Influences of the Chinese macro environment on the past, present and future employment these methods of foreign market entry in China

It is believed these are the most suitable methods of exploring the data since this investigation is of a limited nature.

This research proposal analyses some qualitative data which has been generated through secondary and primary research. The former was gathered through the investors’ opinion reports published by independent global consultancy firms that operate in China. The primary research, on the other hand, was conducted by the author himself. In this he used its employer’s knowledge base to investigate the opinions international marketing consultants on the future development of the Chinese investment environment. The majority of the qualitative research for this study was performed through informal discussions with peers and managerial staff. In these, open questions and answers were used most often in order to facilitate ideas and establish a much better understanding of the Chinese macro-environment.

Its characteristics with regards to investment market entry modes, as seen by the author of this report, are presented below.

5. Literature Review

Regardless of the many reasons that companies might have for international expansion, once their target countries, regions and/or niche markets have been identified, managers face another critical decision: selecting the most appropriate method of foreign market entry which would further the companies’ objectives and strategies. Because making the right choice is never simple and is often influenced by a variety of complexly interrelated factors, the topic of strategies for international expansion has been in the centre of theoretical discussions for a number of years.

Models that aim to describe how foreign market strategies are determined originate from the field of international business but have consequently been explored by marketing experts as a part of international marketing. Root, for example, claims that the choice of market entry strategy is of critical importance to multinational enterprises (MNEs) since it affects their performance in the global market, impacts directly on their long-term competitiveness and determines to a large extent how successful their financial performance is going to be. Other writers view decisions regarding this aspect of the marketing strategy as being of critical importance since the commitments made are likely to affect businesses not only in the short but also the long term. Douglas and Craig state that the method of foreign market entry “signals the firm’s intent to key competitors and determines the basis for future battles”.

Due to the importance of choosing the right market, over the years a number of models have been developed which have aimed to explain why certain modes are preferred to others. International marketing theory contains five most popular paradigms which have been researched and applied widely. These theories together with their advantages and drawbacks are summarised briefly below:

• The stage of development (SD) model was developed by Johanson and Paul in 1986 while studying the internationalisation strategies of small and medium sized enterprises (SMEs). As suggested by the name, it assumed that entry modes chosen by firms were dependent on the stages of their development. The model viewed international expansion as an evolutionary process which was determined by the domestic location of the firm, and by the level of commitment it was prepared to make abroad. As such the SD model for the first time identified the correlation between the size of the enterprise, it resource capabilities and its risk tolerance in a foreign environment with the chosen mode of entry.  Unfortunately, due to the fact that it failed to explain why some SMEs preferred to enter markets for the first time through foreign direct investment (FDI) rather than export it was never widely used in practice.

• The transaction cost analysis model (TCA), originally created by Anderson and Gatignon and its consequent extensions, aimed to explain market entry modes as derivative of organisational structure. It suggested that multinational enterprises chose a specific mode of market entry in order to minimise the so called risk-adjusted efficiency. The latter determined choice as the best solution of the required level of control and the optimisation of the following types of: costs translation specific assets, external uncertainty, internal uncertainty and free riding potential. The TCA model extended the SD model in the fact that it identified the connection between cost (i.e investment) and control. In spite of this more innovative approach, however, it also had some clear weaknesses. First of all, it had limited application in practice since its core, the “transaction costs” were difficult to quantify and therefore to measure. Based on this the model could not be applied to the real world for business decisions. In addition, it had a limited explanation ability where complex choices of market entry were taken. It neglected the influences of government and production cost on market entry; failed to take into consideration the macro and micro environment circumstances in which companies operate; assumed that the only reason for international expansion was the optimisation of profit and excluded any non-transaction benefits. Lastly, while some of the more recent modifications of the model have tried to address these deficiencies, they are in reality still based on transaction cost which remains difficult to quantify prior to the relevant transactions.

• The ownership, location and internationalisation model (OLI) was developed by Dunning and later on modified and extended by him and a number of other authors. The model originated from the attempt to identify and evaluate the factors influencing foreign production. It stated that entry decisions are based on three advantages as perceived by the companies:

• Ownership – advantages that are specific to the nature of the owner and their nationality;
• Internationalisation – advantages arising from the transfer of ownership across national borders within the same organisation; and
• Location advantages – advantages arising from the fact that different locations offer different resources and different environments for businesses some of which may be more beneficial than others.

Dunning believed that the more of these advantages a company possessed the more likely it was to choose a more involved method of market entry (such as joint venture or wholly owned enterprise). He also added that factors such as competitive advantage, market failure and collaboration, as well as dynamic environments should be integrated into the model when internationalisation decisions are made. The greatest advantage of the Dunning OLI model was that it was far more practical than the TC model. For this reason it has had wide application and was supported by empirical research. Despite of its applicability, improved measurability and practicality, however, the model is still solely a static one and this is its major disadvantage. In addition, it aims to explore a number of important factors but neglects some strategic factors, external and internal factors influencing the decision makers, and competitive factors.

• The organisation capacity (OC) model, proposed by Alulakh, Kotabe and Madhock, was based on organisational theory. It viewed the type of market entry adopted by a firm largely as dependent on the possibilities for employment and deployment of the firm’s capabilities in the foreign environment. This theoretical framework regarded the firm as a bundle of capabilities and knowledge where individual skills, organisation and technology were interrelated and mutually reinforcing. This model’s major advantage was that it recognised for the first time the importance of the organisation’s intangible resources. On the other hand, it has some major limitations in that it neglected:

•  the impact of the decision maker on entry mode choice;
• the social, economic and political factors of the environment;
• the fact that capabilities cannot be implemented without organisational efficiency.

• Finally, the decision making process model argued that entry mode choice should be treated as a multistage decision making process during which various factors are taken into consideration. Among there were the objectives of the firm, the existing macro and industry environments, and the associated risks and benefits. The major drawback of this model was that it concentrated on optimising the process but did not take into account which factors might affect it and what their impact on the entry choice might be. In addition it ignored the roles of the organisation and the decision maker in this process.

Research indicates that no other significant theories regarding foreign market entry have been developed since 1998. Rather, many academics have concentrated on examining the impact of certain aspects affecting the entry mode decision. Factors other than the above mentioned have been examined to include: technology transfer, immigrant effect, market size, firm size, CEO successor characteristics, cultural distance, industry barriers and firm advantages, international experience, country risk and environmental uncertainty, role of staffing; foreign exchange and host country currency. All of these can be organised into country specific factors (cultural distance, institution, exchange rate, etc.), industry specific factors (market size, market structure, industry type, etc.), firm specific factors (firm capacity, firm size, etc.) and product specific factors (product type, maturity, sales services, etc.)

The latter classification approximates closely a model that can be found in the recent works of Jobber, according to whom there are two broad areas of consideration for companies that wish to internationalise. These are, on one hand, the macro-environmental issues or otherwise stated the ones originating from the external to the business environment, and micro-environmental issues which relate primarily to the capabilities of the firm. He divides the latter into two categories depending on whether they relate to the industry as a whole or to the company in specific (see fig. 2 below). The author of this research believes that this theoretical model due to its simplicity is far more applicable for businesses and since it includes many of the factors contained in the classical theory, it should be used as the foundation for this work. In his opinion, Jobber’s representation provides a very good structured approach to the analysis of the variety of factors that can potentially impact on a company’s strategic marketing decision of this type. It also follows closely the strategic business method for evaluating opportunities (i.e is true to process) while taking into account many of the above mentioned factors.

The problem with describing the choice of a market entry decision, however, remains “ill-defined, complex and dynamic”. It is a function of a number of factors and the ways and strength of their interaction, and not all of them have the same importance in varied situations. Individuals studying the same environment from different angles and with different expectations may arrive at different conclusions. Different examples selected, different time periods analysed, different methodologies used, or even different used in the analysis can lead to even conflicting results. In the process of identifying the available alternatives, most academics agree that the classification of these is best presented on the basis of the degree of involvement into the target market. Possibly the most comprehensive and complete list of available strategies can be found in Doole and Lowe (see fig 3 below).

The authors argue that when deciding on a method of foreign market entry the most fundamental questions any firm would need to answer are:

• What level of cost can it afford?
• What level of risk would it be willing to take? and
• What control over the business abroad would it require?

Fig 2. Types of factors affecting the selection of foreign markets

Macro-environmental issues

Economic

Socio-cultural

Political

Legal

Foreign market selection

Micro-environmental issues

Market attractiveness                                   Company capability profile

• Market size and growth rate                
• Competition
• Costs of serving the market
• Profit potential
• Market access
• Skills
• Resources
• Product adaptation
• Competitive advantage

Source: Jobber, D., “Principles and Practice of Marketing”, McGraw Hill, 2001

Fig 3. Market entry methods and the level of involvement in international markets

                        

                                                Wholly owned subsidiary

                                                Company acquisition

                                                Assembly operations

                                                Joint venture

                                                Strategic alliance

Modes of foreign                                 Licensing

market entry                                 Contract manufacture

based on levels                                Direct marketing        

of involvement                                Franchising

                                                Distributors and agents

                                                Sales force

                                                Trading companies

                                                Export management companies

                                                Piggyback operations

                                                Domestic purchasing

                                                

And while the factors of “cost” and “control” have originate from the business itself, the “risk” variable arises from the environment and the ways it can impact on a company to influence its performance. It is often difficult or impossible to control and plays a significant role in the process of making an entry decision.

The purpose of this report is to establish to what extent the conditions of the external environment can influence the entry decisions of multinational into China. As the country is keen to attract foreign direct investment, and also due to the size restrictions of this report, the author will concentrate only on those market entry strategies that involve direct investment.

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6. Direct investment modes of entry and the Chinese national environment

In order to deliver its main objectives, this report will concentrate first on exploring the entry strategies currently employed by multinationals. The analysis will begin by uncovering the market entry modes preferred by multinationals at present and will attempt to identify the reasons behind their choices. Based on these, the conditions of the environment that impact on entry mode decisions will be identified. In the last part of its analysis, this report will concentrate on exploring the current status and the expected changes in the macro conditions with an aim to establish how changes in them will impact on the entry strategies chosen my multinationals.

To facilitate an understanding of the key factors for foreign entry choice, it will consider the motives of two types of companies: those that intend to invest in China in the foreseeable future and those that operate in the country at present. It is expected that these, and especially the former group, will be able to identify best the factors of the macro-environment which impact most significantly on investment decisions.

According to a recent survey by PricewaterhouseCoopers (PWC)  the preferred methods of investment in China in the past few years have been wholly owned enterprises (30% of its respondents), followed by representative offices (24%) and equity joint ventures (21%) (see Fig 4). This is more or less in line with the findings of, on one hand a report of Deloitte Touche Tohmatsu, and on the other Andersen and Rand, the latter if which are presented in Table 2 below. Based on the empirical data provided by them, in 2003 the most popular forms of market entry for MNEs in China were equity joint ventures, followed by wholly owned foreign enterprises and contractual joint ventures.

Fig. 4. Main forms of investment in China

Source: PricewaterhouseCoopers, “Doing Business In China: A Survey of Issues Encountered By Foreign Companies Doing Business or Investing In China”, March 2004

Table 2. China FDI by contractual types

Many might argue that this data is more contradictory than consistent with the PWC report but the author believes that this contradiction is only superficial. The data provided by Andersen and Rand refers to actual figures in the year 2003 while the PWC report reflects the preferred MNE methods bearing in mind the outlook for the future.

In fact, since the 1980s joint ventures (JVs) have been the most popular mode of entry into the Chinese national market, in spite of the investment regulations being heavily weighted in favour of the local Chinese partners. This is easily explicable with the ways in which the Chinese government approached FDI before the WTO accession. The latter was keen to ensure that not too much control was left in the hands of foreign investors although China needed to attract foreign investment. Nevertheless, many companies looking to set up operations in China employed this method for the following reasons:

• Joint ventures allow companies with little knowledge of the Chinese market and no connections with the local government and businesses to benefit from the experience and relationships already established by the Chinese partner;
• Joint ventures can take several forms, reflecting the varied types of contribution of the joint venture partners: ownership, financial contributions, management, technology, know-how, etc.;
• There is no minimum foreign contribution required to set up a JV, which is suitable for those investors who preferr to remain a minority shareholder (i.e. minimise risk or test the market) ;
• Contributions are not required to be expressed in monetary terms, i.e. they could take the form of labour, resources and/or services.
• As the local Chinese partner shares the investment (and the equity stake) in the business the risks of unfavourable government intervention are lower thus ensuring that the foreign investors’ risk is more bearable.

On the other hand, JVs have a number of disadvantages some of which are examined below:

• The main disadvantage to forming a JV is that another company shares the profits of the business. Such an arrangement works well if the joint venture business aims to sell its products in China and gradually grow in size, benefiting both partners. If, on the other hand, the purpose of the business is purely to export, it is less likely to require a joint venture partner.
• Up to 2001 when China joined the WTO, foreign companies were not permitted to hold majority shares in joint ventures regardless of the industry and type of product involved. More recently, the regulatory environment in China has changed permitting foreign investors to choose the size of their stake in the JV enterprise.
• In many cases in the past, information about the prospective Chinese JV partners was not available. Foreign investors knew very little about their future associate’s background, experience, resources and capabilities. In addition, it was very difficult to substantiate the Chinese counterparts’ relationships with the local government, suppliers and customers therefore many foreign investors went into JVs with very little information thus increasing the risk of JV failure.
• Finally, a very important disadvantage of JVs and a frequently-cited reason why foreign investors are not attracted to this option is their wish to retain full control over their China-based production and the ways their products are brought to market. This drawback can be overcome by the establishment of a wholly owned foreign enterprise (WOFE) which will be discussed below.

In spite of the above stated disadvantages, to date JVs have been set up in a variety of sectors in China such as manufacturing, real estate, construction, warehousing, telecommunications, wholesale, retail and catering, agriculture, healthcare, etc. However, Table 2 above also indicates that as in the 1990, in 2003 China was only able to attract FDI for relatively small projects the average investment for which was under $1 million. This means that, in spite of its recent efforts, until 2003 the Chinese government has not been able to attract as many high tech projects as it would like.

The most likely reason for the latter is sited in a recent OECD report which confirms that foreign investors prefer to locate their long-term high-value projects in countries that have predictable economic and policy regimes. Besides, until very recently WOFE could not be established in China but with the country’s accession to the WTO, this is about to change. In fact under newly approved regulations foreign companies will be allowed to set up majority joint venture trading companies as from 1st June 2004. Also, from 11th December 2004 foreign investors (both companies and individuals) will be able to set up WOFE, to begin with the area of commercial distribution followed then by a number of other sectors to complete the liberalisation until the end of 2007.

With these regulatory changes in place, it is expected that many companies will opt for the WOFEs or majority JV (MJV) forms of market entry/participation because such investments provide them with complete control over the business and the direction of its operation. The PWC report sited above, confirms this and notes that attitudes of foreign investors are changing following the firm commitments made by China towards the liberalisation of its economy. A large number of the company managers interviewed stated their intentions for the future being as follows (in the order of preference):

• Buy out or reduce the size of participation of their Chinese partners in order to establish a wholly owned or a majority owned venture;
• Enter the market directly through wholly owned investment or a new joint venture;
• Acquire or merge with other enterprises (Fig. 5)

To confirm this trend, another report by Deloitte Touche Tohmatsu (DTT) established that a significant percentage of the companies already in China intended to increase their enterprises and product lines or establish a new enterprise in the future, while a rising percentage of new comers were expecting to enter China through some form of direct investment.

This is hardly surprising due to the many advantages of WOFEs and MJVs. The PWC survey notes that most of the interviewed managers declared as the most significant benefits of these strategies the increased control over the business entity, the accruing financial benefits as well as the fact that the minimum financial requirement for WOFEs was now significantly lower than that of the joint venture.

Other benefits of setting up WOFEs are:

• This method of market entry allows independence and freedom to implement the worldwide strategies of the foreign investor company without having to consider the expectations of a Chinese partner;
• It ensures the entity’s ability to formally carry on business rather than just have a representative office function.
• Because of the above, the enterprise will also be capable of issuing invoices to their customers in renminbi (the Chinese currency) and receive revenues in renminbi;
• Foreign investors will also be able to converting renminbi profits into other currencies for remittance to their parent companies outside of China;
• Previously, the minimum registered capital for companies was Yn 50m. Now, the entry requirements for business have been drastically lowered, to Yn 300,000;
• WOFEs will ensure the protection of intellectual know-how and technology possessed by the foreign investor and guarantee greater efficiency in its operations, management and future development;
• From 2004 the Chinese government has taken extra steps to simplify the administration process for approving the establishment of WOFEs.

Fig 5. Future expansion strategies in China

Source: PricewaterhouseCoopers, “Doing Business In China: A Survey of Issues Encountered By Foreign Companies Doing Business or Investing In China”, March 2004

Probably the biggest disadvantage of this market entry mode is that for an inexperienced investor all the knowledge of the Chinese market, administrative processes, and local suppliers would have to be gained the hard way. For strong relationships are a key factor for successful business in China, whether those be with the local authorities where the enterprise is located or along the supply chain.

The above facts clearly indicate that control and risk minimisation are the key factors which determine the choice of market entry method for foreign investors in China. In spite of the challenges involved, many of them state that are these unlikely to deter entry. The PWC survey mentioned above quotes the following reasons for investing in China as stated by company managers:

• Rapid economic growth and promising economic prospects (33%);
• Potential penetration into the market of China (26%);
• Cheap labour and raw materials (13%);
• Market diversification (12%);
• Elimination of trade barriers with China’s accession to the WTO (8%);
• Government policies encouraging foreign direct investment (4%).

These results indicate that many companies view China as attractive for its endowments and economic growth, a fact which has remained unchanged probably since the 1980s. At the same time a very small percentage perceive the macro-environment as more attractive as a result of the government’s efforts to encourage foreign direct investment.

According to the same managers the most important challenges for setting up a foreign enterprise involve a number of legal, political and economic factors which are presented in Fig 6 below:

Fig 6. Political, legal and economic challenges

These findings correspond closely with the ones presented in the DTT research which sites the following as the main perceived obstacles to investment in Post-WTO China:

• Regulatory environment;
• Implementation of WTO commitments;
• Economic outlook;
• Fraud and piracy;
• Government relations; and
• Taxation.

In this manner both of these reports reveal that the macro-environment is perhaps the most crucial consideration which influences decisions regarding the choice of foreign investment method in China. Although slightly differing terminology is used it is easy to recognise that the stated factors belong to one of the following aspects of the macro environment – political, economic and legal.

Thus, having identified them as key influencers, this report will now proceed to examining how the changes in these factors is expected to impact on the market entry strategies chosen by foreign investors in the future.  

Political factors

 

It is an undisputable fact that during the last 25 years China has made important steps to liberalise its economy. The changes that occurred since 1979 (see Historical section above) have been gradual and as such reflect the perceptions evolution that has taken place at central government as well as local authorities’ level regarding attitudes towards foreign capital. In fact, today the Chinese’s government’s main aim is to actively encourage the participation of FDI into the national economy by providing it with equal opportunities to local companies.

In spite of this, however, China remains a Marxist-style party-state with a history of ideological intolerance and some political unrest in the 1990s. And while in the last decade or so the country has managed to strongly reassure potential investors of the stability of its political regime and the latter’s commitment to economic reforms, some aspects of this factor condition remain unchanged.

Probably the most important of those is the fact that favourable relations with the local government remain a major challenge for most foreign businesses. Managers that have some experience in operating in China state that “Guanxi” (connections in Chinese) remain an important key to doing business in the country. Despite the recent unification of the rules that apply to domestic and foreign companies, the nature of the relationship with the local and/or central government can make or break the business venture. For companies that decide to set up a wholly owned subsidiary (i.e. without the participation of a local partner) this might be particularly challenging. At times even the joint venture method does not guarantee success due to the fact that correctly determining the political connections of the prospective partner and the influences of its senior management with the local and national governments are difficult and often impossible.

As a direct consequence of this many foreign companies still can fall pray to false “guanxi”. In the 2001 Corruption Perception Index published by Transparency International, a global corruption monitoring group, China was ranked 57th out of 91 countries. The problem is substantial and is seriously hindering the growth of foreign direct investment into the country. An indication for this is a recent speech by the President Jiang Zemin in which he called for the need to stop corrupt practices and urged government officials to firmly establish a correct concept of power. Major policy moves to counter corruption so far have included separating the military and the police from business. Nonetheless corruption continues to be a significant issue on the Chinese business scene which would continue to restrain all forms of market entry, including the ones involving direct investment.

Hence, due to their nature, the above two factors are likely to have a negative long-term impact on prospective investors in the future. At the same time the author of this report believes that their influence on strategic choice will be moderate rather than strongly pronounced. The reason for this is that the political constraints discussed above have been in existence for a number of years during which foreign direct investment has continued to rise. Therefore, political factors are viewed here as important considerations but not hindrances to FDI methods of market entry to China.

The Regulatory Environment

The Chinese political, social and economic systems have been and continue to be unique in a variety of ways. Therefore, it is not surprising that in the PWC report quoted above many companies expressed their concerns about the complexity of the Chinese local and national legislative structure as well as its relatively frequent changes. Similarly, the research performed by DTT , also identified the country’s regulatory setting as a major concern in the Chinese investment environment (see Fig 7 below). In it, 76% of the respondents already in China interviewed ranked it as a major obstacle. Of the respondents not already in China 88% stated that it was their most dominant concern. By industry, this feeling was particularly strong in sensitive industries such as banking and finance (86%) and telecommunications (82%).

Fig 7. China’s regulatory environment

Source: Deloitte Touche Tohmatsu “Foreign Investment Into China: Fitness Survey”, 2004

The reason behind these findings are both historical and current.

In the past, the Chinese regulatory system has been known for its complexity and ambiguity. Its key priorities were to attract investment and expertise only in certain areas of the Chinese economy while protecting national industries and enterprises from foreign competition.

Since the Civil law system became effective in 1987, however, continuous efforts have been made to improve various types of legislation. The latter process was spurred by China’s accession to the WTO, which forced the national government to revise a substantial part of its laws. Realising that foreign investors prefer to locate their long-term high-value projects in countries that have predictable policy regimes, China embarked on a significant regulatory system change that aimed to open and restructure its economy.

One of the vital steps that the Chinese government took recently is expected to have a very pronounced impact on the process of liberalising the investment environment in the country. In 2004 China changed its foreign investment laws to remove most constraints to FDI and enable foreign investors to operate in the domestic market in the same manner as their domestic counterparts. In the next two years, until 2007, following its commitments to the WTO, the Chinese government is expected to free foreign investors from operational constraints such as local content requirements, foreign exchange balancing requirements and export performance obligations.

Another reflection of the extensive effort put in attracting foreign investment is the recent change in the process of approving FDI projects established by the Chinese government. In the past, all foreign enterprises needed to provide detailed project proposals with feasibility studies and operation reports, before being able to receive permission to proceed. By reducing the administrative requirements and delays for approving purely foreign investment projects the central government has made it much easier and more convenient for multinational enterprises to establish local representation. The new policy will eliminate the need for the elaborate proposals and protracted approval procedures for all ventures that do not include state funds. Thus in the future companies would only need to submit a simplified application to the government before the project commences. Furthermore, provincial governments will also be given further autonomy over approving foreign invested projects that include state funds. Prior to the reforms, local governments were able to approve projects that included state funds at a maximum of USD 30 million. From 2004 provincial governments instead of the central government will be able to give approval to all projects up to USD 100 million.

In spite of these positive changes it is clear that with the Chinese market opening to foreign companies, numerous other laws and regulations would have to be issued to ensure a stable environment for foreign investment. Hence, a number of foreign investors today, both prospective and current, questions whether the laws will be comprehensive and clear enough to enhance predictability, and most of all whether they will be enforceable.

In the same manner there is concern over whether the extent and pace of the implementation of commitments to the WTO will be sufficient. Between 82 – 94% of the respondents in the Deloitte Touche Tohmatsu survey quoted above stated that non-implementation will be a major concern for them (see Fig. 8).

Fig 8. Implementation of WTO commitments

Source: Deloitte Touche Tohmatsu “Foreign Investment into China: Fitness Survey”, 2004

For although it is clear that the central government intends to abide by the WTO obligations the biggest challenge for implementation lies in overcoming the lack of understanding of WTO rules at China’s local government and enterprise levels where, evidence suggests, opposition to this still exists. According to a regulation issued in April 2001, local governments are prohibited prom engaging in protectionism but this directive has not had its full desired effect. Therefore, in order to tackle this problem and ensure compliance to WTO requirements at local level, the Chinese authorities have committed to issuing yearly reports on the progress of the implementation of the liberalisation laws, the problems that have been encountered and the ways it is planning to deal with them.

Bearing in mind all of the above regulatory changes, this report concludes that in general the legal aspects of the macro environment are developing fast in a direction which favours the growth in foreign direct investment. Through taking clearly defined committed steps towards improving the Chinese regulatory environment, the government is likely to increase the confidence of foreign investors. Hence, it is expected that this aspect of the Chinese macro environment will actively foster the establishment of an increased number of WOFEs, JVs and MJVs.

Economic factors

In the 1980s when China first opened its economy to the world, the country’s main attraction to foreign investors lay in the lower tax incentives offered to multinationals. These were effective in the early part of the reform discussed above and were perceived as a compensation for the lack of many other developed factors that foreign investors sought.

Following the most recent changes in the country and the fact that it is now well on its way of becoming fully integrated into the global economy, recent surveys suggest that foreign investors are no longer “seduced” primarily by financial benefits. According to an OECD report, at present, most multinationals are also looking for an overall economic system that “…is much fairer, simpler, more transparent and more conductive to private investment whether domestic or foreign.”

Nevertheless, taxation of FDI profits remains perhaps one of the most important economic considerations for many MNEs. The latter is crucial since it determines a company’s bottom line (profit after tax figures) and as such is indicative of the business’s performance in front of its shareholders.

The current problem with the Chinese taxation system is, that similarly to its legal counterpart, it is considered as too complicated and ambiguous; therefore difficult to implement in practice by many of the new investors. This fact is clearly indicated by the survey performed by the DTT quoted above. The majority of the respondents interviewed in the latter - 58% - stated that they would like to increase their understanding of the Chinese taxation system and the implications for this of China’s entry into the WTO. For although the WTO does not specially address taxation, the majority of the business featured in the survey believed that the WTO principles of non-discrimination and transparency will transform Chinese taxation system.

In spite of the above deficiency of its taxation environment, in the past few years the Chinese government has taken a variety of steps which aim to raise further the country’s attractiveness to foreign investors. At present, the Chinese government levies low tax on enterprises with foreign participation, and offers preferential tax policies to the sectors and regions where investment is encouraged by the state. For example, the Income Tax on enterprises with foreign investment is currently levied at the rate of 33 percent. The income tax on enterprises with foreign investment located in special economic zones, state new- and hi-tech industrial zones, or economic and technological development zones is levied at the rate of 15 percent. The income tax on production enterprises with foreign investment located in coastal economic open zones, special economic zones, or in the old urban district of cities where economic and technological development zones are located is levied at the rate of 24 percent. Finally, the income tax on enterprises with foreign investment that are engaged in projects such as energy, communications, port and dock is levied at the reduced rate of 15 percent.

At the same time, production enterprises with foreign investment that have an operation period exceeding 10 years are exempt from income tax for the first two years from the year they begin to make profit and allowed a 50 percent reduction for the following three years. Enterprises with foreign investment engaged in agriculture, forestry and animal husbandry, and enterprises with foreign investment established in remote and underdeveloped areas, upon approval by the State Bureau of Taxation, are allowed a 15 to 30 percent reduction on the income tax for a period of another 10 years following the expiration of the period of tax exemption and reduction as provided for above. The income tax on enterprises with foreign investment located in mid-west China that are engaged in projects encouraged by the government is levied at a reduced rate of 15 percent for a period of another three years following the expiration of the Five-Year period of tax exemption and reduction. The enterprises with foreign investment that adopt advanced technology are exempt from income tax for the first two years and allowed a 50 percent reduction for the following six years. In addition to the two-year tax exemption and three-year tax reduction treatment, foreign-invested enterprises producing for export are permitted to apply a reduced income tax rate of 50 percent as long as their annual export accounts for 70 percent or more of their sales volume. The foreign partner in an enterprise that reinvest their share of the profit in a project with an operation period of no less than 5 years is also refunded 40 percent of the income tax already paid on the reinvested amount.

To add to the above, since 1st January 1994, the Chinese government has levied a unified value-added tax, consumption tax and business tax on enterprises with foreign investment and domestic enterprises. Technology transfer and technological development by foreign enterprises and enterprises with foreign investment are exempted from value-added tax, as a measure to expand domestic demand and to encourage technological renovation in foreign-invested enterprises. For foreign-invested enterprises engaged in projects in the encouraged categories, the value-added tax on China-made equipment purchased by the enterprises within their total amount of investment is refunded fully if the equipment is listed under the catalogue offered with income tariff exemption.

Lastly equipment imported for foreign-invested or domestic-invested projects that are encouraged and supported by the state enjoy tariff and import-stage value-added tax exemptions.

Despite the stated preferential tax treatment of foreign invested enterprises in China, many companies currently operating in the country or looking to establish local representation are concerned due to the lack of information on forthcoming changes. The government is said to be working currently on a major restructuring of taxation system and is considering, among other things, unifying the dual-track enterprise income system as well as shifting the value added tax from production to consumption based.

Under the current system input VAT paid in respect of capital expenditure cannot be used to offset output VAT. Under the consumption-based system such input VAT will be creditable. However, it remains largely unclear whether the taxation reforms will benefit foreign investors.

Another important aspects of taxation reform is foreseen to be the unification of the current dual track income tax system where foreign invested enterprises and domestic enterprises are governed by different tax laws. Although the corporate tax rate for both is 33%, tax holidays and other incentives (as described above) currently reduce the effective tax rates for foreign invested enterprises to 17% and 27% for domestic enterprises. Once the unified system is put in place, however, both local and foreign businesses will be subject to the same unified tax rate expected to be between 25% and 30%. Foreign invested enterprises currently enjoying tax holidays are expected to have their privileges extended to make sure they get the benefit of their previous agreements but there is no fixed timetable for unification.

In line with the concerns over the implementation of the WTO commitments there is also scepticism whether taxation enforcement will become completely consistent with the release of the new taxation reforms. In the recent past China had not developed a comprehensive set of taxation laws but instead relied on broadly stated principles. Even with the WTO commitment for transparency it is evident that this system will not be reformed overnight but it is expected that a more predictable system of laws will be available in the future.

In addition to the above concerns over the changes in the Chinese taxation system, many multinationals view fraud and piracy as one of the greatest risks of their operation in the country. According to the DDT survey more than 39% of all current and prospective investors in China perceived these as major concerns, with respondents in certain market sectors rating it even higher than political risk and instability. This is not surprising. The problems of fraud and piracy have had a pronounced negative effect on the sales and market reputation of many international firms operating in China. A survey conducted by the United States based Business Software Alliance estimates that as much as 96% of all the business software used in China is pirated. Similarly according to the Business Week Magazine, many foreign manufacturers in China estimate that 30% of products bearing their name, constitute pirated copies. The overall losses to multinational enterprises for 2002 from piracy were approximated to USD 168 million with the majority of these being in the areas of home entertainment, internet, television, etc., and the total amount of losses between 1998 and 2002 adds up to USD 688 million.

Realising the hindrance of piracy to foreign direct investment, the Chinese patent, trademark and copyright administration bodies have recently taken a variety of measures to reduce intellectual property right piracy across the country in order to protect both domestic and international enterprises. According to official data provided by the State Administration of Industry and Commerce, in 2003 public security authorities uncovered and terminated more than 34,000 cases of copyright infringement and 37,489 trademark violation cases.

The nature of the problem however lies in the lack of legal precision and complete enforcement of the present Intellectual Property Protection Laws. The latter, for example, specify the maximum penalties for patent, trademark and copyright violation but not the minimum. For this reason the deterrent effect the law is expected to play is not fully achieved since its application is allowed to vary from case to case. In addition, the seriousness of the violation is often difficult to establish until the case had been brought into court and the law does not state clearly the procedure of taking intellectual property (IP) violation cases there. For this reason, although the IP legislation in the country is in accordance with the WTO standards, the Chinese government still is unable to protect foreign investors from counterfeit manufacturers, and research shows that there is very little public respect for IP in the country. And while confidence in the patent application process appears to be strong, concerns about the extent of the IP rights violation remain strong with the majority of the foreign investors.

Naturally, the taxation and fraud related problems discussed above are likely to be treated as some of the not particularly favourable conditions of the macro environment by foreign investors. At the same time, however, it is important to remember that, economically, China is one of the fastest growing nations in the world, with many commercial opportunities and rapidly expanding consumer and business markets. Therefore, it is likely that multinational enterprises may not be deterred at entry but these would most probably attempt to devise new methods of market representation in order to combat the problems of fraud and piracy.

7. Conclusion

Due to the favourable effect of all of the above macro environmental factors, it is not surprising that many companies and independent consultancies predict that the amount of foreign direct investment in China is likely to rise significantly in the next five years following the changes described above. This is due to a number of very significant macro environmental changes implemented recently by the Chinese government which liberalised the local economy to unprecedented levels. Most of these are very likely to either directly encourage foreign direct investment in the form of WOFEs and JVs, or further confirm potential investor’s perceptions that China offers a stable and ultimately profitable investment environment.

It is important to remember, however, that many of the factors of the macro environment discussed in this report are still in transition and therefore may be subject to changes not foreseen here. Although the latter are unlikely to have a significant impact on the overall investment climate, it should be noted that frequent environmental scanning and evaluation are crucial for the overall success of any enterprise. In addition, companies evaluating the possibilities of direct investment forms of entry into the Chinese market should also take into consideration a number of other factors and sub-factors of the macro environment such as its socio-cultural aspects, accounting and corporate governance systems, financial and foreign exchange requirements, competitive trends, distribution possibilities, etc. These were not elaborated on in this report due to its size limitation but the author recognises their importance and the fact that they can also influence the choice of market entry strategy for multinational firms.  

Finally, this research report concludes that China is very likely to successfully implements its commitments to liberalisation at both central and local government levels in the next 5 to 10 years, which will certainly guarantee the attraction of the long-term high-technology high-return investment it is aiming at.

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