An Analysis of International Investment as a focus on China

Categories: Franchising International Joint Venture

Analysis, Pages 12 (2856 words)

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Various forms of international investment have different levels of managerial involvement and control that is retained. My interest in the Chinese market has led me to determine which method of investment would be best under the circumstances presented by the Chinese business environment. There are several investment methods covered in our management text that allow varying managerial control. These include licensing, franchising, joint ventures, and fully owned subsidiaries.

China is an ambiguous environment in which it is difficult to get definite answers to questions relating to costs, operating conditions or requirements.

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Management must be patient in dealing with a variety of local officials, ministries, as well as the People's Bank of China. Even commitments are not guarantees, as the PRC likes to exercise its right to change its mind. The government is continuously changing the rules, and going back on agreements. In late 1995 companies were rushing about, trying to close deals in a matter of weeks to avoid the changes in plans to be enacted in 1996.

Some companies had been negotiating these deals for years. The change incorporated large tariffs on foreign firms making them no longer able to bring in capital equipment duty free. Chinese authorities are also highly unpredictable when assessing customs duties and taxes. The average taxes for foreign operations in 1993 were 24% and are rising currently (Doing Business in China pg. 114). Political Environmen Management must be aware of current political situations when attempting to invest in China. Many companies have lost opportunities in China due to political conflicts.

Unfortunately the only retaliation China has, is against U.S. businesses.

Some current political issues include repeated allegations of Chinese human rights violations, threat of withdrawing China's most favored nation trading status, and failure to back the Chinese entry into the World Trade Organization. Another concern of the U.S. is the widening trade gap in China's favor. An example of one company hurt by political problems is Greiner International. GreinerInternational lost a $35 million deal to provide equipment and engineering services for a new airport in Nanjing (South China Weekly Post, Feb. 11, 95). This was due in part U.S. allowing a Taiwanesegovernor to visit for his college reunion.

Legal Environment Companies such as Microsoft have also been victims with the protection of Intellectual Property Rights. Chinese companies have been pirating and exporting to compete with software, film, and music industries. Recently after the threat of trade war, the United States reached an agreement with the Chinese over intellectual property rights. All Chinese quotas and licensing requirements for software and audio visual products, including films and music will be removed. For quite some timenow China has had laws to protect patents and copyrights, but has never bothered enforcing them. Defense of rights is very expensive to up hold especially for a poor and sprawling country.

Another factor is that there are a lot of Chinese who stand in positions of power, who have a lot to lose. The Chinese people themselves view their central government as largely powerless in the face of rebellious local governments and the legions of shady dealers (U.S. News and World Report, Feb. 20, 95). Previous attempts at regulation have been deemed entertaining at best. China's trade minister Wu Yi claims that there will be more foreign legal protection, including intellectual property rights. Local governments will also be given more power to approve foreign projects, to simplify procedures, and hold decision making power in export and import. (Doing Business in China, pg. 114) Even with such promises American companies would be well advised to seek further protection.

In July of 1980 U.S. Congress passed legislation to the Overseas Private Investment Corporation (OPIC) to support U.S. businesses investing in China. OPIC is a U.S. government corporation which provides long-term political risk insurance as well as loan guarantees and various financial programs. OPIC insurance is available for a maximum period of 20 years and covers inconvertibility of currency, expropriation, and losses due to war, revolution or insurrection. China is only the third Communist country to be voted eligible for the program. Resources and Manufacturing The advantage to manufacturing in China is that production facilities will be near major customers, or possibly needed resources. Production expenses can be reduced by using lower cost labor for assembly.

However any form of investment in China that involves manufacturing must be done with great caution. China is large and sprawling, and this problem is compounded by severely underdeveloped infrastructure. The sourcing and transportation of raw materials, ingredients, parts and components are often difficult and time consuming. From within china it may take a long time to find anything that meets required standards of purity, quality, and reliability. A company may (out of necessity) end up with many suppliers scattered about the countryside. This means long lead times, unpredictable flow and perhaps a need for increased inventories (if possible). Sourcingoutside of China is difficult enough due to foreign exchange problems.

In addition there are often unexplained delays in clearing customs, and items may be assessed at different tariff rates on different days. China's manufacturing history of producing strictly on the basis of quantity has led to a lack of concern for productivity, quality, or efficiency among the work force. There is a near total disregard for the needs of end users. If articles are to be manufactured under contract or license, management can expect to have to spend a lot of time educating front line management and laborers. Most people will be willing to change their work philosophy and habits. It is difficult to get control over personnel operations, though some companies have managed.

This area is generally controlled by PRC authorities. Companies who manage some control of personnel may consider hiring those with little or no prior experience as they may be more flexible to change with fewer bad habits. Trade Restrictions Massive injection of funds and technology are needed in railway networks, the iron and steel sector, as well as other backbone industries. China has announced grand plans for $120 billion to be spent on infrastructure.

The plan calls for an additional 10,000 miles of railways, and 125,000 miles of roads (Doing business in China, pg. 136). China needs about twenty times more spending on the infrastructure than the World Bank provides on a yearly basis, in order to reach its modernization goals by the year two thousand. It will take at least twenty to twenty-five years to build an adequate transportation system. China will welcome joint ventures as well aswholly owned ventures in the construction of railways, highways, and civil aviation facilities. There are still 125 million peasants who live without electricity. The demand for power is estimated to exceed supply by at least 20% nationwide (Doing Business in China, pg. 136). Since 1992 there have been disputes with foreign contractors over what is an acceptable profit level for power plants.

The PRC doesn't want investors to receive more than a fifteen percent return on investment. Companies have simply been holding out for an offer of20% or better. In November of 1994 the government finally broke down and signed to a contract at a higher rate. Major infrastructure projects known as BOT (Build, Operate, Transfer) have been opened to foreign investment. The foreign side of the venture handles the construction project, operates it for a set period (15 years normally), and then hands it over to China. Western companies are cautious because it means having assurances about revenue streams in areas where price controls still exist. Banking commerce, tourism, and real estate sectors are areas that are gradually freeing up for foreign investment.

China is still very restrictive on the markets open to foreign investment and the PRCrequirements will often dictate the method of investment. As far as technology and equipment goes, China has been focused on items that cannot be produced locally. This has led to purchases mainly of bare technology and the use of technology to upgrade existing manufacturing facilities. As shown on the chart of China's imports you can see that the main imports are raw materials and machinery. Forthis reason exporting is essentially limited to these areas and may still face very high tariffs. Inaddition foreign exchange problems may prevent a company from getting revenues out of the country.

LicensingLicensing is an excellent investment alternative, especially if there is a valuable patent, trademark, or trade secret. Other factors that make licensing an excellent option are technology or processes that are exclusive, intensive, complex, or a service that is unique and requires specialized inputs of knowledge or management. China is large and sprawling and it can be difficult as well as expensive to service it. Volume may be too low to justify setting up a distribution network, in this case licensing to a company able to handle the distribution may be suggestible. In licensing the rights are sold based on an agreement to manufacture or market brand name products or product specifications, or to use copyrighted materials, patented processes, or other assets. The license may be granted to a company for a fee or royalty which is based on sales.

Usually the license only grants the licensee rights to operate in a specific geographic region. In licensing in the PRC it is necessary that the terms are well defined, especially in the case of technology. Owners of technology must use extreme caution in establishing the limits of the technology to be provided and in protecting all relevant intellectual and industrial property rights. Sufficient time must be allowed as the selection of a licensee is very difficult. Getting a poor licensee is very dangerous, especially when it comes to protection of the licensing agreement.

A company could in fact create its own competition. In the book Pacific Rim Trade this is termed the "copy catsyndrome." It could mean the loss of the technology, trade secrets, or patents. Poor performance on the part of a licensee can produce lower than expected revenues, or substandard quality. Poorlicensees may misapply the technology, market inappropriately, fail to train users, or to service the product properly. This can lead to a bad reputation for the company and product. Even worse a company could use licensed technology in other products (reverse engineering), without the licensing company even being acknowledged.

To avoid these situations the licensee must be carefully selected. The agreement must make it in the interest of the licensee to protect the interests of both companies, and the company must remain vigilant against misuse and breaches. The licensee must benefit more by working with you, than it would without. Franchising Franchising is essentially a licensing agreement with additional benefits including trademarks, equipment, materials, managerial and consulting advice, and possibly some cooperative advertising. A franchise is a right to market goods, services, or trade secrets in a particular territory.

This agreement usually involves an original engagement fee, and future percentage of revenues. The franchise may also involve continual purchase of ingredients or materials. The franchisor may maintain the right to revoke the franchise if certain quality or profitability standards are not met. This is the key in franchising, maintaining control to maintain a standardized quality product. Independent franchises need to be monitored, given direction, and provided with technical support.

Assistance must be given to maintain quality, ensure operating procedures, and oversee marketing and promotion. Foreign franchises usually require enough flexibility as to allow for adjustments to local market conditions. This would include adjustments such as menu items, and to an extentpackaging and promotion. As in licensing there is the possibility of losing control and creatingcompetitors. Often the only way to get a good franchisee and maintain control is to take on an equity partner.

For this reason franchising in international markets relates as much to joint ventures as it does to licensing. Joint ventures are formed when two companies come together to form a separate company. The companies share in the new ventures ownership, management, and control. This allows companies to combine their strengths and share the risk. The companies will share the cost of developing new products or processes, building facilities, and managing and maintaining the operations. If the companies complement well there may be synergistic gain resulting in a more powerful company than either could have accomplished on its own.

In China it may be difficult to enter the market without forming a joint venture. For the most part the PRC requires local ownership in direct foreign investment. Import controls and trade barriers may make the import of products impossible. China's main goals in establishing joint ventures is to produce goods for export. Murray, in his book Doing Business in China states that very few foreign joint ventures have been allowed to produce goods solely for the Chinese market. Another problem arises in Chinese foreign joint ventures in that the Chinese partner, backed by PRC government pressure on the foreign partner, will often insist on handling matters beyond its competence in order to gain experience. The most important areas to maintain control in are financial decision making as well as the quality of the product or service.

The local partner can provide some needed advantages. Local companies contribute a valuable knowledge of Chinese priorities and the working of the system. This knowledge may cover the market, political environment, language, culture, and customers. The local company may have an established reputation, access to marketing channels, and familiarity of the competition. Such apresence could take a long time to build up, if even possible. There are two types of joint ventures available in the PRC. The equity joint venture comprises only about 15% of all foreign joint ventures. The head of this corporation must be a Chinese official, and the foreign equity investment must be at least 25% of total equity.

In contrast the Chinese siderequires a majority share, usually nearing 75%. Contributions of the parties are regulated. The Chinese partner may provide land, improvements, including factory and infrastructure, labor, and some materials and machinery. The foreign partner may supply patent rights, technology, capital equipment and machinery, management, external marketing expertise, and capital. The foreign partner's profits may be repatriated. Contractual joint ventures offer more flexibility and are more popular among investors.

The capital contribution may be something other than money, and the profits of the venture may bed istributed in any proportion agreed upon by the partners, rather than proportional to the respectiveequity shares. The problem with jumping into a joint venture is that it is not easily reversed. It's harder to find agood partner than a good distributor, and it takes a lot longer. It's a large commitment to the market and there will be large losses in an early withdrawal. China is open to joint ventures in airlines with domestic partners on trial basis. The PRC is also encouraging joint ventures in commercial airports, railways and highways.

Some of the best joint venture opportunities in the Chinese market are in the foreign travel and tourism sector, including catering and hotel services. Wholly Owned SubsidiaryWith a large corporation one might prefer to directly invest capital and personnel by building a new operation abroad or by purchasing operating facilities from a foreign company. This allows the company to maintain full control of operations with greater flexibility. This way managers are 100%committed to the best interest of the company. They have full authority and responsibility for planning. There is no worry of creating competition, or losing technology or trade secrets.

The company also maximizes its return as there is no need to share the profit. Disadvantages to the fully owned subsidiary include the high cost of establishment. It takes longer to establish a successful business, especially if attempting to develop a new market for products and services. There are usually no prior relationships with suppliers and customers. The company also has to deal with the fact that to a large extent it is ignorant to local markets and business culture. The Chinese government and people also have a bias against foreign operations. In china foreign companies are finally getting an even playing ground. Restrictions are loosening on the purchase of raw materials, price setting, and sales in the Chinese market.

Many companies still have to export most of their output, having also paid high import duty on vital components. "We should allow [the firms] to sell all their products in China-provided they are advanced and needed by the domestic market - as wellas giving them foreign trade rights," said Ms. Jiao Sufen, Director General of the Foreign Investment Administration at the Ministry of Foreign Trade and Economic Cooperation (Moftec) (Doing Business in China, Pg.113)

Unfortunately there are very few instances in which China allows fully owned foreign ventures. Fully owned ventures must provide a definite benefit such as technology transfer. This paper has been a real eye opener in regard to the Chinese business environment. Exportsseem to be limited only to capital intensive raw materials, and advanced manufacturing technology. For the majority of foreign investments the key is finding a partner that shares your own goals and has as much to gain from success as you do. I have learned that any company whether as a joint or wholly owned venture should start small, develop relationships, and expand upon gaining experience in the environment.