Fiducia China Focus Newsletter

• Fiscal or Monetary Pressure? China Considers to Cut VAT Rebates
  
  

• Survey by AmCham: Rising Profit Margins for US Companies in China
  
  
• ChinaInvesta at the EXPO REAL 2003: Exhibition and Conference Shows Investment Opportunities (6-8 October)
  
  
• China Mobile (Hong Kong) Limited
  
  
• Distance Still Matters – Spotlight on Controlling in China
  
  

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All liabilities excluded. This Newsletter is based on information obtained from sources (government, business associates, companies, publications, etc.) believed to be reliable. However Fiducia Management Consultants does not make representations as to it's accuracy, completeness or correctness.

Fiducia Management Consultants is China Partner of Corporate Development International, a global partnership specialising in mergers, acquisitions and divestitures.   www.cdiglobal.com

Fiscal or Monetary Pressure? China Considers to Cut VAT Rebates

Manufacturers and trading companies throughout China are concerned about plans from the Central Government to lower the size of value-added tax (VAT) rebates.

VAT is a form of sales tax levied on the value added at the manufacturing process, but in order to boost exports, significant rebates were introduced: Currently, manufacturers are charged 13, 15 or 17 percent depending on the goods but rebates between 5 to 17 percent are granted on all products exported outside of China’s mainland.

But this may change now.

As Chinese exports have strongly increased during the last years, the rebate has become a severe fiscal burden on the Central Government. According to the Ministry of Finance, the amount needed for the rebates has been rising at an annual rate of 36.3 percent recently, more than twice the growth rate of the Central Government’s fiscal revenue.

It is estimated, that the back payments of the government against exporters have already piled up to as much as RMB250 billion (US$30.2 bn.) at the end of 2002 and the amount of unpaid rebates is expected to reach RMB300 billion (US$36.2 bn.) at the end of this year – a great amount in times where the government’s fiscal belt is tightening.

According to the proposal, the average rebate rate will thus be lowered from 15 percent to 11 percent, saving the Central government around RMB50 billion (US$6 bn.) annually.

On the other hand, the announcement comes amid growing pressure from the United States, demanding to appreciate the Chinese currency. The US trade deficit with China reached an all time high in 2002, and US manufacturers, especially those from the textile industry, fear that China will grab an even bigger share from the Western markets once the remaining trade quotas are deleted at the end of 2004.

In terms of bilateral trade, a cut of the VAT rebates is similar to a Renminbi appreciation. Unwilling to let the Renminbi flow freely, the Central Government might hope to kill two birds with one stone: Solving the fiscal and the monetary problems.

If the new rebate scheme comes into effect, this would have a strong influence on domestic manufacturers producing for export… and for Western companies buying from them. Suppliers producing for export use the VAT refund to lower their prices. Profit margins are already small and in some cases, the manufacturers sell their products even below cost, getting profitable with VAT refund only. Those manufacturers will undoubtedly pass along the rising costs to their suppliers and their customers.

In the last two months all manufacturers have started to discuss with their customers that they need the right to increase prices. All Western companies buying from China should prepare for negotiations with their suppliers and customers.

No organization can accomplish its goals without proper control.

A company’s operating and financing risks can be dramatically reduced by strict risk controlling systems. But while this works well as long as you are close to the headquarters, it is getting more difficult when companies expand overseas.

In reality, the potential difficulty and uncertainty of cross-boarder controlling seem to be unreasonably amplified, particularly in China where time is needed before legal and business ethical practice can match the high economic growth.

Reasons are the natural dilemma of a power struggle between the headquarter and its subsidiary fostered by the geographic distance, linguistic and cultural barriers, legal differences, currency exchange rate fluctuations and other factors.

Nevertheless, keeping overseas subsidiaries under certain risk control is nothing but imperative. Otherwise, the investors may not even be able to find any trace of their initial investment.

Caution with Formal Financial Reports

Formal financial reporting still remains the essential means of subsidiary control. A striking number of foreign investors rely solely on the annual financial statement to monitor their China business.

However important and direct this way of control is, controllers from the headquarters should exert particular caution in dealing with these figures. Accounting, auditing and taxation systems on a uniform national basis are relatively new to China. The standards and regulations are continuously being reformed to a more internationally accepted level.

Interpretation and enforcement of laws and standards throughout the country is still very poor. A large proportion of the accountants who were trained under the planned economy seriously undermine the quality of the accounting profession.

Furthermore, the local management might want to stay in absolute power. A well-trained ambitious financial person who directly reports to the headquarters might be seen as a threat.

It is well known that local managers have incentives to use accounting discretion to manipulate reported profits because profits are often used to evaluate managerial performance: It is a common practice for Chinese companies to keep several books – one for the tax authority, one for the headquarters and one for the local management itself.

In any case, reliance on these financial figures is potentially disastrous if no precaution is taken. In the worst case, investors sitting thousands of miles away might one day suddenly come to realize that their whole investment vanishes into thin air.

Regarding accounting in China there are several areas which require special attendance:

Account Receivables in order to make big sales

The frontline goal of many trading affiliated managers is to please headquarter with impressive sales figures. In nine out of ten cases, such companies don’t set any credit limit to their customers. It’s very common to find in their books that half of the account receivables are older than 180 days.

Indeed, the compensation system in many companies tends to reward higher sales more than it penalizes an increase in account receivables. Although the payment default rate in China is very high, bad debt provisions or write-offs are not normally shown in the affiliate’s annual reports. This undoubtedly results in falsified profit that could easily deceive investors.

Excessive storage of goods

Due to long delivery lead times, limited logistic services, and currency restrictions, supply is of particular importance in China. A common way to solve this is advance purchases – the local management tries to hold as large amounts of inventory as possible. Such a policy, established without regard to the trade-offs involved, can be very costly. Besides expensive financing, insurance and storage cost, managers must face the obsolescence of inventory. Once again, these costs are not shown on many subsidiaries’ reports.

Influence of Currency Changes

The liabilities to the headquarters tend to accumulate over time since many subsidiaries are in the red. Considering the huge base amount of these liabilities, a slight exchange rate fluctuation might cost companies a fortune. A large number of real life cases spoke for themselves during the past appreciation of the Euro. Those managers in China are probably still daydreaming that they could live twice and had paid back the related-party loans when the dollar was still high.

Conclusion

Currently, China is putting great effort into improving its legal system and overhauling its accounting practice. At present though, prevention is certainly the most cost-effective and safest option. It is important for Western investors to identify and analyze their China operation risks in an ongoing process, and to exert stricter control accordingly. Latter is needed not only for detecting problems and deviations from plans, but also for anticipating problems before they occur.

Besides the setting up of an effective internal control system, and more frequent visits by the subsidiaries, it is also recommendable to outsource the financial and accounting functions of small to medium-sized investments to a third party. This option achieves the utilization of special financial and accounting expertise and helps reach higher independence of the financial information.

An AmCham (American Chamber of Commerce) China survey, released on September 25, revealed a positive business environment in China. From 254 participating companies (only US companies), 75 percent reported being “profitable”, 10 percent said they were “very profitable”. Nearly every second company reported that profit margins had risen compared to the last year.

On the other hand, the questioned companies experienced higher competition in the Chinese market – from foreign as well as from domestic competitors. The trend towards the establishment of WFOEs rather than Joint Ventures seems to continue: 57 percent of all questioned companies answered that they had set up at least one WFOE in China; compared to 20 percent in 1999.

• First hand, transparent information
• Special economic Zones, industrial zones, technology parks are exhibiting
• One day ChinaInvesta conference on legal framework and practical insights in the PRC

“Investment opportunities in China” is the main theme of the ChinaInvesta 6-8 October in Munich, Germany. The exhibition is part of the 6th International Commercial Real Estate Exposition, EXPO REAL 2003. China’s Industry- and technology zones, free trade zones, logistic- and distribution centres each provide detailed information on their advantages as an investment location. The ChinaInvesta Conference at the “Trend Pavilion” on October 7th 2003 will discuss regulations and developments in China’s commercial real estate sector. Supported by the Euro-China Business Association, the governing body of the EU’s China business chambers, experts will also discuss basic conditions for foreign investors, appraisals and current infrastructure projects.

“The ChinaInvesta provides the opportunity for carrying out an initial location search and consider certain investment options”, says Fiducia Managing Director Juergen Kracht. “Talks with representatives of several zones enable visitors to investigate possibilities for future commitments.

You can find the ChinaInvesta at the EXPO REAL at Halle C2 Stand 420. For more information about the ChinaInvesta: www.chinainvesta.com

Contact: Jellis Kan
Fiducia Management Consultants
12/F Fortis Bank Tower, 77 Gloucester Road, Hong Kong
Tel: +852 2258 6636, Fax: +852 2810 4494, E-Mail: jkan@fiducia-china.com

Compared to their saturated home markets, China must seem like the Promised Land in the eyes of the debt-burdened Western mobile operators. With currently 230 million mobile phone users, China has developed into the world’s biggest single mobile phone market and there is still remarkable growing potential: With a phone penetration of only 18 percent, around 4 million new subscribers are added monthly to the pool of customers. Despite this enormous size, the Chinese mobile phone market is mainly controlled in a form of duopoly by two competitors. Thus China Mobile (Hong Kong) Limited (“China Mobile”) could develop into the world’s biggest mobile carrier by subscribers, sharing the market with main competitor China Unicom.

Incorporated in Hong Kong 1997 and the same year listed on the New York and the Hong Kong stock exchange, China Mobile provides a full range of mobile telecommunications services in 21 provincial networks in Mainland China, combining the largest geographically coherent mobile network. Together with its 21 subsidiaries, China Mobile has an aggregated subscriber base of 130 million (June 2003) and enjoys a market share of approximately 67 percent. Other than many Western players, China Mobile concentrates on the growing home market only and has not taken any steps towards foreign markets yet.

In August 2003, brokerage firm JP Morgan said after a meeting with China Mobile that the carrier may buy ten more provincial networks from its state-owned parent company China Mobile Communications Corporation. China Mobile has already bought 21 networks from its parent and an acquisition of the remaining ten networks seems to be within China Mobile’s long-term-strategy.

Rewarding China Mobile’s financial performance and market position, the carrier was ranked first in Businessweek’s “Top 200 Emerging-Market Companies” for the third consecutive year in 2002. But it seems as if the Chinese mobile market was getting more difficult now. Like mobile operators elsewhere, the Chinese players must handle the challenges of the implementation of 3G (third generation) standards. And China’s mobile market is getting crowded: The duopolists are beginning to face additional competition from fixed-line players China Telecom and China Netcom. China Mobile primarily uses the Western standard GSM and is under pressure by the new competitor’s PAS services (in China known as Xiaolingtong) - a system with limited capacity and range but very competitive prices.

Having never been approved by government, Xiaolingtong operates in a legally grey area – the fact that the service has not been shut down illustrates a new attitude of the Central Government towards consumer benefits and lower prices. As a result, the prices have fallen dramatically and will very likely see a further decline. According to analysts, China Mobile’s average revenue per user (“Arpu”) already has fallen by 18 percent last year and will see a further decline.

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