Monthly Archives: March 2011

Maintaining China’s No-Dissent Zone

“Turmoil in Libya worsens as West launches attack” is Xinhua’s headline in the wake of the French, American and British air strikes to enforce the U.N.-sanctioned no-fly zone in Libya. Its reports play up the civilian casualties announced by the Libyan government and accredited a variety of self-serving motives to the leaders of each Western country involved. China, along with Russia, did not veto the resolution when it was before the U.N. Security Council, but abstained from voting and it would have been aware of the consequences of that. Nonetheless, the foreign ministry issued a statement today expressing its regret over the military strikes and saying it did not “agree with resorting to force in international relations”.

While China also has its own business interests in Libya, Beijing has a fine diplomatic line to walk. As it starts to take a greater role on the global stage, it has to balance maintaining its position as an alternative to the West with not being seen as a backer of dictators that massacre their own people. Even more important, this Bystander believes, is how the perception of the Libyan crisis as a proxy for the wider dissent against authoritarian regimes being seen across the Arab world is managed domestically. We expect to see state media repeatedly connect the dots between dissent and turmoil.

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Would You Catch Corrupt Practices In Your Firm?

We suspect that IBM’s $10 million settlement with the U.S. securities regulator over accusations that it gave cash and gifts to Chinese and South Korean government officials in violation of the U.S. Foreign Corrupt Practices Act represents business as usual more than the rare bad apple. For the several years that what the U.S. Securities and Exchange Commission called IBM’s “conduits for bribes” continued, the company had anti-bribery policies in place, yet failed to detect the alleged transgressions. The question for Western multinationals operating in China to ask themselves now is whether they would have done better.

IBM neither admits nor denies wrongdoing, as is the practice in such cases. In its complaint filing the SEC, which handles Foreign Corrupt Practices Act cases; the U.S. Department of Justice would only be involved in a criminal case, said:

From at least 2004 to early 2009, employees of IBM (China) Investment Company Limited and IBM Global Services (China) Co., Ltd. (collectively, “IBM-China”), both wholly-owned IBM subsidiaries, engaged in a widespread practice of providing overseas trips, entertainment, and improper gifts to Chinese government officials. The misconduct in China involved several key IBM-Chipa employees and more than 100 IBM China employees overall.

The SEC accused IBM employees of creating slush funds that were used to pay for overseas excursions by Chinese government officials masquerading as offsite training courses. IBM employees are also alleged to have given gifts, such as cameras and laptops to the officials.  This how the SEC said it all worked:

As part of its business, IBM-China entered into contractual agreements with its government-owned or controlled customers in China for hardware, software, and other services. These contracts contained provisions requiring IBM-China to provide training to the employees of these customers given the high-tech nature of IBM’s products and services. In some cases, IBM held this training offsite and required the customers to travel. In advance of any training trips, IBM-China employees were required to submit a Delegation Trip Request (“DTR”) detailing the business purpose of the trip, all planned sightseeing or entertainment activities, and anticipated expenses. The DTRs required approval by IBM-China managers. IBM-China’s policies required customers to pay for side-trips and stopovers unrelated to the training.

Between 2004 and 2009, IBM’s internal controls failed to detect at least 114 instances in which (1) IBM-China employees and its local travel agency worked together to create fake invoices to match approved DTRs; (2) trips were not connected to any DTRs; (3) trips involved unapproved sightseeing itineraries for Chinese government employees; (4) trips had little or no business content; (5) trips involved one or more deviations from the approved DTR; amI (6) trips where per diem payments and gifts were provided to Chinese government officials. Moreover, IBM-China personnel also used its official travel agency in China to funnel money that was approved for legitimate business trips to fund unapproved trips. IBM-China personnel utilized the company’s procurement process to designate its preferred travel agents as “authorized training providers.” IBM-China personnel then submitted fraudulent purchase requests for “training services” from these “authorized training providers” and caused IBM- China to pay these vendors. The money paid to these vendors was used to pay for unapproved trips by Chinese government employees.

The takeaway for multinationals doing business in China is that 114 instances over at least five years slipped through IBM’s internal policies and controls designed to prevent or detect such violations of the U.S.’s Foreign Corrupt Practices Act. Remember, it is not just the bribes that the act goes after, it is also the accounting tricks that companies employ to cover them up. For whatever reason, in this case those controls proved deficient in preventing employees of IBM’s subsidiaries and, in the South Korean case, joint ventures from using local business partners and travel agencies as “conduits for bribes or other improper payments to government officials over long periods of time.” Are you confident yours would?

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China Raises Banks’ Reserve Ratios Again As Inflation Persists

Persisting inflation has led China’s central bank to raise bank’s required capital reserves for the third time this year. Reserve requirements will increase by half a percentage point effective March 25th, the People’s Bank of China has announced, taking them to 20% for the country’s largest banks though some get customized reserve requirements that push their ratio above that.

Coming as it does so soon after the Sendai earthquake and tsunami suggests that inflation is still regarded as a bigger threat by China’s policymakers than a slowdown in growth that the devastation in Japan might cause, even as the central bank struggles to mop up the excess liquidity in the economy. This Bystander believes that the March figures may show inflation kicking 6% year-on-year, and that another round of interest-rate increases, which would be the fourth since October, won’t be long in coming.

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Safely Buying British

China not only has a taste for British cars; it likes its companies, too. The Economist reveals that China’s sovereign wealth fund has sprinkled a little of its largesse around a lot of Britain’s biggest companies. The State Administration of Foreign Exchange (SAFE), which manages the country’s foreign reserves, has put £13.8 billion (147 billion yuan/$22.3 billion) of its estimated at $350 billion investment fund into 63 of the companies that make up the FTSE 100 index.

Holdings vary in size from 0.18% in the Royal Bank of Scotland to 1.63% in ARM Holdings, a technology firm. (A full list of the fund’s disclosed holdings can be found here.)  Its biggest investment by value is in Royal Dutch Shell; energy and basic materials are the two sectors that attract most of its cash.

Where else in the West is it similarly sprinkling, we wonder?

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SAIC To Put An MG Saloon Back On Britain’s Roads, Drive Into Europe

It is scarcely the thunderous 1950’s police-car lookalike MGZB that Brits of a certain age will remember, but the MG6, seen above in a corporate promotional shot, is soon to go on sale in the U.K., the Wall Street Journal reports, returning a saloon from the storied British sports-car manufacturer to Britain’s roads for the first time in years. The marque is now owned by SAIC Motor, acquired via a tortuous route following MG’s descent into bankruptcy and SAIC’s own merger with NAC. SAIC’s home-market version of the MG6 has sold well in China; the 1.8-litre model of the hatchback going on sale in Europe will be tweaked to European tastes, as will a planned 1.9-litre turbo-diesel.

SAIC is also looking to break new ground for a Chinese carmaker in western Europe. Not only is it producing the car at Longbridge in Britain’s Midlands, it is setting up dealerships in the country, making it the first to have a distribution channel in Europe of its own, though it may also tap into the expertise of the global dealer network of its U.S. partner, GM, as it reportedly plans eventually to sell 40,000 MG6s a year in Europe.

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China’s Nuclear Energy Program Post-Fukushima

The crisis still unfolding at Japan’s devastated Fukushima Daiichi nuclear reactors will have a huge impact on the global nuclear industry. That will not only be in terms of the running of existing reactors and the design and location of future ones, but also in the reevaluation of nuclear’s place in energy policies.

Europe has already started that process. Germany is shutting down reactors; Spain, Russia and the U.K. are ordering safety reviews. China has now followed the U.S. in suspending the approval process for new nuclear power stations so that safety standards can be reexamined. Beijing has also said it will revise its standards for the safety management of nuclear plants without giving any detail about what those revisions might entail.

Fukushima is unlike Chernobyl or even Three Mile Island in that the damage was caused by a natural disaster, whereas the other two were to varying degrees a result of human error. But seismic risks, including tsunamis, are highly relevant in many  parts of the world with expanding nuclear programs to satisfy growing energy needs such as southeastern Europe, India, Iran, Turkey, the U.S. and, of course, China, which accounts for 40% of the world’s nuclear power plants currently under construction. This Asian slice of a U.N.-sponsored seismic risk map, below, shows the most hazardous areas, in the dark red.

Caixin has a map of where China’s existing and planned nuclear power plants are here which you can easily overlay in your mind on the map above, while The Wall Street Journal has a map plotting them against China’s fault lines here.

Beijing has already said it doesn’t plan to alter its plans to build new reactors. The new five-year plan proposes a fourfold expansion of the country’s nuclear power generation capacity from 10 gigawatts (less than 2% of the country’s current electricity generation) to 40 gigawatts. Last year Beijing approved 34 new nuclear power plants to add 37 gigawatts of  capacity. Work has started on 26 six of those units, accounting for 78% of the planned new capacity. The newly announced safety review is likely to mean no more than a pause for breath.

Liu Tienan, chief of China’s National Energy Bureau, does say that China has much to learn from Japan’s crisis, particularly about safety. Modern reactors, so called Generation 3 reactors, are more safely designed than Generation 1 and 2 reactors, the type in use at Fukushima. Generation 3 reactors use a passive cooling system that does not require electricity to run. They may well have survived the Sendai earthquake and tsunami in tact. It was the loss of electric power needed to run the cooling system and its back-ups that put the reactors at risk, not the direct impact of the quake and tsunami. That said plenty of wars have been lost by generals refighting the last one.

China is pursuing home-grown nuclear power generation technology based on what it is transferring from American, French and Japanese nuclear companies (no one really knows what is going on in China’s military nuclear program). On the civilian side, the AP1000 reactors Beijing has chosen for construction on the east coast and plans to build further inland are a Generation III design. They are also being used for 14 proposed reactors in the U.S. The design has been approved by the U.S. Nuclear Regulatory Commission, but there remain some concerns about its safety, particularly its capacity to survive being hit by an aircraft.

No power generation system will ever be 100% safe. When nuclear goes wrong, it tends to go catastrophically wrong. Predicting what could trigger that catastrophe will never be a 100% science, either. In 2003, the Japanese Nuclear Commission was set this safety target:

The mean value of acute fatality risk by radiation exposure resultant from an accident of a nuclear installation to individuals of the public, who live in the vicinity of the site boundary of the nuclear installation, should not exceed the probability of about 1×10^6 per year.

1×10^6 is a million. Japan’s once-in-a-million-years event happened just eight years later.

China’s nuclear program has had its safety issues in the past, and Fukushima will give more strength to the voices raising concerns about nuclear safety. But the country’s need to generate ever more power to fuel growth and to meet a self-imposed goal of generating 15% of its energy needs using non-fossil fuels by 2020 means it is unlikely to scale back its nuclear program, even if it slows the pace of development. Beijing can convince itself that the safety issues can be handled (even if convincing its citizens is another matter, and that may depend on how Fukushima turns out). Its biggest impediment is, as it is everywhere for nuclear, cost. Reactors are expensive to build and have histories of expensive project delays. The country is looking at a potential bill of $150 billion over the next decade for its nuclear program, more if the safety review imposes additional safety-related costs. Meanwhile, there are less expensive alternatives, such as gas, and in future renewables developing rapidly. The future pace of the development of China’s nuclear energy program won’t be decided on safety alone.

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From Fast Imitation To Frugal Innovation

China, like India for that matter, has set off down a development path to convert its companies from imitators to innovators. President Hu Jintao reaffirmed that at an exhibition in Beijing showcasing the country’s scientific and technological achievements during the just concluded five-year plan, urging scientists to enhance China’s capacity for innovation so as to seize the initiative in global competition.

China has made a purposeful start, but it will be a long journey. The country ranks 21st out of 40 countries on its own global innovation list. Against the oft-used benchmark of patents granted, China generates 2,000 a year, one fortieth as many as the U.S., and half of China’s comes from local affiliates of multinationals. Yet that belies advances China is starting to make in fundamental science and technology. Measured by how much the country spends on research and development as a percentage of its gross domestic product, a measure known as GERD, China now ranks third in the world after the U.S. and Japan, having raised its GERD from 0.57% in 1995 to 1.54% in 2008. That translates into annual R&D spending approaching half a trillion yuan ($75 billion), though China’s critics will jibe that much of that should be called R&C spending, for research and copying.

Beijing’s long-term target is for a 2.5% GERD by 2020. The new five-year plan calls for a large increase in R&D spending. There are straws in the wind that suggest that that will manifest itself as an up to 10 trillion yuan ($1.5 trillion) boost for selected advanced industries over the next five years, both directly through soft loans and government procurement and via incentives for foreign companies to set up more R&D facilities in China. The number being floated may be pie in the sky (it is after all two and a half times the size of the 2008 stimulus package) and it is far from clear how much would go for R&D as opposed to infrastructure development, but it is clear that improving the technological capabilities of China’s manufacturers is a policy priority. The anointed industries are biotech, post-fossil-fuels energy, energy conservation and environmental protection, clean-energy vehicles, new materials, and next-generation information technology and high-end equipment manufacturing. The plan calls for these industries to account for 15% of China’s GDP at the end of the next five-year plan, up from 5% going into it.

It is easy to forget that China’s exports have been moving up the value chain away from low-tech products since the 1990s. Firms like Huawei and Lenovo have prospered by absorbing foreign technology and business expertise, and adapting them to produce products for the Chinese market before taking the same strategy into global markets. Not all foreign suppliers of technology and expertise have been happy with the first part of that strategy. They have had to agree to hand over technology to win access to domestic markets and then found that Chinese enterprises are preferring — or being encourage to prefer — to buy locally developed products, patriotic support of the pursuit of “indigenous innovation’.

What also needs not to be lost sight of is that this is a different stripe of innovation, not so much yet leading-edge technological innovation as process innovation; the use of China’s labor quality, supply chain integrity and infrastructure to reduce cost. As S.D. Shibulal, chief operating officer of Infosys Technologies, notes in an INSEAD article on innovation in emerging markets, Chinese companies “are redesigning products to reduce costs; they are redesigning entire business processes to do things better and faster than their rivals.” He dubs this “frugal innovation”.

This lets Chinese companies pickoff niches where they can refine their products and market entry. Haier, the white-goods manufacturer, was a harbinger of  this approach with wine-cooler refrigerators, turning what was a high-end consumer good into a much cheaper middle-market one, and grabbing 60% of the market in the process, according to Peter Williamson, a former INSEAD professor who has written a book on the topic. Consumers were prepared to accept a small drop in quality in return for a large cut in price.

“The real challenge for foreign firms is not so much the top end of the market in many given industries, but the medium sector, which we call the ‘good enough’ sector,” says Anil K. Gupta, a current INSEAD professor. The lesson is that Western multinationals are going to have to learn to compete in the middle market as well as the top-end one, as this is where “future battles for world market share will be fought.”

Meanwhile the challenge for Chinese firms will be to develop their own brands and innovate their own products, then move from manufacturing them at home to designing them there and manufacturing in lower cost countries.

Update: The Economist Intelligence Unit estimates that China’s R&D spending of 500 billion yuan in 2009 will rise to 1.2 trillion yuan by 2015 and to 2.1 trillion yuan by 2020, which is $320 billion at today’s exchange rates. Much of the support will come via fiscal inducements, it says.

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