China’s economic rise in recent decades has provided unmatched opportunities for businesses seeking to lower costs and increase profits. The level of risk faced by companies looking to operate in China was generally easily offset by the potential return on investment (ROI) from a successful foray into the market. But times are changing and the risk-reward ratio is beginning to shrink.
In this interview, Kent Kedl, a partner at global risk consultancy Control Risks and head of their Greater China and North Asia practice, discusses the challenges within China’s regulatory system, the tentative rebound of foreign investment after COVID-19 and the continued requirement for foreign enterprises operating in China to be more flexible.
Q: How important is the reliability of a regulatory system to major companies looking to invest or operate in a country?
A: It’s always been critical and is even more critical now, in part because many US and European companies have a regulatory regime in their home countries that have an extra-territoriality to their laws, which means that the behavior they expect in their own country, they expect globally as well. For example, if you can’t bribe government officials at home, you also can’t bribe them anywhere else around the world.
Q: What are the main factors within such a system that facilitate ease of compliance for companies?
A: Obviously reliability, but I’d use two terms to describe that, transparency and consistency of enforcement. First of all, transparency is the ability to know what the rules are, what is okay to do and what is not okay. All legal systems are aimed at providing transparency to some extent but there is also a reason why we have lawyers, who figure out exactly what it means.
Consistency of enforcement means that everybody is equal under the law. Big companies don’t receive special treatment and you can’t use personal connections to get ahead. Now, this is a pipe dream anywhere around the world, but I think at least aiming for both of these goals is the key to ease of compliance.
Q: How apparent are these factors in the China system and how has this changed over the last decade?
A: Over the past decade, enforcement of whatever rules are in the books has been quite strong. The challenge at the start of the administration was that many rules either weren’t there or were decades old and not really fit for purpose. But instead of going through a massive legal reform and really figuring out what they wanted, they just started enforcing what was already there. In some cases, this was fine: for example, there were fairly robust regulations on anti-corruption, anti-monopoly and environmental laws in place.
But data and data security are newer parts of the Chinese regulatory system, with the first cybersecurity law coming out around 2015, but it was very general and a lot of the terms were not defined. This was frustrating for many of our clients as the specificity required wasn’t there, and it can be doubly frustrating if the definition of compliance isn’t clear but the enforcement of regulation is aggressive. The change has been quite hard for companies in China, who were used to a more laissez-faire system that was supportive of foreign investment.
At the same time, you can’t be upset at China enforcing its own rules. Companies face different legislation all over the world and understanding that compliance is necessary, but if specificity isn’t there, it can cause unpredictable issues. Going back to the data laws, they have become more specific over time, but it’s still a work in progress and that bothers companies trying to operate in the market.
Q: To what degree has data regulation been the change that has had the most impact on foreign entities in China?
A: It is certainly front and center for them, in part because it’s a major issue in various areas around the world. Europe is also quite active when it comes to data regulation with things like the GDPR.
The interesting part about data enforcement in China, though, is that if you look at the real milestone cases in the country, they have involved Chinese companies. There is often a perception in certain foreign media that when a foreign company is regulated or investigated, the whole world comes to a standstill. But at the same time there have been thousands of Chinese companies that have been investigated under the same laws that don’t get the international news coverage.
Didi is an example that did get some coverage, but the regulations were criticized and talk of a tech crackdown was rife. However, the company had not gone through a data security review in China before listing. They didn’t do what they were supposed to do, so it shouldn’t have come as a surprise that they faced repercussions there.
Q: What are the areas and issues that most commonly trip up foreign companies operating in China?
A: In terms of regulation, I think the threat of slipping up is probably the same for both domestic and foreign firms. The major difference for foreign companies is vulnerability, rather than being specifically targeted. They are certainly more vulnerable for a couple of reasons. One is that they don’t necessarily understand where regulatory pressures are going to be coming from because they haven’t been looking at China as an aggressive regulatory environment from the beginning. In the US and EU, businesses have people sitting in the power centers seeking to understand and get ahead of what is going on, work out efficient market access and obtain licenses, but not many foreign companies have invested the resources to do that in China.
This is why a lot of what we do here is regulatory risk assessment and working out what a company’s vulnerabilities are. This has little to do with the legal side, but asking questions such as: What type of company are you? Where is enforcement going in that sector? Where is that likely to intersect with what the company is doing? Frankly, it is not going to be possible to change the threat environment, but a company can reduce its vulnerability.
Second is geopolitical tensions. In the West, companies are thinking any number of deep thoughts about the impact geopolitical tensions will have on business, but in China CEOs are still just moving forward with business, making and selling. Companies are wondering if they can still work with China and that’s a legitimate concern based on changing regulations, but from the Chinese side the interest is still there.
Q: The EU Chamber of Commerce in China has indicated that some companies are reconsidering their position in China, with many looking at lowering their exposure to the country’s market. To what degree do you see this happening?
A: We tend to forget that this has been happening for the last 15 or 20 years to some degree. China’s development has been going on over the last 40 years, but reconsidering and rebalancing has increasingly occurred in the latter half. If you are making sports equipment, small electronics or clothing of any kind, you started reconsidering China 15 years ago.
Once the cost base started to rise, it was a bit more difficult to exclusively choose China and the trade war got people thinking again because they couldn’t be overly reliant on China for their entire supply chain. At that time, resilience wasn’t a key performance indicator (KPI) in procurement because the primary KPI was to reduce costs, so many businesses didn’t diversify their suppliers across countries, instead using multiple suppliers within China because of how cheap it was. Nobody thought about what would happen if China’s supply chains slowed or halted altogether.
Geopolitics has certainly been a factor as well. We don’t see a massive amount of companies leaving, but we do see them rebalancing and right-sizing. For some of them, that means choosing to build new factories away from China. China is no longer a low-cost country, but it is still massively convenient in that you can find suppliers, buyers and sellers all within its borders, not to mention it was the most active economy during the early stages of COVID.
Financial investors are doing a rethink as well, with many pausing some China-related activities. This is partly due to a lack of confidence, but also because some of them feel like they are over-leveraged or over-exposed here and they need to balance out their investments.
Q: Now that COVID is over and the geopolitical arrangements are becoming clearer, what are you seeing in terms of companies making decisions that had perhaps been delayed with regard to investment and business strategy?
A: There were a number of companies looking at strategic investments in China in 2020 and 2021 in particular, manufacturers buying assets, M&A, that kind of thing. We have a pre-investment due diligence practice and it was doing very well in the early days of COVID, but we started to see things slow down at the end of 2021, before the COVID situation got tricky in China.
There were also some deals that were in the pipeline pre-COVID and then once everything cleared, they didn’t happen, and that was due to them no longer making strategic sense, market shifts, priority shifts or the fact that the target was still demanding their pre-COVID valuation. We saw a number of companies walking away from deals. They wanted to see how the dust settled and the China premium was harder to justify.
I do think that in the next couple of years we’ll see companies returning in a more balanced way, and we are already starting to see some green shoots of interest in additional investment. At the end of the day, China is still a massive growth market and companies are finding that the China habit is hard to break.
Q: Do you have a wishlist of regulatory changes that would make China a more hospitable place for business over the next 10 years, and realistically, how many of these do you think could happen?
A: I certainly would like to see the regulatory environment becoming even more specific and more transparent, that would be helpful for everyone, foreign and Chinese companies alike. For example, they are releasing new additions to data regulations seemingly every six months, but it would be good to know exactly what these mean for business and what they require from businesses. I’m confident this will happen but I doubt it will happen as fast as we all want it to.
But along with that, the other thing I hope that happens is foreign companies start to understand that the regulatory regime is not going to reform as quickly as they’d like and they can’t just sit around complaining about it. Geopolitics is in a similar state, and the tensions aren’t going to relax any time soon. The Americans will continue to be aggressive with their policies and the Chinese will continue to respond. We all just have to work with what we have on the table at the time.
It all boils down to flexibility and a willingness to adapt, and we’re seeing more rigidity from foreign companies now, with pretty much all of the decision making having to go back to headquarters. This has obviously not been helped by changing regulations, but the rigid corporate structures in the West don’t suit this market very well.
To end, none of us are thinking that China is going to go back to what it once was, simply because China is changing and it has a completely different role in the world now. But it will be exciting to see what the next stage will look like.
Interview by Patrick Body
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