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Doing Business in China: The Chinese Investment and Trade Environment

Spring 1998

The People's Republic of China (China) impresses the world with its 1.2 billion person consumer market, its continuing economic boom, and its annual average Gross Domestic Product (GDP) growth of approximately 10 percent during this decade. Foreign investment and international trade play important roles in the Chinese economy. Up until January 1998, the Chinese Government had approved more than 300,000 foreign direct investment (FDI) projects with a total invested capital exceeding U.S. $200 billion. China is already the world's second largest recipient of foreign investment and fifth largest trading power. However, China is not yet a free market. Foreign investors may face restrictions such as limited market access and capital repatriation problems. Moreover, doing business in China may involve more risk and uncertainty than other countries due to its poor enforcement of the rule of law and unreasonable interference from the government in business affairs.

Open Door Policy. China has transformed important aspects of its economic and political structures since it adopted an "Open Door Policy" in 1978. Attracting foreign investment and promoting international trade are primary goals of this policy. The Chinese Government has made great efforts to create an attractive legal environment to achieve these goals. Apart from establishing a comprehensive domestic legal system, China has introduced more than two hundred laws and regulations governing foreign investment and trade. At the same time, local governments have enacted numerous regulations which provide detailed rules for foreign investment.

Foreign Direct Investment Vehicles. Under the current Chinese legal system, foreign investors have four alternatives in establishing FDI enterprises:

1. Sino-foreign equity joint ventures (EJV),
2. Sino-foreign contractual joint ventures (CJV),
3. wholly foreign-owned enterprises (WFOE), and
4. joint stock companies.

EJVs and CJVs differ primarily in three ways: (1) Chinese and foreign investors in EJVs jointly manage, share profits and bear risk in strict accordance with their percentage of shares in the registered capital, while in CJVs these interests may be allocated differently by contract; (2) EJVs must register as a limited liability company and have a formal board of directors. However, CJVs can register as other forms such as a partnership, and may have a very flexible management structure; (3) EJVs benefit from predictable laws and are the most popular FDI, but project-oriented investors usually prefer CJVs because of their flexibility.

WFOEs provide a vehicle which allows investors to carry out independent worldwide market strategies but lack the benefits afforded by assistance from local investors (see Dispute Settlement discussion below). WFOE investors may enjoy a lower risk of infringement of technology but are restricted from certain industrial categories which are only available to joint ventures.

The joint stock company is a new form available to foreign investors after adoption of the Company Law of China (1995). Foreign investors may find this form similar to their traditional corporate structure. However, this form requires much higher minimum registered capital (U.S. $3,600,000). Middle or small size businesses may find it difficult to meet this threshold.

Market Access. Foreign investors are not able to access all Chinese industries. The Government regulates market access by periodically publishing a national Guideline and Catalogue for Foreign Investment. The current Guideline and Catalogue lists investments involving new agricultural technology, hi-tech, environmental protection, transportation, postal and telecommunications as "encouraged projects." Investments in these industries may enjoy more incentives such as an exemption from customs duties on imported equipment. Investment projects which may cause pollution, harm land resources or threaten national security are prohibited; automotive, financial services and entertainment industries are usually regulated as restricted projects. Investments in restricted industries are subject to various examination requirements from the government, depending on the specifics of those projects.

Tax Incentives and Currency Convertibility. Generally, foreign investment enterprises in China are now entitled to a two-year complete income tax exemption and another three-year 50 percent income tax exemption. More tax exemptions may be available from local governments. (These exemptions will vary from area to area.)

The Chinese currency (RMB) is not freely convertible. New reforms enable foreign investors to convert RMB into foreign exchange for daily operating purposes such as importing materials and repatriating profits. However, conversion and repatriation of RMB capital is still subject to severe restrictions.

Other Business Modes. Besides direct investment, foreigners may conduct business in China through licensing, franchising, importing and exporting. However, foreign business involving intellectual property transactions may face the risk of infringement by third parties due to China's poor record of enforcement of intellectual property rights. Foreigners should also be aware that importation often requires licenses or quota permission from the Government. Moreover, the Chinese average tariff rate is about five times higher than that of the United States.

Dispute Settlement. A basic understanding of Chinese legal culture and business practice will be helpful for those who wish to do business in China. Chinese culture encourages the settlement of disputes through negotiation and mediation. The Chinese believe that lawsuits ruin the good reputation of both plaintiff and defendant. Consequently, instead of going to court, Chinese businessmen tend to settle disputes through unofficial mediation or negotiation.

"Guangxi" (personal relations) is very important in Chinese culture and modern business. Good guangxi with local partners and government officials is very important to running a successful business in China. Good guangxi with local partners may help foreigners overcome obstacles in a traditionally conservative society and is an important bridge to Chinese business circles. Further, good guangxi with governmental officials will benefit foreign businessmen "legally" in various aspects.

First, China still keeps some administrative guidelines unpublished (although they are not confidential). Good guangxi with government officials will keep businessmen informed of these unpublished rules. Second, in establishing and operating FDI enterprises, good guangxi will smooth out complicated administrative procedures. Third, as an anti-lawsuit society, mediation through administrative officials is a primary means of dispute settlement. Good guangxi will, no doubt, provide the foreign company with an easily accessible way to settle business disputes. Government officials are often involved in mediating foreign investment disputes. This alternative is often efficient because local officials generally have influence and settlements usually are carried out by the parties. However, abuse of power and unreasonable governmental interference may occur during this process.

Today the functions of guangxi are undergoing changes. More and more Chinese have come to recognize lawsuits and formal arbitration as efficient and just methods for settling disputes. Arbitration is a popular and officially sanctioned means of settling international business disputes in China. China has already established a relatively comprehensive and accountable arbitration system. In addition, China became a signatory to the United Nations Convention for the Recognition and Enforcement of Arbitral Awards in 1986. Where partners contractually agree to submit their disputes to international arbitration the Chinese courts have a good record of recognition and enforcement. However, enforcement of arbitration awards in China often encounters obstacles due to protection of local interests. The obstacles include Chinese "public policy" requirements that Chinese courts or arbitration panels and Chinese substantive law be applied to resolve disputes involving various areas of substantive law (e.g. joint venture law, labor law and natural resources law).

Doing business in China may create more risks and uncertainties than in other countries. However, no one can deny the vast opportunities in a market encompassing 1.2 billion consumers.

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