SPECIAL REPORT

Risks and Rewards

How Canadian firms investing in China face political and commercial hurdles

DEIRDRE McMURDY June 13 1994
SPECIAL REPORT

Risks and Rewards

How Canadian firms investing in China face political and commercial hurdles

DEIRDRE McMURDY June 13 1994

Risks and Rewards

SPECIAL REPORT

How Canadian firms investing in China face political and commercial hurdles

DEIRDRE McMURDY

The tinkling notes of Edelweiss and Silent Night waft delicately through the crush of an early-morning market outside the Workers’ Stadium in Beijing. There, in a clearing amid the barrows of leafy produce and bright plastic shoes, dozens of Chinese couples are gracefully gliding through waltzes and foxtrots. Instead of the traditional meditative morning exercise, t’ai chi, many Chinese now prefer open-air ballroom dancing or even country line dancing. That taste for Western culture is also on display on a typical weeknight at the world’s largest McDonald’s restaurant. As the Carpenters coo their syrupy Seventies hits over the sound system, the giggling patrons line up to have their photos taken with a plaster model of Ronald McDonald. And just outside the city, along the dusty, congested road that leads to the Great Wall and the sacred Valley of the Ming Tombs—now home to the immaculate, new Beijing International Golf Club—a gleaming red billboard proclaims: “A more open China is waiting for you.”

The Middle Kingdom has come a long way since Communist leader Mao Tse-tung led a revolution that “liberated” the Chinese people in 1949. While his portrait still dominates Tiananmen Square and street vendors hawk ceramic Mao buttons

and copies of his Little Red Book, China is now in the throes of another, very different, revolution. Although the country’s human-rights record—complete with accounts of torture, mass execution and political persecution—is frequently decried by such organizations as Amnesty International, foreign investors and governments seem prepared to overlook those violations as long as China continues to loosen the shackles on its state-controlled economy. But now, despite the rapid pace of change and the proliferation of such reassuring Western totems as Pizza Hut, shopping malls and stirrup pants, there are even concerns about how smoothly China’s economic future will unfurl. There is an emerging consensus that the easy leaps forward have now been made—and there could be some rough road ahead. “China may be rising but it’s an irregular trend line,” says Richard Belliveau, Canada’s consul general in Shanghai.

On the surface, China has made all the right moves: bidding to host the 1996 Olympics and lobbying to join the General Agreement on Tariffs and Trade by the end of 1994. Such steps have been cheered heartily in the global village and rewarded with funding from international development banks and a host of private investors. About 50 per cent of all direct foreign investment in 1992 was directed to China, including about $5 billion annually from the United States.

Canada has also joined the stampede. Between 1979 and 1992, Canadian companies signed 581 investment contracts with China worth about $1.1 billion, making Canada China’s eighth-largest trading partner. Last week, Foreign Affairs Minister André Ouellet declared that, despite the objections of human-rights activists, trade was Canada’s top priority in dealings with China. That pronouncement followed U.S. President Bill Clinton’s decision on May 26 to renew China’s favored-nation trading status, after threatening to withdraw it because of human-rights abuses. “All the sectors that are priorities in our economic plan are areas where Canada has strength,” notes Sui Hui, director of American and Oceanian affairs at China’s ministry of foreign trade and economic co-operation. “You should do well here.”

To ensure that, a number of Canadian politicians and executives are now jockeying for position. At the federal government level, China has officially been tagged as a market that will allow Canada to expand and to broaden its trade relationships beyond interdependence with the United States. The Canadian International Development Agency (CIDA) spends about six per cent—or $115 million— of its $2-billion annual budget on projects in China. And in the past four months, Gov. Gen. Ramon Hnatyshyn, International Trade Minister Roy MacLaren, Agriculture Minister Ralph Goodale and Ontario Premier Bob Rae have all travelled there.

Prime Minister Jean Chrétien is planning to make a state visit in the fall.

Shadowing the politicians is a who’s who of senior Canadian executives. In the first two weeks in May, there were pilgrimages by Allan Taylor, chairman of the Royal Bank of Canada; William Stinson, chief executive officer of CP Ltd.; and Michael Wilson, former international trade minister, now a consultant. And among the corporate participants in a trade mission to China in late March were American Barrick Resources Ltd., Bombardier Inc., Hudson’s Bay Co. Ltd., SNC-Lavalin, Teleglobe Canada and Westcoast Energy.

Despite Canada’s fresh burst of enthusiasm for China, it may have come on the cusp of some profound upheaval. On the political front, there is the possibility of a disruptive struggle for succession when Premier Deng Xiaoping, who turns 90 in August, cedes power. There are still deep splits within the Communist Party over the pace and the extent of the economic reforms that Deng launched in 1978.

There could also be a crackdown on personal and economic freedom if central government leaders feel that their control is threatened. Upset by unfavorable news coverage of China by the BBC World Service, Chinese officials recently pressured global media tycoon Rupert Murdoch into dropping it from his Star TV satellite channel, which is widely available in China. Last week, Chinese police ordered hotels in Beijing to turn off the international television news network CNN until June 6 because of programs relating to g the fifth anniversary of the Tiananmen Square massacre, á Five years ago, on June 4,1989, government troops fired on | about one million pro-democracy demonstrators who rallied g in Tiananmen Square. As many as 5,000 rioters were killed £ in that brutal confrontation and several members of the in| temational community imposed economic sanctions against

China in protest, “ft was a difficult period for China and the outside world,” concedes Sui Hui, primly perched on the Q edge of a lumpy, overstuffed armchair decorated with deli£ cate lace doilies. ‘We had political problems and the West had economic ones.” But now, she says curtly, “it’s time for both of us to get on and put that in the past.”

Relations between China and the outside world have slowly normalized since the shock of 1989. In May, Canadian Airlines International Ltd. of Calgary resumed direct flights to Beijing from Vancouver— which had been abruptly suspended after Tiananmen Square. Next year, the airline plans to add a service between Beijing and Shanghai. But the re-establishment of ties between China and the rest of the world has also directly contributed to a host of new pressures.

For one thing, the country’s strong economic growth rate—about 13 per cent in 1992 and 1993—has fuelled inflation and a trade deficit that hit $1.8 billion in the first quarter of this year. In that same period, the industrial output of joint ventures and private businesses in China grew at an annualized rate of 80 per cent and, in most urban centres in

China, inflation was about 25 per cent. As a result, the central government has imposed a more modest target of nine per cent growth for 1994, and it hopes to contain inflation to about 10 per cent.

That overheated economy, however, is already exposing other weaknesses in China’s domestic situation. To win support for his ambitious agenda of economic reform, Deng overcame the resistance of Communist Party hardliners in Beijing by courting and delegating extensive authority to China’s 30 provincial governments. But that dilution of central government control—and mounting tension between Beijing and the provinces—has become a serious problem now that tough economic discipline is required to keep the economy in check. Not only has Beijing steadily lost tax revenue to the provinces, but in mid-1993, when vice-premier Zhu Rongji attempted to rein in fiscal policy, his plan was thwarted by resistance from provincial leaders.

China’s high rate of inflation is especially dangerous because it exaggerates the problem of acute regional disparity. These may be boom times in the country’s special economic zones in the south and developed coastal areas such as the port city of Shanghai, but the rural interior provinces—where 70 per cent of China’s population still resides—are increasingly left behind. “Such regional disparity can create economic and political instability,” says Donald Brean, a professor of international finance at the University of Toronto.

The absence of a developed commercial banking structure—since all businesses are owned by the state and all workers are wards of it— means that there are no monetary policy levers to readily tighten credit or curb spending and borrowing. Instead, the government is forced to resort to such crude devices as commodity price controls to cool the surging economy. Those heavy-handed measures, furthermore, reverse much of the effort already made to liberalize China’s markets and to allow supply and demand to set prices. Wing Morse, the genial general manager of the Royal Bank of Canada’s Shanghai branch— and a former U.S. intelligence agent, who specialized in Far Eastern affairs during the Vietnam War—notes: “China has an economic history of fits and starts, control and decontrol. There are bound to be sharp ups and downs as it struggles to keep a grip on its economic growth.”

To some extent, the country’s increasingly overwhelmed infrastructure provides some limit to that growth. In 1992, only about 65 per cent

of China’s households were connected to electricity (compared with 82 per cent in India) . Despite seven per cent annual growth in the power sector and heavy investment by private groups and such agencies as the Asian Development Bank, it has been unable to match the overall rate of China’s domestic economic growth. To keep pace with projected demand, China’s electric power capacity must double by the year 2000.

Similarly, the nation’s infrastructure—roads, trains, mass transit, sewage treatment and water filtration— are stretched to the limit. Rural poverty is adding to that burden by driving peasants into the booming cities to look for work. In Shanghai, according to Hu Yanzhao, chief economist of the urban planning commission, the official population of 13 million does not include a “floating” population of about three million people who subsist in shantytowns while they look for menial jobs or simply beg. In 1993, the city borrowed $4.3 billion to supplement its budget for infrastructure improvements. “Basically, the infrastructure has not been improved since 1949,” says Belliveau, a New Brunswick native whose easy manner has made him—and the consulate—a focal point in Canadian expatriate social circles. “They need absolutely everything.”

More than ever before, China’s ability to meet its changing needs has a direct impact on the global scene. Although the country has historically tried to remain remote from the rest of the world, China’s current boom is the result of an unprecedented reliance upon—and acceptance of—foreign capital, technology and trade. The International Monetary Fund now ranks China as the world’s third-largest economy, behind the United States and Japan. And with a population of 1.2 billion people—one-fifth of the entire global population—China represents a tempting market for companies that have been competing to survive in more mature, developed economies. “The market is flat everywhere else, so competition for contracts here is very intense,” says Lin Sun, technical marketing director for Spar Aerospace in Beijing.

Still, a number of Canadian companies, including Northern Telecom Ltd., Seagram Ltd., The Royal Bank of Canada and Babcock & Wilcox, which operates its international division from Cambridge, Ont., have already established the critical guanxi, or relationships, in China through joint-venture projects. Because its capital is limited and its needs are huge, the Chinese government has developed a strategy of using such partnerships to expand the country’s infrastructure, to modernize its industrial base and to train workers.

Joint venture negotiations, however, tend to be complicated by the fact that China has no commercial legal code and few standardized accounting practices. Because all companies have been state-owned for so long, basic accounting rules were developed for 13 specific sectors—and they do not incorporate such features as profit and loss statements.

Now, through joint venture projects with international accounting firms Deloitte & Touche and KPMG Peat Marwick, the government is developing standards that correspond to those used around the world. Shen Xiaonan, deputy division chief in the department of administration of accounting affairs at the ministry of finance, says: “If we want to attract foreign capital to China, we realize the need for a change.” Still, consul Belliveau warns: “There is a lot of uncertainty about when a contract actually is a contract. It is important for foreign firms to try and anticipate as much as possible before spending any money.”

In addition, while foreign investors may assume that a joint venture automatically gives them preferred access to the burgeoning Chinese market, the Chinese are more anxious to ensure that production is exported and therefore generates hard currency. Typically, they will demand that a certain, fixed percentage of all production—usually at least 50 per cent—is exported. And the strong demand for such joint-venture deals gives Chinese officials a strong bargaining position. “The Chinese have become very picky customers,” says Spar’s Lin. “They’ve learned a lot from the bidders they’ve dealt with and they’ve also learned how to play them off against one another.”

In fact, a number of Canadian companies are learning hard lessons about the tough reality of global competition in China. One of the fiercest battlefields is in the telecommunications sector, where dozens of international giants—including Spar and Northern Telecom—are vying to supply China with modem equipment. At the end of 1992, China had 30 million telecommunications lines installed, and it plans to increase that to 100 million by 2000. That annual rate of growth is equal to the entire existing network of lines in Canada.

However, last January, Chinese officials in Beijing abruptly announced that by July they want to deal with only a handful of suppliers of network transmission equipment suppliers. Northern Telecom is just one of the companies, all of which have spent hundreds of millions of dollars to enter the market, that is fighting to stay in the fray. The third-largest supplier of switching equipment in China, Northern Telecom has been there since 1972—although it has intensified its focus on China relatively recently. Ken Bradley, managing director of Northern Telecom Ltd.’s integrated circuit project, runs his office out of a cramped suite of rooms at the elegant Shanghai Hilton hotel. He says: “The ranks are thinning and you need to be a major player to stay in the game.”

Staying in that game requires a strong will as well as deep pockets. Fuelled by offshore investment, the country has gone through a real estate boom that has sent costs soaring for office space and Westernstyle accommodation. ‘Western-style” is the common euphemism for the extravagant new buildings that have been erected to house the steady traffic of visiting executives as well as the growing expatriate population. Many “expats” reside in hotels for months until a relatively modem apartment becomes available.

In addition to the high premium on housing and office space, a company must have the right connections to get a telephone or other office equipment installed in under a year. Finding replacement parts or standard supplies—an ink cartridge for a computer printer, for example— can become a huge ordeal. “Everything takes about three times longer to accomplish and you must accept that in China,” says Norman Gish, a peppy former Calgary oilman, now managing director of Fracmaster China Ltd., an oilpatch service company. “It’s very expensive to get established—you need staying power, you need patience.”

But however serious a company’s commitment to the Chinese market may be, there are profound structural problems that neither guanxi or foreign technology can change. One of the most significant issues is how to contend with the bloated, inefficient and entrenched state companies that continue to dominate and distort the Chinese

economy. To date, government leaders have largely skirted the immense problems posed by companies that, as cogs in the central economic plan of the state, have been oblivious to the need to tum a profit or to compete. That blind eye is turned, in part, because these companies employ and are directly responsible for the welfare of hundreds of millions of workers across China. “The concept of bankruptcy or the consequences for poor performance are alien to state companies,” says Norbert Chan, manager of Peat Marwick Huazhen in Beijing. “They’ve always been covered by government in any pinch.”

The domestic workforce can also pose formidable challenges for foreign companies entering a joint venture with a state-owned company. Traditionally, loyalty to the Communist Party and adherence to the party line have been rewarded more than competence and individual initiative. And because state-controlled companies produced goods for a planned economy, there was no incentive for workers to move beyond their narrowly defined function, to take risks or to make decisions. Furthermore, the Cultural Revolution, when Mao Tse-tung persecuted millions of Chinese whose views were deemed to be counterrevolutionary, wiped out almost an entire generation of universityeducated potential managers in the 1970s.

As the general manager of one of the first joint-venture projects between a Chinese company and a foreign one, David Lee, a dapper Singaporean with Babcock & Wilcox, first arrived in Beijing in 1985. The central government had invited the company, which manufactures equipment for power generation plants, to join forces with state-owned Beijing Boiler Works. The existing work unit consisted of 2,500 people who were accustomed to producing exactly 60 boilers a year for the state. When that assignment was finished at the bleak industrial complex, which looks like a movie set depicting 1950s Soviet-style industry, there was nothing more for them to do, says Lee. To improve productivity and eventually turn a profit, he had to dispense with the Communist notion that all workers are equal. Lee established 10 clearly defined levels of responsibility and initiated a graduated pay scale and performance bonuses. “We explained to them that we were going to set targets and measure their output,” he says. “It caused quite a stir.”

One of the biggest, ongoing challenges is to overcome China’s rigidly hierarchical culture, according to Lee. “There’s a huge resistance to the thought of a younger manager telling an older worker what to do or how to do something,” he notes. Another hurdle, he says, has been getting workers who have relied on the state to make all major decisions in their lives to begin making their own choices and solving their own problems.

To help that next generation of managers to develop their management skills, a CIDA program provides funding for professors from several Canadian business schools to teach at Chinese universities. On a drizzly May morning on the campus of Fudan University in Shanghai, a small group of adult students are attending a class given by Tony Faria, a professor of marketing strategy from the University of Windsor in Ontario.

For the students, the computer simulation exercises in Faria’s class appear to be rivetting— they gather in small clusters, earnestly discussing their strategy. However, they are used to straight lectures, with no tutorials or question periods. The adjustment, admits Fang Jian-Ping, who attends business school part time and works as a manager in a local toy factory, makes him “a bit nervous.” Fang says: “Our teachers do not have any practical experience and it would be rude to embarrass them with direct questions. But it’s probably better this way.” Still, he insists that he would prefer to work for a state-own company, rather than be an entrepreneur, when he graduates. “There are benefits and security at the state companies,” Fang says. “And you can’t borrow money to start up or operate a company anyway because of the banking policy. Who knows when that will change?” But while students like Fang struggle to bridge the growing gulf between China’s orthodox Communist past and its emerging quasi-capitalist future, it is not longer a question of when—but of how fast—things will continue to change. □