By: Steve Dickinson

This is the final installment of a three part  series on China’s energy challenge.  This series arises from the White Paper on China Energy Policy 2012 that the PRC State Council put out last month, right before the 18th Party Congress. The White Paper sets out China’s current situation and then maps out China’s energy plans for the ten-year term of the new leadership to be installed at the party congress.

In Part One, I set out China’s energy scenario.  In Part Two, I analyzed the White Paper itself.  In this Part Three, I will discuss how China’s energy challenge is likely to impact foreign companies doing business with China or in China.

Foreign companies doing business in China or considering doing business in China should take account of the following:

1. China’s energy constraints almost certainly will mean that China’s economic growth will no longer be 8% or greater.  This means that business plans that rely on continued 8% or more growth in the Chinese economy are not likely to be reliable.

2. China’s energy constraints also mean that foreign investors in China should not simply assume that their full energy needs will be available to them in the future. Careful analysis of China’s energy supply should become a prerequisite for investment in China. In particular, China is seeking to develop energy resources in the Western Region. Availability of energy in those regions may be factor in inducing foreign investors to shift their interest from the coastal regions out to the West. It has long been China’s policy to encourage foreign investment into its Western regions.  Energy supply may finally be the factor that convinces foreign investors to consider regions in China that they previously considered too remote and undeveloped.

As always, where there are challenges there are opportunities. For decades, China has paid lip service to seeking investment and technology from foreign companies in the areas of energy conservation, pollution control and advanced energy technology. By this I mean that the Chinese government always talked about these issues, but when the time came to pay for anything, there were few results. It is perhaps possible that the government and businesses of China are finally willing to make investments in these areas. If this is true, it opens vast areas for foreign companies because the need in these areas is great and the level of Chinese technology and expertise in these areas is low.

What do you think?


By: Steve Dickinson

The PRC State Council Information Office just published  a White Paper on Judicial Reform in China. The purpose of the White Paper is to provide a snapshot view of the progress of legal reform in China over the past ten years. Readers who are interested in the current state of the Chinese legal system and the projection of future trends should take a look. Even for those who do not fully agree with the assessment will benefit by seeing what the top level of the Chinese government believes is important about China’s legal system and its future development.

Four issues raised in the White Paper are of particular interest to foreign investors in China:

1.  The number of lawyers and lawsuits is rapidly increasing. This is contrary to what many foreign investors believe and the implications of this must be understood. The White Paper provides the following basic statistics:

  • There are currently 18,200 law firms in China, up 31.6% from 2000
  • There are 210,000 lawyers registered in China.
  • In 2011, Chinese lawyers acted as counselors for 392,000 clients, up 24.6% from 2008.
  • Chinese lawyers handled 2.315 million litigation cases in 2011, up 17.7% from 2008.

The White Paper does not mention that the number of judges in China has remained static at about 200,000 over this same period.  This has meant an increasing workload for the judges and has negatively affected the quality of decisions. Nonetheless, Chinese people are still making active use of the court system to resolve disputes.

Most foreign business people are unaware of the large amount of litigation that occurs in China and tend to believe that they will never be sued. They therefore do not prepare for lawsuits and, when sued, they do not take the matter seriously and often do not respond promptly and effectively. This is a mistake. As the numbers above show, there are a lot of lawyers in China and they make their money suing people. When a dispute arises, the likelihood of being sued in China is actually quite high. Far higher for example than in Japan or in Korea.

2. China has made major progress in the administration of civil justice.

The improvements fall into four areas:

1) The functions of case filing, trial and execution have been clearly separated. The major change here is in the substantial improvements in executing on judgments. Though this may sound like a purely technical issue, it actually has important practical consequences for foreign companies doing business. Criticisms of the Chinese legal system often center on the difficulty in enforcing judgments. As a result of recent reforms, most Chinese courts have a created a department that focuses exclusively on enforcement. This has resulted in substantial improvement in the enforcement of monetary awards in most major jurisdictions. In addition, pre-judgment attachment of assets has become much more effective, adding a major tool for enforcing monetary awards. For foreign investors, this change cuts both ways. It has made litigation against Chinese companies more attractive since the Chinese company now has a real fear that any judgment will be enforced against it by seizure and sale of assets. On the other hand, it means that where the foreign party is a defendant, there is now a substantial risk that an adverse decision will have a strong negative impact. We are already seeing the impact of this in the willingness of Chinese companies to settle our clients claims against them.

2) The application of the law has been clarified through legal guidance. China is a civil law system, meaning that decided cases are not binding. This lack of case law precedent is often cited as a weakness of the Chinese system, since the laws are written in a sketchy and often vague manner. The Chinese themselves have recognized that weakness and have filled the gap in two ways. First, the Supreme People’s Court regularly issues binding guidelines on the interpretation of important statutes. Second, the SPC and local high courts regularly publish authoritative cases with extensive commentary. These measures have been well received by Chinese lawyers and judges and have substantially improved clarity in the interpretation of Chinese laws. This too has led to Chinese companies focusing on settling claims so as to avoid being sued and losing.

3) Standardization in awards.

The Supreme Court has worked to achieve greater certainty and predictability in damage awards in civil cases. This removes much uncertainty in the litigation process and it also decreases opportunities for local judges to engage in bribery or other unacceptable practices.

4). Case management has been improved.

China’s major courts have installed modern case management systems. Many courts now use an on-line management system that allow parties to independently monitor the progress of a case. In many jurisdictions, streamlined case systems have been adopted that allow for quickly resolving simple matters and small claim matters. The result of all this is that Chinese lawsuits proceed to trial much faster than is common elsewhere in the world. This speed can take foreign parties very much by surprise. A Chinese lawsuit can be filed and tried in the time it takes merely to provide an answer in North American and European courts. From my experience, Chinese courts are not concerned about the thorough preparation of a case. They are more concerned that a case be heard quickly. The Chinese court motto seems to be “Justice delayed is justice denied.” Foreign investors need to take this into account. When service of a lawsuit is received, the defendant must respond immediately. There is no room for delay.

In part two, we will discuss the impact of China’s legal reforms on criminal cases.


This is the final of our three part series on how to handle Chinese negotiating tactics.  Part One can be found here.  Part Two can be found here.

Following on my previous two posts on Chinese negotiating techniques, in this post I will discuss two additional and common techniques used by Chinese companies to drive foreigners mad during the contract negotiation process.

4. Never never land.

The Chinese often will justify its outrageous demands with the vacuous statement that “China is different.” It is shocking how many foreign negotiators fall for this statement and accept such terms. The problem, of course, is that China IS different from many countries. This is a trivial statement, since every country is different from every other country.

The fact is, however, that in terms of laws and regulations, China is not all that different from other countries. Chinese laws are not original. They are based for the most part on foreign models. In addition, as far as foreign investors are concerned, the content of Chinese laws is further constrained by China’s participation in the World Trade Organization (WTO), the World Intellectual Property Organization (WIPO), the Convention on the International Sale of Goods (CISG) and other international standards setting bodies and conventions.

China has worked very hard and successfully over the past decade to bring its foreign investment and business laws in line with international standards. In most cases, China’s laws hew closer to international standards than the often eccentric laws of the United States and England. Chinese laws are based on the civil law standard. What often seems to a U.S. investor as an unusual legal provision is often nothing more than the difference between the common law approach and the civil law approach to certain issues.

Whenever the Chinese side of a negotiation argues that “China is different,” I request that it provide me with a copy of the Chinese statute or regulation that imposes this difference. In over 25 years of negotiation in China, I have never once received a substantive response to this request. On occasion the Chinese side will send over a host of Chinese language documents. To date, it has always turned out that these rules and regulations have nothing to do with the issue at hand and do not impose the rule that the Chinese claim requires that their unreasonable request be accepted. We just wrapped up a negotiation where when the Chinese side did provide us with the law, it said exactly what we had been saying it said all along, just as we knew that it would.

What is “different” about China is that Chinese negotiators do not feel constrained by the rules of good faith negotiation. Thus, when a Chinese company argues that “China is different,” what they really mean is that the fair and impartial laws of China do not reflect the reality of China. The reality is that the Chinese side must take advantage of the foreign side. This means that the foreign side must accede to the unreasonable request of the Chinese side. If the foreign side does not concede to patently unreasonable terms, then no deal can be made.

It is very true in this sense that China is different. However, this is a difference that should not be tolerated by the foreign party to any contract. The response from the foreign side should be first to demand to see the law that requires the unreasonable condition. After the Chinese side fails to provide that law it will usually say something like: “well, the law does not provide for this but our government will not approve the deal unless we include this provision. The response to that statement should be that “if your government will not approve the deal, then we will not do the deal.” This should be made very clear. If the Chinese side does not back down, you should terminate the negotiation.

Let me give an example. It is common in negotiating China Joint Ventures for the Chinese side to insist that the intellectual property contributed to the JV by the foreign partner must ultimately be transferred to the Chinese JV partner. The same is true in many technology license agreements where the Chinese side will say: “sorry, but you cannot protect your IP. You must transfer everything to us at the end of the license.” This situation is obviously the opposite of what the foreign side wants from the transaction. When the foreign side resists, the Chinese side will then play the “never never land” card and state that Chinese law requires such a transfer. In fact, however, Chinese law does not make any such requirement. This is simply what the Chinese side wants out of the deal. Of course, the Chinese government supports the Chinese side, since the free transfer of technology arguably benefits China, so everyone in China is on the same side. Thus government authorities involved will usually do nothing to clarify the situation.

The foreign side will all too often accept the “China is different” justification and go forward with the deal. Later, the Chinese side will drive out the foreign JV partner or terminate the license and appropriate the technology. When that happens, the foreign side will complain about the Chinese law that mandates such a result. However, there was never such a law. It is virtually always a case where the foreign side agreed to a contractual provision that guaranteed its own eventual doom. Chinese law is not at fault. Gullibility in falling for the China is different argument is where the fault lies.

5. Revenge is a dish best served cold.

In the discussion above, I advise that the foreign side strongly resist agreeing to unreasonable Chinese demands and negotiation techniques. I advise that if the Chinese will not back down, then the foreign side should terminate the transaction and return home. My point is the obvious one that the foreign side should not enter into a bad deal or a deal that it does not understand simply because it has been manipulated by standard Chinese bad faith negotiation techniques.

In these tough negotiations, it is usually required that the foreign side just has to say “take it or leave it.” In a surprisingly large number of cases, the Chinese side will “leave it,” even in cases where this decision seems to make little economic sense. Thus, when the foreign side gives the final ultimatum, the foreign side has to be prepared for the Chinese side simply walking away from the deal.

In some cases, however, the Chinese side will back down and will accept restrictive provisions against which it has been vehemently fighting during negotiations. It will accept the challenge and it will “take it,” rather than walk away from the deal. In that case, the foreign side will congratulate itself on their negotiation skills and the fact that it “won” the negotiation.

The problem with this though is that the Chinese side oftentimes does not fully accept its concession and it will treat it as a personal challenge. It will then work to unwind the concession in some way during the life of the transaction. It will focus on taking revenge for its defeat on the contract issue. It will focus on this revenge with little regard for whether it obtains economic benefit from its actions. Even when it will actually suffer economic damage from its conduct, it may still focus on obtaining revenge for its defeat. The passage of time makes little difference. Their only concern is on obtaining revenge.

Why is this? Social researcher Ian McKay has this to say in general about people who seek revenge:

People who are more vengeful tend to be those who are motivated by power, by authority and by the desire for status. They don’t want to lose face.

This description nicely describes the average Chinese business negotiator. They treat contract concessions as a loss of face, and they will focus on getting back their “face” to the exclusion of everything else. The economics of the deal does not matter. What really matters is the balance of power and their face. This attitude is quite foreign to most foreign business people who treat contract negotiations as a purely economic issue and not as a personal matter. It is therefore very hard for foreign business negotiators to understand how this issue can impact their future business relations with a Chinese party.

The issue goes beyond face. If you discuss these matters with Chinese business people you will learn that the Chinese side views the Western approach to contract negotiation as fundamentally unfair. They see the Western insistence on certainty and clarity as fundamentally a bad faith phenomenon. For the Chinese, certainty in contract terms is justified only for a one off, single transaction, “horse trade” style sales contract. The sale of an office building or a single shipment of a commodity is an example of this type of contract.

For any contract that requires a continuing performance over time, the Chinese believe that any attempt to pin them down and impose certainty on their behavior is fundamentally unfair and contrary to reality. For the Chinese, the future is essentially uncertain and the attempt to impose certainty on this uncertain future makes no sense. Any party who insists on this must have a bad intent. Where the Chinese side agrees to such certainty, they do it under protest and they strongly feel that unequal bargaining power on the side of the foreign party has forced them into an inherently unfair transaction. Thus, they do not have moral qualms in taking their revenge by undoing the terms of this inherently unfair agreement at a later date. Their belief that they have the moral high ground fuels their need for revenge and explains why they will seek revenge even in cases where there is no economic benefit.

This feeling runs very deep in China and is difficult to deal with rationally pursuant to the typical Western company business calculation. For foreign parties, it leads to very complex assessments of negotiation strategy. Total victory is seldom useful in China. This then leaves open the question of what sort of compromise short of total victory will result in a contract that is still acceptable to the foreign party.

In my own experience, there are two viable options in dealing with the final battle over key terms. The first is to walk away from the deal. No deal is better than a bad deal, and what looks like bad deal in China will certainly turn out to be just that. Where abandoning the deal is not acceptable, then the foreign side should plan to concede on some issues that are important to the Chinese side so as to provide the Chinese side with some feeling of victory in the conclusion of the negotiation. This concession should always be balanced against an overall assessment of the benefits of the deal to the foreign side. No deal should be concluded in China that does not provide for substantial benefit to the foreign side. Close deals never work out in China. The foreign side needs a lot of room on the benefit side to overcome the constant Chinese pressure to chip away at the foreign benefits at every stage in the process of performance.

What do you think?



By: Steve Dickinson

Dan and I just returned from Yangon, Myanmar. I attended the first Myanmar Investment Summit. Dan and I then met with local attorneys and discussed the foreign investment situation with local business people and interested foreign investors.

I was quite surprised at the situation in Myanmar and the path the government has chosen for promoting the local economy and integrating foreign investment into that development. As described by government officials at the Summit, the development path that Myanmar will follow will progress in three stages:

Stage 1: Transition to a stable, open political system. This stage includes at least the following factors:

a. Participation of all parties in the government. The recent participation of Aung San Suu Kyi’s New Democratic Party in the parliament is an example of this process.

b. Accommodation with all minority groups. The government has signed peace treaties will all the important minority groups (Karen, Kachin, Shan, Chin, Wa, Mon) and intends to bring these groups into a multi-ethnic union of Myanmar where their interests are respected.

c. Termination on restrictions of information. This will be manifested in several ways: free press (newspaper and magazines), open internet, general access to mobile phones and other forms of communication, free and uncensored publication of books, access to foreign newspapers, periodicals and books.

The central theme is that without political stability in an open society the development process cannot succeed.

Stage 2: Reform of the financial system. The government is working with the IMF to entirely reform the domestic financial system. The first step was to unify exchange rate conversion. Myanmar until recently had five different exchange rates. These have been eliminated in favor of a single exchange rate that more closely reflects the value of the Myanmar currency. The next steps will be to modernize Myanmar’s banking system and integrate that system with the world system. Eventually, this will involve partial or complete convertibility of the Myanmar currency.  Finally, Myanmar plans to open a stock exchange within the next five years. The goal is to fully internationalize the Myanmar economy within a five-year period.

The central theme is that Myanmar cannot hope to rapidly increase its GDP if its financial system is not modernized and integrated into the world financial system.

Stage 3: Increase GDP through local and foreign investment. While the Summit was in session, Myanmar’s current, Thein Sein, announced that his goal is for Myanmar’s GDP to triple within the next five years. Speakers at the Summit announced a more modest goal of doubling GDP within five years. This shows the focus of the government on GDP development.

Foreign development will be important for this process in two ways. The first and most obvious is that Myanmar will need substantial foreign investment to build the infrastructure required for any substantial increase in GDP. The second is that Myanmar lacks the technical skills required for any form of modern economic activity. Myanmar will look to foreign investors to transfer such skills as part of the foreign investment process. Currently, foreign investment in Myanmar is concentrated in oil and gas, minerals and power.

The government seeks to push development into manufacturing, real estate, agriculture and services, areas that are virtually untouched currently by foreign investment. The government is working to make foreign investment more attractive by overhauling its legal system for foreign investment. The showcase project for this is the adoption of a new Foreign Investment Law. A preliminary draft of the new Foreign Investment Law has been approved by the parliament. This law is expected to be promulgated some time in July.

Though the government seeks to promote foreign investment, the current steps show an extreme level of caution. This can be seen in two ways. First, unlike the current situation in China, foreign invested enterprises are treated dramatically differently than domestic enterprises. For example, a foreign invested enterprise cannot lease a building for a period greater than one year. For longer periods, foreign invested enterprises must rent land and build the related buildings at their own expense. The resulting lease is limited to an overall term of 60 years, at which time the building and land revert back to the government. Second, all foreign investment projects must be approved by the central government. Local governments are not permitted to grant such approvals. Many business terms such as the price of leased land must be approved by the central government, preventing private business people from negotiating their own terms.

The central theme is that the government desires to increase GDP and to allow the benefits of such increase to accrue to the people rather than to government officials. Though FDI will be a part of such GDP growth, the government is still concerned about preventing foreign investors from obtaining an unfair advantage over the local people. For this reason, the government still insists on restrictive terms for foreign investment and still insists on remaining actively involved in investment decisions to “protect” the people and the assets of the country. In this way, the opening to foreign investment on the part of the government can at best be termed half-hearted.

The striking thing about the Myanmar approach described above is that it is almost exactly the opposite of the approach taken by China towards economic development and foreign investment. The China approach has been:

Stage One: Rapid increase in GDP. With respect to foreign investment, the Chinese ordered local governments to increase foreign investment with virtually no restriction. Key features were:

 a. The Chinese made the investment decision simply too good to refuse. Strong incentives, such as tax holidays, cheap to free land, reduced utility costs, reduced labor costs.

b. The Chinese provided a complete turnkey system to foreign investors. For example, they did not require foreign investors to build factory buildings. They provided already built factories or they built them to foreign specifications.

c. For all but the largest projects, local authorities were permitted to make all investment decisions. Local authorities were never criticized for offering too much to the foreigners; they were only criticized for not securing sufficient investment.

None of this is being done in Myanmar, which comes as a surprise to foreign investors who have become accustomed to the Chinese approach.

Stage Two: Reform of the financial system. The Chinese have always taken the position that financial reform must go slow and must follow advances in GDP growth. This has caused and continues to cause considerable friction between China and the developed world. It has also resulted in a limited range of investment vehicles for the Chinese people, contributing to instabilities in China’s real estate and stock exchange markets.

The Chinese government accepts these dislocations as the price for stability and control. The Myanmar government is taking the opposite position by moving towards an open and international financial system as a prerequisite for enduring and stable economic development.

Stage Three: Political reform. The Chinese government position is that one party rule will endure forever, together with the attendant restrictions on political participation, freedom of expression and access to information. The Chinese government equates one-party rule with stability. The Myanmar position is that one-party, autocratic rule does not result in stability, but rather the opposite. The Myanmar officials I talked with point to the experiences of Taiwan and Korea. Neither of these countries really “took off” as an economic power until after they shifted from autocratic, one party rule to an open democratic system. The Myanmar government sees this experience as an absolute requirement for enduring economic development. This is why they see political reform as the first requirement.

The discussion above is heavily theoretical. What is the reality? In a following post I will discuss what Dan and I saw and heard on the street in Yangon and in our meetings with locals.

By:  Steve Dickinson

At the end of December, the NDRC issued its long awaited 2011 revision to the Catalog for Guidance for Foreign Investment 外商投资产业指导目录(2011年修订). It is a central policy of the Chinese government that foreign investment must be made in a manner that is consistent with Chinese policy and in a way that will promote China’s development. China therefore follows a policy of guided investment, and the Catalog is the guide.

The first Catalog was issued in 1995. This is the fifth revision, replacing the 2007 Catalog. This 2011 version of the Catalog will take effect on January 30, 2012. Foreign invested enterprises approved prior to the effective date will not be effected. However, any changes to existing foreign invested projects that take effect after the effective date must comply with the terms of the new Catalog.

The encouraged category shows where the Chinese government wants foreign investment to go. The restricted and prohibited categories show the sectors that are hands off in China. Even for those who are not considering investment in China, the Catalog is instructive. The encouraged category is quite detailed. For those who are looking for the next sector where China will push for dominance, the Catalog is quite revealing. In the same way, the Catalog can show which sectors the Chinese government has decided to limit or reduce. The Catalog is therefore a model for the development of Chinese industry for the next several years.

In what follows, I will summarize and comment on the official NDRC explanation of the background and policy behind the new Catalog, which can be found here. In a subsequent post, we will provide more detail on the changes introduced in the Catalog.

Foreign Direct Investment (FDI) remains an important element of the Chinese economy. In 2009 and 2010, China remained the number two destination in the world for FDI. Through the end of November, 2011, FDI amounted to $US103.8 billion, an increase of 13.2% over the previous period. It is anticipated that the total for 2011 will be around $US110-120 billion. Even in the face of the world economic crisis, China clearly remains a primary target for foreign investors.

Starting with the 2007 Catalog, China has moved to substantially change the structure of foreign investment in China. The 2011 Catalog follows on this basic program. For the developed Eastern regions of China, the goal of the Catalog is to move foreign investment away from 1) investment in low value added, high labor business, 2) investment in conventional technology, and 3) investment in high pollution and resource intensive technologies. The Catalog is intended to push investment in the East towards high value added and technically advanced manufacturing, strategic technology in both manufacturing and services
and low pollution energy saving technologies. The entire Catalog reflects these goals.

As stated by the NDRC, the new Catalog is intended to reflect the following changes:

1. Continued openness. The continues the trend towards opening up of the economy, consistent with China’s WTO commitments and the need to make us of advanced foreign technology.  The basic numbers reflect this. Three items were added to the encouraged category, while seven items were removed from the restricted category and one item was removed from the prohibited category. In addition, where joint ventures are required, the required Chinese share was reduced in eleven cases and was not increased in any case.

2. Modernization and technical advance in the manufacturing sector. Consistent with the 12th Five Year Plan, the Catalog focuses heavily on promotion of the traditional manufacturing sector. In particular, advanced technology in textiles, chemicals and equipment have been added to the encouraged category. The deletions from the encouraged category reflect the government’s desire to prevent excessive investment in conventional manufacturing technology, particularly where there is extensive current investment by foreign enterprises. This goal is reflected by the deletion of vehicle manufacturing from the encouraged category. The government also intends to prevent excessive investment in certain “trendy” sectors. This goal is reflected by deletion of mono crystalline silicon and chemical processing of coal from the encouraged category.

3. Promotion of strategic new industries. A central goal of the 12th Five Year Plan is to move China beyond reliance on traditional manufacturing and onto strategic new industries that will mark the
manufacturing world of the next several decades. The following seven such strategic industries have been identified:

— Alternative fuel cars:hybrid cars and electric cars as well as better fuel-cell batteries;

— Biotechnology: biomedicines, new vaccines, and advanced medical equipment;

— Environmental and energy-saving technologies: energy efficiency, pollution control, clean coal, waste-matter recycling and seawater usage;

— Alternative energy: ext-generation nuclear power plants, solar power, wind power, smart grids and bioenergy;

— Advanced materials: rare earths, special-usage glass, high-performance steel, high-performance fibres and composites, engineering plastic, nano and superconducting materials;

— New-generation information technology: cloud computing technology, high-end software, virtual technology and new display systems; and

— High-end equipment manufacturing: Aircraft, high-speed rail, satellites and offshore oil/gas equipment.

4. Modern service industry. Service businesses that have a direct, practical value to the Chinese people or to China industry will be encouraged. Among the new entries in the encouraged category are:

— Electric car fueling stations

— Enterprise start-up consulting

— Intellectual property consulting

— Marine oil spill cleanup technology

— Vocational skill training

In addition, medical enterprises and financial leasing have been removed from the restricted category.

5. Adaptation to differences in regional development. The basic approach of the Catalog is actually concentrated on the development of the already advanced coastal region. The goal of pushing China to high
technology modernization conflicts with the extremely low state of development in the Western, Central and Northeast Regions, where the vast majority of the Chinese people actually live. For development in these regions, the government will need to take a different approach to FDI. For example, low value added, high labor content manufacturing that is strongly discouraged for the East may be permitted or even encouraged in the less advanced Western and Central regions. To date, however, no clear policy has emerged. These matters will therefore be addressed in the proposed revisions to the Catalog for Foreign Investment in the Western and Central Regions (2008) 中西部地区外商投资 优势产业目录, which are expected next year.

The intention of the Chinese government towards foreign investment is clear. Foreign investment is intended to support China’s manufacturing sector by providing access to modern advanced technology. There is no longer a focus on job creation and there is little interest in foreign investment in any sector of the economy outside those areas which will help China modernize. Potential foreign investors should take this into account. Investing against the trend in China seldom succeeds.

This is the second in a multi-part series on the changes to China’s foreign investment laws as reflected in its 2007 Catalog of encouraged, restricted and prohibited investments. Part I of this series can be found, entitled, “Breaking News, China Changes Foreign Investment (FDI) Rules,” can be found here.

China’s new catalog on foreign investment continues Beijing’s trend to restrict foreign investment in Chinese real estate. This process started in 2006 when direct foreign investment in real estate was prohibited. All foreign investment in real estate was required to be made through a Chinese company, either a WFOE or a Joint Venture. In May of this year, the notorious Circular 50 was issued, closing many loopholes in that rule. Circular 50 requires all foreign invested real estate projects, no matter the size or nature, be approved at the national level in Beijing. This allows Beijing to turn the market on and off through its approval authority. In July, the State Administration for Foreign Exchange issued Circular 130, regulating and limiting the use of foreign exchange in real estate investments. After the 17th party congress, a number of officials indicated foreign investment in real estate was still viewed as a major problem. The problems were seen in two areas. First, foreign investment is believed to drive up real estate prices to the detriment of local citizens. Second, the flood of money into the real estate market was exacerbating China’s excessive accumulation of foreign reserves. Many foreign investors do not agree with this analysis, but it is widely accepted in China. It is therefore no surprise the Catalog would include provisions restricting foreign investment in real estate.

The changes in treatment of real estate are as follows:

The 2004 Catalog put development of residential housing in the encouraged category. The 2007 Catalog removes this reference. Under the new investment policy, foreign investments not in the encouraged category are strongly discouraged. Since Beijing’s approval of such projects is required, this change means approval of investment by foreigners in any form of housing development is unlikely. On the other hand, investment related to energy efficiency in all areas of real estate is strongly encouraged.

The 2007 Catalog includes three areas concerning real estate in the restricted category. Placement in the restricted category means the investment is strongly discouraged and is seldom approved. Foreign investment is restricted in the following:

Foreign investment in the development of raw land is restricted and limited to joint ventures. WFOEs for this purpose are prohibited. This change was expected, although the limitation to joint ventures is a surprise to me. Raw land development in China is a very sensitive issue, since it usually involves either expropriating the land of urban residents or converting agricultural land to use for construction. Foreign involvement in this highly political and sensitive process is now seen as undesirable. Though the restriction is understandable, the change does raise some important issues. Funds for building construction are plentiful within the Chinese system, but funds for raw land development are not. Provisions in the new Property Law make raw land development even more difficult. We have seen many local governments actively seeking the assistance of foreign investors to provide seed money for such projects. Now that this source of funding has been restricted or eliminated, it is not clear to me what source of funding will take its place.

Foreign investment in both the construction and operation of high level (luxury?) hotels, villas, high level (luxury?) office buildings and international convention centers is restricted. It is hard to imagine what the motivation was for this restriction since these have little to no impact on the domestic real estate market and little to no impact on foreign exchange reserves. These restrictions seem to have no relation to the stated reasons for limiting foreign investment in real estate. Further, these areas are inherently international and are expected to be funded by international investors in nearly every market in the world. Comments in the local press also express confusion about the motivation for this restriction. It seems counterproductive. For example, the second tier cities in China have no surplus of luxury hotels. Is it really the intention of the Chinese government to prohibit Starwood and Shangri La from building new five star hotels in any city in China?

Foreign investment in secondary market real estate sales and all real estate brokerages and consultancies has been restricted. Though many foreign brokerages have an active presence in China, this provision means no new brokerages will be permitted. This is consistent with the policy that foreign investors will not be permitted to invest in real estate development or purchase existing properties. With this restriction in place, what role is there for foreign owned brokerages or consultants?

Much of the Chinese press has reported these changes prohibit all foreign investment in real estate, but this is not strictly true since no area of real estate has been placed in the prohibited category. However, the effect of these provisions, when combined with the prior regulations, is to effectively eliminate most areas of foreign investment in real estate. Even where Beijing might approve a project, the requirement to seek such approval involves such a significant delay most conventional real estate projects cannot succeed. The practice in Beijing has been to simply fail to respond to requests for approval. In this way, a formal denial from Beijing is not required. The effect is a prohibition. I should note that no one in China is at all concerned about these restrictions. The Chinese real estate companies and brokerages are quite confident they can handle all of China’s current needs in the real estate area. There is therefore little chance of a change in policy in this area in the near future.

UPDATE: Stan Abrams, China lawyer extraordinaire, has come out with a post pretty much affirming the death of foreign real estate investment in China, aptly entitled, Real Estate RIP? Check it out.

Just came across another thoughtful set of predictions for China 2007, this one from Shu-Ching Jean Chen of Forbes Magazine:

  • “The Chinese Communist Party will continue to entrench its one-party rule. It is pursuing a Singapore-model, both on the mainland and in Hong Kong, of managing two seemingly contradictory tasks: ruthlessly stamping out political dissent while opening up its economy to global trade. Singapore, with a population of 3 million, has proved the success of combining a benign but autocratic political rein with the friendly face of a capitalist economy. Hong Kong, with 7 million people, could easily follow this prescription. Whether the same formula can work with the mainland’s diverse population of more than 1.3 billion will decide the future stability of China.”
  • “Chinese banks are still corrupt, ineptly bureaucratic and ill-managed, but can remain that way and still prosper.  The government controls all of the banks and will bail them out of any problems “short of a financial meltdown.”
  • China’s “economy is far more open to foreign investors than most believe.” There will always be bureaucratic foot-dragging and red tape to make foreign investing difficult, but the very top of “Chinese officialdom” — those “who make the final decisions” — still “lean toward using foreign investment to jump-start a cumbersome state-dominated economy. Foreign companies doing business in China will for the most part continue to thrive.
  • China’s second tier cities will reign in 2007.  “China’s provincial cities will be the pulse of the Chinese economy in 2007 more than the showcases of Shanghai and Beijing.”
  • Pollution will “darken the sky and blacken the earth.” “Green-minded investors will take notice and diversify their Asian holdings from China to other developing parts of the region.”

I agree with the first three, but disagree with the last two. Shanghai, in particular, will continue to boom in 2007, more so even than in 2006. SMEs [small and medium sized enterprises] and service businesses love Shanghai because it has so much infrastructure in place for them. And yes, we all know it is more expensive than the second tier cities, but what’s a couple thousand dollars a month to be able to participate in such dynamism? When our China lawyers assist service businesses on where to locate in China, the resultant list of potential locations nearly always includes Shanghai. Beijing will also do just fine in 2007 as China’s center for government, technology, and media and entertainment, all of which will continue to thrive. Oh, and there is this little thing called the 2008 Olympics that will play a major role in Beijing’s economy as well. Doing business in China will continue to get easier.

China’s environmental problems will lead to more investment, not less. It will lead to environmental investing and, unfortunately, to investing by those who wish to take advantage of China’s lax environmental enforcement.

Please check back in a year to see who was right.