Late last month, we put on a A Live Discussion on Doing Business With a High Risk China. At this bottom of this post is the full (slightly edited) presentation for your viewing pleasure.
Though we dedicated 1.5 hours to this event and answered a ton of great questions, there were still many more excellent questions that we did not have time to answer. But as promised, we are answering them now, below. The answers to these questions are the combined efforts of Brent Carlson of Alix Partners, Isaac Stone Fish of Strategy Risks, and Dan Harris of Harris Bricken.
If anyone (attendee or not) has any further questions to ask of us, please send those to [email protected] and we will either answer them directly or on here.
Question 1. Chinese drone manufacturer SZ DJI Technology Co provided the Russian army with an advantage by shutting off Ukrainian DJI drones during the initial days of the war to allow Russian DJI drones to operate undetected. Does this substantiate US concerns/allegations of security risks vis-a-vis Huawei, etc?
Answer to Question 1. The allegations, that DJI drones have been supporting the Russian effort and hindering the Ukrainian one, provide essentially just one data point. In a world of imperfect information, it’s helpful to think in terms of a mosaic. We advocate examining all the data points you come across and using those data points to determine what patterns emerge.
Look at Sino-Russian relations leading up to the invasion, as well as how China has been positioning itself since then. Just prior to Russia’s invasion of Ukraine, China, Russia, and Iran were conducting joint military exercises. Also, again, just before the invasion China declared its strategic relationship with Russia to have “no limits.” Since the invasion, China has made very clear that it would not embrace the U.S.-led sanctions on Russia, though China has not directly fought back against them. This policy points to China’s official policy being one of structural ambiguity.
Within this context, look at some recent notable trade compliance cases involving PRC companies, such as ZTE and Huawei. Both show that PRC entities are open to selling into sanctioned markets. More examples are likely to come, but few will get exposure in the public realm. The key questions for companies that do business in or with China should be the following:
- What should we be doing to prevent our China operations from violating sanctions on Russia? How robust are our policies and procedures in this regard?
- How are we doing business partner screening (KYC/KYS)? When was the last time an independent assessment of our compliance program was conducted?
- How does China’s Anti-Foreign Sanctions Law come into play in all this and how can we address it?
Question 2. Can you elaborate on the risks for local staff of foreign companies? What should companies be watching for, which sectors, etc?
Answer to Question 2. With the advent of Hong Kong’s National Security Law, China’s Anti-Foreign Sanctions Law, other related laws, and a growing understanding of the CCP’s willingness to use extrajudicial measures to punish employees of foreign companies in China, its companies need to prioritize the safety of their Chinese and foreign staff in China. How does one do that? One sad but necessary step is restricting the flow of information from headquarters to China — especially until China relaxes its COVID protocols and permits China-based staff to visit other countries, where they can have in-person communication that is less pervious to eavesdropping. Another is not speaking about the need to reduce exposure to Xinjiang to employees in China, but, rather, taking steps externally to reduce that exposure, and then communicating it to China-based staff in other ways.
China’s new Anti-Foreign Sanctions Law does two things. One, it allows Chinese companies to sue foreign companies in Chinese courts for canceling business due to foreign trade compliance issues. And two, it targets individuals and their families to prevent the implementation of foreign trade compliance requirements.
This second part puts company representatives – especially PRC personnel – in real danger as they are now forbidden by Chinese law from implementing increasingly important U.S. trade compliance laws and regulations (and their EU equivalents), including OFAC sanctions, the Export Administration Regulations, and the Uyghur Forced Labor Prevention Act.
Question 3. With respect to Taiwan-PRC tensions, 10 years ago the CCP’s position was to enhance the “brain drain” of educated Taiwanese to first tier universities and cities in Mainland. Why did China suddenly change from its long game on Taiwan?
Answer to Question 3. China has been shifting its long game on Taiwan for some time. The One Country, Two Systems model was designed for the peaceful reunification of Taiwan and the Mainland, reportedly by Deng Xiaoping no less.
But Beijing’s actions with Hong Kong in recent years demonstrate that its One Country, Two Systems model is dead. It has been replaced with a One Country, One System approach, and this is an approach that has been increasingly repressive.
Question 4. It seems that the unspoken summary here is “Don’t wait for someone to yell ‘Fire!’ . . . Run from the smoke-filled theater now!
Answer to Question 4. In strategic planning, businesses need to look at how trends are going and adapt accordingly. After a long hiatus under the post-Cold War peace dividend, geopolitical risks have now become front and center issues. Russia’s invasion of Ukraine demonstrates that geopolitical tensions can and do boil over. Words matter. Actions matter. Look at where China has been heading in recent years and what this has meant for companies that do business in or with China.
We are not saying every company should run from a smoke-filled China, but just as your company no doubt has a fire evacuation plan, it should have a China evacuation plan too.
Question 5. We own a small WFOE that manufactures our consumer/industrial equipment for export to us in the U.S. Any hope we can hang in there through this or do we really need to get out despite the 25-30% increase in our cost of production?
Answer to Question 5. Good question and it reflects what many are thinking. To help answer it, look at the trends, in aggregate, along the lines of the mosaic approach mentioned above. The signs point to more trouble ahead rather than less. Thus, hanging in there may result in getting left out to hang amid the new geopolitical dynamics.
Also, direct costs of production are only one component in the overall analysis. Think about the changing regulatory risks, from trade compliance on the U.S. side, as well as reputational risks. Those risks can blindside a company’s bottom line, and seemingly come out of the blue if not addressed proactively.
Lastly, think about the competitive benefits you might reap by leaving China before some of your competitors do. We have many clients that complain about being in China, but none of our clients that have left China have ever complained about having done so.
Question 6. I’d love to get the links for the articles that mentioned.
Answer to Question 6. We talked about a number of articles during our talk. Among those was an Al Jazeera article, entitled ‘Pearl lost its shine’: Shanghai expats eye exit over COVID rules, describing how a large number of expats “are done with China” and intend to leave as soon as they can. We also talked about a Forbes article, Sorry China. Most Americans Support Higher Prices On Your Imports. This article talked about how in a recent survey 73% of Americans said they support the U.S. government using trade remedies on China to protect U.S. industries and American workers with a similar high number — 71% — supporting the trade war tariffs imposed on $250 billion worth of China imports during the Trump administration. The article concluded that even with inflation at levels not seen since the 1970s, American voters seem willing to force companies to import from elsewhere or make it locally instead.”
One of the points we made in the webinar was that China represents one of the few bipartisan issues in Washington, DC, in an area of hyper-polarization. This speaks volumes.
Question 7. Should U.S. companies be cautious when asking local staff to speculate about COVID measures/lockdown and on the ground conditions? Are those sensitive from a government POV in the same way that sanctions research might be?
Answer to Question 7. Just about everything in China has become political. Discussions around on-the-ground conditions done within the context of their impact on company operations would probably be fine so long as they do not reach beyond company personnel. In any case, it would be prudent in China for local staff to not openly criticize the Chinese government’s policies around COVID measures.
Question 8. Thank you for the discussion. Do you see a split between how smaller- or medium-sized firms are approaching China investment and potential risks vs. Fortune 100 firms? Is there a difference you can discern among listed vs. unlisted companies?
Answer to Question 8. For smaller- or medium-sized companies, the risks – and potential impact from them – are higher simply because China typically constitutes a higher overall percentage of supply chain and/or customer exposure. Thus, the risks from a changing China are more likely to be existential for smaller- or medium-sized companies. A prudent approach for all companies is to start trying to mitigate company-killing exposure by hedging your bets.
The risks generally apply equally across listed vs. private companies.
Question 9. Won’t China learn from the sanctions imposed against Russia and just ensure that its foreign assets are better protected when it makes a move – such as against Taiwan? China will proceed more strategically?
Answer to Question 9. China is on a strategic path to achieve self-sufficiency in terms of food, energy, and technology. Think about what this means.
Turning specifically to China’s moves to protect itself from the type of sanctions imposed on Russia, look at China’s moves to create a replacement for the SWIFT system for inter-bank settlements. It is part of China’s goal to move away from U.S. dollar-denominated transactions to RMB ones. Whether China can actually achieve this is another question.
Some believe that what is happening in Ukraine will dull China’s appetite for making a big move against Taiwan, but others think it will have little to no impact.
Question 10. Are you aware of any U.S. intentions to reduce or eliminate Chinese investments in American pharma companies, and also China establishing U.S. pharma subsidiaries in U.S., with staffing by expatriated Chinese scientists and physicians?
Answer to Question 10. This is an industry that will only come under increasing scrutiny in the new and evolving geopolitical environment. “Biotechnology” is one of the “emerging technologies” of the Export Control Reform Act. Combine this with the supply chain snafus seen under COVID, and it is obvious that this sector is a national security issue, for both sides, the U.S. and China. Accordingly, it’s no longer “business as usual” in this new environment.
Question 11. Are you seeing Chinese entities pulling back on commitments to U.S. PE funds because of sanctions, asset-freeze risk by US?
Answer to Question 11. There is buzz among the venture capital community that China-related opportunities are closing and that the window may close within a couple years.
If one is looking at commitments from a PRC investor into a U.S. PE fund, like everything else in the U.S.-China relationship, the situation is changing. If the China-origin funds will be placed into U.S. funds for investment in the U.S., then expect increasing CFIUS scrutiny. This represents not so much a commitment risk, but rather an allocation risk.
If the investment commitment is going into a fund that invests in sectors and geographies outside of the Chinese government’s priority areas (i.e. technology and domestic PRC), then the commitment risk is high. Look at the massive outbound PRC investment that occurred in the late 20-teens; China turned off the tap when these investments ceased to be viewed as being in the national interest.
Question 12. Since the CCP’s positions on intellectual property, Xinjiang, Tibet, Taiwan, Hong Kong, etc. aren’t likely to change, what do you see the end game being?
Answer to Question 12. Looking at the trends and using the mosaic approach, it looks like the CCP’s end game is to gain greater control over China, which means greater control over all of China’s citizens and over Hong Kong and Taiwan. China’s economy and its relations with other countries are secondary to this.
Question 13. How do you see rest of world aligning on Russia-Ukraine war and China’s trend towards decoupling? Countries like India, Brazil, and South Africa have not aligned with sanctions on Russia. What does this tell companies?
Answer to Question 13. The implication for companies is that such countries/jurisdictions may present trade compliance risks, through transshipments, among other things. Make sure your company’s trade compliance program is robust enough to catch this. Past practices simply will not fly in the new geopolitical environment, and companies that are not savvy regarding these things will get blindsided.
Question 14. Taking each of these themes in turn, how would you answer differently regarding foreign companies that are in China for China? And in line with country’s development priorities in benign sectors?
Answer to Question 14. From the very beginning of foreign investment engagement with China up until today, foreign companies have had to align with the Chinese government’s objectives to truly succeed in China. For example, early on when China wanted to build up its manufacturing, it would accept pretty much any manufacturing company. But then when pollution was becoming too much, China started making things difficult for low-paying and high-polluting manufacturers.
For many years though, foreign companies were mostly in alignment with the Chinese government in that both sides wanted to economically profit from the other, be that monetarily or technologically.
Today, there is a disparity in China’s civil-military fusion. Dual-use technologies lie at the core. There are still many commercial opportunities available in China, but companies increasingly need to balance that against not violating trade regulations or creating reputational and other risks.
Even companies that are “in China for China” can face big risks. Uniqlo’s “Xinjiang cotton collection” is a great example of this. At what point do customers in-home or international non-PRC China markets start calling companies out for what they are doing in or with China? We are increasingly seeing companies suffer reputational damages and even damage with employees for “getting too close” with China.
Question 15. What open sources of information do you recommend?
Answer to Question 15. There is plenty of good media out there in multiple languages. The issue is more in recognizing the signal amid the noise.
Note though that China has greatly restricted media coverage within China in recent years. This means that immediate, on-the-ground coverage is harder to come by.
In terms of pure China coverage, The New York Times, the Washington Post, the Wall Street Journal, Atlantic Magazine, and Axios tend to provide the best China coverage. Newsletters/subscriptions we like include The Wire China and SupChina, Sinocism, China Boss, Trade War,
Question 16. What is your opinion on “Doing business in China or with Chinese” for the foreseeable future, considering the direction of geopolitical affairs now? Is it better to escape from China as soon as possible or is it still possible to do business with China, but with additional precautions? If so, what kind of precautions?
Answer to Question 16. China has changed and it’s no longer the market it was 20 years ago when it acceded to the WTO. Geopolitical considerations increasingly will weigh on businesses across the board. That said, there’s no need to leave money on the table either. In terms of precautions, look at how the trends have been affecting your business and extrapolate. The issue may not be one of intelligence but rather imagination. Business in China can change on a dime. Ask yourself what would happen if your China business suddenly changed overnight. Then ask what you can do to mitigate that impact. Do you really need a 30-person sales force in China, or might you do almost as well with considerably less risk if you had a contract with a Chinese distributor instead? Or maybe you just license your name and your technology/secret sauce to a Chinese company? In the end, it depends on your company’s specific situation and industry.
Question 17. You talked briefly about companies that left China and enjoyed greater profitability as a result. What enabled this?
Answer to Question 17. Any company that invested in diversifying its supply chain from over-dependence on China pre-COVID is doing well amid China’s strict lockdown policy. The enabler simply is that they can supply products when others may be hampered by China lockdowns and supply chain snarls. We also have worked with companies that left China even though doing so increased their costs, but due to tariffs and higher shipping costs, they are now at a lower cost than their competitors and they have gained market share because of this. We also have worked with companies that saved money by setting up new, more computerized factories.
Question 18. Could you please describe some scenarios that can increase the likelihood of a company being tolerated and facilitated in China for China.
Answer to Question 18. Foreign companies that bring money and/or technology or some other expertise into China are still welcome. Watch out for increasing blowback from home company trade compliance regulations and enforcement though. There will be some big cases coming down the pike. Companies that can keep avoiding sanctions and export controls and the increasing awareness/reputational risks that come with the various forced labor issues will, for the most part, likely keep doing well with China. But with China and the world’s rapidly evolving political environment, such safe areas are getting more difficult to find and even when found, are at greater risk of evaporating.