Risk Assessment and Essential Steps on Doing Business in China

I. To Understand the Risk and Reward First

The investment rewards in China will undoubtedly be huge, but to make the most of them, any intelligent investor should have a clear understanding of the risks involved. A detailed analysis of the China risk is well beyond the scope of this article, but understanding the basic layout provides a solid foundation. Also understand that risks should not deter investment - the U.S. was quite risky in 1900. Instead, risk should be understood so it can be properly accounted for.

China is still a communist country. So despite all the free market principles that China has faithfully adopted, as a communist nation the rules that govern a public company in China are different than here in the U.S. Chinese stocks trade on the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Both of these exchanges have similar listing requirements that you would see in U.S. stock exchanges. Companies have to report timely financial statements, have audits performed and meet other requirements of size and capitalization. Beyond that, the accounting rules differ, and that is where things can get murky.To be sure, attempts are being made to bring Chinese accounting standards more in line with U.S.

II. Six Essential steps on assessment the risk managements

Strategic thought on assessment the risk managements are stated as follows.

Six Essential steps

To understand the local laws and regulations, and follow up on changes.
To respect local cultures and find trustworthy advisers with good local wisdom.
To enhance the corporate governance; trust local management, but with appropriate guidance and monitoring from headquarters.
To emphasize a transparent control environment with smooth information flows.
To introduce enterprise risk management mechanisms that will build lines of defence into the organisation.
To plan ahead when moving money into or out of China.

The following statements are important for decision makers and should be taken into consideration on investment risk assessment on doing business in China.

III. Eight important considerations on investment risk assessment

1. Government control

An increasing number of strict regulations exist over the way business can be done in China. While all competitors are subject to the same laws and regulations, the enforcement of those compliance regulations may be different for many local competitors. In certain designated industries, for example, multinational companies are required to co-operate with local joint venture partners, which are generally selected by the Chinese government, and governmental orders may be redirected towards local competitors in the future.

2. Inconsistent interpretation of rules and regulations

The Chinese government has issued a number of laws and regulations relating to taxes, such as corporate income tax law and transfer pricing. However, certain detailed implementation guidelines for these laws and regulations are still not pronounced, even though the respective laws and regulations may have taken effect. In addition, local authorities retain the right to interpret existing laws and regulations, resulting in a lack of consistency between individual provinces and jurisdictions.

3. Concerns about intellectual property

China’s intellectual property laws would need to be updated in order for them to be in line with the intellectual property laws in many mature economies. In order to take action under the Chinese intellectual property laws, local registration of intellectual property in China is required. However, registration frequently requires provision of significant information about the intellectual property to the Chinese authorities.

4. Increased local competition

The Chinese government strongly promotes the evolution of strong local competitors in its key industries. The quality of products delivered by local competitors is rapidly increasing, requiring reaction in terms of innovation at the higher end of the market, as well as cost savings at the lower end of the market.

5. Lack of controls

Historically, businesses in China are not familiar with key concepts of internal control over financial reporting, since the finance function has not been seen as a key function in an organisation. Risks tend to be addressed on a reactive, not proactive, basis. If risks are being managed, a silo approach is often used.

6. Recruitment issues

There is a lack of skilled and well-trained employees, particularly in the areas of engineering and finance. Retention rates are low and some salaries (eg, engineering, finance) have witnessed double-digit growth and in certain areas are at the same levels as in mature markets. Due to governments trying to control housing prices via ‘hu-kou’ (residence registration), talent management will be more challenging in coming years. (For more on this issue, read Grant Thornton’s article: What’s your employment strategy for hiring in China?)

7. Little supply chain management

Effective supply chain management tools are missing in most companies in China due to a reliance on existing relationships. Corruption, bribery and fraud are issues, and raw material prices have surged over the past few years.

8. Opaque practices

Intertwined relationships are a common occurrence. Business perks are maximised, and in certain industries there are commission payments to agents and other third parties. Dealing with local joint venture partners can be tricky for multinational corporations. Nick Farr, of Grant Thornton UK’s China Britain Services Group, adds two extra financial risk management considerations for businesses investing in China or repatriating profits back to the UK.

IV. Conclusion

China with high uncertainty and high potential for profits, scenarios could provide avenues to analyze interrelated, macro-environmental, industrial, and corporate level sources of business risk. In China, managers have to assign subjective probabilities to several key variables in risk analysis.

The lure of enormous markets and profits in China comes entangled with various sources of risks and uncertainties, including inability to ascertain markets’ true sizes, infant distribution channels, copyright violations that strike at the core of the multinationals’ competitive advantages, high-regulatory risks, and corrupt business environments.3 This section highlights some representative risks at macro-environmental, industrial, and corporate levels that affect multinationals’ performance in China.

Dr. Chao Yuang Shiang

4-December-2016