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Managing risks in Chinese joint ventures.

John J. Hampton, D.B.A., is provost of The College of Insurance in New York.

In the past Westerners paid close attention to the market prospects and profits from their joint ventures with Chinese state corporations. In today's business environment, however, they should pay greater attention to the risks. Certainly, in the event that China's political climate improves and U.S. businesses resume negotiations with the Chinese, risk managers should be ready with plans to make these ventures safe and profitable.

The 1980s was an active period of contractual and equity joint venture negotiations between Chinese state organizations and foreign businesses. Western partners in ventures still in operation are reluctant to discuss the difficulties they faced in negotiating and implementing their business operations in China.

Still, it is relatively well known that despite the imposition of martial law in 1989, many of the early hopes and aspirations have not been realized. In fact, frustration has turned to bitterness in some cases.

1991 is an appropriate time to reassess the business climate for ventures with Chinese partners. For one, martial law in Beijing has provided insight into the political exposures confronting joint ventures there. Second, more than a decade of experience working with the Chinese allows businesses to avoid repeating past mistakes. Furthermore, in 1997 Hong Kong will become part of China. Perhaps some of the lessons learned in the 1980s can help Western businesses prepare for 1997.

The 1980s began with great hope. After being closed to foreigners for many years, China, the world's most populous market, opened to Western business. Companies reacted by constructing their business plans with a long-range view and negotiating with the Chinese. As the decade progressed, conflicting signals began to emerge. Although thousands of ventures were getting off the ground, problems were becoming obvious. Inadequacy was felt in nearly every area, including facilities, transportation, communications, government approvals and foreign currency. The timetable for future profits grew more elusive.

The end of the decade was a stressful period in the Chinese economy. Improvements in the infrastructure were not keeping pace with service demand. Materials and supply shortages produced run-away inflation and encouraged corruption. Economic and social tensions ran high. Thus, martial law came to China as a political and economic reaction to a turbulent economy and external political events, consequently disrupting many joint ventures.

Today, Chinese politics permeates every discussion on the future of business in that country. The uncertainties are expected to drain personnel and financial resources from Hong Kong. And while Western businesses may be reluctant to form joint ventures, they will no doubt eventually resume.

Operating Risks

An operating risk is the chance that a joint venture will not make money from its major area of business. To reduce the risk, a business must know whether the goods it manufactures meet market standards, and whether it can control expenses so the goods will be sold at a profit. Unfortunately, Chinese business is rife with operating problems that result in shoddy goods and late deliveries. Yet the joint ventures that proved successful did so by by taking several steps to reduce delays, minimize faulty goods and avoid cost overruns.

Successful ventures had good local management. Operational control of the ventures was in the hands of skilled independent managers. joint venture hotels are good examples. Local managers were trained by Western partners in Hong Kong, where they learned how to provide first-class services. When the hotel opened, these skilled personnel trained other workers. The same principle applies to manufacturing ventures, whether they involve constructing industrial boilers or producing Christmas toys.

Profitable ventures also incorporated slow learning curves into their business plans. The timetable for opening the venture allowed for delays and failures, then more time was needed for training. Still more delays occurred during the testing period to eliminate bugs and overcome obstacles. Finally, the venture was able to deliver goods or services on time.

Infrastructure Risks

As in most developing nations, China suffers from a lack of good roads, vehicles and railroads to deliver goods to markets. Communications, too, are extremely difficult in many areas, and water and electricity are frequently unavailable and unreliable in quantities needed for modern production.

In the 1980s losses or expenses resulting from unreliable infrastructures endangered many Chinese joint ventures. To minimize the impact of infrastructure risks, the venture should be located in a coastal area where China has made progress with roads, communications and services. Less desirable, but also workable, is a river location where the facility can be serviced by at least medium-size vessels.

Operations located in China's interior have an abundance of inexpensive labor, but may lack dependable roads and communications. The success of ventures in the Chinese province of Shenzhen can be attributed to their proximity to Hong Kong, with its excellent distribution and communications capabilities. Ventures in Shanghai, Guhangzhou or Beijing also face fewer problems than comparable activities in interior provinces. Furthermore, although selecting a coastal site conflicted with China's goal to develop its interior provinces, its need for foreign currency outweighs other factors.

Financial Risk

The financial risk inherent in joint ventures is the chance that the business will not earn the hard currency needed to pay debts and provide a profit for the foreign partner. Prospects for earning a profit in China are complicated by the country's view of the time value of money. In negotiations, it quickly becomes apparent that the Chinese partner is not oriented toward investing money that will earn a return. Until recently, state corporations in China invested when funds became available from the central government. No interest was due and the level of required return was not a serious consideration in the funded projects.

The financial risk is made worse by China's shortage of hard currency. Even in the 1980s, when China had favorable trade balances, hard currency was scarce. It is unlikely that China will have adequate amounts of convertible currencies to meet its future economic needs. The country's economy has been further aggravated by business interruptions and decreased tourism as a result of martial law, which was imposed in June 1989.

While it cannot be eliminated, financial risk in joint ventures can be reduced. One way is to limit hard currency investments by not rushing in with dollars, yen or deutsche marks. If the Western partner restricts the amount of convertible currency in the venture, delays and other time value of money obstacles will be reduced.

Another way to limit financial risk in joint ventures is to retain a portion of hard currencies in foreign banks. If the venture does not earn foreign currencies, any discussion of retaining them is irrelevant. However, ventures that earn hard currencies should seek agreements that allow them to deposit some of the funds in foreign banks until needed. Although this arrangement may not be agreeable to the Chinese government, it may be the price China has to pay to retain its Western ties.

In the 1980s many investors were willing to accept losses to do business with China, which partly accounted for China's legendary ability to negotiate good deals for itself. Today, the situation has changed, and the remaining Western partners and negotiators are not facing cutthroat competition.

Legal Risks

Since 1979 China has developed laws and a legal system to deal with contract enforcement and the resolution of business disputes. Still, its system differs markedly from most developed nations. As a result, Western partners should recognize a few simple truths regarding joint ventures.

First, Chinese contracts are not enforceable. The inability to enforce a Chinese contract is deeply rooted in China's heritage and culture. Negotiating a contract and implementing a signed agreement are considered an ongoing business activity.

Contractual disagreements in China are seen as cultural, not legal, matters. Yet despite this, Western partners and their lawyers spend a great deal of time examining the legal system in China and the arbitration clause in their contracts. When disputes arise, they are rarely resolved in the courts but rather through friendly discussions.

Furthermore, even if enforceable in court, enforcement would end the agreement. A contract between Western and Chinese partners is often compared to a Western marriage. Disputes arise but must be settled by the parties themselves. After all, what marriage can continue on a reasonable basis after a serious dispute has been resolved in court?

Western partners that take legal action quickly find out that the law in China is part of a grander scheme. Although progress was made in the 1980s, the legal system continues to have little independent standing in China. Hence, it cannot be relied on as a force that acts separately from the Chinese government.

The nature of the problem is evident in Article 9 of China's 1985 Foreign Economic Contract Law, which states, "Contracts that violate the law or the public interests of the People's Republic of China are invalid." As a result of the hard currency shortages following martial law, contracts were unilaterally declared invalid if they required the use of scarce foreign exchange. The availability of foreign currency was guaranteed when it was in China's interest to make such a guarantee. When the interest changed, so did the validity of the contract.

Insurable Risks

An insurable risk involves a potential loss arising from a source outside a venture's business operations or financial position, including a fire that destroys a factory or a vessel that sinks in a storm. China has a relatively short history of taking steps to increase the safety practices of its manufacturing operations. A typical Chinese factory has inadequate electrical wiring, cluttered work areas and numerous fire and other hazards. As a result, accidents occur more frequently than in manufacturing operations in industrialized nations.

For joint ventures, insurable risks pose two dangers. Even if a loss is covered by a policy with the government-run People's Insurance Company of China, the halt in production can be costly to the business. Expenses, such as employees' salaries, may have to be continued. Insurance to compensate for business interruptions, particularly when those stoppages affect the hard currencies of the venture, is not readily available in China on a cost-effective basis.

Physical losses of equipment made outside China pose another problem. Some of the machinery in most manufacturing ventures must be purchased outside China using convertible currencies. If destroyed or damaged, they can be replaced using insurance money only if the payment is convertible to other currencies. Depending on the availability of foreign exchange in Chinese banks, it may not be possible to replace the equipment destroyed even when it is fully insured.

To reduce the adverse impact of insurable risks, the joint venture should obtain some of it insurance coverage outside China. Although permitted under Chinese law, it was difficult to implement this in the 1980s. Today, Western negotiators who remain firm on this point can probably get their way.

Exchange of Profits

The most frustrating aspect of any investment in a developing nation is the Western investor's inability to exchange profits for hard currency. One solution to this problem is called transfer pricing. In this case, if the venture produces goods that will sell in foreign markets, the profits can be incorporated into the pricing of the products. For example, a product may cost $15, be sold to a marketing company for $25 and have a final selling price of $30. If it is purchased by an affiliate of the Western partner for $23 instead of $25, a $2 profit-available in a hard currency-will have been created outside the joint venture.

The Western partner can also negotiate a percentage of foreign exchange earned. Accounting in China, as in other developing nations, should never be the basis for calculating the profits that accrue to partners. Instead, the agreement should call for a percentage of hard currency eaAkNtino-Italic 0 xpdefoht stipulate that the Western partner may retain a certain percentage of gross foreign exchange earned.

Another way to mitigate the hard currency rule is to take the profit before it is repatriated to the venture. Future agreements can specify that earned foreign exchange must be deposited in a non-Chinese bank. Payment of a percentage of it to the Western partner can be guaranteed by a letter of credit from a non-Chinese bank.

In the 1980s many of the aforementioned tactics would have seemed improbable. Specifically, it was difficult to negotiate transfer pricing or hard currency provisions for Chinese joint ventures. It was also difficult to earn a reasonable rate of return on investment. Today, the situation is poised for changes that allow the Western partner to earn a return. The one area in need of change is the political scene, which continues to keep the country removed from the global economy.

The 1980s began with unrealistic expectations of opportunities available in China. They ended with political uncertainty and economic difficulties. As a result, many business partners have abandoned China, and potential opportunities have been lost. Because of this lack of interest, the 1990s have become an ideal time to reassess the risks in China and perhaps take a calculated gamble. Whatever the outcome of current political tensions, the door that has been opened to Westerners will not easily be closed, but the risks will always remain.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Hampton, John J.
Publication:Risk Management
Date:Apr 1, 1991
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