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To explain political risk and approaches to managing it

To discuss the philosophy and practices of the legal environment

To describe trends in contemporary legal systems

To examine legal issues facing international companies

CASE: China—Complicated Risks, Big Opportunities 1

From 1949 to the late 1970s, China’s was autarkic, championing a self-sufficient economy that relied entirely on its own resources. Communist Party leaders believed contact with foreigners would corrupt the nation’s political structure and pollute its cultural life; hence, they prohibited foreign direct investment and restricted foreign trade. 2 Near the end of the 1970s, however, the Chinese leadership began rethinking its economic strategy. In 1978, realizing it was lagging much of the world, China enacted the Law on Joint Ventures Using Chinese and Foreign Investment. This law effectively began China’s reintegration into the global economy.

Since then, Chinese economic policy has been marked by market liberalization fueling its accelerating entry into the world of foreign trade and investment. Unquestionably, the Chinese Communist Party (CCP) maintains an absolute monopoly on political power. Observed a Beijing scholar, The Party (CCP) is like God. He is everywhere. You just can’t see him. 3 Free market principles, however, shape the country’s business environment. This transformation has yielded astonishing results. Over the past thirty years, China has prospered more from globalization than any other country. Its people have moved from mud huts to high rises, companies have moved from woefully run state-owned enterprises to world-class multinationals, it has accumulated the greatest financial reserves in the world, and it has outsmarted, outlasted, and outperformed many on the world stage. Consequently, many see China’s ascendency as a global event without parallel.

Insert Map 3.1 Pickup from page 88 of DRS 13 th Edition.

THE SIREN CALL OF CHINA

Compelling incentives attract foreign investors to China. The 1980s saw a gold rush by MNEs, ranging from manufacturing ventures and export processing to licensing agreements and service relationships. This rush has run strong for more than 30 years. Despite the global financial crisis, FDI in China increased by $162 billion in 2010. Total FDI in China—representing more than 600,000 ventures opened by companies from around the world—was U.S. $1,476 trillion in 2010 (up from $19 billion in 1990). 4 Why have so many rushed to China? Quite simply, they see stunning opportunities:

Market Potential China, with a population of more than 1.34 billion people, has seen its economic growth reduce the number of poor by more than half-billion since 1981. Hundreds of millions more, although poor, see a brighter future. In 2010, 91 percent of Chinese saw their economic situation as good; in 2002, 52 percent had. 5 Many domestic markets are in early, high growth stages. Many MNEs that came for low cost workers stay for increasingly well-off shoppers.

Market Performance Rapid economic development catapulted China from an also-ran in 1978 to the world’s second-largest economy in 2011; estimates put it as the world’s largest sometime between 2016 and 2036. 6 Growing income powers consumer spending. During the industrialization of the United States and Great Britain in the nineteenth century, their real incomes per capita doubled in 50 years. China’s did the same in nine years.

Infrastructure China is in a multiyear program to build its infrastructure. It is investing trillions of dollars on housing, offices, highways, airports, seaports, waterways, dams, power plants, telecom grids, high-speed trains, and communication networks.

Resources China’s well-educated population creates an immense pool of productive labor. Wage rates are far less those in many other countries—perhaps 5 percent of comparable costs in the US, Japan, Europe and a third of those in Mexico and Turkey. 7 Besides efficient factory workers, China boasts a large and growing number of productive, low-cost brainworkers.

Strategic Positioning MNEs see investment and operation in China as fundamental strategic themes. Like the United States a hundred years ago, China is on the rise. MNEs from the four corners of the globe respond accordingly. Bluntly put, “you are not a global player unless you are in China.” 8

THE COMPLICATION OF REALITY

Notwithstanding the hype and its hyperactive performance, complications tarnish China’s appeal. Its unique political and legal systems make business operations a complex, frustrating process. In a nutshell, China applies state capitalism whereby the government manipulates market activities to achieve political goals. Consequently, MNEs doing business in China often find themselves at a disadvantage. Ambitious Western firms such as Exxon Mobil, ABB, and Vodafone, for example, purchased material stakes in Chinese companies, seeing them as a shortcut to market share and industry position. Political ambiguities and legal difficulties short-circuited their plans. Eventually, many sold their stakes and reset their strategies. 9

China’s rapid emergence has created obstacles. Many reflect a mix of ancient and contemporary political and legal outlooks. Some observers argue that, when it comes to doing business in China, the number one rule is to throw away the rulebook. Sage foreign investors abandon the notion that Western ideas automatically work in China. In the West, for instance, you can form a corporation “for any valid business purpose.” This principle does not exist in China. Incorporating in China requires telling the government—in excruciating detail—who you are, what you want to do, how do you plan to do it, how much you intend to invest, and how many jobs you will create.

Traditionally, centralized authority determined the path and pace of economic development. This situation is hardly unique to China. Many once government-controlled economies like India, Vietnam, and Turkey deal with the legacies of centralized decision-making. China, however, is a particularly tough case given that its political and legal systems impose many time-consuming tasks. Moreover, it tends to stack the odds against foreigners who are bold enough to forge ahead in the face of an elaborate government bureaucracy and a fledgling legal system. 10

DRAGONS AND SNAKES

“If the great invention of European civilization was a legal system,” quipped an observer, “then China’s was bureaucracy.” 11 Frustrated investors blame China’s treacherous business terrain on a bureaucratic system that regulates activity based more on arbitrary agendas than objective standards. Connections, not competencies, sometimes matter more. Those who believe that economics should determine the efficient means of generating prosperity see this as illogical. Still, it is utterly logical to Chinese leaders that regard state control of business activity as the most reliable path toward harmonious prosperity—and, they might add, staying in charge of the show.

Foreign investors navigate often-mysterious political channels. MNEs endure protracted negotiations in obtaining permission to open local operations. At each stop of the long march, national, provincial, and local officials ask how the investment encourages capital formation, promotes exports, creates jobs, and transfers technology. The long-running conflict between central and local Chinese authorities further confuses issues. The vastness of the country means that local officials, whether headquartered in the smallest village or the largest city, are largely left alone by their comrades in Beijing. There are rules and laws but how they move from Beijing to the provinces is a different story. “The center,” notes one observer, often “has no control over the provinces. When it sends people to investigate illegal pirating of CDs, local governors block access to the factories.” 12 A sixteenth-century Chinese proverb, “The mightiest dragon cannot crush the local snake,” captures the spirit of this enduring power struggle. Essentially, even though the central government in Beijing may appear to be all-powerful, its practical reach is limited by the politics of local fiefdoms.

PRECISE LAWS OR AMBIGUOUS GUIDELINES?

China had no formal legal system in 1978 when it launched one of the greatest campaigns of legal reform in history. Development has stabilized what had been an unpredictable legal environment. Still, China faces challenges, including legislative gaps, hazy interpretation, lax enforcement, and philosophical disagreements. “Chinese legislation is chock-full of ambiguities,” says one Beijing-based lawyer, who thinks it will take 10 to 15 years to iron out many wrinkles. Some are less optimistic, comparing the state of the Chinese legal system with that of the United States in the 1920s—then an antiquated composite of statutes and codes that took several decades to modernize. Even to this day, it remains a work in progress.

Others note that, in the case of the Chinese system, even bigger problems reflect a difference in the conception of legality in a society. Western legal systems rest on the rule of law and its doctrine of legitimate regulations administered by public officials who are held accountable for their just enforcement. In contrast, China practices the philosophy of the rule of man, seeing the right of the “man,” today in the form of the CCP, to act free of checks and balances. Besides being the law, the CCP is seen above the law. 13 Criminal defendants, for example, have limited access to legal counsel, few rights to call their own witnesses, or even opportunities to contest testimony. Rare is the Chinese criminal-core proceedings that ends with anything other than a guilty verdict. Rather, said an FBI Special Agent and legal attaché at the U.S. Embassy in Beijing, “there is really no rule of law here…they (CCP) make a decision ahead of time to make a point.” 14

THE LEGALITY OF ILLEGALITY

China’s legal practices, combined with the growing pains of its fledgling legal institutions and evolving political norms, create problems for MNEs. A flashpoint is the theft of intellectual property—the product of someone’s intellect that has commercial value such as patents, trademarks, or copyrights. MNEs complain that the relentless, widespread, and sophisticated theft of their intellectual property fuels China’s economic surge. A ggressive estimates attribute nearly a third of the Chinese economy to piracy. 15 In the United States, the FBI estimates that American companies lose up to $250 billion annually to counterfeiting, half of it because of China’s illegal practices. In 2009, almost 80 percent of the seized counterfeit goods in the United States were made in China. 16 In frustration, the United States has accused the Chinese of counterfeiting software, videos, pharmaceuticals, and other goods—sometimes with the open encouragement of state officials—and falling short in punishing pirates. 17

The United States, as has other countries, fights back. It has complained to the World Trade Organization (WTO), a global institution that sets rules for international trade and intellectual property rights, about “inadequate enforcement.” China’s failure to curb piracy costs software, music, and book publishers billions of dollars in lost sales, argued the United States, as well as makes it unfairly hard for legitimate firms to operate there. Expressing “great regret and strong dissatisfaction at the decision,” a Chinese official responded that the U.S. charge was “not a sensible move.” 18

Meanwhile, on the city streets and country roads of China, counterfeiting is never far away. What accounts for China’s status as the world’s premier number-one counterfeiter? Most analysts point to the mix of China’s quest to catch the west, collectivist orientation, rule-of-man legacy, and dubious enforcement of ambiguous laws. These conditions create an unprecedented political and legal morass. Noted an observer, “We have never seen a problem of this size and magnitude in world history…There’s more counterfeiting going on in China now than we’ve ever seen anywhere.” 19 The problem threatens to escalate. Government policies have “left a deep impression on companies that intellectual property is there for anyone to use it.” Local and provincial economies rely heavily on pirates to power growth. Moreover, make no mistake about it, China excels in making high-quality knockoffs. As they say in Shanghai, “We can copy everything except your mother.” 20

WHERE TO NOW?

The siren call of China continues attracting MNEs. Still, investors question how an opaque, single-party political system and a murky legal system can protect their rights. Some believe that external institutions will improve transparency. China’s 2001 ascension to the WTO, for example, required it to accept rules on all sorts of business matters, including tariffs, subsidies, and intellectual property. China has steadily amended its legal codes to comply with WTO standards. Today, the problem is not a shortage of regulations. The problem is China’s sluggish enforcement.

Despite intimidating political difficulties and confusing legal questions, foreign investors head to China. Perhaps driven by optimism, perhaps by confidence in continued progress, or perhaps by desperation to ride this megatrend, companies leave the sanctuary of predictable markets for the unique ways of the Middle Kingdom. And, once they cross the modern-day Rubicon, they face the daunting task of interpreting China’s political and legal systems.