China 2013: A Year in Review by Chris Devonshire-Ellis

January 10, 2014 Posted by China Briefing Reading Time: 15 minutes

This week, China Briefing is featuring a series of specially-commissioned articles from prominent China-based writers regarding their thoughts on the key developments in the country during 2013, and what lies ahead in 2014. Today’s article is written by Chris Devonshire-Ellis, founder of Dezan Shira & Associates, as well as founder and publisher of China Briefing.

2014 Forecast: Some Decline in China, Growth in Southeast Asia

Jan. 10 – As has been noted both on this website and by other respected China commentators, China is somewhat in a period of transition at the present time. Reforms, led by the new President Xi Jinping, are being enacted, but will still take time to reach their full potential – many of these will be rolled out as ‘pilot’ schemes first, and in some cases, such as the intentions over the Shanghai Free Trade Zone, announced but without the full implementing rules. It was ever thus of course, this deliberation is nothing new. China has been a case of ‘wait and see’ for nearly 30 years now. That the country has generally proceeded with its plans in the past should not go unnoticed.

However, China also has other problems in its makeup that go far beyond internal reforms. The country is still rather insular in its approach to international trade, and in many cases fails to connect the dots. While the country has made a big call for foreign multi-national corporations (MNCs) to set up their Asian Regional Headquarters in either Beijing or Shanghai, the stark facts are that the international corporate mood is slowly ebbing away from making any Chinese cities an “Asian” hub.

Much can be made of the appalling pollution that has engulfed Beijing and Shanghai in recent months, the awful traffic and the now considerable expense. But China’s problems in attracting MNC HQs run deeper – the increasing use of Internet firewalls, spying on corporate emails, and the lack of legal transparency are all now having a profound impact on how global executives view the country. In addition to this, the impact of tough regulations governing the behaviour of global executives overseas – such as the Foreign Corrupt Practices Act (FCPA) – are driving Asian Regional MNC HQs out of China and back to cities such as Singapore, where the rule of law and transparency is far higher and the risk to global executives in falling foul of the FCPA or other related guidelines is rather less.

Just one China corporate example I can refer to involves one of the global shipping companies – they were asked by customs in Dalian to provide packets of US$10,000 cash per ship to offload. This MNC company, newly Asian headquartered in Shanghai, swiftly moved back to Singapore – where it had originally been – to oversee its regional operations. I have seen numerous other examples of decamping back to Singapore from Shanghai over the past 18 months. China offices are fit for managing China, but it is questionable whether they are suitable under the present corporate business environment in China for overviewing Asia. Singapore’s strict adherence to the rule of law makes it a far better and mature destination to run Asian operations than Shanghai.

“Singapore’s strict adherence to the rule of law makes it a far better and mature destination to run Asian operations than Shanghai.”

China’s lack of transparency in the corporate legal environment also impacts upon local executive behaviour in a type of “lead by governmental example” mentality. Foreign companies are often seen as a China subsidiary employment vehicle to milk rather than being an MNC corporate to forge a global career with.

The story of the local Chinese executive working for a foreign WFOE in Shenzhen springs to mind. Having been with the company in an office administrative position for nine months, he resigned to take a better paid job elsewhere. Six months later, he requested his previous foreign employer to pay for treatment for lung disease (the employee was a heavy smoker) at a ‘compensation’ amounting to several hundred thousand Yuan, describing it as a “work related injury.” The company refused, and he sued.

In three separate court hearings the employee lost. Finally, he took to protesting outside the local Mayor’s office at his ‘unfair treatment’ by the foreign company and his ‘unfair treatment’ by the local government. Eventually, the Mayor decided enough was enough and in the ‘interests of promoting social harmony’ advised the foreign WFOE to pay the compensation anyway. Such is the rule of law in China – even if successful. No business in China – and especially foreign investors – wants to upset the local authorities. The Mayor got his way, and “social harmony” was restored, despite the court’s ruling in favor of the foreign investor. These are China’s practical issues no law blog about China will explain – it has to come from on-the-ground experience. The business case shows that, sometimes, doing business in China is just unfair. It is part of the cost – and should be factored into the operational budget. Foreign investors need to know when they cannot win when up against the Chinese system.

More insidious still, albeit less spectacular, a middle finger waving exercise at foreign investment is the widespread practice of local Chinese staff changing corporate suppliers, such as lawyers, tax agents, accountants and so on, in addition to ‘overhauling their supplier base’. What this typically means is a shift to friendly firms, possibly owned by family members, who may turn a blind eye to any shenanigans in the books. Or the imposition of related suppliers, who may initially be cheaper but once in the door rapidly increase their prices. Such practices are endemic in China to an extent not seen to the same level elsewhere in Asia. It pays to have strong managerial overview of local staff and who is in charge of appointing suppliers – from accountants to hardware. The grounds of “they’re cheaper” may not be all what it appears to be, and especially so if your current supplier – professional or material – has had a prior good track record. Change for changes sake in China usually comes with a price tag later.

“Change for changes sake in China usually comes with a price tag later.”

All of which doesn’t make for entirely happy reading for China. However, times are tough and such China internal issues start to become more serious during a global manufacturing slowdown. Prices are rising fast and this impacts most upon your Chinese staff. They will find ways to extract other forms of revenues from your business; now is the time to be diligent. HSBC’s Purchasing Managers Index for China dropped to just 51 in December – just a base point above contraction. 2014 should be a watchword for enacting more, not less attention to detail in your China operations.

Longer term, China will be fine as it moves towards a consumer driven economy. But for 2014, I expect to see the economy only just moving ahead, and as a consequence, more tales of local executive wrong doing, some more scandals involving errant expatriates, and continuing belligerence towards its neighbours, involving Japan and the Philippines in particular. 2014 will be a year of insisting upon tight due diligence in your China operations, and keeping an eye out for trouble spots. I do not expect the business or trade environment in China to improve much until 2016, and I wrote about catering for the continuing lacklustre performance of China and how to budget for trade problems and related issues during 2014 here. China won’t admit to it, but I would put 2014 growth estimates on a national level as being 4-5 percent based upon what I see as hard evidence of growth elsewhere in Asia. But China has its bright spots, and much of this involves Asia, and ASEAN in particular. China is still heavily influenced by what goes on in Asia, more so than the other way around.

“China is still heavily influenced by what goes on in Asia, more so than the other way around.”

In fact, Asia has had rather a good 2013. Away from the China glare, right across Asia there are more immediately brighter spots. Singapore, as mentioned with its superior business and corporate environment, is becoming once again the de facto Asian regional hub of choice. Why is this important when it comes to China? Because Singapore is the regional financial and services hub for ASEAN, the 10 member Asian trade bloc that includes Asian Tigers such as Thailand, Malaysia, Indonesia, Philippines and Vietnam amongst others, and because China has a Free Trade Agreement with ASEAN on thousands of products. As does India. This simple fact is one reason to evaluate where your Asian HQ should be – as free trade across the Asian region is set to increase with the introduction of intra-Asian pacts such as the Regional Comprehensive Economic Partnership (RCEP), and the U.S.-led Trans-Pacific Partnership (TPP).

Trade with ASEAN and the impact of both the RCEP upon China (positively) and TPP (negatively) need to be assessed looking forward to the emergence of a new Asian Free Trade Area that extends from and includes China, India, Japan, South Korea, Australia and New Zealand – as well as all the ASEAN nations. It is no coincidence I choose 2016 as a date for things to improve in Asia – these agreements are due to be ratified at the end of next year. 2014, therefore, should also be a year of assessing Asia, and China’s upcoming role within the region. Being too China-centric is a mistake, and executives time during 2014 should be partially spent on gauging what the role for China in Asia will be. For a snapshot of the prospects of other Asian nations – and their relations with China – I summarize my personal views and observations – having extensively travelled the region last year.

2014 Asian Forecast

Cambodia
Cambodia remains politically a China play, and Chinese infrastructure investment, especially at the Sihanoukville Port, are signs of progress. Although admittedly coming from a low base, GDP growth in the country was 7.2 percent in 2013. Expats in Hanoi and Ho Chi Minh City are already talking about the lower wages in Cambodia for mainly textiles driven investments. Interesting, but this needs to be tempered with Cambodia’s lack of international trade relations – it is the only member of ASEAN that has not negotiated any double tax treaties.

China
China has always been a long-term play and this year is no exception. Quoted growth rates of 7 percent are effectively meaningless in such a large and diverse country. Cities like Shanghai are probably closer to 3-4 percent (New York last year had 4 percent GDP growth), while the Western and Inland Provinces and cities are recording growth rates of up to 14 percent. For established businesses, that means reaching out to the vast numbers of latent consumers in China’s heartland. For export driven manufacturers, that means rising labor costs are eating seriously into margins and looking elsewhere at countries like Vietnam is now a critical business study.

Foreign investors will increasingly be looking at strategies for accessing China’s consumers, however this remains a medium to long-term return on investment (ROI). China’s middle class consumer market is expected to soar to 600 million by 2020 and MNC’s are now preparing themselves to access China’s hinterland where the vast majority reside. That means expanding into China’s inland and Western cities, which will happen through increasing use of local JV partners and subsequent buyouts. Strategic M&A into the heart of China will become more common as MNC’s purchase local retailers and distributors.

In the near future, there will be bumps along the way in 2014 concerning border and maritime disputes. Although largely designed to ease China’s public consciousness away from internal problems, these disputes are likely to continue and could possibly escalate. Otherwise, a business case of ‘steady as she goes’ for 2014 and looking forward to planning for further China and Asian expansion will be key to survive and adapt to rapidly changing consumer dynamics throughout the country – and Asia.

Hong Kong
Hong Kong is becoming more Mainland Chinese. While this is good news for retailers attracting Mainland Chinese tourist shoppers (lower duty in Hong Kong than in mainland China on imported goods, and in some cases, zero) this has also crept into the corporate and governmental arena. This is not so good. The decision to allow Chinese auditors rights to practice in Hong Kong is, frankly, a case of watering down professional due diligence. The Hong Kong Stock Exchange is woefully inadequate in properly assessing the true assets of mainland businesses, and has been caught out on numerous occasions where auditors adhere to the letter, if not spirit, of listing guidelines. Corporate governance is diminishing, slowly being replaced by what can be called “Chinese standards.” The territory remains a great base from which to launch into the mainland – low taxes and ease of business consistently rank it high in global terms. However, the city is being slowly marginalized as an international hub. Hong Kong’s future now lies solely with China – and will be gradually diminished as it becomes just one of what will emerge to be several China doorways.

India
This is an election year in India, meaning not much will be done to improve the business environment. Current Prime Minister Dr. Manmohan Singh, who is 81, is retiring; his leadership is expected to pass to Rahul Ghandi as part of the nation’s ruling dynastic family. Eclipsed in the media by China, India still managed 5 percent growth in 2013. The majority of foreign investors are strategic, either looking to quietly enter the market to take advantage of its middle class consumer base of 250 million, although an increasing number of global corporates are setting up huge export driven manufacturing plants in the country. Ford Motors entire non-U.S. auto-manufacturing capacity has been moved in its entirety to Gujarat. If China makes the mistake of becoming too belligerent in its maritime disputes with other nations, India is likely to quietly pick up those MNC investment dollars. Dezan Shira & Associates‘ own growth in India last year outstripped that in China for the second successive year.

Indonesia
Indonesia ended the year on a high, hosting APEC and with new infrastructure projects announced for Jakarta (new underground/light rail) and continuing improvements in port facilities and rail. The Singapore-Jakarta air route is currently the world’s most in-demand international flight. With growth at 5.7 percent, the country is making strides. Yet, once out of Jakarta, Indonesia becomes a tricky one for foreign investors to negotiate – a mix of 19th century Dutch civil law, Islamic Shariah, and whatever the local Village Chief decides. Nonetheless, with a young and growing population Indonesia is the world’s largest Muslim nation with a population of 250 million and opportunities at all levels are there for the taking – from export manufacturing to supplying the domestic consumer market. Dezan Shira & Associates expect to open a Jakarta office in early 2015.

Japan
Japan’s year was marked by the Senkaku Islands dispute with China, yet after the devastating Tsunami the economy is picking up with growth at 2.6 percent in 2013. Japan’s exports also performed well – in the wake of consistent aggression from China, much of it leaking into bilateral commerce, the Japanese have been turning towards India and Southeast Asia for export growth, and outperforming the Chinese regionally in doing so. It is Japanese, not Chinese, outbound investment into Asia that has been the real soft approach towards pan-Asian trade this year, a trend that can be expected to continue while China grapples with internal reforms and border disputes.

Laos
Laos GDP grew at a whopping 8 percent in 2013, albeit again coming from a low base. However, the country suffers from being landlocked, and also to some extent by its reliance upon Thailand as it largest trade partner. That said, the Laos government has been proactive in negotiating trade agreements and the country now has DTAs with China, Malaysia and Thailand. Others are pending.

Malaysia
Malaysia has been active in engaging in bilateral trade with China, including the joint development of universities and Free Trade Zones in each other’s countries. Malaysia is China’s largest trade partner within the ASEAN bloc, and bilateral trade between the two nations has rocketed and is expected to reach US$100 billion by 2015 – another example of the ASEAN-China FTA increasing trade. Malaysia also signed a “Co-Operation Agreement” with India in November – in anticipation of increased bilateral relations. With GDP growth of 5 percent in 2013, Malaysia’s relatively mature business environment is expected to see it become an increasingly attractive destination for Asian FDI in the next few years, and with those ASEAN trade agreements with both China and India, the country is geographically well positioned to serve both.

Myanmar
Myanmar attracts more media attention than its actual business environment warrants, mainly because of all the talk about democracy and the charisma of Aung San Suu Kyi. In reality, the country requires massive amounts of investment into its infrastructure – and in terms of FDI is either the preserve of big-ticket investors or local entrepreneurs ducking and diving. There is no mid-cap investment opportunity to any great degree in the country just yet. Much remains to be done in a country where electricity is hard to come by out of the cities and mobile phone coverage practically non-existent once out of the very few urban hubs. Nonetheless, GDP growth reached 6.5 percent in 2013, again from a minuscule base. Myanmar remains an enigmatic and romantic destination; however, it is a long haul play and not for the new to Asia executive.

Philippines
The Philippines, despite being rocked by Typhoon Haiyan in November, achieved an impressive 7 percent growth rate in 2013. Better governance and English language speaking capabilities together with a relatively high level of education have made the country one of the fastest growing destinations for business process outsourcing. However, some storm clouds are on the horizon, particularly in its relations with China. A looming United Nations Maritime Arbitration Court has been requested by the Philippines government to rule on disputed islands and reefs claimed by both Manila and Beijing. China has pointedly refused to attend the hearings, which commences in March. Should the Court rule in favor of Manila, China will have some serious thinking to do concerning whether or not to ignore the award – as they have stated is their intent should that happen – and the political fallout if they do. Other schools of thought suggest the UN will fudge the issue, not wanting to provoke China. Bilateral trade between the Philippines and China has been dropping, yet in a calculated move, the Philippines has been making the most of its ASEAN connections to boost trade ties with member nations instead. All this, coupled with increasing FDI from the rest of Asia and the United States, means it will be a fascinating, if bumpy, year for foreign investors in the country.

Singapore
Singapore has done well to maintain its strict code of conduct in business and has deservedly built up a reputation for corporate governance and transparency. Corporate administration is easy and the nation has been ranked as one of the easiest places to do business. As a regional hub, it is fast becoming the preferred choice for MNC’s looking at Asia as a whole – some 7,000 MNC’s have their Asian Regional HQ in the city. This, coupled with a low corporate and individual income tax rate has propelled Singapore as one of the most dynamic cities in Asia. That said, it is increasingly difficult to obtain work permits, which are dependent upon salary levels and professional desirability. It is also becoming expensive. Nonetheless, Singapore as a regional hub for Asia is driven by corporate governance and is one reason it is outperforming Shanghai as a global destination. 2013 GDP Growth rate was 3.5 percent, while Dezan Shira & Associates regional office in Singapore reported a rise in revenues of 79% in 2013 as global MNC’s position themselves for developments in ASEAN.

South Korea
South Korea has also shown improvement during 2013. Exports ticked up, a result of increasing focus on Asia’s developing consumer market as well as upturns in the United States. Exports to China also increased as buyers moved towards the Korean instead of Japanese suppliers as a result of political considerations. That said, South Korea remains heavily unionized and difficult for foreign investors to break into. But like the Japanese, the South Koreans are seeking to develop alternative export markets to China, with India followed by Southeast Asia a destination of choice.

Thailand
Thailand is an Asian Tiger, yet one on the verge of some tumultuous times. An ailing, yet beloved Monarch, coupled with a politically divided country has been interfering with growth potential and is making foreign investors insecure. Although growth last year reached 4.2 percent, this came on the back of serious political unrest. Should things worsen, another military coup cannot be ruled out. Thailand’s problems are unlikely to impact upon the rest of Asia with the possible exception of Laos, but for now the country remains a destination to be treated with some caution.

Vietnam
Vietnam is picking up increasing amounts of investors from China – both Chinese factories and foreign investors are moving to the country. We know, as Dezan Shira & Associates has two offices in Hanoi and Ho Chi Minh and fourin South China alone – the trend towards relocating has been going on for some time. However, the country is embroiled in disagreements with China over the South China Sea, and tensions between the two nations can become strained. Foreign investors meanwhile are flocking to Ho Chi Minh City in particular, as the wage differential with China increasingly makes it worthwhile to do so. As several clients have told me, “if we can get Vietnamese manufacturing capacity to 70 percent of what we can achieve in China, it makes better economic sense to be in Vietnam”. Vietnam’s GDP grew by 5.5 percent last year.

Plus One To Watch: Sri Lanka
Sri Lanka’s GDP grew by 7.25 percent last year, leading the Central Banks Governor, Nivard Cabraal, to state the nation’s intent to be a US$100 billion economy by 2016. That’s a jump of US$67 billion over 2013’s performance.

Infrastructure development has been impressive, with a trans-national highway halfway completed – the section from Colombo to Galle is now open and the Colombo-Kandy route is expected to be complete in 2015. Colombo’s main port has been extensively upgraded while a new port and international airport at Hambantota in the South-East have now been opened. The airport will better connect tourists to the east coast beaches, as well as knock 30 minutes off the flying time from Asia. Much of this has been funded and built by the Chinese. In terms of MNC investment, several 5-star hotels are now putting in significant resorts – the huge Shangri-La complex on Colombo’s coast road is set to open next year.

Like the Philippines, English is widely spoken and this has lead to the development of a business processing industry; HSBC’s global call centre is now in Colombo. While the local laws may be somewhat arcane, they are still navigable. Sri Lanka is one to watch and has the potential to turn into one of Asia’s primary tourist destinations. Wealthy Asians and expats looking for second holiday homes would find Sri Lanka good value right now – an acre of land plus a bungalow can be had for just US$250,000. Get in now before it inevitably becomes more expensive.

…and one to put on the back burner: Mongolia
While the mining community continues to make inroads into Mongolia, it has fallen victim to political greed. Newly democratic, those four-year terms of office have manifested themselves as two year windows to take as much out of the country as possible. Political corruption has become rife, and 2014 may yet yield stories of banking scandals and tales of what should have been. The country needs a strong leadership in power for at least a decade to sort the country out – its longer-term investment needs such as water and energy require this. Yet it’s not being delivered. Winston Churchill once said that “Democracy is the best of a bad bunch”: when it comes to political systems – contemporary Mongolia has proven him right. For now, the middle market that looked as if it could emerge has been lost amongst a sea of corruption. Mongolia needs a strong political leader to emerge to get the country back on track.

Summary
2014 will prove a fascinating year in Asia, although I expect more political grandstanding from China. Beijing hosts APEC this year, when maybe Obama will eventually turn up. China will, barring any unnecessary conflicts, prove resilient, although growth will be slow. It is a year of corporate re-positioning and strategic development, rather than massive profits; 2014 is a year in which to invest, and one in which China’s relationships with ASEAN and the latent Free Trade Agreements should be thoroughly examined. The rest of Asia, with one or two exceptions, seems buoyant – time perhaps for the China entrepreneurs to expand their horizons and explore markets elsewhere. Whatever happens, as always in emerging Asia, diligence and a flair for opportunity will see businesses ride through what could be some difficult moments. But overall, 2014 for Asia looks to be a promising 12 months ahead – bumps along the way notwithstanding.

Chris Devonshire-Ellis is the founder of Dezan Shira & Associates, which celebrated 21 years of operations in China during 2013. He is also the founder and publisher of China Briefing, which surpassed the one-million-viewers-in-one-year barrier in 2013 as well.