Connections key for Western firms in China

As more firms reach for a piece of Chinese economic pie, they'd be wise to placate the bureaucrats while sticking to the adage "When in Rome..."

Michael Kanellos Staff Writer, CNET News.com
Michael Kanellos is editor at large at CNET News.com, where he covers hardware, research and development, start-ups and the tech industry overseas.
Michael Kanellos
3 min read
SHANGHAI, China--For Western companies looking to set up shop in China, it's often who you know.

Although the country is rapidly moving from a planned to a free-market economy, bureaucrats and government officials still hold tremendous sway over economic development, say executives from international and local companies. By establishing close ties with them, companies can gain tax breaks and access to the best university graduates. Ignoring them can lead to delays and legal barriers.

"It's like dealing with unions," said Al Sisto, CEO of San Jose, Calif.-based Phoenix Technologies, which makes system software for PCs and runs operations in China. "You need a lot of handshakes and a visceral feel to make things happen."

With the increased opportunities made possible by China's entry into the World Trade Organization last September, dealing with the country's bureaucracy has become an important issue for high-tech companies--some of which are showing off their latest wares at the CeBit consumer-electronics show here this week.

China remains one of the world's few growth markets for PCs. Although the Chinese market is down from 2000 when consumer PC shipments climbed by 82 percent, shipments of desktops, notebooks and servers are expected to increase by 19 percent, 32 percent and 18 percent, respectively, in 2002, according to statistics from IDC. China is currently reforming its laws to encourage foreign investment.

In addition, labor is cheap. Factory workers earn around $180 a month while average engineers earn between $400 and $800, according to various estimates.

Sisto's Phoenix is one of the companies that has learned, through long experience, to navigate the bureaucratic shoals. It moved operations to China roughly 11 years ago and started to establish close relationships with the Nanjing province.

The company now pays no income tax, receives rent subsidies and gets access to some of the brightest computer graduates from Nanjing University. And as an added bonus, the government managed to put in rail lines, phone hookups, and a second bridge across the Yangtze River on a tight construction schedule.

"Unlike Silicon Valley, things get built on time," Sisto said. "We're moving more and more of our core development to the region to get access to the fine labor pool and emerging new customers."

Half the company's employees, and 70 percent of its revenues, are based in Asia now. And Mandarin is the company's No. 1 language, Sisto said.

"Western companies need to understand the culture and, at times, the power structure," said Vincent Lo, chairman of the Shui On Group, a massive construction and real estate company based in Hong Kong. Lo is also the president of the Shanghai-Hong Kong Council for the Promotion and Development of the Yangtze, a nonprofit group trying to bring investors to western China. "China has always been a government-driven economy. The transition takes time."

The government agrees that regulations sometimes get in the way of expansion, but it points out that the situation is improving.

"International standards that are incompatible with government requirements will force the government to change the regulations," said Jian Daning, director of the Shanghai Waigaoqiao Free Trade Zone, where multinational corporations manufacture products for export.

For investors and government, a quid pro quo
Growth, of course, is what is driving companies to China. The country's economy has grown approximately 10 percent each year since reforms began in 1979, increasing the gross domestic product (GDP) from $177 billion in 1979 to $1.77 trillion in 2001, according to Lawrence J. Lau, the Kwoh-Ting Li professor of economic development at Stanford University.

Foreign interests invested approximately $45 billion in China last year, according to various statistics, and such investment will increase.

Provincial officials are all angling to bring foreign investors to their regions, according to the Shui On Group's Lo and others. The difficulty lies in trying to negotiate the deals. Paying off corrupt officials has been a facet of doing business in some regions for years, according to various sources. 's="" lau,="" but="" government="" can't="" simply="" drop="" these="" debts="" without="" creating="" massive="" social="" problems.="" =""> Investors, therefore, have to come up with exit strategies for the government. In one project, the government was trying to unload the aged TH Cement company, the Shui On Group's Lo recalled. Most bidders would have scrapped the existing facilities, built a state-of-the-art factory and laid off some of the 1,000-plus employees. Shui On promised it would not lay people off. The government awarded it the contract.

As mandated by Chinese law, the operation paid no tax for two years and half the normal taxes for the next three. Shui On has never made under-the-table payments, Lo emphasized.

Housing, food, educational facilities and other community amenities are also part of the equation, said David Lin, CEO of Lite-On, the second largest optical-drive maker in the world. The Taiwanese manufacturer has opened 18 facilities on the mainland, where employees live in dorms.

The government will also help cooperative companies deal with the local regulatory tangle.

Intel broke ground on a $198 million assembly and test plant in 1995 in Shanghai, said Xiao Yin Shao, deputy general manager of Intel's test and assembly plant in the Pudong district of Shanghai. Like similar investments, the operation was exempt from taxes for two years after production and taxed at half the rate for three years.

Later, Intel wanted to invest $300 million more in the same facility. The government warned the company that the plant capacity created through the extra $300 million would be subject to the two-year no tax/three-year half-tax schedule of the original plant and advised Intel to create a new separate entity around the additional investment. As a result, the company's tax burden was lowered.

When in Rome...
Foreign companies often create headaches for themselves by trying to apply their own business techniques.

Americans, for example, tend to over-lawyer deals. Shui On signed an agreement to revitalize the Xintiandi neighborhood in Shanghai. The $3.5 billion dollar agreement was drawn up in a modest four-page contract. "If you want to negotiate stacks of contractual terms, you will never get it done," Lo said.

It's not strictly a Western problem. Hong Kong developers often "don't do well on the mainland" either, Lo said.

Even if companies try to cultivate the appropriate authorities, problems can erupt. Provincial governments remain rivals. If one region becomes jealous of the influx of foreign investment in a neighboring province, it will put up bureaucratic roadblocks to block the lucky province from exporting goods into its territory, Lo said.

Dai Haibo, CEO of Zhangjian High-Tech Development, a large industrial park in Shanghai, noted that if his company recruits too heavily at a neighboring park, warnings can result. "We can recruit people, but we can't stick out," he said.

Over time, legal reforms enacted in the wake of China's entry into the WTO will smooth out many of these wrinkles. WTO membership requires that over the next six years, China level the legal and financial playing fields for anyone participating in the market. Under various provisions, tariffs on high-tech products will be eliminated, and foreign nationals will be permitted to bid on government contracts.

Local governmental influence "has become less important," said Cy Yeung, Intel's wireless-applications manager for the Asia-Pacific region.

Until the WTO reforms are fully implemented, though, one of the more common ways to navigate the market is through a joint venture with Chinese investors.

In some markets, such as telecommunications, joint ventures, with Chinese investors owning the majority of shares, are mandatory. Although joint-venture ownership may be dictated, it can have advantages. China has established a separate legal code for joint ventures, and specially appointed commercial arbitrators tend to be less susceptible to outside influence, according to Cedric Chao, partner with Morrison & Foerster.

Even when not mandatory, linking up with people personally familiar with the terrain is essential.

"With China's accession to the WTO, many previously nationalistic requirements will have to be changed," said Daning. Still, "joint ventures are one of the ways to have an easy access to the marketplace."

Lo concurred. Shui On is working on major projects in Chongqing, which, with a population of 30.9 million, is the largest city in the world. One aspect helping the deal is that the government official managing development in Chongqing is a former vice mayor of Shanghai, where Shui On has operated for years.

"If you try to make a decision from thousands of miles away," Lo said, "you are bound to make mistakes."