China – Political and Regulatory Systems
By Miriam (Penny) Milsom
January 26, 2003
Executive Summary
Introduction
Regime Stability
Laws and Regulations
Protection of Property Rights
Protection of Foreign Assets
Government Price Controls
Corporate Restrictions in China
Establishing Operations in China
Conclusion
Executive Summary
It is important for Staples to analyze the stability of the Chinese government, Chinese laws, property rights, price controls, and business restrictions before entering the Chinese market. These political and regulatory systems can either impede or assist Staples’ operations in an expansion to China. The Chinese government has, in the past, strongly controlled such things as prices, markets, products, foreign assets, and personal assets. However, during the past decade, the Chinese government has chosen to open their markets to world investors and to create laws and regulations more in line with the World Trade Center guidelines. This change in philosophy has encouraged foreign investment in China. However, regardless of the recent move towards an open market, the Chinese socialist political environment should remain a key risk factor in any potential expansion.
Introduction
The Constitution of China, adopted in 1982, states, in the first paragraph of the first article, that, "The People's Republic of China is a socialist state with the people's democratic dictatorship led by the working class and based on the alliance of workers and peasants.” It is necessary to understand this underlying nature of Chinese politics in order to analyze the Chinese political and regulatory systems as they relate to foreign business. These underlying socialist principles remain core to the Chinese culture and are not affected by the globalization that the Chinese government has strongly promoted.
Regime Stability
One threat to the stability of the current regime is citizen unrest. The underlying political principle in China is that the Communist Party provides an increasing standard of living and in return the Chinese people do not challenge the Government’s power. “But even with high growth, the rulers have found it steadily more difficult to damp down conflicts created when some groups in society get left behind. [Last year], tens of thousands of workers hit the streets of two cities in the industrial northeast to protest unpaid wages and benefits” (Jackson, S. 8/13/2002. Par 11).
Such demonstrations are likely to continue as the poor and laid-off workers demand to be heard. Current protesters and their demonstrations are not a major threat to the current regime. However, groups that might create larger and more dangerous tensions “include those people living in the poorer interior provinces, ethnic minorities, farmers, members of the unemployed or underemployed floating population, and laid-off…workers” (Sutter, R. 10/25/01. Par 10).
Another threat to the stability of the Chinese government is the pressure to conform to the world’s demand for a more open market. Friedman, in his book “The Lexus and the Olive Tree,” describes a ‘golden straightjacket.’ This straightjacket is an analogy for the rules and regulations that a country must adhere to in order to attract and retain foreign investment. Many of these rules and regulations are overtly demanded by the World Trade Organization and national treaties while others are silently mandated by a collective group of private investors seeking a safe place to invest. The Chinese government, in an effort to attract foreign funds, is taking appropriate steps to put on this ‘Golden Straightjacket.’ This imaginary straightjacket, however, is putting pressure on the Chinese culture and way of life. Gordon Chang, author of the book "The Coming Collapse of China” suggests that the Chinese Communist party may be unable to solve the problems inherent to adhering to the World Trade Organization’s requests. The cause of the collapse “would be the stress of conforming to WTO norms and other tensions inherent in the broader impact of globalization” (Sutter, R. 10/25/01. Par 2). “The supertanker is headed for the rocks, and the committee of captains is not ready to turn the helm hard in any direction. The country's apparent stability gives a false sense of security” (Jackson, S. 8/13/2002. Par 10).
Another looming risk for the Chinese government is that The Peoples Bank of China is predicting a steady growth of 7 percent per year over the next few years. If, however, that growth were to falter, demonstrations, as in the past, would break out. “A new report … written by three professors from Beijing's Peking and Tsinghua Universities and Hong Kong's Chinese University, predicts that a slowing of growth would lead to unrest on a scale similar to Indonesia in 1998. The implication is that the regime would fall, as Suharto's did” (Jackson, S. 8/13/2002. Par 11).
Although there are risks for China, the Chinese government is anticipating a bright future. Inflation is currently in check and sustained growth is predicted. China’s leadership is likely to continue the process of regulating financial and political affairs to meet WTO norms. And fortunately, with increased regulations, China's political activities are more predictable than they once were.
In addition, today's leaders are “technically competent and much less ideologically rigid than their predecessors. They are also aware of the problems they need to face, and are prepared to deal with at least some of the more important ones” (Sutter, R. 10/25/01. Par 3). According to Sutter, China’s newest leaders are educated individuals, comprised of lawyers, economists and other professional individuals. These new leaders are competent and modern when dealing with economic and social problems. They are more realistic when dealing with domestic and foreign policies. They have also “benefited from many exchanges with the United States and other countries” (Sutter, R. 10/25/01. Par 4).
Hu Jintao is anticipated to become president of China in March. “Hu has shown himself to simultaneously impress people on the right and the left…Hu’s background could help save China from economic catastrophe” (Liu, M. 1/6/2003. p. 76). Although collapse is possible, “the balance of evidence and likely determinants…support a cautious optimism about China's future. The regime appears resilient enough to deal with anticipated problems, despite the challenges” (Sutter, R. 10/25/01. Par 2).
Laws and Regulations
“Policy making in Beijing is like steering a supertanker -- it takes a long time before a policy gets approval and becomes a reality, and even then the central government has limited power over a vast country” (Jackson, S. 8/13/2002. Par 8). In addition, personal rivalries, dishonesty, and graft exist. “Other key problems are leadership succession, nepotism, favoritism and increased corruption” (Sutter, R. 10/25/01. Par 7).
The Chinese government is, however, taking steps to create and enforce a stricter legal system, support freer commerce, and embrace the global marketplace. “The People's Republic of China (PRC) began developing its present legal system in the late 1970's. The passage of the Sino-Foreign Equity Joint Venture Law in 1979 was the first step by the Chinese government to build a legal structure governing foreign investment. Since then, China has continued to build a legal system that will protect their rights as well as the rights of their foreign partners” (ChinaLaw 2002. Par 1).
Protection of Private Property Rights
“Private firms have been one of the driving forces propelling China's rapid economic growth in recent years, as witnessed by their rising shares of production, investment, and job creation” (Kwan, K. 2/8/2002. Par 1). Still, a number of systemic problems do need to be addressed in order to encourage additional development. One of the most important problems China must deal with is the need for additional legal protections for private property rights.
Under the Communist regime, private firms were associated with capitalism. As such, they were typically forbidden or subjected to various restrictions. The situation has improved since the 1970s when China changed to an open-door strategy. Chinese leaders have come to realize that private firms are an important part of the socialist market economy. “This significant shift in government policy, however, has yet to be fully reflected in the provisions of Chinese laws. Because of insufficient protection of private property rights, many entrepreneurs hesitate to expand their business through reinvestment…and this has adverse effects…on the management of individual companies” (Kwan, K. 2/8/2002. Par 2).
Protection of Foreign Assets
China began adopting a more business oriented legal system in the late 1970's. The passage of the Sino-Foreign Equity Joint Venture Law in 1979 was the beginning effort to attract foreign investment. Since then China has built a legal system that attempts to protect the rights of Chinese citizens as well as the rights of their foreign partners. Memoranda of Understanding between China and the United States as well as China's efforts to maintain Most Favored Nation (MFN) status with the United States has helped China gain entry into the General Agreement on Trade and Tariffs (GATT). New Chinese legislation is regularly introduced in an attempt to modernize their economic legal structure.
China is expected to increase the creation and enforcement of laws protecting the property rights of foreign corporations. However, there is a risk that this may not completely protect foreign assets. “Many believe that membership [in the WTO] may have a reverse effect. Putting people out of work may drive the [counterfeit] industry further underground and trigger anti-Western backlash” (BizAsia 11/18/00. par 5).
Government Price Controls
The Chinese government retains the capability to impose strict wage-and-price controls, but this practice in not currently enforced. The majority of prices in China are now dictated by market rates. China lifted price controls on many items as part of entering the World Trade Organization. However, even then, the “impact on the cost of living [was] slight, because most items on the list [were] already traded at market prices, according to Chinese officials” (BBC. 7/31/01. par. 2).
The current policy of relaxed price controls is likely to continue as long as it benefits the Chinese people. Staples will be allowed to sell their goods and services at the market price while China maintains their growing standard of living. The risk to Staples will be in the future if China experiences a severe recession and reverts to the socialistic driven controls on commodity, energy and transportation prices.
Corporate Restrictions in China
There are many restrictions for firms operating in China. Certain firms may be blocked from entering a particular field that is available only to state-owned companies. Certain firms face difficult rules regarding technology, personnel, and financing. Also, certain firms may be forced to shoulder an unreasonably big tax burden.
Furthermore, financing may hinder access to funds. “Four major state-owned banks continue to dominate the Chinese banking sector, and their lending is highly concentrated in state-owned companies, making it difficult for private firms to raise enough funds for financing their business activities” (Kwan, K. 2/8/2002. Par 4).
Recently, however, more and more foreign companies are doing business in China. “In addition to reinforcing the protection of property rights, facilitating competitive and fair market conditions is necessary to allow further development of the Chinese economy. As a major step in this direction, discriminative measures against foreign firms are being gradually removed following China's WTO accession” (Kwan, K. 2/8/2002).
Establishing Operations in China
According to Charles D. Paglee there are five ways to establish operations in China. Staples should examine each way to determine the most effective and profitable manner while minimizing their risk.
The most common way for Staples to set up operations in China is to create a representative office. This will allow Staples time to gain experience and understanding of the potential Chinese market. The job of a representative office will be to act as a conduit between the U.S. Staples Corporation and the Staples’ stores in China. A representative office will not be able to receive fees for services or generate income. Representative offices negotiate contracts which will later be signed by Staples’ home office. The representative office is necessary to perform many business functions such as employing Chinese nationals, opening bank accounts, importing personal and business effects without delay, using telecommunication lines, obtaining display signs or business cards with Staples’ logo and name, etc. However, a representative office may not hire Chinese nationals, purchase land, or build their own buildings. Staples will have six months to register and failure to register will result in significant fines.
In 1993, Chinese law adopted a method for establishing a foreign branch office that would have manufacturing and selling capabilities but would not be considered a Chinese legal person. This law would allow Staples to conduct business (sales and manufacturing) in China while not requiring them to make the more sizable investment required when setting up a wholly foreign owned enterprise. A branch office would be a Staples, rather than a Chinese, legal entity. This will leave Staples open to liabilities from its China operations, should things go wrong. Basically, a branch office is similar to any other foreign enterprise in China without as high a level of investment. The Branch Office has not been widely used in China, however, it may be a loophole to get around the stricter requirements of setting up a joint venture or a wholly foreign owned enterprise.
Developing equity joint ventures is a common and may be the preferred method for Staples to enter the Chinese market. “Joint ventures are usually established to exploit the market knowledge, preferential market treatment, and manufacturing capability of the Chinese side along with the technology, manufacturing know-how, and marketing experience of the foreign partner” (Paglee C. 2005. Par 1). Profit and risk will be shared between Staples and the Chinese firm based on the ratio of investment. Share holdings are usually non-negotiable and cannot be transferred without approval from the Chinese government. Staples will be restricted from withdrawing registered capital during the life of the joint venture contract. Staples must invest at least 25 percent of the investment capital, debt ratio will be regulated, and Staples must abide by Chinese law. Under this arrangement, Staples may hire Chinese nationals, purchase land, and build buildings.
A cooperative venture involves separate legal entities that accept liabilities separately rather than as a single entity. There is no minimum required investment contribution to initiate a cooperative venture. Staples can use such things as labor, resources, and services as investment contributions. Profits are divided according to the terms of the contract rather than investment ratio to allow for more flexible return on investment. Staples will be permitted to withdraw all or a portion of their capital. Trade unions must be allowed to represent the employees in employment matters.
A wholly foreign owned enterprise would be appropriate for Staples if at least half of the annual output is exported or if the nature of the operations relies heavily on advanced technology that is beneficial to China. In this arrangement, Staples will be allowed to sign contracts with government authorities and Chinese businesses. Staples will be able to purchase land rights, rent buildings, and receive utility services. Staples will maintain control of their business activities with little interference from the Chinese government. Staples will be considered a Chinese legal entity and must abide by all Chinese laws. Staples will have to employ Chinese labor in accordance with local and central government labor laws and will be encouraged to establish trade unions. However, Staples will not have the benefit of direct Chinese links and partners to help with the approval process and other regulatory issues. Establishing a wholly foreign owned enterprise may be more difficult and costly for Staples.
Conclusion
Outgoing president Jiang Zemin and his successors are implementing admirable changes, such as bringing the party under the rule of law and encouraging a more open market system. Hopefully, it is not a case of too little, too late. Staples will need to keep careful watch over Chinese politics and new regulations in order to protect their investment if they are to successfully expand to China. If the Chinese government remains committed to opening markets and protecting private property rights, China may be a good place to expand. However, if Chinese minorities and impoverished discontented citizens rebel, the Chinese government may revert to their socialist, communist roots. If this becomes the case, Staples will risk losing their investment.
References
BBC News. 1/21/03. China lifts price controls. Retrieved online 1.21.03 from
news.bbc.co.uk/2/hi/business/1466496.stm
BizAsia. 11.18.2000. Retrieved online 1.16.03 from http://www.bizasia.com/intellectual_property_/hx6f4/protecting_property_rights.htm
ChinaLaw. Retrieved online 1.17.2003 from http://www.qis.net/chinalaw/explan1.htm.
Jackson, S. August 13, 2002. Behind China’s Stability Lied Risk, avoiding meaningful political reform offers a bigger risk. Wall Street Journal. Retrieved online 1.15.03 from http://www.freerepublic.com/focus/news/732340/posts.
Kwan, Chi Hung. 2/8/2002. China in Transition. Chinese Private companies Demanding national treatment at home. Retrieved online 1.6.03 from http://www.rieti.go.jp/en/china/02080201.html.
Paglee, Charles D. Retrieved online 1.21.03 from (http://www.qis.net/chinalaw/explan1.htm).
Sutter, Robert. October 25, 2001. China Brief. Volume 1, Issue 8. The Chinese Regime Will Endure. Retrieved online on 1.16.03 from http://china.jamestown.org/pubs/view/cwe_001_008_002.htm.
Friendman. 2000. The Lexus and the Olive Tree.
Property Rights found online 1.17.03 at http://econ.worldbank.org/files/22114_wps2931.pdf
Liu, Melinda. January 9, 2003. The Man Who Will Run China. Newsweek.