All Roads Lead to China:

Risk.  Everyone in China is exposed to it.  Some recognize it, and act on it, better than others

This was the topic of several conversations between myself and Neal Beatty (Regional Director, Global Client Services for Control Risks).  In some ways it was a followup to the interview I did of Dane Chamorro, his colleague, but this time it was over lunch and encompassed a much larger set of issues…. and given the importance nature of risk, I asked Neal if he would do All Roads readers the favor of answering a few questions about risk in China, if risks here are different than in other regions, and how good firms are at planning for and managing risk.

Below is part 1 of the interview, and with its focus on identifying the risks, and how firms work with “China” risk, there are lessons for everyone.

1. Are the risks of doing business in China any different than say in the US or EU?
Every operating environment has its own risks. What makes overseas operations more complex for multinationals is that many of the operational issues in China (kickbacks, conflict of interest, corruption, etc) are exacerbated by the very fact that they are so far from the comforts of home, and from familiar regulatory and legal environments.

When the company sets up in China, either through acquisition of a local firm, or through establishing a JV or their own facility, the operating environment is often alien. Everyone’s read the books on “doing business in China” and that’s a great start for people new to the country. But that’s just scratching the surface, and often seems to lead managers to over-emphasize or over-simplify a few features of operating environment, so for example you often hear “China is all about “guanxi”; we don’t worry about risk X because our local guys have great connections”. There’s also a tendency even these days to get carried away with the “China is different” concept, and lose sight of commercial and risk-management principles and processes the company applies elsewhere. China is different in many ways and understanding the differences is vital, but that doesn’t mean there’s some mysterious formula here that only a few people understand – like everywhere else, you need a well-informed, comprehensive and rigorously planned out approach to managing risk, not silver bullets. Few companies sit down from the very start, and map out what the risks to the business in China could really be.  They will no doubt have looked into the financial and commercial risks in some detail, but what about the operational or general business risks, not to mention the reputational risks? There is even a potential downside to hiring someone with fantastic local connections to run the business or engage as a joint venture partner, and this needs serious consideration, too.

In China, what you see is not always what you get. This can be especially true of understanding who you’re dealing with in business, whether it’s your key hires, an M&A target, or new partner or supplier. People and entities can have so many hidden interests, connections and potential conflicts that you simply can’t be sure who you’re getting into bed with unless you’ve really done your homework the right way –  specialist due diligence is essential.

2. What are the real risks of doing business in China?  What can business lose if they misjudge their environment?

Some common risk issues include:

• Compliance & integrity issues: internal fraud (kickbacks and conflicts of interest are most common)
• Corruption & Graft: recognized by the government in Beijing as a serious issue in China.  And now an increasingly serious issue in the US and UK with the growing impact of anti-corruption laws.
• IP issues -  counterfeiting, internal theft of critical information, and the protection of your trade secrets are major issues
• Business partners: Who really is your prospective JV partner? How did they accumulate their wealth? Does your partner or key staff have undeclared family or business connections to a competitor or supplier?
• Political and regulatory risks – this is largely more of a strategic, ‘big picture’ issue, but companies who lose touch with the prevailing political pressures affecting their industry can find themselves exposed to problems or shifts that they weren’t expecting.
• Supply Chain risks – lack of transparency and controls along the chain
• Natural Disasters – typhoon, flood, earthquake
• Business disputes – the concept of “illegal detention” by business partners as a means to settle a dispute over payments due; threats by disgruntled former employees.
• Restructuring & labour disputes – closing a factory, or dealing with the disgruntled employee who seeks revenge on a manager
• HR risks – associated with the new HR law and the complexity of hiring & firing staff.

Obviously the extent to which a particular company is exposed to these risks will depend on their specific circumstances, for example the size of the company, the location, the industry and the effectiveness of its own internal risk mitigation controls. But if you show a group of managers the list of risks above, many will admit that they have experienced several of these issues in China.

Most issues will have been dealt with and the business will have survived intact, but once in a while, something happens that has a catastrophic impact on the business, that no-one could have foreseen.

One of the most serious potential risks to any business in China is the tacit acceptance of the “This is China” approach to business ethics and compliance issues. “We can’t do business without paying the occasional bribe to win contracts” or “it’s OK to allow employees to take a few kickbacks from suppliers – that’s how business is done here”. I’ve heard similar sentiments from managers in China and I worry that they are leaving themselves exposed to more serious issues further down the line. By condoning “low level” corruption within the organization, there is a serious risk of it getting out of control and in the worst case putting the entire operation in jeopardy. A zero tolerance approach is certainly not easy, and requires time, effort and budget, but I would say it is the best way to operate in China, just as in other parts of the world. And it is essential that senior management lay down the law and set out the company culture towards such issues from the very start. The Chinese idiom 上梁不正下梁歪 (if the top beam is not straight the whole structure is crooked) is very true.

3. How much of the risk is political vs. cultural vs. commercial?

It is all three. The risks listed above could happen in any country in the world, but what makes China unique is the combination of engrained local business culture and business practices, and very patchy, often lax, legal and regulatory enforcement. This can result in people thinking there are no personal consequences to their actions.

I don’t believe Chinese people are any different in terms of morals or bad behavior than someone from Northern Ireland. But in China, there are cultural norms that sometimes conflict with the corporate expectations. For example, the concept of a conflict of interest is not understood in the same way as in the EU /US. To many Chinese people it seems perfectly reasonable to consider engaging a supplier owned by a family member or old school classmate. After all, I trust these people far more than some random supplier that approaches me at a trade fair. And if laws are unevenly enforced, then employees may never expect that their unethical, and often illegal, behavior might land them in jail.

And a kickback is often seen as nothing more that natural reward for the sales effort, something owed to the salesman, who probably doesn’t make much money anyway: no-one gets hurt, so what is the problem?

Where these three areas (political v cultural v commercial) often overlap is when doing business away from the big Tier One cities. Generally speaking, the influence of local politics on local business is more unrestrained away from the biggest cities. This can pose its own set of unique risks that can only be mitigated by a very thorough due diligence process prior to forming a business relationship in that location.

4. What are the biggest risks that you feel firms overlook when entering China?

I feel the biggest risk is not taking the time to sit back and look really seriously at “what if this doesn’t go according to plan?” or “what if this should happen?” The opportunities in China are huge, as all the business books tell you, but although most people are aware to some degree that there are very considerable risks out there, not so many are keen to think too long about the downside and address that head on when they don’t see any immediate, severe problem.

If you are new to China, whether sourcing, selling or manufacturing, the first step needs to be to ask for advice. But who to ask? Lawyers are a necessity, but as I have seen from my own experience, they do not always give you the full picture of the risks your operation may face.

So the biggest risk is actually not actively assessing and properly planning for the risks! Many firms still don’t really do this until something goes wrong.

5. Are there firms that are in denial on obvious risks?

I would have to say yes.

I once spoke to the head of a multinational R&D facility in Pudong who had first-hand experience of unaccompanied visitors strolling around their facility, with access to any number of laptops left sitting on desks. When asked whether he was concerned about competitors entering the facility to steal trade secrets, the executive replied “but why would anyone want to steal trade secrets from this facility? We have dozens of such facilities in the US, why would they come all the way over here?” The conversation on business risks didn’t go much further.

And then you have an attitude of some foreign managers who, after having worked in China for many years, feel there is no alternative to “low level” kickbacks and bribes. Leaving behind the ethical arguments for a moment, and focusing on the bottom line –it simply is not cheaper in the long run to pay bribes if you had to pay hundreds of millions of dollars in fines in the US and Europe, and you factor in the potential reputational impact.

And then there is the argument ”well, all my Chinese competitors pay bribes to win contracts, so I have to”…

How does the average firm’s risk profile change over the course of its china life?  can a firm run risk free?

I don’t think any company can run “risk free”, no matter what sector or what size of operation. From the largest MNC with multiple manufacturing and distribution facilities around China, to the “one-man-band” sourcing operation, everyone will face risks.

Moreover, you can never reduce risk to zero. No matter how good your risk management program, there will always be someone who does something without considering the possible outcomes and impacts thoroughly, or simply faces a problem that couldn’t be anticipated or couldn’t be prevented. And thus you need to be able to react appropriately and have contingencies in place.  But a good awareness of the risks from the very beginning, along with regular (twice a year) reviews of your level of risk exposure, will go a long way to mitigating many of your operational risks.

Over time, there are few things more important (and perhaps less appreciated) than a good old fashioned system that operates well.  Systems are something that anyone in supply chain, economics, or general management can appreciate (when running well), and in China where everything is about large numbers, the need for processes is unquestionable.

That, for their to be economic, environmental, political, and societal stability, systems need to be in place that ensure that the moving pieces of each system is sitting on a solid foundation of processes.  Stable, and safe, food systems. Environmental regulations that are enforced.  Health care systems that provide fair access to care.  Transportation systems that support the efficient movement of people and goods.  Systems that are grounded in processes, but processes that are dynamic enough to maintain their integrity when tested.

Over the last few years, many of China’s systems have seen their fair share of tests,and given the speed of growth that is needed, there are bound to be failures.  62km long traffic jams are created. Food safety scandals fail to really go away, housing bubbles are created and supported, energy shortages knock out power to China’s largest cities, water shortages force the movement of people, violence on the work site increases, land so on.

the problem now is, that these failures are becoming more frequent, are having a larger impact, and should be seen as larger signs that for all the talk about how good China’s leaders are at planning, their are now issues of processes and systems that threaten economic growth and environmental stability.  That, while China is great at putting together regular 5 year plans and putting into place sweeping changes, the fact is that many of these systemic changes are often weakened by local interests, bad data, and failure to develop processes.  Which, as we have all seen, can have catastrophic consequences.

Lately, some of the more recognizable signs of failures are in 62km traffic jams, in labor disputes, or in the widening gap between the sexes, but more troubling for me are the ones that I would consider core to China’s ongoing concern.  issues within China’s ability to deliver the food, water, and energy that its economy needs to continue growing, issues that are rooted in inefficient processes of extracting, processing, and transporting resources and allocating assets.

It is an issue that goes far deeper than designing some magical traffic busting bus, and cannot be regulated, and for the average manager in China it is jsut something that needs to be effectively planned for, anticipated, and managed.

Systems.  love ‘em or hate ‘em they exist.  The only question is whether your goods will be 58km into the traffic jam, or if you will have developed strategies that maintain their integrity when the circus comes to town.

Over the years, there have been more than a few articles on China’s interest, or lacking interest, in developing domestic innovation and IP in the commercial sector, and China’s use of soft power, or failing to use its soft power, to promote the best interests of the state. And while these issues are rarely tied together, the recent article Pickens urged Bush to take Iraq’s oil in the Aspen Daily News led me to.

Issues that may or may not have little in common, the article took me back to my junior year at the University of Missouri where I learned about Porter’s 5 forces and the widely held belief of first mover advantages. That for a firm, it is important to stay ahead of the competition, and develop “sustainable” competitive advantages in the market.

In the article though, a different reality is being reported

Instead of Iraq’s greatest oil supplies going to the country that waged a seven-year war of liberation there, Pickens bemoaned, they went to China, which cut deals to mine the oil fields of Ramallah, which Pickens estimates holds 15 billion barrels of crude.

“Here we were,” Pickens said. “We paid the price and [we] don’t get it … . It’s heartbreaking to me to lose our people and the Chinese end up with the oil.”

Which led me to think about the wider application of this is, and the fact that while many will bemoan the fact that China will not use its power for the “greater good”, or that it firms (or people) are unwilling to innovate, this article highlights a simple point. That it is simply easier to let others to lead, and that leading isn’t all that it is cracked up to be… particularly if you are a country (or a firm) focused on problems that you have been facing for decades. That, while there are certainly opportunities for being the first to develop a new product, or to hammer out an international conflict, there are too many cases supporting the business as usual model.

Which leads me to my next point.

I have met many people in China, and who follow China, who are literally waiting for the day for this condition to turn around.  That there is going to be this tipping point where China takes the baton and runs with it.  And it is an assumption that in many cases limits their engagement in China as they are either afraid of investing (and getting screwed) in China, or see this tipping point as an opportunity in itself.

So, the word is out.  China is #2， Numero Dos， 第二 … and EVERYONE is talking about it. Some are even saying China will be King of the hill by 2020

Officially word came down with the Japanese Cabinet’s announced their economy put out 1.288 trillion USD, a few points below the 1.337 trillion China had reported earlier. Never mind that Japan is 10x as productive, or that the Japanese economy has essentially been limping along since the early 90s, or that this is not a annual figure (yet)… the law of numbers (and China’s 1.4 billion people) sealed the deal.

What does all this mean, and what should we make of this milestone?  It was something I was asked a few hours back by hometown (St Louis) radio and TV reporter Charles Jaco as part of his roundup of the event where he asked my thoughts on the following issues:

1. Everyone looks @ the Chinese economy as this thundering monolith. But do they have the same problems we do, i.e.–high unemployment, social dislocation, etc?.
2. Everyone often says it’s Chinese consumption that will pull us out of this economic mess. But you indicated to me that’s false and that any cure will have to come from the US, not China. How come

Keeping in mind that St Louis is about as middle country as you can find it in the U.S, that the cit has a LONG history of industry and trade, and that they are in the final stages of a potentially large logistics hub deal with China, the questions were laced with a few angles… (1) What does China being #2 mean for the world (2) is China real and (3) should Americans really be looking to China to save them.

In answering these questions, and keeping in mind I had 2 minutes to dive into these questions, I felt it important (and I still feel it important) to provide a little context.  that, while China had certainly hit a long sought after target, and was certainly looking forward to being king of the hill, that China’s economy was still a very lopsided (as the recent Caijing article points out)… that there is more than a single “China” that needs to be considered.  And that the economy, regardless of how large it has become and the targets it has blown through, is very very fragile… as proven by the fact that China fears any growth below 8% would lead to instability (economic and political)., whereas the other major economies of the world have survived negative growth periods over the last 24 months.

Diving a bit further, and getting into the hurdles that China faces, I started by addressing the misconceptions of what the average “Chinese consumer” is, and where China’s savings are located… that while China, and the Chinese, may have high savings rates, the bulk of the savings were actually held by large state owned enterprises.. and that going forward, China would have to address some very large systemic issues (education, health care, and assets) as well.

On the second question, this was a bit easier as I largely have felt that the entire “China saving the world” story was a bit overbuilt.  Sure, China’s wealth and support of other currencies has been invaluable over the last 24 months, but unless China is going to go on a SUSTAINED overseas spending spree, it would be hard to see how China would save the American economy.  That the American economy, in St Louis, was suffering from local, state, and national issues that would have to be resolved outside of the global economic market place.

So, what does China being #2 mean?  At this point, it essentially is confirming discussions that have been going on in the past.  that China’s size was going to drive the data points forward, but that these numbers need to be viewed in a separate context than just a Country vs. China basis.

That, it is (and will be important) to look at China by itself and understand what the numbers mean for the country.

If there was one group that was hit the hardest by the economic downturn was college graduates, and as I have managed to time both of my graduating dates in the middle of bad economic times, I can attest that it sucks to be looking at a bad job market 6 months away from graduation.

For China, the problem is particularly acute due to the fact that China is putting out more than 6 million college graduates a year (everything is about numbers in China), and while the economy has posted more than 10% growth, the fact is that the economy is not producing jobs for them in the numbers needed.  Sure, there are “labor shortages” occuring on the East coast (perhaps a 30% bump in pay would cure that), and no doubt there are plenty of bridges needing on-site engineers, but graduates are far more likely to stick it out in the big city for a high value jobs… banking, PR, accounting, logistics, etc… and were more interested in jobs that would offer more potential opportunity than a hard hat.

A plot that the above 6 minute clip offers a bit of perspective on.