Great Wall of China    

Summer Palace lake

Summer Palace lake

Beijing's Olympic Stadium

Beijing's Olympic Stadium

Great Wall and mountains

Great Wall and mountains

Summer Palace lake

Forbidden City temple

Meeting with venture capitalist

Meeting with venture capitalist

Old Shanghai at night

Old Shanghai at night

Pudong at night

Pudong at night

Xi'an soldiers

Xi'an soldiers

Xi'an's ancient wall

Xi'an's ancient wall

Dangling panda

Dangling panda

Snoozing panda

Snoozing panda

Pearl River Delta handbag factory

Pearl River Delta handbag factory

Pearl River Delta factory visit

Pearl River Delta – ready for factory visit

Hong Kong skyline

Hong Kong skyline

Closing dinner

Closing dinner at China Club

March 31 to April 17, 2011

Our China 2011 trip was a custom private trip organized for the senior managers of a trust bank. In 17 days, we had 27 meetings in Beijing, Shanghai, Xi'an, Chengdu, the Pearl River Delta and Hong Kong. In between meetings, we visited the major tourist sites of each city.

Below are notes from our many meetings that provide great insights into China as a global economic and political power. We met with executives of operating companies, investors, U.S. Foreign Service officials, lawyers, professors, entrepreneurs, and many more.

A satellite company executive discussed their large China business, pointing out that only a state-owned enterprise (SOE) can own a broadcasting license. There are huge barriers to entry into the satellite business, including international and national regulations, licenses, the large amounts of capital required, and the high risk of launching satellites. But, the returns are substantial.

Chinese bankers told us the People's Bank of China, China's central bank, gives banks lending quotas. While they make some private loans, the bank's real business is funding national projects, including SOE's, with 15 to 20 year loans and interest rates set by the People's Bank of China. The West of China is the government's top priority, so many loans are made there. The biggest risks to the financial system include the potential for an economic slowdown and the performance of the global economy.

University faculty discussed investing and doing business in China. Over the last few years, restrictions have been eased on foreign investments. To repatriate funds, an investor needs the approval of the State Administration of Foreign Exchange and the Ministry of Commerce. High tech start-ups rely on angel investors and venture capital companies. Environmental technologies are big now. Smaller companies without assets have a hard time getting bank credit.

The biggest risks to China's economy are inflation and a potential real estate bubble. Prices are so high that real estate is unaffordable. To curb speculation, the government set down payments for first homes at 20% and 30 to 40% for the second one. Developers buy land rights (the right to use the land for a specified period, not outright ownership of the land) from the government for cash. They use those land rights as collateral for their loans. They can borrow to develop the land, but must put in significant equity. To get the cash they need, they issue high-yield bonds offshore to invest in "equity" (land rights and improvements) onshore, so their leverage is very high. They don't pay the construction company until the houses are sold.

The biggest legal risk is that land rights for housing last 70 years. Business real estate rights are for 40 years. So, the value of the rights depreciates relatively quickly. People are paying too much for a house or property that is depreciating because they don't own the land, just the building or the right to build.

People use savings to buy houses, not to invest in productive assets. This is due to the underdeveloped capital markets in China leaving savers/investors with few good options. The interest rate is so low that it is better to put savings into real estate. A financial crisis, perhaps by the bursting of a real estate bubble, will precipitate a political crisis.

If inflation heats up, there will be runs on the banks, but because the loans are long-term and the deposits, short-term, the banks will not have enough liquidity to meet the demand. China wants to become the center of the global market. They intend for Shanghai to become the financial capital of the world. To do that, the currency must be convertible and capital markets will have to be opened.

We met with senior U.S. Foreign Service officers in both Beijing and Chengdu who gave us their very experienced perspectives on China's economy and politics.

There are centrally-owned, state owned enterprises (SOE's) and provincially-owned SOE's. China is now the number one world vehicle market, at $110 billion, and number one internet user. The projected 2011 GDP growth is 9.3%. China owns $1.622 trillion of U.S. assets. U.S. exports to China are $91 billion, and growing. It's hard to tell exactly what the export number is because U.S. services don't get counted (such as tourism). The number of Chinese students in the U.S. grew over 30% last year.

Primary U.S. exports are high tech, medical equipment, food and coal. Health care equipment exports are growing at the rate of 20% per year.

China's R & D spending is not very efficient. On the political side, import substitution is extensive. On the propaganda side, there is a push for R & D.

The laws are good, but the implementation is not. The U.S. is working to build China's capacity within the legal and judicial system. Chinese companies now sue U.S. companies over IP. The further from the center of power, the less incentive there is to obey the central government's policies. This has made it difficult to manage past bubbles in real estate as local governments do as they please.

Political stability is priority number one in China. They have based their economic model on moving more people to prosperity. But, the lack of a social safety net means that Chinese save for their kids' education, their own health care, and their retirement. The new universal health care policy provides $201 per person per year, which doesn't go far in solving the health care problem for most people.

There are few alternatives for wealth generation. China's goal is to increase consumer spending to twice its exports to the U.S. over the next 5 years. That can't happen with a 30% savings rate. There are also huge income disparities. Rural per capita income is $897, while urban is $2,895. In Shanghai and Beijing, the per capita income is more like $12,000 per year.

Companies seeking to enter the China market find high barriers. Legal, engineering, architectural and financial firms have difficulty getting licenses to work in China and can usually only have a representative office which allows them to consult, but not provide direct services. When people work for a foreign company, China suspends their licenses. Success means having local expertise, partners and contacts. There are many ways around the rules, but you must know and understand them.

Banks won't lend to small and medium-sized businesses (SME's) because there are no incentives to do so. SME's tend to finance themselves by resorting to family, pawn shops and loan sharks. Trust companies finance middling companies, but lots of small companies peak out because they can't get capital. They are generally content to stay where they are. If they get too big and visible, the government will notice them. They lack Western management and ownership structures. If they think they can learn from you, you're their best friend. If not, they're not interested.

Lots of wealth goes to trust companies, real estate development, and natural resources development. There is no federal system, so rules are not universally applied and interpretation is local. Provinces partner with companies and often provide incubators. China's general development model is to try lots of different things and to push risk out to the provinces. They crack down on failures and pick up on successes. There is lots of wealth held at the provincial level. They are building huge infrastructure projects. Wuhan, for example, is building a subway system with 3-year bonds at 2% interest. They are supported by an implicit government guarantee.

Repatriating funds is less problematic than before, with limits varying by sector. You can buy and sell assets. It's important to have a good lawyer.

Inflation could seriously disrupt social stability, which is always a concern to the government. The government will jawbone companies on price increases to hold consumer costs down. China's goals are to 1) "crank out RMB," 2) grow the middle class from 5% in 2009 to 45% in 2025, 3) increase urban migration to 400 million people by 2025, 4) increase imports from the U.S. by 60%.

China is very concerned about building China's brands. But, they stifle innovation with punishment, particularly in sensitive areas.

Health care spending is about 3% of GDP and needs to rise to at least 6 to 7%. What used to be state-provided health care is now paid for 70% by individuals. There is some employer-provided health care in urban areas. Between 200 and 300 million "floaters" (people seeking work in the cities who have no legal right to live there) must provide their own health care. To maintain social stability, eventually China will need to cover migrants' education and health care. But that will increase labor costs. China is a developing country with developed country demographics. Migrant and rural populations are pretty much on their own for safety net services.

Labor costs are lower inland, but it depends on the job. For example, back office workers in Chengdu earn 60% of what Shanghai workers make. The days of cheap labor are over. Every province has raised the minimum wage over the last year.

Low end manufacturing opportunities have moved from China to Southeast Asia. China has an excellent infrastructure, which gives it a competitive advantage. It has lower logistics costs and suppliers nearby. Chinese productivity levels are rising to match wage increases.

In 2000, the government started the Western development program, beginning with infrastructure. This has led to significant growth. But, Western China is behind in modernizing systems. There is no transparency in government or courts. Law enforcement is inconsistent. "Buddy" deals are rampant.

There are problems in second and third tier cities. Foreigners who speak the language think they also understand the culture. They get a partner who works well with them for a while. Then the partner, with strong ties to the local government, "skins them alive."

Poor transparency is likely to hold China back. Chinese law is often far more demanding and specific than U.S. law. Regulators have lots of opportunities to extract bribes. There are very strict labor laws, but the reality is that laws are not enforced with Chinese companies, while U.S. companies must comply. Every Party committee has a political and legal affairs committee. These interfere with the courts.

The infrastructure in Chengdu is much better than it used to be, but still needs improvement. The question is, do lower labor costs make up for higher logistics costs? The market reach is the primary reason companies move inland. They say they're not leaving the coast, merely expanding inland to tap into lower costs. They and their suppliers want to follow the high tech wave that is moving to the West.

Chengdu and Chongqing define the West of China. HP and Acer have moved all their manufacturing to Chongqing, a big coup for Chongqing, which probably gave the companies really good deals to move. Foxconn is in both cities. Both cities' governments aggressively recruit companies, who also move west to tap into local consumers. The companies coming to the West are wholly owned, not joint ventures. Most foreign joint venture partners want to ditch their Chinese joint venture partners. Some industries, like finance, need joint ventures to operate. National security industries are also restricted.

Intel is the largest company in Chengdu. HP, Intel, and Acer provide 400,000 assembly jobs in China. This has brought pressure on labor rates for skilled labor. Local governments are busily recruiting workers for Foxconn, which is building a huge factory that will employ 500,000 workers. All use the local government to recruit for them. Henan Province is a big labor exporter to Chengdu. Companies are also recruiting Szechuan laborers who have migrated to the coast to come back to work.

China's new high speed rail system is mostly for passengers. Air transport is critical, with 50% of HP's products, for example, shipped by air. Companies can also ship by barge. Chongqing has 3 ports.

Inflation is a huge concern. Food prices are rising. Since the time of Deng Xiao Ping, China's annual growth rate has been 8%, with 3% inflation. Rising inflation could cause political and social instability, a great fear for the Party.

Chinese government policy is rigid and focused on stability, with government workers wanting to hold onto power and their jobs. It's important to understand the central role of the Chinese Communist Party. The constitution specifies a dictatorship under the leadership of the Communist Party. China doesn't have a military; the Communist Party has a military. Armed forces swear loyalty to the Secretary of the Chinese Communist Party. There are tyrants in all levels of government and informants everywhere. Children of top party leaders are in top positions in business. Even with privatization, you still need connections to succeed.

China's stimulus, 150% of the U.S. package, went to the SOE's, enabling China to weather the financial crisis. The government pumped money to state-owned banks and said, "lend it." The government won't let big banks fail.

China is knocking down villages to create corporate farms and moving farmers to cities. They are worried about food security, but need to be more market-based in agriculture and to rely more on international food markets. This is a huge opportunity for the U.S. Peasants are fighting for their land rights. They collectively own property and the collectives actually own their land. The government is combining lands and leasing to corporate farmers.

The country must convert more rapidly to domestic consumption. The world can't absorb all they manufacture. They are very worried about Europe and its financial crisis.

There is a gradual change in Chinese people's minds as they become more aware of their rights as Chinese citizens. They read Chinese laws on the internet. As a result, a rights protection movement has started. They petition the system because the "courts stink."

Rich/poor and urban/rural divide issues are a big problem. There is growing environmental awareness because now everyone knows about environmental disasters like the tainted milk scandals. There is a sense of an unspoken social contract: the government says "leave us alone and you'll get rich." Well-educated people and the middle class are making money and may not rock the boat, but poor and uneducated villagers may. College graduates are not getting the jobs they want and they know how to get information and cause trouble.

The new 5-year plan goal is to improve people's livelihoods in a way that addresses both urban and rural poverty. But, the plan focuses on 7 key industries, which is bad for innovation. China wants to create its own product standards rather than adhere to global standards.

One Chinese investment company gave us an interesting picture of how to get deals. About 65% of its business is state-owned. The company president knows the managers of the privatization agency well. They refer SOE's that are going to be privatized to the investment company. Part of the company is owned by its president; the rest, mostly by employees of the privatization agency, which is the source of deals for the company.

A Shanghai venture capital firm partner told us that, in China, the investment horizon is longer than in the U.S., requiring 10 to 15 years to reach a viable exit. Right now, venture capitalists are about the only source of capital for start-ups.

There are many regulatory issues to deal with, particularly licenses for just about everything. Credit risk is also a big issue. When a company goes public, the government will invest. The government uses licenses as a barrier to entry, so you need friends and connections in government. As a company gains influence, it needs to have stronger relations with the government. There are also a few industries, such as media and military technology, that are closed to outside investment.

The typical entrepreneur has lots of entrepreneurial spirit. Chinese nationals with foreign experience, either in education or working for multi-nationals, tend to be the best entrepreneurs. The Chinese education system produces large numbers of graduates, but not of the quality their companies need. There are 6 million college graduates each year. The number one reason for business failures is the lack of strong management.

Companies need to understand the uniqueness of the Chinese market and not just replicate what they sell in the West. Many companies send international managers to run their China operations or buy a Chinese company and take too much control away from the local managers. It's important to have people who understand the market and can react to market changes quickly. For example, KFC customizes all its products for China and Pizza Hut is a high end restaurant, using its global brand that appeals to young professionals, but changing its products and environment completely.

A leading lawyer told us that, unless you have a compelling reason or legal requirement to have a Chinese partner, it's best to go it alone. Often a strong partner is needed to get permits and licenses, which can't be transferred to the foreign partner. Other reasons for having Chinese partners include the need for a distribution network and/or more knowledge of the Chinese market. Most companies think China is too important to fight with their Chinese partner, so they settle IP disputes. Very few joint ventures are successful. The reason for failure: "Same bed, different dreams."

JV's operate under Chinese law. Companies seeking partners, not JV's, need a well-drafted arbitration clause that specifies a foreign partner can use foreign law and foreign courts. Enforcement in China is not a given, however. You couldn't enforce anything against a Politburo member. If your opponent is way down the power chain, you can probably enforce a judgment. Chinese law enforces judgments based on reciprocity and bilateral treaties, both of which are uncommon.

Things to remember:

  1. Foreign governing law, except for JV's, vs. Chinese law in your arbitration clause.
  2. Overseas arbitration tips the balance of procedural fairness in your favor.
  3. You can have full discovery only outside China.
  4. Choose your jurisdiction carefully—Singapore and Hong Kong are good.

Chinese law is vague, but much better than before. The real issue is enforcement. It's better in bigger cities, but depends on the political winds. The courts are snowed under with small disputes. There are not enough judges and these are overworked and underpaid. All judges are Party members. Their careers depend on doing what the Party says, but also being perceived as being good and fair.

Chinese legal education is rote rather than creative problem-solving. Law firms are "representative" offices, set up as partnerships. Chinese lawyers working for a foreign law firm must suspend their Chinese licenses, so a foreign law firm must use a Chinese law firm, but can stand behind them in court.

China realizes it can't be a manufacturing center forever. The world cannot absorb all it produces. It knows it needs creative people, but doesn't want them to ask political questions. Students parrot back to the professor exactly what he's said in class and never question a professor. The big challenge—can you develop a culture of innovation without becoming politically demanding?

Social stability is always key in China. The real estate market is out of control. There are growing gaps between the urban rich and the rural poor. The poor come to the cities and want what everyone else has, but can't find any way to save enough for an apartment. There is growing frustration and, therefore, great potential for unrest. Hu Jintao is the "iron fist in a velvet glove" who has rounded up dissidents. The government greatly fears the Middle East protests. There is no true freedom of speech.

Building quality is very poor. Chinese developers are in and out—they'll sell something that won't last. Maintenance is a big question mark, particularly of infrastructure. Land is always government-owned. Residential land can be leased for 70 years; industrial, for 50; and commercial, for 30. There is an automatic renewal of residential leases, but no one knows what the renewal will cost since the first 70 years has not yet passed and no one knows if the government will want to use the land for other purposes. The decision about what to do with land rights is in the "too difficult" basket. There is no incentive to maintain property because of the uncertainties regarding land rights.

The preferred market for large SOE listings is Hong Kong. Tech and media companies prefer the U.S. SOE's have a long way to go to clean themselves up, and the Chinese government believes that making them public is the most effective way of cleaning them up. The government chooses who can list and who cannot and will not say why they've made their decisions.

The biggest areas of concern in due diligence are:

  1. Commercial—can you believe what the company says it has—products, customers, etc.?
  2. Books are always creative.
  3. Audits are done, but are also often creative.
  4. Companies often underreport revenues to avoid taxes.
  5. Tax receipts are difficult to understand.

It's important to get an outside inspection of books. Look at utility bills, the capacity at which the company is operating, bank reconciliations, the quality of food in the employee cafeteria. Standards have improved dramatically. Big companies have good finance people.

One huge property owner said their China business has been growing 105% per year since 2005. The company secured land in major manufacturing cities, partnering with local governments. They decided the next growth driver would be internal consumption rather than exports, so will need more warehouses for internal logistics. They have advisors from the central government, government bureaus, and schools, including former ministers, high ranking officials and a former WTO negotiator. This helps them secure the resources they need to conduct their business.

The Chinese government is very capitalistic and runs the country like a company. Each province and municipality is like a separate profit center. The central government sets goals which trickle down to the lower levels. Each regional head is measured on his performance—usually on GDP per capita. Now, the environment, sustainability, and property rights are included in performance measures.

The 12th 5-year plan is about moving inland. Chongqing has 30 million people; Shanghai, 20 million. There are hundreds of cities with more than 6 million people. Urbanization is a clear goal, but urban people consume five times what farmers consume. China's arable land is only about 14% of the land mass, with more than 50% of this economically unusable. China wants to maintain the same amount of farmland. The 12th 5-year plan is focused on increasing domestic consumption and developing more regional balance. There is huge purchasing disparity between the coastal and inland areas. $1 in Shanghai will purchase $3 of goods in Chengdu.

The government designates major hub locations and provides development subsidies to them. They look at city planning and set aside major manufacturing locations. Areas of focus in the new 5-year plan are e-commerce, pharmaceuticals, autos and auto parts, retail, consumer electronics, and home appliances. The 20-year-old consumer of today grew up online. E-commerce is retail using warehouses, so it is very important to property owners. E-commerce needs superb distribution logistics.

The government is now cooling the market. They've raised interest rates and tightened the money supply. Chinese think real estate will continue to increase in value. This is a big source of funding for local governments. They finance infrastructure with land sales and property taxes. They are piloting residential property taxes in Shanghai and Chongqing. Industrial land already is subject to property taxes. A big business concern is the ability to get more land.

In the Pearl River Delta, we visited a number of factories and met with the vice mayor of one of the cities, Shihlong. We saw how many companies are moving to automation in the face of rising labor costs. The Vice Mayor told us they are concerned about being environmentally-friendly and want businesses that will help their workers develop higher level skills. The government provides subsidies for start-ups, free rent and grant funds. They will invest more as a company grows. The town owns companies outright and will do joint ventures with outside investors.

Private equity partners in Hong Kong gave us their sense of what is happening in China and how best to invest there. To invest in China, you need an offshore holding company because it's harder for Chinese courts to interfere with offshore lending transactions. Some of the companies they invest in are so small that the government doesn't pay attention to them. The Chinese government continues to interfere in companies in strategic industries.

Chinese companies often have two sets of books. Most private equity firms do their own financial audits of companies, using one of the Big 4 audit firms, before investing. Most Chinese banks lend to SOE's as ordered by the government. The government will either inject money into an SOE or tell the bank to lend. A banking crisis will hit small and medium-sized businesses (SME's) first. That would provide opportunities for private lenders.

The biggest risks to China are:

  1. Declining exports.
  2. Government infrastructure investment drives growth now, but there is a limit to the amount of productive infrastructure projects.
  3. Shift to domestic consumption is problematic given the high savings rate

To bring down the savings rate, China will have to improve the social safety net. Capital is available to companies that would fuel the growth of domestic consumption. The government wants more private equity investments since banks don't make those loans.

Logistics is a fragmented mess. Getting goods to the interior is a problem. You can't get goods during holidays. You can get goods to central locations, but can't distribute them. Each government has its own logistics policies. The tax structure is inefficient so, as goods move from place to place, they are often taxed by each jurisdiction. Goods are constantly handed off from one logistics company to another. In China, logistics are 20% of GDP, compared to 10% in the U.S.

Companies can't control the distribution of their products. Will drivers deliver the goods? Will the trucks make it? There is lots of damage. There is no DHL or UPS or FedEx. The government hasn't decided if it will open logistics to the private sector. The government goes where profits are and will squeeze out private providers. The central government doesn't really control logistics, either—provinces and municipalities are also involved.

In China, management is a big challenge. Many people speak only Chinese. When you hire people with more language skills, the question is, are you paying a translation premium or getting real management skills? Chinese want more control. They work hard. Younger entrepreneurs are often better-educated and more open to Western management practices and strategies.

The Chinese government knows the RMB can't replace the dollar, but they want more governments to accept it as a trade center currency and, ultimately, a reserve currency. Before they end currency controls, they must have banks well-capitalized. The central government doesn't know how much hot money is in China. They don't have a handle on what could be a liquidity crisis. They don't know how much money is smuggled in and out of China.

China is very liquid right now. The Chinese money supply is still growing fast despite rising interest rates. The central government can't stop local governments from feeding money into the economy.

As you can see, we learned a lot and came away with a better understanding of Chinese opportunities and problems. We hope you will enjoy what we've learned and also gain a better understanding of this huge and dynamic country, a major power in the world today.

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