The China Conundrum – To Leave Or To Stay?

Posted by Reading Time: 7 minutes

Trade, politics, and China’s SOEs getting caught in-between

Op-Ed Commentary: Chris Devonshire-Ellis

Part I of a three-part series:

Feb. 20 –There has been a great deal of international media attention over the past few months focused on China’s development, especially as we are on the very cusp of a major once-in-a-decade leadership transition. That there has been a plethora of opinions and analysis under these circumstances is of no surprise of course – 10 years is a long time to be running a country such as China. Yet during that time we have seen two five-year plans unfurled, and by and large these have spelled out the direction in which China is heading. To glimpse the China of tomorrow, one only really needs to examine the current 12th Five-Year Plan, which we reviewed in some detail here.

That of course was promulgated by the government that is about to step down, leaving new President Xi Jinping with yesterday’s policies to follow to some extent. But bear in mind that President Xi and the new Politburo were heavily involved in the production of that document. The chances of straying from its path are slim indeed.

That China has changed over the past decade is irrefutable. Labor costs have and are going to continue to increase as China’s population ages, and this dynamic will impact upon the coming leadership in more direct ways than the previous one. The analysts have been pointing this out for some years now, and ignorance is no defense. Demographic analysis is always an important part of the research required to detect where the opportunities, and potential problems, lie.

China also continues to harbor its own bugbears. Unfair competition from state-owned enterprises towards foreign investors has been heralded in the media once again, even to the extent of suggesting it is government policy to “force” foreign investors out of China. This is nonsense, however even the most reputable international news outlets need to sell headlines that readers will buy. A good old-fashioned “China against foreigners” story can always be relied upon to add extra viewers, but such opinions should be treated with a pinch of salt.

That being said, the manner in which SOEs are treated by the government in China as compared to foreign investors has always been unbalanced. As SOEs are partially or wholly-owned by the State and are therefore expected to be fully conversant with the relevant governing regulations, they tend to be subjected to the lowest level of scrutiny. Foreign investors, purely by proxy, are considered not familiar with Chinese laws, and therefore need to be scrutinized with much more attention to detail and in much more depth to ensure they abide by the law. Foreign businesses in China have thus always been placed in a separate category than local businesses. Such a position is nothing new and not actually all that unreasonable.

However, like many things in China, the devil is in the application of the law, and I have seen instances of large Chinese SOEs, applying for listings in Hong Kong, being allowed to cover up large debts owed in mandatory employee welfare payments. Meanwhile foreign investors may be expected to have to pay the full amount, down to the last dime, for every single employee on the dot each month. It turns out that in the case our firm was conducting due diligence on, and in a legal opinion backed up by one of China’s most prominent law firms – working with us on the case – the SOE could in fact legally negotiate it’s so-called “mandatory” welfare payments with the local government concerned. That hole never appeared in the Hong Kong listing prospectus as it was not covered by the requirements of the Hong Kong Securities and Futures Commission (crucial was the caveat that the debt could be negotiated, had it been proven to be mandatory it would have had to appear in the prospectus as a debt).

Such are the benefits of having a close relationship with the local government. It will take a long time to sort out loopholes such as these which are, in my opinion, executed in bad faith. Yet such discriminations between Chinese and foreign companies have been going on for years. It is pointless to start moaning about them now, and whole reams of articles (including many over the years at China Briefing) have explained these issues in detail. The short answer is that foreign companies can survive and prosper in China in competition with Chinese SOEs. To do so means steering clear of any potential political battles (political due diligence is a seldom-mentioned subject when it comes to China, however it remains an important matter to consider), and engaging directly with the Chinese on questions of quality and technology.

As an example of this, Sri Lanka has recently run into problems with the Chinese contractor of a power plant after quality problems surfaced with the construction, only for the Chinese to hold their hands out for another US$40 million to fix the problem made by the contractor in the first place. The plant at Norochcholai was to have been subsequently operated by the same contractor, but that has now been cancelled.

“We had an agreement for the Chinese contractor to provide six months know-how and technical knowledge from their engineers,” Sri Lanka’s Power and Energy Minister, M.M.C. Ferdinando wryly noted. “Despite numerous requests, this was not forthcoming, and then a problem arose that required again the services of the Chinese contractor to fix.”

Third party engineers brought in from Switzerland to assess the problems noted that “technical specifications or accepted international standards had not been adhered to in the construction, testing or commissioning of the plant.”

Sri Lanka’s diplomatic relations with China – very good up to now based on the promises of investment and development assistance – may now start to be tested when China’s actual delivery fails to match up to promises. When this occurs with a Chinese SOE in an important political and G2G deal for a country like Sri Lanka, China’s ongoing strategy of winning contracts via the cheapest bid is starting to gain a level of notoriety across Asia, Africa and South America. The way to compete with Chinese SOEs is on that very same weakness – quality. That is an issue that the Indian auto parts manufacturer Motherson Sumi Systems has been able to exploit as it takes on China’s own auto parts manufacturers in their own backyard, as we pointed out on India Briefing today. Five years ago, no one would have suggested that an Indian company could compete with China’s own SOEs in the auto parts industry within China. Today it is fact, and Motherson are adding capacity to their China manufacturing plants. Suggesting that foreign investors in China cannot compete with Chinese SOEs is simply not true.

China has also perhaps unwisely demonstrated a willingness, through its SOEs, to use trade as a political weapon. With many of China’s largest SOEs (especially the ones operating lucrative businesses overseas), the connections between government and a commercial enterprise run a very fine line indeed. Companies such as Huawei may never reach their global potential due to concerns over military ties and the potential for bugs to have been inserted into their devices, and both the United Kingdom and India have expressed serious concerns over Huawei’s ability to provide clean technology. With senior Chinese government officials sometimes owning significant shares in these SOEs, there is real potential for deliberate political interference at a diplomatic level in what should remain commercial disputes.

Quite how the relationship stands these days between China’s Foreign Ministry, keeping diplomatic doors open and relationships thriving, and those of China’s Ministry of Commerce would be difficult to assess. The true nature of the Chinese conundrum today is how it will deal with the conflict between commerce and diplomacy, and it is this issue that President Xi will have to solve during his tenure.

Part II and Part III of this series stick to business issues. These two pieces lay out the strategic reasons for expanding in the country, and the reasons of looking elsewhere, and provide no specific all-encompassing answer because, quite simply, there isn’t one. It depends on your type of business. But for those who stay and do battle with China’s SOEs – the quality card remains the one to play.

Part I of a three-part series:

Chris Devonshire-Ellis is the founding partner and principal of Dezan Shira & Associates – a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email, visit, or download the company brochure.

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