The Boat and the Water
China remains one of the world's most popular foreign investment destinations. Yet the evidence suggests that some of the commonly accepted assumptions of mutual benefit are false.
During his address to the Fortune Global Forum in Beijing on May 18, Bo Xilai, the Chinese Minister of Commerce, claimed that China has been very profitable for foreign businesses. He said that of more than 280,000 foreign invested enterprises in operation between 1990 and 2004, two-thirds were profitable.
According to the 2004 survey of the American Chamber of Commerce in China, three-fourths of surveyed U.S. companies in China were making a profit, and for 42 percent of them, their profit ratio in China exceeded their global average. A “2005 Foreign Investment Survey” published by the Chinese edition of Fortune magazine emphasizes that doing business in China is by no means as unprofitable as is often suggested outside of China. More than 90 percent of foreign companies think that they can make a profit within five years.
China Is Currently Facing its Second Wave of “Capital Flight”
These articles make a point of saying that foreign investors can make substantial profits in China. It's a question worth examining. On February 17 of this year, the Financial Times published an article by Geoff Dyer entitled “China: Paradise or Graveyard for Foreign Enterprises?” The facts Dyer cites run counter to Bo Xilai's conclusion: In 2003, China, with a population of 1.3 billion people, generated profits of $4.4 billion for U.S. companies, while Australia, with a population of 19 million, generated $4.9 billion. Mexico, with a population of 95 million, produced profits of $5.75 billion for U.S. companies.
The figures cited by Bo Xilai ignore two facts.
The first is that half of China's foreign investors have pulled out after suffering major losses. The second is that of the more than 500,000 foreign-invested companies in China, some 220,000, or 44 percent, have yet to begin operations. These top-secret Chinese statistics were leaked through a fortuitous set of circumstances. During last year's debate over the unification of the two-tier tax regime (one for foreign invested enterprises and one for domestic Chinese enterprises), a report issued by the State Council's National Development and Reform Commission (NDRC) proposed eliminating preferential tax rates for foreign companies based on the rationale that China is currently attracting too much foreign investment, which is already posing a threat to the security of the Chinese economy.
In addition, anxious Ministry of Commerce officials, who are in charge of foreign investment, last July published figures indicating that the “accumulated amount of foreign investment actually utilized” in China was $559 billion, of which almost half had been withdrawn. There were 505,568 registered foreign-invested enterprises, but the number actually operational was less than two thirds of this figure.
Huang Hai, the Assistant Minister of Commerce, who released these figures, said that because China has no statistics on foreign direct investment stock, the term “accumulated amount of foreign investment actually utilized” has been widely employed instead. This figure does not reflect the termination of operations by foreign enterprises and the withdrawal of foreign capital. Up to the end of last year, China's foreign direct investment stock was approximately $250 billion, only half of the $501.4 billion in foreign investment actually utilized during the same period.
Where are all these profits going?
Here is a revealing statistic: Last July, Su Xiaolu, director of the Anti-Avoidance Division of the State Taxation Bureau, declared that 55 percent of foreign-invested enterprises had reported a loss (although he believed that many had done so fraudulently in order to evade taxes). Local statistics also indicate that foreign companies in China are not profitable. Recently, the Guangdong Province Statistical Bureau conducted an investigation of 696 key foreign-invested enterprises and found that almost half of those in the province's western, eastern and mountainous northern regions had reported losses.
In the current market situation, foreign capital is both entering and leaving China. In April of this year, the international electric power giants American Electric Power Co., Sithe Energy, Alstom, and Siemens withdrew from the Chinese market. If the foreign electric power companies that pulled out of the Chinese market in 2000 and 2001 were the “first ebb tide,” today's pullout is the “second ebb tide.”
In the past ten years, excessive management, regulatory and external costs have inhibited China's business development. Even numerous special economic zones that offer tax breaks have been affected and are finding it hard to generate profits. But the head offices of these foreign companies always claim that there is a bright future for investment in China, and as a result, China-concept stocks were briefly all the rage on Wall Street.
How Foreign Businesses Create a Profitable Outlook
The difficulties of making a profit in China are no secret to foreign enterprises in China. Many foreign CEOs in Beijing admit privately that very few people consider China to be a profitable market. Given the problems, why do more and more foreign companies continue to enter the Chinese market every year?
To put it bluntly, the reason is very simple: foreign companies that have suffered a crushing defeat in the Chinese market deceive their head offices with reports of outstanding performance. On many occasions, I have heard senior managers at major corporations say in private that carping about the losses suffered by China-based subsidiaries is not advantageous to U.S. companies, because a company's image is an important factor in the valuation of its stock.
Moreover, in the world of American industry and commerce, China is generally considered the world's last major unexploited market. By investing in China, companies express confidence in their own future. If they pull all their investments out of China, their corporate image is liable to take a beating.
When I visited Germany in April 2004, the China representative of an insurance company told me as much. Although his research and observations gave him no cause for optimism about the prospects of the China market, his boss simply refused to listen to what he had to say. “Either you give us the evidence [we want to hear], or you get lost!” To stay in the company, he had to find “evidence” of the advantages of the China market.
Under these circumstances, China representatives of major companies invariably tell their head offices that they are making a profit. The only difference is in how skillfully they lie. Numerous public relations firms have emerged in China to help the representative offices of major foreign companies tout their stellar performance by means of slick and plausible arguments when the parent company's CEO or chief financial officer comes to China to check up on their work.
The first line of defense is to prepare heaps of briefings and PowerPoint presentations showing apparently sound and cautiously optimistic but vague long-term projects against a backdrop of favorable market development. At the same time, local executives leave room to maneuver by pointing out that certain uncertain factors have emerged in dealing with the local government.
The second line of defense is to hire help (such as a PR firm) that can play the role of an independent auditor during company meetings. The PR firm's task is to say that after a painstaking investigation and review, it fully approves of the China representative's market plan. The third line of defense is to let the PR firm schedule a trip full of appointments, entertainment events, and meetings and banquets with Chinese partners. The aim is to ensure that even if the CEO or chief financial officer doesn't get to discuss what he had planned in any detail, he will end the trip with a feeling of satisfaction.
If such lies are told often enough, they provide the best cover for the Chinese subsidiary (or representative office) of a major corporation. The first five years are the net investment period. Once these five years are up, the China representative office can find all sorts of reasons to pass the buck. A common excuse is to point to China's changing political and economic environment.
But the day eventually comes when the parent company is no longer willing to invest an excessive amount of irrecoverable funds to preserve its corporate image or share price, and the branch office finally withdraws from China.
PR firms that act as intermediaries between parent companies and their local subsidiaries are a peculiarly Chinese phenomenon. The success of such companies speaks volumes about how little trust there is left in Chinese society.
The Flawed Assumption of Democratization Through Economic Development
However mixed the results for foreign companies, foreign investment is widely considered to be highly beneficial for China. In particular, it has become a universally accepted premise in discussions about China that “economic development will inevitably spur China's democratization.”
Three or four years ago, when there was talk about how China would change politically after it joined the World Trade Organization, many people based their arguments on this premise, which is almost never called into question.
The most forceful argument made at the time was this: After China joined the WTO, multinational companies would compel the Chinese government and industry to conduct business according to the international rules of the game. This was supposed to reduce corruption and spur China's democratization.
My retort was quite simple: First, this presupposition is not supported by international experience, because India and Mexico are WTO members, but corruption in those countries is as rampant as ever. Since joining the WTO hasn't resulted in less corruption there, it's unlikely to bring such a result in China, either.
Second, this presupposition is not supported by Chinese experience. China attracted massive foreign investment in the 1980s and 1990s, but all the evidence indicates that this investment did not improve China's institutional environment. Foreign companies simply adjusted to China's corrupt practices.
This is another illustration of the old saying “When transplanted, the orange tree produces bad fruit.” Although people I've spoken with haven't refuted my two arguments directly, many continue to insist that “a big influx of foreign investment will reduce corruption.”
Because people assume that economic development will inevitably spur China's democratization and that foreign investment is the main engine of economic development, they overstate the impact of foreign investment beyond its economic function and tend to credit it as a factor promoting political development. As a result, attracting foreign investment becomes a mantle of moral principle with which Western investors are only too happy to drape themselves. When Western businesspeople lobby their own governments to formulate policies toward China and try to persuade human rights organizations, this is always their trump card.
The joint effort of the Chinese government and foreign companies has made foreign investment one the horses pulling the troika of China's economic growth, and China is becoming increasingly reliant on foreign investment. Foreign direct investment (FDI) reportedly now accounts for 40 percent of China's GDP. According to the most recent OECD report on “Trends and Recent Developments in Foreign Direct Investment,” in 2003 China attracted an FDI inflow of $53 billion, elevating it for the first time to the top global destination for FDI. The United States ranked second, with an FDI inflow of $39.9 billion.
The world has long forgotten Karl Marx's incisive observation that capital obeys profit and makes its home wherever profit is to be made (“For the sake of 300 percent profit, there is no risk that the capitalist will not run, even at the risk of being hanged.”) Even Chinese nationalists who warned that the influx of foreign capital would squeeze out local industry forgot this truism, and apparently assumed that foreign businesses investing in China were pursuing the lofty goal of promoting China's economic development.
The Chinese government treads very carefully when dealing with foreign investors suspected of being involved in corruption. For example, when in 2003 the Anti-Corruption Department of the Jinan City Procuratorate in Shandong Province began looking into corruption cases involving senior managers of foreign enterprises, its investigators were told not to drive police cars or wear uniforms to avoid bad publicity that might harm foreign enterprises.
Even so, in the past couple of years several cases of foreign companies offering bribes have come to light. According to incomplete statistics, the number of such cases has grown steadily since 2000. In 2003 alone, there were more than 1,500 reported cases of foreign companies suspected of being involved in bribery and corruption-a 20 percent increase over the previous year. Senior public relations executives at foreign companies also circulate colorful stories of bribery and corruption that never appear in the media.
Over the past year, the ethical image and economic repercussions of foreign investment have been repeatedly called into question. Accusations come from three quarters: First, foreign investors' ethical image has taken a drubbing. A string of cases of foreign investors involved in corruption, including serious tax evasion, has come to light. Second, quite a few academics have begun to denounce China for ceding markets without obtaining technology in return. Third, foreign companies themselves have begun to reflect on how successful they have actually been in China.
How Foreign Companies Adapt to China's Corrupt System
Several friends of mine who work as government liaison officers for foreign companies have told me that multinational companies are forced to engage in corruption in China. When these companies first arrived in China in the 1980s and began to open up new markets, those that were not accustomed to giving bribes quickly realized that they were at a disadvantage compared with those who were.
After many lost opportunities, they began to tacitly consent to bribery. The first to assimilate to the corrupt Chinese environment were Hong Kong and Taiwanese entrepreneurs, who had ties of blood and culture with China and no fundamental cultural aversion to corruption. The next to adapt were Japanese and South Korean enterprises, which also had cultural affinities with China. The last were the Europeans and Americans.
Many multinational companies fully realize that in the Chinese environment you have to “pay to play,” and that in order to reap profits that rightly belong to the public, they must first give kickbacks to government officials.
The Chinese have a saying: “Sheep's wool comes off a sheep's body.” Foreign companies that want to do business with China (the sheep) have to pay bribes, but the money from those bribes comes from China anyway, so it's no skin off their backs. As the cost of paying bribes is made up for in huge mark-ups, foreign companies have adopted a wise strategy of “making a big profit at a relatively low cost,” which requires them to play by the Chinese rules of the game, accept “Chinese characteristics,” and participate in corruption. In fact, when it comes to handing out bribes, Western companies have become disciples that surpass their masters; even their Hong Kong and Taiwanese forerunners can't compare in method and style.
Over the past two years, foreign investors have repeatedly been exposed as bribers. On December 4, 2002, Peng Muyu, the head of Yunnan's Department of Foreign Trade and Economic Cooperation, was convicted of taking bribes. When approving a project for a Kunming based-company, he had allowed his wife to receive gifts worth 100,000 yuan.
Another scandal broke in 2004 when on April 8, the American telecommunications equipment maker Lucent Technologies announced that it had fired four executives at its China operation, including the president and chief operating officer Qi Daoxie, for violations of the U.S. Foreign Corrupt Practices Act.
Then, on May 27, Paris examining magistrate Roger Le Loire revealed that the famous French architect Paul Andreu had been awarded the contract to design the National Theater in Beijing in an “irregular way,” “irregular” serving as a euphemism for bribery.
The Golden Key to the Chinese Market
Why do foreign companies have to pay bribes to Chinese government officials to do business in China? This is entirely attributable to China's peculiar political landscape during this period of transformation. Cheryl W. Gray and Daniel Kaufmann have identified five objectives that multinational companies operating in Russia, Brazil and China accomplish through bribing government officials:
- 1. Government contracts: Bribes can influence the choice of private parties to supply public goods and services and the exact terms of those supply contracts. It can also affect the terms of contract renewal during project implementation.
- 2. Government benefits: Bribes can influence the allocation of monetary benefits (tax relief, subsidies, pensions or unemployment insurance) or in-kind benefits (access to privileged schools, medical care, housing and real estate or ownership stakes in enterprises being privatized).
- 3. Public revenues: Bribes can be used to reduce the amount of taxes or other fees collected by the government from private entities.
- 4. Time savings and regulatory avoidance: Bribes can speed up the process of gaining official permission for legal activities.
- 5. Influencing the outcomes of legal and regulatory processes: Bribes can alter the outcomes of legal and regulatory processes by inducing the government to overlook illegal activities (such as drug dealing or pollution) or to unduly favor one party over another in court cases or other legal proceedings.
In all of the countries under discussion, the government still interferes heavily in economic activity. Particularly in China, the government not only establishes the rules of the economic game, but is also the judge and a player. Government officials control policy making and the natural resources necessary for industrial development, as well as the issuing of business licenses, and they use this “social capital” to extract bribes.
Because government officials have diverted this capital to domestic industries and have contrived to make huge illicit profits themselves, they are not about to cede it to foreign companies of their own accord. In accordance with the principle of maximizing profit, they bestow special favors on those foreign investors who can give them more access to benefits such as enabling their children to study abroad and their family members to emigrate.
Generally speaking, multinational enterprises follow relatively standard management practices, and in their home countries they are quite “well-behaved.” But corruption is a common practice in China, and if companies want to make a profit here, they have to follow local custom. Bribery allows them to circumvent policy barriers and quickly gain market access and all sorts of other benefits. Given the reality on the ground, if foreign companies want to keep their hands clean, their only option is to quit the China market.
For that reason, although Chinese people hope that multinational companies will compel the Chinese government and industry to play by the international rules of the game and pull them from the mire of corruption, it is a demonstrable fact that these companies have failed to have a positive effect on Chinese government and industry. Rather, they have learned to conform to China's corrupt system and play by the Chinese rules of the game, and have repeatedly shown themselves to be the main givers of bribes.
In the mid-1990s, the Chinese government was still accusing Hong Kong and Taiwanese investors of corrupting honest Chinese officials. For example, the Supreme Procuratorate of Guangdong Province issued a report arguing that Hong Kong investors used “sugarcoated bullets” to target Chinese officials.
Although the Chinese government is no longer claiming that Hong Kong and Taiwanese businesspeople are colluding to corrupt Chinese officials, some Chinese people think that China should send a punitive expedition against the chief foreign culprits, as if Chinese officials were the victims. What these muddle heads don't realize is that, as the Chinese saying goes, “No flies settle on uncracked eggs.” If foreign companies weren't forced to adapt to China's corrupt system, would they really want to give bribes?
How Did Foreign Enterprises Master Corruption?
On July 23, 2004, the Guangzhou-based Asia-Pacific Economic Times (Yatai Jingji Shibao) published an article entitled “Shocking Bribery: The Inside Story of the Telecom Industry; Anti-Corruption Organizations Face a Serious Challenge.” According to a survey conducted by the Beijing-based consultancy Anbound Group, over the past decade there has been a steady increase in the number of documented cases of multinational companies offering bribes in China. Chinese authorities have investigated at least 500,000 bribery cases, 64 percent of which are related to international trade and foreign businessmen.
The Asia-Pacific Economic Times article revealed tricks foreign enterprises used to give bribes, aside from the methods often used by Chinese companies. As multinational companies enjoy all sorts of advantages and have a lot of money to spend on bribery, they have long surpassed the Taiwanese and Hong Kong businesses that the Guangdong Procuratorate accused of corrupting Chinese government officials. The article highlights the following methods:
- 1. Fictitious positions. To ease pressure on banks to attract deposits and increase service volumes, some foreign banks hire senior officials or the relatives of the heads of large and middle-sized companies and even their drivers as senior executives or even vice presidents earning top salaries. Although the government has stipulated that the children of high-ranking cadres may not go into business, they are not prohibited from holding senior white-collar positions in foreign enterprises. This is a shrewd way of circumventing the law.
- 2. Hiring consultants. In order to land a big project, some multinationals set up completely unrelated companies that hire senior cadres as consultants with annual salaries sometimes exceeding 1 million yuan (approximately $125,000).
- 3. Offering equity rights. This is very common in the real estate industry. To obtain a piece of land, some foreign real estate companies promise Chinese public relations officers equity rights in a future project.
- 4. Student financial aid. Since 1998, a famous foreign enterprise that has invested astonishingly large sums in China has been running an MBA program “mainly for high government officials and senior managers in the telecommunications industry” in conjunction with a number of Chinese colleges, universities and research institutions. It has even had a college named after it. Such educational institutions boast world-class faculty, educational resources, high tuition and a large student body, but students sponsored by foreign companies usually don't have to pay tuition out of their own pockets. Foreign companies choose elite cadres with high potential, knowing that they will forge excellent ties with foreign staff while at the university-ties that stand to benefit the companies over the long term. Compared with how Chinese companies hand out bribes, such methods employed by foreign companies constitute a very clever long-term investment that is not easily detected by law-enforcement agencies.
- 5. Nepotism and cronyism. Many heads of Chinese communication enterprises have their own companies, and the nominal investors in these companies are often their family members or friends, concealing true relationships. It is said that the most common money-laundering tool is a company that ostensibly provides consulting services. Consulting fees can be set very high, which makes consulting an ideal vehicle for bribery. The article noted that bribery may account for 10 percent of the cost of a contract.
The Asia-Pacific Economic Times article's claims that multinational telecommunications companies excel in the art of bribery are supported by Ethan Gutmann in his book Losing New China. It is also what Oriental Outlook Weekly (Liaowang Dongfang Zhoukan) reported in a February 9 article entitled, “The controversial practice of economists acting as spokespersons for private enterprise.” Ethan Gutmann's book recounts how Motorola became involved in graft. The Oriental Outlook Weekly article reports that the Chinese telecommunications industry based its policies almost completely on the advice of a well-known Chinese economist.
The bribes given by “provincial” Hong Kong and Taiwanese investors cannot compare with this sophisticated style of bribery, which is based on a long-term strategy. Hong Kong and Taiwanese investors give bribes as a tactical measure rather than as part of a strategic vision.
Has Foreign Investment Promoted China's Democratization?
Foreign investment has influenced China in a number of ways, both negatively and positively. On the positive side, it has brought China advanced management techniques and employment opportunities. But from the standpoint of political development, the proposition that “massive foreign investment will eventually spur China's democratization” is clearly flawed. Indeed, the negative political impact of foreign investment cannot be underestimated.
First of all, foreign companies lobbying for their own interests have greatly influenced their own governments' China policies. Many foreign businessmen urge their governments to establish good relations with the Chinese government and not to criticize China's human rights record and political system. This has substantially decreased international pressure on China's government to improve human rights, and as a result, the human rights situation in China continues to deteriorate.
Secondly, foreign investors help corrupt Chinese officials establish alternative mechanisms for retiring from politics. Multinational companies often employ overseas channels to pay bribes, for example, opening Swiss bank accounts, obtaining foreign passports and residence permits, or arranging for the children of corrupt officials to study abroad or to emigrate. These are the forms of bribery most coveted by Chinese officials, and which Hong Kong and Taiwanese businesses cannot offer.
With the help of foreign companies, China's corrupt officials have been able to discard the traditional Confucian “Boat and Water” theory that prevented the emperor from exploiting the people. The Confucian idea that “water can bear the boat, but it can also capsize it” required the ruler to maintain a reasonable relationship with the people for his own benefit.
It was similar to the relationship between wolves and sheep. Just as it is in the wolf's best interest not to kill too many sheep so that they will be able to reproduce, it is also in the government's interest not to exploit the people too much. However, now that corrupt officials can retire abroad and do not have to share the polluted environment or the degraded and insecure society that they have created for their people, they can conduct themselves as they see fit without bearing the consequences. The arguments that “economic development will spur political reform” and that “massive foreign investment will help China's democratization” are based on assumptions that ought to be set aside, because China's reality proves that the opposite is actually the case.
Translated by Paul Frank
For more on Qianling He, please read: A True Picture of Socio-Economic China— Qianling He Visits Chicago, Part I and Part II, Economist Explains Why Global Media Promotes the CCP, and Will a Growing Chinese Middle Class Bring About Change in China?
This article is drawn from two series of articles originally published in Chinese in Taiwan News Weekly: “Huaijie chengzhi: waizi zai zhongguode ruxiangsuisu,” August 5-13, 2004, and “Zhongguo xiyin waizi mianlin zhuangzhedian,” June 16-24, 2005.