Fiducia China Focus Newsletter


Fiducia China Focus Newsletter

CONTENT

May 2004

VDE sets up Branch in Hong Kong
CDI Asia Regional Meeting in Hong Kong
Revolution in China’s Trade Sector? China Issues New Management Rules
Carmakers win Key Ruling in Piracy Fight
Update on M&A in China

For previous Issues
www.fiducia-china.com
Publisher
Fiducia Management Consultants

Press Contact:
Patrick Kriegeskorte
contact@fiducia-china.com

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

Revolution in China’s Trade Sector? China Issues New Management Rules

Following the new formulation of China’s Foreign Trade Law (April 6, 2004), the Ministry of Commerce (MOFCOM) published new management rules for foreign trade. If the regulations (which will come into effect on 1 June, 2004) are being implemented without any additional limitations, they would mark a significant liberalization of China’s trade sector and indicate far-reaching changes and opportunities for foreign-invested companies in China.

The situation to date

In order to protect its domestic industries, China’s government is controlling imports tightly. The majority of imports is taken up by state-owned foreign trade companies; without own trading operations, foreign companies are restricted to these Import-Export agencies.

However, entering the World Trade Organization (WTO) in December 2001, China made a number of economic commitments, one of the key obligations was a gradual liberalization of the country’s trade sector.

Currently, full trading rights are only granted to foreign minority joint ventures, but due to the inherent restriction of control, many Western companies exclude this option.

An exception exists for products made in China: Wholly-foreign-owned companies are allowed to distribute and sell self-manufactured products. The definition of being “made in China” is rather vague in this context though; foreign companies are required to add a “reasonable” value to the product. As a result, some foreigners started to import and assemble completely knocked down goods in order to qualify for selling them in China, thus operating in a legally grey area.

An alternative is the set up in a Free-Trade-Zone – wholly foreign owned trading companies are possible here, but this solution is connected with a number of disadvantages, in particular higher costs. In addition, an external party is still needed for the currency conversion in Free-Trade-Zones.

The new regulations

The “Measures for the Administration of Foreign Investment in the Commercial Sector”, published by MOFCOM, are effective from June 1, 2004 and herald the long awaited liberalization of China’s distribution and retail sector.

Foreign companies will be allowed to set up

majority joint venture trading companies starting from 1st of June 2004
wholly owned trading companies starting from 11th of December 2004

May 2004

In detail, the new regulations apply for the following five activities:

Retailing – i.e. selling goods and related services to individual persons from a fixed location, as well as through TV, telephone, mail order, internet, and vending machines
Wholesaling – i.e. selling goods and related services to companies and customers from the industry, trade or other organizations
Representative transactions on the basis of provisions (agent, broker, auctioning)
Franchising
Import/Export, distribution and retailing by existing manufacturing companies

Set-up requirements:
Foreign investors will enjoy national treatment in setting up trading companies with minimum registered capital in accordance with the Company Law of China

for wholesaling enterprises: RMB 500,000 (~US$ 60,000)
for retailing enterprises: RMB 300,000 (~US$ 36,000)

Business duration is limited to 30 years for foreign trading companies set up in the developed coastal areas; companies established in the Western areas are limited to business duration of 40 years. Foreign companies shall “possess a sound reputation and comply with Chinese law”.

Application procedure:
The company formation procedure follows the existing guidelines to set up a Wholly Foreign Owned Enterprise in China. Applications must first be submitted to MOFCOM’s provincial-level counterparts. The applications then have to be forwarded to MOFCOM for approval. The regulations stipulate that the whole approval process should be completed within four months.

After obtaining approval, foreign trading companies are allowed to operate in the following business areas:

Retailing enterprises: retailing, import of merchandise it sells, sourcing and purchasing of domestic goods for export, related services
Wholesaling enterprises: merchandise wholesaling, commission agency (except for auctions), import & export of merchandise, related services

Limitations apply to some specific products such as books, periodicals, newspapers, automobiles, medicines, salt, agricultural chemicals such as pesticides, crude oil and petroleum.

If a foreign investor has more than 30 retail stores in China and distributes products mentioned in the paragraph above from different brands or suppliers, the foreign investor’s share in a retail enterprise is limited to 49%. Retailing enterprises which do not distribute any of the limited products are not restricted on the number of stores in China.

From December 11, 2004, all geographical restrictions for retailing enterprises will be removed; foreign investors will be allowed to establish retail stores anywhere in China.

Comments

Following the WTO-accession, China agreed to liberalize its trade policy. As such, Beijing is simply complying with its obligations. More surprising than the actual law changes are the low minimum requirements. In the past, China usually adhered to a principle of gradual change: In the beginning, new regulations were being “tested” only in selected cities with high investment thresholds, which were then being lowered gradually allowing more companies to enter the market.

This time the Central government took a huge step at once: Previously, the minimum registered capital for retail companies was RMB 50 million (wholesale RMB 80 million) – high thresholds for small or medium sized investments. Under CEPA (applicable to qualifying Hong Kong companies; came into effect in January 2004) a China retail company can be set up if the average annual sales turnover have been exceeding US$ 10 million for three consecutive years (wholesale > US$ 30 million).

Now, with the new regulations in place, the entry requirements for retail business will be lowered to RMB 300,000 (RMB 500,000 for wholesale), thus the door to trading in China will also be open for small and medium sized foreign companies.

Significant is also the fact that existing Wholly Foreign Owned Companies in China will be permitted to extend their business license, adding trade to the allowed business scope. Unlike earlier market openings in the wholesale and retail sector, the regulations level the playing field with domestic companies by eliminating high thresholds. Foreign companies will now be able to broaden their product range and offer their full portfolio, including finished goods manufactured outside China.

China based assembling or repackaging operations that were previously used to facilitate trade are likely to either vanish or to focus purely on trade. Analysts expect a streamlining of the existing sales and distribution operations and a trend towards more professional and specialized trading services. The future of WFOE trading companies in Free Trade Zones such as Waigaoqiao is not looking promising, given their location disadvantage and higher cost base.

Although it will take a few more months until companies can setup trading entities everywhere in China and even though some uncertainties remain (e.g. import quotas), the new regulation will significantly change the China business environment.

How does this affect your China strategy?
Contact Fiducia’s consultants for in depth information on China’s trading sector, upcoming opportunities and challenges, and the optimum strategy for your company.

CDI Asia Regional Meeting in Hong Kong

From April 28th to 29th 2004 Fiducia hosted the CDI Asia Meeting in Hong Kong. Fiducia is China partner of Corporate Development International (CDI) a global network specializing in company search and acquisition advisory services.

The event was split up into two parts, with an internal regional meeting taking place on the first day followed by an Executive Roundtable. Participants of the regional meeting were CDI partners from South Korea, Japan, China/Hong Kong, Malaysia, Indonesia and Australia. Additionally, two new potential CDI partners from Taiwan and Singapore were attending.

The half-day Roundtable Meeting titled “Corporate Growth Strategies for Asia Pacific” on April 29th 2004 was chaired by David O’Rear, Chief Economist at the HK General Chamber of Commerce, who shared his insights into economic and political trends in the Asia-Pacific Region. Additionally, CDI partners presented corporate issues and shared success stories from their home countries. Invitees represented a selected group of regional-based executives of major multinational companies interested to learn about macro-economic trends and opportunities in Asia.

VDE sets up Branch in Hong Kong

The VDE (Association for Electrical, Electronic & Information Technologies) Testing and Certification Institute sets up Greater China headquarters in Hong Kong. The opening ceremony was held on 30th of April 2004.

VDE is one of the world’s largest technology associations with some 1,250 corporate and institutional members. The Hong Kong branch has been set up to improve the global VDE certification service - VDE marks have an excellent international reputation in the electrical and electronics industry. The set up happened in response to the rising demand for certification services in Asia.

The incorporation of VDE Global Service HK Ltd. was handled by Fiducia.

Carmakers win Key Ruling in Piracy Fight

Six of the world’s largest carmakers (BMW, Toyota, Mitsubishi, DaimlerChrysler, Audi and Volvo) have cleared a key hurdle in their conflict with a Guangdong glass factory they accuse to manufacture fake windscreens. The Guangdong provincial prosecutor overturned three earlier rulings by local prosecutors who had refused to take action – this may be a signal that Beijing is putting growing pressure on the provinces to stop counterfeiting.

The United States estimate the damage caused by counterfeit parts to the US vehicle industry at US$ 12 billion; not to mention the harm poor quality products can do to consumers. The Guangdong glass factory for example was exporting branded windshields without shatterproof safety elements. The People’s Republic of China and Taiwan are considered to be the world’s major sources of counterfeit parts for vehicles.

Update on M&A in China

Mergers & Acquisitions (M&A) became in the recent years a main investment vehicle for cross-border transactions worldwide. These days, approximately 80 percent of all global transactions are implemented by way of M&A transactions. However, as regulatory hurdles and business risks in China remain much higher compared with many other M&A markets, the vast majority of foreign direct investments (FDI) flow into the creation of WFOEs, JVs, or other investment projects - M&A accounts for less than 10 percent of FDI. This is shattering, since China became the leading nation attracting the most FDI, surpassing the United States for the first time in 2002.

Nevertheless, China became the 3rd largest M&A market in Asia, and this trend is set to continue and it should be remembered that China’s M&A history is not older than 14 years. According to Thompson Financial, China was Asia’s most active market for M&A in the second quarter of 2002, with 155 transactions with USD 11.9 billion announced. For whole 2002, China accounted for around 12% of all equity sold in the Asian regions.

The size of M&A deals in China and their frequency have improved recently but significant challenges remain: The primary differences to the West are in the duration, the difficulty, and the success rate. In China, deals take more time, are more complex and opaque, and finally fail more frequently. Three main reasons for these differences can be identified:

Maybe the biggest challenge in China is the valuation of the acquisition target. Many companies are not being run in a proper way, unusual bookkeeping practices and cooking the books is widely spread. Other challenges are the identification of the real owners/shareholders, land ownership/leasing rights, hidden relationships to other companies (especially suppliers and customers), etc. In China, only about one in five deals move beyond due diligence (compared to one to two in the West). In western society, motives are like the skin on an apple, peel it off and you’ll find the hidden motive. Not so in China: here you’re dealing with an onion – with many layers. Therefore it is of substantial importance to carefully ascertain the company value of your M&A target.

Getting government approval is another complicating factor. In the West, M&A transactions generally only involve the two parties. In China, on the other side, there is normally a third party present: government bodies. This third participant may not directly take part in the negotiations but it has the final say in the deal. Another problem is determining the gap between the written law and the law as it is actually being practiced. It requires considerable experience to differentiate between these two. In some provinces, especially in the Western ones, government approval authorities are more flexible than the written law.

Dealing with M&A in China, foreign companies should also consider cultural characteristics in China such as the great importance of face. A foreign buyer, for example, should emphasize on helping the local company rather than changing everything. Philips was once in eight month long negotiations without any progress because the Chinese party used a different valuation method. Finally, Philips brought in a third-party government official to persuade the Chinese partner. This intermediary allowed the stalemate to be broken without the Chinese partner to lose face.

As a result, most transactions involved domestic Chinese companies (e.g. restructuring of telecom giants), not cross-border transactions. Although China's M&A activity is likely to increase, this does not change the fact that many listed Chinese enterprises cannot be compared to listed European or American companies. The business risks of any acquisition are still high, and are dependent on identifying valuable target companies and developing workable acquisition strategies. Such company search services are only just maturing in China, but are perhaps more important in China than other M&A markets, as it is no mean feat to separate the wheat from the chaff in this very large field.

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