BEIJING'S trendy taverns generally have two distinct sets of patrons

INSIDE CHINA

The country, the people and doing business

A glimpse into what it takes to survive inside China.

Jehangir S. Pocha.

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BEIJING'S trendy taverns generally have two distinct sets of patrons. There are those who sit in noisy groups and sing as they down vast quantities of Tsingtao beer, and there are those who sit quietly at the bar and stare morosely into their whisky glasses. Usually, there are a few CEOs in both sets.

China may be the Gold Rush of our times, but just as in the old days of the Wild West, not all who venture forth return enriched or with their limbs intact.

India Inc., now free of the economic shackles that bound its arms and the anti-China rhetoric that closed its mind, is scrambling to enter China. Bilateral trade between the uneasy neighbours has tripled to about $3 billion over the last two years and economists estimate that it should treble again by 2006. The desire to ride this growing tide is making a lot of Indian firms actively contemplate expanding into China.

"Everywhere I go in India, people only want to talk about our China venture," says Girija Pande, the Asia-Pacific head of Tata Consulting Services (TCS), which established its operations in China a year ago. But few Indian companies seem sure of how they can get a foothold in zhongguo, the Middle Kingdom, or centre of the universe, as the Chinese call their nation.

"China is a fantastic opportunity, but a tough one," says Patrick Horgan, managing director of the investment firm Apco, which assists foreign companies set up shop in China. "Nothing can be taken for granted here."

Not written agreements, not the loyalty of trusted partners, not even the word of people at the highest levels of power. And certainly not profits.

Investment analysts such as Merrill Lynch say only a handful of the foreign companies selling in the Chinese market are making any money. (See 'Show Me The Money'.) A report by PricewaterhouseCoopers said that China's top 25 companies had an average return of just over 3% last year. Even market leaders such as Coke and Motorola have a return of about 5% - way below what they make anywhere else in Asia.

According to Vincent Chan, the chief economist at UBS Warburg in Beijing, between 1994 and 2000, China's operating surplus (or the portion of GDP which reverts as profit to shareholders) was just 21% of GDP, about the same as in recession-ridden Japan and far lower than South Korea's 30.4% and Taiwan's 31.4%. If true, this would not be a new phenomenon. Ever since Marco Polo thrilled the world with tales of this enigmatic country, traders, mercantilists and colonists began trying to realise the 'China Dream'. Mostly, they failed.

In the 1840s, a British writer who had apparently mastered the art of the sound bite before his time propelled the obsession with China to new heights. "If we could only persuade every person in China to lengthen his shirt-tail by a foot," he said, "we could keep the mills of Lancashire working round the clock." With no MBAs to temper passionate ideas with feasibility studies, and no United Nations to dissuade reckless wars, the British launched what came to be known as the Opium Wars to force the Chinese into trading with the West.

The wars won the British, and the Europeans and the Japanese, trade concessions in cities such as Shanghai and Tianjin. But, the length of Chinese shirt-tails remained the same.

Yet the promise of China has outlasted the mills in Lancashire. Since 1979, when China's supreme leader Deng Xiaoping began to reform the disastrous economic policies of the Maoist years (1949-1976), global investors reliving the China Dream have poured more than $400 billion into the country. But despite the unrelenting hype from the media and economists who sprout macroeconomic data on China's GDP growth, and industrial and human development, opinion is increasingly getting divided over whether China is living up to the promise of its dream.

Sinophiles, such as Atul Dalakoti, the Federation of Indian Chambers of Commerce and Industry's (Ficci) feisty representative in Beijing, dismiss the criticisms. "International investors are not fools. If they are not making money here, why are they still pumping billions into China? These reports on low profitability don't factor in the fact that firms often understate earnings to avoid taxes and retain state subsidies."

So how can an Indian firm considering a China investment sort though the myth and realities of this enigmatic country and make a good decision that will put them in the beer-drinking and singing crowd, and not on the losers' stools? Countless books, consultants and investment banks offer the solution - for as little as Rs 300 for a D-I-Y handbook or Rs 5 crore for a consulting contract. In fact, selling advice on how to do business in China has become an industry in itself.

There is no secret formula for success in China, but there is a list of dos and don'ts with which every China dreamer should be familiar. "The most important thing is to know why you want to be in China," says Apco's Horgan. "Is it to explore the domestic market, to use China as a manufacturing base, or to establish a presence to service global clients?" Each is a valid strategy, but each calls for a very different approach, he says.

The five Special Economic Zones China established in Shenzhen, Zhuhai, Shantou, Xiamen and Hainan provinces as it began its economic reforms remain some of the best manufacturing bases in the world. Over 4,000 different kinds of industrial parks have also mushroomed across the country. (See 'China's Special Economic Zones')

Their world-class infrastructure such as fibre optic telecommunications, high-speed Internet connectivity, highways, quality office space, warehousing and housing, and responsive local government has attracted companies such as General Motors, Alcatel, Mitsui, Nabisco and even the classical ceramic maker Wedgewood.

"Manufacturing in China is so easy it often lulls businesses into trying to extend into local marketing," says a Beijing-based manager with an international consulting firm. But the leap from production to marketing can lead a company to lose focus and rattle its foundations. Pande says that a focussed objective is critical in choosing the right company structure, creating an operation of the right size, at the right location, with the right partners and hiring the right people. "Do your homework. Find profitable segments and stay within them."

Not all segments in all industries are growing. The race to outdo each other has led provinces and local officials to establish massive projects with little attention paid to their economic viability. Industries such as retailing, real estate, home appliances, vehicles, and electronics are under tremendous pressure from growing competition. Fortunately, most of the industries with potential in China are those where Indian firms have competitive advantages -- construction, IT, alternate energy, auto ancillaries, consumer products, pharmaceuticals, leisure, processed foods and heavy machinery.

Yet, commissioning market studies to identify specific opportunities is essential, especially for Indian firms. Most of the published research on China has been done by Western agencies, which identify opportunities in China for companies with a Western cost structure, mindset and capabilities.

For one, China's 'cheap' labour is far more attractive to American or European companies than Indian ones. Executives at TCS say their cost structure in China is actually higher than in India. Though the total absence of even basic labour protections and the superior skills and work ethic of Chinese workers makes them cheaper than Indian workers, the delta may not be wide enough to merit the other costs and risks.

Ross Jackson, director of business development with Dy-mension Software, says: "Chinese workers and managers may be cheap to hire, but once you factor in their cost of training them and the inefficiencies from a language gap, labour costs can end up being much higher than forecasted."

Even in rapidly growing industries, it is essential to assess the level of competition in an industry, segment by segment, before making an investment decision. For example, despite strong demand for white goods, global players such as Maytag and Whirlpool have had to exit the market in the face of stiff competition from local companies such as Haier and Kelon.

This pattern is now spreading even to high-technology, high-value products such as automobiles and cellular phones. In 1999, Nokia had 32% of China's mobile phone market. Today the company's share is 18% and domestic manufacturers such as TCL and Ningbo have captured over 55% of China's 90 million-unit handset market with low-cost, high-quality products. Instead of rejoicing at the continued spread of mobile phones in China, Nokia is worried that Chinese firms will soon begin to compete with it in overseas markets.

After identifying an opportunity, Pande says it is critical for an investor to structure a China-specific business model. "For God's sake don't come here and then try to figure out a business model," he says. This needs months, sometimes years of hard number-crunching, market testing, and manpower and financial planning.

For example, marketing strategies also need to account for local mindsets. Globally, most firms give away products to sell services. But Dy-mension's
For example, marketing strategies also need to account for local mindsets. Globally, most firms give away products to sell services. But Dy-mension's Jackson warns that in China this could throw firms into the red. "Chinese consumers have still not learnt to value intangibles like consulting. Show them a cool gadget and they will pay for it, but try to sell them a valuable service at cost and they will argue."

Show Me The Money!

IN 1995, Electrolux, the Swedish white goods manufacturer, entered China chasing the dream of putting a washer and dryer in every home. Eight years on, it has still to see a krona of profit. Even its most potent local competitor, Kelon, which entered Forbes' list of the world's best small companies, has seen its profits halve.

Profit warnings from MNCs based in China have become almost routine. Since June this year, even market leaders such as Motorola, Nokia, KFC, Pizza Hut and Kodak have lowered earnings expectations further.

"After nearly two decades in which companies have made allowances for China's idiosyncrasies, foreign-invested firms can no longer tolerate low returns," said AT Kearney chairman Fred Steingraber while releasing a study that claimed only 40% of companies in China are profitable. The study also said almost 25% of all MNCs pulled out of at least one venture in China.

Apart from intense competition, economists also say poor capital allocation has lead to overinvestment and overcapacity. Yet both AT Kearney and Merrill Lynch, which has also warned of diminishing profitability in China, confess that the accuracy of their research is hampered by an absence of reliable data. "One is forced to rely more on anecdotal evidence," said Nazmeera Moola, who authored the Merrill Lynch study.

Official figures claim that in 2002 the total profits earned by industrial companies in China increased by 23.1% to reach RMB 256.82 billion, up seven percentage points over the growth rate of the previous year. State figures also claim China's state-owned enterprises (SOEs) saw profits soar by RMB 186.02 billion ($22 billion) in the first two quarters of 2003, up 77.4% year-on-year. Loss-making SOEs reported losses of RMB 36.98 billion ($4.5 billion), 3.8% down over the same period of last year.

While the debate rages, most experts agree even if profitability in China is clearly lower than elsewhere in Asia, China offers companies a chance to operate at volumes that few other countries can match.

While several factors are likely to depress profits in China for the next two years, the long-term potential and importance of China is beyond dispute.

Vincent Chan, UBS Warburg's chief economist in China, has said that joining the WTO will likely reduce China's share of world output from 5.3% to 5.21% before other benefits kick in. But when they do, he expects the share of global exports to rise 40%, from 4.8% to 6.8%.
Last year, foreign investors poured over $52 billion into China, making it the largest recipient of FDI in the world, surpassing even the US. Even though China's FDI figures include large chunks (some say up to 50%) of rerouted domestic earnings, there is little doubt foreign firms are continuing their pursuit of the China Dream.

Horgan emphasises that while formulating a detailed business model can be expensive and tedious, the process must be followed through. Half-hearted planning can end up giving a company a false sense of security. Often the little knowledge executives garner from the media, colleagues and even experts can be more dangerous than doing no research.

For example, when Coke and Pepsi first entered China, they discarded their preferred mode of going it alone and embraced the commonly accepted notion that joint ventures are the way to go in China. By the late-1990s, after years of struggling, they finally found it smarter to jettison their partners.

Yet, most of the successful beer companies in China such as Heineken and Carlsburg are those with local partners -- which emphasises the fact that there are no universally applicable, cross industry rules in China.

Indian firms are entering the Chinese market late and without a track record, and will also need to adjust their short-term expectations. Deprived of the local market knowledge and brand equity that allows them to maintain market share and margins at home, almost all will have to struggle to establish themselves here. One solution is to employ concepts such as profit-paring to adjust a standard business models to the market conditions in China. (Profit-paring adjusts a company's financial model based on the industry conditions, its competitive position and functions in new markets.)

According to Jaya Shree, the half Indian-half Tibetan head of the India China Trade Centre (ICTC), which helps connect Indian and Chinese businesses, "the interesting thing about China is that exciting opportunities also exist in smaller industries that many people might not even think about." Not many people realise that Liu Yongxing, one of the richest people in China, made his billions supplying pig feed. Yet "small businesses never even think of China", says Jaya Shree. He adds, there is an idea that it is for the big players, but we specialise in finding opportunities for small-medium sized businesses.

With fast moving consumer goods (FMCGs) and personal hygiene products growing at over 30% a year, ICTC has identified opportunities in sub-segments such as beauty parlours and cosmetics for Indian firms. It is currently in the process of helping Shahnaz Hussein and Emami set up shop in China.

According to Merrill Lynch, FMCG companies such as Procter and Gamble, Unilever and Groupe Danone are some of the few MNCs claiming profitability in China. And Jaya Shree says that there is no reason why Indian companies cannot carve out niches for themselves, even if they cannot compete with the majors in terms of volume and brand power.

Pande also warns against an aggressive entry. "There is an old Chinese saying: Cross the river by feeling the stones," he says. "We started small, focussing just on servicing our foreign clients... because we wanted to learn the Chinese market. But within a year we have implemented a major technology architecture project for a national bank and reached the final round of bidders to computerise the Shanghai stock exchange."

Information Technology (IT) is clearly the most attractive industry for Indian firms. "Generally, Indian firms suffer from an image problem," says Horgan, "but China has recognised and envied India's success in software and is very keen on encouraging Indian firms to set up in China." Well, perhaps for now. China has always used foreign investment to ramp up the expertise of domestic firms. After the tumult of the Maoist years, China had virtually no domestic industry. Since local industry had no depth, organic growth was impossible and the government opened its doors to foreign investment.

In China, foreign firms are seen as learning tools, says Sharon Hurst, a Beijing-based executive with oil company Conoco-Phillips. "(The Chinese) are so hungry to learn and so quick to improve things that I find it astonishing. When I first came here, local (oil) rigs were fire traps. But when I would go on inspection rounds, there would actually be people following me around making notes on what I was doing, what I was checking. Within a year, their rigs were up to global standards."

Competing with local firms that have learnt their trade from foreign companies and begin to offer similar goods or services at lower prices is one of the biggest challenges foreign firms face in China. "It's one thing when someone is just learning from you," says the Asian vice-president of a European electronics firm, "but it's a different matter when they are blatantly copying what you are doing."

Consider the case of General Motors (GM) and its local manufacturing partner SAIC-Chery. Industry experts say SAIC-Chery reverse-engineered the GM-owned Daewoo's Matiz compact car and began selling their version, branded QQ, for 30% less than the Matiz. Volkswagen (VW), which has its own joint venture with SAIC, one of the partners in SAIC-Chery, also accuses the company of selling original VW parts to Chery, which also reverse-engineers VW cars. Yet significantly, neither GM nor VW, despite their clout, have been able to take their case very far. Given China's murky legal system and the tendency of those in power to protect the interests of domestic firms over foreign ones, both GM and VW have been reluctant to take formal action or even publicly comment against SAIC-Chery. Posters advertising the QQ stand proudly all over Beijing.

"China is a remarkable country," says Jackson. "The sixth Harry Potter book is already out here, it's just that it has not been written by J.K. Rowling."

In knowledge-based industries such as information technology and pharmaceuticals such piracy can be fatal and it emphasises the importance of working with the right people in China. Partnering - whether to do it and with whom - is often the most important decision an investor can make in China, says Dalakoti.

China's Special Economic Zones

ABOUT 75% of the $400 billion in FDI China says it has got has been invested across its 120-odd special economic and export zones. But recent changes have combined to dim the attractiveness of these zones for new investors.

Initially, special zones seduced investors by offering them tax breaks and world-class infrastructure. But China's accession into the WTO will trigger the national treatment principle, which will need the gradual abolition of these sops. Also China has now built world-class infrastructure outside these zones. For example, 98% of China's towns are now connected to a highway.

In response, most zones are trying to reinvent themselves as economic communities based on the general advantages and infrastructure they have accumulated. Premier zones, such as Shenzhen, Pudong and the Suzhou-Singapore Industrial Park, are likely to remain important economic centres because of their size. For example, the Shanghai Pudong New Zone, China's largest, has received investments of $30 billion from over 5,000 MNCs such as Sony, Philips, Christian Dior, Johnson & Johnson, Daewoo and Merrill Lynch.

However, the proximity to clients and suppliers, quality infrastructure and easy access to skilled labour the premier zones offer is increasingly being outweighed by the high cost of establishing operations there. Smaller, provincial level zones have even less to offer investors if stripped of their sops.

One leading indicator of how China sees the future of economic zones is the fact that almost all of the 40 new export promotion zones approved this year are situated in China's 'backward' central and western provinces. Clearly, China is hoping these zones, in areas such as Shaanxi, Sichuan, Gansu and even Tibet, will boost growth in these regions just as they did along the now prosperous coastal provinces. Any investment in these new zones is certain to win strong economic incentives and government support.

In a country where contracts and court rulings are seldom enforced, personal relationships are key. Building them is not easy. "For the first few meetings, the Chinese almost never discuss business," says Jaya Shree. Long days of tennis and evenings of banquets and heavy drinking at girlie clubs can get annoying, but the key is to remain amiable and generous. "They are getting to know you," says Jaya Shree. "The logic is that if we cannot be friends, how can we get along. If we cannot get along, how can we trust each other?"

Even if one understands the process, managing relationships and staff in China is difficult. Part of the problem is cultural. The Chinese are a sophisticated and subtle people with their own basis and style of personal interaction. "Chinese people have several faces," says Jackson. "One has to learn how to read them, and often how to see through them." Part of the problem is plain deceit. "People rarely tell it to you like it is. There is a culture to say and do whatever it takes to close the deal," says Horgan. "Even provincial authorities often lead investors into believing something is legitimate when it isn't."

Yet, forming and keeping the right connections, or guanxi, is critical. China has to develop a transparent, professional way of organising its business and "everything - getting introductions, contracts, information - depends on your guanxi," says Jaya Shree. When China was just opening up, guanxi was all it took to get rich. "It became the one-minute manager solution - 'Go to China, get guanxi'," says Jackson. But local players who try to win investors over with tales of their guanxi should be avoided. A contact can win a contract. But a company still needs core capabilities to execute it.

The "guanxi as substitute for strategy" trap was primarily what foiled the China entrée of US retail giant Wal-Mart. Allying itself with the politically savvy CP Group of Thailand, run by a cabal of Thai ethnic Chinese, the company lost sight of its streamlined logistics, innovative locations and relentless focus on cost which has made it the largest retailers in the world.

Alan Steelman, a senior principal at Monitor, the strategy consulting firm, also faults Wal-Mart for "taking the format that has worked so well in the US and 'plopping' it down in Asia, without taking sufficient strategic thought on the need for adapting to the particular requirements of the market."
Balancing local peculiarities with corporate standards is vital to building a sustainable partnership. "People try to intimidate foreigners by spooking us with the culture bogey," says Terry Williamson, an American businessman. "I remember a meeting where every proposal we put up was shot down under the argument that 'here we don't do things this way'."

Horgan says the problem is not so much that people don't understand China's uniqueness, but that "there is too much acceptance of this idea that China is unique. People abandon their critical faculties and make exceptions, many fraught with risk." Williamson says when he and his team had had enough of the culture threats, they said: "Look, you may do things this way but please remember than we are an American company and we also have our own customs. This is a joint project. If there cannot be mutual accommodation, then let's just call it quits. We had no more 'cultural problems' after that."

Perhaps the only thing as important as making friends is not making enemies. Egos can be very fragile here and memories very long. "Revenge," says Julio Arias, a consultant with Apco, "is not frowned upon here. In fact, it is an obligation."

Stories of partners kidnapped after failed deals and projects being held hostage by offended bureaucrats are legendary. In one case a builder had a multi-million dollar construction site lie stagnant for one year because he could not get municipal clearances. Later, he found the reason was that the daughter of the bureaucrat involved had been bullied by his son 18 years ago when they were schoolmates.

Vetting the background of employees is essential. While setting up a representative office in China, firms are not allowed to hire their own employees. All hiring must be conducted through a government designated service agency such as a Foreign Enterprise Services Corporation (Fesco). Often the people supplied by Fesco are mediocre performers who happen to be related to some official. Hence companies should remember that they are also permitted to find their own employees and have them register with Fesco.

Even after a company is fully operational, it is not uncommon for competitors to try and plant spies into its payroll.

But ask any foreign executive what the tougher part of doing business in China is and the reply is unanimous - negotiations! Predictably, most of the heartache is over pricing with local suppliers. But there is one major card foreigners hold. Raising financing in China is very difficult for local businessmen and most firms suffer from cash flow problems. Offering instant payment instead of credit will reduce prices substantially. For this reason there is also value in teaming with other manufacturers, even competitors, to make bulk purchases. Sharing suppliers with your competitor may seem counterintuitive, but you might as well do it as it will happen anyway.

One key disconnect that makes negotiations so tough is that both parties are usually working to different goals. An investor is usually there to set up a business and make money. To the Chinese, the deal is probably just one part of a grand strategy that the investor may have no insight into or inkling about.

"The Chinese, all Chinese, are focussed on nation-building," says Dalakoti. "This is the key difference with India."

The Communist Party's interpretation of history is that China endured "150 years of humiliation" at the hands of imperial and colonial powers - especially the British in the 19th century, and the Japanese - who seized control of north-eastern China in the 1930s, and at whose hands some 20 million Chinese died. Now, for many young Chinese, it's not just about getting ahead themselves. It's about their nation growing strong enough to take its prominent place on the world stage.

To many companies, particularly in the public sector, "making money is less important than generating wealth", says Dalakoti. "They are more interested in the employment they generate, the rise in salaries, the growth in net assets... and the projects and products they build for China." But this focus, which underlines how much of a socialist patriarchy China still is, does little for investors.

It's tough to compete with players who are not interested in profits. It's even more difficult when your own employees and infrastructure places the perceived needs of the entire country before those of the company, says a European executive in Beijing. "We uncovered a situation where our firm was supplying expensive components to a state enterprise at no profit simply because some employees wanted to help it out."

Political reformers led by new president Hu Jintao want to shape China's economic policies to make them transparent and create a level playing field that can result in a dynamic free market system. But the unique state-controlled national capitalism that Deng Xiaoping and Jiang Zemin created still survives. Officials often see firms as extensions of the nations they come from and jealously guard local firms and what they see as China's national interests.

For example, "there is a national focus on indigenising and increasing local value add," says Chander Dutta, who has been doing business with China since 1996. "My business used to import granite blocks into China. But as soon as local people set up grinding and polishing units the government levied a 20% duty on finished granite. Now all they import is the raw stone and the finish it here."

"This is a very political economy," says Horgan. Beyond understanding today's business environment, investors also need to understand the government's attitude towards specific industries so they can also forecast major policy moves. Though China's 2001 accession to the World Trading Organization will curb its ability to impose arbitrary trade barriers, invisible ones remain high across China. State-owned enterprises are often exempt from regulations and licenses.

Ad hoc technical standards are often imposed by the government to curb trade. This is most common in software and telecommunications, where "the Chinese government... upset by the fact that Western firms use their market clout to develop global standards...have created their own standards". This gives local firms a crutch as foreign software firms have to master these standards, and that takes time and money.

But local governments are "extremely business friendly and responsive," says Pande. "We meet regularly with the mayor of Guangdong and if we give him a list of problems, they are dealt with." Yet, for all the bonhomie, a foreign firm in China will never be 'local', as say, Hindustan Lever has in India.

The Ten Commandments

Pulling together the thoughtful considerations of China-gurus and the real-world experiences of several companies reveals the following principles for doing business in China.
I. Know why you want to be in China -- is it to use it as a manufacturing and export base, to enter the local market or something else.
II. Do not depend on Chinese statistics or anecdotal evidence of the opportunities or problems in China. Invest time and treasure in researching and understanding the market. Find specific segments and opportunities.
III. Pass up China if needed, not everyone has to invest in the country.
IV. Decide early on whether you will go it alone or find a local partner. Choose a local partner after testing its capabilities and reputation. Ensure you retain a leverage that goes beyond legal contracts.
V. Cultivate guanxi but do not be a slave to it
VI. Create an appropriate business model and localise the product and marketing mix.
VII. Understand and manage the local partners and associates. Do not allow them to manage you.
VIII. Invest in local management. Choose staff, supplier and client loyalty over short-term profits. Do not make enemies.
IX. Winning in China takes time: the first guy who blinks loses.
X. Strategise and research growing operations in China with the same rigour as the initial investment.

China, they say, has always been different - complex, contradictory, simultaneously attracting and repelling, both an opportunity and a threat. Investors could love it or hate it, they could choose to link their future to it or they could choose to stay away. Whatever they do, the worst thing would be to ignore it. The doors between India and China are opening after almost three decades. There is bound to be some grinding and screeching from the hinges. But that should not scare Indian business from crossing over and getting to know, if not trading with, its neighbour.

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