmed what we already knew in doing business here in China for 15 years.

        People need to take under consideration the business climate here in China 12-15 years ago . Then many Western companies wanted to come to China to take advantage of the sheer size of the available market. They came to China and found that business was a little different here than in their home country. When they weren’t as successful as they hoped, they left the market. In so doing, they left their Chinese partners “holding the bag” for on-going support of the western products they sold. Memories die hard in China and I don’t know of a single, reputable, partner that would do business with a western company without them showing commitment to the China market by having some sort of in-country operation ; Representative Office or WFOE.

        I’m sure there are exceptions to this in Chinese markets in which we are not experts. That’s fine but we believe these are exceptions (e.g.
        a company that is happy making one or two high priced sales per year) rather than the rule.

        • http://www.chinalawblog.com/ Dan Harris

          Mark,

          Where we have seen this work, and work well, are in the following situations:

          1. Consumer goods company with a very strong brand name for one of its products. This company entered into a distribution agreement with Chinese company with a lot of experience with similar consumer products. All has worked well for last 3-4 years.

          2. US company that makes a large part for something a lot larger. This company licensed its technology to a large Chinese manufacturer and receives a good-sized payment every year from that manuractuer, who wants to keep paying to keep getting most recent technology.

          3. Countless companies that choose to use third party manufactuerers, rather than come to China and manufacture themselves.

          4. US home goods company that had no intention of nor any desire to expaninding to China. This company licenses its name and product to China and gets millions back a year for doing so. This company calls it “found” money.

          5. Multiple US publishing companies that do not want to go into China as a Joint Venture and are not allowed to go in as WFOE (law forbids this). They license their name and some content and it works. Look at all the foreign magazines in China published by Chinese SOEs!

          6. Multiple US companies that sell big equipment from the US without any formal relationship with anyone in China.

          There absolutely are a whole slew of industries in which being in China is absolutely necessary, but there are also a slew of circumstnces where it isn’t. Again, all I am saying is that companies should spend the time to figure out under which category they fall, instead of just listening to those who will profit from their going into China as a WFOE.

          • http://twitter.com/theeastasiaco East Asia Co.

            Dan:

            Your statment above is “All I am saying here is that not all companies must go into China to profit from China and that not going in should at least be a consideration.” And then you list 6 examples , five of which involve a US company which is either selling or liscensing something into China. Of course if you are selling or liscensing into China you don’t really need a presence there. What for ?

            But your point 3 above is a little different. I would say that small companies with small orders can get away with not being in China if they at least make periodic visits to keep vendors accountable. But they need to be there at least sometimes. However, as companies grow and they have more and more production tied up in China it is essential that they establish a full-time presence there.

          • http://www.chinalawblog.com/ Dan Harris

            EAC,

            I agree with you that there will always be limitations for many companies that sell into China from overseas and that for many of those companies it will eventually make sense for them to go there as a WFOE. I do not dispute for a minute that there are real advantages to being in China, for operations, logistics, and marketing. It really comes down to a case by case cost benefit analysis and one that is going to need to be made again and again over time.

    • http://twitter.com/theeastasiaco East Asia Co.

      Regarding your friends statement about the Japanese, I agree with Mark. This guy does not know what he is talking about. The Japanese auto makers have been hard hit by the Diaoyu Islands dispute and Japanese cars sales have plummeted in China by over 40 %. But other companies are doing quite well. In fact there was just an article in one of the Tokyo papers the other day about a Japanese baby products company whose business is booming in China. It seems that regardless of their feelings about the Japanese, most Chinese consumers feel safer with the Japanese products than with Chinese products.

  • Giang Le Hue

    You’d better rename yourself “SOE Law Blog” then. Or go and look at advising in Myanmar or Cambodia or somewhere as you’re basically saying China is screwed for foreign investors. Nice tip.

    • http://www.chinalawblog.com/ Dan Harris

      China has always been difficult for foreign investors and, near as I can tell, always will be. I not only believe that telling the truth leads to more business, but the day I have to lie to get business is the day I quit.

  • Giang Le Hue

    VDan, also, you think you can effectively manage a China “distribution contract” from the US and no need to have a legal entity like a WFOE to deal with that? Man whatever you’re smoking I want some. No VAT rebates, no bonded warehouse inventory under your own control, offsetting all your China costs against USD flucuations…you’re smoking some serious weed Dude. Hallucinagenic.

    • http://www.chinalawblog.com/ Dan Harris

      I’ve seen it. See below.

  • http://www.chinalawblog.com/ Dan Harris

    WSJ article talking of how companies are choosing to operate outside of China due to its poor internet: http://professional.wsj.com/article/SB10001424127887323926104578277511385052752.html. In many ways reinforces the thrust of this post, which is that operating in China is not for everyone. Again, though, of course it is for some people, including my own law firm, which has its own China entity with employees in China.

  • Giang Le Hue

    Yeah, like the WSJ doesn’t need to sell newspapers, and under Murdochs ownership its not politically motivated. Their editors sell business shlock horror purely for dollars and you’re buying into that?

  • Happy Valley

    Mr. Harris’ post on rebalancing is right on. Ballsy but right on. People fail to connect the dots of what’s happening over here. I have been in Shanghai for nearly 20 years. I operate a private firm that specializes in “operational trouble shooting.”

    Simply put, now that China’s economy is on its ass the government are moving to shore up the SOEs. By doing so they’ll go through and nitpick every conceivable piece of redtape to hang private firms by the neck to reduce their market shares.

    It’s the Art of War and the powers that be are wielding it as a VERY big stick. Think about all the news over the last year ~ Foxconn and Apple. Sorry, I work in supply chain and you could eat off a Foxconn factory floor and the whole Proview IPad row was a shameful debacle. Look at KFC, a successful American company floating in a sea of corruption, bribes and kickbacks. How can a company insure food safety when the people employed by said firm on both sides of the chain are out to line their pockets? Due diligence takes you only so far when screwing over a company is the name of the game. The government directs the state media to attack with a raft of negative publicity. All of this is done to send a warning to domestic companies to “clean up their act.” Two birds, one stone. Who directed the Chinese consumer to boycott Japanese products…come on!!! they’ve been directed since birth to do so. Now the attack is on luxury brands in the name of austerity.

    Bubbles don’t pop, they deflate ~ when a company’s revenue stream is cannabalized to the point there’s no profit margin, we get critical mass that leads to crash and burn. I’ve watched venue after venue go down in the past 20 years and it’s all about sky high rents, red tape and government.

    If you look back at the history of modern China leading up to 1949 after WWII it’s following the same pattern….I imagine the “foreigner” tax will be implemented soon enough.

  • hk law

    andreas lauffs – that’s a REAL china lawyer. completely fluent in mandarin, years of experience ON THE GROUND in china. smart and humble.

  • ollumi

    I agree with the email cited at the start of the post, but I believe it needs to be more nuanced. There is in fact a trend toward choking private enterprise from certain regions and industries, which has started, in so far as I could feel it personally, as far back as 8 years ago. The methods are varied and circumspect, rarely so blunt as a full frontal attack, but always effective, whether it is demanding a 30 employee low-medium margin company compartmentalize like a 1000 employee SOE or face endless regulatory “scrutiny”, or the unspoken unwritten rules of engagement in large contracts handed out by the biggest customers, increasingly inevitably SOE’s themselves. Like one of my SOE customers used to say, “they can’t build a business worth a damn, but they can destroy one easily.”

    I don’t think it’s a concerted effort by the top or from the top down, as this assumption places too much emphasis and credit with the organizational efficacy of the “machine” and too little with the behavioral changing effects of in-party (in-company in the case of SOE’s) promotion or even non-demotion prerequisites, which are usually stone-cold, pragmatic for the individual, and rarely aligned with the “overall interests”, in so far as such a thing exists, of any kind of organization, including their own. This is why regions where the immediate impact of investment or continued tax revenues can be seen on the career lines of interested parties “feel” friendlier than regions where other, overarching bottom lines interfere. In reality, the motivations in both cases are the same, only the incentives are different. It’s my belief that party officials are acutely aware of this, but inertia is a hard thing to fight against, particularly when there is status-quo interest and a relative lack of reward for doing so.

    It is also my belief, however, that this particular movement is more momentum from the previous 10 years than new wave started by the next 10 years, so I’ll wait, personally, for a year or two and see for myself.

  • Mark Boylan

    @disqus_GhETQYFyJS:disqus – If you’ve been in Shanghai 20 years you’ll know that China has always had an uneven playing field between Chinese companies and foreign ones, but not so much as to make foreign participation untenable. If it was, you wouldn’t have lasted 20 years would you? There’s also nothing in China’s current 5 year plan suggesting any “foreigner tax” is imminent and there would be uproar if there was.
    These types are articles are nothing but crude China bashing with little thought put into them whatsoever. I’d stick to considered, well read opinion not stuff like this.