INVESTING IN CHINA

The performance and prospects of international companies in the worlds most dynamic economy
A COMPREHENSIVE SERIES OF REPORTS, ANALYSIS AND CASE STUDIES
Sponsored by

OCTOBER 2005

FOREWORD
he flood of foreign direct investment into China has been one of the most consistent and important financial trends of recent years. Annual flows of more than US$50bn have made China the largest destination for FDI and have helped transform its economy. For foreign investors, the attractions are evident. Chinas rising consumer class provides a potentially huge and profitable market where, for early movers at least, margins have often been higher than in mature economies. For exporters seeking efficient links in their supply chains, China is frequently the price setter and an unrivalled source of cost advantage. Both of these trends stand out in the statistics. By 2003, the ratio of the stock of inward investment to GDP was as high as 36 per cent, while more than 50 per cent of Chinas exports came from foreign invested enterprises in 2004. Unlike the experience of Korea and Japan, China has moved much more quickly to open many of its business sectors, while consumers have responded enthusiastically to international brands. But for those venturing into China, the obstacles and difficulties are no less evi-

JOHN RIDDING Editor and Publisher Financial Times, Asia

dent. Regulatory risk and uncertainty loom large, fast-emerging local competition can erode margins surprisingly quickly, intellectual property is vulnerable, while the frequent need for partnerships to penetrate the market brings all the associated management pitfalls of joint ventures and alliances. The Financial Times is uniquely positioned to report and analyse the rewards and the challenges of investing in China. Its experienced team of China correspondents and its global network of specialist business reporters have unrivalled access to officials and senior executives. The result is the most authoritative assessment of foreign capital in China from the macroeconomic context to the details of regulatory change and market reforms. This special report combines the best of the FTs news and commentary, exclusive interviews and case studies. It charts and explains the successful ventures and probes the problems that have snared many investors. From multinationals to entrepreneurs and from the major cities to the remote provinces, it is essential reading for any international company doing business in China or seeking to enter the worlds most dynamic and challenging market.

CONTENTS
4 5 5 6 7 THE CHINA CHALLENGE Dream market or graveyard? Small but capable of a big break The need for market clarity Theres a fortune in the cookie The battle for parcel supremecy First published February 16 May 25 March 9 March 23 March 9

Dream market or graveyard?

Theres a fortune in the cookie

Arnotts, the Australian biscuit maker, sees a big appetite opening up on the mainland
PAGE 6

BANKS 8 Chinas banks smarten up as they switch from state control to commercial lending 10 Banks are taking a new view of China 11 The growing market for ATMs 11 Indian banks chase opportunity 11 China gold rush hides different strategies INDIRECT INVESTMENT/FUNDS Unfair shares: a mishandled market structure raises the prospect that China will get old before it gets rich Class struggle Catch-22 haunts Chinas stock market China pledges to narrow differences Why foreign investors are not saviours Making a play for Chinese funds

June 20 August 19 March 30 July 27 August 22 There are very different views on multinational profitability on the mainland PAGE 4 March 29 August 25 June 20 June 29 July 13 June 6

12 14 14 14 15 16

Big or small? the China car conundrum

Unfair shares
A mishandled market structure raises the prospect that China will get old before it gets rich
PAGE 12

PRIVATE EQUITY/VENTURE CAPITAL 18 New rules slow deal activity 18 Intel banks on driving innovation 19 Optimistic venture capitalists plan to see their returns rising in the east INSURANCE 20 Challenges for foreign insurers 20 Axa moves as market opens PROPERTY 21 Singapore group goes shopping AUTOS 22 Big or small? the China car conundrum 22 China ruled by pragmatism in choosing the latest model 23 The super-rich demand luxury cars SCIENCE AND TECHNOLOGY 24 Philips taps flourishing health trend 25 Chinas seedling biotech crops COMPUTERS/ELECTRONICS 26 In China the agent enters the question 26 Beijing takes on Microsoft 26 Dells bold challenge pays off TAIWAN LOOKS NEXT DOOR 28 The difficult path to a stock market listing 29 Margins under severe pressure as costs mount 29 March of the chipmakers

July 20 June 22 June 22 Automakers are trying to figure out if the trend towards big cars will change PAGE 22

June 8 May 18

October 5

Virtual world where the net is doubleedged sword

April 25 September 13 September 21

May 18 June 24

Making a play for Chinese funds

Some big finance groups are increasing efforts to grab a stake in the country
PAGE 16

August 26 April 25 August 10 Beijing is worried by obsessive role-play gaming among minors PAGE 32

November 24 2004 December 1 2004 December 8 2004

30 30 31 32 33

INTERNET Yahoo search is complete: Alibaba finds a way to reap the riches of online China US internet leaders battle for local allies and talent Crocodile amid the pebbles Virtual world where the net is double-edged sword Online start-up banks on wanderlust

August 12 August 12 August 12 September 6 August 31

Philips taps flourishing health trend

The Dutch electronics giant is planning to expand its medical technology business on the mainland
PAGE 24

MEDIA 34 Star TV falls back down to earth in China 35 The long wait to broadcast 35 Murdoch calls Beijing paranoid LUXURY GOODS 36 Domestic wines hitting the spot 37 Luxury brands look to the east 37 Franck Muller finds time is ripe FOOD, BEVERAGES AND TOBACCO 38 Japan Tobacco eyes Chinese market 38 Anheuser mulls plan for Harbin AEROSPACE Intense battle for custom China likely to drive demand for private jets A tidal wave of travellers fuels aircraft boom Gulfstream opens doors to jet-setters

August 31 April 20 September 19

January 19 June 1 September 28

August 10 June 29

40 40 41 41

June 13 June 13 June 13 May 4

Yahoo search is complete

Foreign money is pouring in as the worlds most populous country narrows the digital divide, though political controls on internet use remain strict
PAGE 31

STEEL, COMMODITIES AND CONSTRUCTION 42 Iron ore groups cash in after lean years 43 Lafarge to double spending in China 43 Peabody eyes mine stakes CHEMICALS 44 Giddy growth leads to investment surge EDITORIAL/COMMENT 46 China has further to grow to catch up with the world 47 Its absurd to jail China copycats 47 Chinas boom has led to only partial change INTELLECTUAL PROPERTY Patent protection takes centre stage Law gives power to protect ideas IPR protection dogged by the grey market Nintendo tackles the pirates Chinas copycats ruffle more feathers Beijing steps up the fight

March 14 August 12 September 21

September 21

April 13 July 18 April 3

Star TV falls back down to earth in China

A deal that suddenly went wrong for Murdochs Asian broadcaster
PAGE 34

48 48 49 49 49 50

July 27 August 10 March 23 February 2 February 2 February 2

TRADEMARKS 51 Nissans drive to protect its identity 51 How to play the name game LEGAL HURDLES 52 Tussles can mean courting disaster 52 Disputes hinder partnerships LOBBYING 54 Barbarians lobbying to open the gate DISTRIBUTION Franchising grips China Fast foods not so level playing field Avon aids government with regulation shift Japanese stores seize chance

August 24 August 24

August 10 May 25

September 28

Giddy growth leads to investment surge

Multinationals are strongly increasing their presence
PAGE 44

55 55 56 56

August 6 July 13 May 11 September 14

RECRUITMENT/OUTSOURCING 57 Indias IT recruiting struggle 57 Share options give market a boost PENSIONS 58 Multinationals embrace pension plan

April 6 July 27

August 17

INVESTING IN CHINA
THE CHINA CHALLENGE

Dream market or graveyard?

There are very different views on multinational profitability on the mainland, writes Geoff Dyer

ew subjects in the business world are prone to more myth-making than the performance of multinational companies in China. While the prospect of reaching 1.3bn consumers still has the potential to dazzle, many hold that China has been a graveyard for companies that have tried sell to the Chinese. Precise numbers are hard to come by, as few multinationals disclose the real performance of their Chinese operations. Most estimates have relied instead on business surveys and anecdotes. In an effort to fill this gap, two well-known China-watchers have trawled through macroeconomic databases to find the real extent of multinational profitability. Their analyses offer very different views of what has been happening. The debate was initiated by Joe Studwell, editor-in-chief of China Economic Quarterly, whose 2002 book The China Dream details the mistaken investments and hubris of a number of foreign companies in the 1990s. Mr Studwell used figures from the US Department of Commerce, which requires foreign

affiliates of companies to report earnings. His results put China in an unflattering light. The last two years have seen a significant increase in multinational profits as the Chinese economy has soared ahead. However, according to Mr Studwell, these increases were from a very low base. Moreover, when compared with neighbours and other developing countries they look much less impressive. While China with its population of 1.3bn produced profits of $4.4bn for US companies in 2003, this was only about $500m more than what Australia with 19m residents generated. Meanwhile, Mexico, which is commonly thought to be losing out badly to China as a base for manufacturing, accounted for $5.75bn of profits, from a population of 95m. The figures do not contradict the consensus view that multinational profits - scarce for most companies in the 1990s - have accelerated in recent years. But they show that China is not the goldmine some executives have made it out to be. It is indisputable that foreign

companies have become more adept at playing China, but I am sceptical that the domestic market is what it is about, he says. The real significance of China is as the biggest cog in the global manufacturing machine. In response to Mr Studwells piece, Jonathan Anderson, UBSs chief economist for Asia, looked at a different source of macroeconomic data, Chinas balance of payments numbers. By comparing

A few cracks open from which flow large profits, but overall the economy does not leak a lot of profits
the outflows of foreign direct investment income to the total stock of FDI, he came up with an estimate of annual returns. The results gave a very different view of profitability. According to the UBS figures, the average return on foreign investment in mainland China from 1993 to 2003 was 10.4 per cent, higher than the margins multinationals achieve in most countries. He adds that Chinese manufacturing statistics show foreign

companies recording consistently higher margins than their domestic competitors. When you look at the numbers, the surprising thing is actually how profitable the place looks, says Mr Anderson, a former International Monetary Fund official. Mr Studwell counters that China looks less profitable if income from royalties, licensing and other private services is included - areas where China has traditionally been reluctant to spend money. With such a calculation, he says, Mexico generates nearly twice as much profit as China. Also, he says, profitability in China is highly concentrated. About a dozen US companies accounted for at least half of profits in 2003, he believes, with the three large carmakers responsible for one quarter. GM China alone earned $437m in 2003. Yet such windfalls are often short-lived, he argues. Mobile handset makers made huge profits at the beginning of the decade, only to see competition from local companies decimate margins. Something similar seems to be happening in motor manufacturing, with big increases in capacity and sluggish demand leading to sharp price cuts. Occasionally a few cracks open

from which flow large profits, but overall the economy does not leak a lot of profits, says Mr Studwell. However, Mr Anderson says that the striking thing about figures over the last decade is how stable the returns have been. In any one year, it might just be a handful of companies, but the point is that these profits are not a flash in the pan. He believes China has produced smaller profits than Mexico because US companies have invested less in China. Overall FDI by US companies in China is $30bn, against $57bn for Mexico, according to UBS. Taking this into account, he says, US companies have made higher returns on their investments in China than in Mexico. The two agree on one point, however; that while China has seen significant multinational investments, the total is probably less than the hype these companies have generated. The US accounts for less than one tenth of the FDI into China, says Mr Anderson. It is absolutely true that the US is not the big driver of FDI. Mr Studwell adds: There has been a lot of talking the talk about investing in China. But it is definitely possible that developed country companies have invested much less than is perceived.

FINANCIAL TIMES

VIEWPOINT

Small but capable of a big break

The pace of expansion in China intimidates smaller-scale companies. Gordon Orr looks at practical approaches to cracking the market
from the continuing liberalisation of Chinas exports also include basic machine tools, automotive components and office and home furniture. Rather than wait for the day when their Chinese competitors show up on their doorstep, western SMEs should implement strategies that will help them overcome the entry barriers to the mainlands domestic and export markets. Companies seeking to break into the Chinese market often consider partnering with a local group. While some see such a partnership as a viable option, others including many large foreign companies find it extremely challenging. Locating a trustworthy partner thousands of miles away can be an enormous drain on scarce management time and company resources. Once a partnership or joint venture is launched, foreign SMEs often discover that their views on important issues such as governance, equity participation and operational control differ markedly from those of their Chinese partners. There are other, potentially more effective ways for SMEs to expand into China. Most belong to powerful national trade bodies, which can help companies to club together and share resources within the same, or across different, sectors. For example, a trade body might decide to launch a shared sourcing centre designed to screen hundreds of potential Chinese vendors and produce a shortlist of local enterprises qualified to meet the needs of its member companies. This centre might offer expertise in areas such as contract negotiation, supplier monitoring and quality assurance. Trade bodies might also want to link up with the owners of industrial parks or development zones to set up shared facilities that foreign SMEs could use as a manufacturing base. Partnering with a Chinese industrial park would give their members access to shared infrastructure and management resources, which could help them get through the start-up phase. These SMEs could also benefit from economies of scale by sharing market research, sales agents and access to distribution channels. Once these companies have created a sufficiently large business, they can move to their own dedicated facilities within the same industrial park. Joining forces with other SMEs under the umbrella of a trade body is only one of several options. It could also be possible to team up with key multinational customers, many of whom are expanding operations in China and would prefer to source from the same network of suppliers as they do at home. Multinational companies might be willing to help suppliers from their home markets to share infrastructure, establish relationships with industrial parks, navigate Chinas investment approval processes and recruit talent. Some may even be willing to lend their management expertise to help suppliers to speed up the launch of their Chinese operations. Most SMEs involved in manufacturing have to face up to the challenges posed by China or face the risk of being squeezed out of their home markets in the years ahead. This will require bold action on the part of SMEs and will not be without risks. SMEs can turn the China threat into an opportunity if they can lower the entry barriers, reduce operational costs and mitigate the risks of entry by pooling resources and sharing capabilities and experience. This approach would not require large amounts of capital. Instead, SMEs should try to renew and tap into the entrepreneurial energy that helped them to establish themselves in the first place. With a little help from their industry peers or multinational customers, SMEs may find they can achieve far more in the China market than they ever would by going it alone.

or many small and medium-sized enterprises in Europe and North America, China can appear daunting. As they watch Chinese companies gain ground in their home markets, SMEs in the west are increasingly vulnerable on several fronts. Not only are they up against new competitors on their home turf, but many have also missed out on the chance to sell into the Chinese market or source low-cost products from it. This is because they are facing relatively high barriers to entry. Many companies are wary of deploying management resources to research Chinese customers or identify qualified vendors. Nor are they willing or able to manage and expand their local operations. By the time they take action to overcome these barriers, it may be too late. Their multinational customers, who are rapidly expanding their operations in China, may have already created networks of local suppliers. As these suppliers hone their skills by serving demanding multinational customers, they will be even better placed to compete in China and overseas. Take the business model of SMEs in the textile industry, which has been hit by the lifting of quotas on Chinese exports. Sectors that are expected to suffer

The writer is chairman of McKinsey & Companys Greater China practice, based in Shanghai

The need for market clarity

Report finds that lack of industry data concerns foreign companies, says Floriam Gimbel

oreign companies seeking to expand in China are increasingly struggling to find suitable investment targets, reflecting the slow pace of market reform, according to a report by AT Kearney, the management consultancy. Over the past five years, China has seen a widening gap between pledged foreign direct investment

and recorded FDI, which has created an investment backlog that could push up asset prices and reduce returns. The speed at which FDI can be absorbed is clearly not as fast as one would hope, says Rajiv Shah, the reports author. The barriers to market entry are coming down thanks to Chinas obligations under the World Trade

Organisation treaty. But we believe the market is getting tougher to work in. In 2004, recorded FDI accounted for 45 per cent of pledged FDI, compared with 65 per cent in 2000. According to the AT Kearney report, foreign companies are most concerned about the lack of reliable industry and market data, tax issues, staffing problems and the need to work around the system. You still need to have deep pockets and good connections to make money in China, says Mr

Shah, citing Goldman Sachss controversial investment banking joint-venture as a case in point. Its not a market where you can delicately put a toe in. You have to be really in there to understand it. The report points to the negative investment results of companies such as Whirlpool, the US white goods manufacturer, which lost more than $50m in a series of joint-ventures. It also cites Kraft, the US food giant, which closed its loss-making dairy business in 2001, eight years after entering the Chinese market. Whirlpool was trying to sell products that failed to meet local demand, while Kraft underestimated the bargaining power of local (milk) suppliers, says Mr

Shah. Recent success stories include the China investments of HSBC, Danone, Kanebo and Amway. Foreign consultancies such as AT Kearney are helping companies with market studies, reflecting the lack of reliable data on consumers and companies. The Peoples Bank of China, the countrys central bank, said it was planning to launch a nationwide creditor database and introduce a credit-reporting system. It is extremely hard to get the right kind of data on clients and competitors, says Mr Shah. Foreigners often jump to the conclusion that they (the Chinese) are hiding something from them. But thats just a reflection of how immature the market is.

FINANCIAL TIMES

INVESTING IN CHINA

Theres a fortune in the cookie

Arnotts, the Australian biscuit maker, sees a big appetite opening up on the mainland, writes Jeremy Grant

n China, biscuits are scarcely a novelty. Locally baked biscuits are sold by weight, and products from wafers to crackers are common fare. But Arnotts, the Australian biscuit manufacturer owned by Campbell Soup of the US, is six months into an ambitious project aimed at cracking a market offering the best growth prospects of any biscuit market for at least the next decade. According to consumer surveyor Euromonitor, per capita consumption of biscuits in China is only 1kg a year. That compares with 9kg in Britain, 7kg in Australia and 7.8kg in the US. If Arnotts has its way, its push into China and other parts of Asia will ensure the region is Arnottised, in the words of Walter Bugno, the companys executive for Asia-Pacific. Were very much at the embryonic stage but our aspirations are big and the market opportunity is quite large, he says. In the coming strategic planning life cycle, it (China) will be the largest initiative that well be undertaking in terms of growth expansion. Arnotts needs to grow beyond its core markets of Australia and New Zealand, because the biscuit business no longer offers stellar growth prospects in either market. The two countries account for 80 per cent of the companys business.

Arnotts, known for its Tim Tams chocolate biscuits, claims a market share in Australia of 65 per cent and a household penetration of almost 100 per cent. For the Arnotts parent company, too, there is a pressing need to grow the biscuit business as its foray into canned soups in Asia is unlikely to provide the growth the company needs. Campbell Soup has not taken off in Hong Kong in spite of years of experimenting with varieties aimed at Chinese tastes. The problem is that its just not the preferred way to eat soup, says Doug Conant, Campbell Soups chief executive. Biscuits is the biggest opportunity for us in Asia. It doesnt mean that someday soup wont be an appropriate thing, but thats the entry strategy. For its push into China, Arnotts sent teams of researchers into Chinese homes. Mr Bugno says: We ran two pieces of research across multiple (Chinese) regions. We went and lived with various families of different socioeconomic backgrounds just to understand their purchase and consumption habits. Arnotts also tested 40 of its products that were already being sold across Asia on focus groups in Shanghai and Guangzhou, includ-

ing Tim Tams, crackers and bread substitutes such as Vita Wheat. From there we determined the scores from most likely to succeed to those that dont stack up and developed a priority list of the ones we would launch, Mr Bugno says. There were three main findings from the research, which included product testing by Oracle Market Research, a specialist in Chinese consumer research. First, Chinese consumers preferred a less sweet chocolate biscuit than in the west. The preference was more towards a compound chocolate rather than a real milk chocolate, says Mr Bugno. Second, there was no significant regional difference in the type of

We lived with families of different socio-economic backgrounds just to understand their consumption habits
biscuits that consumers liked, reinforcing a belief at Arnotts that there could be a national market for its products. Mr Bugno says the companys research showed there was no market leader. The biggest player has a 6 per cent market share nationally, he says. Third, Chinese consumers were interested in indulgence products - a reflection of an increase in

the popularity of food products designed to fulfil a socio-economic desire beyond a basic need to satisfy hunger. Although there are 322 biscuit companies in China, according to the countrys National Bureau of Statistics, most domestic companies lack the technology to develop products beyond basic crackers and bread-based products. That, combined with the findings of its research, may allow Arnotts to gain market share at the premium end of the biscuit market. Rather than going immediately head-tohead with local, established competition we are creating a new segment, says Mr Bugno. We are primarily competing against confectionery products. The products being sold initially only in Guangzhou and Shenzhen are a version of Tim Tams, a range of tartlets. Stikko rolled wafers will also be launched. An Arnotts plant outside Jakarta is supplying products for the two cities. Indonesia was Arnotts first manufacturing facility outside Australia and New Zealand when it opened in 1996. Yet while the Jakarta plant will continue to supply Arnotts in this first phase of the push into China, the company has plans to start

manufacturing in China. Mr Bugno says Arnotts has secured a Chinese distributor for the southern region of the country and is trying to find local partners for manufacturing because, long term, we need to be local, he says. The company will also have to compete with offerings from other foreign manufacturers such as Kraft Foods of the US and Danone of France, as well as Taiwans Tingyuan group. Danone sells four different types of biscuit in China, including a seaweed-flavoured Tuc cracker. Biscuits account for 8 per cent of Danones turnover in China. It will no doubt help that the Chinese name Arnotts has chosen for a version of its Tim Tams translates from Chinese characters into tian dian. In English? Give me more.

FINANCIAL TIMES

Getty Images

The battle for parcel supremacy

China represents the largest and most exciting opportunity in decades for package delivery companies, writes Andrew Ward

henever David Abney looks up from his desk on the executive floor of United Parcel Services headquarters in Atlanta, he sees a large map of China mounted on the wall. I have it right in my line of sight, he says. It reminds me and visitors to my office of the size of the place and the opportunity it provides for us. As president of the package delivery companys international business, Mr Abney is quick to stress that Europe, South America and the rest of Asia are also important markets. But the fact that only China is granted its own map shows where his priorities lie. China is the largest and most exciting opportunity in the 30 years Ive been with UPS, he says. Its not a case of should we or can we. If youre going to be a global company in future you absolutely have to be a player in China. Over the past few months, UPS has committed an additional $600m of investment in China as it vies with rivals FedEx, DHL and TNT for leadership of the market. The increased spending will expand the companys distribution network and secure full control of its express delivery joint-venture in the country. China is becoming an increasingly important source of growth to UPS as the US market slows. The companys export volume out

of China more than doubled last will give us more flexibility in useless unless you can get the year, compared with a 23 per cent making investments and longgoods to market in North America increase in the whole internationterm strategic decisions and will and Europe. al business and 6.6 per cent in the give our brand a stronger presUPS believes it offers a more US. ence, says Mr Abney. comprehensive global service to In the past, UPS has relied on Meanwhile, the supply chain Chinese customers than any of its its domestic package business to management business announced rivals. FedEx lacks the internadrive growth, says Satish Jindel, plans in February to increase its tional freight-handling capability president of SJ Consulting, a number of Chinese warehouses that UPS secured through its transport consultancy. But last from 40 to 60 within two years. acquisition of Menlo Worldwide years weak performance in the US The facilities distribute goods Forwarding last year, while DHL showed it must focus more on such as textiles, technology and and TNT are relatively weak in international business - especially auto parts for import and export. North America. We have the best in China. However, Kurt Kuehn, UPSs network in the US and a powerful UPS is expanding in the country senior vice-president of sales and presence in Europe, so we can conon two fronts. The first is its tramarketing, says building a netnect China to the rest of the world ditional package business, shutwork inside China is only half the better than our more regionallytling small parcels between China challenge. Just as important is focused competitors, says Mr and the rest of the world. The secconnecting it to the rest of the Kuehn. ond is supply chain services, hanworld. Anyone can build a wareDHL and FedEx, however, both dling the export of larger-scale house in China, he says. But its have important advantages over cargo from Chinese UPS. DHL, owned manufacturers to by Deutsche Post, overseas markets. was the first foreign Last December, package delivery UPS agreed to pay company to enter One day in January this year, a Chinese culture. About 100 company officials Sinotrans, its China in 1986 when delegation visited the Atlanta headquarattended the etiquette lesson, organised ters of United Parcel Service to negotiate by Chinese-born Shiao Dong Han, UPS's Chinese partner, it formed its own a business deal over a lavish Chinese director for international retail services. $100m to take full joint-venture with meal. Participants learned about the imporcontrol of their Sinotrans. The meeting was a disaster as UPS tance of building personal relationships express delivery While UPS and executives committed a series of cultural with their Chinese counterparts before joint venture when FedEx are limited to gaffes that risked causing grave offence getting down to business. They were also Beijing relaxes forinternational delivto their guests. advised to always leave a little food eign ownership eries in and out of Blunders included using first names uneaten when dining in China because a rules at the end of China, DHL is the instead of the formal titles favoured by clean plate implies hunger. this year. The deal only one allowed to Chinese businessmen and handing out Despite the executives' disastrous perwill make UPS the make domestic shipclocks as gifts - a symbol of impending formance, Mr Han said UPS's corporate first foreign compaments. This will death in China. culture was well-suited to business in ny in the sector to soon change as Fortunately for UPS, the meeting was China because the company puts a premiwholly own its World Trade a role-playing exercise designed to familum on hard work and loyalty - qualities Chinese operation. Organisation rules iarise its executives with Chinese business that are valued by the Chinese. Having full control force Beijing to lib-

A CORPORATE CULTURE TO DIGEST

eralise but DHLs 37 per cent share of the local market will be difficult to catch. FedEx, meanwhile, has had the best air access to China since its acquisition of Flying Tigers, an international cargo airline, in 1989. The company planned to increase its number of weekly flights to the country to 23, compared with UPSs 18. Both companies were recently awarded an additional six landing slots in China with the promise of a further three each next year, following an aviation agreement between Beijing and Washington. We fly into three different Chinese cities: Shenzhen, Beijing and Shanghai, says David Cunningham, FedExs senior vicepresident for Asia-Pacific. Nobody else does that. In addition to its direct flights between the US and China, FedEx connects China to the rest of Asia through its Subic Bay hub in the Philippines and in March launched a service from Shanghai to Frankfurt - the first direct cargo service between China and Europe. The battle for dominance in China is part of a global parcel war raging between the package delivery giants, with DHL challenging UPS and FedEx in North America, while the US pair take on DHL and TNT in Europe. But the companies understand that they cannot win their battles elsewhere in the world without a strong presence in China.

FINANCIAL TIMES

INVESTING IN CHINA
BANKS

Chinas banks smarten up as they switch

The health of the worlds most dynamic economy may hinge on cleaning up the sector and attracting investors before crisis hits, writes Richard McGregor

hen Guo Suqing was parachuted into the top job at state-owned China Construction Bank in March after the former chairman left under a cloud of scandal, he was surprised to discover that the banks board played little role in overseeing the business. Directors of the bank, Chinas second largest, rarely met. But the banks Communist party committee, headed by the former chairman, convened regularly, even to vet small loans. Mr Guo, who has held a number of senior positions in financial ministries, quickly restored the role of the board. Daringly for China, where the party still tightly controls most state-owned businesses, he has also been willing to say publicly why he pushed the Communist committee aside. The party is not a commercial organisation, said Mr

Guo in an interview. There has been a misunderstanding of the partys role in the past, and wrong practices inside the bank as a result. That is why we are making some changes. The tussle over the party committee at CCB is a battle in a much larger war to transform Chinas banks into genuine commercial operations for the first time in half a century - freed from political pressure to lend to, and carry the cost of bad loans taken out by, state borrowers. Both the government and the public think that financial reform is a top priority for the country, says Mr Guo. Foreigners are more than spectators to this unfolding drama. Bank of America announced in June that it would pay $3bn for a 9 per cent share of CCB, the largest single foreign investment in a Chinese company, ahead of a pioneering overseas listing by CCB, probably this year. Bank of China and Industrial and Commercial Bank of China were also in talks with international institutions to invest before planned initial public offerings. Agriculture Bank of China, the least healthy of the big four state-owned banks, has similar but longer-term plans. Collectively, the big four account for about 55 per cent of the countrys banking assets. With the encouragement of the central

government, about a dozen foreign institutions, including Citibank, HSBC, Standard Chartered and ING, have bought stakes in a number of other Chinese lenders, mainly city commercial banks. Chinas economic rise has made bank reform a battle of global importance. A failure to fix the banking sector would eventually become a significant drag on Chinas economy, perpetuating lending to inefficient businesses at the expense of those that can grow and compete. A prolonged Chinese slowdown would deprive the global economy of a big engine of growth. The fallout would hit international commodity prices which have risen sharply as a result of Chinese demand - as well as depress exports, especially from Japan and south-east Asia, and prompt a reassessment by foreign investors, who have been vital to Chinas development. Yiping Huang, a managing director at Citigroup in Hong Kong, says the frequency and seriousness of recent corruption scandals at state banks raise questions about . . . the inevitability of a banking crisis. With a moribund local stock market and a virtually non-existent bond market, Chinese businesses, both private and state-owned, have become more dependent than ever on banks for capital. In the first quarter of this

year Chinese businesses relied on banks for 99 per cent of their official fundraising, the highest rate in at least a decade, according to figures from the Peoples Bank of China, the central bank. The lack of funding alternatives means that many private companies - the motors of growth in the modern Chinese economy - borrow money for startup finance from underground banks that charge high interest rates. Even when these companies get off the ground, the inability or unwillingness of local bank managers to understand their businesses and build relationships with them leaves many private enterprises reliant on retained earnings for capital. China also needs commercially-oriented banks in readiness for a full opening of its banking and insurance markets to foreign competitors, due in 2007 under the terms of Chinas accession to the World Trade Organisation. Without changes, the banks might become targets in Chinas increasingly testy trade relations with the US and the European Union. Already, there have been murmurings in Washington that cheap credit directed to state industries on political rather than commercial grounds provides those industries with an unfair advantage. For years, Chinas state banks were little more than extensions of industry and AFP

from state control to commercial lending

employment policy, issuing loans on the basis of centrally determined quotas with little regard for borrowers financial health. Borrowers treated the money more as working capital than as loans to be repaid. Just six years ago, ICBC, the countrys biggest bank, had a bad loan ratio of nearly 50 per cent. The policy landscape has changed dramatically in recent years. The invitations to foreigners to invest, along with the planned overseas listings, form part of a set of policies designed to transform their operations. The China Banking Regulatory Commission, the chief regulator, which was established as an independent entity only about three years ago, has laid out strict benchmarks on capital adequacy and provisioning for bad loans to be met over the next 18 months. Liu Mingkang, the regulators tough-talking head, also says: For the first time in Chinese banking history, banks have been armed with the tools to measure the performance of branches. In the past, they just measured market share and deposit growth and so forth. But this time, we said: We have to measure you with the yardstick of risk-adjusted return on capital or weighted average cost of capital. Nicholas Lardy, of the Institute for International Economics in Washington, says government policy has been very good but adds: The challenge at the end of the day is trying to figure out how successful they have been in implementing these new policies. By one measure - that of culling staff and closing branches to boost profits - the big four have been very successful. Five years ago, ICBC had a workforce of about 500,000. It has since closed about half its 40,000-odd branches and cut about 130,000 staff. Jiang Jianqing, the banks chairman, says he still has too many workers but pleads political sensitivities when asked how he will reduce his payroll further. This is the question I am least willing to answer, he says. But we will gradually solve the problem of overstaffing through retirements. The other banks have had similar purges. Mr Lardy says the big four have collectively reduced their branches from 160,000 in 1997 to 80,000 in 2003 in search of higher earnings. The government invested a substantial amount of taxpayers money in paying for reform. A total of $60bn in cash, paid out of Chinas foreign exchange reserves, has been injected into CCB, BoC and ICBC since late 2003 to help recapitalise them before their IPOs. A further Rmb2,179bn (144bn) in bad loans has been taken off the books of the big four since 1999 and handed over to debt disposal companies. The debt disposals have seen a huge drop in bad loan ratios, a crucial measure for the banks wanting to sell shares to overseas investors. In the case of ICBC, the ratio fell from 47.5 per cent in 1999 to 19 per cent at cash, while 69 people, including 29 bank officials, are due to be charged for trying to steal $894m from an ICBC branch in southern China, according to local media. Mr Guo, in comments to the Chinese media before he was appointed to run CCB, gave the scandals a positive spin, saying that the progress of reform has meant scandals are unable to hide anywhere. Mr Liu calls them a wake-up call for the need to improve internal controls and in-house auditing. It is not a good thing that we have had so many bad stories, he says. Mr Guo acknowledges that branch managers are still too independent from head office and under intense personal pressure to keep marginal enterprises afloat in order to support local economies and employment. Just like in the US and the UK, when you want to shut down enterprises, the local government will object, he says. Some older general managers (in the provinces) will have closer ties to the government if they want to be elected to the (local) Peoples Congress. These kinds of relationships extend beyond the role of the Communist party to the enduring tensions between the imperial centre and the unruly provinces. No amount of world-class regulations on risk-weighted lending practices, issued with a flourish out of Beijing, will change ingrained managerial behaviour and interests overnight. Politics aside, bank managers will soon have performance-related pay, giving them an incentive to create profitable businesses. Instead of concentrating on building volume, Mr Jiang at ICBC is urging managers to use their branches to sell investment products and insurance. I am like a teacher instructing my class in talking with midlevel managers, he says. Revenues from fee-based businesses at ICBC, such as credit cards and asset management, are up sevenfold in four years. These now account for nearly 10 per cent of revenues, more than double the proportion in 2001. Indeed, one of the strengths touted by Chinese banks is the size of the market and their dominant share. If in the next 20 years the Chinese economy grows at the current rate, GDP will quadruple in size, says Mr Jiang. That is a lot of potential growth for a bank that says it is just getting to know its customers - in the case of ICBC, all 100m of them - properly.

PRICE WILL BE THE KEY TO INVESTORS INTEREST

Listing some $20bn-worth of shares from Chinas state banks on international capital markets could be a tough job for investment bankers. They will have to counter overseas perceptions of a banking system saddled with bad debts and huge branch networks, struggling with a lack of modern software systems and plagued by fraud and deception. Bank of Communications, Chinas fifth-largest lender, became the first Chinese bank to test international investors mood in June when it priced a $1.88bn initial public offering. Strong demand enabled BoCom, in which HSBC holds a 19.9 per cent stake, to price the IPO near the top end of its price range. The challenge for BoComs bigger and more troubled rivals such as China Construction Bank and Bank of China is to convince international fund managers that they have undergone more than a mere facelift. Bankers and analysts say the IPO candidates will try to focus investors attention on their financial health, which has been improving thanks to internal reforms and government bail-outs. Non-performing loans are a fraction of previous levels, costs are on a tighter rein and profitability among the big four state-owned banks has been on the rise. The willingness by international financial groups to spend significant sums to buy a stake in Chinese lenders such as the $3bn investment by Bank of America in a 9 per cent stake in CCB - should help shore up investor confidence. Will investors be convinced that the changes in decadeold bad practices are sustainable? The situation for banks such as CCB and BoC looks relatively good at the moment, says one Hong Kong-based sector analyst. But I doubt whether investors will believe these banks have transformed from state-run monoliths into paragons of virtue in 18 months. Foreign bankers involved in the deals believe they can turn the sectors weaknesses into investment opportunities. They point to the chance for fund managers to share in the growth of banks that will benefit from Chinas rapid industrialisation and increasing wealth. The pitch to potential investors is easy, says a banker who has worked on several Chinese equity deals. These are huge opportunities to capitalise on Chinas untapped consumer finance, asset management and credit card sectors, as well as its maturing corporate sector. To make the most of these opportunities, Chinese banks will have to avoid repeating mistakes of the past. The risk is high that loans granted in the past three- to four-year boom cycle could season into more NPLs, say UBS analysts in a note. Investors acceptance of these risks will largely depend on the price they will be asked to pay. The foreign banks that have bought minority stakes in their Chinese counterparts over the past five years have paid between 1.5 times and 1.8 times book value for the holdings. However, the time horizon of strategic investors is longer than those of fund managers, enabling them to pay higher prices. An analysis by UBS based on the expected profitability, long-term growth and dividend payout ratio of large Chinese lenders concluded that a more realistic valuation would be between 1.4 times and 1.7 times book value. That would be in line with the median valuation of banks in Asia excluding Japan, but at a discount to US and European lenders, according to analysts at Fox-Pitt, Kelton. Investors willingness to support the IPOs will boil down to whether they agree with Liu Mingkang, chairman of the China Banking Regulatory Commission. When asked in a recent interview why foreign investors should buy into a Chinese lender, Chinas top financial regulator said: Life does not have to be perfect to be wonderful. It is good timing to buy a bank and work with the regulator and gain the benefit.

The challenge at the end of the day is trying to figure out how successful they have been in implementing these new policies
the end of 2004 and is set to decline much further. The bad debt ratio for most banks is expected to rise again in the short term, because of the surge in lending in China in 2002 and 2003, but not to previous levels. ICBC claims to have a bad loan ratio of 1.6 per cent on loans extended since 1999. The focus on creditworthiness, and a central government squeeze on lending in order to slow some sectors of the economy, has already seen the rate of loan growth slow. From a year-on-year increase of 20 per cent in 2003, the growth rate fell to 14 per cent in 2004 and 12.5 per cent to April this year. Perhaps the most important, and least appreciated, benchmark is one singled out by Mr Liu, the regulator - the ability of commercial banks headquarters in Beijing to control their sprawling branch networks. In the past, head offices have had little idea of what was going on in far-flung branches and even less power to influence them. The difficulty of managing such large networks has been underlined by revelations of big thefts - allegedly inside-jobs - from local bank branches. Since last September, more than 50 staff at CCB have been accused in four cases of embezzling about Rmb760m, a scandal separate to the one involving the former chairman. One branch manager from BoC disappeared with more than $100m in

Francesco Guerrera

FINANCIAL TIMES

INVESTING IN CHINA

Banks are taking a new view of China

A huge population and underdeveloped banking system are attracting foreign investors despite bad loan problems, say Francesco Guerrera and Richard McGregor

ess than a fortnight before announcing the deal, Sir Fred Goodwin, chief executive of Royal Bank of Scotland, said the UK group was very much looking rather than leaping at the prospect of buying a multi-billion dollar stake in Bank of China. Mr Goodwin did not spend too much time looking. The BoC deal he signed is part of a string of foreign investments that have turned Chinas highgrowth, high-risk banks from international pariahs into one of the countrys hottest sectors for overseas investors. Yet the unusual structure of the foreign investment in BoC highlights the problems faced by overseas financial buyers in China.

The country - with its fast-growing economy, huge population and underdeveloped banking system exerts a powerful attraction on financial groups seeking to expand their geographical footprint. But at the same time, the poor state of the banks - saddled with bad loans by decades of loss-making lending to state enterprises and high prices demanded for minority stakes prompt few foreigners to leap into deals. BoC, which is preparing a $3bn$4bn overseas listing in 2006, spent two frustrating years looking for strategic investors willing to part with billions of dollars for a 10 per cent stake. Those it eventually found - leaving aside its continuing talks with

Singapores Temasek - have widely differing reasons for buying. Li Ka-shing, who controls the conglomerate Hutchison Whampoa, is always keen to underline his pro-Beijing credentials by helping to fund state companies. For Merrill Lynch, the BoC deal was a chance to steal a march on its Wall Street rivals. The purchase of the stake is virtually certain to guarantee the US investment bank an underwriting role on BoCs listing alongside UBS, a long-time favourite. It could help Merrill Lynch, so far regarded as an also-ran in the race to advise on a listing of a large Chinese bank, to elbow out its rival Goldman Sachs, which has long-standing links with BoC but no equity holding.

Goldman Sachs recent decision to enter talks to buy a $1bn stake in Industrial and Commercial Bank of China, the countrys largest, has not helped its case. The fact that the BoC announcement names only Merrill Lynch as RBSs adviser although Goldman Sachs is understood to have helped RBS during at least some of its talks with BoC - could be a further sign the US bank has fallen out of favour. Merrill Lynch declined to comment but other foreign investment banks have dismissed suggestions that their stake-buying is linked to receiving mandates for equity offerings. However, the practice has become commonplace since last year when Citigroup was chosen to underwrite a $5bn listing for China Construction Bank after offering to purchase a stake - only to be dismissed for failing to actu-

ally acquire the holding. Deutsche Bank is believed to have made a similar offer to CCB last year, while Credit Suisse, JPMorgan and ING are understood to have considered investing in a number of state banks. Investment bankers say the countrys lenders expect foreign financial firms to put up capital if they want to have a chance of underwriting their IPOs. With fees for Chinese IPOs at about 3 per cent of the total value of the offering, analysts argue a simple stake-for-mandate exchange does not make financial sense for Wall Street firms. However, most foreign investment banks see their purchases in Chinese lenders as private-equitytype deals, which can yield a return if their shares rise after the IPO. For the Chinese banks, the tie-ups are aimed at gaining management skills and technological know-how.

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The growing market for ATMs

The big banks decision to centralise data collection is good for foreign companies, writes Richard McGregor
he overhaul of the Chinese banking system to prepare it for the full force of foreign competition from next year is prompting big lenders to look to overseas suppliers to improve service levels for customers. That is good news for companies such as Diebold, the Ohio-based company that along with NCR dominates the global market for automated teller machines. Diebold this year signed a $25m deal to sell 1,100 ATM terminals and 100 bulk cash recycling machines to Industrial and Commercial Bank of China, the countrys biggest lender. It was the single biggest order for Diebold in China for its advanced line of ATMs, known as Opteva, and symbolic of the growing importance of a market now expanding at about 20 to 30 per cent a year. There is big room for us to grow here, says Daniel Hu, Diebolds managing director for China. ICBC alone has 27,000 branches, not all of which are served by ATMs. The key to growth in China for companies such as Diebold and IT heavyweights such as HewlettPackard and IBM was the move three to four years ago by the big banks to centralise their data collection decisions in Beijing. The move was driven by a number of factors, most notably Chinas accession to the World Trade Organisation in 2001, which set a timetable of 2006 for the entry of foreign banks into the mainland on more or less equal terms with local competitors. Corruption was also a factor. China has seen a number of spectacular bank thefts in recent years, mostly from provincial branches that head offices in Beijing do not have the technological ability to monitor. In the process of overhauling the banks IT services, therefore, all purchasing of ATMs has now been centralised in Beijing. Mr Hu says Diebold initially dealt with four different parts of ICBC, all calling themselves ICBC. During the old days, customer information was not sitting in the headquarters but in the branches, he says. If I opened an account in the Shanghai branch and I was in Beijing, they wouldnt know anything about me. Foreign banks entering the mainland are not planning to match the vast nationwide branch networks of Chinas big lenders. But they expect to be able to compete in the pursuit of the countrys middle- and upper-class customers using the kinds of services they have spent years refining in other markets. Many of the services will be built around credit cards, a market just taking off in China. Most customers now have debit cards. Tracking the wealth and spending habits of Chinas new middle class will be crucial. The Chinese banks need to get to know their own customers now, says Mr Hu. Chinese banks also need to get to know their ATMs a little better to get value out of them - if Diebolds experience is any guide. Diebolds revenues in mature markets are split evenly between the sales of the machines themselves and the money it makes from the subsequent servicing of them. In China, services account for only about 10 per cent of revenues. As a result, Mr Hu says ATMs have a shorter shelf life in China, of about half the 10 to 15 years they stay in service in countries such as the US and Australia. The Chinese companies think that they spent a lot of money buying the equipment and that they can work the machines themselves, he says. China had about 40,000 to 50,000 ATMs in 1999 and its banks have been buying about 8,000 to 10,000 a year since then, according to Mr Hu. But it has only about 70,000 now, because so many machines have to be replaced because of their age or lack of service. Mr Hu admits that the margins Diebold enjoys in the US are not matched in China, partly because of the so-called multi-vendor bidding system used by mainland banks when buying the machines. Diebold manufactures ATMs and exports them from a plant in Shanghai, but China has another 14 local and foreign makers of the machines, all competing for a slice of the market. Diebold sold 4,400 machines in China and Taiwan last year, with revenues of more than Dollars 100m. Global revenues for the company were $2.38bn.

1330 Avenue of the Americas, New York, NY 10019 Tel: +212 641 6500 Fax: +212 641 6515

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Editorial Comment

China gold rush hides different strategies

The wave of foreign investment into Chinas banking system has aspects of a gold rush. Foreign banks are staking out territory in promising but highly uncertain terrain. In June Royal Bank of Scotland and its partners Merrill Lynch and Li Ka-shing became the latest to put down a sackful of dollars: $3.1bn for 10 per cent of Bank of China. Shareholders generally look askance at such strategic investments preferring that companies either acquire target businesses outright or do not invest in them at all. Those buying stakes in China plead special circumstances, with some justification. Nonetheless, there is clearly a risk that their capital will be squandered by managements better known for growing loans than for controlling bad debts. The vigorous debate about RBS-Bank of China is a welcome sign that shareholders will not accept any China initiative unthinkingly. Managements must show how they intend to deliver returns to match the risks. There are potentially three ways: buying cheap; adding value; and creating options. Investing banks could buy stakes for less than their underlying value. True value, though, is hard to establish, given lax accounting and a flood of recent lending that may turn bad. More plausibly, they could add value to their Chinese partners by contributing more sophisticated risk-management, better corporate governance and new product know-how. Without control, however, the Chinese banks will change only as fast as they want to. Investing banks may also view a few billion dollars as a price worth paying for exclusive joint venture agreements to distribute credit cards, insurance, investment products and the like as regulations permit. Perhaps. But branch staff have no idea how to sell sophisticated products. Moreover, there is potential for conflicts of interest with other shareholders. Why should profitable new operations be hived off into 50-50 joint ventures with a 5 per cent shareholder?

Managements must show how they intend to deliver returns to match the risks
Different foreign banks emphasise different elements. RBS-Bank of China is premised on joint ventures and distribution. HSBCBank of Communications envisages deeper involvement. Not coincidentally, banks with pan-Asian presence HSBC and Citigroup - have tended to buy into smaller banks they might one day hope to control, while those with China-focused strategies - RBS and Bank of America - have invested in big banks unlikely ever to cede control, but with extensive branch distribution networks. Shareholders should differentiate between them. Investment bankers, meanwhile, must accept that they are unlikely to win mandates to float Chinese banks unless they are prepared to buy into them. The flotation fees alone do not justify tying up so much capital. They should evaluate these opportunities as private equity investments. The rate of return they must achieve should be a private equity one too.

Indian banks chase opportunity

By Khozem Merchant

CICI hopes to open its first branch in Hong Kong by the end of this year, but it is opportunity on the mainland that is exciting Indias largest private-sector bank. The company wants to position itself as a partner for Indian companies entering the Chinese market, providing debt and other tradelinked products as bilateral trade rises sharply from a low base of $14bn last year. ICICI already has a representative office in Shanghai, but it is reluctant to upgrade its status to a branch because of the onerous regulatory capital requirements. Executives also found branch licenses too restrictive for a bank that is accustomed to fast roll-outs. For example, the timetable for branch license-holders to graduate to a more sophisticated level of

operation such as offering foreign exchange products to overseas companies in China and renmimbibased services to international customers is considered too lengthy. The risk-reward equation for opening a branch on the mainland was not appealing, said Bhargav Dasgupta, head of ICICIs international banking group. A branch in Hong Kong would allow ICICI to bypass the mainlands capital requirement and target China-bound Indian companies, also servicing the 10,000-strong rich Indian expatriates in the territory. ICICI is not alone among Indian banks in exploring opportunities in China. In June, the Reserve Bank of India, the regulator, gave a nod to public sector banks Allahabad Bank, UTI and UCO to open representative offices in China. They will join State Bank of India, the countrys largest bank, which has a representative unit in Shanghai and a branch license.

Bankers say the Reserver Bank of Indias support for banks expansion into China reflects its confidence in Indias relatively healthy banking system. The banks are following Indian companies that have a growing need for investment funding in China. Indian technology companies may have made the most notable foray into China, but Delhibased drugs manufacturer Ranbaxy and other manufacturers have been there longer. ICICIs application to set up a branch in Hong Kong would mark the next stage of the banks global expansion. In the past two years, ICICI has opened branches in London and Toronto, and offshore units in Singapore and Dubai. ICICIs international balance sheet has swelled quickly to more than $4bn, and the bank expects overseas operations to contribute at least one-fifth of earnings within three years.

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INVESTING IN CHINA
INDIRECT INVESTMENT/FUNDS

Unfair shares: a mishandled market structure raises the prospect that China will get old before it gets rich
Sliding stock prices and the priority given to flotations by mediocre state enterprises are hampering Beijings economic ambitions, Geoff Dyer and Francesco Guerrera write

few months ago, a man broke into a government building in Beijing and attempted to set himself on fire. After being thrown out by security guards, he tried again before police arrived to stop him. The man, whose name the authorities refused to disclose, was not protesting against human rights abuses or the loss of his home to an unscrupulous property developer - the sort of injustices that more often give ordinary Chinese the courage to defy the all-powerful state. Instead, his rage was at the China Securities Regulatory Commission, the stock market watchdog, and his attempt on his life was made at its headquarters, reportedly in despair at the dismal recent

performance of Chinese share prices. Chinas transformation from a command economy to semi-capitalist juggernaut has proceeded at a pace that has consistently confounded sceptics. Yet one part of this process that has badly misfired has been the effort over the last decade to build a strong domestic capital market. In the late 1990s, when the stock market was growing rapidly and Communist party newspapers urged people to buy shares, some observers predicted that the Shanghai and Shenzhen bourses would take over from Hong Kong as the markets of choice for Chinas leading companies. Today, that idea appears far-fetched. Although the government claims tens of millions of Chinese have bought shares at

some stage, the countrys markets have slid in the past four years as retail investors have been driven away by falling prices, the states overbearing influence on listed companies and corruption and incompetence among local securities houses. In spite of national economic growth of nearly 10 per cent, the Shanghai composite index dropped 15 per cent last year, making it the worst performing of all main world markets, and it is down further this year. The collapse has been so pronounced that the total market value of Chinas public companies has fallen since 2000 even though 513 new listings came into existence during the period. Chinas capital markets are really floundering and the authorities dont seem to have a real idea of what to do, says Fraser Howie, co-author of the book Privatising China*. While the problems are not new, the consequences of the market torpor and of the securities industrys inadequacies are

mounting rapidly. The suicide attempt at the CSRC is evidence of the anger among middle-class shareholders. Protests over savings lost in the stock market have been growing - an alarming prospect for leaders in Beijing whose grip on power depends largely on ensuring social cohesion and rising wealth. There are serious economic implications too. The malfunctioning stock market is a missed opportunity to fund a new breed of company capable of competing internationally. More worrying for the foreign investors who each year pour billions of dollars into China, the slump in its capital markets is adding pressure on a financial system already strained by a banking sector drowning in bad loans and malpractice. How did the Chinese market get in such a mess? The problems started with the companies chosen to list. From the start, the authorities saw the stock market as a new source of funds for state-owned companies, including many struggling ones, and there-

Future considerations: a stock trader contemplates the Chinese markets performance

AFP

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fore a way to relieve the banks from their onerous role as providers of cheap funds to government corporations. The stock market did the banks a huge favour by taking the burden of financing mediocre companies away from them, says Joe Zhang, a former Chinese central bank official who is now co-head of research at UBS in Hong Kong. These companies raised money from moms and pops rather than from the banking system. To facilitate such a process - and lure retail investors to companies of dubious quality - Beijing set rules that ensured initial public offerings were underpriced, thus guaranteeing investors handsome gains in the first few days of trading. But in turning the stock market into an instrument of state economic planning, the government sowed the seeds of future decline. That was compounded by a cultural and ideological reluctance by ministries and local authorities to relinquish ownership of their companies. Only one-third of issued shares in listed companies form the free float for trading on the exchanges. The rest are mostly owned directly by the state or its companies. The corporate (issuers) that stole the money with IPOs put something back by buying shares in other state-owned companies. It is one way to offset those illgotten gains, a Hong Kong-based banker ruefully observes. With the state so dominant, minority shareholders get short shrift from listed companies. The companies never come to visit us unless they are looking to do a secondary offering, says Frank Yao, chief investment officer at Hua An Fund Management in Shanghai. They think that as they have already raised money from these guys they dont need to pay us any attention. These problems are compounded by the inadequacies of Chinas securities industry. A corporate bond market barely exists. Few brokerages have the skills or financial wherewithal to underwrite a public equity offering. Mismanagement is so rife that many of the countrys 130 brokers are near bankruptcy. Their undoing was brought about by the sale of lossmaking products such as investment funds that promised guaranteed returns on equities - and the use of clients money for brokers own proprietary trading, say independent commentators. Such cavalier practices, and the prolonged bear market, left huge numbers of investors out of pocket, turning them off equities and thus exacerbating the market slide. Apart from its potential social implications, the lack of a robust capital market is likely to have a strong influence on the future shape and development of Chinese capitalism. Cheap manufacturing might be Chinas current competitive advantage but, in the long run, Beijing planners want the country to move more into lucrative hightechnology sectors that provide better-paying jobs. A recent emergence of labour shortages in the Pearl River region of southern China has given new urgency to these ideas. To make such a transformation, China will need a dynamic private sector, run by entrepreneurs who have the drive to build innovative companies. Yet it is exactly these sorts of companies that are being squeezed out by an equity market that caters mostly to state-controlled groups. Permission for IPOs is given first and foremost to state companies, leaving private enterprises without an easy funding route. Estimates vary, but only between 30 and 130 of the 1,300 companies listed on the

Chinese market have a private-sector background - and even some of those are in reality controlled by branches of the state. The cities and provinces deliberately pushed lousy state-owned companies on to the stock market to reduce the pressure on their own finances, says Mr Zhang at UBS. It is not surprising the market is in the state it is today. He points out that the 100 companies that UBS tracks have performed well over the last few years: it is the long

years ago is that in a decade or so many more people will be retiring than entering the workforce. China will get old before it gets rich, says Stuart Leckie, a pensions expert in Hong Kong. The World Bank says future pension liabilities for China could reach 140 per cent of gross domestic product. This is not vastly out of line with other developing countries but it does underscore the need for a ready supply of inflation-beating assets in which

tail of mediocre state groups that have pulled down the overall market. Private-sector companies can get bank financing, especially if they have good political connections. Yet the lack of an equity funding route is likely to curtail Chinas ability to develop a strong private sector. In this area, many argue that India is already ahead, as most of its biggest companies come from the private sector and have grown through raising capital on the equity and bond markets. The issue is important in terms of public policy, where China needs a robust stock market to stave off a looming pensions crisis. One of the by-products of the one-child policy introduced 25

pension funds and individuals can invest. In spite of saving more than most other nations - about 40 per cent of individual income - the Chinese have few options other than to park their cash in banks that pay them risible interest rates and sometimes squander their savings on loans to troubled state companies. The government should be doing everything it can to develop a capital market that can protect pension assets, says Yasue Pai, senior consultant at Stirling Financial in Hong Kong. They have to fix the problem in the next 10-20 years before the system becomes unsustainable. Over the past few months, Beijing has

BOURSE RIVAL IS FAR FROM A CERTAIN BET

When Asias financial crisis sent regional equities plunging in October 1997, one bourse stood firm. The Shanghai stock market rose more than 6 per cent during that turbulent month - protected from the maelstrom by Chinas non-convertible currency and its borders closed to capital. The contrast with Hong Kong, the former British colony handed over to China only three months before, could hardly have been more marked. The Hang Seng index of that territorys leading shares tumbled 40 per cent amid the crisis, putting into question Hong Kongs status as the premier financial centre of greater China. Leading figures in the territory had already been voicing concerns over the challenge posed by Shanghai as the natural market for the best companies in the enlarged country. At some time in the future there is a definite possibility Shanghai might become a more important financial centre than Hong Kong, is how John Strickland, then chairman of Hongkong Bank, HSBCs Asian arm, put it a month before the July 1997 handover. In the ensuing years, as Shanghai became the standardbearer of Chinas rapid industrialisation, the concerns expressed by Mr Strickland never ceased to grip Hong Kong. Gloomy headlines such as A crisis of confidence, A tale of two cities and Hong Kong on the slide have repeatedly reminded the territorys leaders and citizens that nothing lasts for ever. In the pessimists view, it is only a matter of time before Beijing rules that China will have a single domestic stock market based in Shanghais gleaming Pudong financial district. As one Hong Kong-based banker puts it: There is no other major country in the world whose home stock market is, effectively, abroad. Recent decisions by the authorities appear to point in that direction. Leading companies such as Bank of Communications and Shenhua Group, a coal producer, have been advised by Beijing to list at least half of their initial public offerings in Shanghai. Large Hong Kong-listed Chinese groups such as Petrochina, the state oil giant, have been encouraged to obtain a secondary listing in Shanghai to show their faith in that market. But for all the authorities prodding and Shanghais lofty ambitions, Hong Kong retains substantial advantages over its mainland rival. Aside from the legal and financial benefits associated with Hong Kong - the worlds most open economy, a working rule of law and a freely traded currency - the territorys stock market is more than half as big again as the bourses in Shanghai and Shenzhen combined and has none of the artificial restrictions of those markets. Foreign investors are free to buy any Hong Kong shares, whereas Beijing imposes quotas. Indeed, Hong Kong regulators and stock market officials say they are targeting the higher standards of disclosure and market activity of New York and London rather than worrying about rivals closer to home. Paul Chow, chief executive of Hong Kong Exchanges and Clearing, the parent of the stock exchange, was quoted by the local press as saying: When it comes to a dual listing for a Chinese company, the Hong Kong bourse will always be one of their exchanges . . . We are not worried about which other bourse the listing candidate will choose. Officials in Shanghai will dispute Mr Chows use of the word always but, given the markets problems, their dream of supplanting their southern rival in Asias financial rankings appears a lot more remote today than it did in 1997.

shown considerable concern about the state of the markets, taking a number of measures to stimulate share prices. Among the most significant changes, the authorities have halved taxes on share trading and made it easier for insurance companies, which have more than $7bn in assets, to buy shares. Foreign investment banks, including Deutsche Bank, Merrill Lynch and UBS, have been allowed to set up assetmanagement joint ventures with Chinese partners. The central bank has also established rules allowing Chinas large commercial banks to set up mutual fund operations, which could eventually lead to the banks channelling significant amounts of savings into equities. The problem, however, lies in the very nature of these administrative fiats: the governments unwillingness to step back and let the market operate is a constraint on its development. Last year, for example, when the authorities decided to introduce a fairer system for IPO pricing, they placed a six-month ban on new listings. The move was aimed at giving the regulators enough time to devise the rules. Yet it reinforced the impression that nothing in Chinese markets, not even an IPO, happens without Beijings say-so. At some stage, the government will have to reduce its equity holdings - the non-tradable state shares that account for around two-thirds of equity in listed companies. Yet, on the two occasions that the reformist regulators at the CSRC were able to overcome objections within the government about selling state shares, they were forced into retreat by the subsequent fall in the market as investors began to worry about a glut of new shares. Although a new plan is being prepared, there is considerable confusion about the governments objectives. Everyone can agree that state shares are a problem but no one knows where the government wants to go - whether they want to sell out entirely or not, says Mr Howie. Reforming the domestic brokerages also poses tough questions for the government. Allowing foreign securities houses to set up wholly owned subsidiaries could prompt the local brokers to sharpen their act. Consolidation among struggling brokers would also help. Some moves have happened. Goldman Sachs, for example, was allowed to create a Chinese brokerage business from scratch, after paying a Rmb510m ($62m) donation to bail out a failed domestic securities house. Allowing further foreign competition and cleaning up the indigenous broking sector would, however, mean confronting powerful vested interests in the provinces and cities, which own most of the troubled entities, and could be expensive. If the brokerages consolidate, that just transfers huge debts from one firm to another, says Wang Kai Guo, chairman of Haitong Securities in Shanghai. In the end, the government will have to spend some money to solve the problem. Few see any quick fixes available to Beijing. Most possible reforms involve rethinking the role the state plays in the economy. Even self-confessed optimists such as Mr Yao of Hua An Fund Management admit there is a growing opinion in the capital markets that the authorities should start again from scratch. Still, the protests from shareholders who have seen their savings shrink are unlikely to disappear.

*Carl Walter and Fraser Howie, Privatising China (John Wiley)

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INVESTING IN CHINA
THE LEX COLUMN COMMENT

Catch-22 haunts Chinas stock market

One country, two systems. As China prepares to launch the biggest reforms in the stock markets 15-year history, international investors may end up short-changed. Beijing, after a reasonably successful pilot test, is now giving the green light to listed companies to offload $270bn-worth of state-owned shares. Assuming the 13,000plus domestically listed Ashare companies follow their predecessors, existing shareholders will be compensated for the additional liquidity with bonus shares from state holdings - typically worth about 40 per cent of their existing investment. The wrinkle is that about 130 companies already have international shareholders, through dual listings of hardcurrency B-shares or Hong Kong-listed H-shares. There is no ruling on whether overseas investors will receive compensation, but lawyers reckon there could be legal grounds for some level of amends. Legal disputes are more likely if the value of H-shares falls. In spite of the non-fungibility of A- and H-shares, that is possible. A-shares traditional premium has contracted sharply in recent years, but, overall, it is still about 25 per cent. The award of bonus shares in China would put the two classes of equity on more equal valuations on a per share basis. Parity is logical, but concern at not receiving equal treatment could drive H-shares lower. Foreign investors would balk at paying the same price if the benefits accrued on the other side of the border. kept most of their equity in state hands, in the form of non-tradeable shares. Until these are sold to private investors, reforms and new company flotations remain blocked. But every time the government has talked of disposing of them, investors have taken fright and fear of depressing the market further has caused it to back off. After two false starts, it is trying again. It is lining up 42 companies, including some big names, for a change in share structure. That suggests it may at last be ready to bite the bullet. But not, it seems, hard enough. For officials are also talking of a multibillion dollar fund to revive the market while the shares are sold off, and of emergency loans to brokers hovering near bankruptcy after they unwisely offered clients guaranteed returns. The support proposals suggest the government has still not learnt the right lessons. By definition, it can stabilise the market only by buying tradable shares. Yet by doing so, it will renationalise by the back door the same companies it says it wants to get off its hands. That amounts to saving the capitalist village by destroying it at huge potential cost to taxpayers. It is pure Catch-22. Instead of defying the law of supply and demand, Beijing should minimise its impact. Most of Chinas 1,377 listed companies are of low quality. They were floated originally not because they were good businesses but because they were poor performers or politically well connected. The duds should be de-listed and allowed to wither. The rest should be sold as quickly as possible, and investors left to set their value. That may temporarily disrupt the market but is the only way to put it on a solid long-term footing. In any case, share prices are already so low that they cannot fall much further. Second, Chinas deficient corporate governance standards must be strengthened. It is unrealistic to float third-rate companies on the stock exchange and expect shareholder pressure to transform them into superstars. Investors need to be confident before they buy, particularly when they have been as badly bitten as Chinas. That means effective governance rules and structures must be put in place first. Third, the government must decide whether it wants an efficient stock market or a Chinesedominated one. If it wants the former, it should leave ailing local brokerages to die and invite experienced foreign institutions to do the job. The proof of the argument is Hong Kong, which opened its markets to the world and has been rewarded with pole position as the mainlands financial centre. But for those things to happen, Beijing must rid itself of two shibboleths. One is the delusion that it can have everything at once: private ownership and state control; massive share sales and a stable market; indifferent listed companies and high share prices. By seeking the best of all worlds, it ends up with the worst. Policy should be about making choices, not ducking them. The other belief is in the wisdom of gradualism: in Deng Xiaopings words, crossing the river by feeling the stones. Chinas product markets have been successfully reshaped by a process of trial and error. But financial markets are different and easily unsettled by policy uncertainty. Sometimes, the only way to cross a river is to plunge in and race for the other side. This is one of those times.

GUY DE JONQUIERES
Chinas equity market has often been called a casino. The analogy is unfair. In my - limited - experience, most casinos offer predictable odds, are properly regulated and are operated by people who know what they are doing. The same cannot be said of Chinas stock exchanges, where prices have slumped by twothirds in five years while shady dealings, fraud and sheer incompetence have abounded. That has left industry heavily reliant for capital on the rickety banking system, with its long history of bad loans. Unless China spreads the risk by developing bigger and better-functioning equity and bond markets that command public trust, the financial foundations of its growth will remain shaky. Beijing knows this. However, its efforts to clean up the mess have been hamstrung by a dilemma of its own making. When it began listing stateowned companies 15 years ago, it

The writer is the FTs Asia columnist and commentator

China pledges to narrow differences

By Florian Gimbel and Barney Jopson

hina has pledged to narrow differences between its own accounting standards and international norms, a move that could bolster investor trust in corporate information from the fast-growing economy. Wang Jun, assistant finance minister, said China would actively promote and accelerate an effort to bring the countrys rules in line with international accounting standards. The move raises the prospect of a sharp improvement in the transparency of Chinese accounts, with

financial statements produced in a form foreign equity and business investors can more easily understand. Attempts to upgrade Chinese standards, however, are likely to face several barriers. Convergence of international financial reporting standards and audit standards has become an inevitable trend, said Mr Wang, speaking at a London conference held by the Institute of Chartered Accountants. Genuine convergence will make it easier for investors to compare different investment opportunities. Chris Ruffle, investment director at Martin Currie Investment in Shanghai, said: As a firm, we are not too impressed by (Chinese

companies) published figures, which is why we need to go out and see the companies in which we invest. But he added: We wont see the benefits of the (accounting) reform in the short-term, because China is still suffering from a shortage of trained accountants. Chinese blue chips with listings in Hong Kong and New York already report under US or international accounting standards. Mr Wang met officials from the International Accounting Standards Board, which is planning to send a convergence team to China in November. Sir David Tweedie, chairman of the IASB, welcomed the

announcement, but added: They have particular problems in China that dont exist anywhere else. International accounting standards require companies to report assets and liabilities at fair value - market price or a close approximation - but in China, Sir David said, that was often impossible. How do I deal with fair value when a share is traded in Shanghai and Hong Kong with prices that are one-third different? I dont know, he said. It was also unclear how Chinese companies would account for assets whose prices were determined by the state.

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Why foreign investors are not saviours

Geoff Dyer and Florian Gimbel examine what the latest increase in the equity investors quota means for Chinas capital market

fter months of intense lobbying by foreign fund managers and investment banks, Chinese authorities have finally given them what they want - a licence to pour a further $6bn into one of the worlds worst-performing capital markets. While Chinas domestic investors are reeling from the continuing equity downturn, some foreign investors are smelling buying opportunities in a stock market that is now hovering above its eight-year low. In the short term, the market is unlikely to benefit from the extra inflow, because the lifting of the (foreign investment) quota has been priced in, says Shifeng Ke, a director at Edinburgh-based Martin Currie. But some valuations look very attractive. Martin Currie, which has invested $320m in domestic Ashares on behalf of UK and US pension funds and endowments, is hoping to benefit from Chinas decision to lift the total amount foreigners can invest from $4bn to $10bn, under the Qualified Foreign Institutional Investors programme. The list of applicants also includes Singapore-based APS Asset Management, which runs an $84m A-share fund, as well as Fortis Investment Management, part of the Belgo-Dutch banking group, which is hoping to lift its quota from $100m to $500m. But fund managers appetite pales in comparison with that of the big investment banks such as UBS, which has called on the Chinese government to support the countrys troubled equity markets by lifting the QFII quota. UBS, the biggest broker of Chinese securities for foreign investors, has been lobbying Beijing to lift its $800m quota. Morgan Stanley and Citigroup are the second largest investors with a $400m quota each, followed by Deutsche Bank ($300m), Nikko Cordial ($250m), HSBC ($200m) and CSFB ($150m). UBS and Morgan Stanley declined to comment, but analysts believe they have used the bulk of their quotas to give institutional and private banking clients access to the domestic Chinese markets. They have also allowed fund managers such as Martin Currie to use

part of their quotas - a lucrative business that may suffer as the total quota increases. One London-based fund management executive says: The idea behind QFII is to bring in stable long-term investors. But some investment banks have used a big chunk of their quotas to create offshore (-based) derivatives products designed to give their private clients access to the Chinese market, which is something that the authorities have not been pleased about. One Shanghai-based fund manager believes new quotas will be awarded to companies that can demonstrate their long-term commitment. For the first time, applicants will have to divulge details about the type of client

that will benefit from the increased quota, he adds. Chinese regulators - notably the

The Chinese market is still a crap-shoot. Most state-owned companies simply have little concept of a return on capital
State Administration of Foreign Exchange (Safe) - have sought to limit the amount invested in domestic stock markets under the QFII scheme, amid worries it

could be used by speculators to bet on a revaluation of the renminbi. But others - including the China Securities Regulatory Commission (CSRC), the stock market regulator - have been arguing for a widening of the QFII scheme to prop up the markets. The two main financial regulators seem to have agreed to bury the hatchet for now, says one executive at a global bank. Some industry experts believe the latest move could help breathe new life into a scheme that allows domestic institutions to invest in overseas securities - a plan that has been opposed by the CSRC amid concerns over a potential capital flight and a drop in domestic stock listings. Last year, Chinese insurance companies,

which boast substantial foreign currency holdings after their overseas listings, were allowed to invest some funds abroad, under the Qualified Domestic Institutional Investor scheme. With an extra $6bn of foreign money flowing into the stock market, they (the regulators) want to make sure they can potentially offset the new inflows through QDII, says Mr Ke of Martin Currie. He also points to potential changes in the way Chinese stocks are represented in regional indexes, which are tracked by international investors. If China lifts the quota to, say, $20bn, then the A-share market could well be considered for inclusion in the MSCI Asia index, he adds, citing Taiwan as a case in point. Taiwan, which launched a QFII scheme in 1991, was included in the MSCI Asia index in 1996, albeit at an artificially low weighting. In 2003, the island replaced its $3bn QFII quota with a simple registration requirement, prompting MSCI to accord Taiwan a full index weighting in May. Chinas planned $10bn QFII quota accounts for 2.2 per cent of the $450bn A-share market, although the new money would not necessarily all go into equities. One analyst believes that less than $1bn of the present quota of $4bn is actually invested in shares. The expansion of the potential foreign investor base is a parallel effort to the CSRCs plan to reform the split shareholder structure of the stock market, which could lead to billions of dollars of previously non-tradeable shares being sold on the market. Nontradeable shares account for about two-thirds of listed companies equity. The Chinese market is still a crap-shoot, says one Shanghaibased economist. There is little transparency and most stateowned companies simply have little or no concept of a return on capital. The increase in foreign investment has also raised some hackles in the mainland investment community. Zhang Weixing, chief analyst of China Huadian Investment Consultants, says it reflects a trend going back to the Qing dynasty, when Chinese officials treated foreign neighbours better than their own citizens. (The authorities) hope Chinese investors will sell shares, which were bought at higher prices, he said. Some officials expect foreign investors to solve the historical and complicated problem of the Chinese market, but they are not a saviour.

In step with the times: investment banks have been given the green light to pump another $6bn into capital markets

AP

Additional reporting by Kathrin Hille

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INVESTING IN CHINA

Making a play for Chinese funds

In spite of the equity downturn, some big finance groups are increasing efforts to grab a stake in the country, says Florian Gimbel

ome foreign fund managers may rue the day they decided to expand into China. Over the past 12 months, many China-based fund managers have been forced to abandon their financial targets and tear up plans for fund launches because of the continuing downturn in the countrys equity markets.

ent rules. While the first batch of foreign managers - including ING, Fortis, and Societe Generale - could pick a local partner and launch a greenfield joint venture, recent entrants have been forced to buy into existing businesses. This, in turn, has raised questions about the valuation of Chinabased fund management business-

eign managers, including HSBCs local venture, that have yet to launch products. This year two big foreign companies - UBS and Deutsche Bank entered the fray, acquiring stakes in existing firms. While both companies chose the acquisition route, their targets, and investment approach, could hardly be more different. UBS took a maximum 49 per cent stake in Dragon Asset Management, a small firm that is believed to be lossmaking. By contrast, Deutsche Bank acquired a 19.5 per cent stake in

Global Asset Managements AsiaPacific operation, says this approach will allow his company to steer the joint venture away from risky business strategies that could end up hurting the UBS brand. He also points to the benefits of having a small number of big shareholders. The Chinese investment market will change beyond recognition in the next five years, he says. We would not want to have a joint venture board of directors that is bogged down in endless discussions because there are too many shareholders. Deutsche Bank says it chose to

But while there are mutterings of retrenchment and withdrawal among some managers, others are prepared to stay. And some of the worlds biggest financial groups, such as UBS, Deutsche Bank and CSFB, are stepping up their efforts to grab a slice of Chinas massive savings pool, including $3,000bn in bank deposits. China, which requires foreign fund managers to take minority stakes in local joint ventures, is expected to remain a priority for inter-national groups seeking to expand in Asia. But industry experts believe new entrants will have to play by differ-

es, which have a total of more than $40bn of assets under management. Last year industry assets doubled in spite of bleak investor sentiment in the second half. Stewart Edgar, head of strategic development at Fortis Investments, part of the Belgo-Dutch financial group, points to a shortage of suitable joint venture partners. If I were to come into the market now, I would not even think of launching a greenfield business, he says. Chinas seven-year-old fund management industry consists of 41 fully operational firms, including 15 Sino-foreign joint ventures. There are eight further Sino-for-

Harvest Fund Management, one of the biggest local firms, which is believed to have made $30m in fee income from its retail business last year. Peter Alexander, head of Z-Ben Advisors, a specialist research company, believes foreign managers who want to enter the market will follow one of these two models. UBS is facing operational risk but it has a high level of control over the business, he says. Deutsche is following a less risky approach because it has chosen a strong partner. But its ability to oversee the business may be limited. Christof Kutscher, head of UBS

go for a relatively small stake partly because it wanted to treat the joint venture as an affiliate - an investment that does not affect pretax profits. If this business grows and becomes more profitable, we will have to pay a fair price for any additional stake, says Choy Peng Wah, head of Deutsche Asset Managements operations in Asia, excluding Japan. It is clear there will be hurdles, but there is also a lot of respect among the shareholders. During the past 12 months foreign managers have been seeking to lift their stakes in local joint

ventures. But industry experts believe negotiations are running into trouble as some Chinese joint venture partners, notably nonfinancial companies, try to sell their stakes at a maximum price. Under new rules, which came into effect at the end of December, foreign managers can lift their ownership limit from 33 per cent to 49 per cent. Most Sino-foreign joint venture agreements allow the foreign partner to buy the additional 16 per cent at an agreed price, an option some local partners think no longer reflects the success of certain businesses. It does not help that Deutsche Bank was rumoured to have paid a high price - up to seven times book value - for its stake in Harvest, compared with two or three times book value in some option agreements. Analysts estimate Deutsche Bank and UBS bought their stakes for about $22m and $17m, respectively. Deutsche put a value on its joint venture at the wrong time, because it provided other local partners with a perfect excuse to renegotiate their option formulas, says a senior executive at a European fund house. It is a classic situation where the Chinese side does not want to lose face. In some cases, such as INGs joint venture with China Merchant Securities, negotiations are more complicated still, because the parent company of the local partner, a bank, is thought to be trying to buy a stake in the joint venture. The Chinese regulator recently started approving fund management ventures by commercial banks, notably Industrial and Commercial Bank of Chinas tie-up with CSFB. The move is expected to increase competitive pressures on existing managers, including Sino-foreign joint ventures and local securities firms. When the competition heats up, marginal players will be squeezed out, says Mr Choy at Deutsche Bank. Many people will find they are competing with their biggest distributors. Hence the importance of finding the right investment target and joint venture partner. If you are looking for an investment, you have to focus on quality companies that have demonstrated their ability to make money, says Mr Edgar at Fortis. You need good cash flow to invest in future business opportunities such as company pensions and overseas investments by domestic clients. Given the hostile stock market environment, some foreign joint venture partners might want to throw in the towel. Others, however, will cling to the notion that China is an opportunity they cannot afford to miss.

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INVESTING IN CHINA
PRIVATE EQUITY/VENTURE CAPITAL

New rules slow deal activity

Regulations governing offshore private equity deals have prompted a slump in activity
This is partly because international investors tend to be more comfortable with corporate governance in these jurisdictions. Traditionally, the owners of Chinese companies have agreed to swap their equity stakes for shares in an offshore holding company, in preparation for a potential private equity or venture capital deal. While the offshore entity holds all equity interests, the Chinese company continues to operate the business. The restructuring provides the owners with liquidity in a convertible currency, because it effectively converts the renminbidenominated registered capital of the Chinese company into foreign currency denominated shares in an offshore company. Over the past six months, however, China has seen a marked slowdown in the number of new offshore structures, reflecting the impact of regulatory changes. In January, the Chinese State Administration of Foreign Exchange, or SAFE, which sets the rules for money flowing in and out of the country, issued Circular No. 11, followed by Circular No. 29 in April. Under the new regulations, Chinese companies and individuals have to seek SAFE approval for investments in a foreign entity and transfers of equity interests and other assets within China in exchange for equity interests or other assets outside China. In addition, offshore structures launched before the issuance of Circular No. 11 must be registered with SAFE. Subsequent changes to the share capital of the offshore holding company must also be registered with SAFE within 30 days of such a change. Unfortunately, these circulars did not specify the criteria on which the approval of applications can be based. Nor do they contain sufficient detail on the registration process. These uncertainties have led to delays in many investments. In China, which has seen relatively few private equity deals, the volume of deals fell by more than 44 per cent to $659m in the first six months of this year, according to research by the Asian Venture Capital Journal. The slowdown in activity appears to have been caused by the new regulatory uncertainties rather than a change in market sentiment. While SAFE officials have insisted that the circulars were designed to clarify foreign exchange and tax regulations, they have yet to address the unintended consequences of their actions. All eyes are now on SAFE, which is expected to provide more guidance for Chinas private equity and venture capital investors.

MAURICE HOO LEGAL VIEW

Chinas foreign exchange regulators have created a number of challenges for private equity investors who are structuring their deals by using offshorebased holding companies. Of the nine Chinese businesses that were listed on the Nasdaq exchange in 2004, eight were incorporated in the Cayman Islands and one in Hong Kong.

The writer is a partner at law firm Paul, Hastings, Janofsky & Walker, in Hong Kong

Intel banks on driving innovation

The chipmaker has earmarked $200m to fund companies that can launch new products using its technologies, writes Andrew Yeh

hinas electronics industry has long been more about cut-price assembly than high-tech innovation. But Intel, the US computer semiconductor giant, says the situation is changing - and it is putting $200m where its mouth is. In June Intel Capital, the venture capital investment arm of the worlds largest chipmaker, announced the creation of a fund intended to help cultivate Chinese companies that can create new products incorporating its personal computer processors and wireless technologies. The pace of IT innovation [in China] is accelerating, says Arvind Sodhani, president of Intel Capital. Companies around the world should look beyond Chinas purchasing power and view the countrys innovators as potential suppliers. This [fund] is a vote of confidence in Chinese technology companies. The $200m fund - equivalent to nearly one-fifth of Intel Capitals $1.1bn marks the first time the company has specifically targeted

a single foreign country. According to Mr Sodhani, China is now Intels most important market for strategic investments outside the US. It accounted for $4.65bn in revenues in of the companys revenues in 2004 - more than 13 per cent of total sales. Intel has other good reasons to open its purse. While most venture capital firms focus firmly on generating returns, Intel Capital is explicitly strategic: it aims to invest in companies that complement Intels technology initiatives. It backs ventures likely to create products or technologies that will help to establish Intel in new markets and reinforce the global hegemony of its Pentium and Centrino PC central processing units, or CPUs. China is a much lesser source of innovation than the US, Europe or Japan, but the size of the country and its rapidly growing economy mean that helping to guide its IT industrys development is a strategic choice. By setting up a China-focused fund, Intel can also burnish its reputation among Beijing policymakers. Many in the Chinese government have been concerned by Intels global near-monopoly and the fact that although China has become a centre of the PC assembly business, most of the value of PC sales flows back to foreign companies, led by Intel and Microsoft. Intel has already established a chip packaging plant in western Chinas Sichuan province.

Investments by Intel Capital cover 50 companies in the Chinese mainland and Hong Kong, including stakes in UTStarcom, the wireless telephone technology company; AsiaInfo Holdings, the software supplier; and Sohu.com, the web portal. The company generally favours small, minority stakes-usually less than $10m each, targeting many ventures in their early stages of development. Intel Capitals increased attention on China is part of a broader effort to look beyond the US: overseas investments accounted for only 5 per cent of its deals in 1998, but 40 per cent in 2004. The chipmaker, which is based in Santa Clara, California based chipmaker, says its new China fund will target companies involved in mobile communications, broadband applications and the design and production of integrated circuits. Intel is also seeking to promote digital home technologies in China, which could create potentially huge future growth for its parents products by expanding the role of the PC into all areas of household life. As part of the strategy, Intel Capital signed a co-operation agreement with the state-owned Chinese television and newspaper giant Shanghai Media Group under which they will work together to offer local consumers digital content, likely to include video and music. SMG will provide the local content while Intel will provide the

engineers and technical expertise required to distribute it through such channels as televisions, computers and mobile phones. Intels new fund could help to promote wider venture capital interest in China, although the countrys venture capital sector still faces considerable challenges.

But while investment is seen as a vital driver for innovation, Chinas shaky and inefficient capital markets mean there is an absence of exit opportunities for early investors, a problem only partially resolved in recent years by a surge in the number of IT industry mergers and acquisitions.

Intel inside: the company says it has given a vote of confidence to Chinese tech companies

AP

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Premium return: the Ping An stake sale produced a good profit

MAXPPP

Optimistic venture capitalists plan to see their returns rising in the east
Francesco Guerrera finds markets slowly opening up

ing An means safety in Mandarin Chinese and no one knows that better than the private equity arms of Goldman Sachs and Morgan Stanley. When the two firms sold their 10 per cent stake in the eponymous Chinese insurer to HSBC last month, they turned their original investment of $70m into $1.1bn - a safe profit on their initial outlay. By reaping a 14-fold return on Ping An, albeit over 11 years, the two US investment banks provided the most spectacular example of a successful venture capital deal in Asia. Although mid-cap and venture capital investors have been active in the region for decades, their industry has traditionally been overshadowed by the more eyecatching deals struck by large buy-out funds. Since 2000, mid-cap transactions - investments of between $40m and $80m - have accounted for about 15 per cent of the annual volume of private equity deals - or just over $1bn a year - according to the Centre for Asia Private Equity Research. This is partly due to the smaller average size of the transactions, which pale in comparison to the multibillion dollar deals completed by large private equity groups such as Carlyle Group, Newbridge

Capital and Lone Star. But the low volume of venture capital activity is also down to the recent history of Asian capitalism. After the regions financial crisis of 1997-98, a number of large companies were in dire financial condition and in need of managerial and operational overhauls, making them the perfect prey for US buy-out funds. By contrast, the economic turmoil triggered by the crisis made it more difficult for entrepreneurs to turn their ideas into businesses, leaving venture capitalists to scramble for opportunities. In Asia, if you look back over the past 25 years, there have been a number of corrections that have caught private equity investors off-guard, says Gary Lawrence, managing director of Excelsior Capital Asia, a Hong Kong-based venture capital fund. The franchises that are going to be successful in Asia over the longer term are the ones that are able to not only capitalise on the regions growth but also manage the risks associated with future corrections. At present, though, many of the venture capital executives in the region appear optimistic. They argue that strong growth in many Asian economies, the opening up of large markets such as China and India, and an increased inter-

est from international investors in the region, augur well for the future. We believe there are plenty of opportunities to invest in quality mid-cap companies with strong and reputable managements, says the head of a mid-cap private equity group. When you compare our target market with the large-cap market, it is significantly less crowded.

China is different from many of the other markets we invest in

The question, however, is whether venture capitalist groups will manage to turn the favourable macro-economic environment into a string of successful deals, especially in untapped markets such as China and India. A critical issue, in this respect, is the willingness by Asian entrepreneurs to turn away from the grey economy and banks - their traditional funding sources - and rely more on venture capitalists. The development of venture capital in the region will largely depend on companies wanting to make a journey away from being funded by informal sources, argues Paul Fletcher, senior managing partner for Actis, a group that has invested in China, India and Malaysia.

Private equity executive say that although Asian entrepreneurs have become more open towards venture capitalists in the recent past, there remains a significant degree of scepticism. Many companies want to know why they should have us as an investor, given that they think they can get the same type of funding with no strings attached, from other sources, says a private equity executive. Venture capital groups retort that their involvement is likely to improve the companys management practices and operations. One of the key issues (in Asia) is corporate governance, says Jamie Paton, North Asia head for 3i of the UK. Private equity investors can help in this respect by bringing their international experience at putting in place board and reporting line structures. That message is not always understood, particularly in markets that are only slowly opening up to private equity. In China, a promised land for many venture capitalists, industry executives stress the importance of having local knowledge, rather than relying on investment banks and other intermediaries, to sift between the wheat and the chaff of the countrys nascent capitalism. China is different from many of the other markets we invest in. The intermediary market in China

is still developing, and investors have to be on the ground to capture quality deal-flow, says Mr Paton, whose firm has opened an office in Shanghai this year. In China, there are a large number of ambitious entrepreneurs, so the challenge for us is to ensure we find those with the depth and ability to make a difference. With more groups looking for those quality entpreneurs - and more funds being poured into Asia-based venture capitalists the competition is bound to increase over the next few years. Yet, experienced private equity groups mantain Asias shortcomings can also act as barriers to entrants among both the large buy-out funds and private equity groups. When a business with an enterprise value of $500m-$600m comes on to the market, in Asia you will have half a dozen groups capable of looking at it, whereas in Europe and the US you would have dozens, so in that respect we have fewer competitors, says John Lewis, a Shanghai-based partner for JPMorgan Partners. Industry experts believe the same is true for smaller deals. But until many more venture capital groups manage to turn small investments into large deals, along the lines of the Ping An sale, it will be difficult to believe that the Asian venture capital sector has come of age.

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INVESTING IN CHINA
INSURANCE

Challenges for foreign insurers

Deregulation will allow outside companies to grab a bigger slice of the rapidly growing Chinese market, writes Florian Gimbel
ome of the worlds biggest insurers have recently trumpeted their plans to expand into little-known Chinese cities. While this is an indication of the China bug that has afflicted the global insurance industry, it also illustrates the challenges faced by foreign groups that are seeking to grab a slice of this rapidly growing market. Faced with a maze of restrictions that limit their efforts to certain cities and products, foreign insurers have made few inroads into a market that is dominated by big local groups such as China Life and Ping An. Some foreign players are making huge investments and are beefing up their teams, says Philip Leung, a Shanghai-based partner of Bain & Company, the management consultancy. The billiondollar question is how they can crack the market. Foreign insurers, which are required to take a stake of up to 50 per cent in a local joint venture, have little hope of generating a return on their investment in the medium term. According to Bain, Sino-foreign insurance joint ventures have been lossmaking because of a lack of scale and the cost of winning new business. You are not going to be profitable in the initial years because the customer acquisition costs are high, says Mr Leung, co-author of a new Bain report on Sino-foreign insurers. In the first year, [insurance] agents pocket 50-60 per cent

of the premiums. With an estimated share of 3 per cent of total insurance premiums, foreign insurers are forced to follow a niche strategy. Bain believes they should target relatively affluent clients in the 15 biggest cities, leaving them with a potential customer base of 50m to 200m people. Chinas life insurance market is forecast to increase to $143bn in 2010, up from $40bn last year. A case in point is American International Group, the first foreign insurer to be awarded a licence in 1992 and the only foreign insurer that has a wholly owned China business. AIG is the biggest foreign insurer in Shanghai but its share of the citys insurance premiums is only one-

tenth of the market share of China Life. We believe a foreign insurer remains unprofitable so long as the company has less than a third of the market share of the leading player, says Mr Leung. UK insurers have also been expanding aggressively in China in recent months. Prudential, the UKs second largest life assurer, has the right to sell life assurance in eight Chinese cities, while Aviva, its larger UK rival, has five city life assurance licences. While Sino-foreign join ventures are expected to benefit from geographical expansion, they have yet to secure distribution channels that can help accelerate the growth of their business. Mr Leung believes Sino-foreign

insurers have to change their approach to bank distribution, whose share of the local insurance market is expected to rise from 3.6 per cent in 2002 to 30 percent in 2010, according to Bain. Because of the decentralised nature of Chinese banks, foreign insurers have been force to strike deals with individual bank branches, which is very labour intensive, he says. The key is to find a local partner that can give you access to effective bank distribution. Analysts point to the local joint venture of Fortis, the Belgo-Dutch financial group, which is thought to derive up to 70 per cent of its new business from banking relationships. Some foreign insurers have been able to strike bank dis-

tribution deals, partly because of their long-standing connections with local politicians and business leaders. But cultivating relationships is no guarantee of success. Bain believes only a few foreign insurers will be able to boost their market share through acquisitions, because of a lack of suitable partners. HSBC, which holds a 20 per cent stake in Ping An, Chinas second largest life assurer, is likely to buck the trend. Analysts have predicted that the UK banking giant would form a joint venture to develop and sell insurance products with Ping An, which controls about 17 per cent of Chinas life assurance market. Over the next two years, Sinoforeign insurance joint ventures are expected to benefit from further insurance market deregulation and pension reform. Bain believes foreign groups will also benefit from their expertise in investment-linked insurance products, which already account for about 40 per cent of new premiums in Shanghai. China will follow Taiwan and Hong Kong, where the insurance penetration is very high, says Mr Leung. Given the continuing downturn in equity markets, affluent Chinese may see investmentlinked products as an increasingly attractive option.

Additional reporting by Andrea Felsted

Axa moves as market opens

The insurance group is entering Chuna following further deregulation, says Virginia Marsh

fter spending five years turning around Axa Asia Pacifics Australia and New Zealand business, Les Owen is now focusing on new growth opportunities in China. He thinks the timing is right. Following a further deregulation of Chinas insurance sector in December, Sino-foreign joint ventures are allowed to enter the group insurance and individual insurance markets and no longer have to seek separate licences for each city in which they wish to operate. Mr Owen, chief executive of the Melbourne-based company, esti-

mates that until now foreign groups have effectively been focusing on only 10 per cent of the market. But Axa AP, a listed subsidiary of the French insurance giant, is in no mood to rush its expansion plans. Our strategy is really to focus on one city at a time to ensure we have the management strength and the signs of success in each city before we move on to the next one, says Mr Owen. It is possible we will seek to open in two more cities by the end of 2006, but unless things go particularly well it will probably be that sort of pace.

Axas joint venture with Minmetals, the Chinese stateowned group, has operations in Shanghai, Guangzhou and Beijing. The next phase of expansion involves moving beyond Guangzhou into the surrounding Guangdong province, which includes the city of Foshan. Mr Owen says that, while there are well-entrenched local rivals, market growth is such that foreign groups can still do well by focusing on new business. While the total life market is forecast to grow by about 12 per cent a year until 2010, Axa expects the market that foreigners focus on to grow by up to 50 per cent a year. Insurers are likely to benefit from Chinas relatively low insurance penetration and its deteriorating demographic profile that

could fuel demand for long-term savings products. Over the next 40 years, the countrys dependency ratio - the number of people of working age for every pensioner - is expected to drop from 9:1 to less than 3:1, according to United Nations projections. Despite the recent deregulation, which reflects Chinas Word Trade Organisation commitments, Sinoforeign joint ventures still need regulatory approval to expand in new areas, a process that can lead to delays, says Mr Owen. He believes the shortage of good staff is the greatest constraint for foreign groups. Until now, foreign joint ventures have effectively operated in the same small number of cities and therefore competed against

each other for staff, he says. With the market opening up, it ought to make competition for staff perhaps alittle less intense, as we wont necessarily all be competing against each other in the same segments of the market. Another challenge is the poor performance of the Chinese stock markets. Rather than invest in life insurance policies or in investment-linked life policies, theres a bit of a tendency to see property as the place to put your savings, says Mr Owen. New business actually declined a little in 2004, particularly in Shanghai. We have no doubt that in the medium to long term, [China] is a very important market but, in the shortterm, there are some operational and market challenges.

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PROPERTY

Singapore group goes shopping

A decade after the city-states inauspicious foray into China, CapitaLand is focusing on a burgeoning mall market, writes John Burton

hen CapitaLand sold the Raffles Hotel in July, it was trading in the historic Singapore landmark for what it sees as the future - Chinese shopping malls. The S$1.4bn ($820m) raised from the disposal of hotel assets is supposed to help finance CapitaLands expansion in China, which has become a lucrative source of profits for the stateowned property developer. The success in China of CapitaLand and Keppel Land, both controlled by Temasek Holdings, the Singapore state investment company, is a far cry from the first stumbling efforts by the city-states property groups to enter the mainland a decade ago.

Our assets are split 5050 between residential and commercial and that is a ratio that we are comfortable with
Then, a consortium of Singapore state companies invested heavily to create a new township, the Suzhou Industrial Park. But the high fees charged failed to attract customers and Singapore ceded control of the loss-making venture to Chinese partners. Liew Mun Leong, CapitaLand chief executive, acknowledges that Singapore property groups lacked knowledge in tackling the Chinese market in the mid-1990s. As head of Pidemco Land before it was merged with DBS Land to form CapitaLand in 2000, Mr Liew worried that his staff were too inexperienced in investing abroad and spent several years training them. It has been only in the past few years that Mr Liew felt that CapitaLand was ready to make a big push into China. The results have been satisfying. In the first half of 2005, CapitaLands China investments split equally between residential and commercial properties accounted for 29 per cent of group profits, though they make up only 11 per cent of total assets.

CapitaLand is now embarking on its next phase - building shopping malls around China - which will extend its geographical reach beyond the Shanghai and Beijing markets it previously favoured. The opening of a shopping mall in Chongqing in June will be followed by 20 others that CapitaLand plans to own and operate in provincial cities by the end of 2006 in partnership with Wal-Mart Stores. Shopping malls are the new wave in Chinese property development. China is adopting shopping malls at a faster pace than when they were introduced in the US, with half of the 400 malls in China having been built in only the last two or three years, says Charles Neo, an analyst at UBS in Singapore. It is expected that CapitaLand will construct at least another 25 malls by 2010 after the company secured the rights to build at least 70 per cent of the stores that WalMart plans to open in China. CapitaLands move into China is seen as a natural response to tough conditions in its home market. Prices for Singapores retail and residential units have not recovered from the bursting of a property bubble in the late 1990s. Analysts estimate CapitaLand earns returns of 25-30 per cent on housing projects in China against 5-7 per cent in Singapore. It has invested Rmb7.5bn ($920m) in China in the past decade. To provide financial support for its expansion plans, CapitaLand is considering spinning off its Chinese retail and commercial assets into a real estate investment trust, following the successful launch of a Singapore-based reit, CapitaMall Trust, in 2002. CapitaLands focus on China has raised concerns because of fears of overheated housing prices that are already beginning to fall in booming markets such as Shanghai, where the Singapore group has half of its assets. But analysts believe CapitaLand is moving to protect itself against these risks by its diversification into shopping malls, while moving into other cities, including Guangzhou and Ningbo. In Beijing, it already operates

Business cycle: CapitaLand plans to own 20 malls in provincial cities in partnership with US retail giant Wal-Mart in 2006 two malls with Beijing Hualian, a leading Chinese retail group, and has an option to build six more over the next two years. Our assets are split 50-50 between residential and commercial and that is a ratio that we are comfortable with for now, says Lim Ming Yan, CapitaLand China chief executive. We see opportunities in both sectors. Analysts say CapitaLand is partly protected against a collapse in frothy housing prices because of its focus on mid to high-range apartments rather than the luxury home segment that has suffered the sharpest price falls in recent months. We focus on local demand for these units and we think there is genuine underlying demand for them, says Mr Lim. He plans to build another 7,000 housing units in China in addition to 6,000 already constructed. Nonetheless, UBS predicts that earnings from housing sales for CapitaLand could fall by 20 per cent next year after China recently increased property transaction taxes to curb speculation. Similar challenges face Keppel Land, which derives nearly as much of its earnings from China as CapitaLand does, while relying heavily on residential projects on

Bloomberg

the mainland. Keppel Land, which has invested S$320m in China, is focusing on the development of planned township communities, which is a profitable niche, says Mr Neo of UBS. Moreover, Keppel Land is switching its attention to secondary cities rather than the main coastal cities because of higher growth potential and lower land costs. Its biggest housing project will be in Chengdu in Sichuan province, with the number of units to be built there exceeding those it has in Shanghai and Beijing.

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INVESTING IN CHINA
AUTOS

Big or small? the China car conundrum

By Geoff Dyer

olls-Royce has only been selling cars in China for just over a year, but the companys new Phantom model attracting huge attention at the Shanghai Motor Show in April with its extended body that allows extra leg-room in the back. Such luxuries go down well in China. In developing countries, the most popular cars are usually compact models within the reach of consumers with only modest purchasing power. In China, however, the best-selling cars over the past decade have tended to be much larger, from the Volkswagen Santana to the Buick Regal. Leg room has been the key. The main buyers were taxi companies

and government officials with chauffeurs, while the early private consumers were mostly drawn from the ranks of the new rich. Carmakers are trying to figure out if this preference for large cars is about to change. Given the recent transformation in the competitive environment in the industry in China, understanding where the market is moving has become increasingly important. In 2003, sales grew by more than 70 per cent and factories were operating 24 hours a day just to meet demand. Now, as Christoph Stark, president of BMW in China, puts it: We face over-capacity, falling prices, huge changes in market share, heating-up competition and higher costs of manufacture than worldwide. One of the industrys responses

has been to launch a flood of new models on to the market. One analyst says more than 40 new models will be offered to Chinese consumers this year. However, given the pressure on costs, companies must prioritise their marketing spend, which has made the question of whether the market is moving towards smaller cars a crucial one. Industry executives have noted that one of the car models with the fastest-growing sales in recent months has been Cherys QQ, the Chinese companys hatchback which can sell for less than $6,000. Hyundai of South Korea, which tripled its sales in the mainland last year and became the market leader in the first quarter, is building a new factory in Beijing to make compact cars.

I think it is inevitable that you will see the sale of more and more smaller cars, says Jim Padilla, president of Ford Motor Company. According to Clint Laurent, executive director of Asian Demographics, an economic consultancy in Hong Kong, there are powerful demographic trends that will lead the market towards smaller cars. China has a fast-growing group of households with two incomes and no children, more educated and sophisticated consumers who are less interested in social prestige, he says. Yale Zhang, a consultant at CSM Worldwide in Shanghai, sees a similar development in the consumer base for cars. Tang Weiyan, vice president of Shanghai Automotive Trade

Association (SATA), said the high cost of buying a new licence plate in Shanghai - the city auctions them each month for around Rmb40,000 ($4,833) each - had inhibited the demand for small cars. The licence plate costs almost the same as for the car, which has priced a lot of potential buyers out of the market, he said. Not everyone believes, however, that the market will shift towards smaller brands. I am not a small car believer, says Sun Jian, a consultant at AT Kearney in Shanghai. The first televisions introduced into China were mostly 19-inch models he says. But as incomes rose, consumers went straight to large 29-inch TVs, missing out the mid-sizes. It will be the same with cars. People in China like big things, he says.

China ruled by pragmatism in choosing the latest model

By Geoff Dyer
an Xiaobo, a 32-year-old designer from Shanghai, says the only time he regretted buying a Japanese car was when he drove his Toyota to an anti-Japanese demonstration in April. When they saw my car, the crowd started throwing things and charging me, he says. That one moment aside, he is happy with his purchase. If I could afford it, I would like to buy a European or American car, he says. But with the oil prices so high, I chose to buy a Japanese car as they save a lot of gas and are well made. His attitude might come as a surprise given that a wave of antiJapanese sentiment has engulfed China this year. Tempers were running highest during the April demonstrations. But in recent weeks the media have been filled with stories of Japanese war

crimes to accompany the various anniversaries surrounding the end of the second world war. Yet in spite of the surge in antiJapanese feeling, the countrys carmakers have quietly been making ever-deeper inroads into the Chinese market, the fastest growing in the world. Japanese companies now account for about 36 per cent of car sales in China, almost twice as much as European brands and nearly three times more than US makes. When it comes to buying a car in China, pragmatism is winning out over nationalism. Yet for many years the market was dominated by Volkswagen, with General Motors taking second place. While GM has held its ground, increasing sales strongly this year, VW has seen its market share chipped away by Honda, Toyota and Nissan. Japanese brands have added eight percentage points of market share in the past two years at a

time when political tensions have been increasing. The Chinese might riot against the Japanese in the streets and smash up a few of their cars, but it does not seem to stop them from wanting to buy them, says Benjamin Asher at Automotive Resources Asia, a consultancy. The Chinese market has been following a trend familiar to anyone who has watched the rise of Japanese cars in the US and Europe, with their reputation for both quality and reliability. At the Toyota salesroom on Wuzhong Lu, a road in Shanghais western suburbs lined with car dealerships, there is a six-week waiting list to buy a new Corolla, so strong is the demand. I am not a great fan of Japan or Japanese things myself, says a 23year-old salesman at the Toyota dealership. But these cars are so well designed that I think it is worthwhile. Not all Japanese consumer products have escaped the protests.

Asahi beer was one of a handful of products placed on a blacklist by some retailers in April and Nongunshan, a Shanghai supermarket chain, is still not selling the brand. However, retailers say that the strong attraction many Japanese brands have in China has helped them ride out the storm. The Sony Vaio is the most popular laptop here, says Wang Yan, who runs a large outlet at Cyber Mart, a maze of electrical goods shops in central Shanghai. They are not too expensive and people like the fact that it is easy to connect with other items such as video cameras. Wang Weixing, a historian at the Jiangsu Academy of Social Sciences in Nanjing, says that Japanese brands benefit from the strong affinity many young Chinese have with Japanese popular culture. For every student demonstrating, there is another who listens to Japanese music and buys Japanese gadgets, he says.

The entry of Japanese car companies into China has not always gone smoothly. Toyota has twice had to apologise for advertisements deemed insensitive - including one that showed a Land Cruiser towing a truck that many people thought looked like a Chinese military vehicle. They also face intense competition. Chinese consumers in search of cheap deals are looking more and more at vehicles made by local companies and Audi, part of the Volkswagen group, is still the choice for government officials. However, among the growing middle-market of consumers - families who shop at the new superstores and executives who drive to work - Japanese cars are increasingly popular. It is not just that they save on petrol and are well made, says Yale Zhang, an industry consultant in Shanghai. It is also lots of small details, like the shape of the door handles or the mirrors, that make Japanese cars popular.

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The super-rich demand luxury cars

Sales of Audis, Mercedes and even Bentleys are taking off among Chinas wealthy entrepreneurs, reports Geoff Dyer

aiyuan, Chinas coal capital, has been in the headlines this year because of the many mining accidents that have claimed hundreds of lives. Yet the polluted city in the central Chinese province of Shanxi is also winning itself another reputation, as one of the hottest markets for luxury cars in China. Rapid economic growth and the surge in demand for energy in China has sent the coal price soaring, creating thousands of precarious mines and a new elite of wealthy coal entrepreneurs. And they have taken to buying glamorous vehicles. The new money swirling around the region has prompted wild rumours - one local newspaper reported that a single coal-mine

owner had ordered 20 Hummers, the General Motors battlefieldstyle off-roader. But the Shanxi provincial vehicle administration has confirmed a sharp rise in purchases of Mercedes-Benzs, BMWs and even the odd Bentley. Conventional wisdom has pointed to two main trends this year in the Chinese car market - slower growth and smaller cars. After a spectacular surge at the start of the decade, the annual increase in sales has slowed to a more sedate pace of about 10-15 per cent. Analysts say there has also been a shift from saloon cars to smaller vehicles, as more cost-conscious families are drawn into a market once dominated by executives and governmentofficials. Indeed, one of the fastest-growing models in the country this year is the Chery QQ, a $6,000, no-frills mini-compact from a Chinese company. Yet, at the other end of the market, sales of luxury vehicles are also growing fast as the expanding band of super-rich in China, who have made their money on anything from coal-mining to datamining, splash out on cars to

match their new status. According to Merrill Lynch there are now 300,000 dollar millionaires in China. Our target clients are those whose assets are above $10m, says Sergey Krivtsov, senior manager of Lamborghini China, which began selling in the country this year.

Entrepreneurs, movie stars and executives . . . want sporty cars to reflect their identity and show they are different
That means entrepreneurs, movie stars and some senior executives, who want sporty cars to reflect their identity and to show they are different from others. The upscale car business in China has until recently been largely a battle between three German producers. Audi, a member of the Volkswagen group, has been producing cars in China since

the early 1990s and for many years dominated the market, becoming the favoured car of Communist party officials. However, Audi has begun to suffer from intense competition from BMW and Mercedes-Benz. Although it remains well ahead of its German rivals, Audi has seen sales of its sedans, made in Volkswagens joint venture in Changchun in the north-east, fall 33 per cent in the first half of the year to 18,507 units. Meanwhile, BMWs sales of vehicles assembled at its own joint venture in the north-east were 10 per cent higher. According to Helmut Panke, BMWs chairman, who visited China earlier this year, the proportion of the Chinese car market taken up by the luxury segment will double over the next five years to about 6 per cent and China will become one of the companys top five markets. Mercedes-Benz, which saw sales increase 17 per cent in the first half of the year, recently announced plans to begin manufacturing cars in China together with its partner in Beijing.

These upmarket brands have recently been joined by many of the makers of super-luxury cars. Bentley, for example, says it sold 40 vehicles in China last year and hopes to sell 60-70 this year. Zheng Biao, general manager, says Bentley will launch the Continental Flying Spur model this year at a price just below Rmb3m ($370,000), less than other super-luxury cars but more expensive than most luxury vehicles. We are eyeing this gap in the market because we think it has lots of potential. This model is targeted at the nouveau riche and female rich, he says. Ferrari is hoping the Formula One fever created by the inauguration last year of the Chinese Grand Prix will help boost its sales. The company has opened showrooms around the country as well as a large shop next to Xintiandi, one of Shanghais premier retail complexes, to sell Ferrari-branded clothes and hats. It says it expects to double sales this year to 80, with the country becoming one of its five largest markets in four years time.

Cutting a dash: one of Chinas new elite tries out a luxury car at the Beijing auto show

Getty Images

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INVESTING IN CHINA
SCIENCE AND TECHNOLOGY

Philips taps flourishing health trend

The Dutch electronics giant is planning to expand its medical technology business on the mainland, reports Geoff Dyer
ver the past few years, Philips has been trying to move away from its traditional emphasis on consumer electronics, given the brutal competition in that sector, and boost its presence in the healthcare field. Now the Dutch group is bringing its new healthcare strategy to China, the country whose low-cost manufacturers are seen as having caused the consumer electronics bloodbath Philips is seeking to escape from. This is going to be one of our main focuses globally, and that very much includes China, says Gerard Kleisterlee, chief executive of Philips. Although Philips is best-known around the world for lighting and electrical goods, it has long had a sizeable medical technologies business, making machines for diagnosis, such as MRI and ultrasound scanners, and patient monitoring devices. Indeed, around half of the groups revenues in the US market come from its medical business, which is now Philips second largest division. Philips was one of the first multinationals to come into China in the 1980s when the economy began to open up and, with 35 different businesses around the country, China is now central to the groups operations. Total activity - which includes exports and sales in the domestic market reached 9bn ($11.4bn) in 2004, making China the biggest country in the world for Philips in terms of revenue. The first stage in boosting the healthcare business in China came last year with the creation of a joint venture with Neusoft, a medical technology company spun off from North Eastern University in Shenyang. As well as gaining access to Neusofts researchers their joint research centre now has 500 engineers - Philips also added to its manufacturing capacity in China. It is about the need to have both an R&D and a manufacturing platform in China to strengthen our position in healthcare areas, says David Chang, chief executive of Philips China. The Kleisterlee strategy for healthcare, however, is much broader than traditional medical diagnostics. The Dutch group is looking to pioneer new products that blend healthcare with lifestyle issues. These can range

from a personal defibrillator, which monitors a patients heart condition while he or she stays at home, to a massage chair. And the group is looking to make acquisitions in China to flesh out this part of its healthcare business.

Philips new focus on its medical business is largely based on the rapidly increasing growth of healthcare spending in the developed world. But as Clint Laurent, managing director of Asian Demographics in Hong Kong, points out, the push into healthcare taps into powerful trends in Chinese society. While the one-child policy and growing urbanisation have sharply reduced the fertility rate in China, the number of older

consumers whose pockets have been filled by two decades of economic growth is expanding rapidly. Youth-focused industries like shoes and McDonalds might start to flatten out, says Mr Laurent, but managed care and healthcare are likely to see explosive growth. According to Mr Chang, companies need a two-pronged approach to tap this market. Philips sophisticated medical equipment will be targeted at the new private hospi-

Operation China: Philips sophisticated medical equipment will be targeted at private hospitals serving the new urban elite

tals that are springing up to serve the growing urban elite. However, he says that the Neusoft joint venture will focus more on less well-off customers. It is dangerous to look at it as one market, because there is both a high end and an economy end. Multinationals continuously fret about introducing new technologies into China, especially in the healthcare area where many innovations have been swiftly copied. However, Mr Kleisterlee, who used to run Philips China and Taiwan operations, appears relaxed about the risks. We know that it is not easy to hold on to intellectual property in China, so we may not bring every new technology here, he says. The company faced similar challenges when it first moved into Japan and then South Korea when those countries were at a similar stage of development. It is really not that different from the experience of other countries, Mr Kleisterlee says. Some of that confidence comes from the nature of medical diagnostics. While a pill can be relatively easy to copy once chemists have worked out the formula, the manufacture of CT scanners requires a broad range of expertise, which is one reason the industry is dominated by a small group of companies. Because there are a lot of expensive technologies that need to be mastered, it will take longer for the Chinese competition to materialise, says Mr Kleisterlee. Philips has raised expectations that it will make a large acquisition in the medical area. However But Mr Kleisterlee says the group will not follow the path of General Electric, which last year paid $9.5bn for Amersham, the UK company that makes the chemical agents used in diagnostic machines to highlight specific areas of the body. That deal has helped foster excitement about the potential for diagnostics companies to harness new insights from biotechnology research to look directly into the behaviour of cells, rather than focusing on the organ as a whole. The result could be earlier diagnosis and much better monitoring of the effects of drugs on patients. Although Mr Kleisterlee says he is optimistic about the long-term potential of the science, he says the best approach is to establish a broad range of alliances with biotechnology companies to see where the research goes over the next decade. It is hard to see that one company will have all the agents needed for a particular type of diagnosis, he says.

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Chinas seedling biotech crops

Disagreements over genetically modified cotton in China were a mere skirmish compared with the looming battles over rice, says Geoff Dyer

or the past few years, Monsanto and Greenpeace have fought pitched battles all around the world over the issue of genetically modified crops. The US multinational and the environmental campaign group have crossed swords on the soya bean farms of Brazil, Indias cotton plantations and the UKs experiments into GM maize. The two icons of the GM debate, however, are facing a tough, new adversary - China. Chinas efforts in biotechnology are still small and its investment pales in comparison with the research budget of a large multinational - it spent only $121m last year on research into plant biotechnology. The numbers hide a real determination, however. China has quietly established itself as a capable competitor in GM crops. It is usually only the foreigners who have the technology, but in this area we decided to push aggressively, says Jikun Huang, director of the Centre of Chinese Agricultural Policy. GM is an important alternative for China to deal with future agriculture problems, such as food security and farm incomes. As a result, China poses an unusual threat to both Monsanto and Greenpeace. For the US company, China is one of the developing countries most in favour of the new and controversial technology, yet it is equally keen to see its own companies grab part of the market. This competitive threat from China also makes it harder for Greenpeace to argue that GM crops are a tool of transnational corporate interests. Chinas first venture into GM crops came with cotton. From the 1970s, a rapid rise in the use of pesticides in cultivating cotton crops had become a significant health threat to Chinese farmers. The crops would sometimes be sprayed daily with pesticides and on smaller farms this was often done by hand, leaving traces of the chemicals on hair and clothes. In the mid-1990s, Chinese scientists introduced a type of cotton seed that contains a protein from the soil micro-organism bacillus thuringiensis (Bt) that can protect plants from some insects. Monsantos main cotton product is based on the same gene. Since then there has been a huge take-up by farmers, with around 65 per cent of the Chinese cotton crop now GM. According to Mr Huang, the Bt cotton has raised yields among Chinese farmers by 9 per cent and has contributed to an 80 per cent reduction in pesticide use.

Unknown commodity: the Chinese government is studying a controversial application to sell rice commercially The result has also been that Chinese companies have been going head-to-head with Monsanto. Precise figures for market share are hard to come by. Mr Huang reckons that the Chinese companies have about 60 per cent and Monsanto 40 per cent. Monsanto would not disclose an estimate of market share. The US company is more effective at marketing than its mostly state-owned Chinese rivals, which gave it a strong head start. However, as the Chinese seeds can be saved by farmers and re-used, they have gained ground on Monsanto. The Chinese have also developed about 100 varieties, which means there are many more options based on soil and climate, although it can also lead to lower

AP

quality. Moreover, other developing countries, such as India and the Philippines, are thinking about introducing the Chinese seeds. GM cotton has been a mere skirmish compared with the looming battle over rice. The Chinese government is currently studying an application to allow the commercial sale of GM rice. If this goes

WHY CHINA HAS BEEN HOLDING BACK ON SOYA DEVELOPMENT

Rice is not the only genetically modified crop that China has so far refused to approve. Soya is the most successful GM product, dominating produce from the US and Argentina and making big inroads into farms in Brazil. Yet China has yet to give the OK. The reason lies in the mix of pragmatism and industrial policy that has governed Chinas attitude to other GM crops. The government has no health concerns about GM soya - China is the biggest importer of soya and much of that trade is GM. However, when the government debated the issue in the mid-1990s, the decision was made that China could benefit by selling non-GM soya at higher prices to European customers sceptical about the science. As a result, it put little emphasis on developing its own seeds. This followed a similar approach over GM tobacco, which was approved in the early 1990s but later withdrawn because of pressure from overseas customers. The debate has shifted, however, as Chinas soya imports have surged and research is now being backed. But until China has its own varieties, which could take many years, the government is not expected rapidly to approve GM soya. One of the problems with soya is that the sector is dominated by Monsanto, says Jikun Huang, director of the Centre of Chinese Agricultural Policy. The approval process will depend on what sort of technology is developed in China. That still leaves opportunities for some companies. Chinese producers of soya protein, which is used in sausages, and other health and food products have found strong demand from European and US consumers concerned about the potential dangers of GM products.

ahead, China will be the first country to approve the genetically modified version of a big food staple. (Soya beans, the biggest GM crop, are mostly used in animal feed and oil.) In other words, it would be a substantial breakthrough for the proponents of the new technology. China has developed three separate types of GM rice, each of which has undergone trials around the country. One of the varieties is based on the Bt gene used in cotton, while the others contain genes to make the crop resistant to diseases or herbicides. The first application for commercial use was lodged in 1998 and was rejected. However, last year the agriculture ministry signalled it would look again at GM rice. Chinas Biosafety committee met this week to discuss the issue but no decision was taken. Mr Huang believes approval is a year away. Supporters of GM rice received a boost earlier this year with the publication of research that claimed significant benefits for two of the Chinese varieties. Based on the observation of rice farms in Fujian and Hubei provinces, the authors (Mr Huang and scientists at University of California-Davis) found that one variety increased yields by 6 per cent and the other by 9 per cent compared with conventional strains. The studies also showed that the amount and costs of pesticides used on conventional rice was eight to 10 times higher. Although Chinese GM rice has some momentum behind it, opponents are fighting hard to prevent its approval. Greenpeace has found evidence that GM rice has spread beyond the field trials in Hubei into mainstream production. It also says GM rice was found at wholesalers in Guangzhou in southern China, an indication that it has already entered the food chain. As well as the untested environmental impact, it says, the rice could cause allergic reactions. According to Sze Pang Cheung, a campaigner at Greenpeaces China office, the discoveries call into question Chinas ability to regulate GM crops. Opinion polls that Greenpeace has commissioned also point to increasing consumer unease about the prospect of GM food in China. Even Monsanto, which is reckoned to be behind the Chinese in developing GM rice, is not optimistic about the products prospects. It looks like it will be a long time before GM rice is approved in China, says an executive at the groups China office.

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INVESTING IN CHINA
COMPUTERS/ELECTRONICS COMMENT

In China the agent enters the question

By Mure Dickie and Scott Morrison
Qu Jianwei, a Beijing information technology manager, likes Dell computers but is no fan of its build-to-order business model. I pretty much never use Dells custom-build service, says Mr Qu, who handles buying for an advertising company. It feels safer to buy from an agent than online. That view, common in China, raises the question for Dell of how it should tackle a market very different from those where its approach has proved successful. China is perhaps the greatest untapped source of PC demand and has been described by Kevin Rollins, Dell chief executive, as his strategic focus country. So far, Dell has focused on winning high-end corporate and institutional buyers. But the biggest growth in Chinese demand will come from what Dell calls transactional customers: small and mediumsized enterprises and consumers. Aiming too squarely at big buyers risks missing out on millions who will buy PCs in coming years. Most of the growth in China will come from getting people to buy their first PCs. Dell might be whistling past the graveyard, says Endpoint Technologies Associates analyst Roger Kay. Some say Dell is wise not to aim at such customers. Judy Chui of Daiwa Institute of Research in Hong Kong notes the costs and logistical difficulties of tapping less developed markets where margins are slim. She calls Dells approach sensible. But fierce competition means revenues are trailing far behind unit sales - and the local challenge is likely to get fiercer. The recent purchase by Lenovo, Chinas leading computer manufacturer, of IBMs PC business means it can court big corporate customers while reaching out to consumers in its heartland. The strongest evidence that Dells model is not yet matched to the China market are the numerous unofficial agents who buy its computers and sell them on for a profit. Dell condemns the practice but still offers its aftersales service for resold PCs. Mr Qu, who buys his Dells from an agent, suspects Dell is not unhappy to see its products end up in segments its business model does not reach. I reckon they tolerate it as a sales method.

Beijing takes on Microsoft

By Mure Dickie in Beijing

u Yulin - Communist party member, former national model worker and top IT official for the rural Beijing district of Pinggu - is a symbol of the determination of Chinas government to support locally developed software and the difficulties it faces in doing so. Mr Wu leads a pilot programme intended to demonstrate that Chinese software can substitute the wares of Microsoft and other foreign producers. That means pushing Pinggu officials to replace the operating systems and office software running on their tens of thousands of personal computers with Chinese alternatives, mainly based on the international open-source Linux operating system. But Mr Wu himself is not yet practicing what he preaches, the laptop on his desk still runs Microsofts Windows operating system. This is the computer I usually take with me when I go on work trips, he says, somewhat sheepishly. I need to be able to get on to other peoples networks. Mr Wus reluctance to use the uninstall command on his Microsoft software underlines the wider challenges that face China

as it labours to foster a software industry that can offer credible alternatives to products by the US giant and other global vendors. Recently, Beijing drew up draft regulations that would impose tight controls on the procurement of foreign software by government bodies, categorising suppliers as domestic, non-domestic or preferred non-domestic. The move risks upsetting Washington, which has expressed concern about possible discrimination against US companies, and international software companies that have been lobbying Beijing to maintain an open software market. The Computing Technology Industry Association has told the Chinese government it is dismayed by the draft rules. (They) will make it exceedingly difficult for international technology firms - including the scores of international firms that have already made substantial investments in China - to participate and compete on an equal and fair basis in the government procurement market, the international trade group said Such concerns reflect the relative importance of official procurement in the mainlands software market. While Beijing is pushing officials only to use legitimate software, almost all in private use is pirated.

Ironically, the spread of pirated Microsoft Windows and Office software has given them a de facto monopoly in China as strong as in other markets around the world, despite Beijings hopes, beginning in the 1990s, of cultivating homegrown alternatives. Many Chinese, however, see government use of Linux software, which is co-operatively developed and freely shared, as a way of reducing the countrys dependence on the Redmond-based giant. Government procurement can give Chinese vendors, who modify Linux for local use and offer aftersales service, a chance to demonstrate that their products work, says Mr Wu, who in 2002 won Chinas national May 1 Labour Prize, an award for model socialist workers. We are pushing Linux-based domestic software . . . in order to give it a good chance to compete on an equal footing, he says. Such efforts are already having an effect. State media have said that local products account for 35 per cent of recent software purchases by provincial governments - and 68 per cent of orders for office software. Mr Wu hopes that within a few months, 90 per cent of Pinggu government PCs will only be running Chinese-made software. For many officials, however, the switch is not easy. Some have

been upset that Linux operating systems do not support online games - although the Pinggu government has now banned bureaucrats from playing these while at work. As Mr Wus continuing use of Windows suggests, a more substantial issue has been connectivity. Officials have struggled to get Linux-installed PCs to work with existing printers and other devices such as digital cameras or external drives. Mr Wu is confident such problems can be addressed, although he admits that a number of Pinggu PCs will have to have both Linux and Windows installed to prevent problems. Some Chinese officials are concerned, however, that too strong a commitment to domestic software will make it harder for government departments to buy the software that best fits their needs. Indeed, the Pinggu project itself is an example of possible confusion of interests. As well as Chinese Linux programs, the district is buying a document management system developed by local state-owned companies controlled by Mr Wu himself. Why are we promoting the use of domestic software? he asks. There are a number of reasons, and one is that we want to develop information technology in our district. We want our own thing.

Dells bold challenge pays off

By Justine Lau in Hong Kong

hen Dell entered China in 1998, its direct selling model met with strong scepticism as the countrys poorly developed transport infrastructure was expected to make it difficult to deliver made-to-order personal computers on time. The worlds largest personal computer maker soon proved the doubters wrong - it achieved profitability in its first year and is now the third largest PC seller in China. In the past two years, the US company has extended its strong growth into online sales - an area that even Chinese companies find highly challenging. According to a survey by China Internet Network Informational Centre, less than 20 per cent of Chinas estimated 103m internet users have shopped online. But Dell says its online sales

have grown from literally nowhere two years ago to 30 per cent of its so-called transactional business - business with small and medium-sized enterprises as well as consumers - or 12 per cent of its total sales in China. About 40 per cent of Dells customers in China are transactional, while the remaining 60 per cent are large corporate and institutional customers. We had to be creative when it came to how we got payment from our customers. We worked out unique arrangements with our banking system. It works flawlessly now, said William Amelio, Dells Asia Pacific and Japan president. Dell last year became the first computer company in China to provide an internet payment system that allows customers to pay online without telephone confirmation. By offering this and other payment options, including bank transfers and credit card sales,

Dell expects online sales - which currently account for 90 per cent of transaction sales in Japan to reach 60 per cent in China. The unexpected success of Dells direct sales model in China has helped it win 8.4 per cent of the market in just seven years, putting heavy pressure on Lenovo, the countrys biggest PC maker. Lenovo still accounts for about one in four of the computers sold in China, but its margins have been squeezed by Dells success in wooing big corporate buyers of relatively high-end machines. Dell is planning to increase the pressure. The US company says it aims eventually to more than double its market share in China to about 19 per cent - bringing it into line with Dell markets elsewhere. In response to Dells challenge, Lenovo was forced to restructure its sales channel last year to be able to deal directly with large corporate customers.

But Dell says it has continued to win customers from Lenovo, both in China and around the world, even after the Chinese company completed its acquisition of IBMs PC business in May. Despite Dells recent success, however, analysts do not see any threat to Lenovos market dominance, given its strong links with government departments and the education sector - some of the biggest sources of demand in the Chinese market. Dell also last year pulled back from challenging in the highly competitive, lower-margin market for cheap consumer PCs, after being taken aback by the really aggressive competition from local rivals. Bryan Ma, analyst at IDC, said: Lenovo is such an entrenched incumbent that we are looking at quite a long time before Dell can double its market share.

Additional reporting by Mure Dickie in Beijing

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EDS 1

INVESTING IN CHINA
TAIWAN LOOKS NEXT DOOR

The difficult path to a stock market listing

Kathrin Hille looks at how Taiwanese-controlled Globe Union has overcome hurdles on the way to an IPO

hen Chuang Hsien-yu chats with fellow Taiwanese investors in China, he has important advice: Take it slow and think first, so that youll not suffer years of bitterness and end up dying your hair every two months to stop it going grey. The president of Shenzhen Globe Union, a Taiwanese-controlled maker of faucets and fixtures, speaks from experience. He says his hair has indeed gone grey over his efforts to seek a local stock market listing. While foreign investors generally remain hesitant about taking their mainland companies public on Chinas domestic A-share market, given the lack of depth and transparency of mainland bourses, Taiwanese-invested groups are flocking to apply for initial public offerings. In May last year, Globe Union became the first company majority-owned by a foreign investor to get listing approval in China. As many as 100 Taiwanese-controlled firms will have issued Ashares seven to 10 years from now, and thats a conservative estimate, says Thomas Liu, president of Friendly Business Group, a Taiwanese consultancy that advises on mainland listings. Companies with a Taiwanese background are applying at an average rate of one a month, said an official at the China Securities Regulatory Commission. After helping to build Chinas export industry by moving lowcost manufacturing to the mainland in the 1980s, then shaping Chinas IT industry by relocating part of its electronics industry in the 1990s, Taiwanese investors next area of influence will be Chinas capital markets, predicts Mr. Liu. Taiwanese companies are widely believed to be the secondlargest source of foreign direct investment in China. According to Chinese government statistics, they had poured a cumulative $39bn into the mainland by the end of October 2004. But both Beijing and Taipei have estimated the real amount could be almost double that figure, as many Taiwanese businesspeople channel their money to the mainland through third countries to circumvent Taiwanese government restrictions on investments in China. However, being a pioneer can have a heavy cost. Mr Chuang describes his companys three-

year IPO approval process as a war of resistance. As a first stage, listing candidates must show their operations have been profitable for three consecutive years - no small hurdle for many Taiwanese groups that transfer the profits earned by their mainland subsidiaries to holding companies in tax havens such as the British Virgin Islands. The next requirement - to restructure into shareholding companies - proves an even tougher challenge. You should never do this unless you really want an IPO, because it transfers your company to the supervision of the central government from that of local authorities, says Mr Chuang. Listing candidates must not be in direct competition with other public companies. Neither are they allowed to engage in the same field of business as other companies related to their corporate group in China. This rule virtually excludes large manufacturers with several plants in China. Globe Union managed to get its restructuring approved in less than a year, but the biggest hurdle still lay ahead. China demands listing candidates not only meet financial rules but also much less transparent political conditions related to which sectors the authorities may have identified as key industries at any particular time. Approvals have to be in line with our industrial policy, says Men Liqun, an official at the State Development and Reform Commission, which reviews IPO applications along with the CSRC, the Ministry of Commerce and the Taiwan Affairs Office. When Mr Chuang first approached the authorities, his application was met with scepticism. I was told: You are in a traditional industry, an approval will be difficult. So Globe Union - the first to introduce lead-free fixtures in China - applied for recognition as a high-technology enterprise under three different government programmes. Last but not least, every Taiwanese company undergoes a political correctness check. Companies that are perceived as supporting Chen Shui-bian, Taiwans president whom China has criticised for his pro-independence policies, should not even bother to apply, say Taiwanese executives in China.

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Margins under severe pressure as costs mount

Kathrin Hille looks at the structural obstacles facing Taiwanese manufacturers
he overheating of the Chinese economy and the governments efforts to cool it down are squeezing Taiwanese businesses on the mainland, forcing one of the largest groups of foreign investors in China to restructure and upgrade. Power shortages, rising labour costs and reductions in export tax rebates have triggered a sharp drop in profit margins at Taiwanese invested companies, say financial experts in Shanghai. The average gross profit margin at firms audited by us slipped from 28-30 per cent to 17-18 per cent between the first and the third quarter of 2004, says Thomas Liu, president of the Friendly Business Group, a Taiwanese law and accountancy

firm with more than 2,000 Taiwanese corporate customers in China. Observers say the trend highlights structural weaknesses in the Taiwanese-owned manufacturing base on the mainland. Many Taiwanese firms in labourintensive industries such as shoes and textiles, toys, umbrellas and furniture came here in the 1980s and early 1990s with the sole objective of producing more cheaply than in Taiwan, says Liao Yi, executive president at Pacific Securities, a Chinese brokerage. That worked marvellously at the beginning. But they failed to upgrade production technology and management and move to higher-end products as costs started to increase. The government in Taipei bans its companies from pouring money into high-technology manufacturing, infrastructure projects and many other industries on the mainland out of fear that the island might become too economically dependent on its huge, hostile neighbour.

But according to Chinas Ministry of Commerce, Taiwan accounted for 16 per cent of inward foreign direct investment in 2003, making it the second largest source of FDI after Hong Kong if money channelled through third-country tax havens is included. The financial performance of this large group, in comparison with other foreign investors, remains hard to grasp. But Taiwanese executives confirmed that their margins had come under pressure from rising costs, macroeconomic controls and increasing competition. An initial heavy blow was Beijings decision to lower export tax rebates on a wide range of products last year. Representatives from 180 Taiwanese companies at a conference in Shanghai said tax rebates and other tax incentives were a pillar of their profitability in China. After the export tax rebate rate was cut twice, we are now making a loss, says Steve Chou, vice-president of Shanghai SVA DD&TT, an electronic components maker.

Beijings move to increase the legal minimum wage earlier last year has driven up costs further. Our companies are hit particularly hard because many of them pay no more than the minimum wage and were forced to adjust, says Mr Liu. The strains on Chinas infrastructure are another factor. Manufacturers in many regions of eastern China have been forced to shut down machinery four days a week due to electricity rationing. Wen Sheng-fu, vice-president at Tatung Information Technology in Wujiang, Jiangsu province, says the company has been hurt by delayed shipments from component makers. Taiwanese executives say they feel an urgent need to increase margins but are concerned that they lack a competitive advantage over other foreign investors and Chinese private enterprises. These two groups outperform the Taiwanese, apart from a few exceptions, in the domestic market. Currently, 80 per cent of production of Taiwanese-owned companies in China goes into exports.

We have to address the domestic market. Thats where the growth is, says Mr Wen. However, he says Tatung shied away from the formidable challenge of building a country-wide distribution and sales network because it lacked a strong brand that would immediately drive sales. Beijings macroeconomic controls have added to the woes of Taiwanese businesses on the mainland. Mr Liu says half of his 2,000 clients in China were using local banks, at least partially due to the fact that Taiwan does not allow its banks to lend on the mainland. Many have seen their credit lines cut by half, or their loans called in. The experience of Thermos (China) Housewares in Jiangsu shows that the credit crunch extends far beyond those industries Beijing intended to restrict in the first place. Thermos, which manufactures bottles, pots, mugs and tumblers, had its credit lines cut this summer. The reason given by its bankers: its products are made of steel.

March of the chipmakers

Kathrin Hille says Taiwanese companies are drawn less by low manufacturing costs than by fear of missing the market

hen Taiwan Semiconductor Manufacturing Company, the worlds largest contract chip maker, started commercial production in Shanghai last year, its executives made no attempt to conceal the impact the foundrys arrival could have on Chinas chip design industry. FC Tseng, deputy chief executive and chairman of the mainland subsidiary, said: TSMC (Shanghai) will focus on the development of Chinas semiconductor market. He said the groups collaboration with its mainland customers - the integrated circuit design houses that have outsourced manufacturing to the foundry - would increase local competitiveness and mark a leading effort in strengthening Chinas IC design industry. Effectively, Taiwans hi-tech leader has promised to boost companies on the mainland that could compete directly against the islands IC design industry, a sector that until now has been barred by Taipei from sharing its technology with China. The push by Taiwanese companies into the mainland is no longer driven by the wish to profit from lower-cost manufacturing, but by the fear of missing out on the emergence of a huge market.

During the 1990s the electronics sector accounted for 28 per cent of Taiwanese investment in China. That share jumped to 38.1 per cent between 2001 and 2003, and reached a record high of 45.2 per cent in the first 10 months of las year. Much of this has been concentrated in downstream manufacturing and assembly. But with TSMCs arrival, the focus has switched to the core segment chip making. Taipei, concerned that the island could lose its dominant role, restricts chip makers mainland investment, but three years ago loosened a complete ban. TSMC became the first to win approval to move one of its eight-inch, less advanced plants to China. Chip testing companies will be the next to cross the Taiwan strait. If we let the foundries go, there is no reason to hold the testers and packagers back, said Ho Meiyueh, minister of economic affairs. The government is waiting for tensions with the mainland to cool before carrying out the next change. But its plan for the packaging and testing segment is ready. It will not limit the number of testing and packaging firms allowed to invest in China. There are more companies in this segment, and they are less capital-

and technology-intensive, Ms Ho said. In the case of chip makers, the government will only allow a certain number to invest in the mainland every year, she added. We will set these slots according to the impact we see from TSMCs production in China. But it might have more to worry about in the

upstream segment - those IC design houses TSMC has pledged to strengthen on the mainland. The history of Taiwans IT industry illustrates that the presence of strong foundries creates a cluster of related chip companies. Since TSMC and United Microelectronics, its smaller Taiwanese peer, were set up in the 1980s, Taiwans IC design industry has evolved into the worlds second largest, with $7.7bn in revenues and five of its design houses in the global top 20. These form the backbone of the high-end industry Taiwan hopes to keep at home to retain an advantage over China. But they are as eager as

their foundry partners to be part of the mainlands emerging semiconductor industry. According to Chinese statistics, the mainlands chip design revenues will grow 60 per cent to $883m this year. The Industrial Economics and Knowledge Centre, a government-backed research body in Taiwan, estimates that up to 400 small and medium-sized companies operate. Many are driven by Taiwanese money. Mediatek, Via, Sunplus and Novatek, four of the islands largest IC design companies, have either bought into chip designers on the mainland or begun sponsoring research at Chinese universities. Other Taiwanese investors, such as Innosis, have set up chip designers in China. Innosis - which has 183 employees, 160 of them engineers - was founded in Suzhou in 1999 with money from Macronix, a Taiwanese company that designs and manufactures memory products. Like many of the mainlands IC design start-ups, Innosis has one Taiwanese engineer and depends on Chinese engineering graduates from US universities. We are not yet ready to design top-end products, but rely on close assistance from foundries and systems providers, said Andersen Pan, a project manager. Taiwanese analysts estimate that it will be another eight to 10 years before such companies grow into serious competitors. But given the growth in financial and technological input from their Taiwanese peers, it is certain to happen.

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INVESTING IN CHINA
INTERNET

Yahoo search is complete: Alibaba finds a way to reap the riches of online China
Foreign money is pouring in as the worlds most populous country narrows the digital divide, though political controls on internet use remain strict, write Mure Dickie and Richard Waters
For some observers, such valuations are a return to the internet insanity of the final years of the last century. But the hopes and money being invested in Chinese internet ventures are not so easily dismissed. Yahoo, after all, has often confounded sceptics. And enthusiasm for Baidu rests largely on the powerful performance of Google, Baidus role-model and minority investor, since its own listing last year. There is also no doubt about the importance of the internet to the worlds most populous country. Official estimates say that more than 103m Chinese are internet users. By the end of the year at least 120m are expected to be online but internet penetration will still lag levels in regional neighbours such as Taiwan or South Korea. As economic growth raises urban incomes, that digital divide will surely narrow. In many ways, the internets impact in China is greater than elsewhere, since it has created a zone for communication and information exchange far freer than any other in a nation still under the political sway of an authoritarian Communist party. For internet pioneers like Charles Zhang, founder and president of Sohu, the US-listed Chinese portal, the internet is at the centre of a period of change in China that is equivalent to hundreds of years of European history. The renaissance, the enlightenment, the industrial revolution, the digital revolution - in China it is compressed into a 20year time space, he says. Sohu was one of the three main Chinese portals that came back from post-bubble disaster to show that, with a combination of advertising and mobile telephone messaging-based services, they could make real money from their users - a success that made them the darlings of Nasdaq back in 2003. Despite such success stories, however, for companies working in - and individuals surfing across - the Chinese internet, life remains very different from that in developed nations. In e-commerce, politics are hardly a problem, but there are many other difficulties. When Amazon acquired Joyo.com, its Chinese counterpart, for around $75m last year, it was buying into a business that relied on cash-collecting bicycle boys to complete many of its sales in urban areas, since postal services are slow, online payment cumbersome and credit card use low. For Jack Ma, Alibaba chairman and chief executive, such problems are also opportunities. Hhe paints a rosy picture of the likely growth of e-commerce in a market that his partners at Yahoo say will have more internet users than the US in five years, and stresses the role that Alibabas own online payment system would play. There is clearly huge potential demand. Research firm iResearch says online transactions in China were worth Rmb324bn ($40bn) this year, far more than the Rmb141bn recorded for 2003 but only a fraction of the Rmb1,737bn it forecasts for 2007. However, internet entrepreneurs must still contend with an opaque and unpredictable regulatory environment. It is unclear how responsible the Chinese government plans to hold online auction sites for the products sold through their websites. Chinese propaganda officials have also recently ordered tighter controls on any media imports or internet activity that might threaten national cultural security - an edict aimed in part at companies, such as Yahoo, that operate portals with a wide range of content. Changes of policy or regulation are a constant hazard for Chinese internet companies. Sohu and other portals, for example, have been hit by a clampdown by the stateowned mobile phone company on risque or over-marketed message-based services. New

n Beijing recently, a locally-based internet entrepreneur was making his pitch to a visiting US venture capitalist when he reached the ever-awkward bit about how he would turn his wonderful idea into sales. Dont worry about revenues - focus on your traffic, the venture capitalist told him, in a comment redolent of the heady 1990s internet bubble, when banal business realities took a back seat to flights of online fancy. I was actually quite shocked, says the entrepreneur, a veteran of bubble days. It was, like, the worlds getting easier than I thought. But perhaps he should not have been surprised. Recent weeks have shown investors willingness to put aside conservative approaches to valuations and business plans when it comes to China, the internets greatest untamed frontier. In August Yahoo, the US portal, announced it would pay $1bn as part of a deal to gain a 40 per cent stake in Alibaba, a Chinese e-commerce company that had cash revenues of only $68m in 2004. The deal followed hard on the heels of a stunning Nasdaq debut by Baidu.com, the Chinese internet search company. Baidus shares quickly soared to levels that gave it a p/e ratio of more than 2,000.

US internet leaders battle for local allies and talent

t has become one of the biggest strategic dilemmas for the US companies that dominate the worlds internet activity. China, all agree, is the best long-term opportunity on the planet. But chances to break in and create stable e-commerce, search and internet-based communications businesses are few and far between. That is clear from the shifting alliances that have characterised early efforts to establish a presence in China, and helps explain why Yahoo, though the biggest shareholder in the enlarged Alibaba, has conceded direct control over its operations. US companies are finding it challenging

to break in for cultural and regulatory reasons, says Scott Kessler, an analyst at Standard & Poors. Yahoos willingness to accept a minority stake reflects the difficulty all foreign internet companies have had breaking into China, says another US analyst. Its definitely been a challenge to take models developed in the US and make them work. That has led to a scramble for local allies. EBay, which claimed 65 per cent of online auction activity in the country last year, dallied with portal companies Netease and Sina, running jointly-branded trading services, before buying EachNet, an auction company.

Yahoo also forged an alliance with Sina while buying search provider 3721. Amazon, Google and Barry Dillers InterActiveCorp have

US companies are finding it challenging to break in for cultural and regulatory reasons
taken stakes in Chinese start-ups over the past two years. The industry is rife with rumours that most of these companies are now struggling to hold on to talented executives. A tussle

over talent is apparent from a fight that broke out in July between Google and Microsoft. Microsoft has sued to stop Kai-Fu Lee, a former employee, from being hired to run its rivals Beijing research labs - a role he had at Microsoft in the 1990s. In such a fast-moving market, even forcing Mr Lee to take the oneyear gardening leave specified in his Microsoft contract would be a victory for the software company. This struggle to secure market position and talent is now starting to harden into more solid positions. The Alibaba partnership really gives Yahoo a unified China strategy, says Mr Kessler.

EBay, which is pouring $100m into its Chinese business this year, also believes it has found a long-term platform on which to build. Making the best of the situation, Jerry Yang, Yahoos co-founder, compares the Alibaba partnership with Yahoo Japan - an alliance with Softbank that has become hugely profitable for the US company, which holds a 34 per cent stake. Whether Yahoo would adopt a different approach in China if it could is another matter. I dont know if they have an option here - large acquisitions of Chinese companies are pretty rare at the moment, says Mark Mahaney, an analyst at Citigroup Smith Barney in the US.

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rules could also cool enthusiasm for Chinas rapidly growing online games industry, which had made Shanda, another Nasdaqlisted company, the countrys most valuable dotcom until its recent eclipse by Baidu and Alibaba. Communist party officials admit to deep unease at the appeal and influence of socalled massively multiplayer online roleplaying games, operated by companies such as Shanda. They recently called for action to limit how long players indulge in swords-and-sorcery worlds - where conversations are already closely monitored for content that might be politically or socially incorrect. Foreign-owned companies in China must also weigh the extent to which they bow to state efforts at thought control that are often quietly tested or defied by local companies. Microsoft was widely criticised in the US after the Financial Times recently revealed that it had banned the use of the words democracy and freedom from parts of its new Chinese MSN website in an apparent effort to avoid offending Beijings censors. Microsoft had already tried to win official favour by running MSN as a joint venture with a state investment company controlled by Jiang Mianheng, the son of Jiang Zemin, the former Chinese president. Such a strategy can open doors but some observers warn that it makes a foreign company vulnerable to changes of political wind. The influence of Mr Jiang senior, for example, appears to be fading. Do they really want to be in bed with a Jiang? asks one Beijing-based analyst. For foreign companies, such quandaries compound the challenges of coping with cultural and linguistic differences as well as the task of working around a rampant copyright piracy that means local internet surfers can read unauthorised translations of the latest Harry Potter novel long before it is offered for sale by online bookstores. Few doubt that Chinas internet will be a huge opportunity. As Jerry Yang, Yahoo cofounder, says: The numbers are starting to get very, very big. But it is also clear that these are early days for Chinas internet, and that it will long be difficult to predict with confidence which of the sectors corporate contenders will thrive and which perish. In the meantime, investors may prefer to put their money into ventures that are still worrying about revenues.

In confidence: Jack Ma, founder of Alibaba and Daniel Rosensweig, chief operating officer of Yahoo, announce their deal

AP

Crocodile amid the pebbles

ocal e-commerce companies such as Alibaba were like crocodiles in the Yangtze River that foreign sharks would find hard to fight if they swam up from the sea, Jack Ma, its chairman, said last year. The smell of the water is different, he laughed, citing as evidence the failure of Yahoo, the US portal, to prevail in China against Nasdaq-listed but Chinese-run rivals such as Sina, Sohu and Netease. Such arguments clearly resonated with Yahoo, which was at pains to stress that its alliance with Alibaba did not mean it felt it had failed in China. We look at it as an opportunity to get much bigger,

much faster, working with a great management team, said Daniel Rosensweig, Yahoo chief operating officer. There is also little question that Yahoos willingness largely to outsource its future in China is based on deep confidence in Mr Ma, who calls Jerry Yang, Yahoo co-founder, an old friend. Alibaba officials say the plans were dubbed Project Pebble because they were sparked by a meeting between Mr Ma and Mr Yang at Californias Pebble Beach. When Mr Yang visited Beijing in the 1990s, it was Mr Ma who introduced him to people of influence in the Chinese capital. The Beijing press conference in August was even illustrated by a 1998 happy

snap of the entrepreneurs sitting side by side on the Great Wall. With Yahoos Chinese assets, Alibaba seems poised to change the national internet landscape from its base in the scenic eastern city of Hangzhou. The company commands a strong position in business-to-business e-commerce, online individual auctions, search and communications services such as email and instant messaging. It can bring those businesses together, for example by marketing paidsearch services to some of the 15m users that Alibaba says have registered for its e-commerce and auction websites. Everybody searches, everybody is going to be buying on the inter-

net, says Mr Rosensweig. You can see why these assets, these brands, these technologies create a company that nobody else can compete with. Yahoo already has a solid 21 per cent of the Chinese search market, according to Analysys International, compared with 37 per cent for Baidu, Chinas newly Nasdaq-listed internet search service leader, and Googles 23 per cent. Ebay, the global leader in online auctions, may also feel threatened. But an Ebay official in China dismisses such talk, noting the strength of the parent companys financial and technological resources and waving aside

Alibabas claim to be outpacing its auction business. Ebay fans also say Alibabas auction success has been based on offering its services for free, a policy that has prompted some complaints that many of the items offered for sale are of little value. But Ebay will need to disprove Mr Mas claims that China managers answering to a faraway head office cannot control costs and sniff market winds as well as a truly local company. There is much to fight for. We are playing for the long term, says Yahoos Mr Yang, who believes that e-commerce in China will be a billiondollar market in a few years. We believe the prize is huge.

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INVESTING IN CHINA

Virtual world where the net is double-edged sword

Beijing is worried by obsessive role-play gaming among minors, writes Mure Dickie

n a few months, some of Chinas keenest players of massively multiplayer online role-playing games will start finding marathon sessions in front of the computer a bit less fun. Under a code of conduct drawn up by Beijings press and publications administration, leading local operators have agreed to introduce an anti-addiction system to their online games, which are known as MMORPGs and are played by an estimated 25m Chinese. The new system is designed to protect players mental and physical health by nagging them to log off if they play beyond a healthy time-limit of three consecutive hours. After that, the benefits their virtual characters gain from time online are cut until after five hours they collect no more treasure or experience points. Worse still, every 15 minutes they will receive the onscreen warning: You have entered unhealthy game time, please go offline immediately to rest. The launch of the anti-addiction system underlines widespread concerns about the social impact of MMORPGs in China, where they have soared in popularity in recent years but have also been blamed by media and Communist party groups for fostering sloth, truancy and crime. We must clearly recognise that the internet is a double-edged sword and that its development will have some negative effects, acknowledged Tang Jun, president of leading games company Shanda Interactive in a declaration to launch the new code of conduct. When it comes to the operations of online games, the most pressing problem is addiction, particularly the obsession of some minors who have harmed their physical health, neglected their studies and undermined the stability of their homes and society, Mr Tang said. It may be privately upsetting for games executives publicly to accept the contention of social critics that some of their customers should spend less time with their products. But the demand for an anti-addiction system is also a powerful indication of just how successful MMORPGs have become in China. The reasons for that success lie

in the proliferation of personal computers and internet access both the result in part of a government policy of national informatisation. Local companies have also adroitly adapted to the particular needs of a market where the bulk of players log on not at home, but in the crowded but cheap internet cafes now common even in small provincial towns. Shanda, for example, won its leading status in part by using cafe managers to market the pre-paid cards that players use to access its teeming servers. Online games have also benefited from a lack of competition from games consoles in China, since rampant piracy has kept producers such as Sony, Microsoft and Nintendo away from the market. MMORPGs are affected by piracy - some players hack in to their virtual worlds without paying and others set up illegal copies of their games on private servers. But their subscription fee-based model and legitimate operators ability to offer much better service than pirates makes them much less vulnerable than console games. The result is games that already often have hundreds of thousands of people online at the same time. As the number of Chinese using the internet climbs toward an expected 120m by the end of this year, the player population is sure to grow further. Investment bank CSFB forecasts that Chinas online games market will increase 65 per cent to $633m this year and will be the worlds largest by 2006. International investors are keen to be part of the story, and Nasdaq-listed Chinese online games providers such as Shanda, Netease and The9 have won high valuations. Though barred from directly operating online games in China, foreign companies also want to win a slice of the market by licensing their games to local partners. The Chinese companies then localise them to degrees ranging from mere translation into Chinese to making characters more Asiatic and altering gameplay. The results can be dramatic. In late July, The9 launched World of Warcraft, a fantasy MMORPG developed by US games provider

Blizzard Entertainment and known as World of Magic Beasts in Chinese. Even though the game requires the purchase of a CD as well as a subscription, World of Warcraft had 1.5m paying customers a month after its June 7 formal launch, a number that has since climbed above 2m - roughly as many players as the game has in North America, Europe and South Korea combined. Blizzard is understandably pleased - seeing Chinese gamers respond so enthusiastically to the game has been extremely gratifying, Mike Morhaime, president and co-founder said recently - and its early success will fuel other international developers enthusiasm. Not all will have as much fun, however. New entrants to the market in the next few years are likely to face fierce competition from a raft of local companies currently developing or adapting games. Chinas government is determined not to let foreigners dominate the industry and is moving to support local companies by helping to set up

port Chinese games companies is not merely a matter of protectionism. It also reflects the governments desire to keep in control of a new medium that many think could have a deep ideological influence on the young. Officials routinely ban computer games that are judged to offend against Chinas dignity, include politically suspect content or even merely have passing references to Taiwan that do not reflect Beijings claim to sovereignty over the island. For games companies, winning official favour means monitoring games players online conversations in real time. When Beijing was cracking down on antiJapanese demonstrations earlier this year, game-masters at Chinese MMORPGs were ordered to jam any talk of public protest and even to eject offenders from the virtual world. Political sensitivities are less of an issue with casual games, the hot new area for online operators. Ranging from online chess to

arcade games, such services are usually offered free, with providers hoping to make money either from advertising or by selling access to enhanced versions and virtual items such as fancy avatars. Michael Tong, chief operating officer at Netease, says that 300,000 players registered to use its casual games service within a month of its unofficial open for beta testing, without much of a marketing effort. Casual games should help operators bridge the gap between PC online games and wireless versions for mobile phones. While the business model for wireless games remains somewhat unclear in China, the potential market is enormous. More than 300m people in the country already have mobile phones and millions more sign up for wireless subscriptions every month. Shanda, at least, hopes to branch out in another direction by launching a television set-top box, intended to bring its games to a much wider audience while also offering services such as internet television, video downloads and karaoke. Some analysts have speculated that Shanda might hope the box will also become a form of home games console. However the market develops, Chinese gamers should soon have access to many more online options. Even the countrys most hardcore players may not be too upset when their favourite MMORPG starts to nag them to take a break.

On a mission: beast character from World of Warcraft

training facilities for game developers and offering preferential tax status. Meanwhile, Chinese operators, most of which began by licensing South Korean games, now want to widen their margins by developing their own. In some cases, the result has been angry disputes. Korean developer Actoz Soft, for example, is part owner of Legend of Mir II, a hugely popular MMORPG that was central to Shandas success. But Actoz later sued Shanda over accusations it underpaid royalties and pirated its ideas to develop its own swords-and-sorcery role-playing game. The row was resolved only when Shanda bought a controlling stake in its partner and rival for more than $90m. Beijings determination to sup-

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Online start-up banks on wanderlust

Travel search engine Qunar hopes to eclipse bigger rivals with an unusual business model, writes Mure Dickie
he name of Chinese startup travel search website Qunar translates roughly as Where are you going? For Qunar itself, the answer is: all over the place. Just half a year since its inception and three months after launching its Chinese-language website, Qunar has begun betatesting a search service for internet surfers in regional neighbours such as Hong Kong, Singapore and the Philippines. Japan, South Korea and India are scheduled to follow by the end of the year. The ambitious roll-out schedule for a company still seeking its first round of venture capital reflects a belief that the growth of both travel and internet use in China makes the country an ideal base. As people start getting rich, the first thing they want to do is travel, says Fritz Demopoulos, an American who co-founded Qunar with partners from China and Malaysia. He adds that Chinese social surveys have found that while respondents greatest wish was to be the boss, the more realistic, runner-up goal was to see the world. There is little doubting the potential of Chinas online travel sector. The number of Chinese using the internet is expected to hit 120m by the end of this year and the online population broadly matches the people who are driving growth in airline ticket and hotel sales. Internet travel agents - led by Nasdaq-listed, locally based ventures Ctrip.com and eLong - have won a strong presence and rising revenues by offering cheap fares and easy booking. Qunars hopes, however, are based on a very different business model. The venture is part of a new wave of travel meta-search companies. Like famous search providers such as Google, the meta-searchers use automated software bots to trawl the web for information that users can then easily search through. But Qunar and its peers do not just list internet travel websites, they also burrow into them for detailed information about prices and availability. We have a laser-like focus, says Mr Demopoulos. The results from hundreds of travel sites are then listed on Qunars website and can be sorted easily by price or time of departure or arrival. Qunar also aims to weed out false offers - the bane of many online travel bookers - by following up some searches to establish whether what is advertised is really available. Google doesnt have to take

Aiming high: Chinese tourists in Paris

AP

responsibility for its search results, says Mr Demopoulos. For vertical search we need to take a bit more responsibility. We have girls out there checking that tickets actually exist and scolding the companies a bit if they dont, he says. With the search service offered free, Qunar hopes to generate revenues from other sources. The aim is to win advertising from travel service providers that can be displayed on the site or as paid search results similar to those offered by Google. Qunar also wants to generate referral or transaction fees from travel companies that win orders from Qunar users. But even Mr Demopoulos admits that the business model is still doubted by many in the travel industry. Qunar lists offers from online travel agents among its search results and woos them as advertisers, for example, but also makes it easier for users to get good deals directly from airlines or hotel chains, cutting out the middleman altogether. So far, eLong is working with the start-up, while Ctrip is standing aloof. Qunar expects to rely eventually on paid action fees for transactions actually conducted, but this will take time because of tracking difficulties and the fact that many people use internet searches to find a vendor, but book at a later date or by phone. The first challenge is to win users to the Chinese site, which still suffers some technical glitches but generally offers a clear andneutral selection of domestic flights. Qunar is sure that China is a good place to test the meta-search theory before expanding in the region. The company already has 22 staff and a city office, with about half its $150,000 initial founders capital left to spend. Zhuang Chenchao, co-founder, says few places could match Beijings pool of tech-savvy, lowcost potential employees. Salaries for staff with basic programming training from a two-year vocational college start at about $200 a month, he says. Like all internet start-ups, Qunar also faces the risk that an internet giant will muscle into its market. Indeed, Yahoo is already testing its international travel search site, Yahoo Farechase. But Mr Demopoulos says Qunars combination of scaleable search technology with low-cost human monitoring of results offers some protection. And if his venture can quickly establish its name among regional travellers, it will be well placed to fend off competition later on. No wonder Qunar is so keen to start going places.

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INVESTING IN CHINA
MEDIA

Star TV falls back down to earth in China

Mure Dickie examines a deal that suddenly went wrong for Murdochs Asian broadcaster

hen Star TV drew up an innovative tie-up with Chinese regional television broadcaster Qinghai Satellite last year, the Asian TV operation of Rupert Murdochs News Corp had good reason to hope it would win at least tacit approval from regulators. After all, Beijing had recently announced an unprecedented opening of the TV production sector to foreign investment and the Qinghai deal was structured to leave legal responsibility for broadcasts with the Chinese company. The Star-invested intermediary set up to control advertising rights and content for Qinghai TV was also backed by Ding Yucheng, son of influential former Communist party propaganda tsar Ding Guangen. And few media moguls have worked harder than Mr Murdoch over the past decade to

cultivate Chinese leaders. For all such efforts, however, the Qinghai TV gambit proved too much for Beijing. Amid a widening government campaign to tighten media controls, the regional broadcaster announced in July that its co-operation with Star TV was dead. A western industry executive says Beijing appears to have been worried about the implications of giving News Corp commercial sway over even a minor broadcaster in a poor province. If they let a deal like that go through, who on the ground is going to monitor it? the executive says. The failure of even such a carefully calculated attempt to stretch the boundaries in the TV sector underlines the disappointment of international media groups barred from a significant role in the worlds largest untapped media industry.

News Corps lack of progress in China contrasts sharply with Star TVs explosive success in the other great Asian developing media market, India. But it is shared by rivals such as Viacom that have seen years of effort rewarded with little more than a toehold. Foreign hopes were raised last year when Beijing scrapped its ban on overseas investment in TV and film production ventures, said local newspapers could list commercial operations overseas and signalled foreign newspapers would be allowed to print in China. This year, however, the mood has been very different. Just this month, the propaganda department announced new rules intended to defend national cultural security, enforcing tighter controls on foreign content. The move has prompted concerns that Beijing is regretting its decision to open the sector. However, analysts and industry executives say China appears committed to commercialising and opening the media, though more

cautiously and with a stress on control that matches the generally conservative policies of President Hu Jintao. The government is drawing breath, says Alastair Campbell, China president for Thomson, the French media and entertainment services and equipment group, which works with both foreign and Chinese producers. It would be hugely difficult for Beijing to halt reform completely. The digitalisation of Chinas TV network is set to create huge demand for content that local companies will struggle to meet alone. And many influential statecontrolled companies yearn for the chance to win foreign investors and set up joint ventures with industry leaders. However, predictions of continued gradual opening are likely to be of little comfort to Mr Murdoch, who approved the Qinghai TV tieup after meeting with the younger Mr Ding, according to one person familiar with Star TVs business. News Corp invested heavily in Runde Investments, a company set up to manage Qinghai - spend-

ing as much as $40m, according to one person familiar with the business. Star has also suffered other setbacks. Like other foreign broadcasters, it is only allowed to beam its signal to areas of southern Guangdong province, upmarket hotels and approved residences. But Star is now under investigation by authorities in Beijing after a former employee accused it of illegally selling access to its satellite broadcasts of its channels to other subscribers. Star TV declined to comment on that case or on the Qinghai venture. In August, a TV contest based on Pop Idol demonstrated the potential of foreign media methods, beating the most popular show offered by dominant state broadcaster CCTV on ratings. It was a success reminiscent of Stars conquest of India with its local version of Who Wants to Be a Millionaire? But unfortunately for the foreigners, this hit was produced by a provincial Chinese broadcaster from central Henan.

Rupert Murdoch: ready to take off his diplomatic gloves

Reuters

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VIEWPOINT

The long wait to broadcast

Even though Beijings stance towards foreign media investment remains restrictive, it will ease in time, writes Michael Spiessbach
he Vernal Equinox in March signalled a welcome thaw of winters ice. Not so in Chinas media sector. In November 2004, Chinas media watchdog made a big push towards liberalisation by allowing qualified foreign companies to invest in joint ventures designed to produce radio and television programmes for Chinese audiences. Three months later, the regulator decided to back-pedal on its original plan by restricting the entire cast of qualified foreign investors to one joint venture each - a spring frost that has caught many foreign media investors by surprise. After flooding the regulator with joint venture applications, foreign media groups could be forgiven for feeling slightly let down. Yet the recent setback should not keep them from trying to expand in this politically sensitive sector. The move to limit media liberalisation - which is not required under Chinas World Trade Organisation commitments reflects a traditional cultural maxim: when crossing a river, one must cautiously feel ones way over the rocks. Only someone such as Deng Xiaoping, the architect of Chinas economic miracle, could defy tradition by stating: It is glorious to be rich. By contrast, Beijings present leadership would not have the courage - nor the hubris - to take

equally bold steps. In the parallel universe of the Chinese Communist party, economic openness does not necessarily lead to greater openness in the media sector. When Mr Deng made his famous statement only about 10m Chinese households had television sets on which to watch it. Today, programmes such as China Central Televisions Lunar New Year show attract more than 500m Chinese viewers watching on 350m television sets. Yet, while the development of broadcast infrastructure continues to accelerate, programming liberalisation moves at a snails pace. The governments approach reminds me of a traffic sign in my car park in Hong Kong, which encourages drivers to speed slowly. Indeed, faced with a poor rural population of about 800m people, Beijing has little incentive to disseminate media products that glorify the increasingly comfortable lifestyle of the emerging middle class. Broadcast media - especially if open to foreign influence - is seen as a grave risk. As Lee Kuan Yew, the founder of modern Singapore, once said: The mass media enables the less advanced parts of China to see how backward they are and to say (to Beijing): Look, when is my turn? For now, Chinas have-nots will not be allowed to see the relatively high standards of living their coun-

trymen in the coastal regions enjoy - to say nothing of western lifestyles. Conjecture of nefarious motivations aside, Mao Zedongs warning that it only takes a spark to start a prairie fire still permeates the thinking of media mandarins in Beijing. Moreover, avoiding social and regional tensions is only one of many challenges facing the leadership. At the moment, the Beijing juggler is trying to keep a dauntingly large number of balls in the air. Pressing issues include non-performing bank loans worth $500bn, an underemployed floating popula-

tion the size of the US workforce, unfunded social security plans, massive urbanisation, a backward agricultural sector and the heavy financial burden of moribund stateowned companies. The last thing that Beijing wants is an unfettered media sector that could undermine its delicate balancing act. The governments media instincts were on display in 2001, when it forced foreign broadcasters to channel satellite transmissions into China through a unified satellite platform that could be turned off by Beijing at will. Contradictory media diktats are

neither new nor permanent. Take foreign media giants such as Rupert Murdochs News Corp and Disney. They had been famously suspended from play but are now out of the penalty box and back in the game. Like farmers sowing seed, foreign media investors must take the long-term view. The present chill in Chinas media sector will pass.

The author is vice-chairman of China M&A Management, a Beijing-based advisory firm, and Chairman of China operations of WorldSpace, the satellite radio company

Murdoch calls Beijing paranoid

By Aline van Duyn and Joshua Chaffin in New York and Mure Dickie in Beijing

upert Murdoch has worked hard to avoid offending Chinese leaders ever since he earned their ire with a 1993 declaration that satellite television posed an unambiguous threat to totalitarian regimes everywhere. Later efforts by the News Corp

chairman and chief executive to win Beijings favour included dropping plans to publish a book by former Hong Kong governor Chris Patten that was critical of China and barring the BBC from his regional broadcasting system. But now Mr Murdoch appears to be ready to take his diplomatic gloves off again. At a conference in New York in September he admitted that News Corp had hit a brick wall in China - and accused Chinese authorities of

being paranoid about foreign media. The comments were the most public and direct expression of dissatisfaction yet by an international media mogul at Chinas reluctance to open what is the worlds largest untapped media market. Beijing has this year largely halted its cautious opening of the TV production business and the ruling Communist partys propaganda department recently issued rules aimed at defending national

cultural security by tightening controls on foreign imports. Mr Murdoch said recent actions by Beijing marked a reversal of their policy of opening the market to international media companies and that Chinese authorities were quite paranoid about what gets through. He also criticised Yahoo, the US internet portal, for supplying information to Chinese authorities that helped their case against a local journalist jailed for 10 years on charges of revealing state secrets. I think they were wrong, Mr Murdoch said. China offered no immediate reaction to Mr Murdochs com-

ments, but Beijing leaders are unlikely to be pleased by such direct criticism. Mr Murdoch has won only a toehold in the Chinese market for Star TV, News Corps Asian broadcaster. Meanwhile, at the same New York conference, Dick Parsons, chairman and chief executive of media group Time Warner, said he had decided against distributing his AOL internet business in China because the government wanted to monitor messages sent via the service. We made a judgment it wasnt a market we wanted to enter at this time, he said.

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INVESTING IN CHINA
LUXURY GOODS

Domestic wines hitting the spot

Changing tastes have opened up the market for western-style wines, says Justine Lau

hen Dynasty Fine Wines Group began producing what it claimed to be the first bottles of western-style wine in China 25 years ago, customers thought the drinks were rotten. Chinese grape wines had always been sweet but our wine tasted a bit sour, admits Gao Xiaode, general manager at Dynasty, a joint venture between state-owned Tianjin Development Holdings and Frances Remy Cointreau. In China, people think food and drinks that have a sour taste have gone bad. Thanks to several marketing campaigns and encouragement from the Chinese government, many consumers have since embraced wine as a fashionable beverage and healthier alternative to traditional rice spirits. The change in Chinese palates not only helped Dynasty to become the countrys second largest wine producer, but it also paved the way for a HK$550m ($70m) listing on the Hong Kong stock exchange last January. Benefiting from Chinas runaway economy and the increasingly chic lifestyles of its urban population, the wine retail market nearly doubled from Rmb1.9bn in 1997 to Rmb3.4bn ($411m) in 2003,

according to Access Asia, a Shanghai-based research house. The World Wine Industry Association expects wine sales in China to increase by 35 per cent in the period of 2003-08, compared with the global average of 5.4 per cent. While white wines account for more than 60 per cent of the Chinese market, red wines have seen stronger sales growth in recent months. Analysts point to the widespread belief that red wines are healthier than white wines. It also helps that red is seen as a lucky colour in China. Expensive bottles of red wine have become the latest trophy drink of the Chinese nouveau riche, who like to drink such wines when eating out, says Access Asia in a recent report. Despite the occasional Bordeaux blanc or Jacobs Creek, domestic winemakers such as Changyu Group, the countrys biggest wine producer, accounted for 90 per cent of domestic sales in 2003, helped by lower prices and extensive distribution networks. Foreign brands are required to pay import duties, which dropped from a peak of 44.6 per cent in 2001 to 14 per cent last year. As a result, the average price of a bottle of imported wine is about

US$10, compared with US$2-$4 for Chinese wine. But some analysts believe Chinese wineries will lose their competitive advantage, pointing to a further reduction in import taxes and a growing popularity of foreign brands among wealthy consumers. Our customers prefer foreign brands because Chinese wineries have a much shorter history and their production is considered less sophisticated, says Mark Ruan, assistant food and beverages director at the Portman RitzCarlton hotel in Shanghai. Yet Dynasty remains sanguine. The companys turnover for the first nine months of last year rose 25.4 per cent to Rmb620.9m, while net profits jumped 40.4 per cent to Rmb96.5m, according to the companys listing prospectus. Ten years ago, customers might have thought that a bottle with a foreign brand was better, says Mr Gao of Dynasty. But now they realise that for the same amount of money they can buy much better Chinese wine. While alcoholic drinks are an integral part of Chinese celebrations and family reunions, wine accounts for just over 1 per cent of the alcoholic drinks market. Annual per capita consumption is

less than a quarter of a litre, compared with 3 litres in Japan and 59 litres in France. Indeed, the retail wine market as a proportion of total alcoholic drinks sales has been gradually shrinking since 1997, according to Access Asia. We are confident that wine consumption will continue to grow because (disposable household) incomes are rising, insists Mr Gao. More people will be able to buy luxury goods such as wine. To prove its point, Dynasty is planning to use the proceeds of its initial public offering to lift its production capacity from about 30,000 tonnes last year to 70,000 by 2008. The company is also stepping up its marketing efforts, in the hope of winning over sceptical consumers. Paul French, one of the authors of the Access Asia report, believes Chinese wine companies have yet to push their products beyond the status symbol level and into the mass market. In China, some people drink wine because they like it, while others drink it because its fashionable. But how many of them will become repeat buyers? asks Mr French. Its like coffee. Its fashionable now but in a couple of years people may move on.

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Luxury brands look to the east

Manufacturing in low-paying economies could raise profit margins but only if the made in China label sells, writes Geoff Dyer

uropean luxury goods companies have cultivated the notion that their products are made by skilled craftsmen from Italy or France whose knowledge has been passed on through generations of the same family. Such images, however, are coming under threat. Just as every other manufacturing sector has done over the past decade, the luxury goods industry is starting to contemplate moving some of its production capacity to China. Given the lure of Chinas regimented, low-cost workshops, luxury industry executives have been toying with this idea for some time. But few have dared to make their views public. Not so for Prada, one of the worlds leading fashion houses. At a Financial Times conference in Shanghai, Patrizio Bertelli, chairman and chief executive of the Italian group, revealed that Prada was considering outsourcing some production to China and other countries that can offer cheaper labour. The relocation of some production should not be a reason to wage a war of religion, Mr Bertelli said. Low-cost labour will pose a threat to European labour over the next 10 years. But using Chinese labour will be seen as an opportunity to contain cost and price, which will be beneficial to consumers. Over the past decade, these arguments have become commonplace in the textiles sector, with many manufacturers of T-shirts,

running shoes and ties sourcing their production from a number of developing countries, most notably China. However, for the luxury goods sector, relocation has been something of a taboo - despite in spite of continuing rumours that a few companies are quietly using China for parts of their production. The risks are obvious. By opting for low-cost Chinese labour, luxury goods companies could lose the whiff of glamour that surrounds their brands and justifies their relatively high prices. As Umberto Angeloni, chief

executive of Brioni Roman Style, the Italian fashion house, puts it: When you start changing the made in label, you create an expectation among consumers of lower prices, because everybody perceives costs in such countries to be 90 per cent lower. But the pressures on the luxury industry to consider the China option are growing. According to Michael Zaoui, a managing director at Morgan Stanley and one of the industrys leading investment bankers, the growth prospects for the sector have slowed over the past four years. This is partly because luxury retailers have nearly reached the limits of potential floor space available to them in department stores. Margins have deteriorated because prices have not kept up with [rising] costs, which leaves you with two choices: to act on

prices or on costs, he says. Can you make luxury more expensive than it is today? I dont think so, as consumers want to pay less. One solution is to cut costs and relocate. A few companies have made a virtue out of their China production. Shanghai Tang, owned by Zurich-listed Richemont, is generally recognised as the first luxury goods company to come from China. Raphael le Masne de Chermont, Shanghai Tangs executive chairman, says that there was a strong tradition of what was called imperial tailoring in Shanghai before the Communists took over. Of the 18 people left who still retain those skills, he says, 12 work for Shanghai Tang. For us, made in China is not a theme, it is our strength, Mr le Masne de Chermont says.

Of course we will continue producing in China. There are some products that you cannot produce well in China - for instance, leather goods - but one day everything else will be produced here. Most outsourcing advocates believe the strategy has to be implemented carefully. The real problem is integrating Chinese labour with our labour, says Mr Bertelli at Prada. The Chinese have excellent labour, but it is possible that some items, like bags and shoes, may continue to be made in Italy. He believes companies can minimise the potential damage of outsourcing by changing the labelling policy. I think it is feasible that, in the case of a Prada product that is made in more than one country, the made in Italy label could be replaced by a made by Prada label, he says. In other words, the companys brand name would be used as a guarantee of manufacturing quality and not just design. James McArthur, executive vice-president at Gucci Group, says the reaction of customers will depend on the brand. Oldstyle luxury brands might face considerable risks. By contrast, products in the Stella McCartney line - a new brand developed by the British designer - are now partially made in Hungary. There is no customer resistance because the brand is good enough and the price is right, he says. Mr Zaoui at Morgan Stanley believes outsourcing does not pose significant dangers for companies with strong brands. Even luxury companies will learn to manufacture in China, he says. Do not worry so much about the label and its meaning! Your strength is your brand. Cartiers brand, for instance, is worth three times more than Apple, Pepsi and Nike in relation to sales.

Additional reporting by Jeff Wagner

Franck Muller finds time is ripe

By Justine Lau in Hong Kong
ranck Muller, the Swiss watchmaker, has big expansion plans in China as it seeks to become the latest luxury goods manufacturer to take advantage of the increased wealth and spending power of the mainland consumer. Singapore-based Sincere Watch, which distributes Franck Muller in China and nine other Asian countries, says the most popular luxury watch in the mainland may once have been an Omega or Longines costing under Rmb10,000 ($1,200). But Chinese shoppers are now ready to spend more. Sincere Watch plans to open its

second Franck Muller China outlet in Beijing this year and says it eventually wants a presence in every major watch city in the mainland, including Shenyang, Hangzhou and Harbin. It already has a boutique in Shanghai. It is also in talks with local distributors to have Franck Muller watches sold in retail stores. China and Hong Kong together is bigger than any other market. Our future growth is definitely China, says Tay Liam Wee, Sincere Watch managing director. Consumption of luxury goods by Chinese has grown rapidly in the past few years and with men being at the forefront of that trend, watches have benefited from particularly strong demand.

According to a Goldman Sachs report last year, watches were the most popular luxury goods in China, accounting for 35 per cent of total sales, compared with 15 per cent globally. Swiss watches accounted for 88 per cent of the total Rmb16bn watch sales in China in 2004, with imports nearly doubling over the past two years The Federation of the Swiss Watch Industry says China imported SFr189.9m ($147m) of watches from Switzerland in the first seven months of this year. That is up 30.2 per cent from the same period in 2004 and 91.2 per cent higher than in 2003. On the back of this growth, Franck Muller opened its first bou-

tique in an upmarket Shanghai mall last year. Strong demand from customers, who spend an average Rmb100,000 on a Franck Muller watch, is expected to help the store turn profitable this year. Sincere Watch says the establishment of branded boutiques is especially important in order to develop Franck Mullers brand, which is less well known than some of the other 300 watch brands sold in China. Chinese consumers need to be educated. When they see this brand could actually open a store in Citic Square [Shanghai mall], they know it is a brand they want to own, says Kevin Chau, Sincere Watch (HK) executive director. Mr Chau says Chinese con-

sumers like to shop at singlebrand boutiques rather than general watch stores for luxury items. Fake goods are the biggest fear for Chinese customers. If they shop in a boutique, they can be assured that everything is real. As the brand continues to expand, Franck Muller faces various challenges, such as finding good locations and also dealing with local regulations. The company had to apply for two different import licences to sell its products in two places in Shanghai, Mr Chau says. We knew that every city has its own regulation. What we didnt know was that there are also many kinds of regulation inside the same city.

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INVESTING IN CHINA
FOOD, BEVERAGES AND TOBACCO

Japan Anheuser mulls plan for Harbin Tobacco N eyes Chinese market
By Mariko Sanchanta in Tokyo

he chief executive of Japan Tobacco, the worlds third-biggest cigarette maker, has urged China to open up its tobacco market to foreign competition. Katsuhiko Honda said of the worlds single biggest cigarette market: The progress in China has been slow and I have some frustration regarding the speed with which they are opening their market. Though we have a good relationship with the Chinese monopoly authorities, the market should be liberalised as soon as possible. Chinas tobacco monopoly has said that new joint ventures with foreign manufacturers will not be approved in the near term. Establishing a long-term presence in China in the future is crucial for the company, said Mr Honda. Japan Tobaccos flag-ship cigarette brands are Camel, Winston, Mild Seven and Salem. At home, Japan Tobaccos smoker base is dwindling, due to rising health consciousness, more stringent tobacco advertising regulations and Japans shrinking population. Japan Tobaccos domestic market share has declined to 66 per cent following the termination of its Marlboro licensing agreement at the end of April. Meanwhile sales of cigarettes in China in 2004 reached Rmb475bn ($58bn). Official estimates say some 1,800bn cigarettes are sold in China every year to 320m smokers. Analysts say the companys future profit driver will be its international tobacco business and it will probably have to acquire a company abroad to gain access to growth markets if it wants to maintain competitiveness. Japan Tobaccos last big acquisition was in 1999, when it bought RJR Internationals assets. Our M&A strategy should not be about size, it should be about value, said Mr Honda.

early a year after a $700m acquisition, many companies would be keen to justify the deal with talk of costs cut and synergies exploited. But not AnheuserBusch. In fact, the worlds largest beer maker is happy to admit that it has still not decided what it wants to do with Harbin Brewery, the Chinese regional producer it bought in mid-2004 in a move that won headlines around the world. We are still in the learning process about Harbin, says Stephen Burrows, chief executive officer of Anheuser-Busch International. Before we get ahead of ourselves, we want to make sure we have a complete understanding of the company. Mr Burrows refusal to be rushed reflects Anheusers longterm approach towards China, which it considers to be its highest priority overseas market. In the US, beer sales are under pressure from wines and spirits, and Anheuser rivals such as the global number two brewer SABMiller are nibbling away at the St Louis-based giants market dominance. By contrast, Chinas low per capita beer consumption and rapid economic development offer a vision of huge future growth for a market that is already the worlds largest in terms of volume. And while Anheuser has been seen as a relatively slow mover internationally, in China its track record looks impressive compared with a slew of disastrous investments by global rivals in the 1990s. Anheuser, which has invested $1.4bn in China so far, has a 27 per cent stake in Tsingtao, the countrys largest brewer, and also owns a plant in the central city of Wuhan that makes its flagship beer Budweiser. So Mr Burrows feels he can afford a measured approach towards Harbin Brewery, which was

The US brewers refusal to be hurried reflects a long-term approach towards its highest priority overseas market, writes Mure Dickie

a Hong Kong-listed SABMiller ally before Anheuser seized an opportunity to launch a takeover bid last May. Weve owned the company for less than a year and rushing towards something without a plan to get there is a recipe for failure, Mr Burrows says. There are enough international brewers that have come and left China because they lost money by rushing things. Even with time to think, deciding exactly what to do with Harbin may not be easy. Anheuser should easily be able to improve quality at Harbins 13 breweries across north-eastern China, and to apply international expertise to what is the countrys oldest beer brand.

Harbin has also long wanted to expand beyond the north-east, but Anheuser must be careful not to offend its partner Tsingtao, which already has a venerable national brand and would like to strengthen its own presence in Harbins heartland. Mr Burrows says Anheuser and Harbin have yet to hold formal discussions with Tsingtao about how the companies might work together, but suggests that joint production and purchasing are possibilities. Some analysts expect Tsingtao to eventually resolve the issue by buying a stake in Harbin although the Chinese brewery is unlikely to be willing to offer anything like the hefty price that Anheuser paid.

Whatever happens, it will be some time before Anheusers actual returns from China come close to matching the markets potential. China currently accounts for less than 3 per cent of earnings and it will be difficult to raise profits soon given fierce price competition and an expected surge in new brewing capacity. Joe Zhang of UBS Investment Research in Hong Kong points out that urban Chinese already drink quite a lot of beer but have little interest in brands, while it will take time and perseverance to persuade rural drinkers to switch from traditional spirits. Meanwhile, logistics also remain difficult and breweries pricing power is very limited. The beer market is not getting easier it is getting slightly worse, Mr Zhang says. Still, Anheuser seems better placed than most international brewers to succeed. Its Wuhan plant has been profitable on an operating basis since 2001 and is increasing capacity to 3.4m tonnes a year. Anheusers success with Budweiser is based on an impressive marketing feat: persuading many wealthy Chinese consumers that the everyman US Bud beer is a super premium brew worth paying three or more times as much for as local brands. Investors will no doubt be pleased if Anheuser can do as well with Harbin and Tsingtao, even if it takes time to come up with a detailed strategy. Indeed, even with Harbin undigested, the US brewer says it might make other Chinese acquisitions if good opportunities arise. Mr Burrows clearly does not doubt the wisdom of buying first and planning later - and suggests rivals who mull too long may miss out. For other brewers who arent here in a significant way, the window is closing quickly, he says.

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EDS 2

INVESTING IN CHINA
AEROSPACE

Intense battle for custom

Andrew Yeh looks at an industry rebound
n common with many aspects of Chinas economy these days, the countrys aviation sector has been in a constant state of flux. As demand for domestic and international travel services strenthens, local carriers and several international airlines have been preparing for an intense battle for the custom of the countrys travellers. Chinas state controlled carriers have been buying aircraft from rivals Boeing and Airbus and are looking to expand their flight networks. At the same time, several global airlines are looking to introduce services to Chinese cities. As a whole, Chinas airline industry has seen a dramatic

rebound since 2003 when the outbreak of Sars crippled travel enthusiasm and industry revenues in the region. Chinas aviation market recorded profits of Rmb8.69bn last year, equivalent to the accumulated profits over the previous decade, the countrys aviation regulator has estimated. Of that amount, the three largest carriers - Air China, China Southern and China Eastern accounted for 62 per cent. The number of passenger trips in China last year increased by 39 per cent while traffic for international routes shot up 52 per cent. But even as business has improved, the main domestic airlines have been on guard as foreign carriers look to broaden their presence. Some Chinese airlines have undergone significant internal reorganisation to raise their competitiveness.

Several North American, European and regional airlines have been positioning themselves to expand flights to China. A bilateral agreement reached last year between the US and Chinese governments, for instance, outlines plans significantly to boost the number of passenger and air cargo flights between the two countries over six years. That agreement pledges more than to double the number of airlines flying between the countries and increase the number of weekly flights from 54 last year to 249 after six years. US airlines have submitted applications to regulators to fly to popular Chinese destinations such as Beijing, Shanghai and Guangzhou. Local carriers such as Air China and Hainan Airlines have likewise said they are looking

to expand services abroad, particularly to the US. In the immediate future, however, there will be comparatively more interest from US carriers looking to expand services to China than for Chinese carriers flying to the US, industry experts say. Continental Airlines will join United Airlines and Northwest Airlines in becoming the third US airline to serve China with its Beijing-Newark, New Jersey route. American Airlines is preparing for its maiden flight to China, a Chicago-Shanghai route, next year. Jim Compton, executive vicepresident of Continental, says international routes such as these will be crucial to its business as it has been under great pressure from a host of budget airlines at home. Many European airlines are also looking at adding flights to China. Tim Ramage, Beijing general manager for British Airways, says competition has intensified over the years as Chinas middle class

becomes more willing to spend money and more discerning in its preferences for various flight services. He predicts there will eventually be more international routes to secondary cities such as Chongqing and Chengdu, both located in heavily populated Sichuan province. In the initial stages demand exceeded supply, he says of Chinas market generally. Now supply matches demand and carriers have to compete more aggressively to win customers. Many industry experts expect the travel flow to and from China to remain strong in the years ahead. Martin Lin, head of the aviation group of the American Chamber of Commerce in Beijing, says there will be a trend of greater numbers of US based travellers going to China while the opposite is true for air cargo. Official statistics from last year show the number of international visitors was nearly four times that of outbound travellers.

China likely to drive demand for private jets

Andrew Yeh looks at the implications as the business aircraft sector opens up
hinas demand for small business aircraft is projected to gather momentum as its aviation sector opens up and more people seek greater travel convenience, according to a consensus of industry experts. Many foreign business jet makers believe Chinas growing class of multi-millionaires and its rapidly internationalising enterprises will fuel demand for one of lifes most extravagant status symbols in the years ahead. Several local airlines already offer charter services within China and have purchased foreign aircraft. But there are probably only a handful of people in the country who own their own aircraft, according to industry estimates.

But the worlds leading makers are predicting China will be an important driver of sales. This year, Shanghai hosted a large-scale business aircraft trade show, the first of its kind on the mainland. The event, organised by the Washington-based National Business Aviation Association, featured a display of popular models at the citys Hongqiao International Airport. Orders for aircraft have been on the rise. Todd Duhnke, director of international sales for US manufacturer Cessna Aircraft, for example, says eight orders last year nearly doubled its fleet of Citation aircraft in the country to 17. Jeff Lowe, Hong Kong based vice-president of Gulfstream Aerospace, another US company, says he expects to see a gradual progression in China over the next few years. Companies and individuals will first use charter jets on an ad hoc basis, then start buying blocks of charter time at a discount, and finally some rich Chinese will consider fractional or sole ownership of a jet, he says.

We all see a lot of business there, says Mr Lowe during an interview aboard a Gulfstream G550, one of the companys most advanced aircraft. Theres more wealth being generated in China and a global expansion of Chinese corporations. Gulfstream, in common with a number of leading business aircraft manufacturers, has until now relied primarily on selling to Chinas charter operators. But foreign manufacturers have been looking to make more sales to wealthy individuals, which have been very rare. Jackie Berger, of Raytheon Aircraft in Kansas, says her company has sold nine aircraft to Hainan Airlines (Deer Jet) and Shanghai Airlines, two of Chinas domestic charter operators, but made only its first sale to a private buyer this year - a Beechcraft Premier I to entrepreneur Qiu Dedao. Mr Qiu, who heads a chemical fibre company in Hangzhou near Shanghai, paid about $6m for his jet after attending an air show in

Singapore last year, according to Raytheon. Rich Chinese who buy jets are in large part drawn to their efficiencies. Zhang Yue, a businessman from the central province of Hunan who owns several Cessna aircraft, says the better mood that comes with having a jet far outweighs any complications. Mr Zhang pointed out he can now decide to go anywhere in the country within an hour and often takes guests on board. Ms Berger added that corporate jets can conveniently travel to more remote areas and land with ease on shorter runways. The downside is that owning a jet in China can be troublesome and the cost of maintaining one can be high - there are necessary expenses for hiring pilots, servicing the aircraft, miscellaneous flight and landing fees. And as in other developed countries, the cost of chartering is steep. A Shandong Airlines representative says a Bombardier Challenger will cost Rmb38,000 an hour and an official with Hainan Airlines says

its Gulfstream will cost Rmb40,000 an hour. The countrys charter airlines report they have been getting a steady stream of requests mainly from large enterprises, with occasional calls from high society Chinese. As of now, foreign charter operators have mostly been only looking at China. US-based NetJets, which has a network of 50 aircraft in Europe alone, does not have any business in China, says a company representative. But there are signs the market has been opening up for foreign jet companies, and many are eager to market themselves in China. Beijing has already eased controls on market entry by approving more models of foreign aircraft. John Rosanvallon, chief executive officer of Dassault Falcon Jet, says he expects all of his companys models to get regulatory approval by the end of this year, and other foreign aircraft makers have reported similar progress. On the regulatory side, Beijing has allowed private jets access to its skies, under restrictions.

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A tidal wave of travellers fuels aircraft boom

By Geoff Dyer in Shanghai

ne of the by-products of Chinas rapid economic growth has been the creation of a cottage industry in statistics designed to make the jaw drop. There are the tens of billions of text messages sent every year or the hundreds of millions of people studying English or the millions of new car owners every year - these epic numbers are being churned out on a regular basis. Of all the dizzying numbers, however, some of the most surprising are the figures for the likely tidal wave of travel into and out of China over the next decades. According to the World Tourism Organisation, China will become the worlds largest tourist destination by 2020 and the fourth-largest source of tourists. That means Chinese airports will have to deal with 210m travellers a year.

For aircraft manufacturers these statistics are obviously unalloyed good news. While many of the established airlines in the developed world are facing large losses and having to rethink their entire business models, Chinas airlines have been opening their cheque books at regular intervals. Just in January this year, China Southern - the biggest airline in the country - placed an order for 10 Boeing 787s, as well as signing up for five A380s, Airbuss new superjumbo. According to a forecast compiled by Airbus, Chinese airlines may need 1,790 new aircraft by 2023 - which would be worth about $230bn. Chinese demand is certainly filling up the industrys order books but it is also leading to two important trends that could have a big impact on the future shape of the sector. The first is the expansion of sourcing components from the mainland, from tail fins to nose

cones to aircraft doors. The motivation for this is dual. In part it is an effort to take advantage of lower manufacturing costs in China in order to boost productivity. It also helps when negotiating large deals with state owned Chinese airlines if a company can point out that some of the production will take place in China. Boeing, the second largest maker of commercial aircraft in the world, announced in early June that it had signed contracts with four Chinese companies to provide parts worth about $600m. The package included the first contract with a Chinese supplier to make parts of the 787 jetliner, the companys first new model in 15 years. As a result, Boeing now has $1.6bn of contracts with Chinese parts makers and more than 3,500 Boeing aircraft have components from China. Airbus has also developed a strategy of sourcing some of its components in China, including

work for the A320, the companys rival to Boeings 737. In 1999, Airbus agreed to outsource tooling and technology for manufacturing the aircrafts wings to China, while in April JeanPierre Raffarin, the then French prime minister, and Wen Jiabao, the Chinese premier, signed the $70m third phase of the deal which will enable Chinese companies to produce complete wings. Embraer, the Brazilian manufacturer of regional jets, has gone a stage further - it has set up a joint venture in China to make its aircraft. It has 51 per cent of the venture with two companies - Hafei and Harbin Aircraft Industry Group - which are controlled by China Aviation Industry. China is a perfect market for Embraers aircraft which seat between 50 and 120 people. With more than 100 cities with populations of more than 1m, China has 500 routes that carry fewer than 120 passengers per aircraft -

accounting for about 80 per cent of all passenger flights. Embraers investment indicates the second trend behind the expansion of the Chinese market Chinas steps to develop its own aircraft manufacturing sector. The Brazilian company has not invested in China just to be close to future potential customers but also under a broader agreement to boost Chinas own industry. China required us to work with the government to help build a regional airline industry, says Mauricio Botelho, Embraer president. Their interest was not only commerical but strategic, they wanted the capability to manufacture aircraft in the country. One Chinese project is already reasonably advanced. Avic-1 Commerical Aircraft Company, a company linked to the Chinese army, has begun building prototypes for the ARJ-21, a passenger jet it hopes to begin selling from about 2008.

Gulfstream opens doors to jet-setters

The US aircraft maker hopes to find its first private buyer in China, writes Andrew Yeh

A Gulfstream jet

FT montage, photos by: Bloomberg and Getty Images

$48m Gulfstream G550 jet is not an easy sell anywhere but Gulfstream Aerospace thought the chances were good enough in China to keep one parked on the runway at Beijings main airport one sunny afternoon. We havent sold one yet but who knows, someone may come in here and write a cheque, says Jeff Lowe, vice-president of Gulfstream Aerospace in Asia, next to the G550 that had been flown in from company headquarters in Savannah, Georgia. The mainland Chinese are not afraid to demonstrate their wealth - they are very American in that sense, he said. Mr Lowe and a small crew

recently spent a day accommodating a group of prospective Chinese buyers, guiding them on a tour of the jets luxury interior. The G550 is Gulfstreams top-ofthe-line business jet that can zip from Hong Kong to London in 10 hours. Gulfstream is currently one of many foreign jet manufacturers looking to cash in on Chinas future private and charter jet market, confident the countrys richest individuals and freespending enterprises will want to buy their own aircraft. Zhang Yue, an air conditioning tycoon who in 1997 bought a Cessna Citation Excel 560 becoming the countrys first private owner of a luxury jet, said his primary motivation for the purchase

was impatience with the countrys infrastructure. Im very unhappy with Chinas transportation system, says Mr Zhang at company headquarters in the inland city of Changsha, in Hunan province. Mr Zhang says he was initially concerned that people would disapprove of his jet ownership but he now realises people are not bothered. He now owns five Cessnas and a helicopter, making him by far the countrys most extravagant private aircraft aficionado. Qiu Dedao, head of a chemical fibre enterprise in the eastern city of Hangzhou, earlier this year purchased a six-seat Raytheon Beechcraft Premier I. The USbased jet company said it expected additional sales from China. Unlike Cessna and Raytheon, Gulfstream has yet to find a private buyer in China. Chinas leaders also have their own prefer-

ences for private air travel. Canadas Bombardier has sold tailor-made business aircraft to the countrys top leadership. However, private jet use remains rare, partly because of logistical and regulatory barriers. If a guy buys a jet here, the first thing he thinks is: Where do I get it fixed? and Who do I get to fly it for me? says Mr Lowe, who estimates there may be more private jets based in the airport in Orange County, California than in all of Asia. Lack of modern airport facilities, landing and parking fees, and a shortage of reliable pilots deter potential jet owners. An official with a top flight school in south-western Sichuan province, which began offering pilot training in the early 1990s, estimates the average cost of maintenance for a private jet can reach Rmb1m ($120,821) a year. Chinese jet owners and those

flying in from overseas have to rely on domestic airlines for flight support and repair. Mr Qiu, the textile magnate, uses Hainan Airlines charter operation to manage his jet. Moreover, national security regulations limit private air traffic. The Central Military Commissions rules state that an aircraft flying from overseas into Chinas airspace must get clearance from the government and detail its destination, timetable, and reasons for travel to flight control operators. Violators are liable for fines of up to Rmb100,000. However, jets from overseas flying into Chinese airspace used to have to give up to a couple weeks notice but can now inform flight officials just days in advance, according to Chinas rules and industry experts.

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INVESTING IN CHINA
STEEL, COMMODITIES AND CONSTRUCTION

Iron ore groups cash in after lean years

Demand from China for steel has put the miners in the driving seat in price negotiations, leading to price rises of up to 80%, write Geoff Dyer and Richard McGregor
now significantly cheaper for Asian companies to buy ore from Australia. BHP is telling the Japanese they will have to pay them more, and if they refuse it is threatening to sell its product to (China) instead, says an analyst. Chinas new-found prominence in commodities markets should give it more influence. However, despite the fact that its steel industry is by far the worlds biggest, Chinese buyers still find themselves sidelined in the price-setting talks. The reason for this is rooted not just in past traditions but also in the way Chinese business functions. In Japan, there are five major steel companies which have negotiated as a united front with iron ore suppliers for more than two decades. However, getting the Chinese steel mills to act in concert, according to one China-based industry analyst, is like herding grasshoppers. Baosteel, the biggest producer in China, accounts for less than 10 per cent of output. New steel mills are being built all over the country, creating an even more fragmented industry, and China now has several hundred trading companies dealing in iron ore. Qi Xiangdong, deputy secretary of China Iron & Steel Association, said the Chinese mills were forced by the present system to stand in line and accept whatever prices came down the line. Japan is the first to negotiate with Brazilian and Australian ore companies, and then the South Korean and some American mills, he said. That left Baosteel little room to negotiate. The sentiments expressed in internet chatrooms are even sharper. On one site, which lists the Japanese holdings in global resource companies, one netizen complained: They (the Japanese) just want to control the strategic resources that China needs for its development and play games with China. The China Iron & Steel Association has long tried to organise a cartel among local players similar to the Japanese to allow the mainland to use its buying power to negotiate lower prices, but has so far failed. The steel industry is now pushing for a system of import licences for iron ore which would effectively shut out the smaller steel mills and traders. By putting pressure on the many smaller mills producing lowquality output, the price hike could encourage consolidation and help forge a more unified industry. Despite Chinas resentment at being forced to take a price negotiated by others, some traders believe the Chinese would be wise to stand back in the price talks. Harry Banga, of the Noble Group in Hong Kong, a commodities trading company, says Chinas overwhelming demand for the resource gives them little negotiating room. The Japanese can at least point to their stagnant economy. If the Chinese negotiate, says Mr Banga, They have nothing to say except, give us more.

round February every year, the three big Brazilian and Australian iron ore companies sit down with two European and Japanese steel-mills to thrash out a price for the year. Once settled, the new price is usually accepted across the global steel industry. It has been a cosy, stable system, and for most of the 1990s the price of iron ore barely moved. All that has changed this year. Price rises of 70 and 80 per cent have been negotiated by two of the iron ore miners, while the third, BHP Billiton, is believed to be bargaining for an even bigger increase. The reason for their sudden rush of good fortune is China. For 20 years, the iron miners have been in a bear market, suffering from under-investment and being pushed around by the steel mills, says Ian Roper, of Macquarie Securities in Shanghai. But because of the demand from China, they are now calling the shots. In most industries, the words China and price send a chill through boardrooms, raising the spectre that cut-throat competition from low-cost Chinese producers is going to put them out of business. But the China price means quite the opposite in resources as Chinese demand has lifted the prices of many commodities over the last two years. And unlike in manufacturing, China has little control over it. The iron ore mining groups started to feel the impact of the China effect in 2003 and 2004 when prices began rising and China overtook Japan as the largest iron ore importer. But the real benefit has come this year. Companhia Vale do Rio Doce from Brazil, the biggest iron ore mining group, and Rio Tinto have both sealed 71.5 per cent increases in prices from Japanese and European steel mills. Having seen steel prices almost triple since 2001, the steel companies have been unable to resist the huge hike. BHP Billiton, which has yet to agree on new prices for 2005, is believed to be pushing for an even bigger increase on the basis that, due to soaring shipping costs, it is

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Lafarge to double spending in China

Peabody eyes mine stakes

By Richard McGregor in Beijing
eabody Energy, the worlds largest coal company by sales, is planning to expand in China through joint-venture mines and other coal-related projects to tap into what it says will be a continuing strong growth in demand for the resource. Peabody says it will be restricted to minority stakes in Chinese mines, but believes there are numerous ways it can do business in the country, the worlds largest consumer of coal. One way would be to position itself as part of a likely rapid expansion in China of coal-to-gas and coal-to-oil projects, an area in which Chinese state-owned miners are preparing to make substantial investments. They understand the key to future growth is coal, said Peabody CFO Richard Navarre. Mr Navarre said Peabody was also looking at Mongolia, where it may be able to have full ownership of mines or buy into deposits now controlled by foreign companies, such as Canadas Ivanhoe. Both China and Mongolia, like the US, have abundant coal and relatively scarce reserves of oil and gas, something Peabody believes will propel growth. Peabody puts global coal consumption at about 5bn tonnes annually and expects this to nearly double by 2020 to meet demand from the power and steel sectors alone. Ninety per cent of coal demand growth in the next few years will be from the US, China and India, Mr Navarre said. Coal consumption will grow even faster if prices of oil and gas remain high, making coal liquefaction and gasification investments more attractive. Coal is picking up where oil and gas cannot keep up, he said. Peabodys exposure to China now is through sales from mines it owns or shares in Australia. In spite of Washingtons recent rebuff of an attempt by CNOOC, a Chinese oil major, to buy a US energy company, Mr Navarre said Chinese officials had so far welcomed Peabody into China. They have already restricted us to some extent because we cannot buy 100 per cent of projects. China, which produces nearly 2bn tonnes of coal a year, has 28,000 mines, but Mr Navarre said there were only a handful of world-class Chinese companies with which Peabody was interested in teaming up.

Lafarge expects its construction related China operations to be profitable in less than four years

Getty Images brink of collapse only hours before its announcement in Hong Kong. The companies would not be drawn on the details of the disagreement. Socam was advised by JPMorgan, while Lafarge said it did not use outside advisers. Lafarge will have operational control over the joint venture, in which it holds a 55 per cent stake. Vincent Lo, chairman and founder of Shui On, Socams parent, will be chairman of the joint venture, 45 per cent-owned by Socam. The business is expected to be profitable from the start, despite a continuing slide in cement prices amid sluggish demand. Last year, Socams cement operations in mainland China reported an operating loss. Mr Kasriel said he expected Lafarges China operations, including joint ventures in areas such as concrete, roofing, gypsum and cement, to be profitable in less than four years. The joint venture partners are planning to invest a further $120m over the next 17 months, as part of existing spending plans to upgrade facilities. Fresh investments by the partners would be in proportion to their holdings in the joint venture. Mr Lo, a Hong Kong property tycoon, said the joint venture was close to acquiring cement operations owned by the government of Chinas Yunnan province. The deal would lift the companys production capacity to 17.4m tonnes a year.

By Florian Gimbel in Hong Kong and Peggy Hollinger in Paris

afarge, the worlds biggest cement producer, is planning to double its investments in China to about $800m over the next couple of years, reflecting its determination to participate in forthcoming privatisations and infrastructure projects. The company, which in August announced a joint venture deal with Shui On Construction and Materials (Socam), its Hong Konglisted rival, is hoping to increase its share of Chinas fragmented cement market, which has been hit by government-led attempts to

cool the booming property sector. Bernard Kasriel, chief executive of Lafarge, said the $650m joint venture would pool the companies existing cement operations, concentrated in the countrys southwest. He insisted the business would be technically superior to the outdated production facilities that account for 70 per cent of Chinas cement production. If they (the inefficient producers) had to pay the full price for fuel and electricity, most of them would not be able to compete, he told the Financial Times, pointing to an expected rise in input costs from artificially low levels. The joint venture deal, first reported by the FT, was on the

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INVESTING IN CHINA
CHEMICALS

Amanda Hutt

Giddy growth leads to investment surge

Multinationals are strongly increasing their presence, says Geoff Dyer
he chemicals sector in China is following the same path as many other heavy industries in the country. Demand is growing at so rapid a rate that China is already a major market for most of the biggest companies in the sector and is likely to become the largest in a decade or two. Yet the giddy growth has also led to a surge of investment which has produced overcapacity - at least in some parts of the market for chemicals. Just as the steel industry and car industry are experiencing, the result is a sharp decline in profit margins. The growth in chemicals demand has certainly been sharp. According to the industry association in China, chemicals and petrochemical output grew by 32.2 per cent in 2004. Investment grew by a similar rate - 34.6 per cent. As well as petrochemicals, the segments of the market that have attracted the most interest have been fertilisers, synthetic materi-

als, and speciality chemicals. Such a surge in demand has prompted multinational chemicals companies to increase their presence in the country significantly. in October BASF, the German company, will formally open a massive complex in Nanjing based on its Verbund concept - a series of integrated plants that use the waste from one product as raw materials for another. The complex, which is a joint venture with state-owned petrochemical company Sinopec, will have a steam cracker facility and nine downstream plants, with a total investment of $2.9bn - the biggest in the German groups 140year history. BASF is not alone. Dow Chemical chief executive Andrew Liveris expects China to be its biggest market by 2030 - it is currently third behind the US and Germany. Axel Claus Heitmann, chief executive of Lanxness - the chemicals company which was spun out of Germanys Bayer earlier this year - believes that China could supplant the US as the companys principal market in just a little over a decade. Mr Liveris thinks the high growth rate in demand for chemi-

cals is certain to continue. Even if growth falls from the current level of 9 per cent, double-digit growth rates in chemicals will occur in China just being here, he says. Yet investment by multinationals has been more than matched by domestic companies. The mixture of easy credit from state banks and the search for shortterm profits that characterises the Chinese economy has produced the same cycle of over-investment that the steel and autos sectors are dealing with.

Multinationals hope to prosper by bringing to bear greater scientific expertise

Jonathan Anderson, head of economics for Asia at UBS in Hong Kong, calculates that the seasonally adjusted profit margin in the chemicals sector in China has fallen from 5 per cent a year ago to close to 3 per cent. A 40 per cent drop in profit margins is a big collapse in one year. The mainlands industry association predicts that profits will fall

by 20 to 30 per cent this year. According to Kang Kai, analyst at Guotai Junan, a brokerage in Shanghai: The overcapacity is most intense in general products. Some producers further down the chain will really feel the pinch when they will not be able to pass on rising costs because of the overcapacity. Overcapacity in certain segments is not the only issue companies are having to deal with. The industry has been hit by a number of factors. The series of measures announced last year by the government to try and slow the economy down has inevitably fed through to demand for chemicals. The imposition of new quotas on textiles exports is also expected to restrain the growth in demand for synthetic fibres. However, the other big problem has been the increase in the cost of raw materials, especially oil. In a situation of growing capacity and predictions of slower economic growth, it becomes harder for companies to pass on cost increases to their customers. Analysts say the result is that products such as synthetic fibres, paint and dying materials and basic chemicals will be the most affected.

The multinationals hope to prosper in this much tougher environment by bringing to bear their greater scientific expertise. Dow Chemical is setting up its own research and development centre in Shanghai. DSM, the Dutch speciality chemicals company has also opened a Shanghai research operation. While foreign companies are still wary of the protection of intellectual property rights in China, many argue that unless they can offer Chinese customers some sort of technological edge, they will suffer from ever declining margins. Hans Wijers, chief executive of Akzo Nobel, the Dutch chemicalsto-drugs group which has just opened a new coatings plant in Suzhou, says the company can charge much higher prices for its paints because the quality is much higher than most locally made products. The surge in oil prices has also opened up other possibilities. Dow is considering entering a joint venture with Shenhua Group, Chinas largest coal group, to build a plant that will turn coal into olefins, a feedstock of the petrochemicals industry.

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DHL

INVESTING IN CHINA
EDITORIAL/COMMENT

China has further to grow to catch up with the world

the high level of losses has been the pouring of credit into the voracious maw of the state-owned enterprises. Between 1993 and 2000, more than 60 per cent of all credit to enterprises went to state enterprises. According to two economists from the International Monetary Fund, the share of private investment in total investment was only between 15 and 27 per cent between 1991 and 1997, largely because private business had little recourse to bank lending. Yet jobs created by the private sector accounted for 56 per cent of the total*. Still more remarkably, inward foreign direct investment was only about 4 per cent of GDP in the first half of the 1990s and 5 per cent in the second. Yet, according to two other IMF economists, FDI generated almost all of the efficiency gains**. The share of foreign-owned companies in gross exports is also close to 50 per cent. Their share in the gross output of industrial enterprises rose from nothing in the early 1980s to 12 per cent in 1995 and 29 per cent in 2002. Objectors to the position that China could have grown even faster may argue that a country of Chinas scale needed higher investment in infrastructure than its smaller neighbours. But this high investment is likely to bear fruit in the years to come. Some also argue that Chinas GDP is underestimated and its investment rate exaggerated. But if the investment rate is indeed lower than officially estimated, it may well go even higher in the years ahead. Furthermore, at present rates of economic growth, it would take more than a quarter of a century for China to achieve Japans current level of GDP per head. It would take more than three decades for China to achieve the same GDP per head, relative to the US, as South Korea has today. The potential for catching up remains immense. Do not assume that Chinas rapid growth is an extraordinary flash in the pan. It is neither extraordinary nor a flash in the pan. The social and political obstacles to rapid and sustained growth are large. But the catch-up opportunity remains enormous. The era of Chinas rapid catch-up growth could well be in its middle, not at its end.

MARTIN WOLF
For how long can Chinas rapid growth continue? This is an obvious, even banal, question. But asking it suggests that there is something extraordinary about the growth of the Asian colossus over the past two-and-a-half decades. Yet the only way in which China is exceptional is in its scale. Otherwise, it is merely at an early stage on the path of rapid convergence previously trodden by Japan, Taiwan and South Korea. According to data from the economic historian Angus Maddison (updated to 2004), Chinas gross domestic product per head at purchasing power parity rose by 370 per cent between 1978 and 2004, a trend rate of 6.1 per cent a year (see chart). Yet between 1950 and

1973, Japans GDP per head had increased by 460 per cent, a trend rate of 8.2 per cent. Between 1962 and 1990, South Koreas GDP per head rose by 680 per cent, a trend rate of 7.6 per cent, while Taiwans rose by 600 per cent, between 1958 and 1987, a trend rate of 7.1 per cent. Chinas growth then has been far from spectacular by the standards of its smaller Asian neighbours. Yet there are reasons to believe that China should have been able to outperform them all. First, the speed with which a country can grow is a function of how far it is behind the productivity levels of the worlds most advanced economies. This is why each generation of catch-up economies has tended to grow faster than the previous one. When Chinas surge began, its GDP per head at PPP was only one-twentieth of that of the US. Even now, after a quarter century of fast growth, Chinas output per head is about one-sixth of that of the US. Japans GDP per head was one-fifth of that of the US in 1950,

even before its unmatched surge began (see chart). Second, China possesses all the ingredients of rapid growth, as did Japan, South Korea and Taiwan before it: a hard-working and initially cheap labour force, the ability to transfer huge numbers of workers from low productivity agriculture to higher productivity manufacturing, an accommodating external environment, political stability and a developmentoriented government. Third, China apparently possesses an extraordinarily high rate of gross fixed investment, at over 40 per cent of gross domestic product (see chart). What makes Chinas high investment rate so extraordinary is that it is occurring at such a low level of GDP per head. Chinas GDP per head (at PPP) is today the same as that of South Koreas in 1982, Taiwans in 1976 and Japans in 1961. In those years, the gross fixed investment rates of South Korea and Taiwan were both below 30 per cent of GDP, while Japans was 32 per cent.

Given the opportunities it enjoyed and its investment effort, China should have grown even faster. The failure to do so is explained by the inefficiency of investment. A simple measure of investment efficiency is the incremental capital output ratio - the ratio of investment to additional output. The lower the ICOR the greater the bang for the investment buck. Chinas ICOR has now risen to a five-year moving average of five. In its period of rapid growth in the 1960s, Japans ICOR was close to three. In the 1960s and 1970s, the ICORs of South Korea and Taiwan were between two and three. Several further pieces of evidence support the view that Chinas growth pattern has been inefficient. One is the high level of bad loans in the banking system. If an economy growing at close to 10 per cent a year generates bad loans on this scale, the misallocation of capital has to be huge. The principal explanation for

* Christopher Duenwald and Jahanguir Aziz, The GrowthFinancial Development Nexus, in China: Competing in the Global Economy (International Monetary Fund); ** Wanda Tseng and Harm Zebregs, Foreign Direct Investment in China: some Lessons for Other Countries (IMF)

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COMMENT

Its absurd to jail China copycats

atively arcane branch of commercial law, is now a pillar of corporate strategy. It has become a central preoccupation of multinational companies operating in developing countries and the most prolific source of US trade grievances against Beijing since China joined the World Trade Organisation in 2001. It is easy to see why. As intangible attributes increasingly determine the value of many types of product and service, and as technology makes them easier to emulate, control of IPR has become steadily more critical to competitive advantage. The trend has created a growth industry of lawyers, consultants and lobbyists who exude near-religious fervour for the rightness of their cause. It has also spawned new laws, notably the WTO agreement on trade-related aspects of intellectual property (Trips). Rammed through by the US, it is the ultimate deterrent in the arsenal of IPR enforcement. However, there is a paradox here. Trade negotiations are supposed to open markets and the WTOs rules are meant to keep them open. Yet intellectual property rights, by definition, limit competition. Patents and copyright confer on innovators and authors exclusive rights over their work. Society tolerates such monopolies as necessary to achieve the higher purpose of encouraging creative endeavour. Arguments over exactly how to strike the balance between private profit and public good are as old as the system itself. Ultimately, perfect trade-offs are unattainable. But in the west, efforts to tilt the scales in producers favour have grown of late. Under industry pressure, the US greatly widened the scope of patenting in the 1990s, provoking ridicule in the process by accepting a flood of applications for such inventions as tennis strokes and techniques for exercising a cat. Less frivolously, but just as controversially, patenting has been extended to business methods, such as Amazon.coms one click online ordering system. Meanwhile, software publishers have lobbied, so far unsuccessfully, in the US for copyright laws so restrictive they could curtail access to scientific research previously in the public domain. The EU has stricter copyright laws than the US and is tightening enforcement. It has also dreamt up a new category of IPR: geographic indications that reserve the use of food names for the places where they were originally made. That has produced legal absurdities, such as a requirement that sliced Parma ham packed by EU supermarkets may be labelled as such only if sliced in front of customers. IPR owners also stretch the point by insisting stiff enforcement is needed to combat unsafe products by eliminating counterfeits. Not only are many dangerous products, such as defective construction materials, branded weakly - or not at all - in poor countries; they thrive primarily because of deficient health and safety regulation, not because of poor IPR protection. In any case, some widely counterfeited items, such as cigarettes, are hazardous even when genuine. But like a man with a hammer, the IPR lobby often seems only to see nails - and is prolific at finding new ones. Trips is one of the biggest hammers around. But it has proved very difficult to use. When big pharmaceuticals companies aimed it at South Africa, a supplier of cheap generic drugs to poor nations, a public outcry forced them to back down. Nobody wants to risk a similar public relations disaster. The US hoped Trips would discipline China and insisted Beijing comply fully with its terms when it joined the WTO. Yet, in spite of much finger-pointing over Chinas IPR violations, Washington has so far not shied away from challenged them in the WTO. That may be because it wants to avoid straining bilateral trade relations further. But industry lobbies are also cool on the idea, fearing China would take revenge on their operations there. One executive of a large US information technology company likens wielding Trips to pressing the nuclear button. While that remains the case, US protests are likely to remain bluster, eliciting only token responses from Beijing. Furthermore, China knows market forces are operating in its favour. In spite of western strictures about IPR violations deterring foreign direct investment, it attracts more of it than any other country. That puts the onus on foreign companies to devise their own solutions. As the latest McKinsey Quarterly points out, some are already doing so. One leading high-technology company safeguards its most valuable IPR by denying Chinese workers access to the source codes for its products. Others screen local staff rigorously and use a variety of incentives to secure their loyalty. It all costs time and money, of course. But anyone who thinks China is an easy market is probably in the wrong business. And it may be no bad thing if multinational companies are forced to think of new ways to defend their interests, instead of just pushing to expand ever wider the frontiers of IPR and relying on lawyers, legislators and trade negotiators to police them.

GUY DE JONQUIERES
It is becoming a time-honoured ritual. US trade officials descend in Beijing to thump the table over Chinas persistent violations of intellectual property rights. Their hosts declare themselves shocked, positively shocked, and promise to do better. The Americans depart, demanding evidence of real progress soon, or else. That happened in July, as it has done regularly for more than a decade. On past form, Beijing will round up some of the usual suspects and stage a few show trials. Life will then go on much as before, until the Americans start kicking up again. US pressure has achieved little because it is pushing on a string. China has reams of legislation protecting IPR. But as well as being plagued by corruption, it lacks a tradition of private property rights, effective rule of law, research-intensive industries and strong brands. It has neither the means nor the incentives to enforce its rules rigorously. No wonder Americans feel frustrated. IPR protection, once a rel-

The writer is the FTs Asia columnist and commentator

JOE STUDWELL

Chinas boom has led to only partial change

As Chinas economy shows signs of a modest slowdown from annual growth officially reported at more than 9 per cent in 2003 and 2004 - but which physical indicators suggest probably exceeded 10 per cent - it is time to ask whether this latest China boom has been qualitatively different from previous ones. Those who believe China is continuing its march away from a state-driven economy cite hard evidence. The efficiencies of the export economy are a given. China will ship about $750bn of goods in 2005 (though much less on a value-added basis, as so many components are imported) and there is no structural reason why this headline figure cannot continue growing at 15 to 20 per cent a year. Imports, meanwhile, increased between 2000 and 2004 by almost four times as much as in the entire 1990s, an increment of $395bn versus $107bn. In recent years, Chinese imports have fuelled a global commodities bonanza and set world prices for everything from steel to palm oil. Then there is the rapid expansion of private enterprise. A recent survey suggests that, for the first time since 1949, most registered companies in China are privately owned. On average, the businesses are tiny with mean registered capital of Dollars 145,000 and 14 employees. Fewer than 1,200 private companies have registered capital of more than $12m. Nonetheless, the growth of private enterprise is heartening. The case for changing China is considerable, but cannot be separated from the financial story of a state that exercises a vice-like grip on banks, stock markets and bond issuance. Unfortunately, the most extreme statistical series in this latest period is not about trade or ownership but loans outstanding in the financial system. In just three years from 2002 to 2004, loans increased by 58 per cent, or $785bn. In 2003, new lending equalled almost one quarter of gross domestic product. This latest boom was driven by a credit binge. It was not supposed to happen. Responding to the massive nonperforming loans accumulated by Chinese banks in the 1990s, the government ordered they reduce their NPL ratios - bad loans as a proportion of total loans. The move was universally applauded. With hindsight, however, the focus on NPL ratios was a terrible mistake. That is because Chinas banks are technically insolvent but enjoy high liquidity. To cut NPL ratios, they merely increased the denominator of the ratios: their loans. Lending rose rapidly, driving growth as a side-effect as NPL ratios fell from 28 per cent in 2002 to 13.2 per cent at the end of 2004. Assisting the process were transfers of old NPLs, made before the recent credit drive, to newly-minted asset management companies. The largest banks shifted an initial $169bn worth in 1999-2000 and another $50bn last year. Critically, provisioning for NPLs from the past five years has been almost zero. The result is voodoo accounting. If, for example, one restores the $50bn transferred to AMCs in 2004, aggregate NPLs in the system went up, not down. A falling NPL ratio was purely a function of loan growth and the refusal to provision since 2000. Yet even the most prudentially savvy bank could not expand its new loan book by 50 per cent a year, as seen in China in 2002-2003, without incurring bad debts. As an indicator, a 10 per cent non-performance rate on new loans by the 16 biggest banks in 2002-2004 bounces the NPL ratio back up to 20 per cent. There is reason to expect worse. Last October, the China Banking Regulatory Commission conceded that the default rate on $22bn of car loans extended since 2002 already exceeded 50 per cent. The AMCs have become dumping grounds not just for commercial bank NPLs but also for the assets of failed investment conglomerates, securities businesses and government infrastructure projects. The state makes the AMCs issue interest-bearing bonds for which it refuses to accept explicit liability. Separately, Beijing has raided tens of billions of dollars of foreign exchange reserves to shore up banks capital. The endgame in these financial shenanigans is supposed to be the international listing of cleaned up state banks, something that has been promised to the markets since 2002 but never quite happens. The chairman of the first institution to be listed, China Construction Bank, is currently detained on corruption charges. A new paradigm? The big picture in 2005 is that Chinas economy has been incrementally, but not fundamentally, altered by this latest cycle. In China it is, in sum, business as usual.

The writer is editor-in-chief of the China Economic Quarterly and author of The China Dream (Profile Books/ Grove Press)

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INVESTING IN CHINA
INTELLECTUAL PROPERTY

Patent protection takes centre stage

Alexandra Harney and Andrew Yeh examine what measures foreign companies can take against counterfeiters
They all stem from a basic concept: assume the worst. People need to be aware that they are operating in a hostile environment, says Chris Bailey, senior consultant at Rouse & Co International, an IPR consultancy. Its difficult to expect the unexpected, but they need to do that. Expecting the unexpected means scrutinising every person the company does business with, from employees to distributors to suppliers. Some companies go to great lengths to screen potential staff, even restricting their hiring to candidates who have previous experience at a non-Chinese company. Suppliers and distributors need to be similarly vetted, consultants say, as they are often the people who are manufacturing or distributing counterfeit goods alongside the originals. Due diligence on suppliers is essential. Some companies prefer to avoid Chinese companies entirely and insist on doing business only with other multinationals. Others opt to work with suppliers that are established outside China. Other foreign companies can also be valuable sources of information on the types of IPR risks they have confronted. You dont have to reinvent the wheel, so learn from other peoples mistakes and leverage them, says Sarena Lin, associate principal in the Taipei office of McKinsey, the consultancy. Contracts are also a simple way to guard against risk. Employee contracts should include non-compete clauses, to prevent staff from fleeing into the arms of a competitor, and spell out the consequences of sharing intellectual property, consultants and lawyers say. Mr Bailey suggests that foreign investors think of contracts as a relationship manual rather than simple documentation. He and others recommend making presentations to staff and suppliers to drive home the meaning of the contract. Security measures are less frequently implemented by smaller groups. These include checking employees bags before they leave the building, and installing surveillance cameras in research and development units and even manufacturing areas. Ms Lin says that one foreign software company she visited has installed computers without hard drives for its employees to use, so that all information must be downloaded on to a central server rather than stored on the employees computer. These computers also lack USB terminals to prevent employees from copying sensitive information to memory devices. Other companies still prefer to keep their most important technology out of China. Consultants agree that the better the product, the higher its margins, the more likely it is to be copied. Gordon Gao, an attorney with Paul, Hastings, Janofsky and Walker in Beijing, says companies must put in place procedures that systematically protect intellectual property, including basic security measures and prohibiting too many people from seeing important documents. The law requires a company to try to keep trade secrets, he says. If you havent taken any procedures, how can you prove its secret? To win in court, companies need to register trademarks and patents, not only in China but around the world. Chinese companies are increasingly looking abroad for products to copy, consultants and executives say. Mr Ricci is following their advice. He has hired a lawyer and patents his sofas around the world. When he hears about a copy, his lawyer fires off a letter to the company to say the model is already patented. He has already won one court case against a counterfeiter.

uca Ricci is no stranger to counterfeiting. The Italian president of DeCoro has been making sofas in China since 1997, and has seen them being copied for almost as long. Imitations of DeCoro sofas appear on the market within months of the originals leaving Mr Riccis factory in Shenzhen, just across the border from Hong Kong. Chinese competitors take photos from DeCoros website and paste them on to their own. I think we are the most copied company in the world, sighs Mr Ricci. Despite international pressure and efforts by Beijing to improve the countrys law enforcement, protecting intellectual property rights (IPR) is still a serious headache for many multinational companies in China. The Quality Brands Protection Committee, an industry association representing 111 foreign firms with interests in China, says 78 per cent of its members agree that the problem of fake exports has worsened since 2003. Even with more people aware of the problem, lawyers, consultants and executives say there are several simple measures many companies fail to take that can lessen their IPR-related risks in China.

Label queens: women in Hong Kong flock round a street traderselling counterfeit bags

AFP

Law gives power to protect ideas

Companies should use pre-litigation rules to stop infringers profiting from their innovations
But pre-litigation relief is under-utilised in China. IP owners should become more aware of this option as a way to exert pressure on those who infringe their IP rights. Applicants are usually required to provide a bond. Initially, most courts in China required the bond to be in the form of a payment to the court. This was often unappealing to IP owners, as it meant a substantial amount of their money would be tied up for a significant period of time. Recently, however, more courts have been prepared to accept a bank guarantee. In cases where the IP owner has assets in China, a letter of undertaking may also be acceptable. The court has to be satisfied that the bond will be sufficient to cover damages that may be caused to an alleged infringer if an injunction turns out to have been wrongfully obtained. Some courts have experience in pre-litigation relief and are relatively well equipped to assess the risk involved and order a reasonable bond amount. More inexperienced courts may require amounts that are unreasonable or disproportionate to the potential harm that may be caused to the respondent. In such cases, the applicants legal representatives should provide information for the court to make a proper risk assessment. There is no detailed law to govern the application procedure, and the threshold for the fundamental requirement of full and frank disclosure is not clear cut. But Chinese courts still require the applicant to provide sufficient evidence for a prima facie case against the defendant. The applicant must also be able to show that damages would not be a sufficient remedy if the infringing act is not stopped immediately. In practice, most courts are unable to meet the 48-hour deadline set out in the patent law for a decision on a pre-litigation relief application. In our experience, however, if the applicant can produce all the evidence and the bond promptly, the court will usually make an order within a few business days. Once relief is granted, IP owners must file legal proceedings within 15 days. Otherwise, the pre-litigation order will lapse. What should an IP owner do if the respondent refuses to comply with an injunction? Under Chinese law, the court has the power to issue penalties. In practice, however, obtaining effective enforcement may not always be straightforward, given the courts limited resources. However, as the courts become more familiar with the process, pre-litigation relief will become an increasingly effective tool to stop IP infringements.

AUDREY SHUM LEGAL VIEW

Intellectual property litigation has increased in China since the introduction of a new patent law in early 2000. One reason may be the availability of pre-litigation relief, under which a claimant can apply to the courts for an injunction that would force a temporary halt to the alleged infringement or at least preserve evidence.

The writer is an associate with Clifford Chances Litigation and Dispute Resolution practice in Hong Kong

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IPR protection dogged by the grey market

Piracy is hard to tackle when it involves a supplier or business partner, writes Florian Gimbel
oreign companies seeking to stamp out copyright violations in their Chinese operations should steer clear of the countrys court system, according to a report by KPMG, the professional services firm. It says multinational companies are finding it increasingly difficult to deal with Chinese suppliers and business partners that are selling discounted legitimate products into Chinas burgeoning grey market. While many international companies have launched high-profile anti-piracy campaigns against unrelated Chinese companies, they remain wary of confronting dishonest business partners. Its like a disease, says Mark Bowra, a Shanghai-based partner at KPMGs forensic practice. No one wants to admit that he has got an internal problem. The latest research, conducted by the Economist Corporate Network on behalf of KPMG, sug-

gests that foreign companies are facing a potential backlash from business partners, consumers and officials if they take a hard-line approach to contractual violations. A pure stick approach doesnt and will not work and it

will take years for China to improve its legal enforcement of intellectual property rights, says Connie Bolland, the reports author. Few companies take into account hidden costs such as

overruns from illegal excess production of official suppliers. Ms Bolland believes some regard the unauthorised sale of their products as a form of marketing cost. A small amount of grey market activity may in fact lead to extra

sales, she says. Unofficial distribution may reach consumers in locations that official channels fail to cover. Yet how can companies avoid unacceptable levels of grey market activity? KPMG advises clients to beef up their intellectual property rights units, keep close taps on inventory and conduct friendly audits - well-trailed inspections that give suppliers time to sort out egregious irregularities. Mr Bowra points to an international software company that recently realised a distributor was using a forged government contract to sell products cheaply into the grey market. The company had to cut out the dishonest guys, because the honest distributors were losing money and market share, he says. Once manufacturers are seen to have a weak anti-piracy policy, they might find it increasingly hard to persuade distributors to sell their brands.

Nintendo tackles the pirates

Illegal copying is no longer the computer games groups biggest challenge, says Michiyo Nakamoto
hen Nintendo unveiled plans to enter the Chinese market more than a year ago, it seemed to have a clever plan for preventing piracy of its games software. Instead of taking its popular games consoles directly to the Chinese market, it developed a new machine, the iQue player, which uses a memory card to store games that are downloaded directly at the retailer. Users can download only one game at a time and must erase that game in order to buy a new one on the same memory card. After buying a game, users get subsequent downloads of that game for free. Nintendo also decided that the best way to combat piracy was to nurture the Chinese video games market through a local company that consumers would accept as one of their own. The idea was that local brands and content were less likely to be pirated. Nintendo also thought the Chinese authorities would be more proactive in protecting the intellectual property of local, rather than foreign, companies. In 1993, Nintendo launched its new company, named iQue (China), as a 50:50 joint venture with Wei Yen, a Chinese entrepreneur and former executive vicepresident of Silicon Graphics, the US computer maker. Nintendo has since remained coy about its China strategy. While its 1994 annual report lists iQue (China) as an affiliated company with equity method applied, any reference or link to the joint venture is conspicuously absent from Nintendos website. The website lists Nintendo Company as a distributor of its products in China. Financial Times that Nintendo was taking a long-term view of the Chinese market. Piracy is not a problem, but whether or not sales are growing is a different issue, he added. iQue (China) declined to comment. Akinari Nakamura, an assistant professor at Ritsumeikan University, believes Nintendos Chinese business faces two issues the need to upgrade its games and stiff competition from free and pirated online games. There are many games that are free, so getting people to buy games is going to be difficult, says Mr Nakamura, who has written a book about the Chinese games market. Chinese consumers are able to download very advanced games, whereas the iQue console only plays games that were developed for Nintendo 64, a machine that is one generation old. He also points to the visual quality and popularity of iQue games, which he believes do not match that of Sonys PlayStation 2. Committed players buy a PlayStation 2 console and use pirated games for very little money, he says. It normally takes only one or two weeks for the latest games launched in the US to be pirated and distributed in China. Nintendos Chinese business may have found a solution to its piracy problem, but a new marketing strategy has yet to emerge.

Chinas copycats ruffle more feathers

From lighters to Peking duck, nothing is safe, finds Andrew Yeh

Piracy is not a problem, but whether or not sales are growing is a different issue
Some industry experts believe Nintendo has been hit by weak sales of the iQue player. At the end of last year, Satoru Iwata, Nintendo president, said the Chinese business was not yet profitable. In many ways there is a need for a different approach to marketing. So, we are now rebuilding our marketing approach in China, he added. One Nintendo executive told the

hen it comes to Chinese copycats, it is always best to expect the unexpected. While the counterfeiting problem is particularly acute in southern provinces such as Guangdong, it can pop up just about anywhere. Moreover, counterfeiters have built decentralised production and distribution networks, creating headaches for foreign executives. The concern about piracy increases as western companies ramp up their commitment to China, says David Michael, vice-president of the Boston Consulting Group in Beijing. The number of companies that have fallen victim to Chinas copycats continues to grow. For example, local companies in the inland province of Hunan have become adept at duplicating

industrial pumps by Ohio based Gorman-Rupp and adhesive materials by ABRO Industries, an Indiana-based gluemaker. Meanwhile, Zippo Manufacturing, the American lighter company, has seen its trademark violated by counterfeiters in the coastal province of Zhejiang, a hotbed of copycats. Imitations of other iconic US brands such as Duracell batteries and Viagra are readily available, as are the pirated versions of Hollywood films and Microsoft software. Yet Chinese brands are not immune, either, to counterfeiting. Recently Quanjude, a restaurant famous for its Peking duck, noticed that a Shandongbased company was selling prepackaged cooked chickens under the name of Tongjude just outside one of its main restaurants in Beijing.

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INVESTING IN CHINA

Beijing steps up the fight

The real challenge is tackling counterfeiting at the local level, writes Andrew Yeh

ilheney razors. N-Mart Super Center. Future Cola. Starsbuck. If these Chinese brands sound familiar, it is because their names echo some of the best-known US brands: Gillette, Coca-Cola, Starbucks and Wal-Mart. Just as China has become a leading producer of everything from shirts to semiconductors, it has also become the worlds most adept imitator of foreign brands and business concepts. Local brands such as Future Cola, Gilheney razors and Starsbuck are operating in a grey area, where the distinction between legitimate me-too products and illegal copying remains unclear - although some companies such as General Motors of the US have moved to seek clarification in Chinese courts. America, the European Union and Japan have all criticised Chinas approach to intellectual property rights and Beijing has promised harsher penalties for counterfeiters. But just as legitimate businesses adapt to changing markets and regulations, Chinas copycats are becoming increasingly adept at eluding the authorities. And it is a lucrative enterprise for them: counterfeit products worth

between $19bn and $24bn are produced every year, according to an estimate by the State Councils Development Research Centre, a government research body. As a result, foreign direct investors are increasingly wary of sharing their expertise with local partners. They can copy anything, says Horace Lam, a Beijing-based attorney at Lovells, the US law firm. It takes them some time, but they are getting smarter and smarter. Chinas copycats use a combination of strategies to outwit the authorities, including employing several layers of middle-men, producing parts in separate factories, churning out products at night and shipping fakes in limited batches. Furthermore, says Mr Lam, counterfeiters often benefit from the protection of local officials. They can add an extra level of security by establishing themselves offshore, like organised crime networks. Joseph Simone at US law firm Baker & McKenzie adds that enforcement measures such as fines, raids and seizures have not been much of a deterrent. Boston Consulting Group, a management consultancy, says the complex web of government departments charged with enforcing anti-piracy laws has helped to

undermine the drive against counterfeiting. While some departments have a relatively clear remit, others have potential conflicts of interest. Industry experts point to the State Administration for Industry and Commerce, whose regional offices provide business licences and also police trademark violations. Some bureaux are both understaffed and notoriously leaky. Beijing insists it is seeking ways of tackling the problem. Last year, only a tiny fraction of the 10,000 or so intellectual property cases were brought under criminal law. But counterfeiters now face tougher criminal sanctions, including prison sentences. The fact that the government has made such progress is remarkable, says Li Mingde, a professor at the Chinese Academy of Social Sciences. The lack of adequate legal training among many Chinese judges is a weakness. Nor are there sufficiently strong laws on trade secrets, making it harder to prevent the theft of patents, trademarks and copyrights, according to BCG. Mr Li believes the problem partly reflects the evolving nature of Chinas economy and development policy. At this stage of its development - which he compares to that

of the US in the 1950s and 1960s China relies on labour rather than innovation, which creates a climate in which copycats can thrive. Yet while they can see the threats to their business, many foreign companies have been slow to protect their technology against counterfeiting. If you dont defend yourself, people will hijack your rights, says Mr Lam. When we look at the product portfolio of some foreign (businesses), we see the gaps. If you dont spend money now, you will spend it later. US industry and trade officials have been among the most vocal critics of Chinas policy on intellectual property, with complaints focusing on luxury goods, software, entertainment and industrial products. US officials have made two demands: step up the raids on local manufacturers and put more offenders behind bars. Yet some industry experts believe US officials are getting little help from the companies they represent. US and EU companies have been doing a pathetic job in providing quantifiable information to their respective governments, says one China-based lawyer. Companies should not be complaining if they are not providing data. Counterfeiting is a problem all

over the world, not just in China. But in the US and Europe, customs departments estimate that China accounts for the bulk of counterfeit goods seized at their borders. Last year, US customs saw a 47 per cent rise in the total value of seized counterfeit goods from China. Wu Yi, Chinas leading official dealing with intellectual property rights, has repeatedly told his US counterparts that results will take time. However, there are signs of increasing international co-operation. The dismantling last year of a DVD-exporting ring based in China would not have been possible without the Chinese police and the US Department of Homeland Security working together. This led to the seizure of some 210,000 DVDs and the destruction of several warehouses. It will take years, though, for the central government to find ways of enforcing its attempts to crack the problem at local level. One answer would be for foreign companies to take legal action in China. The outcome would be uncertain, but it would give them some control over the process. If Starbucks wants to end any confusion with Starsbuck, it may have to act itself.

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TRADEMARKS

Nissans drive to protect its identity

The carmaker has been granted well-known trademark status - but other companies are not so fortunate, says Michiyo Nakamoto

our years ago, Nissan was surprised to find that an electronics company in China had applied to use the Japanese automakers trademark. Within days, Nissan filed its opposition to the Chinese companys move, arguing that since the Nissan name was well known, it should not be used by any other company even if it made optical devices, rather than cars. Last month, after a wait of more than four years, Nissan became the first Japanese carmaker to receive well-known trademark status in China, a designation that makes it illegal to use the Nissan name on any category of goods or services. The carmaker hopes that this success will help reduce the number of infringements it has to deal with. At the very least, it will make it easier for Nissan to take legal action against companies that use its logo, by reducing the amount of paperwork needed. In the past, when it discovered that its name had been used illegally, Nissan had to collect substantial evidence to prove its case. With its recently won well-known trademark, this process can be now eliminated. Nissan, like many foreign manufacturers in China, has had to combat illegal use of its name on a wide range of products. In particular, it has been faced with continuing cases of companies using its name on spare parts, such as oil filters and brake parts, according to Mia Nielsen, manager of Nissans

Communications Department in Tokyo. So far, 21 foreign brands, including McDonalds, Jaguar, Boss and Yves St Laurent, have received well-known trademark recognition in China. But there appears to be a bias towards Chinese brands, says one Japanese official. This year, only four foreign brands were designated well-known trademarks. YKK, which is the only other Japanese company to have been recognised in this way in China, said it does not expect counterfeit-

ing to disappear as a result of the added protection. The zipper maker has consistently had two to three ongoing lawsuits in China since the 1980s. But with lawsuits taking two to three years, we hope the process can be speeded up with this recognition, a YKK official says. Carmaker Honda, which has trademark protection in China for its logo and specific brands but not well-known trademark status, says it has launched 37 lawsuits since 1997, while there were more than

1,000 cases of trademark infringements that did not go to court but on which Chinese regulators have taken action. Toyota found out the hard way how vulnerable a company can be in China without a well-known trademark. In a closely watched case in 2003, a Beijing court threw out a lawsuit Toyota had brought against a Chinese competitor, Geely, alleging that Chinas largest private automaker had stolen its logo for use on its Meiri sedan and had

Lap of luxury: Nissans new 350Z should receive special protection in China after being awarded well-known trademark status

Reuters

used the Toyota name to promote its product. In the first case in China involving automotive intellectual property rights, the Beijing court said it did not recognise the Toyota brand as a distinctive brand in China that required protection. Both Toyota and Honda have applied for well-known trademark status, which has been open to foreign companies since a 2003 revision of the Chinese commercial code. However, it can take years to receive well-known trademark status, as the Nissan case indicates, and companies that already have an ordinary trademark may find it difficult to win the added protection. Honda has many trademarks in China and as a result, it might be difficult to win well-known trademark status since the idea behind this system seems to be to try to protect companies that are not already protected, a Honda official says. Companies need to be extremely vigilant to discover cases of infringement. Nissan looks out for trademark infringement practically on a daily basis. But it took the carmaker a year to find out that the Chinese electronics company had applied to use the Nissan name. Furthermore, since a wellknown trademark does not protect against design infringement, which is also a serious problem in China, we need to strengthen patent protection as well, says a Nissan official.

How to play the name game

Investors must choose company names with care, write Lester Ross and Grace Chen
impact in common Chinese dialects should also be taken into account. To ascertain that a selected name is not already in use, a company normally conducts searches with both the Trademark Office (TMO) and the local Administration for Industry and Commerce (AIC) in relevant jurisdictions. However, as more foreign companies set up subsidiaries in China, the potential for name duplication is much greater. Foreign investors typically enter the China market through a representative office, which is not a Chinese legal entity. Consequently, the authorities are not called on to verify that no other company name conflicts with the representative offices Chinese or foreign language name. Problems arise when the foreign company creates a formal subsidiary in China and cannot use its Chinese name because an identical or similar name has already been registered by another company in a related industry. Some local AICs are particularly strict in judging what constitutes similarity, even refusing to accept a name that shares two characters or homonymous characters with a previously registered name. The lack of co-ordination among the TMO and the local AICs presents a trap for the unwary foreign investor. Even companies with recognised Chinese names in Hong Kong, Macao, Taiwan or elsewhere may not be permitted to use them in China. To minimise such risks, foreign investors should register the Chinese- language name as a trademark covering all relevant goods and services, which will help support any trademark infringement claims that may be filed against future registrants using identical or similar company names in closely related industries. However, the mere existence of trademark registrations will not bar other companies from registering under identical or similar names. Even if there are no immediate plans to establish a subsidiary, a foreign investor should nonetheless consider establishing a small company to preserve its right to the company name. The company should ideally be registered in its preferred location, but registration in another location is also acceptable, as a branch may be established in the preferred location at a later date. These precautionary measures, while not foolproof, can help safeguard a foreign investors right to identify itself and its products with the desired Chinese name and thereby enhance the value of its brand.

LEGAL VIEW
Selecting the right company name in China is of paramount importance. The name not only identifies the company, but also brands its products or services in the domestic market. Much thought is given to choosing the appropriate Chinese characters, which should be visually appealing in both simplified and classical forms. The names auditory

Lester Ross is a managing partner and Grace Chen an associate at Wilmer Cutler Pickering Hale and Dorr in Beijing

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INVESTING IN CHINA
LEGAL HURDLES

Tussles can mean courting disaster

Furniture-maker Simon Lichtenberg is finding the system outside main cities can seem unfair to foreigners. Geoff Dyer reports
he first time Simon Lichtenberg realised he was in trouble was the March afternoon when Liu Xiaoming, chief judge of a court from Leshan in Sichuan province, arrived at his door, having travelled the 2,300 miles to Shanghai with two police officers to deliver personally a court order freezing part of Mr Lichtenbergs companys bank account and a section of its factory. Five months later, Mr Lichtenbergs furniture company is on the losing end of a lawsuit from a Sichuan leather supplier that his lawyer calls a classic case of legal protectionism, and Mr Lichtenberg says is a warning about doing business in the lessdeveloped parts of China. Following heavy investment in China over the past decade, foreign companies have moved inland from the booming coastal areas, both to sell products and source materials. In the process, legal disputes over commercial deals have been commonplace, although most are settled through some form of negotiation and do not often become public. The case involving Trayton Furniture and the Sichuan leather supplier is a rare glimpse of how such legal disputes can function and leave foreign investors feeling that local political and business interests have colluded against them. Any company with powerful political connections in a small town is dangerous, says Mr Lichtenberg. Born in Denmark, Mr Lichtenberg has been doing business in China for more than 10 years, starting as a timber trader. In 1997, he began manufacturing leather sofas for export to retailers such as Bo Concept and Ikea. The business required little up-front investment or marketing and the production costs were one-third of those in Scandinavia. The company now has 1,200 employees and profits of about Rmb20m ($2.5m). One big challenge has been getting hold of the leather. Until recently, there were few suppliers and the quality was often indifferent. That is how Trayton came into contact with Zhenjing Leather Factory, a company based in Leshan, a small city 100 miles from the Sichuan provincial capital, Chengdu. Zhenjing is part of a group of businesses, including chemicals and coal, owned by He Zhenggang. Mr Lichtenberg says he was a little wary of Zhenjing - it was in a faraway city and had a powerful position in the local economy. However, Zhenjing was then one of the largest leather companies in China and had been awarded a loan by the International Finance Corporation, an arm of the World Bank. his factory with a court order for non-payment of goods. The ruling called for Rmb3m of cash in Traytons bank account and Rmb4.2m of assets at the factory to be frozen - together more than double the value of the disputed leather. According to Edward Epstein, one of Traytons lawyers at Salans in Shanghai, the court order should be invalid for a number of reasons. For a start, the original contract said that disputes over quality would be held in Shanghai. Moreover, there was no need to freeze any assets as Trayton could comfortably pay the Rmb3m if it lost the case. However, the lawsuit was not issued on behalf of Zhenjing, but by one of its branch companies, Xinhua. To sustain this argument, the Sichuan company produced faxes of four sales invoices for leather goods issued by Xinhua, which it claimed overrode the original contract signed by Trayton and Zhenjing. The court agreed. Mr Lius judgment ruled that the faxes counted as a contract and ignored the quality report about the leather. By starting legal proceedings in the Wutongqiao district court, Mr He ensured the entire legal case stayed close to home. Defendants in China get just one appeal and that can only be heard at the next level of the judicial system - in this case the inter-

Such legal disputes can leave foreign investors feeling that local political and business interests have colluded against them
Over the course of 2004, Trayton bought Rmb37m worth of leather from Zhenjing. However, it complained about the quality of Rmb3m of the goods, where the top-coating had started to peel off. After an independent testing company confirmed quality problems, Trayton says it decided to withhold payment and return the leather. Mr Lichtenberg did not hear back from Zhenjing until Mr Liu, chief judge of the Wutongqiao district court in Leshan, arrived at

mediate court in Leshan. Trayton alleges a further legal sleight of hand. In theory, the district court is not allowed to hear cases worth more than Rmb1m. However, Mr Liu says that the same intermediate court in Leshan gave him special permission to hear the case. According to Mr Epstein: The Wutongqiao court unlawfully obtained jurisdiction to hear a dispute about a contract that does not exist. Wang Liping, lawyer for the Sichuan company, says that Traytons arguments miss the point. The faxes show that Trayton did have a business relationship with Xinhua. Moreover, she adds: If they deem the product to be of poor quality, they may sue Zhenjing Leather in Shanghai. But here we are talking about an issue of payment default. Mr He has refused to be interviewed. However, Deng Chongjing, who runs the Shanghai office of Zhenjing, says: Every other client except Trayton has to pay before we deliver goods. They could not finish using the leather so they want to get a refund. He adds: If they found our leather products of poor quality, why not solve it through legal means? The appeal is due to be heard in the Leshan court soon, but Mr Lichtenberg believes there is no chance of success. He says he has written to the party secretary in Sichuan but received no reply. The legal system in Shanghai is more or less regulated, but Sichuan is way behind eastern China, he says.

Disputes hinder partnerships

By Florian Gimbel in Hong Kong

Imitation goods seized in Beijing show the scale of intellectual property theft

AP

oreign companies trying to resolve business disputes in China are largely avoiding the local courts and official arbitration systems, reflecting concerns about favouritism towards local rivals, according to a US report. The survey - based on a poll of 112 executives from the US, the UK and Japan - suggests foreign investors are largely dissatisfied with the business climate in the mainland, following its accession to the World Trade Organisation three years ago. The report, produced by the Center for International Business at the Tuck School of Business at Dartmouth in the US, found fewer than one-third of the respondents believed the Chinese central government was doing a good job in meeting its WTO obligations. Just 18 per cent believed the provincial

and local governments were doing a good job meeting their WTO commitments. Joseph Massey, director of the CIB, said: The survey shows that multinational firms give the Chinese central government generally passing grades. But the actual implementation of those [WTO] obligations stillneeds to be improved. Chinas record on intellectual property rights protection topped the list of investors concerns. Some 62 per cent of the respondents gave low marks to Chinas IPR enforcement at the provincial and local levels, while more than half were dissatisfied with enforcement at the national level. Prof Massey said there was a perceived lack of an open and transparent regulatory regime and judicial processes that ensure impartial resolution of business disputes. Of the respondents that had a business dispute with a Chinese company, more than 90 per cent

described their attempts to resolve the issues as a serious or very serious problem. While respondents said they had taken multiple actions to try to settle the dispute, most of them said they would avoid local courts and official Chinese arbitration systems. The report said favouritism toward local business interests was felt to be a significant problem in the local Chinese court system. One-quarter of respondents companies had a business dispute with a Chinese company. More than half of those had disputes over nonpayments or discounting of payments specified in original contractual agreements. As Chinas exports grow, frictions with [overseas] trading partners are intensifying, said Prof Massey. China needs to take prompt and substantial steps to address these concerns of foreign business to bring the business environment in line with its obligations under the WTO.

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LOBBYING VIEWPOINT

ver the past year, the chorus of concern over Chinese protectionism has grown increasingly loud. Robert Zoellick, US deputy secretary of state, is the latest to raise his voice, warning that Beijing could no longer adopt mercantilist trade policies without incurring retaliation from its trading partners. An assumption behind Mr Zoellick's threat is the notion that Chinese companies and government agencies uniformly favour protectionism and that western businesses are dependent on intervention by their own governments to thwart such efforts. The fact is, however, that a growing segment of Chinese industry prefers open markets; and foreign investors have become direct participants in seeking to influence China's national economic policies. The result is pro-liberal coalitions of Chinese and foreign companies, which regularly beat back protectionist Chinese policies without officials such as Mr Zoellick having to chime in. As China has moved from a planned economy to a market one, the government has adopted hundreds of thousands of regulations on every aspect of a company's business life cycle, from registering and raising capital, to distributing profits and paying taxes. Chinese companies no longer passively wait for laws to be issued before deciding whether to obey or violate them. Interviews with hundreds of Chinese and foreign executives and officials instead reveal that lobbying the national government has become as common as water flowing down the Yangtze in the summer. There are about 350 Chinese national industry associations but because many suffer from official manipulation, companies primarily lobby their regulators directly. National policies on taxes, trade, standards, intellectual property, the environment, finance and pricing all bear the fingerprints of Chinese companies lobbying for change. Foreign companies have also become politically active in China. Large multinationals are in constant communication with multiple national agencies. Beijing and Shanghai are home to hundreds of foreign-based chambers of commerce and trade associations. Foreign public affairs and public relations groups, such as APCO and Ogilvy, are also busy in China. To increase the effectiveness of their campaigns, foreign companies often hire former Chinese government and Communist party officials to help lobby their former colleagues. With government downsizing, the revolving door has been spinning at light speed.

Barbarians lobbying to open the gate

While China is often portrayed as a bastion of protectionism, the reality for foreign groups is different, writes Scott Kennedy
Lobbying on national policy issues is not as vulnerable to corruption and influence-peddling as ties between local government and business. Bribes and friends can help a company get a permit or licence, but national policies pass through more gates and are more technically complicated, pushing businesses to make a case more on its merits than on who they know. Not only are Chinese and foreign companies both pressing Beijing on policy after policy, they often find themselves on the same side on specific issues. Why? The answer is simple: globalisation. Since reforms began in 1979, foreign companies have invested $600bn in China, $38bn alone in the first eight months of this year. There are more than 250,000 foreign companies operating in China, often in joint ventures. Global businesses and their Chinese counterparts have become intertwined in tightly integrated networks as financiers, suppliers, producers and distributors. When foreign companies are hurt by protectionism, so too are their Chinese partners. As a result, the phrase, "use foreign barbarians to counter [other] foreign barbarians", made famous during the Qing dynasty, has been turned on its head. Now the barbarians are using their ties with their Chinese allies

to halt such policies. Take fair trade policy, for example. China is the most common target of anti-dumping investigations, but China has also become the third most active initiator of cases against foreign companies, for supposedly dumping their goods in China. However, foreign groups have walked away with partial or complete victories in more than 45 per cent of the cases adjudicated by China's ministry of commerce because their Chinese customers regularly speak up on their behalf. Typical was a stainless steel case involving South Korean and Japanese companies. Some of China's largest home appliance and carmakers successfully lobbied against fully instituting punitive tariffs sought by domestic steel producers, arguing that they required the higher quality foreign steel to remain competitive. Foreigners have also been in a frenzy over Chinese efforts to set unique technical standards in information technology. The government has vigorously promoted a third-generation cellular phone standard (TD-SCDMA), but foreign companies and Chinese enterprises that see greater promise in foreign options (CDMA2000 and WCDMA) have persuaded Beijing to allow those technologies to compete in China once Beijing issues operating licences. Standards-making bodies in China increasingly have foreign participants, meaning that when Chinese groups eventually do succeed in setting standards, foreign companies will benefit as well. Foreign observers may also be overly concerned about discriminatory policies related to government procurement. A six-year campaign to push government agencies to purchase domestic software whenever feasible has made little headway. Microsoft and other global software giants have vigorously lobbied against such measures and they have been joined by various local governments and domestic software companies that make applications based on Windows platforms. Last year the Beijing municipal government cancelled a planned purchase of Microsoft software and bought domestic alternatives. But then, early this year, it bought the Microsoft software it needed. Although the Chinese regime is still authoritarian and supports domestic industry, the business of lobbying is alive and well, to the benefit of Chinese and foreigners alike. Let us hope that the liberal lobby is as strong in the US and Europe as it is in China.

Connected: lobbying by foreign and domestic enterprises has opened doors for foreign third-generation cellphone standards

Getty Images

The writer is an assistant professor of Chinese politics at Indiana University, and author of The Business of Lobbying in China, Harvard University Press

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DISTRIBUTION

Franchising grips China

As the country sets up a framework for foreign franchises, Geoff Dyer looks at how the concept fills a niche in its business world

KFC has 1,300 fast-food stores in China

Getty Images

ig trade shows have become a standard part of Chinas economic landscape, a quick and easy way for the new armies of consumers and entrepreneurs to see the latest products. The annual auto show is always mobbed, as are similar events for computers and other latest electrical gadgets. The surprise hit this year, however, had nothing to do with consumer goods or cheap thrills. Instead, the crowds flocked to the World Trade Centre in Beijing to find out more about franchising. The annual China Franchising Convention in May attracted 45,000 people in just three days. The event was the first time McDonalds had published its franchise requirements in China. Around 20,000 people took away copies of the guidelines. Franchising is becoming the latest craze to grip Chinas rapidly growing entrepreneurial class. The concept fills an ideal niche in the Chinese business world. There are growing numbers of business people with enough capital to take on such a franchising operation, which can require an initial investment of over $300,000 for a well-known foreign title. Given the precarious terrain that private entrepreneurs still face in China, in securing financing and dealing with government regulations, the backing of a world-famous brand-name is high-

ly attractive. There are now nearly 200 franchise brands in China ranging from supermarket and convenience stores to drug stores and laundries. More and more people have the potential to invest in purchasing their own wellknown trademarks, says Lucy Wu Rui Ling, deputy secretary general of the China Chain store Franchise Association (CCFA) Under the agreement for its accession to the WTO, China has set up a new framework for foreign franchises operating in the country, which improves the protection of brands and trade secrets and establishes clearer rules for recruiting franchisees. According to Xiao Chaoyang, a lawyer at Longan in Beijing and an expert on franchises: The new law opens the market almost completely to foreign investors. The main requirement, he says, is that foreign franchisees have at least two direct stores. The government sees franchises as a very important tool to developing and improving the service sector and the distribution network, says Ms Wu. They can play an important role in creating jobs. Yet for all the interest from potential Chinese investors, the large fast-food and drinks chains are still highly cautious about using franchises. The main concern has always been the low protection of intellectual property and

brand names. The companies fear that they will train someone how to run one of their businesses, only for that person to take all the trade secrets and start a rival company next door. The changes in the rules have gone some way to allaying those concerns, but they have not disappeared completely. There are other reasons for moving slowly in a country where many of these retail concepts are still in their infancy. Starbucks President Company, which has the right to run the coffee shops in the eastern region of China, has so far decided against opening franchise stores for fear that quality of service might suffer. We need to establish the standard service and good image in the mainland market, says Grace Qian, for the company. Its more difficult to maintain our standard service if we open too many franchise stores. McDonalds and KFC, both of which have published franchise requirements, are now bringing the franchise format they have used in so many other parts of the world to China, but they are doing so very carefully. Yum! Brands, owner of KFC, has 1,300 fast-food stores in China and is planning to open a further 375 units this year. We believe that its critical that we are highly selective about who we partner with, says Qun Wan Jamieson, senior director for public affairs for Yum! in China.

Fast foods not so level playing field

Michael Phillips and Richard Yee write that new rules for franchises are inconsistent
Most foreign groups have avoided the franchise model, partly because of a lack of specific regulations. Hence the move by Chinas commerce ministry of Commerce to introduce a new set of franchise rules on February 1. The new rules include a number of important points. First, they include several qualifications, some of which are designed to create a level playing field. Under these rules, the franchisor must own at least two Chinabased outlets, which it has directly operated for more than a year. In addition, a foreign invested enterprise must apply for various approvals from the Chinese authorities. Although designed to create a level playing field for domestic and foreign investors, these two rules fall short of the goal. They either do not apply to a domestic franchisor or impose a far greater burden on the foreign operator than on its domestic counterpart. Second, the new laws include extensive disclosure obligations. The franchisor is obliged to disclose to a proposed franchisee the operational results of its existing franchisees as well as any other information requested by a franchisee. Moreover, the new rules grant a cause of action to a franchisee for any loss caused by a franchisors misrepresentation. Third, there is specified liability for goods or products. The franchisor is liable for goods supplied by its designated suppliers, even though the franchisor may not have control over third-party suppliers. Finally, there is a lack of clarity on offshore franchisors. The franchisor must be a lawfully established company. If one interprets lawfully as a reference to Chinese law, then a foreign franchisor has to establish a wholly owned subsidiary or a joint venture enterprise. Where does that leave offshore companies that grant franchises directly to domestic Chinese franchisees without establishing a foreign invested enterprise in China? The new rules are silent on this issue. Some experts - including our firm - believe such operations are effectively illegal, while others suggest that the new rules are just an additional regulatory tool. The new rules are not expected to affect synthetic franchise relationships, which are based on a series of separate contracts, including service, licence, trademark and technical assistance agreements between a foreign company and its Chinese partner. It remains to be seen whether the new law will be fully embraced. Without addressing its inconsistencies, foreign parties are likely to continue granting synthetic franchises.

LEGAL VIEW
For many western fast-food companies, China is the place to be. Whereas markets such as the US and western Europe are reaching saturation, Chinas restaurant industry is expected to generate $91bn in sales this year. Western fast-food groups have been in China for some time. Early entrants include KFC, which opened shop in 1987, as well as McDonalds and Subway.

Michael Phillips is a partner and Richard Yee an associate at law firm Heller Ehrman in Hong Kong

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Avon aids government with regulation shift

The group has been chosen to test strict rules that could end the ban on direct sales, say Alexandra Haney and Justine Lau

n April 13 1998, Chinese government officials fanned out around the country, closing down branches of some of the worlds biggest direct sales companies. Among the groups to have their doors closed that day was Avon. The worlds largest direct seller of beauty and related products understood the motivation for the crackdown: Beijing, concerned about the rapid spread of pyramid selling schemes, had opted for a blanket ban on direct sales. An Avon delegation was dispatched to Beijing. Avon has been such a good corporate citizen. We didnt make any trouble for you, S.K. Kao, vice-president for greater China, recalls his colleagues telling the authorities. Seven years later, Avons China strategy has once again changed to meet Beijings demands. In April, the government chose the group to conduct a trial of new regulations for the direct sales industry. While the trial undoubtedly gives Avon a head start on its competitors, the cosmetics groups experience illustrates how challenging complying with Chinese regulations can be for foreign investors. After the 1998 crackdown, the government issued a new regulation allowing 10 approved direct sales companies to do business, so long as they did so through retail outlets. Avon, along with rival direct sales groups Amway and Mary Kay, set up a retail network. It now has 6,300 beauty boutiques across China, which Avon claims makes it the largest chain store in the country. Avon reported sales of $220m in China last year.

Despite the controls on the 10 must register names, contact companies, pyramid sales operadetails and transaction history of tions continued to proliferate. every sales person on a website Between September 2003 and October 2004, the authorities uncovered 2,797 illegal pyramid sales schemes, involving more than 200,000 sales agents. In the southern city of Guangzhou in 2003, officials closed down some 666 pyramid sales offices, according to Chinese media reports. Beijing takes these scams, which often involve hundreds of millions of renminbi, seriously because it sees them as a threat to social stability. They want to find an effective regulation that can protect the best interests of the Chinese people and help crack down on illegal chuanxiao [pyramid sales] for good, says Mr Kao. The rules of the trial underscore Beijings desire for control. Avon can conduct direct sales Direct approach: Avon will employ aound 3,000 sales agents in only three places - Beijing and Tianjin, the northern that Chinas State Administration port city, and southern for Industry and Commerce and Guangdong province. It may not the Ministry of Commerce use more than 3,000 sales agents, (Mofcom) can monitor. each of whom must pass an exam In addition, Avon had to open covering, among other things, an account at a state-owned bank, Chinas laws on direct sales. Avon where it deposited Rmb20bn

($2.4bn) to guard against possible fraud. These rules are the result of nearly a year of collaboration between Avon and the Chinese government. Since Beijing asked the group to draw up a proposal for a trial of the new regulations last year, there have been 11 revisions on the direct selling test, Mr Kao says. He flies from Guangzhou, the capital of Guangdong province, where he is based, to Beijing twice a month. Even opening the corporate bank account was not easy. Avon executives had to fly to Beijing with the company chop or stamp - which in China substitutes for a signature - to open the account. Mofcom receives the income earned on that account, Mr Kao says. The test will not be a money-making venture, he adds. Che Zhouyong We are doing this for the government. Not everyone sees Avons role positively. After Andrea Jung, Avons chairman and chief executive, announced the trial in April the groups distributors in Guangzhou complained that it

would hurt their business. But Mr Kao says the beauty boutiques, which generate 80 per cent of Avons sales in China, will not be affected by the test. He contends that the beauty boutique owners overwhelmingly support Avons participation. The only benefit Avon gets from this direct sales test is that we probably know what the model will be like in the future, Mr Kao says. Nu Skin, the New York-listed skincare group that is one of Avons rivals, says it is encouraged by the arrangement. Its a clear indication that the government is moving towards direct selling and it is more confident that this will develop in a more positive way, says Corey Lindley, president for greater China at Nu Skin. Nu Skin, which entered China in 2003, has about 120 stores there. The company operates as a pure retailer in mainland China and employs about 6,000 sales people. Turnover jumped from US$38m in 2003 to US$106m in 2004. But, in an indication of the rivalry in Chinas cosmetics and skincare industry, Mr Lindley says Avon will need time to resolve problems with franchisees who wonder how they will fit into [the direct selling] relationship. We have developed a strategy to operate harmoniously our retail business with direct sales. As China moves toward lifting the ban on direct sales, however, Avon, Nu Skin, Mary Kay and Amway share a common challenge. They must persuade potential customers and distributors that they are different from the pyramid schemes that have cheated so many in the past.

Japanese stores seize chance

Seven-Eleven is at the forefront of retailers preparing for franchising, says Mariko Sanchanta
ndeterred by the violent anti-Japan protests in China earlier this year, Japanese retailers are taking advantage of deregulation in the Chinese market that will soon allow them to open franchise stores in the mainland. Seven-Eleven Japan, the countrys leading convenience store

operator, plans to open its first franchise store in China by the end of the year. By 2008, it hopes to have 350 shops across China. Seven-Eleven currently operates 25 directly managed stores in Beijing. As part of the liberalisation promised when it joined the World Trade Organisation, China further

opened up the retail sector to foreign companies last December by abolishing restrictions that limited the regions where foreign retailers can operate. In February, a new law opening up franchise management to foreign groups came into force. Seven-Eleven Japan says it has already filed its application with the Chinese government and that it is on track to receive approval in time for its first franchise store opening at the end of the year. It says many Chinese are keen on the idea of becoming franchisees in what it describes as a win-win scenario for China and Japan. The move means that SevenEleven will be able aggressively to expand its operations in the Chinese market at a relatively low cost. Seven-Eleven is expected to become the first foreign convenience store operator to receive

approval for franchise operations under the new law. Japanese convenience store operators have expanded aggressively into the Chinese market amid stagnant sales at home. Lawson, Japans second leading convenience store operator, has 250 shops in Shanghai and says its operations are profitable. Japanese convenience stories sell everything from bottled drinks to tights. Japanese supermarkets and retailers - one of the most visible manifestations of the countrys presence in China in recent years - became prime targets for attacks and boycotts in April during the anti-Japan protests. But with sales growth in China far outpacing Japanese sales, the opportunities in the market clearly outweigh the risks. Same-store convenience sales in Japan have

declined in June for the 11th consecutive month, while per-shopper expenditure slipped 1.3 per cent to Y561 ($5) per visit. In a move that underlines the harsh domestic environment, Seven-Eleven recently announced price cuts on a variety of bottled and canned drinks. The move triggered a price war as other convenience store operators followed suit. The competition in the saturated Japanese market is so severe that many convenience store operators are not only looking to China. Family Mart, one of Japans leading chains, recently opened its first US shop in Los Angeles. Meanwhile, Seven-Eleven Japan has offered to buy out 7-Eleven Inc, its US affiliate for $1bn, as part of its efforts to diversify its revenues and boost profits.

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RECRUITMENT/OUTSOURCING

Indias IT recruiting struggle

Plans to use Shanghai as a launch pad for Japan have been affected by a dearth of suitable staff, writes Khozem Merchant
he crowd of Indian technology companies seeking opportunities in China could profit from a visit to the Shanghai software development premises of MphasiS, a medium-sized Mumbai-based IT services company. What they heard there might send them racing back home. We have not cracked China, admits Jerry Rao, chief executive of MphasiS, which has IT services and call centre affiliates in India, the US and Mexico. In Shanghai, we have 100 developers, mostly Chinese, but should have 400. Scaling up has been an unexpectedly large problem, he says. MphasiS was among the first wave of Indian technology companies that ventured into China either as the IT partners of multinationals or via small local acquisitions. The strategy was centred on mitigating rising wages and other costs in India, spreading geographical risk and using China as a launch pad into Japan and South Korea. MphasiS, which employs 9,000 worldwide and earned sales of $126m in the year to March 2004, bought the Shanghai centre from CapitalOne, the US credit card

issuer, in October 2002. The aim was to bypass the timeconsuming hassle of setting up a technology company in a country marked by uncertain regulations. Buying an existing unit would also allow MphasiS to expand quickly and benefit from the huge rise in demand for software-related services within China, as well as from global companies looking for an IT partner in the worlds fastest-growing economy. The reality, however, has been disappointing. Weve fallen behind our expectations. One hundred software developers is a trivial number for us, says Mr Rao, who is also chairman of Nasscom, the Indian IT industry association. It is a small number for most Indian companies. Tata Consultancy Services, Infosys, Wipro and Satyam, the big four Indian IT companies, typically add several thousand staff each quarter to their India operations, but their China presence remains small. MphasiS takes on 700 employees every three months in its IT and call centre units in India. At issue for these companies is Chinas relatively immature IT services market, which means there is no fluid labour market for Chinese-speaking programmers. Companies such as MphasiS cannot quickly and inexpensively employ locally in response to a sudden burst of project-based work, which is a feature of the industry. In particular, there is a lack of suitable local applicants for jobs as project managers and quality control managers, say

Indian IT executives in China. In India, such people, typically with 5 to 12 years experience including stints in the US, are paid premium salaries. MphasiS has been forced to send five project managers from India to Shanghai, raising the companys operating costs there. A lack of bilingual Chinese IT professionals, for jobs such as team leader, is also holding back expansion. One English and Chinese speaking programmer is required to oversee a team of four local developers who speak only Chinese. Because there is only a small number of bilingual programmers, they can command a salary premium of 30-40 per cent.

Our approach is based on whats good for customers and not being able to recruit in bulk is a major issue
We can take them on but that would wreck our cost model, says Mr Rao. These labour market deficiencies have not gone unnoticed among customers in the US, which is the biggest market for Indian IT. Whereas clients already in the mainland might allocate work to MphasiSs Shanghai centre, those new to outsourcing in general and China in particular are nervous. The client from Texas says no to China and prefers to deal only with (our office in) Bangalore,

says the MphasiS chief executive. Mr Rao is dismayed by the slower-than-expected growth in China, but not defeated. He says there are two big reasons for staying put. From a marketing perspective, MphasiS believes it is important to have a presence in China during this lean phase. Secondly, MphasiS is learning about the China market for the future, in the belief that it will eventually become lucrative. MphasiSs caution is shared by some of the next wave of mid-sized companies drawing up China strategies. Patni Computer Systems in Mumbai has spent two years studying the market but is still undecided, which is notable for a company that appears to have a strong case for a presence in China: Hitachi, the South Korean electronic goods manufacturer, and clients from Japan accounted for 4 per cent of Patnis sales of $326m in the year to March 2004. Patnis biggest China fear is scaling up. In January, the company recruited 480 junior programmers in India. Judging by the experience of others we would never be able to do that in China. Theres a lack of traction as well as an issue over the quality of software professionals, says Deepak Khosla, a senior executive at Patni. Our approach is based on whats good for customers, and not being able to recruit in bulk and quickly is obviously a major issue, he adds. The irony is that the ambivalence of companies like Patni and

the less than exciting experience of early entrants such as MphasiS may still have only a faint impact on those examining entry into China. This is because domestic cost pressures in India are increasingly forcing companies to turn to China as a necessary, if perhaps premature, addition to their operating base. Just as companies in the US and Europe view their subsidiaries in India as lower cost options to serve clients, India could look to (lower cost) China, says Gartner, a technology consultancy. Cognizant Technology Solutions, also among Indias top half dozen IT companies with sales of $585m in 2003-04, admits various cost factors have driven it to Chinas door. Foremost is soaring salaries and high attrition, driven partly by the arrival in India of IT consulting giants such as Accenture and EDS. Each departure at GEs call centres in Delhi costs the US company $5,000 to fill. A second concern is the patchy quality of labour lower down among the 290,000 new engineering graduates looking for IT jobs each year. This means companies need to spend more on training. Cognizant plans to raise its training budget to 4 per cent of sales, which Lakshmi Narayanan, chief executive, says is tolerable so long as we can improve productivity. He says there is no question of the long-term case for China, where Cognizant plans to raise its presence from a standing start now to 250 staff by 2006. But unless theres improvement on several fronts at home in the next two years, well be going to China for reasons to do with India rather than with China, Mr Narayanan says.

Share options give market a boost

Companies have been given a powerful tool to retain talented staff, writes Seung Chong
and retain employees, in particular senior management who can be rewarded by reference to share performance. But, in order to take advantage of the regime, a company must apparently have first converted its non-tradeable shares into tradeable shares. The overhang of non-tradeable shares has been blamed for the underperforming stock market, so the desire to issue options may be a powerful inducement to management to convert the non-tradeable shares. Multinational companies seeking to standardise their global employment practices have been among the first to implement share incentive schemes in China. But the existing legal regime was not devised with share option schemes in mind. Grey areas can be found in the rules on securities offerings and safe harbours designed to implement a share option scheme. There are also practical obstacles such as the difficulty of remitting foreign currency to exercise options. One solution is to implement cashless schemes. Under this plan, arrangements are made for the option holders to fund the exercise of options, and they are paid the net proceeds of the equity sale. But the problem with cashless schemes is that they defeat the very aim of encouraging long-term holdings by employees. Some multinational companies have introduced phantom stock schemes or share appreciation rights. These are essentially cash bonus schemes, where the amount is linked to share price rises. Phantom schemes are often seen as undesirable because the payment has to be taken through the profit and loss account. In devising a new regime, it is hoped that Chinese regulators will create a seamless and internally consistent regime for domestic companies and multinationals. But this may be a tall order. Several factors need to be taken into account. First, the regulator is in the process of introducing new legal concepts such as the prohibition on companies to provide financial assistance to purchase its own shares. Second, new option schemes will have to dovetail with the expected amendments to Chinas company law. Third, any new regime will have to be an interagency effort as State-owned Assets Supervision and Administration Commission oversees many companies that may want to introduce share schemes. Finally, share option schemes can only work in an environment where good governance is the norm. China needs, among others, tighter rules and enforcement on insider trading and an improved culture of compliance.

LEGAL VIEW
Last weeks decision by the China Securities Regulatory Commission (CSRC) to allow listed companies to issue share options to employees is a salutary step to boost the domestic markets. It gives companies the opportunity to add an important constituency to their shareholder base. It also gives the companies a powerful tool to incentivise

The author is a lawyer with Simmons & Simmons, Hong Kong.

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INVESTING IN CHINA
PENSIONS

Multinationals embrace pension plan

war for talent is brutal, he says. If they want to retain their highflyers, they have to offer more than the basic state pension. A recent Watson Wyatt survey based on a poll of 130 multinational companies - shows that 27 per cent of respondents have already deferred compensation plans that are similar to western-style company pensions. These could be converted into enterprise annuities, where contributions are held in a legally distinct pension fund governed by trust law. Mr Charles believes most provinces and cities such as Beijing and Shanghai will develop pension tax policies over the next 12 months. He also thinks pension services providers will learn to live with what many analysts regard as an overly complicated system. Beijing has handed out four types of operating licences - for fund management, trustee services, fund administration and custody. This, says Mr Charles, may prompt licence holders to form partnerships that can offer service packages. The reform is not going to be a damp squib, he insists. Watson Wyatt points to a number of privately owned Chinese companies that might want to follow their multinational rivals. Another source of demand for enterprise annuity plans could come from state-owned companies converting partially funded pension plans. Conversion would put real money into the system much quicker, says Mr Charles. The problem is that companies would create under-funded pension plans. Mr Leckie identifies three potential sources of demand that could dwarf the expected demand from multinationals. First, companies may decide to convert their pension-type insurance arrangements, known as group insurance, into pension funds. Second, there are 11 designated industry pension schemes in areas such as power and banking that could be switched to the new system. Third, cities are expected to channel surplus social security contributions into the new system. In recent years, the Shanghai government has forced employers to use total salaries - rather than the legal maximum of three times average city pay - as the basis for their social security contributions. Despite the expected growth in enterprise annuity over the next decade, many companies will remain outside the system. Pointing to labour-intensive sectors, Mr Leckie concludes: Lowpaid workers dont want company pensions. They are more concerned about their take-home pay.

Foreign companies, desperate to hang on to talented staff, are likely to welcome the new scheme, writes Florian Gimbel

oreign multinationals will drive the reform of Chinas corporate pension system as they try to regain the upper hand in the war for talent, according to Watson Wyatt, the worlds biggest investment consultancy. In recent years, foreign companies have been faced with a sharp increase in staff turnover and double digit salary growth in many industries and cities. This cost

pressure may prompt them to add a new retention tool - a US-style company pension - to their growing list of employee perks. While their local rivals seem relatively unenthusiastic about the new voluntary pension system, foreign companies are increasingly willing to take the plunge. We have seen a higher-than-expected level of interest from multinational clients, says Bob Charles, head of retirement benefits consulting at Watsons Asian operation. Thats where it [the implementation of the reform] will start. In October, Beijing launched the new system by handing out the first batch of operating licences to insurers, banks, securities firms and fund managers, including the local fund management joint ventures of three European groups - ING, Fortis and Deutsche Bank - as well as

Canadas Bank of Montreal. Chinas corporate pension assets will increase to 105bn ($130bn) by 2015, up from 6.4bn in mid-2004, implying an annual growth rate of almost 30 per cent, according to a recent study by the Organisation for Economic Co-operation and Development and Allianz Global Investors, the German fund manager. While pension services providers are eyeing what could be a huge market, many potential clients remain wary of adding another element to their rapidly rising social security costs. As they face tough competition and shrinking margins, few companies may want to pay up to 8.3 per cent of employees salaries into a newly established company pension fund. Companies in Shanghai already pay social security contributions including housing, medical and

pension-like benefits - that are equivalent to 40 per cent of total salaries, according to Stuart Leckie, a Hong Kong-based pensions expert. It does not help that Beijing has failed to launch a nationwide system of tax relief for corporate pension contributions - an omission that many analysts believe could hold back, or even scupper, the reform. Still, a growing number of multinationals believe they can get their moneys worth by joining the new system, known as enterprise annuity. Most human-resource directors are saying: We dont really care about pensions, but we do care a lot about high [staff] turnover, says Mr Charles. Mr Leckie agrees that multinationals are interested in pensions. They tend to be in the go-go sectors of the economy, where the

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