China: Opportunity or Threat?Stephen Chipman Partner

January 2006

Year of the Rooster2005

Year of the Dog2006

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Overview – China today

• Political stability• Diplomatic outreach ("charm offensive")• Rapid drive toward free market system• Accession to WTO in 2002 - accelerating reform• Government restructuring• Private sector outperforms public sector• Coastal areas lead the way• Growing global recognition

– 2008 Olympics– Shanghai Grand Prix– Manned space flight

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Overview - economics

• Population: 1.3 billion (2004), 21% of Global Population• 120 cities with over 1 million residents• GDP (official) $1.5 trillion (2005)• World's second largest economy (PPP basis)• Foreign direct investment - $62 billion (2004), $65 billion

(estimate 2005)• Largest manufacturer of clothes, shoes, toys and consumer

electronics in the world• Major imports: steel, chemicals, machinery, resources,

vehicles and aircrafts• Principal trading partners: Hong Kong, Japan, United States

and European Union

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Overview – economicsGDP Growth of China

Source: World Bank & HK Government Statistics

%

0

2

4

6

8

10

12

2002 2003 2004

World

China

2005

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Overview – economicsEconomic geography

Main areas of Economic Activities• PRD – Pearl River Delta Region• YRD – Yangtze River Delta Region• The North East – Beijing, Shenyang, Harbin• The West – Chongqing, Chengdu• The South West – Kunming, Border Countries

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Overview – economicsEconomic geography

Where are they?

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China

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Overview Current political and economic issues

• Lack of Bond market and weak equity markets• Weak banking system and level of non-performing loans• State Owned Enterprises (SOE's)• Rural migration and potential for social unrest (60% of

population live in country)• Currency pressure (easing recently)• Ability of infrastructure to keep pace• Weak central government• Raw material shortages• Talent shortages (approx. 450,000 engineering graduates

per annum

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China – opportunities Low cost production

China - the world's factory?• Labor capacity - 1.3 billion population

– only 30% mobilized– 480 million rural workers - ready and waiting– need to absorb 22 million workers a year for 10-15 years

• Manufacturing labor costs per hour– USA: $20.32– China: 59 cents

• Foreign investment – over 30% of China's hotel industrial output, over 50% of its exports

• Increasing capital intensive and technology manufacturing (reference: GT manufacturing study)

• Outbound investment: R&D, distribution channels, brand

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China – opportunities Low cost production

Labor rate comparison

China 59 cents/hour

India 43 cents/hour

Czech Republic $2.86/hour

Mexico $2.27/hour

Taiwan $6.13/hour

Singapore $7.78/hour

USA $20.32/hour

Source: IMD World Competitiveness Yearbook 2003, CSFB Research

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China – opportunities Domestic market

Growing Chinese domestic market for goods and services• Emerging urban middle class (approx. $200 million)• Surge in urban purchasing power

– 95% of urban residential properties are owned– 160m urban households – approximately $20,000 in

assets– Refrigerators and washing machines in over 80% of

homes• Purchasing and financing of homes, cars, durable goods

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Doing business in China Structural options

• Representative office• 3 Types of Direct Investment – Foreign Investment

Enterprises– Equity Joint Venture Enterprises – Co-operative Joint Venture Enterprises – Wholly Owned Foreign Enterprises (WOFE)

• Foreign Investment Commercial Enterprise (FICE)• Sub-contract relationships (sourcing)• Acquisitions

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China - business and structural options

Which is best suited for you?

Considerations• Substitution or incremental?• Nature of your product - labor content?• Intellectual property risk?• Location of customers?• Level of China experience within your organization?• Is the domestic market part of your strategy?• Vision and strategy for your organization?• How much time do you have?

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China - business and structural options

Pros• minimum investment• speed• leverage China expertise of

others• limited management time• options• MOF approval not required

Cons• margin squeeze• availability and reliability• intellectual property• being held hostage• being dumped

Sub-contracting

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China - business and structural options

Pros• local knowledge and

expertise• relationships• management of plant• skin in the game• less margin squeeze

Cons• different visions• communication and culture• control• increased financial risk• increased management

time and commitment• intellectual property risk• MOF approval required

Joint ventures

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China - business and structural options

Pros• control• quality and performance• clear vision• alignment with organization's

goals and objectives• retain the margin• customer relationships -

keep control

Cons• increased investment risk• increased management

time and commitment• lack of local expertise and

cultural knowledge• communication issues• time period to execute• MOF approval required

Wholly-Owned Foreign Enterprise (WOFE)

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Foreign Invested Commercial Enterprise (FICE)

• FICE organized under FIE regime (JV or WFOE)• Foreign investors can now establish entities that

engage in the following activities:– Wholesaling– Retailing– Franchising

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Challenges and practical advice Other considerations

• Culture and communication

• Understanding management time and commitment

• Selection of location

• Selection of General Manager

• Changing regulatory environment

• Managing foreign exchange matters

• Lack of alignment of goals/objectives with partners

• Lack of alignment with overall organizational vision and strategy

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Challenges and practical advice How companies can get started

• Read about doing business in China• Talk to others that have been through it• Get on a plane - not once or twice• Engage expertise to drive the project

– look for "been there, done it" - references– be careful of the "language" lure– look to existing relationships (accountants, lawyers,

bankers)• Other resources

– Chambers of Commerce based in Hong Kong (e.g. AmCham)

– Hong Kong Trade Development Council (www.tdc.org.hk)