Foreign Direct Investment in China : Theories and Practices [1 ed.] 9781135932732, 9780415678490

Citation preview

Foreign Direct Investment in China

Foreign direct investment has contributed significantly in transforming the Chinese economy over the past three decades. China has become one of the most popular destinations for foreign direct investment. For corporations and business executives who wish to participate in the expanding China market, understanding correctly the driving forces and impacts of foreign direct investment in China, as well as the ways to smartly execute investment transactions there, has become the fundamental knowledge that they need to grasp. This book is a combination of the author’s research and 15 years of practical experience in managing investment transactions in China. This book uniquely offers both a theoretical overview of the phenomenon of FDI in China (Chapters 2–4) as well as the practical steps in executing investment transactions there (Chapters 5–7). The author also provides illustrative charts and tables, literature summaries, and transaction templates based on case studies from his real-life experience on the ground. This is so far the only book on FDI in China which covers both the theoretical perspectives as well as practical advice on investment. This book serves not only as a useful resource for students, teachers, and policy makers who are interested in both theoretical and practical aspects of FDI in China, but also as a valuable guidebook for business development executives, investment professionals, and transaction lawyers who are involved in direct investment deals in China on a daily basis. Michael H.K. Ng is Assistant Professor in the Faculty of Law at the University of Hong Kong. Before joining academia, he gained 15 years of experience in direct investment in China. Apart from being an experienced commercial lawyer, he also previously served as the Chief Investment Officer of Hutchison Whampoa Group’s listed conglomerate and partner of a China-focused private equity fund. He specializes in cross-border mergers and acquisitions, direct investments, joint ventures, and corporate finance transactions and offers graduate courses on foreign direct investment in China at the university. He also researches the legal history of China and Hong Kong. His works have appeared in the Journal of Comparative Law, the International Journal of Asian Studies, and Hong Kong Law Journal, among others.

This page intentionally left blank

Foreign Direct Investment in China Theories and practices Michael H.K. Ng

First published 2013 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2013 Michael H.K. Ng The right of Michael H.K. Ng to be identified as the Author of the editorial material, and of the authors for the individual chapters, has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Ng, Michael H.K. Foreign direct investment in China : theories and practices / by Michael H.K. Ng. p. cm. Includes bibliographical references and index. 1. Investments, Foreign – China. I. Title. HG5782.N49 2013 332.67′30951–dc23 2012040046 ISBN: 978-0-415-67849-0 (hbk) ISBN: 978-0-203-54734-2 (ebk) Typeset in Times New Roman by Out of House Publishing

To my family

This page intentionally left blank

Contents

List of figures List of tables

viii x

1

Introduction

1

2

Foreign direct investment in China: history and development (Research assistant: Henry Keung)

7

3

Introducing theoretical frameworks: determinants of FDI (Research assistant: Henry Keung)

26

4

Introducing theoretical frameworks: effects of FDI (Research assistant: Irene Xu)

49

5

Key steps for direct investment transactions in China: due diligence

67

Key steps for direct investment transactions in China: term sheet

95

6

7

Strategizing investments in China in the next decade

120

Notes Bibliography Index

165 170 176

Figures

1.1 1.2 1.3 1.4 1.5 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 3.1 3.2 4.1

Utilized FDI in China, 1979–2012 FDI inflow: the US, China, Hong Kong, and Singapore, 2006–2011 FDI inflow: China and major developed economies, 2000–2011 FDI inflow: China and major developing economies, 2000–2011 FDI inflow: major developing economies, 2011 Share of utilized FDI in China, 1986–2010 Utilized FDI in China in different periods Annual growth rate in utilized FDI in China, 1984–2010 Different forms of FDI in China, 1987–2012 FDI inflow: China and major developed economies, 2000–2011 FDI inflow: China and major developing economies, 2000–2011 Cumulative FDI inflow (utilized) – top 10 province/city, 2000–2010 FDI inflow (utilized) – top 10 province/city, 2000 FDI inflow (utilized) – top 10 province/city, 2005 FDI inflow (utilized) – top 10 province/city, 2010 Cumulative FDI (utilized) – top 10 industry sector, 2004–2010 FDI (utilized) – top 10 industry sector, 2010 Cumulative FDI (utilized) – top 10 source country/region, 2000–2009 FDI (utilized) – top 10 source country/region, 2000 FDI (utilized) – top 10 source country/region, 2005 FDI (utilized) – top 10 source country/region, 2009 Percentage share in source of investment in R&D by MNCs, 2002–2005 Percentage share in destination of investment in R&D by MNCs, 2002–2005 Percent share of FDI in China’s total exports, 1986–2010

2 2 2 3 3 8 11 12 16 17 17 18 18 19 19 20 20 21 22 22 23 33 33 54

List of figures ix 5.1 5.2 7.1 7.2 7.3

Sample investment transaction procedures Sample corporate chart Share of China’s FDI by region, 2010 Sectors of selected VC investments in Central Western China, 2008–2010 Locations of selected VC investments in Central Western China, 2008–2010

68 74 122 130 130

Tables

1.1 Top 10 prospective host economies for FDI for 2012–2014, according to WIPS 3.1 Recent literature on the determinants of FDI in China 4.1 Recent literature on the effects of FDI in China 5.1 Sample accounts receivable aging table 7.1 Fastest growing cities in China 7.2 Average annual wage in manufacturing sector, 2008–2010

4 36 55 77 123 124

1

Introduction

Foreign direct investment (“FDI”) refers to the investment made by an enterprise in an economy other than its home economy. It differs from passive portfolio investment in the stock and debt markets in a way that direct investment reflects the objective of establishing a lasting interest by the investing enterprise. The lasting interest implies the existence of a longterm relationship between the investor and the investee enterprise and a significant degree of influence on the management of the investee enterprise. While management influence may not necessarily mean a shareholding of over 50 percent, a shareholding below 10 percent will normally not be regarded as direct investment.1 FDI as a subdiscipline of economics and international business studies has developed quickly since the late 1960s in English-language academia. Over the past two decades, study of FDI study in China has become a popular theme for researchers in international business studies, in economics, or in China business studies, both in English and Chinese academic literatures, for obvious reasons. China has now become one of the most popular destinations for FDI. In 2011, the total utilized FDI in China amounted to USD 124 billion, which is 28 times the FDI inflow two decades ago (see Figure 1.1). China has now become world no. 2 in terms of FDI inflow (see figures 1.2 and 1.3) and no. 1 among developing economies (see figures 1.4 and 1.5). Since the Chinese economy overwhelmingly relies on FDI as its source of foreign capital, as opposed to bank loan or portfolio investment,2 it showed a relative resilience to the recent financial crises that took place in 1998 and 2008. During these crisis years the FDI inflow in China only slightly dropped in 2009 and picked up its growth momentum fairly quickly afterwards (see Figure 1.4). This evidenced a relatively longer-term commitment of investors’ capital in this emerging and yet relatively stable market. China, primarily through FDI, has become the largest exporter in the world,3 a critical player in the globalized manufacturing network, and one of the most significant purchasers in raw materials. With its growing economy and continuing urbanization, China will continue to play a crucial role in the overseas expansion strategy of multinational corporations (“MNCs”). According to the World Investment Prospects Survey (“WIPS”) conducted by the United Nations Conference on Trade and Development

2

Introduction

140,000 120,000 100,000 80,000 60,000 40,000 20,000 1979–1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

0

Figure 1.1 Utilized FDI in China, 1979–2012 (USD million) Source: UNCTAD STAT, Ministry of Commerce, PRC 350,000

2006

2007

2008

2009

2010

2011

300,000 250,000 200,000 150,000 100,000 50,000 0 USA

China

Hong Kong

Singapore

Figure 1.2 FDI inflow: the US, China, Hong Kong, and Singapore, 2006–2011 (USD million) Source: World Investment Report 2012, UNCTAD4 400,000 300,000 200,000 100,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 –100,000 USA

China

UK

Germany

Figure 1.3 FDI inflow: China and major developed economies, 2000–2011 (USD million) Source: UNCTAD STAT

Introduction 3 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 China

Russia

Brazil

India

Figure 1.4 FDI inflow: China and major developing economies, 2000–2011 (USD million) Source: UNCTAD STAT

140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 Brazil

India

Russia

China

Figure 1.5 FDI inflow: major developing economies, 2011 (USD million) Source: World Investment Report 2012, UNCTAD

(“UNCTAD”) in 2012, China continues to be in the top spot as investors’ preferred destination for foreign investment (see Table 1.1). Given a global interest in understanding FDI in China or the Chinese economy in general in the past two decades, it is not uncommon to find undergraduate or graduate courses on FDI in China in major universities, as well as books on the same theme. In many of these courses at university level, economists or international business professors primarily teach the theoretical and empirical analysis of the phenomenon of FDI in China so that students can understand the rationale and effects of investment made by MNCs in other parts of the world in general and in China specifically. On the other hand, business or finance professors, or visiting speakers (who are often former bankers, fund managers, or investors) will offer in mergers and acquisitions courses the skill sets in executing a transaction that can hopefully minimize risks and maximize returns. Very rarely are we able to find a course that can cover both the theoretical and practical aspects in

4

Introduction

Table 1.1 Top 10 prospective host economies for FDI for 2012–2014, according to WIPS

China USA India Indonesia Brazil Australia UK Germany Russia Thailand

2012 ranking

2011 ranking

1 2 3 4 5 6 7 8 9 10

1 2 3 6 4 8 13 8 5 12

Source: World Investment Report 2012, UNCTAD

“understanding and making” FDI in China. The same issues were found in most of the academic books or practitioners’ primers in this area. This book grew from the postgraduate course “Foreign Direct Investment in China: Theories and Practices” that I taught at the Chinese University of Hong Kong. This course is atypical as an FDI course because it steps across the border between theoretical analysis and practical experience. This book, as a summary of the teaching materials of my course, bears these characteristics. I am especially thankful to the Chinese University for offering an interdisciplinary environment that is able to include this course in its contemporary China studies program. Soon after the course’s debut, it became the most popular elective in the program. Its success gave me confidence that the right combination of theories and practices in FDI in China satisfied the need of today’s readers. This book covers both the theoretical perspectives in understanding FDI in China as an international business activity performed by MNCs in order to seek bigger markets or higher margins, as well as the practical aspects of transacting a good FDI deal in a market with a vast population and a huge disparity in cultural and economic development such as China. This book primarily targets students and practitioners who are interested in having a holistic description of the FDI environment in China, rather than reading an in-depth academic monograph stemming from theoretical discussion, empirical analysis, and regression models or a practitioners’ manual that only covers the skill sets as to how to make a good transaction without talking about why a transaction would or should happen in China now but not in other places in the world at another time.

Introduction 5 The outline of this book is as follows. Chapter 1 gives an introduction of where China is standing in the global FDI market. It sets out the background, purposes, and structure of this book. Chapter 2 presents an overview of the historical development of FDI in China since 1978. It describes the various periods of the economic, policy, and legal development of the FDI regime and the features of each phase. It also describes the most recent development trend of the FDI inflow in China in the last decade and uncovers some noteworthy changes. This chapter will also try to make some sense of the development of FDI in the past three decades in an attempt to understand the forthcoming stages of development. Chapter 3 begins to offer an introduction to the theoretical frameworks that scholars in international business studies and economics proposed in understanding FDI in general and FDI in China specifically. One of the most important theoretical issues is the discussion about the determinants of FDI. The chapter will discuss the key incentives for an enterprise to venture into an overseas market proposed by theorists, and give a summary of selective recent research literatures offered in the field of understanding the determinants behind FDI in China. Another theoretical aspect that interests scholars in FDI is the effects of FDI towards the host country (i.e., the investee country). Like Chapter 3, Chapter 4 will give an overview of the theoretical discussion in relation to understanding major effects of FDI over the host country in a number of areas such as its effects on employment, economic output and technological spillovers. A summary of selected recent journal articles on the effects of FDI in China will also be provided. Chapter 5 and Chapter 6 deal with more practical issues in executing FDI transactions in China, with primary focus on FDI transactions in the form of acquisitions and joint ventures. Chapter 5 begins with a brief introduction to the typical transaction procedures in executing FDI deals in China. The chapter will then focus on one of the most crucial steps in making investments in China – due diligence. It describes the functions of different types of due diligence including financial, legal, technical, personnel as well as market due diligence. This chapter will go into details as to the meaning and significance of major due diligence items and how to prepare due diligence checklists for financial and legal due diligence. Sample due diligence information request lists will also be provided at the end of the chapter. Chapter 6 covers another major milestone in making investment deals in China – drafting a term sheet. The chapter discusses the major differences between a term sheet and a legal document, the reasons for the existence of key terms in a term sheet, the choice of different types of investment instruments, the structuring of defense mechanisms in a deal, the implications of adding or deleting these terms, and the way to negotiate for the right terms

6

Introduction

on behalf of the investors. Sample term sheets for different types of transaction, namely majority deals, minority investments, and joint ventures, will also be provided at the end of the chapter. Chapter 7 concludes this book by discussing how to strategize your investment in China in the next decade. The success of the coastal cities in attracting FDI for the past two decades has brought opportunities and threats for foreign investors. Obviously highly urbanized coastal cities have given more opportunities for foreign investors who have eyes on the pockets of domestic consumers in these markets. However, at the same time rising costs and an overcrowded investment environment would squeeze the potential margin of return for these investors. So where could we find again the opportunities that occurred in special economic zones or the Yangtze Delta region in the early 1990s? This chapter uses a number of research reports from international consulting firms and investment banks to understand the location and sectors to which direct investors have to pay attention in the next wave of economic development in China. This book would not have become reality without the help of a number of people. I owe a big debt to Professor Billy K.L. So, my teacher and mentor, who gave me the opportunity to teach the FDI in China course at the university and encouraged me to write this book based on the course materials. I am also very grateful to two outstanding students of my course, Henry Keung and Irene Xu, who helped prepare data for chapters 1–3 of this book. I hope this book will become one of the most useful resources for students and teachers in business, law, economics as well as contemporary China studies, and a practical tool for investment deal makers and policy makers in China who find theories and practices equally rewarding for their business and career.

Further reading For recent trends of FDI of the different regions in the world, see United Nations Conference on Trade and Development (UNCTAD). 2012. World Investment Report 2012. New York: United Nations. For data on foreign direct investment of the world, see UNCTAD STAT website. United Nations (http://unctadstat.unctad.org/TableViewer/tableView.aspx?Report Id=88). For data on foreign direct investment in China, see Invest in China website. Ministry of Commerce, government of PRC (http://www.fdi.gov.cn/pub/FDI_EN/default. htm).

2

Foreign direct investment in China History and development

After the reopening of the economy in 1978, foreign direct investment was among the earliest economic reforms that China undertook. The reasons are very simple: China was back then in urgent need of foreign capital to build up a foreign reserve base, to support government expenditure in infrastructure building and to reconstruct the market economy that was in turmoil. The country also badly needed jobs after its economy was severely damaged by the Cultural Revolution and other communist movements from the 1960s to 1970s. Foreign direct investment reform was kicked off by the implementation of a number of important policies, laws, regulations, and administrative measures. The process took more than 20 years before China became the most popular destination for foreign direct investment. Its development can be divided into four periods over the past three decades.

Establishment period: 1979–1985 After the establishment of the People’s Republic until the 1970s, China’s foreign capital came primarily from external bank loans from the former Soviet Union. A few joint ventures were formed with the Soviet Union and Eastern European countries but were short-lived (Wei and Liu 2001, 8–10).1 After the Third Plenary Session of the Eleventh Central Committee of the Chinese Communist Party in 1978, Deng Xiaoping and his followers broke away from the extremely leftist economic policy and began to steer the economy through the path of market liberalization. Foreign investment became a key reform area since then to assist the country in building up foreign capital reserve, absorbing technology, and reconstructing the private market. In 1979, the Sino-foreign Equity Joint Venture Law (“EJV Law”) was promulgated by the central government at the second session of the Fifth National People’s Congress. Despite the fact that the EJV Law was a set of broad-brush principles without detailed regulations, this law formalized and legalized the act of investment of foreign investors into Chinese enterprises and the formation of Sino-foreign joint venture businesses. The law was a big step in assuring foreign investors that their investment would have a legal status and be protected according to the

8

FDI in China: history and development 80 70 60 50 40 30 20 10

HK

Taiwan

Japan

USA

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

0

EU

Figure 2.1 Share of utilized FDI in China, 1986–2010 (%) Source: Statistics on FDI in China 2011, Ministry of Commerce, PRC

Chinese law. This helped in easing foreign investors’ concern and fear of the risk of confiscation of their property. More detailed rules on taxes, foreign exchange, and labor management were issued subsequently to support the implementation of the EJV Law. Another big step for attracting foreign investment was the establishment of the Special Economic Zone (“SEZ”). In order to speed up the economic modernization efforts especially in enhancing the development of manufacturing industry and the transfer of the relevant production technology, SEZs were established at four coastal cities: Shenzhen (Guangdong Province), Zhuhai (Guangdong Province), Shantou (Guangdong Province), and Xiamen (Fujian Province), by the issuance of SEZ regulations in 1980. These cities were chosen as the first batch of SEZs because of their close proximity with ethnic Chinese business communities in Hong Kong, Macau, and Taiwan. In the SEZs, foreign investors, especially investors from Hong Kong, Macau, and Taiwan, were allowed to form wholly foreign owned enterprises and were given special tax and policies preferences. The local governments of SEZ were delegated with more power to approve investment projects, issue licenses, permit land use, and handle banking and customs procedural matters for FDI projects.2 Among the overseas Chinese business communities, Hong Kong investors were by far the largest group of direct investors in China since 1978 (see Figure 2.1). Most of these investments were in labor-intensive manufacturing sectors, as well as hotel and restaurant projects in Southern China, especially Guangdong Province.

FDI in China: history and development

9

Apart from bringing in jobs and foreign capital, SEZs also served as the bases for absorbing technology and know-how in manufacturing industries and export operations, especially in relation to production of light electronics, garment and apparels, building materials, toys, and plastics products, where industrialists in Hong Kong excelled in the world export market in the 1960s to 1970s. SEZs also served as a test pilot base for experimenting with new FDI policies, which were more widely used in other areas of the country after they had become successful in the SEZs. Given the initial popularity of the SEZs in Southern China to foreign manufacturers especially industrialists from Hong Kong and Taiwan, 14 more coastal cities were opened up in 1984 to foreign trade and investment as Open Coastal Cities (“OCC”), namely Dalian (Liaoning Province), Qinhuangdao (Hebei Province), Tianjin (municipality under central government), Yantai (Shandong Province), Qingdao (Shandong Province), Lianyungang (Jiangsu Province), Nantong (Jiangsu Province), Shanghai (municipality under central government), Ningbo (Zhejiang Province), Wenzhou (Zhejiang Province), Fuzhou (Fujian Province), Guangzhou (Guangdong Province), Zhanjiang (Guangdong Province), and Beihai (Guangxi Province). Foreign Invested Enterprises (“FIEs” including wholly foreign owned enterprises and joint ventures) in OCCs were only required to pay 80 percent of income tax applied to local business (Wei and Liu 2001, 15). In 1985 Economic and Technical Development Zones (“ETDZs”) were set up, most of which were within these OCCs to offer more tax incentives for foreign investment in higher technology industries. From 1983 to 1985, approval authority of local government in these zones was gradually extended to projects under USD 30 million for coastal cities and USD 10 million for inland cities.3 The key difference between ETDZs and the former SEZs was that in ETDZs the local government aimed at attracting industries bearing higher technology content as contrasted with the low-technology, labor-intensive factories invested in by overseas Chinese investors in Southern China. Key successful examples are the entry of Nokia and Motorola into these zones during this period (Yueh 2011, 233). Larger coastal regions such as the Yangtze River Delta, Pearl River Delta, and South Fujian Delta were also given the power to grant investment incentives in 1985. This power was then extended to Liaodong Peninsula and Shandong Peninsula in 1988. Foreign investors in these zones and regions were given preference in tax treatment and administrative procedures. New ETDZs continued to be launched in the early 1990s; while other special-purpose zones such as Export Processing Zones, High Technology Development Zones, Free Trade Zones, and National Border and Economic Cooperation Zones were opened in different parts of China. Not all of these ports and zones experienced the same level of success as the SEZs, especially when more and more similar zones under different names were established locally from the late 1980s to the early 1990s. The reasons for the relatively slow growth in investment inflow in some of these regions in this period include the shortage of skilled labor, the lack of infrastructure

10

FDI in China: history and development

in transportation and communication, and the inefficient enforcement of regulatory and approval frameworks at the local level. Other regulatory hurdles such as the requirement that chairmanship of EJVs should be vested with the Chinese partner also deterred investors from engaging in Sinoforeign joint ventures.

Initial growth period (1986–1991) The promulgation of the Wholly Foreign Owned Enterprise Law (“WFOE Law”) in 1986 marked the beginning of another stage of development of FDI in China. In fact, more than a hundred wholly foreign owned enterprises had existed in China, based on a case by case approval, in designated cities even prior to this promulgation (Chen 2011, 51).4 WFOE law gave assurance to the foreign investors that the property of WFOEs will be protected under the Chinese law and foreign investors could legally repatriate profit back to their home country by lawful remittance. Additional supporting regulations such as Provisions for Encouragement of Foreign Investment were promulgated by the central government that, upon the basis of the WFOE Law, further formalized preferential treatments in tax, the freedom to import materials and equipment for production, and the right of foreign investors to exchange foreign currency on a limited basis so that foreign investors can have easier management of the foreign exchange balancing requirement under the law.5 Further tax benefits such as tax reductions, tax holidays, and import tax exemption were extended to FIEs involved in new technologies, new products, and export-oriented goods. Subsequently, the corporate income tax of FIEs was formalized which legalized some of the aforementioned preferential tax treatments.6 EJVs and WFOEs were granted privileged access to resources, such as electricity, water, raw materials. More infrastructure projects were launched to facilitate foreign investment during this period. Low-interest loans were also provided by the stateowned banks to Sino-foreign joint ventures. Along with the formalization of WFOEs, further amendment was also made to the EJV laws in 1990. One important change was to remove the provision which required that only the Chinese partner could be the chairman of EJV. Since a chairman in a Chinese company could act and enter into contract on behalf of the company without giving notice to other shareholders and directors, this removal gave more confidence to foreign investors in exercising control and operation in an EJV environment. In 1988, the Sino-foreign Cooperative Joint Venture Law (“CJV Law”) was passed. Under the CJV Law, joint venture partners could negotiate for their respective share of profit regardless of the initial capital contribution of each party. This gave more flexibility for partnership, especially for those Chinese partners or state-owned enterprises (“SOEs”) who did not have the same amount of monetary capital as the foreign partners did. Under the EJV Law, these Chinese partners could not ask for a share of profit more

FDI in China: history and development

11

1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 1979–1985

1986–1992

1993–2000

2001–2012

Figure 2.2 Utilized FDI in China in different periods (USD million) Source: UNCTAD STAT Ministry of Commerce, PRC

than their contributed proportion of monetary capital in the EJV, regardless of other “soft” contributions to the business such as knowledge of the markets, relationships along the value chain, and special connection with the government officials possessed by the Chinese partners. Under the CJV Law, they could utilize such soft contributions to bargain for a better deal in profit sharing with the foreign partners. In the same year, Hainan became the fifth SEZ and more areas were opened in Northern China for foreign investment as well. The number of cities open for foreign investment increased in this period from 184 to 284 (Yueh 2011, 233). In 1990, Pudong district in Shanghai was designated as a new development zone to attract foreign investments which paved the way for a high-growth period in Shanghai as well as the Yangtze Delta region after the tour of Deng Xiaoping to Southern China in 1992. Total utilized FDI in China during this phase amounted to USD 30 billion, which is five times that of the previous period (1979–1985), as shown in Figure 2.2.

High growth period (1992–2000) Development of FDI in China suffered a setback in the late 1980s to 1992 due to the fear of foreign investors about the possibility that the Chinese government might become more conservative in economic policies after the Tiananmen incident of 1989. In 1992, Deng Xiaoping made a famous tour to Southern China where a number of important speeches were made.7 The essence of the speeches pointed towards assuring the public about China’s determination towards market liberalization and encouraging local governments to accelerate in implementing the economic reform policies. The tour also gave more comfort to the local governments in bringing more foreign investments on board. After the tour, policies that favored FDI started to spread from the coastal to inland regions, especially regions with borders with neighboring countries. Fourteen more economic regions were

12

FDI in China: history and development

200% 150% 100% 50%

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

–50%

1984

0%

Figure 2.3 Annual growth rate in utilized FDI in China, 1984–2010 (%) Source: Statistics on FDI in China 2011, Ministry of Commerce, PRC

opened along the border areas. In 1995 the Investment Catalogue for the Guidance of Foreign Investment (“Investment Catalogue”) was promulgated which gave more documentary track for foreign investors to follow when making decision as to which industry they could invest in. The Investment Catalogue divided industries into four categories, namely, encouraged, restricted, prohibited, and permitted. Favorable tax and administrative treatments were given to foreign investors who invested in the encouraged industries. Restricted industries are those sectors where foreign investment is subject to a limitation in maximum shareholding. Foreign investment is not allowed in the prohibited industries, which are normally concerned with national security, natural and rare resources, media, as well as domestic markets. Sectors not falling into the above three categories are permitted category, which means that foreign investment is allowed in these sectors, subject to normal administrative and licensing requirements. The exemplary growth in FDI from the period of 1992–1995 reflected the effects of these efforts, as shown in Figure 2.3. Despite the rejuvenated growth after Deng’s Southern tour, the Chinese government was well aware of the fact that FDI in China had been concentrated in low-technology, highly labor-intensive export businesses. Much was yet to be done in facilitating transfer or spillover of technology and skill sets from FIEs into the local sectors. In 1995, High-technology Development Zones were developed in most of the provinces in China in order to promote foreign investment in high-technology industries. Within these zones, subsidies in land price and taxes were given to investors. A number of important legislations were also passed in the 1990s which significantly solidified the legal framework for FDI, including the Foreign Enterprise Income Tax Law and the Foreign Exchange Regulations, and a set of laws relating to copyrights and trademarks. Among them one of the most important laws enacted during the period was the Company Law of 1994. Enterprises and businesses in China were formally corporatized for the fi rst time after 1978. This is also an important piece of law that placed businesses in China under the ideological framework of separate

FDI in China: history and development

13

legal entities (which was an important driver for economic development in Western business history). WFOEs and EJVs were since then formally placed under the governance of limited liability companies and governed by the WFOE and EJV Laws as well as the Company Law. Along with these measures, retail and distribution markets were also liberalized. Retail giants such as Carrefour entered the market in the mid to late 1990s. With more certainty in legal regime and more incentives in the policy environments, FDI inflow in this phase amounted to over USD 310 billion from over 150 countries, more than 8 times that of the total FDI utilized in the previous two phases, as shown in Figure 2.2 above.

Post-WTO period (2001 onwards) After 15 years of negotiation, in December 2001 China became the 143rd member of the World Trade Organization (“WTO”). Accession into the WTO resulted in more commitments from China in opening trade and investment market to foreign investors. These commitments included gradually privatizing state-owned enterprises, increasing transparency in the legal and administrative systems, strengthening protection of intellectual property rights, reducing tariffs and taxes, and allowing foreign participation in previously restricted industries especially the service sectors such as finance and banking industries, telecommunications, tourism, logistics, accounting, legal services, and education. Major opening of these service sectors after the WTO accession included the gradual opening of large state-owned banks for foreign shareholders, subject to a foreign ownership cap. Investments of Goldman Sachs into the Industrial and Commercial Bank of China, Royal Bank of Scotland into the Bank of China, as well as the Bank of America into the China Construction Bank are some of these notable examples of foreign entry into state-owned banking sectors after the WTO accession.8 The participation of foreign investment in the state-owned banks was followed by the public listing of these banks on the Hong Kong stock exchange. Other major moves included allowing foreign investment in local insurance companies, securities brokerage firms and telecommunication companies, reducing agricultural duties and subsidies, reducing import tariffs for the automobile industry, and the gradual elimination of restrictions on distribution businesses for most retail products. A number of amendments were also made to the laws and regulations relating EJV and WFOE in order to align these rules with the WTO commitments. Major amendments include those in the WFOE and EJV Laws so that some of the major restrictions on the activities of FIEs such as the restriction in balancing foreign exchange, mandatory export, and restrictive sourcing requirements were abolished (Chen 2011, 55–6). Company Law was also further amended in 2005–2006 whereby corporate governance mechanisms such as petition by minority shareholders and appointment of independent directors were introduced. Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign

14 FDI in China: history and development Investors were passed in 2003 and a detailed provision on the same subject was passed in 2006. These are the first sets of M&A laws in China under which foreign investors were able to acquire, by either asset acquisition or share acquisition, local businesses in China according to the law, although a considerable number of acquisitions had been made by overseas (especially Hong Kong) enterprises in late 1990s to early 2000s prior to the promulgation of such M&A law.9 Although there were continued criticisms from foreign investors about the implementation of China’s commitments made to the world upon accession to the WTO,10 FDI inflow into China did not slow down within the last decade since the WTO accession, despite the fi nancial crisis that occurred in this period. Total FDI from 2001 to 2011 totaled over USD 880 billion, which is more than twice the total FDI in the 1990s (see Figure 2.2 above).

Major types of FIE structures Despite the changes and evolution of FDI policies, laws and market developments during the aforementioned three decades, major forms by which foreign investors are able to do business in China did not change much throughout these various stages. These forms are the equity joint venture, the cooperative joint venture, and the wholly foreign owned enterprise. These different forms carry different benefits and shortcomings for foreign investors and the Chinese partners. The popularity of these different modes of entry also changed over time as the FDI regulatory regime and the macroeconomic environment developed amid closer integration of the global economy. The following sections will set out these major differences for different modes of entry for FDI. It will also discuss their respective popularity with foreign investors since the passing of the first set of WFOE Laws in 1986. Equity joint ventures EJVs are the oldest form of FIE permitted in China. The first set of laws regulating the establishment and operation of EJVs was the Sino-foreign Equity Joint Venture Law passed in 1979 and the EJV Law Implementing Rules in 1980. An EJV is characterized by a number of features: • • •

•

It is a joint venture co-invested by the Chinese partner(s) and the foreign partner(s). Its profit is to be shared according to the proportion of respective capital contribution by the partners. There are regulations as to how much of the capital contribution can be made in kind other than cash for different types of industries according to applicable regulations. Capital cannot be repatriated before the termination of the EJV.

FDI in China: history and development •

15

The EVJ is governed, like a limited liability company, by its board of directors, with a chairman who is also the legal representative of the joint venture.

Cooperative joint ventures CVJs were formalized by the Sino-foreign Cooperative Joint Venture Law in 1988 and its subsequent implementing rules in 1995. A CJV, also known as a contractual joint venture, is a joint venture with many similar features to an EJV, but with a number of important differences. They include the provision that the profit-sharing ratio can be determined by the CJV contract, irrespective of the ratio of capital contribution from partners. Another major difference is that the CJV Law allows capital repatriation before the end of the CJV term. CJVs are especially beneficial to the Chinese partners, private enterprises, or state-owned enterprises which might not have compatible monetary capital with the foreign investor, but possess some kind of intangible asset, such as the brand name, market control, business or government networks. Final profit sharing ratio can be an outcome of commercial negotiation between the partners.

Wholly foreign owned enterprises WFOEs were formalized through the passing of the Wholly Foreign Owned Enterprise Law in 1986. The Implementing Rules for WFOE took force in 1990. A number of revisions of the law and the rules took place thereafter to remove certain restrictions according to the commitments made by China upon the accession of the WTO. Compared with EJVs and CJVs, WFOEs have more restrictions in terms of the kind of industries they can participate in, the form and amount of minimum registered capital (which varies according to different types of industries), and the way for repatriation of investments. Apart from the WFOE Law, a WFOE should also follow the PRC Company Law regarding corporate governance and operation, and the Investment Catalogue in terms of the type of industries it can invest in.11 In order to let the local economy benefit from the spillover of industrial know-how and technology through cooperating with the foreign partners, EJVs were the only permitted form of FIEs after the reopening of the China market for foreign investment in 1978. This is obviously the best tactic for an emerging yet potentially sizable economy to capture foreign capital and technology, to accumulate exchange reserve and export orders, without sacrificing the control of the industry and more importantly the potentially lucrative domestic market to foreign operators. From Figure 2.4, we can understand that despite the passing of the WFOE Law in 1986, EJVs continued to be the most popular forms of FIEs until China’s accession into the WTO in 2001. It was because WFOEs were still subject to a lot of restrictions as to the industry they could participate in from the 1980s to the early

16

FDI in China: history and development 90

EJV

CJV

WFOE

80 70 60 50 40 30 20 10 0

1987

1992

1997

2002

2007

2012

Figure 2.4 Different forms of FDI in China, 1987–2012 (% of total utilized FDI) Source: http://www.fdi.gov.cn and Ho (2007) (2012 figures from January to June)

1990s. These restrictions were gradually relaxed after the Southern tour of Deng Xiaoping in 1992. More relaxation was made after China’s accession into the WTO in 2001 as mentioned in the previous section. Therefore, since the early 2000s, WFOEs have become the most popular form of FIEs, with CJVs becoming nearly negligible as a proportion of total FDI projects. This trend is expected to continue in the future as more service and retail industries in the domestic markets have been opened to foreign investors to operate as sole owners. Compared with labor-intensive manufacturing industries, foreign investors in higher technology, professional service, and domestic market-driven retail industries rely relatively less on the local relationship and more on management and operation expertise. WFOE will naturally be a preferred mode of entry which gives investors a total control of the assets and business operation.

Recent trend of China’s FDI inflow As the previous section mentioned, forms of FDI have changed quite a bit since the early 2000s following China’s accession into the WTO. Not only its forms, but its patterns also evolved quite significantly as more and more foreign capital is invested into a wider spectrum of China’s business sectors. This section will show some of these changes that took place in the first decade after China’s accession into the WTO.

FDI in China: history and development

17

400,000 300,000 200,000 100,000 0 –100,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 USA

China

Germany

UK

Figure 2.5 FDI inflow: China and major developed economies, 2000–2011 (USD million) Source: UNCTAD STAT

140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 China

Russia

Brazil

India

Figure 2.6 FDI inflow: China and major developing economies, 2000–2011 (USD million) Source: UNCTAD STAT

FDI inflow Figures 2.5 and 2.6 show the amount of FDI inflow obtained by China from 2000 to 2011. It shows a continuous trend of growth throughout the period. The period from 2003 to 2008 shows a marked increase. Even in the period after the 2008 financial crisis, China’s FDI inflow only declined slightly for a year before returning to the path of growth. This is consistent with the resilience shown by the Chinese economy to the financial crisis, partly contributed by the fiscal stimulus rolled out by the central government and the continuous expansion of the domestic markets. This also showed the merits of the relatively longer-term commitment of foreign investors in the direct investment markets, as compared with portfolio investors in the stock and bonds markets who can flee easily during recession or stock market fluctuation.

FDI in China: history and development

ei

g

n

H

Be

ub

ijin

ia Fu j

nj Ti a

jia Zh e

in

ng

ai gh Sh

an

an

do

ng Sh

Li

ao

ni

ng

ua

ng

do

ng G

Ji a

ng

200 180 160 140 120 100 80 60 40 20 0

su

USD billions

18

Figure 2.7 Cumulative FDI inflow (utilized) – top 10 province/city, 2000–2010 Source: China Data Online 12

USD billions

10 8 6 4 2

ei ub H

jin an

ia ej Zh

Ti

ng

g ijin Be

ng ao Li

an

do

gh Sh

an Sh

ni

ng

ai

n jia Fu

gs an Ji

G

ua

ng

do

ng

u

0

Figure 2.8 FDI inflow (utilized) – top 10 province/city, 2000 Source: China Data Online

Provincial distribution While the nationwide FDI inflow did not change much in its trend of continuous growth, the regional distribution pattern of FDI gradually changed over the past decade. Figure 2.7 shows the amount of FDI attracted by different provinces or major cities over the past decade. From a cumulative angle, Jiangsu, Guangdong, Liaoning, Shandong, and Shanghai ranked the five most popular areas for foreign investors, for obvious reasons. They were among the earliest coastal areas that were opened to foreign investments, with SEZs or ETDZs. However, if we compare figures 2.8, 2.9, and 2.10 which respectively show the ranking of FDI inflow of provinces and cities in 2000, 2005, and 2010, we are able to see the change in the trend of FDI inflow into these areas. In

FDI in China: history and development

19

14

USD billions

12 10 8 6 4 2

G

xi ng Ji a

Fu j

ia

n

in

Li

Ti a

nj

g Be

ni ao

an Sh

ijin

ng

ai gh

ng jia

do an

Zh e

ua

Sh

ng

Ji a

do

ng

su

ng

ng

0

Figure 2.9 FDI inflow (utilized) – top 10 province/city, 2005

n jia Fu

H

en

an

g ijin

do an Sh

Be

ng

jin an Ti

ej Zh

an Sh

ng ua

ia

ai gh

ng do

ng G

Li

ao

ni

gs an Ji

ng

30 25 20 15 10 5 0

u

USD billions

Source: China Data Online

Figure 2.10 FDI inflow (utilized) – top 10 province/city, 2010 Source: China Data Online

2000, Guangdong and Fujian, being the earliest areas opened to FDI and the earliest bases for FIEs in the manufacturing sector, ranked the first and the third places respectively, with Jiangsu ranking in-between. In the mid-2000s, Jiangsu overtook Guangdong as the most popular place for FDI. Zhejiang, Liaoning, and Shandong also caught up while Fujian’s development clearly lagged behind in the period despite owning a SEZ at Xiamen. In 2010, a similar trend solidified and continued that made the gap between Guangdong and Jiangsu widen further. That reflected the speedy development of the Yangtze River Delta and Liandong Peninsula as a result of the second phase of opening in the 1990s. It is also noteworthy that Henan for the first time in 10 years since 2000 surpassed Fujian in the league table. This reflected the impact of the policy favoritism towards the western and inland region in the past number of years. This trend is expected to continue, as will be explained in more detail in the discussion about strategizing investment in the next decade in Chapter 7.

FDI in China: history and development

Hotels and catering services

Scientific research, technical service and geologic prospecting

Agriculture, forestry, animal husbandry and fishery

Production and supply of electricity, gas and water

Information transmission, computer services and software

Transport, storage and post

Wholesale and retail trades

Leasing and business services

Real estate

350 300 250 200 150 100 50 0 Manufacturing

USD billions

20

Figure 2.11 Cumulative FDI (utilized) – top 10 industry sector, 2004–2010 Source: China Statistical Yearbook, various years

USD billions

60 50 40 30 20 10 Agriculture, forestry, animal husbandry and fishery

Scientific research, technical service and geologic prospecting

Services to households and other services

Production and supply of electricity, gas and water

Transport, storage and post

Information transmission, computer services and software

Wholesale and retail trades

Leasing and business services

Real estate

Manufacturing

0

Figure 2.12 FDI (utilized) – top 10 industry sector, 2010 Source: China Statistical Yearbook, various years

Sector characteristics In terms of sectors in which foreign investors are most interested, figures 2.11 and 2.12 respectively show the distribution over the past ten years and the situation as in 2010. From both a cumulative and single-year angle, not surprisingly, manufacturing industry led the way by far, followed by other service sectors such as real estate, leasing and business services, wholesale and retail trades, IT businesses, and transportation and storage. However, in the latest World Investment Report published by UNCTAD in 2012, it mentioned that while FDI in China continued to grow to up to USD 124 billion in 2011, FDI flow

21

Germany

Samoa

Cayman Islands

Taiwan, China

Singapore

Republic of Korea

United States

Japan

Virgin Islands

300 250 200 150 100 50 0 Hong Kong, China

USD billions

FDI in China: history and development

Figure 2.13 Cumulative FDI (utilized) – top 10 source country/region, 2000–2009 Source: China Statistical Yearbook, various years

into the service industry for the first time surpassed those into manufacturing. UNCTAD attributed this to the result of a rise in FDI inflow to non-financial services and a slowdown of inflow to the manufacturing sectors. UNCTAD expects this trend to continue as China continues to open other sizable service sectors such as its financial services sector (UNCTAD 2012, 43–4). Source countries of China’s FDI Figure 2.13 shows the change of pattern in source economies that brought foreign investment into China from 2000 to 2009. Hong Kong, being the key investing economy into China since the opening of the Post-Mao China, continued to be the top of the league in terms of source of China’s FDI inflow. Hong Kong investors contributed to a significant extent to FDI in Southern China’s manufacturing industries, especially in Guangdong Province. While we do see from a cumulative angle that the United States ranked at the top of the range as the key FDI contributor to China, newly developed Asian economies such as Taiwan and South Korea have caught up and overtaken the United States recently, as shown in figures 2.14 –2.16. We can also see from these graphs that the Virgin Islands has been occupying the second place next to Hong Kong for most of the time. This does not mean that local investors in the Virgin Islands made these investments in China. This is probably owing to the fact that the Virgin Islands is one of the most popular tax havens where foreign investors form their offshore companies and use them as holding vehicles to invest in China. Even Chinese enterprises, prior to the tightening up of regulations in the mid-2000s, used Virgin Islands’ companies to acquire their assets and businesses in China as round-tripping to bring the Chinese businesses for overseas listing or for other commercial purposes.12 Given the physical, ethnical, and cultural vicinity, Hong Kong is likely to continue to occupy a significant role in FDI in China in the future, though given the structural change in the economy and changing policy preference of China, Hong Kong investors may move their investment from low value-added,

FDI in China: history and development

Germany

France

Germany

Samoa

United Kingdom

Republic of Korea

Singapore

Taiwan, China

Japan

Virgin Islands

United States

18 16 14 12 10 8 6 4 2 0

Hong Kong, China

USD billions

22

Figure 2.14 FDI (utilized) – top 10 source country/region, 2000

Cayman Islands

Taiwan, China

Singapore

United States

Republic of Korea

Japan

Virgin Islands

20 18 16 14 12 10 8 6 4 2 0 Hong Kong, China

USD billions

Source: China Statistical Yearbook, various years

Figure 2.15 FDI (utilized) – top 10 source country/region, 2005 Source: China Statistical Yearbook, various years

export-oriented manufacturing industry located primarily in the Guangdong area, to higher value-added, domestic market-focused manufacturing and service industry located not just in Southern China, but also in the western and inland regions such as Hebei, Sichuan, Chongqing or Yunnan.

Features of FDI development in China From what has been mentioned in the above sections, we are able to notice a number of important features in the development of FDI in China over the past three decades.

23

Germany

Taiwan, China

Samoa

United States

Cayman Islands

Republic of Korea

Singapore

Japan

Virgin Islands

50 45 40 35 30 25 20 15 10 5 0 Hong Kong, China

USD billions

FDI in China: history and development

Figure 2.16 FDI (utilized) – top 10 source country/region, 2009 Source: China Statistical Yearbook, various years

Ideology and leadership The economic policies (including the attitudes and policies towards foreign investors) turned from favoring Marxist ideologies to favoring marketization primarily due to the change of party leadership in 1978. Without asserting the leadership by Deng Xiaoping and his followers (and reassertion in the Southern tour of 1992) to steer through the opening of the Chinese markets, liberalization of FDI, and other economic reforms would probably not have taken root. The numerous changes made to the Investment Catalogue reflected not just the influence or pressure from international trade organizations and business communities, but also the thoughts of the then party leaders towards the long-term development of the political economy of China. Revisions made to the Investment Catalogue largely synchronized with party leaders’ thoughts in the various five-year plans.13 The latest revision to the Investment Catalogue, which took effect in January 2012, revealed the concern of the Chinese government in the economic development of China especially about the overconcentration of FDI in export-oriented, labor-intensive, and lowtechnology business and their adverse impact on the environment. Promotion of eco-friendly, higher technology, and domestic consumption-driven investments were placed with the highest priority in the revised Investment Catalogue, which synchronized with emphasis on coordinated and sustainable economic development advocated in the concept known as the “Scientific Development Concept” proposed by the Hu-Wen-led party leaders.14 Attract, select, and control Since the reopening of the Chinese market in 1978, the Chinese government had been on the one hand giving incentives in tax treatments, administrative

24

FDI in China: history and development

procedures, and access to resources to attract foreign investment so that foreign reserve and know-how could be accumulated; on the other hand such incentives were given based on a highly selective criteria in terms of recipients, sectors, and geographic locations. In terms of recipients, the earlier policies favored investments from ethnic Chinese communities, especially those from Hong Kong, Macau, and Taiwan. The commonalities in language and culture played an important role in fostering trust and cooperation in these earlier joint ventures. Such commonalities also made control and communication easier for the local government to monitor the operation of the foreign investors’ activities in the market. In terms of sectors, export-oriented industries were the center of FDI policy focus for about two decades, which made China the biggest processing plants of the world and one of the countries with the highest amount of foreign reserve. This selection was aligned with the policy motives of placing accumulating foreign reserve and absorbing manufacturing know-how as a priority. While continuing to open more sectors to foreign investment, at the same time, the Chinese government had always been very mindful about controlling or confining foreign investors in the sectors according to its national interests and policies priorities. It is very sensitive to the protection of domestic markets and industries that were crucial to national security and economy from potential foreign domination. Therefore, it was not until the accession of China to the WTO that restrictions on sectors such as retail and distribution, financial services and banking, telecommunication, and automobiles were gradually relaxed. Pilot testing and gradualism Given a country of vast geographical area, sizable population, and huge diversity in income level at different regions, China had been employing in many important policies a strategy of pilot testing and gradualism. SEZs were the pilot test bases for the new FDI policies right after the reopening in 1978. When the policies got their initial success in attracting FDI from Hong Kong and Taiwan, and after the government got less worried about losing control of these investors by successfully confining them in export sectors without losing the domestic market, such policies were extended to a wider pilot base in HTDZs and other special trading zones in Yangtze Delta and other coastal regions, and eventually to similar zones established in other provinces. This type of sequencing and gradualist approaches were actually not only shown in FDI policies over the past three decades, but also in important policies in housing reforms and opening of real estate markets, as well as to the development of corporate governance in Chinese business.15 Given the success of this approach in giving the central government a more controlled environment in economic reforms, this approach should be expected to continue in other economic policies to be rolled out in the future, such as what we are seeing now in the pilot-testing reforms of the

FDI in China: history and development

25

value-added-tax system in Shanghai and Beijing or of fi nancial and credit markets in Wenzhou (Zhejiang Province).

Further reading For data on characteristics of FDI inflow in China, see Ministry of Commerce. 2011. Statistics on FDI in China. Ministry of Commerce of PRC and Invest in China website. Ministry of Commerce, government of PRC (http://www.fdi. gov.cn/pub/FDI_EN/default.htm); for general economic data of China, see All China Marketing Research Co. China Data Online (http://chinadataonline.org) and State Statistical Bureau of the People’s Republic of China. China Statistical Yearbooks of various years. For FDI data of the world, see Organisation for Economic Co-operation and Development. OECD StatExtracts (http://stats.oecd.org/Index.aspx); UNCTAD STAT website. United Nations (http://unctadstat.unctad.org/TableViewer/ tableView.aspx?ReportId=88); for latest regional trends, see United Nations Conference on Trade and Development (UNCTAD). 2012. World Investment Report 2012. New York. United Nations. Chen, Chunlai. 2011. Foreign direct investment in China: Location determinants, investor differences and economic impacts. Cheltenham; Northampton, MA: Edward Elgar, chapter 2. Naughton, Barry. 2007. The Chinese economy: Transitions and growth. Cambridge, MA: MIT Press, chapter 4.

3

Introducing theoretical frameworks Determinants of FDI

Determinants of FDI Since the public appearance of Steven Hymer’s dissertation “The International Operations of National Firms: A Study of Direct Foreign Investment” written in 1960 (published as a book in 1976), more scholars became interested in theorizing the activities of multinational corporations in making investment abroad based on different market structures and characteristics of investing firms (Cui 2001, 32–3; Moosa 2002, 29).1 One of the most popular areas of empirical research and theoretical studies in FDI is to understand and analyze the determinants, i.e., the driving factors behind a company that opts for investing in a country or economy (known as the host country) other than its original place of production (known as the home country) as a part of its business strategy.2 This chapter will first introduce some basic theories that attempt to explain reasons for FDI in general and then summarize some recent scholarship that explores the determinants of FDI in China. Expansion to overseas market involves not only business opportunities but also a lot of risks. A company that decides to do so must support the decision on sound strategic grounds. The first and foremost reason for a commercial organization to engage in FDI, like other activities or business it engages in, should be to maximize profit. Usually a company that intends to expand overseas is seeking the following advantages in the host country in order to maximize its profit:3 1.

2.

3.

Market-seeking: the home market has been saturated and expectation of continuous growth of profit cannot be met without tapping into the emerging market overseas. Resource-seeking: there is a shortage of specific raw materials in the home country. Therefore the company has to look for stable supply of necessary raw materials, for example, precious metals, petroleum, wood, and limestone, from the host country at a reasonable price. Cost-seeking: the price of input (such as land, raw materials, and labor) in the home country has become increasingly unaffordable to maintain

Theoretical frameworks: determinants of FDI 27 the reasonable profit margin expected by the company or investors. Cheaper input costs from overseas markets become important in safeguarding the company from declining profit margins. However, the above motives themselves are not sufficient for the company to operate its subsidiaries abroad, given the huge risks involved in operating in overseas emerging markets such as China, India, Latin America, Eastern Europe, and Africa. These risks include: 1.

2.

3.

Management risks – before an overseas plant or subsidiary can be set up and function properly, the home country investors have to figure out whom can be appropriately placed to manage the overseas operation. Recruitment sometimes can be difficult. For service industries such as high-end hotels, restaurant chains, and shopping arcades, it would be easier to recruit talent because these businesses are normally located in relatively advanced cities or downtowns, with better communication, accommodation, and catering facilities for the expatriates. For some industries such as mining, cement, toll-roads, manufacturing, or agricultural products processing, plants could be located in much more backward and remote areas that would likely pose hardship to management talents recruited from developed economies. Even if senior management from abroad could be recruited to kick off the investment project, whether the managerial style and management process could fit into the local business culture well would create uncertainty and difficulty to the efficiency of operation. Legal risks – the difference between the legal systems of the home and the host countries poses another risk to the investors. Taking China as an example, it is using largely a civil law system as compared with common law systems used by investors from Anglo-American legal systems. If overseas investors expect the degree of independence of judiciary and prosecution that they get used to in the home country to be exercised to the same degree in China, they would have a lot of difficulties in running its business and settling commercial disputes. Also there is a large variance in terms of the degree of enforcement of the same laws in different provinces, cities, and counties. There can also be local regulations issued by specific local governments in relation to business operation of particular industries to supplement the formal laws promulgated by the central government. Government policies, though not exactly pieces of law per se, have substantial influence on how government departments understand, interpret, and enforce legislation. Learning of and adaptation to foreign laws and legal practices costs time, money, and effort, and may sometimes pose threats to the profitability of an operation.4 Taxation risks – like the legal system, the tax system is another area where foreign investors may have difficulty in adaptation. Taking

28

4.

Theoretical frameworks: determinants of FDI China as an example again, it operates a totally different tax system from that of its largest investor – Hong Kong. In China, taxes are collected not just from the central government’s tax authority, but are also charged by local tax bureaus. In contrast with Hong Kong, China also charges indirect business tax. Different tax holidays, tax exemptions, and tax rebates are allowed in China that vary with different kinds of industry, different regions, and different shareholders’ composition (e.g., whether the enterprise is foreign owned, locally owned, or a joint venture). This variance in most of the cases does not exist in Hong Kong. Therefore, Hong Kong investors that are used to just paying a 16.5 percent profit tax rate may fi nd the tax system annoying.5 Investors may also have to compare the production cost saved in China with the possible increase in tax burden when ascertaining the profitability of an overseas operation. Distribution risks – distribution can be a headache for investors in developing economies, especially for a vast market such as China or India. Distribution risks relate highly with the efficiency of contract enforcement. When a manufacturer engages a distributor, it has to deliver goods to the distributor normally on credit, and receive payments after a certain period of time. The manufacturer also has to be sure that the distributor it has engaged has the ability to deliver the goods to the retail markets it targets, place the goods onto the shelves according to its request, and implement in-shop promotion as it desires, such as hanging flyers onto the right position in a shop. Most of these depend on the delivery and implementation capabilities of the distributor. In a smaller market with a better court system, all of these detailed work requirements can be spelled out in a distribution contract. Performance on delivery and promotion works can be monitored by spot-checks of the manufacturer. Breaches in performance can be remedied by legal actions. However, in an emerging market like China, it is not uncommon for foreign manufacturers to suffer from delay or default in payments, unsatisfactory delivery, and poor implementation of contract terms by the distributors. Some investors may consider vertically integrating the distribution services by starting a distribution business from scratch or acquiring existing distributors in order to ensure the quality of distributorship. However, this strategy might not work well in emerging markets. Distributorship work can rarely be done well by foreign operators in emerging markets because the work involves managing local drivers, deliverers, and shop-keepers, and requires good knowledge of local transportation systems and local government agencies. Therefore choice of distributor is sometimes an important factor that affects the profitability and liquidity of a manufacturer, especially for those small and medium FIEs with limited working capital.

Theoretical frameworks: determinants of FDI 29 5.

6.

7.

Currency and repatriation risks – obviously currency fluctuation can create significant risks to the profit of investors. For most of the small and medium manufacturing FIEs in Southern China, for example, slight and gradual increase in the value of the Renminbi could wipe out the already thin (5–10 percent) net profit margin. Huge depreciation, on the other hand, can also be a disaster. Recent examples include the serious inflation in Vietnam after the 2008 financial crisis that has adversely affected the FDI inflow into the country.6 Another risk on currency is the exchange control risk. As mentioned in the last chapter, lack of convertibility of local currency and the requirement in balancing foreign exchange accounts (such as the case of China prior to 2001) can create serious operating issues for FIEs as well. Political risks – political stability can influence economic environment. Riots and changeover in the central government’s authority obviously would affect the confidence of foreign investors and policies towards foreign investment. Even a change of the head of local-level government, taking China as an example again, may also involve uncertainty as to whether the incoming head of local government would continue to honor the commitment made by the outgoing official in their policy towards a particular type of foreign investor. Therefore, it is not uncommon for foreign investors in China to ensure that the commitment made by one local government is delivered before the local party leader steps down from the office. IP risks – IP risks relate to the effectiveness of the enforcement of intellectual property rights (“IPR”) in the host jurisdiction. Without an effective IPR legal regime, it would be highly tempting for local manufacturers, local suppliers, distributors, or customers to imitate the proprietary technology through unintentional spillover or direct piracy.

Therefore, if a company wants to explore an overseas market, whether for a sale market of its products or a cheaper access to raw materials and labor supply, it can opt for options other than directly investing to set up a company or factory abroad in order to mitigate the above risks. These options include: 1.

2.

Export – if a manufacturer is looking for an overseas market, it can choose to export its products to the targeted new market. For a smaller number of retail outlets, the fi rm may export the goods directly to the specific outlets. If more scattered sale outlets are involved, the fi rm can consider the next option of assigning distributorship to a local partner. Distributorship – if the plan of exporting the goods to the overseas markets involves more than one market or if the retail market involves a

30

3.

Theoretical frameworks: determinants of FDI large number of sale outlets for its products (e.g., soft drinks sold in the supermarkets), the manufacturer, in order to minimize efforts in dealing with numerous buyers and collecting payment from numerous small retailers, will assign one or a number of distributors to sell its products in the markets. In a lot of cases, distributorship service does not only involve physical delivery but also marketing and promotion solutions. Manufacturers will rely on distributors especially when they are targeting the global market. Examples of these global distributor groups include the Inchcape Group (global marketer and distributor of many Japanese-brand automobiles) and the Jebsen Group (global trader, marketer, and distributor of automobiles, luxury goods, and beverages). Licensing – if a manufacturer is worried about the risks in collecting payment from local merchants or distributors, ensuring distribution quality, or dealing with numerous local parties, it can choose to capture the demand of overseas markets by licensing the right to produce its products to an overseas manufacturer. By doing so, the original manufacturer can charge a pre-paid one-time or annual license fee, sometimes plus revenue sharing, and let the local manufacturer utilize the assignor’s product design to produce and sell the products. This method is commonly used by small and medium enterprises producing hightechnology products or products with proprietary design or patents because these enterprises may lack the capital or resources to set up plants abroad or follow up with salesmen and distributors on a daily basis in the overseas markets.

If the above three options do not work in the best interest for the firms’ longerterm profitability, the firms will consider investing abroad to set up their overseas operations. Scholars have tried to understand the characteristics of these firms, despite the risks and disadvantages mentioned above, that facilitate them to engage in direct competition in the overseas markets. These characteristics can be broadly categorized into three types according to the scholarly research in the field. 1.

Ownership advantage7 – this explanation is also known as the industrial organization hypothesis. The hypothesis says a firm must possess certain kinds of unique advantages over other players in the overseas market in terms of the products it offers and the skill sets it possesses. These advantages include: a. proprietary technology; b. manufacturing or operation know-how; c. trademark or patent; d. amount of capital; e. access to raw materials; f. scale of production; and g. research and development capability.

Theoretical frameworks: determinants of FDI 31 2.

3.

Internalization advantage8 – the investor company is able to save profit margin by internalizing otherwise third party transactions along the value chain, whether upstream or downstream. For example, a steel company invests in iron ore to save raw material costs; a consumer goods company invests in distribution channels or logistics companies to save distribution charges. Location advantage9 – this theory was originally based on the fact that some inputs of production are immobile, i.e., it is not more efficient to transport the input into the home country than to move the production base closer to the source of these inputs. If the location can provide the investor firm with equally good input and resources at a cheaper cost or better quality input at an equal cost, motivation will exist to drive the firm to invest overseas. Location advantages can include: a. cheaper labor supply and abundance of human capital; b. foreign language capability – e.g., MNCs invest in Indian cities to build customers service or call centers to serve English speaking customers worldwide; c. cheaper land cost; d. infrastructure support such as port facilities, highways, and power supply; e. cheaper capital cost (for example, low interest loans will be provided by the banks in the host country to encourage foreign investment); f. accessibility of raw materials, such as minerals, metals, fuel and gas, wood, agricultural products, and poultry; g. climate suitability – e.g., locations with special climate and humidity for growing tropical plants such as mango and pineapples in Guangxi, Yunnan in China, or provinces in Thailand and the Philippines; and h. tax holidays and exemptions.

Another influential theoretical framework, known as the eclectic theory proposed by Dunning (1977, 1979, 1988) contended that all of the above advantages have to be present in order to motivate an investor to take the risk of investing abroad. The theory says if any of the three conditions is not present, the firm will choose to export, license, or enter into other means of contractual arrangement to exploit the foreign market and not engage in FDI. If a firm possesses ownership advantage and location advantage but lacks internalization advantage, then the firm can choose to license its technology or product design to overseas manufacturers instead of investing to set up manufacturing plant overseas. If there is only ownership and internalization advantage, but no location advantage, then the firm can choose to export the products to overseas distributors instead of manufacturing at a foreign location. If all three conditions are present in the host country, then a firm has a stronger motive to make FDI in that country as a base to manufacture and distribute its products.

32

Theoretical frameworks: determinants of FDI

Another hypothesis, known as product cycle theory, proposed by Vernon (1966), offered another explanation for the factors that drive an enterprise to go abroad for setting up business based on the life cycle of a product. He suggested that a fi rm engages in FDI at a particular stage of life cycle of the products innovated by it. Initial production of the product takes place at home, he argued, because of physical proximity to production input such as raw materials and to major customers. Producing in the home country makes sense because it facilitates coordination between research department and production facilities. Producing at home at the initial stage also makes getting feedback from customers easier in order to fi ne-tune product specifications and designs over time. Product demand at this stage mainly comes from the home country. As competition at the home market gets fierce, the fi rm will consider engaging in exports for the purpose of expanding its sales into the overseas market to avoid competition in price with similar products at home. As competition continues and similar products reach a level of standardization even at the overseas market, i.e., product differentiation can no longer work well for protecting profit margins in the overseas market, a fi rm may engage in FDI to further invest to produce in the host country in order to reach overseas customers locally and get cheaper production input to improve margins. Therefore, at this stage, the FDI engaged by the fi rm moves gradually from an expansionary move, i.e., market-seeking, to a defensive move of seeking lower cost. While the theory could well explain a lot of the technology-rich industries that grew in the US, its major defect is that it assumes research and development (“R&D”) of fi rms took place in the home country for domestic demand before the product reaches other markets abroad. This assumption may not be able to stand amid innovation globalization. Gert Bruche (2009) in his recent research shows that it was true that from the 1960s to the 1980s the major R&D of MNCs remained more home-centric and centralized despite the global integration of production and sales networks. From the 1990s, R&D has become more mobile. China and India rose quickly as an increasingly popular hub for R&D. While most of the foreign investment in R&D still came from North America (about 50 percent), 58 percent of the money was invested in Asia Pacific (see figures 3.1 and 3.2) in which China shares 17 percent and India shares approximately 25 percent. This trend is expected to have a positive growth given that education and investment in science and technology in China and India continue to grow.10

Determinants of FDI in China – overview of recent research As China has become one of the most popular destinations for foreign direct investment, it has also attracted extensive discussion among scholars. The research in FDI has recently become the largest single academic research

Theoretical frameworks: determinants of FDI 33 8% North America 28%

50%

Asia Pacific European Union Other

14%

Figure 3.1 Percentage share in source of investment in R&D by MNCs, 2002–2005 Source: Bruche (2009, 274) (adapted from Huggins et al. 2007, 442)

6% 14% North America

22%

Asia Pacific European Union Other 58%

Figure 3.2 Percentage share in destination of investment in R&D by MNCs, 2002–2005 Source: Bruche (2009, 274) (adapted from Huggins et al. 2007, 442)

topic on China. It has been over 30 years since scholars started to research on explaining and understanding foreign investors’ activities in China (Chen 2011, 3–4). Among the research published from 1998 to 2006, about a quarter of it related to discussing the factors behind an entry decision into FDI made by the investing firms (Lau and Bruton 2008, 34–6). In describing and analyzing the determinants of FDI in China, scholars approached it primarily from five angles. 1.

National approach – scholars began with a nation-wide approach to understand the factors behind the choice of China, versus remaining in the home country or choosing other emerging markets like India or Vietnam as the target place for investments. Earlier work such as the working paper published by the Organisation for Economic Co-operation and Development (“OECD”) in December 2000 used this approach to understand the drivers behind FDI in China as a whole (OECD 2000).

34

Theoretical frameworks: determinants of FDI

2.

Regional approach – obviously given the diversity in regional development in China, analyzing investors’ activities in China as a whole may sometimes appear inadequate. More recently, scholars started to uncover the regional variance among provinces and cities in China with different levels of openness in FDI policies and markets. Researchers tried to understand the factors behind such differences in FDI inflow into different areas in China. Cheng and Kwan (2000) researched possible determinants for FDI in 29 regions in China and contended that large regional market size, good infrastructure, preferential policies, and wage cost affect the choice of region for investment by foreign investors. Fung et al. (2002) also found that regions with better infrastructure tend to be more attractive to FDI because logistical-related costs could be reduced. Chen (2011, chapter 5) found that provinces with higher GDP, higher per capita income, higher rate of economic growth, higher level of accumulated FDI stock, higher availability of telecommunications, and higher ratio of university student enrolment would attract more FDI inflow. In addition, increase in FDI in one region would have, as found by a spatial-economic study of Coughlin and Segev (2000), positive effects on FDI in neighboring provinces. Sectoral approach – not only can FDI patterns vary with different regions, they can differ in terms of different type of industries that investors enter into. For examples, patterns in the service industry varied from those in manufacturing; export-oriented businesses differed from the ones focusing on the domestic retail market. Ho (2007) studied 12 sectors in 1997–2002 in Guangdong at the regional level and China at a national level to examine the impact of labor productivity, labor wage, innovation level, and state-owned ratio (represented by the level of deregulation) and their effects on the choice of investors in terms of investment sectors. Ho found that at a nationwide level, labor productivity, labor wage, and innovation level influenced investors’ choice. At the Guangdong level, investors are more concerned with labor productivity, wage level, and the level of state ownership of the sector. Home country approach – some researchers also noticed the different investment patterns in China shown by investors from different home countries. Investors from Hong Kong, Taiwan, Japan, and the US are among the most popular research targets for scholars interested in this approach. Lin (2010) surveyed over 600 Taiwanese firms in 10 industries to understand their motives in investing in China. It was found that business network linkages, the expansion of local markets, and policy incentives were among the strongest factors in driving Taiwanese investors in their choice of investment location in China. Also focused on Taiwanese firms, a more recent research by Jean et al. (2011) found that ethnic ties impacted senior managers of firms in selecting regions for setting up plants and businesses in China. Comparative studies on home countries with different levels of economic development were conducted by Pan

3.

4.

Theoretical frameworks: determinants of FDI 35

5.

(2003). In the study, impacts of various factors in affecting investment patterns in China of 30 countries from 1984 to 1996 were examined. It was found that source country GDP has significant negative effects on FDI in China. The results tended to suggest that the smaller the size of the source country’s economy, the more likely its investors will invest in China. In addition, exchange rates, diplomatic ties, and geographic distance were not found to be playing important roles in predicting inflow patterns of FDI into China. Another piece of research, by Ali and Guo (2005), showed that market size mattered more for investors from the US while cost of production is the major concern for export-oriented Asian investors (including Hong Kong, Taiwan, Korea, and Japan) in determining investment location. For investors in highly developed economies such as the US, Du and Tao (2008) found in a survey of over 6,000 US firms that regions in China with better protection mechanisms in intellectual property rights and contract enforcement are more attractive. Institutional approach – recent research showed that scholars were also interested in understanding how soft infrastructures, such as policy incentives, legal reform, and education level, tended to impose higher influence than hard infrastructures (such as highways, land and natural resources, labor supply) in China in motivating investors. Fung et al. (2005) explicitly examined the difference between the effects of hard and soft institutional reforms in determining FDI in China. They cross-examined these reforms in affecting the investment decisions for investors from fours sources: Hong Kong, Japan, the US, and Taiwan. They found that soft infrastructure such as the level of share of SOEs in the regional economy, level of corruption, and policy transparency outperformed hard infrastructure such as highway and railway networks in affecting investment decisions.

Although these studies contributed considerably to the understanding of entry decisions of foreign investors in China, there are a number of gaps that scholars are yet to explore in full: Lau and Bruton (2008, 38–42) in reviewing what has been done in scholarly research in FDI in China for the past two decades, said that more work has to be done in understanding the factors that lead to success and failure in managing foreign invested firms in China beyond the issues of determinants on entry decision. In addition, the authors call for research that goes beyond the existing theoretical foundation originated in the West for studying FDI in China. Also, research concerning outward FDI in China and the comparison of FDI in China and other emerging economies are in general lacking. Before we move on to another popular theoretical aspect in FDI research – the effects of FDI – Table 3.1 below summarizes for easy reference the findings of recent research literatures (arranged in reverse chronological order in the areas of FDI determinants in China for the past decade). These findings have been published in selected academic journals in the field of international business, economics, and management studies.

Authors

Re-examining location antecedents and pace of foreign direct investment: Evidence from Taiwanese investments in China

Ching-I Chen and Ching-Hsuan Yeh

Institutions and Julan Du, Yi Lu, and FDI location Zhigang Tao choice: The role of cultural distances

Article title

Journal of Business Research, 65(8), 2012, pp. 1171–8

Journal of Asian Economics, 23(12), 2012, pp. 210–23

Source * The study compares the sensitivities of the location choice of FDI from six major source countries/areas (Hong Kong, Taiwan, US, EU, Japan, and Korea) toward the variation in the strength of economic institutions across China’s regions. The period 1993–2001 is used. * It also analyzes how cultural distance shapes the responses of different FDI source countries/areas to the variation in local institutions. * The study examines changes in the preference of Taiwanese listed fi rms in their location and pace of FDI by analyzing a total of 2,688 investments in China from 731 Taiwanese-listed fi rms (TLFs) during 1997–2007.

Objectives

Table 3.1 Recent literature on the determinants of FDI in China

* Infrastructure, labor cost, market size, and openness are important for early FDI. * Production efficiency, labor quality, and R&D capability are essential to later FDI. * Two antecedents, agglomeration and policy incentive, have consistent influence on location choice during the entire FDI process. * Greater FDI experience accelerates Taiwanese fi rms’ investment pace.

* It is found that FIEs from the source countries/areas that are culturally more remote from China often exhibit a stronger aversion to regions with weaker economic institutions. * This pattern is often more salient when FDI takes the form of fully-owned enterprises (WFOEs) than when it takes the form of joint ventures (JVs).

Findings

Asia Pacific Journal of Management, 28, 2011, pp. 325–52

* This study investigates the location choice behavior of fi rms originating in newly industrialized economies (Taiwanese fi rms) investing in emerging countries (China and Vietnam). It focuses on the attributes of these fi rms including their ownership advantage, degree of networking, network centrality, and investment motives. This model estimates how each attribute increases or decreases the chance that a given location will be chosen over other potential locations.

* This study found that: (1) firms with stronger ownership advantages prefer to invest in more developed than less developed locations; (2) firms occupying favorable positions in their network prefer to invest in more developed than less developed locations; (3) firms with a high degree of networking prefer to invest in less developed than more developed locations; (4) firms choose to invest in more developed than less developed locations to gain access to a large market; and (5) firms with strong resource-seeking motives prefer to invest in more developed than less developed locations to access their resources. * The study examines and differentiates * It is the combined effect of weighted location advantages and government the relative importance of the incentives that explains interprovince province-level FDI determinants to FDI inflow variations – better than different industries and also integrates the weighted location advantages or the varying FDI incentives from the government incentives individually. national and provincial governments.

International Business Review, 20(3), June 2011, pp. 338–52

Han-Sheng Lei and Yung-Shuan Chen

* Results show that ethnic ties of top managers matter in facilitating fi rms’ FDI location choice. * However, ethnic ties do not help much to improve fi rm performance in China.

* The study examines ethnic ties and their impact on FDI location choice and fi rm performance from the data of 88 Taiwanese business groups.

Ruey-Jer Bryan Jean, International Danchi Tan, and Rudolf Business R. Sinkovics Review, 20(6), December 2011, pp. 627–35

FDI distribution Deepak Sethi, William Q. Judge, and Qian Sun within China: An integrative conceptual framework for analyzing

Ethnic ties, location choice, and fi rm performance in foreign direct investment: A study of Taiwanese business groups’ FDI in China The right tree for the right bird: Location choice decision of Taiwanese fi rms’ FDI in China and Vietnam

* Network linkages, the expansion of markets and China’s incentive policies positively affect the intention to engage in FDI. * A fi rm with a higher degree of export orientation and larger fi rm size also has a strong effect on motivating FDI.

* Though China is a unitary nation with a uniform legal system, the institutions that contribute to a well-operating market economy (e.g., property rights protection and contract enforcement) can vary across provinces and influence an MNE’s location choice. * It is found that US MNCs prefer to invest in those regions that have better protection of intellectual property rights, lower degree of government intervention in business

* This study illustrates the factors that affect a fi rm’s intention to engage in FDI in China, using Taiwanese fi rms in the information technology sector as an example. * These factors are analyzed from the sample of 667 Taiwanese fi rms in 10 industries between 1996 and 2005. * The study examines the impacts of economic institutions, including property rights protection and contract enforcement, on the location choice of FDI. * A data set of 6,288 US multinationals investing in various China’s regions for the period of 1993–2001 is used.

Journal of Comparative Economics, 36(3), September 2008, pp. 412–29

* While the general-purpose incentives have been successful in attracting FDI, high-technology sector incentives have been relatively less effective in China.

Findings

Journal of Business Research, 63, 2010, pp. 479–85

Objectives

Feng-Jyh Lin The determinants of foreign direct investment in China: The case of Taiwanese fi rms in the IT industry Julan Du, Yi Lu, and Economic institutions and Zhigang Tao FDI location choice: Evidence from US multinationals in China

Source * The study further empirically analyzes the regional disparities of FDI across the manufacturing, information technology (IT), and extractive industry sectors within the 31 provinces of China during 1999–2006.

Authors

intra-country FDI variations

Article title

Table 3.1 (cont.)

Journal of Development Economics, 85, 2008, pp. 129–49

International Business Review, 16(2), April 2007, pp. 207–28

Transportation Research Part A, 41, 2007, pp. 597–609

Mary Amiti and Beata Smarzynska Javorcik

Xufei Ma and Andrew Delios

Junjie Hong

Trade costs and location of foreign fi rms in China

A new tale of two cities: Japanese FDIs in Shanghai and Beijing, 1979–2003

Transport and the location of foreign logistics fi rms: The Chinese experience

* This study examines the influence of transport and other factors on the location of foreign logistics fi rms across Chinese cities. 40 cities and 1,775 foreign logistics fi rms in these cities were studied, which take up more than 90 percent of all foreign logistics

* The study investigates how this variance in economic and political characteristics influences the timing of entry, entry mode, industrial traits, and survival rates for Japanese FDI made in China’s two major metropolises – Shanghai, the economic center, and Beijing, the political capital.

* This study examines the determinants of entry by investors, based on information on 515 Chinese industries at the provincial level during 1998–2001. The analysis is based on new economic focuses on market and supplier access within and outside the province of entry, as well as production and trade costs.

operations, lower level of government corruption, and better contract enforcement. * The fi ndings suggest that access to customers and suppliers of intermediate inputs are the key determinants of FDI inflows. * The result also shows that market and supplier access in the province of entry matters more than access to the rest of China. This may be due to the underdeveloped transport infrastructure and informal barriers to trade and is consistent with the fragmentation of the Chinese market. * Data from 1,610 subsidiaries of Japanese fi rms established during the 1979–2003 period, shows that Japanese MNCs tended to choose an economic-oriented rather than a political-oriented city as their investment location, with the consequence being higher survival likelihoods in Shanghai than in Beijing. * The location choice of foreign logistics fi rms depended on transport conditions in terms of roadway, railway, and waterway, as well as market size, labor quality, agglomeration economies, and government incentives.

Authors

Determinants of L.V. Na and W.S. foreign direct Lightfoot investment at the regional level in China

Article title

Table 3.1 (cont.)

Journal of Technology Management in China, 1(3), 2006, pp. 262–78

Source

Findings * The importance of transport was found to vary with some fi rm-specific characteristics. Provincial roadway transport was more important for independent logistics fi rms and overseas Chinese fi rms compared to their counterparts. New logistics companies were more concerned with roadway transport infrastructure than mature enterprises. * This study shows that GDP that proxies for the market size and growth potential is a big attraction for FDI. * Labor quality and the progress of reform or the degree of openness are also important determinants of the distribution of FDI. * There is some mild evidence that high labor cost deters the inflow of FDI and the level of infrastructure has positive relation to FDI.

Objectives establishments during the period (1992–2001) in China.

* This paper examines 5 potential determinants of FDI in 30 regions (including provinces, centrally controlled municipalities and semi-autonomous regions) of China. The specific focus is on 2002, which is the fi rst full year after China’s accession to the WTO. * It focuses on determining if there is a significant relationship between foreign direct investment at the regional level and market demand, infrastructure development and agglomeration, labor quality, labor cost, and the degree of industrialization and openness.

Japanese Economic Review, 56(4), December 2005

International Business Review, 14, December 2005, pp. 739–63

K.C. Fung, Alicia Hard or soft? Garcia-Herrero, Hitomi Institutional Iizaka, and Alan Siu reforms and infrastructure spending as determinants of foreign direct investment in China

The role of corporate governance in FDI decisions: Evidence from Taiwan

Yung-Chih Lien, Jenifer Piesse, Roger Strange, and Igor Filatotchev

Japan and the World Economy, 18(4), December 2006, pp. 512–27

Spatial John F. Cassidy determinants of and Bernadette Japanese FDI in Andreosso-O’Callaghan China

* The results show that tertiary education, inland waterways, as well as coastal location are positive and significant determinants of Japanese FDI in China. * China’s provincial GDP is not a significant determinant of Japanese FDI. * It is found that soft infrastructure outperforms hard infrastructure as a determinant of FDI, especially important for US and Japanese investors.

* This study examines whether hard infrastructure in the form of more highways and railroads or soft infrastructure in the form of more transparent institutions and deeper reforms lead to more FDI. * Data on FDI from the US, Japan, Hong Kong, Taiwan, and Korea to various regions of China from 1990 to 2002 are used. * Hard infrastructure is proxied by the density of railways and highways. * Soft infrastructure is proxied by the share of output accounted for by state-owned enterprises in each province in each year. A larger share should indicate worse soft institutions for FDI. * This study examines the effects of * Research results indicate that governance factors on the decision to family control and share ownership by domestic financial institutions in Taiwanese firms are associated with the decision to undertake FDI. It is also found that family control is positively associated with decisions to invest in

* The study examines the spatial determinants of Japanese direct investment in China.

Authors

Ting Gao Labor quality and the location of foreign direct investment: Evidence from China

Determinants of Shaukat Ali and Wei FDI in China Guo

Article title

Table 3.1 (cont.) Objectives

China Economic Review, 16(3), 2005, pp. 274–92

* This study is concerned with the previous evidence that labor quality is insignificant in explaining the regional distribution of FDI in China. * The study uses data in 21 Chinese provinces and 14 source countries covering the 4-year period of 1996–1999.

undertake FDI . These factors include (1) the extent of family control, (2) the presence of domestic and foreign institutional shareholders and (3) the composition of the board of directors. * Data have been collected for a sample of 228 companies listed on Taiwan stock exchange between 1995 and 1999. Journal * This paper examines likely of Global determinants of FDI in China by Business and analyzing responses from 22 fi rms Technology, operating in China to look for the 1(2), Fall 2005 important motivations for them to undertake FDI.

Source

* The evidence in this paper indicates that the location of FDI from developed economies such as the US and Japan is more sensitive to labor quality than FDI from Asian developing economies. (such as Hong

* Results show that market size is a major factor for FDI especially for the US investors. For export-orientated Asian fi rms, low labor costs are the main driver. Government incentive policies and global integration are other important reasons for undertaking FDI for these fi rms. * Labor quality plays a significant and positive role in attracting FDI. This is in contrast to the empirical results in Cheng and Kwan (2000) which showed no significant FDI effect of labor quality.

China, whereas state and institutional share ownership is positively associated with FDI in the rest of the world.

Findings

Journal of Business Research, 56, 2003, pp. 835–45

China Economic Review, 14, 2003, pp. 304–15

FDI location at Qiu Chadee, Feng Qiu, the subnational and Elizabeth L. Rose level: A study of EJVs in China

Japanese direct investment in China

K.C. Fung, Hitomi Iizaka, and Alan Siu

Journal of Business Research, 56, 2003, pp. 829–33

Yigang Pan The inflow of foreign direct investment to China: The impact of country-specific factors

Kong, Macau, Taiwan, South Korea, Thailand and Singapore) * Exchange rate is not a significant * This study examines the impacts of determinant for FDI inflow in China. source and host country factors (such * Source country GDP has a as exchange rate, geographic distrance and GDP level) on the inflow of FDI into significant impact on FDI in China, but a negative one, i.e., the smaller the China between 1984 and 1996. size of source country, the more FDI * Data on FDI into China from 30 in China it tends to have. countries, between 1984 and 1996, are * Diplomatic ties and geographic used to investigate this issue. distance does not play a significant role in predicting the inflow of FDI into China. * The results show that the duration * This paper adds to the literature on of the EJV agreement, the origin of MNEs’ location choices, focusing on how business characteristics are related the foreign investor, and the type of business activity are related to to location, using a sample of 6,430 the location of the EJVs’ business foreign equity joint ventures (EJVs) in activities within China. China during 1984–1996. * Firm characteristics being studied include country of origin, manufacturing vs. service orientation, foreign equity ownership, contract duration, size of investment, and investment timing. The fi ndings show that: * This paper uses survey data to study * Local demands affect significantly the characteristics of Japanese direct the inflow of investment from both investment in China as compared sources. to those in the newly industrializing economies and in the member countries * Wage costs exert a larger influence on Hong Kong investment than on of ASEAN. Japanese investment.

Journal of Comparative Economics, 30, 2002, pp. 567–78

K.C. Fung, Hitomi Iizaka, and Stephen Parker

Determinants of US and Japanese direct investment in China

Source

Asia Pacific Journal of Management, 19, 2002, pp. 63–86

Authors

Changhui Zhou, Andrew Locational determinants of Delios, and Yang Jing Yu Japanese foreign direct investment in China

Article title

Table 3.1 (cont.)

* This paper uses regional panel data between the years 1991 and 1997 to investigate the relative importance of the determinants of US and Japanese direct investment in China, then the estimated results are studied in comparison with

* This study examines 2,933 cases of Japanese investment in 27 provinces and regions in China to identify the role that policy determinants in influencing location choice of Japanese fi rms in China.

* Japanese fi rms appear to be attracted to Economic and Technology Development Zones, whereas Hong Kong fi rms are more attracted to Special Economic Zones and Open Coastal Cities.

* This paper also examines the determinants of Japanese direct investment in China using a regional data set from 1990 to 2000, compared with other source investors such as Hong Kong.

* The quality of infrastructure matters more for Hong Kong investors than Japanese investors. * The results show that the Special Economic Zones (SEZs) and Open Coastal Cities (OCCs) policies had a stronger influence on Japanese FDI in China during the early years than after the mid-1990s when competition from other special investment zones has intensified. * On top of policy incentives, Japanese FDI in China was also sensitive to infrastructure development of a location such as highway and railway networks. * Findings show that the level of local GDP significantly affect the inflow of investment from both sources. * Policy variables are also found to have significant positive effects on investment.

Findings

Objectives

* Labor quality exerts a larger influence on Japanese investment than on US investment. Kevin Zhang Contemporary * This article assesses effects of location * The results indicate that China’s What attracts characteristics and government policies huge market size and liberalized FDI Economic foreign on FDI inflow in 29 provinces of China regime are main drivers of FDI boom Policy, multinational in China. during 1987–1998. It focuses on labor 19(3), 2001, corporations to * The regional distribution of FDI quality, market size, labor costs, and pp. 336–46 China? within China is influenced largely by infrastructure conditions. FDI incentives, historical-cultural links with foreign investors, and regional economic difference. Leonard K. Cheng and International * The present paper examines the effects * The results show that that large What are the Journal of of various determinants to FDI in China regional market, good infrastructure, determinants of Yum K. Kwan Economics, by analyzing data from 29 regions in and preferential policy had a positive the location of 51, 2000, China from 1985 to 1995. effect but wage cost had a negative foreign direct pp. 379–400 effect on FDI. investment? * The effect of education was positive The Chinese but not statistically significant. In experience addition, there was also a strong self-reinforcing effect of FDI on itself. It is found that: * This paper examines how very large Joint venture Yigang Pan and Xiaolian Journal of * Large foreign fi rms such as Fortune formation Li International MNCs differ from smaller fi rms in 500 corporations have higher equity structuring their EJVs in China. of very large Business shares in EJVs than small foreign fi rms * Empirical testing is conducted based multinational Studies, in China. Large foreign fi rms are more on a sample of 1,298 EJVs in China fi rms 31(1), 2000, likely to team up with another foreign during the period from 1981 to 1998. pp. 179–89 fi rm in EJV than small foreign fi rms in China. They are also less affected by the risk conditions in China than small foreign fi rms, and are more likely than

the determinants of investments from Taiwan and Hong Kong.

Authors

The location of foreign insurance companies in China

Journal of International Business Studies, 31(4), 2000, pp. 535–54

Source

Xiaohong Wu and Roger International Strange Business Review, 9(3), 2000, pp. 383–98

The hierarchical Yigang Pan and David model of market K. Tse entry modes

Article title

Table 3.1 (cont.) Findings

small foreign fi rms to invest in global industries and in large-scale EJVs in China. * The choice of entry modes can be * This study examines the factors behind the choice of entry mode for FDI a hierarchical process that starts with a decision between equity and in China. Entry modes are viewed as non-equity modes. At this level, equity-based versus non-equity-based. macro-level factors such as country Within equity-based modes the choice risks often play a role. Once fi rms is between wholly owned operations decide on equity or non-equity modes and equity joint ventures, while within managers would focus on more non-equity-based models the choice is micro-level factors, such as specific between contractual agreements and contract terms, human resources export. issues, distribution channel and so on. * The data used are a sample of over 10,000 foreign entry activities into China from 1979 to 1998. * This paper assesses the determinants *The fi ndings show that proximity to the headquarters of the regulatory of location choice of representative authority, openness for the award of offices of foreign insurance companies operating licenses, current and future based on a sample of 138 foreign market demand, and the presence of representative offices established over other foreign investment are all found the period 1992–1996. to have significant effects upon the choice of location. * Cost and infrastructure considerations were generally found to be of little significance.

Objectives

Cletus C. Coughlin and Foreign direct Eran Segev investment in China: A spatial econometric study World Economy, 23(1), 2000, pp. 1–23

* This paper explores the effects of FDI in one region as a determinant of FDI inflow of another/neighboring region/ province.

* Increased FDI in a province has positive effects on FDI in nearby provinces. * Authors argue for the reasons for this phenomenon, known as spatial dependence. One reason for spatial dependence is that by raising resource costs in a province, FDI may make the cost structure in neighboring provinces relatively more desirable.

48

Theoretical frameworks: determinants of FDI

Further reading Chen, Chunlai. 2011. Foreign direct investment in China: Location determinants, investor differences and economic impacts. Cheltenham; Northampton, MA: Edward Elgar, chapters 3–5. Dunning, John. 1977. “Trade, location of economic activity and the MNE: A search for an eclectic approach.” In The international allocation of economic activity, edited by B. Ohlin, P.O. Hesslborn and P.M. Wijkman, 395–418. London: Macmillan. Dunning, John. 1979. “Explaining changing patterns of international production: In defence of the eclectic theory.” Oxford Bulletin of Economics and Statistics 41: 269–95. Dunning, John. 1988. “The eclectic paradigm of international production: A restatement and some possible extensions.” Journal of International Business Studies 19: 1–31. Fung, K.C., Hitomi Iizaka, and Stephen Parker. 2002. “Determinants of US and Japanese direct investment in China.” Journal of Comparative Economics 30: 567–78. Hymer, Stephen. 1976 (1960 Ph.D. thesis). The international operations of national firms: A study of direct foreign investment. Cambridge, MA: MIP Press. Moosa, Imad. 2002. Foreign direct investment. Hampshire and New York: Palgrave, chapter 2. Vernon, Raymond. 1966. “International investment and international trade in the product cycle.” Quarterly Journal of Economics 80: 190 –207. Vernon, Raymond. 1979. ‘The product cycle hypothesis in a new international environment.’ Oxford Bulletin of Economics and Statistics 41: 256 –67.

4

Introducing theoretical frameworks Effects of FDI

Another major theoretical interest of researchers is to explore and analyze the effects of foreign direct investment. There are studies that focus on understanding the effects to the home market when business fi rms start to invest abroad as multinational corporations. For the purpose of this book, I am more concerned with the effects on the host country, i.e., the country where FDI took place. There is an abundant source of scholarship that supports the activities of FDI by revealing that FDI causes positive effects to the host countries. Here are some of the common areas relating to the effects of FDI to the host countries that scholars are interested in:1 • • • • •

FDI and economic output of the host country; FDI and employment and wages level of the host country; FDI and cultural change; FDI and spillovers in technology to the host country; and FDI and linkages in trade/export volumes of the host country.

This chapter will briefly explain the arguments and counter arguments for these effects brought by foreign direct investment to the host country as well as how the effects of FDI in China have been analyzed by recent research.

FDI and economic output FDI brings technology, capital, and operation skills into the host country. Therefore, conventional scholarly research tended to show that there is a positive co-relationship between the increase in foreign direct investment and the increase of economic output or, to put it simply, the GDP growth, of the host country (Dunning 1977, 1993; Kindleberger 1969; Lall and Streeten 1977). Typical arguments that support FDI include: FDI utilizes surplus resources (such as labor, land, raw materials) of a country for productions, thus enhancing the overall productivity. However, recent research challenged this view and placed conditions upon which such

50

Theoretical frameworks: effects of FDI

positive co-relationship can exist or sustain. These conditions include whether the investors are able to utilize existing resources of the host country with higher productivity. If the investors utilize existing resources with lower productivity than that of the local enterprises, it will not only crowd out the investment opportunities of the local entrepreneurs but also adversely affect the economic output of the host country. If the investors utilize unused or underutilized resources of the host country, FDI can help the economic growth of the host country (Moosa 2002, 68–74; Winters 1991). The effectiveness of enhancement of economic growth by FDI also depends on the degree of complementarity and substitutability between FDI and domestic investment. If MNCs invest in the sector where local investors could have done with similar productivity, the positive effects of the FDI to the local economic growth will be reduced (De Mello 1999). The effects on economic growth also depend on the level of repatriation of capital by investors. The more the investor retains its earnings made in the invested business and continues to reinvest its surplus for further capital expenditure, the more the FDI can contribute to the overall economic output of the host country. Despite the fact that more than 12 percent of the total growth of China during 1986 to 2005 was contributed by FDI (Chen 2011, 231), evidence on China also showed divergent results with respect to the effects of FDI on economic growth, especially when regional analysis was carried out by scholars. While considerable empirical evidence was provided by researchers to support the argument that FDI supports trade, export, and economic growth of China (Buckley et al. 2002; Chen 2000; Zhang 1999), other recent research shows that the level of such effect depends on a number of conditions. These conditions are the level of infrastructure, level of research and development activities, level of human capital stock, as well as the level of economic interaction with the world (Chen 2011). Accordingly, choice of sectors for FDI is very important for a government when it formulates its FDI laws and policies. If a sector where foreign investors are not able to tap into underutilized resources is chosen, or where local economy is not able to receive or absorb foreign skills and technology, or where foreign investment is substituting local investment, the effects for increasing overall economic output will be adversely impacted.

FDI and employment Proponents for liberalization of FDI markets in developing economies contend that FDI will benefit the host economy by, among others, increasing jobs in the employment market and increasing wage level. Researchers on FDI in China also support the positive effects of FDI in creating employment in China, especially when absolute figures on jobs directly created by foreign investors were examined (Kang and Chao 2005, 27–48). Chen (2011, 210–17) found that by the end of 2008, foreign invested firms employed one-third of the manufacturing labor force in China. However, other recent research

Theoretical frameworks: effects of FDI 51 also showed that the degree of benefits to the local job market depends on, among other factors, the modes of entry of investors and the sectors in which FDI is involved. Some of these factors include: •

•

•

•

•

What location advantages is the investor looking for? Are the investors looking for domestic market, cheap labor force, cheaper land cost, or natural resources? If the investors invested in the host country simply for an access to raw materials, the job creation effect will be less conspicuous than those looking for labor force. Mergers and acquisitions versus greenfield project? Greenfield project refers to the fact that an investor invests in an FDI project by starting a new project from scratch. That means new capital will have to be invested in the host country so that new plants can be built, new offices set up, a management team recruited, and a manual labor force hired. In this process, new jobs will be created. In the case of FDI by way of mergers and acquisitions of existing business in the host country, the whole or partial amount of the new capital invested by the foreign investors will be used for paying the purchase price of the existing shareholding of local partners, instead of building new plants, purchasing machineries, or investing in human resources. Moreover, after acquisition or mergers, retrenchment of redundancy could take place that might even reduce existing jobs. Automation replacing manual labor? From a job-creation point of view, local manufacturers with lesser capital and lower technological capability have to use more manual labor and fewer machines in the production process. Foreign investors, instead of putting money to create more jobs, may use high-technology machinery to replace the manual labor force in the industrial process. If this is the case, mechanicalization of industry can reduce jobs in the sector. FDI creating services along value chains? How many jobs can be created by FDI also depends on which sector in which the FDI is involved. An export-oriented business in highly mechanicalized production where most of the key machinery was imported and most of the processes are mechanicalized, will create fewer jobs as compared with low-end, labor-intensive industry targeted for domestic markets, which could create jobs not only within the firm, but also jobs for related suppliers, distributor, and logistics markets along the value chain. Skilled versus unskilled labor? Despite increase in absolute job number, Li and Luo (2008) drew from the experience of Taiwan and South Korea to conclude that FDI created jobs in different patterns in various stages of economic development from the 1960s to the 1990s in these two countries. The income gap widened and the unemployment rate rose when the rapid growth of manufacturing sector slowed down. Driffield and Taylor (2000) used the case of FDI in the UK to illustrate that FDI had contributed to increasing wage inequality and the use of more skilled

52

Theoretical frameworks: effects of FDI labor relative to unskilled workers. Therefore, one possible consequence for FDI is the widening of wage inequality, mostly at the expense of the less skilled labor force.

FDI and technology spillovers Spillover takes place when the technology brought in by investors is transferred to or learned by local enterprises and business community, without a contractual relationship (Meyer 2004). Despite intensive debates over the factors that may affect the occurrence of technological spillovers, the majority of empirical findings are in favor of the positive effects of technology spillovers from FDI (Ho 2007; Tian 2007); the same is supported by the studies of technology spillover effects of FDI in China (Cheung and Lin 2004; Liu 2002).2 Spillovers may take place due to a number of processes after the technology has been introduced through FDI to the foreign invested firm in the host country. These processes were summarized by Görg and Strobl (2001, 723) into three categories: • •

•

Staff movement effected spillovers – technology could be brought into another business together with the departing managers or technicians. Demonstration effected spillovers – technology could be learned along the value chain by suppliers, competitors, or customers during the course of provision of goods and services. Competition effected spillovers – competition from MNCs may force local fi rms to upgrade their technology and management processes by learning from the foreign competitors.

Conventional views supported that FDI is beneficial to the rise in productivity of the local firms through technology spillovers. Supporters are of the view that local businesses will benefit from learning higher technology and know-how which they would not have had the chance to learn without FDI. However, spillover effects were also doubted recently by some scholars; the key challenges being the difficulty and barriers for technology to be learned and imitated. Successful spillovers depend on local circumstances and a number of external factors (Chen 2011, 232–48; Ho 2007, 67–98; Moosa 2002, 86–90; Tian 2007). Most of these factors relate to the inability to absorb the advanced technology brought in by the investors. The inability to absorb the technology may be caused by a number of reasons: • • •

Technology may require special resource inputs that are not available locally, for example, precious metals or advanced machinery. Technology may require a certain education level to learn, which the local businessmen or technicians in general have not yet reached. Technology produces products for higher-income countries. Most of the products produced by foreign invested enterprises do not enter into

Theoretical frameworks: effects of FDI 53

•

the domestic market. Therefore the technology used in production is not applicable for production of products that can suit the demand of the host country. Deployment of technology may be capital intensive. Even if local industrialists have learned how to compose the products, the fact that the composition process requires expensive machinery imported from overseas makes the technology less employable in the host market.

Effects of technology spillovers can also relate to the degree of competition in the local market. The higher the local competition is, there is a higher chance that technology will be spilled over to local businesses. The more intense the competition is, there are more incentives for local businessmen to survive the competition by imitating the design and quality of goods produced by foreign enterprises, which presumably are of a higher quality. Spillover can also be a function of technology gap between the foreign invested fi rms and the local players. Findlay (1978) found that technology spillovers tend to occur when the gap in technology in production between local players and investors is large. That means the larger the gradient in technology is, the more likely the technology will be spilled over to the local economy. Yet, other recent researchers found that if the gap has become very large, spillover is less likely to occur (Tian 2007). Given all of the local circumstances, there is regional difference in terms of the degree of positive spillover effects observed in different regions in China. Cheung and Lin (2004) studied the relative extent of technology spillovers through analysis of 26 provinces and 4 municipalities from 1995 to 2000. Western areas of China tended to be relatively more prone to technology spillovers. The effect looked less strong in coastal regions. Ho (2007, 67–98) also found that western regions experienced a greater degree of technology spillovers from FDI than municipal cities. Spillover effects also vary in relation to the level of FDI. Chen (2011, 237–48) found that FDI has significant positive spillovers on local fi rms’ productivity in China’s manufacturing sector. The marginal positive effect, however, decreases and becomes negative as the share of FDI increases. On top of understanding how technology spillovers occurred, researchers are also interested in knowing how the investors fi nd ways to avoid spillovers of the proprietary technology brought from the home country. Murray et al. (2005) tried to understand the efforts to avoid spillovers taken by different kinds of fi rms. Research with close to 500 foreign invested fi rms in China shows that foreign fi rms took different strategies in tackling the risk of possible technology spillovers. Firms with a lower level of product innovativeness tended to rely on alliance suppliers for sourcing major components. Firms with a higher level of product innovativeness tended to rely less on suppliers for sourcing components to minimize risk of spillovers of technology to suppliers and competitions.

54

Theoretical frameworks: effects of FDI 70 60 50 40 30 20 10 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2007 2009 2010

0

Figure 4.1 Percent share of FDI in China’s total exports, 1986–2010 Source: Ministry of Commerce of PRC, Statistics on FDI in China 2011

FDI and cultural change FDI was also found to have a relationship with the working culture of the foreign invested firms or the local business community. Jiang et al. (2011) studied the effects of culture, firm size, and firm age over Chinese senior executives’ trust in their foreign partners. Over a hundred managers were interviewed. It was found that trust relationship within FIEs related not only to cultural similarity but also to firm-level characteristics. The paper shows that overseas partners of the same cultural ethnicity with the local executives are advantaged in the trust relationship with Chinese partners. It was also found that firm size had negative relationship to the trust level among Chinese executives and foreign partners, i.e., trust level declines as the firm size increases. Jiang et al. (2010) studied the change in firm culture by FDI. Firms in 42 major cities in the period 1999–2004 were studied. Five cultural dimensions, namely, assertiveness, human orientation, future orientation, performance orientation, and in-group collectivism were studied. It was found that FDI had significant impact on the degree of future orientation, performance orientation, and in-group collectivism. More interestingly, it shows that FDI from the US and the UK had a significant negative effect on the degree of assertiveness of the investee firm. FDI from Japan and Singapore positively affected the firm’s degree of in-group collectivism. Meanings of the cultural dimensions used in this research are described in Table 4.1.

FDI and trade linkages Considerable studies pointed to the view that FDI has positive effects on the trade volume of the host countries. China is a popular target for the studies about the positive linkage between FDI and international trade (Lardy 1995; Liu et al. 2001; Sun and Parikh 2001). Foreign investors’ shares in China’s total exports rose from less than 2 percent in 1986 to close to 55 percent in 2010 (see Figure 4.1). Nevertheless, there are factors that can affect the

Source

Journal of International Business Studies, 42, 2011, pp. 1150–73

Authors

Crystal X. Jiang, Roy Y.J. Chua, Masaaki Kotabe, and Janet Y. Murray

Article title

Effects of cultural ethnicity, fi rm size, and fi rm age on senior executives’ trust in their overseas business partners: Evidence from China

Findings * Trust relationships between Chinese executives and their overseas partners depend not only on the degree of cultural similarity but also on fi rmlevel characteristics: 1. The relationship between affect-based and cognition-based trust is positive and significant. 2. When the overseas partners are from the same cultural ethnicity, the Chinese executives’ cognition-based trust was more strongly associated with affect-based trust. 3. When the overseas partners are from different cultural ethnicity, the Chinese executives’ affectbased trust had a stronger association with cognition-based trust. 4. Firm size had a significant negative effect on cognition-based trust for overseas partners of different cultural ethnicity than those of the same cultural ethnicity.

Methodology * The authors investigate the effects of culture, fi rm size, and fi rm age on Chinese senior executives’ trust in their overseas business partners in the Chinese market. A total of 108 Chinese senior executives (i.e., presidents, CEOs/COOs/VPs) participated in the face-to-face interviews to conduct the survey. Each of the participants was required to name two senior executives at overseas partner fi rms; one of them was of Chinese ethnicity and the other was of non-Chinese ethnicity. The overseas partners selected by the participants could be either consumers, suppliers, or joint business collaborators who had helped the Chinese companies generate the largest sales in the period of 2003–2006. * The authors divide trust into cognition- and affect-based trust. Cognition-based trust refers to one’s judgment of another person’s technical competency and reliability. Affect-based trust refers to one’s care and concern

Table 4.1 Recent literature on the effects of FDI in China

Authors

Kai Li, Dale Griffi n, Heng Yue, and Longkai Zhao

Article title

National culture and capital structure decisions: Evidence from foreign joint ventures in China

Table 4.1 (cont.)

Journal of International Business Studies, 42, 2011, pp. 477–503

Source for the other party’s welfare and interests, and in the belief that these caring sentiments will be reciprocated (McAllister 1995). * The authors ran two models to test how various characteristics of the foreign joint venture fi rms and culture of the foreign joint venture fi rms’ countries affect the use of debt/leverage in the joint venture. The authors defi ne national culture as having a value of either “Mastery” or “Embeddedness.” Mastery encourages exerting control over one’s environment/fi rm strategy and emphasizes individual success. Embeddedness describes a culture where a person is looked upon as an entity embedded in the collectivity, where emphasis is put on maintaining the status quo and restraint actions that might disrupt the solidarity of a group or the existing order.

Methodology

* The simple regression model shows that the foreign fi rm’s size and asset maturity as well as the level of foreign ownership are positively correlated with the leverage in the joint venture. However, a higher profitability, asset tangibility, and industry concentration in the foreign fi rm typically results in lower leverage in the joint venture. * The main fi nding from the HLM model is that when foreign fi rms’ countries exhibit a stronger culture of Mastery, the joint ventures will typically have less leverage and less short-term debt, but the joint venture is more likely to have long-term debt (instead of short-term debt). This implies that fi rms from these countries tend to have a fi nancing preference of equity fi rst, then long-term debt, and fi nally short-term debt as a last option. Foreign fi rms from countries with a higher level of a Mastery culture also tend to choose smaller joint venture partners, less concentrated industries and regions with rapid economic growth when they start a joint venture in China.

Findings

Foreign direct investment and environmental pollution in China: A simultaneous equations estimation

Qun Bao, Yuanyuan Chen, and Ligang Song

Environment and Development Economics, 16, 2010, pp. 71–92

* The authors estimate how FDI has affected emissions of 5 main pollutants in China over the period 1992–2004. An extensive panel data set of 29 provinces has been used in the estimation. The authors start out by decomposing the pollutant emissions of FDI into 3 effects: the scale effect (1), the composition effect (2), and the technique effect (3). The scale effect reflects that FDI can enlarge the local output and hence use more resources and emit more pollutants. The composition effect reflects that foreign fi rms may affect China’s industrial composition (e.g., capital-labor ratio) and hence the pollution intensity. The technique effect reflects that foreign fi rms may introduce more environmentally friendly techniques and create efficiency spillover effects to local fi rms.

* The level of Embeddedness cultural value in the foreign country has no significant direct effect on the leverage in the joint venture. The research did however show that fi rms from foreign countries high on Embeddedness tend to choose regions with higher levels of institutional development for their investment. * The main fi nding is that FDI helps reduce pollution emissions in China in general. Though the scale effect and composition effect of the FDI generally increase the pollution, the technique effect more than outweighs these effects in the opposite direction. In other words, FDI helps reduce the pollution emission intensity per unit of industrial output. The study also shows the importance of the indirect effects of FDI on emissions. The indirect effects, which are caused by raising the capital-labor ratio and speeding up the economic growth, also significantly contribute to FDI’s environment protection.

Authors

FDI and the change of the Lu Jiang, Chinese culture Qiangbing Chen, and Yali Liu

Article title

Table 4.1 (cont.)

International Journal of Social Economics, 37(2), 2010, pp. 101–18

Source

Findings * FDI has significant impact on Chinese culture, especially in the degree of future orientation, performance orientation, and in-group collectivism. In addition, the paper shows that FDI from the US and the UK has a significant and negative effect on the degree of assertiveness; FDI from Japan, Singapore, the US, and the UK has significantly negative effects on the degree of performance orientation; FDI from Japan and Singapore has a significantly positive effect on the degree of in-group collectivism.

Methodology * The authors use statistical models to test whether FDI has a significant effect on Chinese culture. Further, they investigate whether FDI from a different cultural source has different impacts on Chinese culture. Data on 42 major cities in China in the period of 1999–2004 are collected. The authors use a 5-dimension approach to measure culture values. The 5 cultural dimensions are assertiveness, human orientation, future orientation, performance orientation, and ingroup collectivism. 1) Assertiveness refers to the degree to which people are aggressive, confrontational, and assertive in their relationship with others. The authors believe a lawsuit case is a relevant indicator of the degree of assertiveness, so they use civil lawsuit cases per 10,000 residents to represent the degree of assertiveness.

2) Human orientation refers to the degree to which a collective encourages individuals to be fair, generous, caring, and kind to others. The authors select donation-to-disposable personal income ratio to represent the degree of human orientation. 3) Future orientation is the degree to which individuals engage in future-oriented behavior such as planning and investment in the future. The authors select saving deposit-income ratio to represent the degree of future orientation. 4) Performance orientation is the extent to which a collective encourages group members to performance improvement and excellence. The authors believe in a high-performanceorientation society; people may draw more attention to economic development than environment quality. Hence they select pollution control investment to represent the degree of performance orientation.

Authors

Spillovers and Sea Jin competition among Chang and foreign and local fi rms in Dean Xu China

Article title

Table 4.1 (cont.)

Strategic Management Journal, 29, 2008, pp. 495–518

Source 5) In-group collectivism refers to the degree to which individuals express pride, loyalty, and cohesiveness in their organizations or families. The authors use the average household size as an indicator of the degree of in-group collectivism. * The authors examine the spillover and competition effects in China between local fi rms and FIEs, among FIEs, and among local fi rms, based on data of more than 200,000 fi rms including FIEs both HMT (HK, Macao, and Taiwan) foreign fi rms and non-HMT foreign fi rms, and local fi rms (both conventional and reformed fi rms) during 1998–2005. * Spillover effects here refer to the positive impact of FDI on local fi rms and other FIEs. The presence of FIEs enhances the local fi rms’ and other FIEs’ chances of survival. Competition effects refer to the negative impact of FDI on local fi rms and other FIEs, which decreases the other fi rms’ chances of survival.

Methodology

* The positive spillover effects of FDI are evident on all local firms including conventional and reformed local firms, from both HMT and nonHMT foreign firms in the national market. In a regional market, the competition effects are more likely to be stronger than the positive spillover effects, while the positive spillover effects are more likely to be stronger than the competitor effects in the national market. It is because the competition among FIEs and local firms is more intense in the regional level than in the national level. * In addition, HMT firms pose greater threats to local firms’ survival than non-HMT foreign firms do because HMT firms have the advantages of both local resources and transferable assets to compete with local firms. In contrast, nonHMT foreign firms have transferable assets but limited local resources to compete with local firms, compared to HMT firms. Local resources include marketing and distribution channels, access to information and network connections. Transferable assets refer to advanced technologies, brand names, and managerial know-how.

Findings

The effect of foreign direct investment on domestic capital formation, trade, and economic growth in a transition economy: Evidence from China

Gang Xu Global and Ruifang Economy Wang Journal, 7(2), 2007, pp. 1–22

* The authors ran four independent regression models to estimate how FDI affects: (1) domestic investments; (2) economic growth in China; (3) Chinese exports; and (4) Chinese imports respectively. The models look at ratios. Two regression models are run separately for 1980s and for the 1990s as FDI in the two decades had different characteristics. Low levels of FDI concentrating on importing goods to China, refi ning the goods, and then exporting them out again characterized the 1980s. The FDI levels were much higher in the 1990s with a greater focus on technology and production.

* The regressions show that the FDI had the following effects: 1. Domestic investments: for the 1990s the FDI resulted in a statistically significant increase in domestic investments, in other words it had a pulling-in instead of a crowding-out effect. No statistically significant results were reached for the 1980s, probably due to the low level of FDI at the time. 2. Economic growth: investments in fi xed assets led to an increase in China’s GDP in both decades. Part of these investments was FDI. The ratio of FDI to domestically fi nanced investments only had a statistically significant positive effect on GDP for the 1990s, which means that this is the fi rst decade where China really benefited from the transfer of technology and knowledge spillovers from FDI. 3. Exports: the model shows that FDI led to increased exports from China in both decades. The effect was much stronger in the 1980s, which is likely a result of the FDI characteristics for that decade. In the 1990s the devaluation of the Yuan versus the USD also led to increased exports. 4. Imports: FDI led to increased imports to China in both decades, but most strongly in the 1980s.

Li Dong and Asia Pacific Keith W. Journal Glaister Management, 24, 2007, pp. 191–205

National and corporate culture differences in international strategic alliances: Perceptions of Chinese partners

Source

Authors

Article title

Table 4.1 (cont.)

* The authors investigate how Chinese partners experience national and corporate culture differences in international strategic alliances (ISAs). They tested the following three hypotheses: 1. From the perspective of Chinese partners, national culture differences will be a more important factor contributing to different views between Chinese and foreign managers on the management of ISAs compared with corporate culture differences. 2. Two subhypotheses: a. From the perspective of Chinese partners, the perception and effects of national culture differences will be less in older ISAs than in younger ISAs in China. b. From the perspective of Chinese partners, the perception and effects of corporate culture differences will be less in older ISAs than in younger ISAs in China.

Methodology

* 1) Hypothesis 1: Overall the authors did not find any significant evidence to support this hypothesis. Their analysis did however indicate that national and corporate culture might have slightly different impacts on certain aspects of the management and outcomes of ISAs. For instance, there is likely a stronger link between national culture and language barriers, and between corporate culture and effective learning between the partners. 2) Hypothesis 2 a. In general, the perception of national culture differences was less problematic for managing older alliances. b. Corporate culture differences appeared to be significantly less of an issue for the older alliances than the newer ones, providing support for hypothesis 2b. 3) Strong support was also found for hypothesis 3. Because equity-based structure binds the partners together and gives them more incentives to smooth out differences and maintain the cooperation.

Findings

Productivity spillovers from R&D, exports and FDI in China’s manufacturing sector

Y. Wei and X. Liu

Journal of International Business Studies, 37, 2006, pp. 544–57

3. In the perception of Chinese partners, national and corporate culture-related impediments to the management of ISAs are greater in non-equity-based SAs than in equity-based SAs. To test the hypotheses, the authors tested for correlations between factors in a questionnaire answered by 238 Chinese partners. * The authors assess productivity spillovers from FIEs to local Chinese firms from three channels, i.e., R&D, exports, and FDI in China’s manufacturing sector based on the data of over 10,000 local and FIEs during 1998–2001. Inter- and intraindustry as well as inter- and intra-region are measured for the spillover effects. If the spillover effects are received by the firms in the same region, spillovers are regarded as local in scale (i.e., intra-region); if the spillovers benefit the firms in other regions, the spillover effects are national (i.e., interregional). In addition to the difference between local and national spillovers in geographical scale. The study also looks at intra- and interindustry spillovers.

* There are positive interindustry spillovers from R&D and exports. Positive intra- and interindustry spillover effects from FDI to local Chinese fi rms are significant within regions. Non-HMT foreign fi rms play a much greater role in interindustry spillovers than HMT fi rms within regions. The fact that the spillover effects are confi ned within region is probably because of regional protection in China.

Authors

Julie Juan Li

Article title

The formation of managerial networks of foreign fi rms in China: The effects of strategic orientations

Table 4.1 (cont.)

Asia Pacific Journal of Management, 22, 2005 pp. 423–43

Source Intra-industry spillovers refer to horizontal spillovers that the benefit receivers are in the same industries. Interindustry spillovers are regarded as horizontal spillovers that the benefit receivers are in other industries. * The author investigates how FIEs’ strategic orientations (i.e., market, technology, and entrepreneurship-oriented strategy) adopted in the Chinese market influence the formation of their two managerial networks (i.e., top managers’ ties with government officers and the business community), and further how managerial networking affects FIEs’ performance in China based on the interview of 181 fi rms located in Shanghai, Guangzhou and Beijing.

Methodology

* Managers of FIEs at market-oriented firms develop relationship with both government officials and managers at other firms. Building close relationship with government officials enables FIEs to gain critical information which is controlled by the government, or permission to enter the market; developing close ties with managers at other firms enables FIEs to get important market information to better serve their target customers. * Comparing to building ties with government officers, managers of FIEs at technologyoriented fi rms are more likely to establish close relationship with managers at other fi rms which provide important support with R&D and exchange of technology. * Managers at entrepreneurship-oriented fi rms are more likely to build ties with government officers because these FIEs depend on the

Findings

Spillover effects of FDI on innovation in China: Evidence from the provincial data

Kui Yin China Cheung and Economic Ping Lin Review, 15, 2004, pp. 25–44

preferential policies and protection provided by the government which controls the crucial resources in the emerging market like China. In contrast, FIEs that are entrepreneurship oriented are less likely to build close ties with managers at other fi rms. * The effects of FDI on innovation (three patent * The authors examine the applications) are positive and significant in all spillover effects of FDI on three regions, the west, central, and the coastal innovation in China through in China. The spillover effects in western China data analysis of 26 provinces and 4 administrative cities in the are the strongest where FDI inflow is spatially more concentrated within the region, while the period of 1995–2000. * There are three types of patent spillover effects in the coast are less strong where FDI inflow is located across the region. Among applications to show spillover three patent applications, spillover effect of FDI effects of FDI on innovation. on external design patent is the most significant. They are invention (i.e., a new It is because external design patents are less technical solution related to a product, process, or environment technically sophisticated compared to invention thereof), utility model (i.e., a new and utility model patents. technical solution related to the * Moreover, the spillover effects of FDI on design patents in the coastal region are the strongest shape or structure of a product that is not directly related to its compared to the west and central regions. It aesthetic properties), and external is because the innovation activities are closely design (i.e., a new design of shape, related to the level of economic development. In the coastal region, the level of human capital and pattern, or combination, or of infrastructure and other resources is relatively color or aesthetic properties). higher than the other two regions, providing local fi rms with more efficient and effective resources to develop their own innovative activities based on learning from the technologies of FIEs.

66

Theoretical frameworks: effects of FDI

degree of the positive impact of FDI on exports of the host country. One of these factors is trade linkage, which refers to how much of the foreign capital is invested in the sector of manufacturing goods for export. If FDI is invested into industries primarily catering for domestic markets, for example in producing high-technology products for local retail market or in local financial industries similar to those FDI brought into the US, the impact of FDI in export/trade surplus creation will be reduced. Another important factor that can affect the degree of influence of FDI over trade performance is intra-industry linkage. Similar to what we have discussed on the impact of FDI over local employment, linkage between trade and FDI depends on the reliance of FDI on the local value chain. If the invested firms manufactured goods that need a lot of support from local suppliers in terms of raw materials and supplies of major components, the effects on exports will be higher. If the raw materials and components are mostly imported from overseas suppliers, the net effect on exports will be diminished. This can be demonstrated in Chen’s (2011, 250–65) empirical study based on data of manufacturing industries in China from 2000 to 2003. The study found that FIEs had a positive effect on the export propensity of local firms. However, due to the fact that the FIEs are more export-orientated and imported raw materials from overseas and exported the finished goods after processing, the export linkage benefits downstream players relatively more than upstream players in the host market. Apart from determinants of FDI in China, effects of FDI continued to be one of the most popular topics for scholarly research for FDI in China. Table 4.1 below shows a summary of recent research on the effect of FDI specifically for China from selected journals in the field published in the past decade.

Further reading Buckley, Peter, ed. 2010. Foreign direct investment, China and the world economy. Basingstoke: Palgrave Macmillan, section III. Moosa, Imad. 2002 . Foreign direct investment. Hampshire and New York: Palgrave, chapters 3 and 10. OECD guidelines for multinational enterprises. 2011 edition, available at: http://www. oecd.org/daf/internationalinvestment/guidelinesformultinationalenterprises/.

5

Key steps for direct investment transactions in China Due diligence

Purpose of due diligence Business strategy should always come before any direct investment is made in the overseas market, especially in emerging markets such as China. An MNC’s business team should ask themselves why they desire to invest and operate abroad; what advantages they have over local competitors, and if they have enough resources to manage an overseas operation. If they are satisfied with these basic questions, they can consider further what kind of entry modes they should choose to execute the direct investment: greenfield, partnership, or acquisition. As mentioned in Chapter 1, this chapter is more concerned with the steps that the investment team needs to take if they opt for the partnership or acquisition mode. No matter whether an investor is looking for an existing business to partner with or to acquire a local business target, the investor has to make sure that the partner or the target fits well with their strategy so that it will deliver the financial results as planned. Due diligence is the process where the investor is looking to obtain reasonable assurance for these questions. Only after reasonable assurance is obtained from the first round of due diligence exercise should the investor be seriously considering offering a term sheet to lock up both parties for the remaining steps in the transaction. A brief deal flow of an FDI in China is shown in Figure 5.1. In the process of searching for an investment target, the investment team will ask for a lot of business information from the potential investee so that the investor team can form their view as to the business prospects of the target and as to whether the target fits their investment theses. Given most of the information provided by the potential investee companies are only marketing materials or selective information about the enterprise, which are normally packaged from the angle of the investees or the sellers, such information may not contain complete and accurate views about the business conditions and fi nancial health of the target. Therefore, before the investment team discuss any intention to invest with or propose the investment terms to the potential investee, it is important for the investment team to carry out due diligence to verify as far as they can the information provided by or found from the target company. Without completion of a

68 Key steps for investment: due diligence

1

. .

Formulation of business plan and investment strategy

Searching for targets, through proprietary search or through investment advisor

2

.

Preliminary due diligence, normally handled by in-house investment and business team

3

.

Proposing and negotiating term sheet

4

. 5

.

Confirmatory due diligence, normally handled by external professional firms

Preparation of post-investment integration plan, identifying potential management issues and resolutions

6

7

. .

8

.

Drafting and signing of legal agreements

Obtaining relevant government approval, injecting capital, and completing transaction

Kicking off integration plan and appointing new management

9

Figure 5.1 Sample investment transaction procedures

Key steps for investment: due diligence 69 well-managed due diligence, a sound basis upon which investment terms are negotiated cannot exist. For example, an IT-equipment manufacturer in Guangdong represents in its information memorandum provided to the investor that it earned USD 20 million in net profit for the past fi nancial year, which represents a continuous 20 percent year-on-year growth for the past five years. The owner of an IT company is looking for a price for buyout of his business based on a price to earnings multiple of 8 times. From the surface of the information, it seems to the investment team that given the amount of earnings, the annual growth rate, and the prospects of the market, the price sought by the owner is quite attractive. However, it is not uncommon in China or other emerging economies that the net profit largely does not represent the amount of cash generated by the business. There can be a big gap between the amount of net profit and net cash flow generated from the business. The reason for this gap can vary and will be discussed further in a later section of this chapter. Therefore, without doing further work to understand the cash flow situation of the company, an 8-time price to earnings multiple could turn out to be an 18-time price to cash flow multiple, which is not a cheap asking price.

Types of due diligence Due diligence is one of the most – if not the most – crucial parts of the investment process. Due diligence refers to the process of verification of the business information of a target enterprise. It resembles the body checking process of a person, by which the health, physical strength, and weakness of a person can be uncovered. The purpose of due diligence is to reveal the business strength and weakness of an enterprise, to verify to the furthest extent possible the financial conditions, legal status, market position, and, more importantly, the future prospects of a business. Vertically, due diligence can be tiered into preliminary due diligence where the investment team of the potential investor will carry out some preliminary steps to study the information of the business. A full due diligence, after the preliminary due diligence has been satisfactorily completed and key terms of the investment have been agreed between the potential investor an investee enterprise, will normally be outsourced to professional firms to conduct and complete. Full due diligence works, sometimes known as confirmatory due diligence, given its in-depth nature and the amount of work involved, normally can be further subdivided into numerous specialized areas such as: financial due diligence, legal due diligence, market due diligence, technology due diligence, personnel due diligence, and other forms of specialized due diligence depending on the nature of business to be invested. The following are the general descriptions of different types of due diligence normally involved in making direct investment or acquisitions in China. Full details on what matters to be covered in financial and legal due diligence, the two most important types of due diligence of all, will be dealt with in the other sections later in this chapter.

70

Key steps for investment: due diligence

Financial due diligence This is the verification process normally done by audit fi rms or professional accountants. It involves compilation and verification of fi nancial and accounting information obtained from the company. Additional information will also be acquired by interviewing staff members, senior management of the investee company, customers, suppliers, and other industry players. Legal due diligence This is normally carried out by law fi rms or practicing lawyers. The process involves verification of legal status, validity of licenses held by the investee enterprise, details of its liability, and ownership of assets. Apart from perusing relevant documents and interviewing staff members of the target company, the legal due diligence team will also make enquiries with different government departments, customers, and suppliers to verify the ownership of major assets and the validity of major contracts and licences. Market due diligence Market due diligence can be done by an in-house team of the investor company, if the acquisition or investment being considered is a horizontal acquisition, that is, the investor and investee are in generally the same product market. This team usually comprises staff members coming from the merchandizing, procurement, technical, research, and sales teams. This combination ensures that people with expertise along the value chain can contribute to the understanding of the market position, market share, and sourcing, as well as sales capability of the investee company. If the acquisition is a vertical one, for example, the investee is acquiring raw materials suppliers at the upstream or a distributor at the downstream, the market due diligence is normally outsourced to market research fi rms which have expertise and market data in specific areas of the value chain. Technical due diligence This work takes place in a situation where the target company is involved in a higher-technology business such as information technology, software, solar energy components manufacturing, engineering, machinery, or electronics. Like the market due diligence, if the investor company possesses similar technical knowledge and business lines to the investee company, this technical due diligence team normally comprises their own in-house technical experts. For example, many technology firms in the US such as Intel have their own investment and due diligence team that help investigate potential investment targets on their technical capabilities. If the investor is tapping into a new technology venture out of its own specialised area, external experts have to be hired. Such expert teams normally come from a

Key steps for investment: due diligence 71 technology consulting fi rm or from the pool of retired senior executives of reputable technology companies in the field. Personnel due diligence This involves investigation of the career and educational background, family relationships, professional credentials, or even criminal records and civil litigation filings of the key persons in the business including the senior management team and major shareholders. This exercise is particularly important for investing in emerging markets such as China. The purpose is to grasp an understanding of how a particular entrepreneur came to the present business status and wealth level, and what kinds of business networks or government relationships they were engaging in that were crucial for the business. Personnel investigation is a very professional work so normally this is to be done by a firm of professional practice in personnel due diligence and background investigation. The sections below will go into details about what kind of investigations have to be covered and what kind of information has to be collected in the two most crucial due diligence works in the investment process – fi nancial and legal due diligence.

Financial due diligence Financial due diligence and audit Sometimes an investment team will feel puzzled by choosing between doing an audit or a financial due diligence of the target business. On the face of it, the cost and time involved for each is obvious. An audit normally takes no less than three to six months to complete while fi nancial due diligence can be completed as quickly as one to two months, depending on the complexity and size of the business involved. While financial due diligence may only cost USD 50,000–100,000 in professional fees, an audit can be charged at five to ten times more, again depending on the nature and size of the subject business. So it is not unusual that investment teams will choose financial due diligence in order to get a deal completed quickly at the cheapest possible transaction cost. While there is nothing wrong with investment professionals striving to get an investment completed in the shortest possible time frame and minimal costs before other competing firms get in, one has to bear in mind the key difference between the two tasks, apart from cost and time involved, before making a sensible decision as to which type of task – audit or financial due diligence – best fits their project. An audit is an exercise where, through obtaining reasonable assurance from the examination of internal control of the target firm and carrying out of substantive tests based on samplings, an audit firm will express an opinion about whether the financial statement presented by the management of the target company is free from material misstatements, or in other words

72

Key steps for investment: due diligence

represents a true and fair view of the affairs of the company. This audit opinion is commonly known as the “true and fair opinion.” This expression of opinion imposes considerably heavy responsibility and potential liability over auditors as to the integrity of the financial statements of the target company. Financial due diligence, on the other hand, is an exercise where the accountants are responsible for compiling and analyzing the information provided by the target company so that the investor can have an understanding of the information to facilitate its investment decision. This compilation and analysis will highlight the business information that the investor wants to know, for example, the customer base of the target company, major suppliers of raw materials, aging of account receivables, etc. It will highlight the risk areas that the investor should be aware of when it makes an investment decision and a determination in valuation, for example, the issues in internal control, possible tax liabilities, turnover rate of staff, concentration of customers, etc. However, a financial due diligence report does not express an opinion about whether the target company’s fi nancial statements represent a true and fair view of the affairs of the company. In other words, financial due diligence takes the information provided by the target company as largely true, or does not carry out the amount of substantive tests to verify its truth to such an extent as an audit does. What it does is largely analyze information on hand to provide a picture from commercial and investment angles. From a liability point of view, fi nancial due diligence gives lower obligation and less potential liability to the accounting firm because it does not express an audit opinion. Therefore, from the perspective of verification, an audit will give a much higher and deeper level of comfort to an investor as to the genuineness of the financial conditions of an investee company, compared with financial due diligence. That is why an audit charges much more than a financial due diligence job, so as to take into account the risk an audit firm has to bear in expressing a “true and fair” opinion. Nevertheless, I am not saying that financial due diligence is always less useful than an audit. An audit merely involves examination of internal control and substantive tests with a single purpose of expressing an opinion as to the completeness and accuracy of the financial statements. An audit normally does not deal with wider business issues such as analyzing revenue stream, cost structure, customers’ composition, movement in profit margin, etc. In contrast, financial due diligence is much more flexible in handling more business-related matters according to the procedures agreed upon by the investor and the accounting firm. Therefore, from this angle fi nancial due diligence takes up a broader scope in business analysis for the investor, though it does not go as deep as an audit in verification of the financial statements. Investigations typically covered in financial due diligence Each due diligence exercise is different. Depending on each investment case, each due diligence exercise places different weight on different areas according to the specific needs of the investors in each project. Yet, most financial due

Key steps for investment: due diligence 73 diligence exercises aim at giving investors a clearer picture of these common areas: profitability, cost and liability, internal control, corporate governance, valuation of assets, major investment risks. The following section will give an introductory idea on major investigations typically covered by a financial due diligence exercise. For a detailed information request list of a typical financial due diligence, please refer to Appendix 5.1. Corporate structure CORPORATE CHART

This is a chart that shows the shareholding relationship among companies within the same corporation. It is not uncommon in China that shares of subsidiary companies are not directly held by the holding company but by the spouse or relatives of the major shareholders. Therefore, it is important to the subsidiaries whose shares are held by other individuals in trust for the holding company or the major shareholder (see Figure 5.2). The company should also provide all corporate fi lings with the government and requisite business licenses issued by government departments to all the companies shown inside the corporate chart. ORGANIZATION CHART AND MANAGEMENT BACKGROUND

This is a chart that shows how a corporation is managed and how the division of works within the corporation and among senior management is designed. Apart from getting information to compile a chart that represents the hierarchy of the company’s authority and shows the reporting lines, it is important for the due diligence team to request the background information (including career and education background) of the senior management, all shareholders, and all members of the board of directors. It is also important to request copies of the employment contracts (including any stock options or incentive schemes) of middle to senior management. Again, it is not uncommon in China to have relatives of the major shareholders working as members of the senior management team. This relationship should be identified in the due diligence exercise so as to enhance the investor’s understanding of the internal control environment and management culture of the target firm. Financial statements Some of the key documents required from the target company in fi nancial due diligence include: •

•

annual and monthly financial statements (income statement, balance sheet, cash flow statement) of all companies within the target group and the consolidated financial statements for the group; business plans;

Outside Target Group

74

Key steps for investment: due diligence

Mr. He (HK citizen)

Mrs. He (USA citizen)

100%

He Holdings Ltd. (Cayman Islands)

55%

45%

Within Target Group

49%

He Investment Ltd. (BVI)

100%

100%

He Suppliers Co. Ltd. (PRC WFOE)

He Consultancy Co. Ltd. (HK)

Lin Production Co. Ltd. (PRC Limited Liability Co)

51% He Manufacturing Co. Ltd. (PRC EJV)

Figure 5.2 Sample corporate chart

• • • • •

• • • •

annual and monthly budgets; audited reports; copies of trial balances and ledgers; description of major accounting policies; description of financial reporting processes, internal control policies and procedures, sales and procurement procedures, human resources procedures; description of non-recurring items; description of off balance sheet items; filings and documents relating to taxation; copies of material contracts;

Key steps for investment: due diligence 75 • •

documents relating to dealings with bank and financial institutions; corporate documents, including the company’s constitutions, meeting minutes of board of directors and shareholders, business licenses, and certificates of incorporation.

The following are some of the major areas that the due diligence team should focus on when they are examining the aforementioned documents. Balance sheet – asset items CA SH A N D BA N K BA L A NC E , BA N K R E C ONC I L I AT ION

The due diligence team has to perform bank reconciliation to align the cash and bank balances with the balances shown in the financial statements, so that any off balance sheet cash transactions can be identified. Ideally, independent confirmation with major banks of the target company should be sought in confirming the accuracy of the bank balance shown in the bank statements supplied by the company. Major processes of approval, recording, and handling of cash transactions should also be identified and understood. I N V E N T ORY

Inventory can form a major chunk of the net asset value of a company, especially for companies involved in retail sale and chain store operation. However, very often in China, the volume and value of inventory recorded in the financial statement may not necessarily reflect the true marketable value or quantity actually held by the target company. Therefore, one of the most important tasks of the financial due diligence team is to ascertain the quantity and value of the inventory, be it foodstuff, toys or apparels, or raw materials stored at the target company’s warehouse. This normally would take plenty of time given the vast physical areas a retail chain operation may cover in China. Total investigation of all warehouses and shops is not possible in most of the cases. Therefore, prudent sampling should be designed so that the investigation results can form a reliable opinion for the investors in valuing the inventory actually owned by the target company. Apart from the quantity of inventory, the methodology in valuing inventory poses another challenge in financial due diligence. International accounting standards impose more conservative methodologies and policies in valuing and writing off the value of inventory than the local accounting practices adopted by private enterprises in China. Therefore, considerable writing-off in valuation of inventory could result if international accounting standard is applied in valuing the inventory of a target company. Such writing-off can sometimes be the main issue of argument in pricing between the buyer and seller in an investment transaction in pricing because both the net asset value (if pricing is based

76

Key steps for investment: due diligence

on net asset per share) and the net earnings (if pricing is based on multiple of earnings) will be reduced if part of the inventory is written off. PL A N T S , PROPE RT Y, A N D M AC H I N E RY

The major task of the due diligence team is to ascertain the existence, quantity, and value of all plants, property, and machinery (“PPM”) appearing in the balance sheets, according to international accounting standards. As in the case of inventory, international accounting standards require more conservative policies in depreciating and writing off the value of these items than the local accounting practices adopted by private enterprises in China. Therefore it is not uncommon to notice discrepancies in the valuation of these fixed assets between the book value of the local accounting records and the value after adjustment according to international accounting standards. Like inventory write-off, any adjustment as to the depreciation or depletion of value in fixed assets will have an influence on the valuation of the target business because net asset value and net earnings will be adversely affected. AC C OU N T S R E C E I VA BL E

Accounts receivable represents the amount that customers owe to the company due to day-to-day sale transactions. In-depth analysis of the accounts receivable is needed in a number of areas. The first one is an aging analysis which requires analysis of how much debt is owed to the company for how long. A usual aging analysis can appear in the form of a table like the one shown in Table 5.1. The purpose of an aging analysis is to understand the situation of the creditworthiness of the company’s customers and the reasons behind the situation of having long overdue debt. More importantly, the trends of aging can give an idea of the liquidity or adequacy of working capital of the company. An aging analysis can also reflect the bargaining power and competitiveness of the company’s products in the market. If the company has a strong bargaining power along the value chain, it can impose more stringent credit terms over its clients and demand a shorter settlement period for invoices. If competition is overly keen in the areas that the company is operating in, the company may have to seek business by granting a longer credit period to customers, which will put more pressure on its working capital requirement. An increasing credit period may indicate that the operating environment is turning sour, which may in turn affect the unit price and gross margin of the products, and the company’s earnings eventually. Closely tied with the aging analysis is an assessment of the amount of bad debts involved in the accounts receivable balance. As in the case of inventory, international accounting standards impose more conservative policies in valuing and writing off the value of overdue accounts receivable. While some long overdue debt (e.g., over 12 months) might seem to be recoverable according to the knowledge of the local entrepreneurs, it is likely that such

Key steps for investment: due diligence 77 Table 5.1 Sample accounts receivable aging table Customer Credit Amount Current Aged name term outstanding 1–30 (days) days Timer Ginner Popper Li Chung Fiely Chen Holding Carey Gao Gao Sumisu

30 30 45 30 60 30

78,590 173,750 100,740 49,500 8,520 76,382

30 45 90

45,482 45,620 1,052,300

5,400 52,000

Aged Aged 31– 60 61–90 days days

Aged Aged 91–120 more than 120 days

65,000 5,690 2,500 58,960 58,740 2,000 2,050 90,020 5,100 45,000 8,520 6,592

6,590

45,482 45,620 4,900 985,200 52,000 130,000 1,290,282 131,542 54,600 2,050

10,200 22,410

4,500 63,200

5,620

debt would be treated as bad debt by international accounting standards and be partially or wholly written off in the balance sheet. Debt written off is treated as an expense and will thus reduce the net profit of a company. As the valuation of the company is very often calculated by the multiple of net profit, a 10-dollar loss in bad debt can mean a 100-dollar loss in valuation after multiplication. Therefore bad debt treatment can be another area of argument between the buyer and seller about the total valuation of the company. Another important analysis on the accounts receivable is to identify the company’s major debtors. Independent confi rmation with major customers on debt balances should be carried out to verify the accuracy of the accounts receivable appearing in the balance sheet. Last but not least, accounts receivable also reflects the unit price of products produced by the target company. The rise, decline, or fluctuation of the unit price gives important information about the competition landscape and bargaining power of the company in the market. In general, it would be more desirable if the target company is a price setter in the market rather than a price taker, which has to take whatever price set by the overall demand and supply in the market. O T H E R R E C E I VA BL E S

It is common to notice an item known as other receivables in local Chinese balance sheets. This item normally refers to debts unrelated to the ordinary course of business such as loans to shareholders, managers, or other industry peers. The purpose of the loan, the identity of the debtors, the amount involved, and the terms of repayment have to be uncovered during due diligence exercise so that the prospect of recovery of such debt can be

78

Key steps for investment: due diligence

ascertained. If the chance of recoverability is low, a write-off in value should be done in the post-due diligence adjusted fi nancial statements. I N TA NGI BL E A S SE T S A N D G O ODW I LL

Another common practice of local Chinese book-keeping is to assign a value to copyright and brand and record it as goodwill in the balance sheet. According to international accounting practices, value of intangible assets has to be supported by projected cash flow generated therefrom.1 Therefore it is probable that the net asset value of the balance sheet will be substantially lowered if the value of intangible assets that appear in the target company’s balance sheet is not recognized or has to be written down after financial due diligence. Balance sheet – liability items AC C OU N T S PAYA BL E

The investment team needs to be aware of the credit period given by suppliers and vendors to the target company. This reflects the bargaining position of the target company in the market vis-à-vis raw material suppliers or upstream service providers. The fluctuation of the unit price of raw materials reflected in the accounts payable also gives important information about risks in maintaining the gross margin of products. SHORT-T E R M A N D L ONG -T E R M L OA N S

Loan balances should be verified by studying the loan documentation and independent confirmation with major lenders. Specific provisions in the loan documentation such as maturity date of the loan, interest rate, penalty clauses, and collaterals should be documented during financial due diligence in order to understand the impact of the loan on the general liquidity, future profitability, and cash flow of the operation. Any loan advanced by major shareholders or related parties should be identified to ensure that the income or cash flow of the target company was not inappropriately or illegally transferred to the related party lender through a loan arrangement under which outrageous interest is charged for tax evasion or other improper purposes. O T H E R PAYA BL E S

Other payables mean payable items that are not accrued out of the ordinary course of business. In some cases, such items could include consultancy or management service fees that are designed to transfer the income out of the company through a service that is hardly verifiable. These fees, without evidence to substantiate, may pose risks of money laundering, exaggeration of revenue, or tax evasion. Therefore, the nature and the payee of such payables

Key steps for investment: due diligence 79 should be identified to ensure that there is no inappropriate transfer of funds or profit of the company to the third party through payable arrangement. Any unsubstantiated transfer of profit through this arrangement can attract tax liabilities and penalties due to improper avoidance of tax or underreporting of taxable income. C OM M I T M E N T S , C ON T I NGE N T L I A BI L I T Y, A N D OF F BA L A NC E SH E E T I T E M S

The target company should be required to disclose any potential liability, including pending lawsuits, potential exposure to penalties and claims, potential breaches of contract that the company is likely to have committed, and such other material commitments made by the company but not disclosed in the financial statements or the notes to the accounts. Balance sheet – equity account Any movement in share capital through issuance of new shares, sale of existing shares, granting of stock options, etc. should be properly documented. The terms of such issuance or sale should be identified by the due diligence team by studying the sale and issuance documentation. Income statement REVENUE

The due diligence team should understand and document the sale cycle and sale procedures of the target company, from soliciting sales, approving customers’ credit (for non-cash transactions), invoicing, collection of debt, handling of cash receipt, recording of sale amount, and operation of the pointof-sale system. This exercise gives an overall impression as to whether the amount of revenue recorded in the book of the company substantially reflects the genuine amount of sale transactions that have taken place. Apart from an overview of procedures, analysis of the monthly revenue should be carried out so that monthly, quarterly, and yearly sales trends can be understood. The same trends should be analyzed in terms of the unit price of each category of goods and services so that the major revenue streams, core competence, and competitiveness of the company in each category can be examined. Major customers can also be identified from the revenue record. Normally, a top-10 or top-20 customer list with total amount of business transacted with these customers will be compiled. The purpose of compilation of a list of major customers is to assess the reliance of the target business on its major customers and to understand the importance of individual customer to the business performance and future growth of the target company. While over-reliance on one or two customers makes the target business

80

Key steps for investment: due diligence

more risky, an overly scattered or changing customer base may imply that the company’s product quality fails to secure long-term relationship with a stable clientele. Whether the list looks healthy should depend on specific industry practices, competitiveness of the target company, and the macroeconomic environment. Cost of goods sold Cost of goods sold, also known as the direct cost, normally comprises the cost of labor and raw materials for producing the goods and services offered by the company. The purchase cycle and procedures, and approval process of raw materials acquisitions should be understood and documented so that risks of related party purchase, transfer pricing, overvaluing raw materials and inventory, and loopholes in internal control can be identified. OV E R H E A D S

This normally comprises administrative, office expenses, and financial costs. Major items should be identified and the percentage of overheads as a share of total revenue of the target company should be compared with benchmarks of other market peers, so that the administrative efficiency of operation of the target company can be revealed and compared with other similar players. G RO S S PROF I T M A RGI N

This is the percentage of gross profit as a share of revenue, calculated by the following formula: Gross Profit / Total Revenue × 100%. N E T PROF I T M A RGI N

This is the percentage of net profit after tax as a share of revenue, calculated as follows: Net Profit after Tax / Total Revenue × 100%. It is crucial to understand the gross profit margin and net profit margin of the target company and to compare these with those of similar products producers in the market. A lower-than-peers gross margin may indicate that the target company is unable to demand an equally high unit price for its products, due to poorer quality or less efficient distribution channels, or unable to strike a competitive price for raw materials, due to the size of the business or bargaining power with the suppliers. Overall this reflects the market competitiveness of the company’s products. Gross profit margin also shows the resilience ability of the company in the event of market downturn. In general, a lower gross margin poses higher risk for the company because lower margins offer smaller cushions for the company to lower its sale price to defend incoming competitors.

Key steps for investment: due diligence 81 A lower-than-peers net profit margin may indicate that the company is incurring more overheads such as administrative and managerial costs. This indicates that the operation is being run in a less efficient fashion as compared with similar players in the market. It can also reflect the financial costs such as interest on loans that the company is bearing to support its operation because interest expenses are categorized as a part of the overheads. However, lower net profit margin may also be affected by non-cash items such as depreciation and amortization charges which may not indicate operation inefficiency but an amortization of the past infrastructure built (such as factory and machinery, or acquisition of other business) for the business. TA X AT ION

The target company should be requested to produce all documentary records as to tax filings, payment, and exemption. All correspondences with tax authorities and tax advisors have to be inspected. Enquiries have to be made as to the area where in the opinion of the finance staff tax liability or penalty could potentially occur in the near future. R E L AT E D PA RT Y T R A N SAC T ION S

The target’s senior management and shareholders have to disclose all related party transactions made with any companies within the target group. A list of each transaction, its amount, major terms, and rationale behind these transactions has to be compiled. The due diligence team should make enquiries as to the chance of recurrence of these transactions and advise investors as to the investment risk of these transactions such as the risk of transfer pricing, potential exaggeration of turnover or asset value, potential claim as to tax evasion, and possible contravention with applicable laws and regulations. Cash flow statement The cash flow statement is particularly important for investors who are interested in emerging markets such as China. As cash collection and legal enforcement may sometimes pose difficulties for enterprises in China, cash flow generated from operations would give more comfort and less risk to the future growth and liquidity of the operation. Looking into the cash flow statement together with the income statement can also help identify some common tricks and traps in exaggerating the income of business, as the following cases will show: Case 1: High net profit level but very low cash flow from operation This situation may pose risks as to the accuracy of the profit figure appearing on the income statement. This may indicate that the company has difficulty in collecting debt form debtors, producing healthy working capital level for a sustainable operation, or generating enough cash surplus to resist market

82

Key steps for investment: due diligence

downturn or meet sudden need in working capital. Worse, there can be a situation where the company did not write off long overdue debt in order to keep the profit high on on the accounting book. A low cash level may also be due to a high level of inventory which could pose a higher risk of future write-down, especially if the inventory is perishable goods such as foodstuff. Sometimes, this could also mean that an intentional exaggeration of profit occurred where a fake contract was made with fake customers so that revenue and profit could be jetted up but account receivables would never been recovered, hence the low level of cash flow. Case 2: High net profit level, high cash flow from operation, but very low level of total cash flow generated for the year If the company is able to produce a high profit level with a good level of cash flow from operations, this indicates that the company is managing its working capital well and generates good cash return for investors from its daily operation. However investors should pay attention if the cash proceeds from operations are largely consumed by the other two items under the cash flow statement – cash used for financing activities and cash for investment activities and the total cash flow still remains at a very low level. Cash used in financing activities includes repayment of debts, while cash used for investing activities includes purchase of plants, property, and machinery. While both items can make sense when it is in the interest of the business to repay debt or further invest into fi xed assets when it has surplus cash, investors should be aware of two possible tricky situations mentioned below: If the surplus cash of the company has to continue to service repayment of debt for a number of years, this would affect the dividend payment to investors and thus pose an adverse effect on investment return. The profit level of the company will be affected if the interest rate goes up. The same logic applies to investment in fixed assets. If the company has to continue to invest in capital expenditure in order to scale up its operation and grow revenue, it also hurts the return of the investors since its ability to generate surplus cash flow and pay out dividends is low. The above is a situation where investors have to look at the business case to determine if it makes sense for the company to use its cash proceeds to service expenditure in financing or purchasing of fi xed assets. However, there are situations where a high level of cash flow from operations and a low level of total cash generated for the year could indicate an existence of fraud. For example, there can be a situation where a company enters into fake contracts with fake customers so that the revenue can be exaggerated on the income statement. In order to escape from the eyes of auditors from questioning the recoverability of accounts receivable resulting from the fake transaction, cash repayment is arranged to settle the debt owed by the fake customers so that cash flow from operation is created at the cash flow statement and the bank account of the company. Soon afterwards, a similar amount of cash is used by the company to purchase fi xed assets or machinery so that the cash is spent again. The net result is that the amount of revenue in the

Key steps for investment: due diligence 83 income statement will be jetted up, and spent for subsequent purchase of fi xed assets (usually purchased at an unreasonably high price) at the balance sheet. This round-tripping of money can exaggerate the revenue, the net profit, and the cash flow from operation, the net asset value of the company, and, at the end, the valuation of the company which is normally calculated by the multiple of net profit. Therefore, an experienced due diligence team, when faced with a continuous high level of cash from operation with a high level of capital expenditure, will physically visit target company’s customers to ensure the genuineness of the sale transaction and conduct independent assessments of the market price of the asset purchased to ensure the necessity and reasonableness of the price of the asset purchase.

Legal due diligence Legal due diligence, normally carried out by qualified lawyers or law firms, aims at discovering supporting documents and information to verify the following legally important areas relating to the company’s business and the proposed investment: •

•

• • •

Structure – to ascertain the company’s corporate and shareholding structures so as to facilitate the injection of capital from investors, issuance of equity or debt instruments to investors, and implementation of possible post-investment restructuring, and possible exit strategy of the investors. Validity – to ascertain the validity of existence of the company, the validity of licenses regarding the specific business areas and specific activities of the company’s operation. Ownership – to verify the company’s ownership its major assets and the shareholders’ ownership in the company. Liability – to identify major liabilities incurred by the company and advise on the legal and business impact of the liabilities. Transaction risk – to identify potential legal risk in relation to the proposed transactions, for example, potential risk of the transaction not being approved by the government authorities due to foreign investment restrictions or other policies reasons.

In order to achieve the aforementioned purposes, the following documents have to be requested by the legal due diligence team. Investigations typically covered in legal due diligence Constitutional documents These refer to the memorandum and articles of association for all Chinese and overseas companies incorporated under the target group. Studying

84

Key steps for investment: due diligence

these documents can provide investors with a detailed understanding of the rules of governance, such as meeting procedures of the board, shareholders’ rights and responsibilities, director’s duties, upon which the group is supposed to be run. Returns and filings These refer to all of the periodic returns and filings of all companies under the target group submitted to the government authorities. These documents contain information about the change of shareholdings, change in officers and directors, as well as a pledge of the major assets of the companies. With this information the corporate structure of the investee group can be drawn up to identify the shareholding relationship among the companies of the group. Shareholders agreement and share purchase agreement A shareholders agreement is an important agreement relating to the rights and responsibilities among existing shareholders. It deals with, on top of the articles of association of the company, how the operation of the business is managed, how the board of directors is run, and how shareholders’ matters are transacted at annual meetings or extraordinary meetings, as well as how the company can be wound up. A share purchase agreement can show the path as to how the shares of the company were acquired by the existing shareholders and give a sense of the historical cost per share of the company. Meeting minutes Meeting minutes of the board of directors and the shareholders meeting give important information as to what has been discussed and resolved at the highest governance bodies of the company. This also gives a sense of the degree of corporate governance of the company. A higher degree of details of the minutes and higher frequency of meeting normally give more comfort to investors as to the state of corporate governance and internal control of the target firm. Business license and certificates A business license, taking China as an example, gives important information as to the validity of the business activities according to the law and regulations and describes its approved scope of business. In China, a business cannot operate beyond the scope of business stated in the license. For special industries, like mining, food manufacturing, media, banking, etc., a company has to possess a specific industry certificate for operating in that particular industry on top of the general business license. These licenses are subject to periodic review and renewal from the Chinese government agencies.

Key steps for investment: due diligence 85 Material contracts and commitments Material contracts can refer to a broad range of different types of contracts that are material to the business operation of the target company. These may include tenancy agreements for the principal places of business, real estate purchase agreements, title deeds for buildings or apartments, purchase contracts for machinery, loan and mortgage documents, employment contracts of key management team, major distributor or outsourcing contracts, tender agreements with governments, major consultancy agreements, major sourcing or merchandising contracts, major licensing agreements, major currency swap/hedging contracts, etc. Materiality depends on the worth of the subject matter, the length of commitment, and the impact on the business worth of the target company and specific industry practices. The due diligence team should record and make a list of the key terms of all material contracts. Debts and liability This item can overlap with material contracts mentioned above. This will include all kinds of loan agreements, credit agreements, mortgage or pledge agreements, guarantee agreements, whether or not entered into with licensed banks. It also includes lawsuits that have occurred or may occur in a foreseeable future that may pose contingent liability to the company. This also includes any debenture, note or convertible note instruments issued or likely to be issued by the company. The due diligence team should record and make a list of the key terms of all of these documents. Litigation and contingent liability This item includes records of historical and current lawsuits, or potential lawsuits with all counter parties in business such as customers, contractors, service providers, banks, employees, governments, professional consultants, insurance companies, etc. A list of all past, current, and potential litigations should be made by the investigation team. Discussion should also be held with the financial due diligence team so that the finance team can take a view as to whether to request a provision for the contingent liability be made in the financial statements. Intellectual property right This item includes documentary proof of the proprietary design and technology owned by the company. Documents pertaining to patents, trademarks, and copyrights or applications pending registration of the same should be collected by the due diligence team. It should also include licensing agreements or assignments of licenses to and from other parties in relation to intellectual property rights.

86

Key steps for investment: due diligence

Employment matters This request includes sample employment contracts with low- to mid-level staff, copies of employment agreements with key management staff, service contracts, if any, with major shareholders and directors, staff manuals, documents containing guidelines and procedures of recruitment, details of pension schemes, benefits and incentives schemes (including cash and stock incentives). A record of turnover of mid- to high-level management staff should also be recorded. Banking A record of major banks and financial institutions that took deposits from and provided credit facility to the company should be provided. Insurance Insurance agreements and a record of insurance companies’ dealings with the company including records of payment of premium, policy documents, and documentation on claims should be provided. Financial statements and taxation Financial records and audited reports (including the profit and loss, balance sheet, and cash flow statements) of at least the last three years and the records of payment of relevant taxes should be provided by the target company. Tax filings and returns, and correspondence with tax advisors and tax authorities should also be obtained. More importantly, as a legal due diligence team rarely comprises financial professionals, the legal team should meet the financial due diligence team so that any defects found in the financial statement can be communicated to the legal team, who will then form their view as to the legal risk arising from such defects.

Appendix 5.1: sample financial due diligence information request list Historical financial statements • • • • •

Provide monthly income statement, balance sheet, cash flow statement of all group companies (“the Group”). Provide all consolidation workings for financial statements. Audited reports and notes to the accounts for the Group. Internal auditors’ reports and audit committee minutes of the Group. Description of major accounting policies.

Key steps for investment: due diligence 87 • • • • •

Reconciliation of the management accounts and the audited accounts including audit adjustments. Internal management accounts package on a monthly basis, including a description of monthly financial reporting process. Description of internal control process. Copies of trial balance and general ledger and reconciliation to the financial statements. Identification of major non-recurring items.

Corporate and legal documents • • • •

• •

• • • • •

Group shareholding chart showing all shareholders, including beneficial shareholders and nominees. An organization chart of the Group, including a list of their respective directors, officers, key personnel, and heads of departments. A schedule showing all employees, indicating name, date of birth, date of commencement, salary, benefits, and function. Constitutional documents including memorandum and articles of association, business license, feasibility report or establishment proposal submitted to the government, joint venture contract, and minutes to amend these documents and such other documents of constitutional effects. Board of directors’ and shareholders’ meeting minutes. Material trading contracts including suppliers, outsourcing, tender, license, sale and purchase, leasing, assignment, distribution contracts, and other major contracts made for ordinary course of business. Contracts in relation to real estate including assignment, pledge, mortgage, renting, leasing, licensing and subletting agreements. Contracts, facility letters, debentures, and documents in relation to loan, guarantee, pledge, mortgage provided to/by the Group. List of loan, guarantees provided to/by the Group to directors and employees. List of all related party transactions. List of known and potential breaches of contracts, potential litigations, pending and ongoing court cases, with supporting documents.

Assets Fixed assets • •

Fixed assets ledger that shows date of purchase, cost, net book value, written-off items, with reconciliation to financial statements. Schedule of written-off, obsolete, and diminished value items.

88

Key steps for investment: due diligence

• •

Schedule of pledged fi xed assets and details of the pledge terms. List of capitalized project costs, supported with project details, policies, and aging of capitalization. Description of depreciation and capitalization policies. Schedule of construction in progress and explanation of accrual of costs in relation thereto.

• •

Accounts receivable • • •

Explanation of policy for giving credit to customers. Analysis of all accounts receivable by customers, including an aging analysis by days. Explanation of policy for making provisions for doubtful debts and amounts written off. Explanation of other receivables, prepayments, deferred expenses including aging analysis of them and policy for provisions made to them.

Cash at bank • •

List of all bank accounts and bank balances, provision of all bank reconciliation statements. List of bank loans and facility given to the Group.

Intangible assets •

• •

List of intellectual property owned by the Group including registered or registration-pending trademarks, patents, copyrights, proprietary technology, showing the cost of acquisition, creation, schedule of amortization, and policies of amortization. Schedule of agreements relating to the use and licensing of intellectual property rights owned, used, or licensed by and to the Group. Schedule of cash flow projection for all goodwill recorded, with detailed assumption pages.

Inventory • • • •

Inventory summary by categories. List of obsolete, slow-moving and damaged inventories and provision policies. Inventories count report. Comparison of cost and market prices of each inventory category.

Equities •

Breakdown and movement of equity account.

Key steps for investment: due diligence 89 Liabilities Accounts payable • •

Aging analysis of creditors. List of top ten suppliers, and details of products, amount, credit period in relation to these suppliers.

Other payables • •

List and breakdown of the balances with description. Analysis of accruals for staff costs (e.g., bonus, incentives, salary, commission) and statutory pension, supported with explanation on accrual basis.

Loans •

List of all loans showing lender, interest, tenure and major terms and conditions, covenants and undertakings and list of related guarantees, pledges, indemnities, supported with relevant documentation.

Off balance sheet items • •

Details of any contingent liabilities and off balance sheet items that the Group can be exposed to. List of long-term (longer than six months) contractual commitments made by the Group.

Income statements Revenue •

• • • •

Overview of sales process showing the workflow from soliciting a customer, price setting, contract negotiation and signing, product delivery, invoice issuance, and payment collection. Price list of products by product categories. Policy of sales commission and schedule of sales commission in relation to each salesperson/sales team. Schedule of variation of price of products on a monthly basis. Monthly sales and gross profit.

Cost of sales •

Analysis of purchase by key suppliers.

90

Key steps for investment: due diligence

•

Analysis of cost of sales by products category equipment, equipment rental. Schedule of variation of cost of sales on a monthly basis.

•

General and administrative expenses • •

Analysis of G&A expenses by expenses type. Schedule of variation of G&A expenses on a monthly basis.

Other income and expenses •

Breakdown and explanation by nature.

Business plan •

Financial projection of the Group for the next three years, supported with a forecasted income statement, balance sheet, cash flow statement and the assumption pages.

Staff related items • •

•

• •

Emoluments, terms of employment, and dates of commencement of office of all the directors of each of the Group companies. All profit sharing, share option and share incentive schemes and other similar incentive arrangements for the employees of each of the Group companies. All retirement benefit and life assurance schemes, and all voluntary pensions of each of the Group companies currently payable, indicating which are not approved by the relevant authorities, and copies of all trust deeds, rules, announcements to employees, and employee booklets. Analysis of total employment costs by department showing salary costs, bonus, and benefits. Profiles of key members of management.

Taxation • • • • •

Copies of all tax filings with government authorities. Details of tax investigation and potential tax liabilities. Copies of documents of tax holidays or exemption granted. Names and contact information of tax advisors. Correspondences with tax authorities and tax advisors.

Key steps for investment: due diligence 91

Appendix 5.2: sample legal due diligence checklist Corporate documents •

• • • • • • • •

•

Memorandum and articles of association including all amendments of them together with all related resolutions pertaining to such amendments. Certificate of incorporation, any change of name certificate, and business registration certificate. Address(es) of the registered office and principal place of business. Particulars of the authorized and issued share capital. Full names and addresses of all the directors. Full name and address of the company secretary. Full name and address of the auditors. Location of the register of directors, minute book, and other corporate registers of each of the Group companies. Full names and addresses of the shareholders (and of the beneficial owners if different) and a copy of the share register and register of transfers. Particulars of all agreements between each of the Group companies and any of their respective shareholders or third parties relating to the voting, disposal, or acquisition of shares or securities of each of the Group companies.

Financial information • •

• •

• •

Audited accounts for the last three years and management accounts for each month in the current financial year. All loans made to or by each of the Group companies, including all loans and indebtedness to their respective directors, officers, employees, or shareholders or any other Group company in which any such director, employee, or shareholder is interested. A schedule of all indebtedness owed by each of the Group companies. All guarantees, indemnities, and other contingent obligations given by each of the Group companies in relation to the obligations of any person or company. All outstanding mortgages, charges (whether registered or not) and other security arrangements. All hire purchase or installment purchase agreements, finance leases, letters of credit, performance and other bonds, and similar documents involving or relating to each of the Group companies.

92

Key steps for investment: due diligence

Properties • •

A schedule of all properties owned or occupied by each of the Group companies. Copies of all title documents in relation to all properties owned by the Group companies.

Other assets • • • •

A list of all major tangible assets of each of the Group companies. All licenses, permits, approvals, title documents required to own, lease, or control any of the assets of any of the Group companies. All shares and other securities currently held and held in the past three years. A list of outstanding accounts receivable in excess of RMB100,000.

Intellectual property •

A schedule of all patents, trademarks, service marks, trade names, copyrights, know-how, and registered designs owned by, licensed to or by, or used by the Group companies, and copies of such documents. All infringements or alleged infringements of the intellectual property rights of others by the Group companies. All assignments of intellectual property rights by or to the Group companies.

Legal proceedings •

•

•

All pending or threatened litigation, arbitration proceedings, or governmental investigations and proceedings involving the Group companies. A schedule of all orders, writs, decrees, injunction, judgments, or rulings (including consent decrees and judgments) relating to the above litigation, arbitration, and governmental proceedings. All pleadings, correspondences, and other material documents relating to the above litigation, arbitration, and governmental authorities.

Commitments and trading contracts • •

A schedule of all suppliers and customers of the Group companies. A schedule of all capital commitments of the Group companies and the contracts, if any, in relation to these commitments.

Key steps for investment: due diligence 93 •

•

• • •

All contracts for the performance by the Group companies of any goods or services which have more than one year to run or by virtue of which goods or services exceeding RMB100,000 in value. All contracts for the purchase by the Group companies of goods or services having more than one year to run or involving a future commitment exceeding RMB100,000. All agreements with any customer or supplier representing 5 percent or more of the goods or services supplied by or to the Group companies. All distribution, partnership, agency, joint venture, or similar agreements entered into by the Group companies. All agreements relating to the acquisition or disposal of shares or businesses in excess of RMB500,000.

Banking • •

Full names and addresses of bankers of the Group companies. Facility letters, letters of credits, loan letters, or similar document for advance or overdraft facilities issued by these banks.

Taxation • • •

•

Full name and address of the tax advisers of the Group companies. All tax losses carried forward and of writing down allowances claimed. Documents and correspondence relating to all past and current disputes and unagreed assessments between the Group companies with tax authorities. All penalties, fines, or interest charges imposed on the Group companies in relation to any taxes.

Insurance • • • •

All insurance policies maintained by each of the Group companies and all contracts, policies, certificates of insurance. Documents of all claims made by the Group companies. Receipts of payment of premiums. All outstanding and unsettled insurance claims.

Employee matters • • •

An organization chart of the Group companies. A list of directors, officers, and key personnel. A schedule of personnel record of all employees.

94

Key steps for investment: due diligence

•

Service contracts with directors, shareholders, and their related parties. All profit sharing and share option schemes for employees, directors, officers, or third parties. All retirement benefit and life assurance schemes.

• •

Environmental matters •

•

All internal and external reports relating to environmental matters in relation to the Group companies’ business. All licenses and permits relating to environmental matters in relation to the Group companies’ business. All complaints, notices, summons, warnings about environmental matters in relation to the Group companies’ business. All records of environmental damage made by the Group companies.

Further reading Howson, Peter. 2008. Checklists for due diligence. Aldershot: Gower Publishing. Lo, Vai lo and Xiaowen Tian. 2009. Law for foreign business and investment in China. Abingdon and New York: Routledge.

6

Key steps for direct investment transactions in China Term sheet

What is a term sheet? A term sheet refers to a checklist of major commercial terms upon which an investment is intended to be made. Since an investment transaction will have to take a lot of time and cost to complete all due diligence procedures and formal legal documentation, an agreed term sheet provides a certain degree of confidence for both the investor and investee to spend further time and cost to continue investigation and negotiation. If the parties cannot even agree on the key terms such as the valuation of the potential investee business and the percentage of shareholding of the investor after investment, then it makes no sense for the investor to engage more people and professional costs in continuing to study the project, nor for the potential investee to entertain further requests of the investor for more information about the target business. It would rather move on to start a fresh discussion with other potential investors. A term sheet differs from a legal agreement for investment, or from a sale and purchase contract in a number of ways: •

•

Legal effect – normally a term sheet is legally non-binding and reflects only a memorandum of understanding on major terms between the parties. Theoretically major terms contained in the term sheet can be changed when both parties sit down to negotiate for the final legal agreement, though such change should normally be justified by valid reasons, such as discovery of new data on assets, income prospects, or potential liability of the target company. In practice, an arbitrary change in major terms after a term sheet is signed will hurt the credibility of the party initiating the change. It can also impact the future cooperation dynamics, relationship, and trust among the parties. Therefore, before a term sheet is proposed, detailed consideration as to the strategy behind all the terms proposed and the consequence of these terms should be given in order to avoid the chance of major change after signing. Simplicity – although a term sheet is usually drafted by lawyers, investment team members, or financial advisors, it is normally drafted in a bullet-point style and written in plain language. It should not be written

96

•

Key steps for investment: term sheet in an agreement format nor contain too many legal acronyms. A term sheet is supposed to be able to be quickly understood by businessmen and senior management of both parties in making a prompt decision on whether or not the deal is worth pursuing. Time limit – a term sheet is normally valid for a specific period of time; say a couple of weeks to a month or two. After the deadline has lapsed, both parties can move on to talking with other interested parties and the terms that have been offered in a term sheet can be withdrawn or changed even if the same parties come back to the negotiation table again after the deadline.

Major terms contained in a term sheet Major terms contained in a term sheet vary from case to case, depending on the nature of the investment, the shareholding structure, pricing mechanism, and the ongoing management rights, among other factors. Appendix 6.1 shows a sample term sheet for the acquisition of significant minority with management rights in a company in China. Appendix 6.2 is a sample term sheet for a formation of a joint venture where the foreign investor holds 51 percent. Appendix 6.3 is a sample term sheet that describes an acquisition of majority interest in an entity. Although the exact content and format of a term sheet varies with different cases, a typical term sheet should at least address the following important aspects of a deal. Parties When an investor is going to inject new capital into an investee company for its newly issued shares, in most of the cases a term sheet is entered into between the investor and the investee company, which is the issuer of the new shares. In the case of acquisitions where the control of the investee company was changed to the hands of the investor by the sale of existing shares of shareholders to the investor, the parties to sign the term sheet should be the investor and the selling shareholders. However, there are exceptions to this general rule. In the case of new issuance of shares to the investor, if the investor would like the major shareholders to make representations and warranties as to the existing state of affairs of the company or to undertake to carry out future acts, the shareholders, together with the investee company, will also be required to be the signing parties to the term sheet. Even in the case of sale of existing shares to the investor, the company may be required to be the party to the term sheet if certain representations and warranties have to be made by the investee company. Instrument An investor may prefer, according to its investment purposes and financial needs, to use different types of instruments to finance a target company to

Key steps for investment: term sheet 97 grow, or to execute an acquisition or a takeover deal. Broadly speaking, these instruments can be categorized into equity instruments and debt instruments, which would further be subcategorized into more specific investment instruments. Equity instrument A target company normally issues common stock (also known as ordinary shares) to an investor, for the amount of capital the investor injects into the target company. Ordinary shares hold similar rights with other holders of the same type of shares (including those shares owned by the original owners) of the company, i.e., they rank pari passu with other ordinary shareholders. These shareholders will receive dividends when the board of directors declare a dividend distribution, can vote in the shareholders’ meeting according to the number of shares they hold, enjoy similar shareholders’ rights in the governance of the company, and rank after general creditors in the distribution of assets in the event of liquidation of the company. The beauty of being a shareholder obviously lies in the rights to receive dividends, to share governance right, and to enjoy an increment in share valuation if the business of the company grows after the investor injects capital, and enjoy capital gain and liquidity if the company is listed in a public stock exchange subsequently. However, on the other hand, an ordinary shareholder runs a larger risk than a creditor or debt-instrument holder if the business turns sour. They are ranked the lowest in the order of repayment in case of liquidation and may not receive any dividend if the company does not have any surplus in cash. Also, the liquidity of the shares in the company will be extremely low if the company does not perform well, thus stopping the investor from exiting a deteriorating business in the worst-case scenario. Debt instrument Some investors prefer to finance a target company with debt instruments first (i.e., the target company issues notes or bonds to investors in exchange for capital), and reserve the right to further invest in equity if they subsequently think the company is really performing well. This approach serves well the conservative investors in the way that they are entitled to receive fi xed income (i.e., periodic cash flow in the form of interest payment) no matter whether the company is performing well or not. Debt holders also enjoy priority in repayment over shareholders in the event that the company has to be liquidated. However, this downside protection takes away the rights of the investors to be involved in the management of the company and the right to enjoy upside in capital gain resulted from rising share valuation if the company’s business grows well. Even if the investors are interested in investing in the equity of the company afterwards, the then valuation of the company will normally be much higher than that at the time when the debt was advanced to the company, due to the growth of the business.

98

Key steps for investment: term sheet

Convertible debt1 This allows an investor to enjoy both the benefits of being a shareholder and the protection of being a debt holder, as mentioned above. Many investors, especially institutional investors, prefer to use convertible debt instruments to execute direct investment transactions, especially when the investors will not hold the majority of shares in the target company but have to partner with the original shareholders in running the company in a joint-venture setting. The features of convertible debt instruments are: • •

•

•

•

•

It is a debt instrument (i.e., named as a convertible note or a convertible bond) until it is converted into ordinary shares. As a debt instrument, this gives investors all downside protection and the right to earn interest payment as other general creditors (such as commercial banks). The instrument contains a conversion clause whereby the investor has the right to convert the instrument into ordinary shares at a pre-agreed valuation or valuation formula. Even before conversion, the investor (a debt holder) is normally allowed to participate in the management of the company, to appoint a representative to the board and to vote at the shareholders’ meeting as if they were a shareholder. This gives the investor the rights of a pseudo-shareholder without having to sacrifice the downside protection attached to a debt. Once the investor converts the debt into shares, it becomes an ordinary shareholder who enjoys the same right as the other shareholders. The conversion normally takes place when the company‘s business has grown substantially after a period of time and especially when the company is ready to be publicly listed. This gives the original debt holder both the right, after conversion, to enjoy dividend payment (when the dividend is more than the fi xed interest payment) and the right to enjoy capital gain resulted from an increased share valuation after the company’s shares are listed in the public stock exchange. The valuation upon which the conversion takes effect will be determined when the debt is granted. Therefore this helps avoid the aforementioned situation faced by a normal debt holder where the company’s shares become very expensive to purchase after the company‘s business has grown.

Valuation If an investor determines to invest into a company by equity or convertible debt instrument, it has to agree with the company on the valuation of the shares of the company (in the case of an equity deal) or the valuation of the shares of the company upon which the conversion of debt will take place (in the case of a convertible debt deal). A valuation of a company is

Key steps for investment: term sheet 99 normally determined by the price to net earnings multiple of the company. More conservative investors may want to use a multiple of cash flow from operation, free cash flow, or even EBITDA2 to calculate the valuation of a business. These multiples have advantages over the net earnings multiple in that they minimize the potential risk of bad debt or impact from non-cash items contained in net earnings. If an investor makes an investment based on forecasted net earnings or cash flow and the completion of the transaction takes place prior to the release of the audited financial statements, it is advisable to build in the term sheet an earn-out arrangement, as mentioned in the next section, so that the investor will not end up overpaying for the value of the business based on an overestimated projection of net earnings or cash flow. Earn-out An earn-out clause normally provides for an adjustment mechanism where the valuation of the company will be adjusted by its future performance. This is a protective provision to save the investor from an unexpected downside risk resulting from the declining performance of the investee’s business after the investment transaction has been completed. For instance, if an investee company made USD 35 million in net profit in 2010 and an investor intends to invest into the company in 2011. After due diligence, the investor prepares to value the company at 8 times its 2011 projected earnings of USD 50 million. Therefore the valuation of the investee company should be USD 400 million (8 × USD 50 million). If the investor is investing another USD 600 million into the company, it should get 60 percent of the post-investment company (600/ (600+400)) based on this valuation and projected earnings, subject to an earn-out mechanism. The investor completes the investment in the third quarter of 2011. However, when the year end of 2011 comes, the company misses its profit target of 2011 and makes only USD 40 million in net profit. An earn-out provision will be triggered in this case so that the valuation of the company will be adjusted downward according to the actual net profit of the company to become USD 320 million (8 × USD 40 million). Accordingly, the shareholding percentage of the investor in the company will be increased from 60 percent to 65.2 percent (600/(600+320)). If the company exceeds its projected target, the investor can end up with a lesser shareholding than originally estimated based on the earn-out provision.3 Due diligence Due diligence provision will set out what kind of investigation the investor intends to carry out in order to understand the state of affairs of the company from legal, fi nancial, business, and technical points of view. The clause will also estimate how much time will be needed to complete this due diligence exercise. The investee company will undertake in this clause

100

Key steps for investment: term sheet

to fully cooperate with the investor in its due diligence exercise and will, in a timely manner, provide necessary documents as reasonably requested. Some investors will also stipulate that the cost of due diligence exercises will be borne solely or in part by the investee company. Management and business rights As a contrast with portfolio investment, direct investment requests a certain degree of control over the investee company. Control is especially important for an investor-operator who is looking for operation synergies between the investee’s business with business lines of the investor corporation. In order to realize the synergies, an investor will request for management rights that suit its specific business needs. The investor will request board seats on the board of directors of the target company according to its shareholding (or converted shareholding if it is a convertible debt holder). Other management rights will also be requested at the term sheet stage. These rights may include appointment of senior management such as the CEO, COO, or CFO, a merger of the investor’s and investee’s business lines, the right to reorganize the operation team structure, the right to handle distribution for the investee’s products, the first right of access to the investee’s raw materials, etc. The final list of management and business rights depends on the business strategy and motives of the investor and investee. Shareholders’ rights Equity and convertible debt investors will normally enjoy a list of shareholders’ rights relating to major capital, structural, and business events, which have to be spelled out in the term sheet. Some of these rights include: • • •

•

•

•

The right to appoint director(s) at the board. The right to vote at the shareholders’ meeting. Certain veto rights as to the significant affairs of the company, such as purchase and sale of substantial assets, entering into related party transactions, entering into material contracts such as loan agreements and long-term leases, issuance of new shares, appointment of senior management team, change of payment authority, entering into mergers, acquisitions, and investment transactions, conducting business other than the ordinary course of business, formulation of business plan, etc. Tag along right: the investor will have the right to sell to any potential investors who have agreed to purchase any portion of the shares of the original shareholders of the target company. Drag along right: the investor will have the right to force the original shareholders of the target company to sell their shares to the potential investors to whom the investor has agreed to sell its shares. Preemptive right: the investor will have the priority of purchase if the company is to issue new shares.

Key steps for investment: term sheet 101 Exit This provision is particularly important for private equity or venture capital investors. It provides the timetable which the company should follow in bringing the business of the company to a size that is qualified for an initial public offering in a reputable stock exchange. It also provides for a penalty clause which stipulates the compensation from the company or the original owners of the company (on top of dividends or interest payments already agreed) payable to the investors if the company fails to be listed in an agreed stock exchange according to the agreed timetable. The exit provision may be omitted in the event that the investor is an operator-investor and does not primarily aim to exit the investment within a timeframe.4 Confidentiality A confidentiality clause stipulates the confidentiality obligations for each party in relation to the transaction negotiation and information disclosed by the company. Each party should agree not to disclose information circulated during the course of the transaction, whether or not the investment is consummated in the end. Exceptions to the obligations include information disclosed under the public domain or required to be disclosed by a law enforcement agency or the court. Exclusivity One of the key purposes of entering into a term sheet is to lock both parties into an environment of friendly but exclusive negotiation, so that the parties, especially the investor, are willing to spend more time and cost in investigation. Most investors will not spend further time and more costs in pursuing a costly due diligence exercise unless they are sure that the target company is not shopping around for other investors with a higher bidding price before an agreed deadline, which can be weeks or months from the date of signing of a term sheet. Therefore the clause of exclusivity is normally an indispensable request from the investor. Without this clause, the investor may end up running into an auction situation that may unreasonably drive up the price. Expenses In a lot of cases, investors would like the target company to share or even to bear solely the professional expenses incurred in the due diligence exercises and preparation of legal agreements. Whether the target company would agree to such provision depends on the bargaining power between investors and investees. Sometimes, a term sheet can provide that the investors have to bear all due diligence and legal drafting expenses if the investment is not consummated after due diligence; whereas the company has to bear or

102

Key steps for investment: term sheet

to share such expenses out of the proceeds invested by the investor if the deal is consummated in the end. Sometimes, the term sheet can also provide that due diligence expenses to be borne by the investee company can be capped by a maximum amount, so that the investee company will not run into a huge bill of professional costs even if the investor turn out to be not investing. Legal effect Although a term sheet is largely legally non-binding over the signing parties, a number of clauses in the term sheet should be made legally binding upon the parties otherwise the primary purpose of signing a term sheet i.e., locking in both parties to spend further time in a deal and not to shop around, would be lost. So the legal effect clause in a term sheet will spell out that the term sheet is non-legally binding save for a number of clauses including the legal effect clause, the confidentiality clause, exclusivity clause, and the expenses clause, which would remain legally binding obligations over the parties. That means, the parties can still go to the court to claim compensation from the defaulting party if these specific clauses are breached.

Key steps for investment: term sheet 103

Appendix 6.1 Sample term sheet 1: acquisition of minority interest Issuance of convertible bond by BRUCE LTD Term sheet5 This summary of principal indicative terms and conditions (this “Term Sheet”) is not meant to be, nor shall it be construed as, an attempt to define all of the terms and conditions of the described transaction. Rather, it is intended to outline certain basic points of business understanding upon which the financing contemplated herein would proceed. The terms and conditions set out in the Term Sheet are indicative only and do not constitute a binding commitment by PROINVEST CAPITAL LTD, and/or their respective affiliates (“Investors”) to make an investment as described herein. : BRUCE LTD, a company to be incorporated and existing under the laws of the British Virgin Islands with limited liability, which will be the group holding company of the [fast food retail] businesses under the trade name of [BRUCE] operated in China. Investors : PROINVEST CAPITAL LTD Instrument Type : Convertible Bond (“CB”) to be issued by Issuer in United States dollar denomination (“USD”). Maturity : The fifth anniversary of the issue date of the CB (or such later date as the Investors may agree, the “Maturity Date”). Existing : ZHANG MIN and LI HUA, who hold 45%, and 55% of Shareholders Issuer, respectively. Investment : The total investment amount from Investors is up to Amount and USD [] million (the “Investment Amount”) to acquire Purpose up to a []%6 shareholding interest in Issuer upon conversion of the CB on a fully diluted and as-converted basis (the “Initial Ownership”). Issuer shall use proceeds from the CB to expand Issuer’s existing core business and/or for other purposes/projects approved by Investors. Valuation / : Issuer anticipates that its 2009 audited consolidated Conversion net profit after tax (excluding non-recurring items), as Ratio audited by one of international reputable accounting firms to be agreed by Proinvest (“NPAT”), would be no less than USD [ ] million (the “Anticipated 2009 NPAT”). Issuer

104

Key steps for investment: term sheet

Closing Date

:

Interest

:

Qualified IPO9 :

Earn-out based : on Performance Guarantee / Adjustment to Conversion Ratio

At any time after the transaction is completed, the CB shall, at the sole discretion of Investors, be convertible at its face value (i.e., the Investment Amount) into such number of newly issued shares of Issuer, credited as fully paid, which shall be based on post-money valuation that equals to 5 times of the Anticipated 2009 NPAT,7 resulting in Investors receiving approximately [ ]% of the issued share capital of Issuer on a fully diluted basis (the “Conversion Ratio”). The Conversion Ratio shall be subject to adjustment provided below. The date upon the payment of the Investment Amount by Investors to Issuer (“Closing Date”). Until such time CB is converted into the Common Shares or redeemed, Issuer shall pay Investors interest semi-annually in cash in USD (“Interest”). The annual interest rate should be 5%.8 Existing Shareholders and Issuer shall use best endeavors to complete, within [36] months of the Closing Date, an initial public offering of Issuer’s common shares (the “Common Shares”) on the Hong Kong Stock Exchange or any other exchange acceptable to Investors at a post-listing valuation of no less than USD[500] million (a “QIPO”) Existing Shareholders and Issuer shall guarantee the Anticipated 2009 NPAT and the anticipated 2010 NPAT (“Anticipated 2010 NPAT”). Anticipated 2010 NPAT shall be the higher of (i) 120% of actual 2009 NPAT and (ii) RMB [ ] million. In the event the Anticipated 2009 NPAT or the Anticipated 2010 NPAT is not achieved, the CB can be converted into additional shareholding in the Issuer based on the adjustment formula below (using post-money valuation of 5 times as an example): For 2009: Investment Amount / (Actual 2009 NPAT × 5)] – Initial Ownership = additional shares to be issued to Investors upon conversion This adjustment is applicable for Issuer’s 2009 and 2010 performance only. Under no circumstances shall there be reverse adjustment even if the performance exceeds budget.10

Key steps for investment: term sheet 105 Conversion into : The CB shall be convertible into the Common Shares Common Shares under the following circumstances: (i) Mandatory Conversion: immediately prior to the consummation of a QIPO, the CB shall be converted into the Common Shares. Should the listing of Issuer be withdrawn, rejected, or lapsed for whatever reasons subsequent to the Mandatory Conversion, the Common Shares so held by Investors shall, at the sole discretion of Investors, be entitled to be converted back into the CB with the same rights, preferences, privileges, and restrictions attached. (ii) Voluntary Conversion: Investors will have the right, at their sole discretion, to convert all or a portion of their CB into the Common Shares at any time after the Closing Date. Investors shall have the right, at any time after the Redemption third anniversary of the Closing Date, to require Issuer Right11 to redeem all or a part of the CB at an internal rate of return (“IRR”) of [25%], inclusive of interest paid (“Redemption Amount”). Accelerated : Investors shall have the right to immediately require Redemption Issuer to redeem all or a part of the CB at the full Redemption Amount if one of the following events occurs: (i) breach any of the Undertakings (as defi ned below); (ii) Issuer is able to go for a QIPO but chooses not to; (iii) material inaccuracy of representations and warranties; (iv) other events to be defined in the Investment Documentation; (v) departure of key men (to be defined). Guarantee / : Existing Shareholders shall pledge to Investors Security their shares of Issuer to secure Issuer’s and Existing Shareholders’ obligations under the Investment Documentation, including obligations to perform their respective undertakings and covenants, obligations to pay the Redemption Amount and indemnification obligations in the case of misrepresentations and warranties.

106

Key steps for investment: term sheet

Shareholders Non-compete

Pre-emptive Rights

Right of First Refusal

Tag Along Rights

Drag Along Rights

: Existing Shareholders shall make full disclosure to Investors as to whether they and/or their affi liates are engaged in any business which, either directly or indirectly, competes with Issuer’s and/or its subsidiaries’ business, and shall undertake not to compete with Issuer’s and/or its subsidiaries’ business so long as Investors have an interest in Issuer. : Prior to completion of a QIPO, Investors will have pre-emptive rights with respect to any further issuance of Issuer’s shares or securities convertible or exercisable into Common Shares, on a pro rata basis with all the other shareholders, and will have the right to purchase any of such securities not purchased by the other holders of such rights. : Subject to clause (v) under Section entitled “Undertakings,” in the event that any Existing Shareholder desires to transfer all or a portion of his shares (or other evidence of equity) in Issuer or any of its subsidiaries, Investors shall have the right to purchase such shares (or its pro rata portion of such shares) on the same terms and conditions as those offered by bona fide purchasers. : Prior to completion of a QIPO, Investors shall have customary co-sale rights in relation to any transfer of shares of Issuer by any Existing Shareholder, provided that if any sale of Issuer’s shares by Existing Shareholders would cause them to lose their majority shareholder status or to lose their effective control over Issuer, Investors shall have the right to sell all of their CB or converted Common Shares in such sale. : Investors shall have the right to drag all shareholders of Issuer to sell all of their shares or to put Issuer for sale (i) at any time during the term of the CB, if Investors received a bona fide offer to subscribe for or purchase shares of Issuer at a price no lower than [3] times Investors’ entry price and if QIPO has not occurred before Investors have received such offer, (ii) at any time after the third anniversary of the Closing Date at a price no lower than Investors’ entry price, if QIPO has not occurred before such third anniversary, or (iii) at any time after the Maturity Date, if QIPO has not occurred before the Maturity Date.

Key steps for investment: term sheet 107

Existing Shares and Anti-Dilution

:

Voting Rights

:

Board Representation

:

Protective Provisions

:

The net proceeds resulting from such sale shall be distributed to Investors and all shareholders of Issuer in accordance with their respective percentage interest in Issuer on a fully diluted and as-converted basis. After the Closing, Investors shall be entitled to customary anti-dilution provisions. If Issuer issues or sells its shares to parties other than Investors at a price lower than the Valuation, Investors shall be entitled to either adjust the Conversion Ratio or require Issuer to pay in cash the difference between such selling price and Investors’ entry price. Investors shall be entitled to vote on all matters submitted to a vote of the shareholders and will be entitled to the number of votes equal to the number of Common Shares underlying their CB held. Issuer’s board shall have five members, of which Investors will have the right to appoint two directors. Investors shall be entitled to appoint two directors to the board of each subsidiary of Issuer. If Issuer sets up any board committee in the future, Investors shall have the right to appoint at least [one/ two] director to each such committee. Issuer and each subsidiary of Issuer shall provide each Investor-appointed director with customary indemnity and insurance acceptable to Investors. The rights under this Section will terminate upon a QIPO. Unanimous consent by the Board shall be required for: (i) amendment of Issuer’s Memorandum and Articles of Association; (ii) issuance of any securities and reclassification of any outstanding securities; (iii) any merger or consolidation of Issuer with one or more other corporations; (iv) the liquidation or dissolution of Issuer; (v) approval or adoption of any annual budget and any business plan of the Issuer or any modification thereof; (vi) acquisitions, divestments, or disposals by the Issuer; (vii) any material changes to Issuer’s nature of business and strategic direction; (viii) capital expenditures for any project not in the approved annual budget; (ix) incurrence of any indebtedness;

108

Key steps for investment: term sheet

Due Diligence

Closing Conditions

Undertakings

(x) any related-party transactions; (xi) any payment outside the ordinary course of business and any payment of dividends; (xii) selection, appointment, and termination of auditors; (xiii) appointment of, termination of employment of, and determination of compensation of CEO, CFO, and other senior management members; (xiv) other matters to be agreed in the Investment Documentation. Investors shall have the right to appoint the CFO of the Issuer, who will be responsible for the entire financial control and management of the Issuer and its subsidiaries and affiliates. : Issuer will use its best efforts to assist Investors in conducting and completing their due diligence for evaluating this Investment. : Closing of this Investment Transaction is subject to, inter alia: (i) approval from Investors’ Investment Committee; (ii) approvals from the relevant government authorities; (iii) completion of legal and financial due diligence to the satisfaction of Investors; (iv) receipt by Investors of Issuer’s 2009–2011 audited accounts signed by a big four accounting firm (i.e., PWC, E&Y, Deloitte, KPMG); such audited accounts should not deviate materially from the management accounts previously provided to Investors; (v) satisfactory negotiation and execution of the Investment Documentation; and (vi) other reasonable customary closing conditions for transactions of this nature. : Existing Shareholders and Issuer will make the following undertakings on a joint and several basis (except for (v) which will be undertaken by Existing Shareholders only): (i) Issuer shall focus on its existing business and the relevant related activities in China; (ii) to use respective best endeavors to complete a QIPO within [36 months] from the Closing Date; (iii) to compensate Investors for Performance Guarantee;

Key steps for investment: term sheet 109 (iv)

to pay cash to Investors upon the exercising of the Accelerated Redemption by Investors; (v) the Existing Shareholders agree not to pledge or sell their shares of Issuer and Issuer’s current and future subsidiaries to any third party without Investors’ consent before a QIPO; (vi) key management team to sign a [3-year] employment contract; (vii) other customary undertakings on transactions of this nature, to be specified in the relevant documentations. Representations, : As customary for transactions of this nature; to include, Warranties, and without limitation: Indemnities (i) usual corporate representations including status, due authorizations, validity, and admissibility in evidence; (ii) binding obligations; (iii) no winding up and/or insolvency; (iv) no defaults; (v) no material adverse change; (vi) accuracy of information; (vii) full disclosure; (viii) ownership; and (ix) no proceedings pending or threatened. Legal Effect : This Term Sheet is neither an offer to make an investment nor an agreement among the parties hereto and does not create any binding obligation on any party to proceed with or consummate the Investment hereunder, except that the paragraphs entitled “Confidentiality,” “Non-Binding,” “Expenses,” “Exclusivity,” and “Governing Law and Dispute Resolution” shall be legally binding on the parties hereto. Exclusivity : Upon signing of this Term Sheet and until the expiry of two months thereof (subject to an automatic one-month extension in the event that there is still outstanding due diligence work, the “Exclusivity Period”), Issuer will not, directly or indirectly, solicit, discuss, or negotiate with any third party regarding investment in Issuer or any of its subsidiaries, nor will it permit any third party to conduct diligence review for the purchase of an interest (whether debt or equity, and whether directly or indirectly) in Issuer or any subsidiary of Issuer or any business thereof.

110 Key steps for investment: term sheet

Confidentiality

:

Expenses

:

Investment : Documentation

Governing Law / Dispute Resolution

:

In the event that Issuer breaches this Exclusivity clause or decides not to proceed with the transaction contemplated herein within the Exclusivity Period, Issuer and Existing Shareholders shall, jointly and severally, reimburse Investors all of their out-of-pocket expenses and their professional fees (including legal fees and due diligence expenses). Neither party and/or any related parties shall disclose the existence and/or contents of either this Term Sheet or the fact that Investors are contemplating the Investment in Issuer, without the prior written consent of the other, other than to their respective senior management, affiliates, investment committees, legal counsel, accountants or other professional advisors who need to know such information for the purpose of assisting the parties in this transaction. The aforesaid restriction shall not apply with disclosure requirements necessary or desirable under relevant laws and regulations made in furtherance to the Investment. Issuer shall bear all reasonable out-of-pocket expenses, including but not limited to legal fees, due diligence, accounting and technical fees, etc., incurred by Investors in relation to the transaction contemplated hereunder, subject to a cap of (i) [USD100,000], if the transaction contemplated herein is consummated and (ii) [USD200,000], if the transaction contemplated herein is not consummated. Investment shall be evidenced by inter alia a CB subscription agreement, a security-holders agreement and Issuer’s revised memorandum and articles of association reflecting the terms of the Investment, where appropriate. Certain customary affirmative and negative financial and other covenants by Issuer, Existing Shareholders, and Issuer’s subsidiaries to be agreed upon by the parties will be set forth in the Investment Documentation. Hong Kong SAR law. Any dispute arising out of or relating to this Term Sheet shall be finally settled by arbitration under the UNCITRAL Rules of Arbitration and administered by the Hong Kong International Arbitration Center. The seat of the arbitration shall be Hong Kong. Losing party shall bear all arbitration costs and expenses incurred by each party to the arbitration.

Key steps for investment: term sheet 111 For and on behalf of: BRUCE LTD

Date: For and on behalf of:

PROINVEST CAPITAL LTD Date:

112 Key steps for investment: term sheet

Appendix 6.2 Sample term sheet 2: formation of new joint venture where foreign party holds 51% Key terms between Proinvest Capital Ltd and Chen Jin to form an equity joint venture in China to run the business of Drink Co. Ltd. Transaction

•

•

•

•

Management Rights

•

Board Composition

• •

•

1. 2. 3. 4. Funding

•

Whereas Chen Jin (“Chen”) owns and controls all the assets and cash (“Assets”) relating to the operation of the Drink Co Ltd located at Chongqing. Chen intends to form a new equity joint venture with Proinvest Capital Ltd to run the New Drink Co Ltd (“EJV”). Chen will inject the Assets into the EJV and Proinvest Capital Ltd (“Proinvest”) will invest cash capital of USD 30m into the EJV. After injection of cash capital and Assets by the respective parties, Chen shall own 49% and Proinvest shall own 51% of the EJV. Chen shall nominate the key management team members (except CFO) of the EJV. Proinvest shall appoint the CFO of the EJV. The Board of Directors of EJV shall comprise 5 directors in which 3 shall be nominated by Proinvest and 2 nominated by Chen. Matters tabled to the Board shall be resolved by simple majority of votes save and except the following which shall require unanimous consent of all directors: Fundamental change of nature of business Sale of all or substantial portion of assets Winding up of the EJV Change of Memorandum or Articles of Association Proinvest and Chen shall agree on a [5]-year-business plan of EJV, which shall be annexed to the legal agreements12 for this transaction. Shall the EJV need funding that is greater than the funding amount stipulated in the business plan mentioned above, the excess portion of funding shall be advanced by Chen solely by way of interest-free shareholders’ loan. Such advance shall not in any event result in any dilution to Proinvest’s shareholding in EJV.

Key steps for investment: term sheet 113 Put Option

•

Dividends

•

Non-compete

•

Shareholders’ Rights •

Operation synergies: • Exclusive Right of sales and marketing in China Definitive Legal • Agreements

Due Diligence

•

Shall the EJV incur loss in any financial year that is greater than the loss stipulated in the B-Plan, or shall the EJV need funding that is greater than the funding amount stipulated in the B-Plan, Proinvest shall have the put option to sell any or all of its shareholding in EJV to Chen and Chen shall purchase the same at the price equivalent to Proinvest’s investment costs plus interest costs at [ ]% p.a. Shares in EJV owned by Proinvest will rank equally with those owned by Chen with respect to the distribution of dividends. No distribution of dividends shall be made by EJV prior to the repayment of 100% of the shareholders’ loans advanced by shareholders, if any. Each of Proinvest and Chen agrees not to seek any stake in any other beverage business in China without the consent of the other party for so long as they hold shares in EJV greater than [15%] and a Board seat in EJV. Proinvest shall have usual and standard shareholders’ rights in EJV including but not limited to rights of access to books and records, anti-dilution, tag-along, drag-along, pre-emptive rights, first right of refusal over shares offered by other shareholders, etc., which shall be elaborated in the definitive legal agreements. Proinvest shall be the sole and exclusive sales and marketing agent for EJV in China and Proinvest shall be allowed to subcontract this right to other agents, which it thinks fit.13 Each party shall try their best efforts to conclude the definitive legal agreements relating to this transaction no later than 3 months after the signing of this Term Sheet. The completion of this transaction shall be subject to, inter alia, the completion of business, financial, legal and technical due diligence on Drink Co Ltd and the Assets to the satisfaction of Proinvest.

114 Key steps for investment: term sheet Exclusivity of Negotiation

•

Confidentiality

•

Legal Effect

•

From the date of signing of this Term Sheet until [ ], Chen shall not negotiate with any person or party other than Proinvest with respect to the subject matter of this Term Sheet. Except as and to the extent required by law and listing rules, without the prior written consent of the other parties hereto, no party shall, and each shall direct its employees, officers, and advisors not to, directly or indirectly, make any public comment, statement, or communication with respect to, or otherwise disclose or permit the disclosure of any term of this Term Sheet, the existence of discussions regarding the subject matters of this Term Sheet or the existence of this Term Sheet. This Term Sheet merely sets out the intentions of the parties to it regarding a potential definitive legal agreement and outlines some of the principal terms agreed as at the date of it. Save as the clauses of “Exclusivity of Negotiation” and “Confidentiality” and “Legal Effect” which shall be governed by the laws of Hong Kong, this Term Sheet shall not be legally binding but shall form the basis of the definitive legal agreements. The definitive legal agreements will be subject to the review and approval of each party’s senior management prior to execution.

Signed for and on behalf of PROINVEST

Date: Signed by Chen

Date:

Key steps for investment: term sheet 115

Appendix 6.3 Sample term sheet 3: Acquisition of majority interest Relating to the acquisition of a [80]% interest in Mega Co. Ltd. by Proinvest Capital Ltd. Background Mega Co. Ltd. (“Mega”) has achieved remarkable success in the past several years, building what is today China’s leading advertising company. This Term Sheet reflects the intention of the parties to meet the funding need of Mega for the purpose of its further expansion according to its business strategies to become one of the most influential advertising companies in the global Chinese community. In this context, we propose the following transaction terms: Vendor Purchaser Interest to be Acquired Valuation and Consideration

Earn-out

Mr He Min, the sole shareholder of Mega. A wholly owned subsidiary vehicle of PROINVEST Capital Ltd (“PROINVEST”).14 [80]% equity interest in Mega (the “Company” or “Mega”). Pre-money valuation of USD 100 million based on [5] times the anticipated Net Profit after Tax of Mega for the period ended 31 December 2013 (“2013 NPAT”) of USD [20]m. Therefore the consideration for acquiring 80% shareholding in Mega from Mr. He is: 20m × 5 × 0.8 = USD 80m The Valuation is based on the anticipated 2013 NPAT of USD [20]m, In the event the 2013 NPAT of USD [20]m is not achieved, the valuation will be adjusted accordingly by further issuing additional shares to the investor so that the shareholding of the investor will equal the result of this formula: Investment Amount / (Audited actual 2013 NPAT × 5) In the event that the 2013 NPAT of USD [20] m is exceeded, the valuation will be adjusted accordingly by further issuing additional shares to Mr. He so that the shareholding of the investor will equal the result of the aforementioned formula, except that the investor’s shareholding in Mega shall in any event be no less than [70]%.

116

Key steps for investment: term sheet

PROINVEST will, at the time of the completion of this transaction, advance a shareholders’ loan up to USD [20]m, repayable in 4 years, at the annual interest rate of 5% to Mega for the purpose of funding its expansion plan. The loan will be secured by all assets of Mega and He’s shareholding in Mega. Detailed terms of the loan will be set out in the loan agreements. Use of Loan The loan advanced by PROINVEST will be used to fund capital expenditures and working capital associated with the Company’s planned business expansion agreed by PROINVEST. Conditions Precedent for • Execution of a 3-year employment Closing contract between the Company and Mr. He on his service as the CEO of Mega; • Execution of a new shareholders agreement between Mr. He and PROINVEST; and • Such other conditions precedent as designated by PROINVEST in the definitive agreements. Representations and Standard representations and warranties for Warranties the purchase of a majority stake.15 Definitive Agreements The Definitive Agreements will be based on the terms set out in this Term Sheet. Each party shall try their best efforts to conclude the definitive agreements relating to this transaction no later than [31 September 2013]. Completion Completion shall be subject to, inter alia, 1. due diligence to the satisfaction of PROINVEST; and 2. approval from the relevant government or regulatory authority, if needed. Expected Completion Date [30 November 2013] Funding Future funding requirements of the Company may be satisfied (other than the shareholders’ loan advanced by PROINVEST mentioned above) by the following: • working capital loans from banks or other financial institutions; • shareholders’ loans: to be provided by all shareholders [in proportion to their shareholdings]; New Funding

Key steps for investment: term sheet 117 •

Non-competition

Management Rights

Board of Directors

Right of First Refusal

Tag-along Right

Drag-along Right

further equity contributions from shareholders: equity interest in the Company of the other non-funding shareholder will be diluted accordingly; and • introduction of new investor(s): shareholdings of all shareholders will be diluted accordingly as a result. Any new equity funding will be subject to the pre-emptive right of existing shareholders. Mr. He will undertake to procure that he and any entity in which he has a controlling interest will not engage, either directly or indirectly, in businesses that may compete with that of the Company in China without PROINVEST’s written consent. PROINVEST will have control over all aspects of operating the Company, including the setting of business strategy, development of business plans, personnel decisions, etc. PROINVEST shall have the right to appoint [3] directors and Mr. He shall have the right to appoint 1 director each to the Board of the Company after completion. Resolutions of the Board and at shareholders’ meetings shall be passed by simple majority of votes. PROINVEST will have the right of first refusal to acquire Mr. He’s shareholding in the Company in the event Mr. He wishes to sell some or all of its/his interest in the Company. Mr. He will have a tag-along right, whereby if a bona fide potential buyer wishes to acquire PROINVEST’s interest in the Company, an identical offer will have to be made to Mr. He. If the offer by the potential buyer is for less than 100% of the Company, all shareholders (including PROINVEST) will sell their respective interests to the potential buyer in equal proportions. In the event that a bona fide potential buyer wishes to acquire an interest in the Company at a valuation equal to or more than 3 times that of Proinvest’s investment then PROINVEST has the right to drag along the Minority Shareholders to sell all their shares.

118

Key steps for investment: term sheet

Exclusivity of Negotiation Upon acceptance of this Term Sheet, and Confidentiality PROINVEST shall be granted an exclusivity period up to the date of signing of the Definitive Agreements, or in any event until [30 Nov 2013], during which Mr. He and the Company, including their respective affiliated companies, directors, officers, employees, advisors, or agents shall not discuss or negotiate with any other party on the subject matter of this Term Sheet. Each of the parties undertakes that it will not (save as required by law, regulation, order, regulatory authorities, or publicity purpose for PROINVEST, being a listed company) disclose to any third party any information or make any announcement in connection with this Term Sheet unless the other parties shall have given their consent to such disclosure or announcement. For the avoidance of doubt, advisors to PROINVEST engaged in the evaluation of the potential transaction shall not be regarded as third party provided that they have committed themselves to the same extent of confidentiality as agreed in this Term Sheet. Legal Effect This Term Sheet merely sets out the intentions of the parties to it regarding a potential definitive agreement and outlines some of the principal terms agreed as at the date of it. This Term Sheet shall not be legally binding, save for the provisions regarding “Exclusivity of Negotiation and Confidentiality” and “Governing Law and Jurisdiction,” and shall form the basis of the Definitive Agreements. Governing Law and This Term Sheet shall be governed by and Jurisdiction construed in accordance with the laws of Hong Kong.

Accepted:

For and on behalf of PROINVEST

Key steps for investment: term sheet 119

Date:

He Min.

Date:

Further reading Bragg, Steven. 2009. Mergers and acquisitions: A condensed practitioner’s guide. Hoboken, NJ: John Wiley & Sons. Frankel, Michael. 2005. Mergers and acquisitions basics: The key steps of acquisitions, divestitures, and investments. Hoboken, NJ: John Wiley & Sons. Li, Yinya. 2005. Investing in China: The emerging venture capital industry. London; Sterling, VA: GMB.

7

Strategizing investments in China in the next decade

What went right? China’s past three decades evidenced a growth story led by the economic development of the southern and coastal regions. Special Economic Zones in Guangdong and Fujian, the Yangtze River Delta, the Liaodong and Shandong peninsulas, and the Bohai sea areas one after another became a regional power hub to support the continuous economic growth of the country. Among these regions, the main beneficiary provinces and municipal cities from the earlier FDI policies along the eastern coast were Guangdong, Jiangsu, Fujian, Shanghai, Shandong, Liaoning, Beijing, Tianjin, and Zhejiang. In terms of sectors, export-oriented manufacturing was the main focus of FDI development of the first 10–15 years. Hong Kong and other overseas Chinese businesspeople played the most significant role in the earliest development phase by setting up factories in Guangdong. Industries during this period were characterized by low-technology, labor-intensive, export-order-driven garment and light industrial products processing and production plants operated in Dongguan and Shenzhen. Into the 1990s, the government tried to speed up the technology transfer by encouraging MNCs that possess higher technology capabilities to set up plants in the Yangtze River Delta. High-tech firms in telecommunications, mobile phones, and computer-ware processing or manufacturing were subsequently set up in different technology zones in the coastal areas. This economic development, to a large extent driven by foreign investments, turned on the urbanization process of the southern and the coastal cities. Urbanization and economic growth gave rise to wage increase and domestic demands for improvement of lifestyle. Such development in turn created investment opportunities for foreign investors who are not just treating China as a manufacturing base along the supply chain of products for the export markets, but also as a potentially huge domestic market. Sectors in food and beverage, real estate, supermarkets, hotels, and daily commodities catered for domestic consumption became targets of many multinationals after the 1990s. Upon China’s accession into the WTO in 2001, these coastal areas became popular targets for the opened retail and distribution businesses.

Strategizing investments in the next decade 121 Foreign investors were also allowed to invest by phases in large-scale service sectors monopolized by the state such as the banking, insurance, and telecommunication sectors. Given the initial skepticism towards the market economy and foreign investments, the Chinese government adopted pilot testing strategies in most of its important financial and economic reform policies before these policies were proved successful. After the central government found these new policies manageable and fruit-producing in the test bases, the policies were extended to other provinces or even to the entire country. FDI policies are no exception. In attracting foreign investors to participate in the growing market economy of China, geographical and development diversity of different regions in China gave policy makers not much choice except applying a gradualist approach and geographical imbalanced policies in boosting economic development of different regions. Severe lack of foreign capital at the beginning of market-opening made the coastal and southern regions the most sensible spots to house foreigninvested export-driven manufacturers in order to accumulate foreign reserve and absorb industrial know-how. Pilot testing, gradualism, and sequencing played an important role in the story of FDI development of China for the past three decades.1 Given the successful outcome of the rise of the east coast, this strategy or story should be expected to repeat, with some modifications as we will discuss later, for western and inland regions in China in the forthcoming decade.

Go west and go inland Despite the fact that since the mid-1990s the Chinese government has put effort into shifting the FDI inflows from the east coast to the western inland of the country, the FDI utilized in the eastern areas still amounted to approximately 85 percent of the total FDI in the country as of 2010 (see Figure 7.1). Increasing competition, rising wage and land prices made the coastal markets more crowded and investment opportunities pricier than twenty years ago for multinationals. Relatively speaking, the potential for growth of the western and inland regions should look more attractive for foreign investors in the next decade. Smart investors would look for the next SEZ or Shanghai elsewhere in China rather than hoping for the strong growth of the coastal cities to continue. The Economist Intelligence Unit (“EIU”) surveyed China’s 287 prefecturelevel cities to look for the next growth stories. It found that the trend that the coastal cities are leading the growth changed in 2007 when inland China began to outpace coastal areas in growth rate: 19 percent for Central China versus 16 percent for the eastern region at the end of 2010.2 EIU came up with an abbreviation: CHAMPS, which stands for six among the 20 fastest-growing Chinese cities. The surveyed cities were ranked by a mixture of indicators such as forecast of population, projected GDP growth, disposable income per head, as well as the projected construction in infrastructure and size of urban

122

Strategizing investments in the next decade 9% 6% Eastern USD 89.8b Central USD 6.8b Western USD 9b 85%

Figure 7.1 Share of China’s FDI by region, 2010 Source: Ministry of Commerce data quoted in China Foreign Investment Report 2011, Beijing: Economy and Management Publishing House Note: Eastern region includes Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong, Hainan; Central region includes Shanxi, Jilin, Heilongjiang, Anhui, Jiangxi, Henan, Hubei, Hunan; Western region includes Chongqing, Sichuan, Guizhou, Yunnan, Tibet, Shaanxi, Kansu, Qinghai, Ningxia, Xinjiang, Guangxi, and Inner Mongolia.

areas. The highest 20 scorers are listed in Table 7.1 below. Among these top players are CHAMPS which includes Chongqing (Sichuan Province),3 Hefei (Anhui Province), Anshan (Liaoning Province), Maanshan (Anhui Province), Pingdingshan (Henan Province), and Shenyang (Liaoning Province), where, according to EIU, a wide variety of business opportunities is available for investors. Among the 20 top scorers, cities from central, inland, and western provinces (Anhui, Chongqing, and Henan) make up more than half of them. These cities shared commonalities that are very important for the next round of growth, including a large urban area, high level of investment in fixed assets, large population size, relatively higher disposable income and living expenditure per head (Economist Intelligence Unit 2010, 3–4). Financial Times China Confidential (“FTCC”) also echoed the potential of western and inland China in the next wave of economic growth.4 It used the manufacturing industry as an example. In an article FTCC said that the momentum gained by the migration of manufacturing capacity towards the inland areas would transform the economy of China. Key beneficiaries of this movement would be Jiangxi, Anhui, Hunan, Chongqing, Sichuan, Guangxi, and Henan. It estimated that 39 million people in central or western areas (3 percent of China’s population as of 2010), were moving from rural to urban areas each year that would continue to fuel the urbanization of these regions. It also found that industrial output in inland provinces grew by over 20 percent over the years versus the nationwide average of about 15 percent. One key difference of the manufacturing story of these inland areas from the story that happened 20 years ago at the east coast is that this new manufacturing capacity is aimed not primarily at the export customers but

Strategizing investments in the next decade 123 Table 7.1 Fastest growing cities in China Rank

City Name (province name)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Hefei (Anhui) Baotou (Inner Mongolia) Shenyang (Liaoning) Jiaozuo (Henan) Changchun (Jilin) Hohhot (inner Mongolia) Wuhu (Anhui) Zhengzhou (Henan) Xinxiang (Henan) Chongqing Pingdingshan (Henan) Nanchang (Jiangxi) Luoyang (Henan) Xiamen (Fujian) Xuzhou (Jiangsu) Maanshan (Anhui) Wuhan (Hubei) Anshan (Liaoming) Changsha (Hunan) Huainan (Anhui)

Source: Economist Intelligence Unit (2010, 3)

at the rising domestic markets. The overall rise in disposable income nationwide further feeds these regions’ rising manufacturing capacity. Despite many news headlines about the shortage of labor in manufacturing industries and the decline of labor-intensive models in China due to rise of workers’ wages, Morgan Stanley’s research report disagreed.5 It said while the number of laborers is important in producing economic growth, the quality of labor ultimately has the maximum impact. Its research revealed that China’s strong growth over the past two decades reflects rapid labor productivity growth rather than labor supply growth. So it concluded that there is substantial room for a more efficient allocation of labor in China, but proper incentives and infrastructure must be implemented to move rural labor into urban jobs. Institutional infrastructural reform such as deregulation in the household registration system (hukou) and provision of more social housing would favor the next wave of urbanization, especially when coupled with more policies incentives given to foreign direct investments to the western and inland provinces. If these are done properly, such urbanization should drive increases in urban and rural non-agricultural employment, which should ensure an abundant labor supply until 2020.

124

Strategizing investments in the next decade

Table 7.2 Average annual wage in manufacturing sector, 2008–2010 (RMB) Cities/Provinces

Regions

2008

2009

2010

Shanghai Beijing Tianjin Guangdong Chongqing Sichuan Shanxi Henan

Eastern Northern Northern Southern Western Western Western Central

43,678 38,136 33,356 24,751 24,249 22,090 20,345 21,181

46,672 41,595 36,495 27,578 27,770 24,448 21,806 23,330

52,163 48,298 42,482 31,277 31,894 28,577 25,350 25,864

Source: China Statistical Yearbooks (various years), Beijing: Beijing Statistics Press (available at: http://www.stats.gov.cn/tjsj/ndsj/2011/indexeh.htm)

International consulting firm LEK also took a similar view. While we heard broadly that rising wages would shift manufacturing sectors from China to other low-cost countries such as Vietnam and Cambodia, LEK is of the view that this statement erroneously presumed parity in cost structure over China.6 LEK said in one of its research articles that while coastal cities such as Shanghai may suffer from rising wages, there were many areas inland whose wages remained much lower. These regions were especially advantageous for companies that don’t need to pay a premium for nearby port facilities for export, but target for consumers in China or other nearby markets that can be reached by ground transportation such as the central and southern Asian countries. It found that one fashion manufacturer for a famous international brand that serves local Chinese customers recently moved its plant from Guangdong to Sichuan to reduce its cost by 40 percent. Table 7.2 shows the wage trend of different regions in China to illustrate the reason behind this view. The article also said that China will be increasingly supplying skilled labor, alongside with a continuous supply of manual labor for the inland regions, as China’s workforce is increasingly skilled given the rising education standard and the continued investment in research and development, especially in biotechnology, nanotechnology, and alternative energy. In another LEK report7 it took a bullish view on the prospects of infrastructure sectors in the western and inland regions such as the construction and building materials sectors. It said the sectors would stay strong due to the continuous urbanization and the policy rolled out from the 12th Five Year Plan. Particular beneficiaries include: (1) real estate, driven by continued urbanization, and low-income housing development; (2) infrastructure, driven by development of the metro in new cities; and (3) industrial-related, driven by cross-regional restructuring in industrial sectors to remove overcapacity. It also said that the construction booms in China are highly

Strategizing investments in the next decade 125 regional. The report projected potential next high-growth regions for the construction sector to be Yunnan, Henan, Guangxi, Hunan, and Shanxi, all of which are located in the western and inland regions. International players in building materials were making direct investment in these regions by way of mergers and acquisitions to prepare for the next wave of infrastructure growth.

Urbanization and domestic consumption Apart from paying attention to the industrial and infrastructural developments of the western and inland regions, retail markets in China have been the focus of foreign investors for more than a decade. With the growth of the middle class and their disposable income level, domestic consumption markets in the first to the third tier cities in China were among the top agenda items in MNCs’ strategic plans. But as we said, China has huge regional diversity in culture, income, language, and consumption patterns, so how should foreign investors understand the varying development in domestic markets of different parts of China and how should they prepare a game plan for that? In a report written by another reputable international consulting firm – McKinsey & Co. – Chinese customers were viewed as among the world’s most pragmatic consumers.8 The report wrote that Chinese consumers are willing to trade increased spending in sectors that mean more to them with fewer purchases in categories that are less important. The research revealed that Chinese consumers spend more on products they value, and trade down in less compelling ones to compensate. That was reflected by the declining shopping frequencies for Chinese consumers, however with growing basket sizes for each purchase. Therefore, hypermarkets would become increasingly appealing for Chinese shoppers and they are likely to stay longer and spend more on each excursion. An extension of the interest in easier, less frequent but more valuable shopping experience would be the rising trend of home delivery and loyalty programs for Chinese shoppers. One important finding in the report is that though Chinese consumers are brand-conscious, they are not loyal to brands. In addition, customer reviews on the product quality are highly regarded in China, and as such internet reviews and word-of-mouth reputation are very important sources of information for the Chinese consumer. The global accounting and consulting firm PricewaterhouseCoopers (“PwC”), in a report also agreed that hypermarket expansion is sweeping Asia, with foreign firms undertaking aggressive expansion in China as infrastructure develops.9 Its research revealed that demand growth in the food and beverage sector should be the strongest in China, which is expected to grow by nearly 6 percent a year for the period 2011–2014. It is also optimistic on a number of sectors, partly owing to the next wave of urbanization spinning from the first to the second tier cities in China. PwC has confidence

126

Strategizing investments in the next decade

in the Chinese luxury market and sees a trend of global retailers moving beyond tier-one cities. Another trend mentioned in the report is that despite there being already 140 million Chinese internet users shopping online, the sector is still underdeveloped due to lack of transaction security. Therefore another high growth is yet to come after transaction security, credit card and leasing payment mechanisms, and ease of using cell phones to transact have developed fully. It also mentioned that fast-moving consumer goods (“FMCG”) producers would continue to benefit from middle-class consumption. Therefore it is forecasted that foreign investment in the Chinese FMCG sector will continue to increase. China and India will continue to drive growth in the appliance and house ware segment. Another sector that China has a big gap to fill is home appliances and electronics, especially for the second-tier cities in the western and inland areas as well as the rural areas in general where China should experience another wave of strong growth driven by the desire to improve lifestyle. International investment bank Goldman Sachs in an analyst’s report also mentioned its view on the consumption pattern of Chinese customers going forward.10 It said the magnitude of China’s consumer base remains the key growth driver for international brands and retailers. While there was a rush to reap benefits from China’s urbanization, the report mentioned that currently most companies reach fewer than 100 million consumers. In the next wave, it said, global consumer product brands, luxury goods, restaurants, child-focused segments, department stores, and hypermarkets are likely to do well. However, the report also raised a number of cautions for foreign investors in these sectors, which distinguish China from other emerging markets. First, there are enormous regional differences in demand and high degrees of localization that give pressure to foreign players in utilizing logistical resources and know-how to achieve a better economy of scale, especially when they face competition from local brands. While global brands are getting a better reception from the emerging middle class owing to product quality and status symbol, regional dominance will continue to grow stronger in lower-tier cities. Second, staff retention in marketing, sourcing, and general management would be another headache for foreign firms going forward.

Policy and regulatory direction Apart from being sensitive to the regional economic development, investors in China should keep themselves abreast of the latest changes in policies and regulations. Updating with such information would help investors in strategizing their investment plan in a number of aspects, including the choice of sectors for investment, choice of location for setting up headquarters, plants and branches, choice of mode of entry (i.e., JV or WFOE), choice of partners, be they along the value chain or within the JV, and the choice of management team that possess the right skill sets, network, and local

Strategizing investments in the next decade 127 connection in the business and government circles. Alongside the 12th Five Year Plan approved by the National People’s Congress of China in March 2011, the Investment Catalogue has been further revised to take into consideration the economic direction steered by the central government leaders (a full 2011 Investment Catalogue is appended to this chapter as Appendix 7.1). Changes made to the Investment Catalogue shed light as to the direction of economic development in China as well as the possible investment strategy for direct investors in the next decade. The Investment Catalogue, first published in 1995, served as a part of regulatory efforts by the central government in giving a centralized guide to foreign investors as to which industries they are encouraged to invest in and which they are not allowed to participate in. According to the evolving economic directions set by the central government, the Investment Catalogue from time to time classifies industries into Encouraged, Restricted, or Prohibited categories. The Catalogue influences the approval process, both in terms of time and complexity, of the foreign invested enterprises application, as well as the investment return of the business. For encouraged industry, foreign investors may be offered incentives in taxes, land usage, and administrative processes by the local governments. The category of restricted industries normally sets limits as to the maximum amount of shareholdings allowed to be held by foreign investors. A sector that is not listed in the catalogue is presumably permitted for foreign investment, subject to local regulations. A number of key changes were made to the Investment Catalogue in 2011, which took effect in January 2012. The new catalogue continues to promote foreign investment by further opening up new sectors for foreign investment and reducing the number of restricted sectors. The 2011 Investment Catalogue contains 354 items in the Encouraged category, 80 items in the Restricted category, and 39 items in the Prohibited category. The net change is, compared with the 2007 version, Encouraged items increase by 3 items, while Restricted and Prohibited items reduce by 7 and 1 items respectively.11 In terms of sector direction, the 2011 Investment Catalogue reshuffles some of the sectors in different categories in accordance with the basic principles to accelerate restructuring of traditional manufacturing industry, to promote higher and cleaner technology, and to assist the development in service industry as laid down in the 12th Five Year Plan. One of the main themes in the 12th Five Year Plan is to restructure the manufacturing sector in China and raise its value-added level. Accordingly, promotion of higher value-added industry is the focus of the revised Encouraged category in the 2011 Investment Catalogue. New products and new technology in textile, chemical, and machinery manufacturing will be specifically welcomed. Environmentally unfriendly industries or industries with overcapacity problems such as complete automobiles manufacturing, poly-silicon production, and coal mining were removed from the

128

Strategizing investments in the next decade

Encouraged category. The 2011 Investment Catalogue also positions certain sectors as the strategic manufacturing industries that the central government aims at incubating and encouraging foreign investors to participate in. They include the energy-saving industry, IT technology, biotechnology, new and alternative energy, components for new-energy automobiles, internet network components based on IPv6, etc. Another focus in the 2011 Investment Catalogue is the promotion of the service industry. Nine items related to the service sector were added to the 2011 Investment Catalogue. They include charging stations for electric automobiles, intellectual property service, marine oil pollution cleaning, vocational training, and venture capital service. Medical institutions and financial services were also moved from the Restricted category. A number of changes related to specific sectors are worth noting under the 2011 Investment Catalogue: •

•

•

•

Logistics – foreign investment in domestic express mail, once permitted in the previous version of the Investment Catalogue, now has become a prohibited sector for foreigners under the 2011 Catalogue. On the other hand, delivery of commodities, low-temperature delivery of foodstuff, and agricultural products are regarded as modern logistics business and encouraged under the new Investment Catalogue. Real estate – as a response to the overheating real estate market, the development of villas is now placed under the Prohibited category (previously Restricted). Despite the fact that prohibition only applies to villa development under the Catalogue, in practice it is now very difficult for foreign investors to obtain local approval for forming FIEs even in development of multistorey residential apartments. Media and publications – while operation in publication of books, magazines, newspapers, and audio-visual products is still prohibited in China, the new Investment Catalogue permitted FIEs to operate in the main distribution and import of print publications and audio-visual products. Health care – under the previous Investment Catalogue, foreign investors had to work in joint ventures with Chinese partners in distribution, wholesale, and retail of pharmaceutical products as well as operating medical care institutions. Now these limits have been lifted under the new Investment Catalogue and these businesses have been placed within the Permitted category. This is in line with the overall direction of developing the higher technology service industry as set out in the 12th Five Year Plan.

Despite the above rules and principles in guiding foreign investments on a nationwide basis as set out in the 2011 Investment Catalogue, exceptions and more relaxed rules will apply in certain regions. Two broad regions were given flexibilities in developing foreign investments. The fi rst one is

Strategizing investments in the next decade 129 the central and the western provinces. Since 2000, the central government promulgated, on top of the Investment Catalogue, a specific catalogue of priority industries for foreign investment in the central-western region (“the Central-Western Catalogue”). The purpose of this Central-Western Catalogue is to help shift foreign investment from the increasingly crowded eastern and coastal cities to the western and inland provinces. Therefore, some sectors not included under the Encouraged category of the Investment Catalogue can be classified as encouraged ones under the Central-Western Catalogue. Examples include cement manufacturing using the less polluting dry method, manufacturing of stainless steel products, and development and operation of tourism destinations.12 Hopefully, with these incentives, the labor-intensive manufacturing sector which once contributed to the high growth of the economy in the coastal areas, would repeat its functions in generating the next group of high-growth cities in the central and the western areas. Another region where the central government relaxed its rules set out in the 2011 Investment Catalogue was Hong Kong and Taiwan. Under the Mainland and Hong Kong Closer Economic Partnership Arrangement (“CEPA”) and Economic Cooperation Framework Agreement (“ECFA”) with Taiwan although investors in Hong Kong and Taiwan were in general regarded as foreign investors under the 2011 Investment Catalogue, they were permitted to operate in WFOEs and JVs in certain services industries where other foreign investors were prohibited and offered preferential treatments not available to other foreign investors.13 There is a common belief that venture capitalists can normally act faster in getting involved in sectors where higher growth is forthcoming before ordinary investors become aware of the trend. The following survey conducted by a Chinese consulting fi rm, China Venture, on which areas venture capitalists have already taken action on investing in, may shed some light on how these investors thought about the areas where the next wave of growth could be found.14 The survey interviewed over 130 venture capital firms who have invested in over 200 enterprises located in Central and Western China from September 2008 to August 2010. Total investments made by these institutions were reported to reach over USD 5 billion. The survey results, as shown below (Figure 7.2 and Figure 7.3), revealed that among the Central and Western Chinese regions, Hubei, Hunan, and Sichuan are the most popular locations for venture capitalists’ incubations, followed by Anhui, Shaanxi, and Chongqing. In terms of sectors, manufacturing still remained the most popular. However, the proportion of manufacturing investment made by these venture capitalists is well below the share of FDI in manufacturing sector in the total FDI in China. Energy, health care, and agricultural sectors are getting more and more popular among venture capitalists, which seemed to have followed quite closely with the overall foreign investment policies recently announced by the central government.

130

Strategizing investments in the next decade 28

C

rs th e

ha

in

O

ic a

st or e

l

3

m he

le ea

C

R

Au

3

st at e

ob

d. .. an ia

ed

4

ile

4

Ag

ric

Fo o

ul tu

d

M

an d

an g rin

8

5

e

IT

ve be

d

lth ea H

M

6

to m

6

in g

re ca

er gy En

tu rin g fa c an u

9

ra g

12

12

fis h

30 25 20 15 10 5 0

Figure 7.2 Sectors of selected VC investments in Central Western China, 2008– 2010 (%) Source: China Venture report, 2010 (http://report.chinaventure.com.cn/r//f/261.aspx)

20 18 16 14 12 10 8 6 4 2 0

18

17 13 9

8 6

O

th

er

ng

s

2

xi an Sh

ng

xi

an

ua G

H

en

i an

gx

ng qi

ho

ng

aa

2

C

Ji

i nx

i Sh

hu An

n ua ch Si

un H

H

ub

ei

an

3

ia

6

nj

7

Xi

9

Figure 7.3 Locations of selected VC investments in Central Western China, 2008– 2010 (%) Source: China Venture report, 2010 (http://report.chinaventure.com.cn/r//f/261.aspx)

Appendix 7.1 Industry catalogue for the guidance of foreign investment 201115 Source: Ministry of commerce of PRC Catalogue of encouraged foreign investment industries I.

Farming, forestry, animal husbandry, and fishery industries

(1) Planting, development, and production of woody edible oil, ingredient and industrial raw material

Strategizing investments in the next decade 131 (2) Cultivation technologies development and production of green and organic vegetables (including edible fungus, watermelon, and melon), dried and fresh fruits and tea (3) New technology development and production of sugar-yielding crops, fruit trees, forage grass (4) Production of flowers and plants, and construction and operation of nursery base (5) Planting of rubber, oil palm, sisals, and coffees (6) Cultivation of traditional Chinese medicines (limited to equity joint venture and contractual joint venture) (7) Reusing in fields and comprehensive utilization of straws and stalks of crop, development and production of resources of organic fertilizers (8) Planting of forest trees (including bamboo) and cultivation of fine strains of forest trees and cultivation of new breed varieties of polyploid trees (9) Breeding of aquatic offspring (excluding precious quality varieties peculiar to China) (10) Construction and operation of ecological environment protection projects preventing and treating desertification and soil erosion such as planting trees and grasses, etc. (11) Breeding of aquatic products, cage culture in deep water, large-scale breeding of aquatic products, and breeding of eco-ocean products II.

Mining and quarrying industries

(1) Prospecting, exploitation, and utilization of coal-bed gas (limited to equity joint venture and contractual joint venture) (2) Venture prospecting and exploitation of petroleum, natural gas (limited to equity joint venture and contractual joint venture) (3) Exploitation of oil and gas deposits (fields) with low osmosis (limited to equity joint venture and contractual joint venture) (4) Development and application of new technologies that can increase the recovery factor of crude oil (limited to equity joint venture and contractual joint venture) (5) Development and application of new technologies for prospecting and exploitation of petroleum, such as geophysical prospecting, well drilling, well logging and downhole operation, etc. (limited to equity joint venture and contractual joint venture) (6) Prospecting and exploitation of such conventional oil resources as oil shale, oil sand, heavy oil, and super heavy oil (limited to equity joint venture and contractual joint venture) (7) Prospecting, exploitation, and beneficiation of iron ores and manganese ores (8) Development and application of new technologies for improving the utilization of tailings and the comprehensive utilization of recovery technology of the mine ecology

132

Strategizing investments in the next decade

(9) Prospecting and exploitation of unconventional natural gas resources such as shale gas and submarine natural gas hydrate (limited to equity joint venture and contractual joint venture) III. 1.

2.

3.

4.

5.

6.

Manufacturing industries Farm products processing industry (1) Development and production of biology feeds, straws and stalks feeds, and aquatic feeds (2) Aquatic products processing, seashell products cleansing and processing, and development of function food made from seaweed (3) Processing of vegetables, dried and fresh fruits, fowl and livestock products Food manufacturing industry (1) Development and production of food for babies and agedness, as well as health-care food (2) Development and production of forest food (3) Production of natural additives for foodstuff and food ingredients Drinks manufacturing industry (1) Development and production of drinks of fruits, vegetables, albumen, tea, and coffee Tobacco processing industry (1) Production of secondary cellulose acetate and processing of tows (limited to equity joint venture and contractual joint venture) Textile industry (1) Production of multifunctional textiles of lightweight, high-intensity, thermostability, cold-endurance, chemical-resistance, and light fastness for industrial use made with non-woven, machine knitting, knitting, and combined technologies (2) Weaving and dyeing as well as post dressing of high-grade loomage face fabric made with advanced technologies and equipment of energy-saving and emission reduction (3) Processing of special natural fiber products satisfying the requirement of comprehensive utilization of ecology and resources and environment protection (including animal fiber, fibrilia, silk, and colored cotton such as cashmere) (4) Production of clothes with computer integrated manufacturing system (5) Production of functional, environment-friendly, and special clothes (6) Production of top-grade carpet, embroidery and drawnwork product Leather, coat, and feather (down and feather) products industry (1) Cleaning processing of leather and fur (2) Post-ornament and processing of leather with new technology

Strategizing investments in the next decade 133 (3) Top-grade leather processing (4) Comprehensive use of leather waste 7. Lumber processing industry and wood bamboo, vine, palm, grass products industry (1) Development and production of new technology and products for the comprehensive utilization of “sub-quality, small wood and fuel wood” and bamboo in the forest area 8. Paper making and paper products industry (1) Production of chemical wood pulp with an annual production capacity of over 300 thousand tons by a single production line, chemical mechanical wood pulp with an annual production capacity of over 100 thousand tons by a single production line, and concurrent high-end paper and paperboard production mainly with overseas lumber resources 9. Petroleum refining and coking, nuclear fuel processing industry (1) Deep processing of needle coke and coal tar 10. Chemical raw material and products manufacturing industry (1) Development and production of new-type downstream products of sodium-process bleaching powder, polyvinyl chloride, and organosilicon (2) Production of supporting raw materials for synthesized materials: production of propylene oxide by epoxidation of propylene with hydrogen peroxide, epoxy chloropropane from glycerol, NDC, and CHDM (3) Production of synthetic fiber raw materials: precision terephthalic acid, vinyl cyanide, caprolactam, nylon 66 salt and polyurethane elastic fiber, and 1, 3-propanediol (4) Production of synthetic rubber: liquid butadiene styrene rubber by butadiene method (excluding styrene-butadiene rubber), high cis-1, 4-polybutadiene rubber, butyl rubber, isoamyl rubber, polyurethane rubber, acrylic rubber, chlorophydrin rubber, ethylene-propylene-rubber, fluororubber, silicon rubber, and other special rubber production) (5) Production of engineering plastics and plastic alloys: PC with an annual production capacity of over 60 thousand tons, POM, polyamide (nylon 6, nylon 66, nylon 11, and nylon 12), EVA, polyphenylene sulfide, PEEK, polyimide, polysulfone, polyether sulphone, PAR, liquid crystal polymer, and other products (6) Fine chemistry industry: new products and technology for catalytic agent; processing technology for the commercialization of dye (pigment); production of high-tech chemicals for electronics and paper-making, food additives, feed additives, leather chemical products (excluding N,N-dimethylformamide), oil-well auxiliaries, surface active agent, water treatment agent, adhesives, inorganic fiber, inorganic nanomaterial production, and deep processing of pigment encapsulation

134

Strategizing investments in the next decade

(7) Production of environment-friendly printing ink and environmentfriendly arene oil (8) Production of nature spices, synthetic spices, and single ion spices (9) Production of high capability coatings, water automotive coatings, and assorted water resin (10) Production of chlorofluorocarbon substitution (11) Production of fluororesin, fluorine film materials, fluorinecontaining intermediate products for medical use, environmentfriendly cryogen and detergent (12) Production of fluorine recycling from phosphorus chemicals and aluminum smelting (13) Development and production of new technology and products for the forestry chemicals (14) Development and production of inorganic, organic, and biologic films for environment protection (15) Development and production of new-type fertilizer: biologic fertilizer, high-density fertilizer, compound fertilizer, controlled release fertilizer, compound microbial inoculant, compound microbial manure, degradation agent for stalks and garbage, and microbial preparation of special functions (16) Development and production of effective, safe, and environmentfriendly new varieties, new formulations, special-purpose intermediates, and accessory ingredients of pesticides; and development and application of relevant clean production processing (methylene technology for producing acetochlor, method for paraquat by ammoniacal cyanide process, aqueous phase synthesis of chlorpyrifos, recycling chloromethane during production of glyphosate, production of oriented synthesis chiral pesticides and cubic pesticides, and synthesis technology for diethyl thiophosphoryl chloride) (17) Development and production of biopesticide and bio-control products: microbial insecticide, microbial fungicide, agricultural antibiotic, insect pheromone, enemy insect, and microbial herbicide (18) Comprehensive utilization and disposal of exhaust gas, discharge liquid, waste residue (19) Production of organic polymer material: covering film for plane, rare earth cerium sulphide red dye, lead-free in electronic packages, serials of special sizing agent by photoetching for color Plasma Display Panel, small diameter and large specific surface area superfine fiber, high precision fuel filter paper, and Li-ion battery membrane 11. Medical and pharmaceutical products industry (1) Production of new type compound medication of active composition medication (including bulk drug and preparation)

Strategizing investments in the next decade 135 (2)

Production of amino acids: tryptophan prepared by zymotechnics, hstidine, methionine for feed (3) Production of new anti-cancer medication, new cardiocerebrovascular medication and new nervous system using medication (4) Production of new type medication using bioengineering technology (5) Production of AIDS vaccine, hepatitis C vaccine, contraceptive vaccine, and new vaccines such as cervical cancer vaccine, malaria vaccine, and hand-foot-mouth disease vaccine (6) Production of biology vaccine (7) Exploitation and production of marine drug (8) Drug preparation: production of new formulation using new technologies of sustained-release, release, targeting, and percutaneous absorption (9) Exploitation and production of new type of pharmaceutic adjuavant (10) Production of antibacterial active pharmaceutical ingredients for animals (including antibiotics and chemosynthesis drugs) (11) Exploitation and production of animals using antibacterial drug, insect repellent, pesticide, anticoccidial drug, and new formulation (12) Production of new diagnosis reagent 12. Manufacturing industry of chemical fiber (1) Production of hi-tech chemical fiber (excluding viscose fiber) of differential chemical fiber, aramid, carbon fiber, polyethylene of high-strength and high-mode, polyphenylene sulphide (PPS) and so on (2) Production of new style of fiber and non-fiber polyester: PTT, PEN, PCT, and PETG (3) Production of biopolymer fiber by using new renewable resources and environment-friendly processing: lyocell, cellulose made from bamboo and hemp, PLA, chitin fiber, PHA, and plant and animal protein fiber (4) Production of polyamide, single line production capacity of 150 ton a day (5) Production of meridian tyre aramid fiber and tyre cord 13. Industry of plastic products (1) Development and production of new-type multi-functional photo-biological broad agricultural films (2) Digestion and recycle of waste plastics (3) Exploitation and production of new technology and new production of plastic soft package (high barrier, multi-function film and material)

136 Strategizing investments in the next decade 14. Non-metal mineral products processing industry (1) Development and production of energy-saving, environmentprotecting, lightweight and high-intensity, high-performance, and multi-functional architecture materials (2) Use plastic to replace steel and wood, energy-saving and high-efficient chemical architecture material production (3) Production of elastomer, plastic changeable asphaltum waterproof coiled materials, broad (more than 2 meters) waterproof EPDM coiled materials and matched materials, broad (more than 2 meters) waterproof PVC coiled material, and TPO waterproof coiled materials with a production capacity of more than 10,000,000 sq.m. (4) Development and production of functional glass with new technologies: electromagnetic wave shielding glass, micro-electronics glass substrate, infrared transmitting lead-free glass, electronic-grade large-scale quartz glass products (pipes, boards, crucibles and apparatuses), multi-functional windshield glass of excellent optical performance, extreme IT materials and products (including quartz glass bushing and ceramic wafer for waveguide-grade, high-precise optical fiber preform rod), and purification processing of raw materials for high pure (≥99.998%) or ultrapure (≥99.999%) crystal (5) Production of conductive glass for film batteries and glass for solar illuminator (6) Production of glass fiber products and special glass fiber: low dielectric glass fiber, quartz glass fiber, high silica glass fiber, high strength and high elasticity glass and ceramic fiber and their products (7) Production of optical fiber and its products: coherent fiber bundle and laser medical optic fiber, exceeding two generation and three generation microchannel plate, optic fiber panel and inverse image implement and light cone glass (8) Standardization refine of ceramic material and production of high-level decorative materials used for ceramics (9) Production of environment-friendly (non-chromizing) refractory material used in furnaces such as cement, electronic glasses, ceramics, and microporous carbon brick (10) Production of AIN ceramic base piece and multiple-hole ceramics (11) Production of inorganic, non-metal materials and products: compound materials, special kind of ceramics, special kind of airproof materials (including quick oil sealed materials), special friction materials (including high-speed friction brake materials), special kinds of cementation materials, special type latex materials, water rubber materials, and nanomaterials (12) Production of thermal insulation materials of organic-inorganic compound foam

Strategizing investments in the next decade 137 (13) Production of high-tech compound materials: sequential fiber increasing thermoplasticity compound materials and prepreg, endure heat > 300°C colophony compound material moulding craftwork assistant materials, colophony compound material (including top grade sports articles and vehicle parts of lightweight and high-intensity), special function compound materials and products (including deep water and diving compound material products and medical and healing use compound material products), carbon/carbon compound materials, high capability ceramic compound materials and products, metal compound materials and products, metal layer compound materials and products, pressure ≥320MPa super-high-pressure compound rubber pipes, air bus aviation tyres (14) Production of precision high capability ceramic materials: carborundum super-minute powder (purity > 99%, average granule diameter < 1μm), Si3N4 super-minute powder (purity > 99%, average granule diameter < 1μm), high pure and super-minute alumina powder (purity > 99%, average granule diameter < 0.5μm), low temperature sintered zirconia powder(sintered temperature < 1350°C), high pure AlN powder (purity > 99%, average granule diameter < 1μm), rutile TiO2 powder (purity > 98.5%), white char black (average granule diameter < 100nm =, barium titanate (purity > 99%, average granule diameter < 1μm =. (15) Development and production of high-quality artificial crystal and crystal film products: high-quality artificially synthesized crystal (piezoelectric crystal and crystals for ultraviolet ray transmitting crystal), super hard crystal (cubic boron nitride crystal), high-temperature resistant and highly insulated artificially synthesized crystal (artificially synthesized mica), new electro-optic crystal, high-power laser crystal and large-size glittering crystal, diamond fi lm tools, super-thin artificial diamond saw blades with thickness of not more than 0.3mm (16) Deep processing of non-metal mineral products (super-thin comminution, high level pure, fine production, modification) (17) Production of super high power black lead electrode (18) Production of pearlite mica (granule diameter: 3–150μm) (19) Production of multi-dimension and multi-direction integer weaving fabric and profile modeling fabric (20) Use new dry cement kiln to innocuously dispose solid waste (21) Recycling of construction waste (22) Comprehensive utilization of industrial by-products gypsum (23) Development and application of new technologies for the comprehensive utilization of non-metal mine tailings, and the ecological restoration of mines

138 Strategizing investments in the next decade 15. Non-ferrous metallurgical smelting and rolling processing industry (1) Production of diameter > 200mm silicon single crystal and polishing piece (2) Production of high-tech non-ferrous metallurgical materials: compound semiconductor materials (gallium arsenide, gallium phoshpide, gallium reexplanation, gallium nitride), high temperature superconduct materials, memory alloy materials (titanium nickel, copper and iron memory alloy materials), super minute (nanometer) calcium carbide and super minute (nanometer) crystal hard ally, superhard compound materials, noble metal compound materials, aluminum foil used for radiator, middle and high pressure cathode capacitance aluminum foil, special kind of large aluminum alloy materials, aluminum alloy precise model forge product, electrization railway built on stilts leads, super-thin copper strip, erosion proof heat exchanger copper alloy material, high capability copper nickel, copper and iron alloy strip, beryllium copper strip, thread, tube, and stick process material, high temperature bearable tungsten filament, magnesium alloy cast, non-lead solder, magnesium alloy and its applicable products, bubble aluminum, titanium alloy strip materials and titanium jointing pipes, atomic energy grade sponge zirconium, tungsten and molybdenum deep machining products 16. Metal products industry (1) Research, development, and manufacturing of new lightweight and environment-friendly materials for aviation, aerospace, automobiles, and motorcycles (special-purpose aluminum sheets, aluminum-magnesium alloy materials, and aluminum alloy motorcycle frames and so on) (2) Development and production of high-grade hardware for construction, hot-water heating equipment, and hardware parts (3) Production and processing (including painting and processing inner and outer surface of the products) of metal packing products (thickness < 0.3mm) used to pack all kinds of grain, oil and food, fruits, vegetables, beverages, daily using materials and such contents (4) Manufacturing of nickel-saving stainless steel products 17. General machine-building industry (1) Manufacturing of numerically controlled machine tools of high level and key spare parts: numerically controlled machine tools which exceed quintuple linkage, digital control coordinate spindle processing centre, digital control system which exceeds quintuple linkage and servomechanism installations, high-speed and super-strong knives for exact digital control manufacturing (2) Manufacturing of multi-station forging forming machine of 1,000 tons or more (3) Manufacturing of equipments for breaking up and smashing retired cars

Strategizing investments in the next decade 139 (4) Manufacturing of soft FTL product line (5) Manufacturing of vertical articulated industrial robots, welding robots, and welding equipments thereof (6) Manufacturing of special processing machines: complete sets of laser cutting and welding equipments, exact processing laser equipments, digital-control and low-speed wire-cuts, submicron cracker (7) Manufacturing of wheel or crawler crane of 300 tons or more (limited to equity joint ventures or contractual joint ventures) (8) Design and manufacturing of high pressure plunger pumps of pressure (35–42MPa) and engine, design, and manufacturing of low-speed big torquey engine of pressure (35–42MPa) (9) Manufacturing of integrated hydraulic-pressure multiple unit valve with working pressure ≥ 25MPa and electro-hydraulic proportional servo elements (10) Design and manufacturing of valve terminal, pneumatic solenoid valve of less than 0.35W and high-frequency electrically controlled gas valve of 200Hz or more (11) Design and manufacturing of hydrostatic drive device (12) Development and manufacturing of non-contacting gas film seal of pressure more than 10MPa, dry gas seal of pressure more than 10MPa (including experience device) (13) Development and manufacturing of macromolecule material device for automobiles (rub piece, changed phenol aldehyde plunger, non-metal liquid pressure mother pump and so on) (14) Manufacturing of car boss axletree of 3 and 4 generation-function elements of boss axletree of flange and transducer inside or outside of the axletree, digital control machine tool or processing center axletree of high or mid class (the processing center should have more than three axis interlocking function and 3–4μm repeated precision), high-speed wire or board rolling mill axletree (assistant axletree and roller axletree of single-wire rolling mill of more than 120m/s and of thin-board rolling mill of more than 2mm), high-speed railway axletree (with speed of more than 200km/h), low-noise axletree of vibration of less than Z4 (Z4, Z4P, V4, V4P), level P4, P2 axletree of various axletree (15) Manufacturing of high-density, high-precision and complex-shaped powder metallurgical parts and chains used for automobile, engineering machinery, etc. (16) Manufacturing of gear transmission for wind power, high-speed train, gear transmission agent with adjustable blades for vessels, and large-sized and heavy-loaded gear boxes (17) Manufacturing of high binding spares of 12.9 level or more (18) Development and manufacturing of accumulator bladders and rubber and plastic seals for hydropneumatic use (19) Remanufacturing of machine tools, spare parts of cars (except five matured varieties) and project machines

140 Strategizing investments in the next decade (20) Manufacturing of miniature precision transmission joint pieces (clutches) (21) Manufacturing of coupling shaft for heavy rolling mills (22) Remanufacturing of machinery such as machine tools, engineering machinery, and railway locomotives, and remanufacturing of automotive parts and components 18. Special equipment manufacturing (1) Manufacturing of mine trolley mining, loading, and transporting device: mechanical drive tipper for mine of 100 tons or more, mobile crusher, wheeled digger of 3000 m3/h or more, loading machine for mine of 5 m3 or more, electric driving mining machine of 2000 kw or more and so on (2) Manufacturing of geophysical, logging equipment: MEME geophone, digital telemetry seismograph, digital imaging, computerized logging system, horizontal wells, directional wells, drilling rig equipment and apparatus, MWD logging while drilling (3) Manufacturing of equipment for oil exploration, drilling, collection and transportation: floating drilling systems and floating production systems with an operating water depth of more than 1500 meters and the supporting subsea oil extraction, collection, and transportation equipment (4) Manufacturing of large-caliber rotary drilling rigs with a caliber of 2 meters or more and depth of 30 meters or more, push benchers with a diameter of 1.2 meters or more, complete sets of large equipment with a pull-back force of 300 tons or more for laying underground pipes and lines without digging, and underground diaphragm wall construction drilling rigs (5) Design and manufacturing of large bulldozers of 520 horsepower or more (6) Design and manufacturing of pedrail soil shifter of ground pressure of 0.03MPa or less, power of 220 hp or more, large soil shifter of 520 hp or more (7) Design and manufacturing of purge machine of 100 m3/h or more, digging device in digging vessel of 5000 tons or more (8) Design and manufacturing of tuffcrete diosmosing-proof wall for flood control bar (9) Manufacturing of machine for underwater mass: soil shifter, loader, and digger 9 miles under water (10) Manufacturing of devices of road bridge maintaining and automatic testing (11) Manufacturing of devices of road tunnel supervision, winding, disaster control and rescuing system (12) Design and manufacturing of the large-scale railway construction, and operation of large-scale road maintenance machinery and safety equipment

Strategizing investments in the next decade 141 (13) Manufacturing of (asphalt) shingles equipment, galvanized steel, and other metal roof production equipment (14) Manufacturing of spot spraying polyurethane waterproof thermal insulation system equipment which could protect environment and conserve energy, technology and equipment of polyurethane sealant paste preparation, technology and production equipment of modified silicone sealing paste preparation (15) Design and manufacturing of thin-slab continuous casting machine, high-precision strip mill (with thickness of precisely 10 microns) (16) Manufacturing of the key equipment of complete sets of ethylene equipment with an annual capacity of 1 million tons or more: mixing granulators with an annual processing capacity of 400,000 tons or more, helical-conveyer centrifuges with a diameter of 1000 mm or more, and low-flow high-head centrifugal pump (17) Manufacturing of high power DC electric arc furnace of 50 tons or more (18) Manufacturing of colorful panting or plating board devices (19) Manufacturing of selecting device for multi-element, fine-powder and hard-selecting mine (20) Design and manufacturing of production equipment for automotive power batteries (21) Manufacturing of large complete devices of chemical processing of coal (limited to equity joint ventures or contractual joint ventures) (22) Design, manufacturing and maintaining of metal product moulds (such as extrusion moulds of pipe, stick, and shape of copper, aluminum, titanium, and zirconium) (23) Design and maintaining of punching mould of cover elements of automobile outside, clamp and test tools of automobile and motorcycle (24) Design and maintaining of punching mould with precision of more than 0.02 mm (including 0.02 mm), precise mould with precision of more than 0.05 mm (including 0.05 mm) and mould standard elements (25) Design and manufacturing of nonmetal product moulds (26) Manufacturing of beer fi lling device of 60,000 bottles /h or more, drink mid or high hot filling device of 5 bottles /h, asepticism filling device of 36,000 bottles /h or more (27) Manufacturing of producing technologies and key equipments for aminophenol, zymi, food additives and so on (28) Manufacturing of complete feed processing equipment of 10 tons/h or more and key parts thereof (29) Manufacturing of light board and box device of 0.75 mm high or less

142 Strategizing investments in the next decade (30) Manufacturing of single in folio colorful lithographic printing machine with speed of more than 16,000 pages in folio /h (720 ×1020 mm), diprosopia in folio colorful lithographic printing machine with speed of 13,000 pages in folio /h (720 ×1020 mm), colorful lithographic in folio printing machine with speed of 13,000 pages in folio /h (1000 ×1400 mm) (31) Manufacturing of automatic coating machines for electron guns (32) Manufacturing of colorful soft printing machine with speed of 300 meters/m or more and coverage of 1000 mm or more (33) Manufacturing of computer mass color pre-coordination systems, mass color remote handling systems, mass speed following systems, prints quality automatic testing and following systems, no-axis turning technologies, high-speed automatic splicer, paper giving machine and high-speed and automatic remote handling paper folding machine, automatic overprinting system, cooling device, silanion putting system, bias-adjusting device and so on (34) Deep processing technique and equipment manufacturing of plate glass (35) Special high-tech industrial sewing machines manufacturing (36) Manufacturing of complete set of new type of paper (including pulp) making machines (37) Manufacturing of equipment with new technique for post ornament and processing of leather (38) Development and manufacturing of new agriculture processing and storage equipment: new equipment for the processing, storage, preservation, classifying, packing, and drying of food, oil, vegetables, dried fruits and fresh fruits, flowers, meat and aqua-products; agricultural product quality testing equipment; the quality detection equipment of agricultural products’ damage; Rheometer; Farinograph; ultrafi ne pulverization equipment; highly efficient dewatering equipment; 5-grade plus high efficient fruit juice condensation equipment; equipment for disinfection of powder food in media; aseptic packaging equipment for semi-solid and solid food; packaging materials for aseptic packaging, DVS bacteria starter for dairy production, disc-type separation centrifuges (39) Manufacturing of Agricultural machinery: facility agriculture equipment (greenhouse automatic irrigation equipment, autocontrol configuration and fertilization equipment of nutritious liquid, efficient vegetable nursery equipment, soil nutrient analysis instruments), tractor and associated farm tools with 120 kilowatts and above matching engine power, low fuel consumption, low noise and low-emission diesel engine, spray machines with residual fog tablets, recovery unit matching of large tractor, high-performance rice transplanter, cotton harvesting machine, adapted to a variety

Strategizing investments in the next decade 143

(40) (41)

(42)

(43) (44) (45) (46) (47)

(48) (49) (50) (51) (52) (53) (54)

(55)

(56) (57)

(58)

of row-spacing self-moving maize reaping machine (hydraulic drive or mechanical drive) Manufacturing of new technical forestry equipment Manufacturing of equipment for reusing in fields and comprehensive utilization of straws and stalks of crop, manufacturing of equipment for comprehensive utilization of rice husk Manufacturing of equipment for comprehensive utilization of waste agriculture products and waste fowl and livestock products which are bred in scale Manufacturing of festival fertilizer, pesticide section, water-saving technical agriculture equipment Manufacturing of cleaning equipment for electromechanical wells and equipments for laundering drug production Manufacturing of electronic endoscopes Manufacturing of Fundus cameras Manufacturing of medical imaging equipments’ key components (high magnetic field intensity and superconduct MRI, CT, X-ray computed tomography, type-B ultrasonic) Manufacturing of medical ultrasonic transducer (3D) Manufacturing of boron neutron capture therapy equipments Manufacturing of X-ray stereotactic radiotherapy system Manufacturing of hemodialysis, blood filter Manufacturing of multi-layer co-extruded water-cooled blown film equipment for non-PVC medical infusion bags New techniques of quality control of medicine products and new equipment manufacturing New analytical techniques and extraction technologies, and equipment development and manufacturing for the effective parts of traditional Chinese medicines Producing and manufacturing of new packing materials, new containers for medicine, and advanced medicine producing equipment Development and manufacturing of equipment of new type of knitting machines, key parts and textile testing, laboratory equipment Manufacturing of water pollution prevention and control equipment: horizontal spiral centrifugal dehydrators, membrane and membrane materials, ozone generators with a capacity of more than 50 kg/h, chlorine dioxide generators with a capacity of more than 10 kg/h, ultraviolet disinfection devices, small domestic sewage treatment equipment used in rural areas, and heavy metal wastewater treatment equipment Manufacturing of solid waste treatment and disposal equipment: sewage plant sludge disposal and resource utilization equipment, complete sets of refuse incineration equipment with a daily treatment capacity of 500 tons or more, landfill leachate treatment

144 Strategizing investments in the next decade

(59) (60) (61) (62) (63) (64) (65) (66) (67) (68) (69)

(70) (71)

(72) (73) (74) (75) (76)

(77)

technology and equipment, anti-seepage geomembranes in landfills, building waste treatment and resource recovery utilization equipment, devices for disposal of hazardous waste, devices for biogas power generation in landfills, scrap steel treatment equipment, and remediation equipment for contaminated soil Development and manufacturing of equipment for the comprehensive utilization of red mud from aluminum industry Manufacturing of equipment for the comprehensive utilization of mine tailings Manufacturing of waste plastics, electronics, rubber, battery recycling equipments Manufacturing of reclamation equipment for used and waste textiles Manufacturing of equipment for the remanufacturing of waste mechanical and electrical products Manufacturing of equipment for comprehensive utilization of scrap tires Environmental protection technology and equipment manufacturing of aquatic ecosystem Manufacturing of portable assembling water purification equipment Unconventional water treatment, recycling equipment and water quality monitoring instruments Leak test equipment and instruments for industrial water pipeline networks and equipment (appliances) Development and manufacturing of 100,000 cubic meters and above daily production seawater desalination and recycling cooling technology and complete sets of equipments Manufacturing of special meteorological observation and analysis equipments Development of seismic station, seismic network, and mobile seismological observation technology system, and manufacturing of equipments Manufacturing of three-drum radial tire building machines Manufacturing of rolling resistance testing machine and tire noise lab Manufacturing of new heating measurement and temperature control device technical equipments Manufacturing of preparation, storage, and transportation equipment and inspection systems of hydrogen energy Manufacturing of new heavy residue gasification atomization nozzle, steam leakage rate of 0.5 percent and below efficient steam traps, 1000°C and above high-temperature ceramic heat exchanger manufacturer Manufacturing of devices for recovery of marine oil spill

Strategizing investments in the next decade 145 (78) Manufacturing of equipment for utilization of low concentration coal-mine gas and ventilation air methane 19. Communication and transportation equipment industries (1) Manufacturing of complete automobiles (foreign investments shall not exceed 50%) and construction of automobiles research and development organization (2) Manufacturing of automobile engine, reused manufacture of engines and construction of engine research and development organization: gasoline motor with output per liter not lower than 50 kw, diesel motor with output per liter not lower than 40 kw and discharge capacity below 3 liters, diesel motor with output per liter not lower than 30 kw and discharge capacity above 3 liters, motor driven by such new resources as fuel cells and compound fuel (3) Manufacturing of key spare parts for automobiles as well as research and development of key technologies: complete disc brakes, complete driving rods, automatic gearboxes, fuel pumps of diesel engine, inhalant supercharger of engines, adhesive axial organ (used for four-wheel drive), hydraulic tappet, electronic cluster gauge, crankshaft and connecting bar (diesel motor above 8 liters), anti-lock brake system (ABS, ECU, valve body, sensor), ESP, BBW, electronic braking distribution system (EBD), driving control system, gas generator for automobile airbags, electronic fuel injection system, sprays technology on fuel common rail technology (utmost spray pressure above 1600 pa), VGT, VNT, discharge control equipment of motor meeting the pollutant discharge standard of the fourth phase of China, ITM and coupler assembly, steer-by-wire system, diesel particulate fi lter (DPF), intelligent cylinder, special rubber automobile components (4) Manufacturing of key parts and components of new energy vehicles: high energy power batteries (energy density ≥ 110Wh/kg cycle life ≥ 2000 times, and the proportion of foreign investment not exceeding 50%), anode materials of batteries (specific capacity ≥ 150mAh/g, and cycle life of 2000 times with not less than 80% of initial discharge capacity), battery separators (thickness of 15–40μm, porosity of 40–60%); battery management systems, motor management systems, and electronic control integration of electric vehicles; driving motors of electric vehicles (peak power density ≥ 2.5kW/kg, high efficiency area: 65%, working area efficiency ≥ 80%), automotive DC/DC (input voltage of 100–400V), high-power electronic devices (IGBTs, voltage class ≥ 600V, current ≥ 300A); and plug-in hybrid electromechanical coupling drive systems (5) Manufacturing of key parts for high discharge motorcycle (discharge of over 250ml): technology of electrical control fuel injection

146 Strategizing investments in the next decade

(6)

(7)

(8) (9)

(10) (11) (12) (13)

(14) (15)

for motorcycle (limited to equity joint ventures or contractual joint ventures), engine discharging control device which satisfies motorcycle discharging criteria stage III of China Equipment for railway transportation (limited to equity joint ventures or contractual joint ventures): research and development, design as well as manufacturing of complete train and key spare parts (drive system, control system, brake system) of rapid transit railway, railway of passenger special line, intercity railway, trunk railway and equipment for urban railway transportation; research and development, design as well as manufacturing of passenger service facilities and equipment for rapid transit railway, railway of passenger special line, intercity railway, and urban railway transportation; design as well as research and development of related information system in the process of construction of information age; research and development, design as well as manufacturing of railway and bridge facilities and equipments for rapid transit railway, railway of passenger special line, intercity railway, manufacturing of equipment and fi xtures for electrical railway, research and development of technologies for controlling railway noise and vibrating, manufacturing of discharging equipment for trains, manufacturing of safety monitoring equipment for railway transportation Design, manufacturing and maintaining of civil plane: those of trunk and branch lines (Chinese part shall hold the majority of shares), general ones (limited to equity joint ventures or contractual joint ventures) Production and maintaining of spares parts for civil planes Design and manufacturing of civil helicopters: those of three tons or more (Chinese part shall hold the majority of shares), those of less than three tons (limited to equity joint ventures or contractual joint ventures) Production of spares parts for civil helicopters Manufacturing of ground and water effect plane (Chinese part shall hold the majority of shares) Design and manufacturing of no-people plane and aerostat (Chinese part shall hold the majority of shares) Design, manufacturing, and maintaining of plane engines and spare parts as well as air assistant power system (limited to equity joint ventures or contractual joint ventures) Design and manufacturing of civil air-borne equipment (limited to equity joint ventures or contractual joint ventures) Manufacturing of flight ground equipments: civil airfield facilities, support equipment for civil airfield work, ground equipment for flight test, equipment for flight simulation and practice, equipment for aeronautic testing and measuring, equipment for aeronautic

Strategizing investments in the next decade 147 ground testing, comprehensive testing equipment for machines, special equipment for aeronautic manufacturing, equipment for pilot manufacturing aeronautic materials, ground receiving and applying equipment for civil aircraft, ground testing equipment for rocket launcher, equipment for dynamic and environmental experience for rocket launcher (16) Manufacturing of mechanical and electrical products for aircrafts, temperature control products for aircrafts, test equipment for planet products and structure and organization products for aircrafts (17) Manufacturing of light gas-turbine engine (18) Design of luxury cruise and equipment for deep-water (over 3000 meters) ocean project (limited to equity joint ventures or contractual joint ventures) (19) Manufacturing and maintaining of equipment for ocean project (including stages) (Chinese part shall hold the majority of shares) (20) Design of diesel engine in low or medium speed for vessel (limited to equity joint ventures or contractual joint ventures) (21) Manufacturing of diesel engine in low and medium speed for vessel as well as crankshafts (Chinese part shall hold the majority of shares) (22) Design and manufacturing of machinery for vessel compartment (Chinese part shall hold the relative majority of shares) (23) Design and manufacturing of communication and directing systems for vessels: communication systems, electronic directing equipment, vessel radar, electric compass automatic pilot, public broadcasting systems inside vessels and so on (24) Design and manufacturing of cruiser (limited to equity joint ventures or contractual joint ventures) 20. Electric machinery and equipment manufacturing industries (1) Manufacturing of key auxiliary equipment used for 1 million KW ultra supercritical fire-electricity generating set (limited to equity joint ventures and cooperative joint ventures): safety valve and control valve (2) Manufacturing of the equipment of coal-fired power plant and denitrification technology for sintering machine in steel industry (3) Design and manufacturing of seal parts for fire-electricity equipment (4) Manufacturing of large-scale castings and forgings used for coal-fired power plant and hydropower station (5) Manufacturing of key auxiliary equipment used for hydroelectric generating set (6) Manufacturing of power transmitting and transforming equipment (limited to equity joint ventures and cooperative joint ventures): amorphous alloy transformer, operator used for high-voltage

148 Strategizing investments in the next decade switch of 500KV or more, arc extinguishing device, large-scale disk type insulator (over 1000KV and 50KA), outlet device used for transformer of 500KV or more, casing pipe (AC:500KV, 750KV, 1000KV, and all DC specifications), voltage regulating switch (loaded and unloaded voltage regulating switch for AC 500KV, 750KV, and 1000KV), dry-type smoothing reactor used for DC transmission, more or less 800KV converter valve used for DC transmission (water cooling equipment and DC field equipment), electrical apparatus contact material as well as non-Pb and non-Cd solders accorded with EU command of RoHS (7) Manufacturing of complete sets of or key new energy equipments for electricity power generation: photovoltaic power generation, geothermal power generation, tidal power generation, wave power generation, rubbish power generation, methane power generation, and wind power generation of 2.5MW or above (8) Manufacturing of large pumped-storage power units of 350MW power ratings or more (limited to equity joint ventures and cooperative joint ventures): pump turbines and speed controller, large-scale reversible pump-turbine units with varied speed, power generator and excitation, launching apparatus and other accessory equipments (9) Manufacturing of Stirling generating set (10) Development and manufacturing of straight line and plane motor and drive system (11) Manufacturing of high-tech green battery: dynamic Ni-Mh battery, zinc and nickel storage cell, zinc and silver storage cell, lithium-ion battery, solar battery, fuel battery and so on (excluding high-power battery for new energy vehicles) (12) Electric motor is manufactured by refrigerating and air-conditioning compressors adopting DC speed adjustment technology or CO2 natural refrigerants, and by refrigerating and air-conditioning equipments applying renewable energy (air source, water source, and geothermal source) (13) Manufacturing of solar air conditioning, heating system, and solar dryer apparatus (14) Manufacturing of biomass drying pyrolysis system and biomass gasification unit (15) Manufacturing of AC-FM voltage regulation drawbar 21. Communication equipment, computer and other electronic equipment manufacturing (1) Manufacturing of HD digital video camera and digital soundplaying equipment (2) Manufacturing of flat panel display such as TFT-LCD, PDP, and OLED, and materials of flat panel display (excluding TFT-LCD glass substrate of the sixth generation or below)

Strategizing investments in the next decade 149 (3)

(4)

(5)

(6)

(7) (8) (9) (10) (11)

(12) (13)

(14) (15)

Manufacturing of such key parts as optical engine, light source, projection screen, high-resolution projection tube and LCOS module used in large-screen color projection display Manufacturing of digital audio and visual coding or decoding equipment, digital broadcasting TV studio equipment, digital cable TV system equipment, digital audio broadcasting transmission equipment, digital television converter, digital television broadcasting Single Frequency Network (SFN), satellite digital TV up-linking station and front-end equipment of SMATV Design of integrate circuit, and manufacturing of large digital integrate circuit with its wire width of 0.18 micron or below, manufacturing of simulated and digital analogy integrate circuit of 0.8 micron or below, and the encapsulation and test of such advanced equipment as BGA, PGA, CSP, MCM and so on Manufacturing of large- and medium-sized computer, highperformance computer with its operation more than 100 trillion times, portable micro computer, high-rank server with its operation more than 1 trillion times per second, large-scale simulated system and large industrial control mechanism and controller Manufacturing of computer digital signal processing system and board card Manufacturing of figure and image recognition and processing system Development and manufacturing of large-capability optical and disk driver as well as relevant components Manufacturing of high-speed storage system and intelligent storage equipment with its capability more than 100 TB Manufacturing of Computer Assistance Design (three-dimensional CAD), Computer Assisted Testing (CAT), Computer Aided Manufacture (CAM), Computer Aided Engineering (CAE), and other computer application systems Development and manufacturing of software product Development and manufacturing of specialized electronic material (excluding the development and manufacturing of optical fiber perform rod) Manufacturing of specialized electronic equipment, testing equipment, and tools and moulds Manufacturing of new type electronic components and parts: slice components, sensitive components and sensors, frequency monitoring and selecting components, mix integrated circuit, electrical and electronic components, photoelectric components, new type components for machinery and electronics, high polymer solid capacitor, super capacitor, integrated passive components, high-density interlinked build-up board, multilayer flexible board, flexible printing circuit board, and packaging substrate

150 Strategizing investments in the next decade (16) Manufacturing of touch control system (touch control screen and components) (17) High-brightness LBD with its luminous efficiency more than 1001m/W, epitaxial slice LBD (blue) with its luminous efficiency more than 1001m/W, white luminous tube with luminous efficiency more than 1001m/W and its power more than 200mW (18) Development and manufacturing of key components and parts used in high-precision digital CD drive (19) Reproduction of read-only compact disk and manufacturing of recordable compact disk (20) Design and manufacturing of civil satellites (Chinese partner shall hold the majority of shares) (21) Manufacturing of civil satellites effective payload (Chinese partner shall hold the majority of shares) (22) Manufacturing of spare parts for civil satellites (23) Manufacturing of telecommunication system equipment for satellites (24) Manufacturing of receiving equipment of satellite navigation and key components (25) Manufacturing of optical communication measuring instrument and light transceiver with its speed more than 10Gb/s (26) Manufacturing of Ultra Broad Band (UWB) communication equipment (27) Manufacturing of wireless Local Area Network (including support of WAPI) and Wide Area Network equipment (28) Rate time division multiplex equipment (TDM) with speed more than 40Gbps, dense wavelength division multiplex equipment (DWDM), broadband passive network devices (including EPON, GPON, WDM-PON, etc.), next-generation DSL chip and its equipment, optical cross connect (OXC), automatic switch optical network (ASON), and optical fiber communication and transmission equipment more than 40G/sSDH (29) Development and manufacturing of next-generation Internet system equipment, terminal equipment, testing equipment, software and chips based on IPv6 (30) Development and manufacturing of third-generation and the following mobile communication systems: mobile phone, base station, core network equipment, and network testing equipment (31) Development and manufacturing of high-end router, network switcher of more than 1 gigabit (32) Manufacturing of the equipment for air traffic control system (limited to joint venture and cooperation) 22. Machinery manufacturing industries for instrument and meter as well as culture and office

Strategizing investments in the next decade 151 (1)

Manufacturing of automation control system and apparatus in industrial processing: field-bus control system, large programmable logic controller (PLC), two-phase flowmeter and solid flowmeter, new type sensor and field measurement instrument (2) Development and manufacturing of large-scale sophisticated instruments: electron microscope, laser scanning microscope, scanning tunneling microscope, electron microprobe, large-scale metallurgical microscope, photoelectric direct-reading spectrometer, Raman spectrometer, mass spectrometer, chromatography-mass spectrometer, nuclear magnetic resonance spectrometer, energy dispersive system, X-ray fluorescence spectrometer, diffraction analysis system, industrial CT, 450KV industrial X-ray inspection machine, large-scale dynamic balancing machine, automatic testing system of on-line mechanical quality, three coordinate measuring machine, laser comparator, electrical prospecting apparatus, over 500m airborne electrical prospecting and gamma-ray spectrometry measuring instrument, borehole gravimetry and three-dimensional magnetograph, high-precision microgal and aviation gravity gradiometer, high precision micro-gamma gravity and airborne gravity gradiometry instrument, grating scale and encoder (3) Manufacturing of high-precision digital voltmeter, current meter (with measuring range of seven bit and a half and above) (4) Manufacturing of wattless power automatic compensation equipment (5) Manufacturing of new instrument and equipment for safety production (6) Manufacturing of VXI bus automatic test system (in accordance with IEEE1155 international standards) (7) Development and manufacturing of comprehensive management system for under-mine monitoring and disaster-forecasting apparatus and coal safety measurement (8) Manufacturing of the equipment for engineering measurement and global geographical observation: digital triangle surveying system, digital programmed system for three-dimensional topography model (acreage>1000 × 1000mm, horizontal error