During the first 25 years of China’s opening up process, joint ventures were the favored vehicle for FDI in China. In 2005, the favored form of investment shifted from JVs to direct investment through WOFEs (Wholly Foreign Owned Entities). During the last year, however, foreign SMEs have been shifting away from WFOEs and back to joint ventures. An even more dramatic shift has seen SMEs decide not to have any direct involvement in China at all. For these companies, licensed manufacturing and sales via distributors has become an attractive alternative.
The shift away from WFOEs has occurred because of the worsening environment for small private businesses in China. Consider just the following in terms of the shift that has occurred in the last ten years:
- Taxes: In 2003, WFOEs operated in China tax-free. WFOEs are now subject to basic income tax, VAT taxes and a host of local taxes and fees.
- Wages: In 2003, Chinese wages were some of the lowest in the world. Now, the wage for the average worker on the coast is higher than in Mexico. In 2004, a WFOE could hire and fire workers at will and employ them for as many hours a week as the workers would tolerate. Now, employment is subject to a strict employment contract law system that makes firing workers difficult or impossible and that requires overtime for work in excess of 40 hours per week.
- Benefits: In 2003, foreign employers could safely ignore paying benefits to their workers. Now, foreign employers are required to pay benefits to both foreign and Chinese employees that amount to almost 40% of the employee wage.
- Rent: In 2003, rent in Chinese cities was low by world standards. Employers who located outside the major cities often negotiated free rent merely by agreeing to locate in a rural or relatively undeveloped area. Now, free rent is unheard of and rents in general are some of the highest in the world.
- Environmental and safety regulations: In 2003, a foreign manufacturer could operate in China with minimal concern about environmental and safety regulations. Now, in virtually all jurisdictions, the Chinese authorities require compliance with relatively strict standards.
As this list of major changes shows, the business environment for foreign investors in China has changed dramatically in just one decade. However, many foreign companies that are planning operations in China assume the situation is the same as it was in 2003. It is a nasty shock to most when they evaluate their potential China operation under the current conditions.
Stated simply, many small WFOEs simply do not “pencil out.” However, because China remains an absolutely critical market for countless foreign companies, simply abandoning the China market is not feasible for many. Companies that must operate in China are starting to shift their Chinese investment plans. We are seeing two trends along these lines:
First, joint ventures are experiencing a revival. In the most basic situations, what the joint venture means is that the foreign investor is saying to its Chinese partner: we cannot make this project work by ourselves in China. We need your help. We will provide you with funding and expertise. What we want from you is management and guidance to allow the venture to earn a profit in this difficult environment.
In addition, more complex forms of joint venture are being considered. Two variations we have seen lately are:
- The foreign company has technology but no money and no ability to manufacture or market anywhere in the world. The foreign company seeks to do a Joint Venture with a Chinese company that will provide both necessary funding and the support needed to commercialize the product based on the technology. The structures for these China Joint Ventures are complex and are made more difficult by the antiquated and inflexible Chinese laws on joint ventures, financing and IP protection.
- The foreign company has an existing successful product that it wants to manufacture and then market in China. Licensing is one option. The other is a complex joint venture. As above, the Chinese side of the proposed joint venture is seen not just as a source of manufacturing expertise, but also as a source of funding.
Years ago, my law firm developed a reputation for not liking joint ventures and there was some truth to that. Our China lawyers did not like joint ventures that were mainly based on the Chinese side claiming that was our client’s only option. We did not like joint ventures for joint ventures’ sake when there were better options available to our clients. We fully recognize China’s landscape has changed and whereas six or seven years ago eight out of ten joint venture proposals that crossed our desk did not make good sense, that ratio has probably completely flipped today, to the point that in the overwhelming number of instances, our lawyers make no effort to talk clients out of their proposed joint venture.
The second trend we are seeing is companies abandoning the concept of directly investing in China and instead moving to a contractual approach. We are seeing this especially with foreign SMEs determining they do not have the resources to do manufacturing WFOEs in China. Basically, they are determining Chinese owned factories are better/cheaper at manufacturing in China than foreigners. This includes multi-nationals such as Apple and HP.
In response, the current trend is to work towards purely contract manufacturing (product outsourcing), with no JV and no WFOE involved. This often involves complex IP issues and can also involve complex issues of start-up funding for the Chinese manufacturer. In connection with this trend, the foreign parties are finding they need to work with their manufacturers to bring up their level of product quality to obtain required certifications such as HACCP and GMP.
Non-manufacturing businesses are also following this trend. In the creative industries, foreign companies are licensing their expertise to Chinese companies who then do the work on the ground. The same approach is taken even where a final product will be produced, such as a magazine or website. I estimate that my law firm is doing at least five times this sort of work as opposed to just a few years ago and I am seeing the same sort of numbers with China joint venture deals.
This approach also requires complex contracting. In 2004, few foreign businesses had any faith in the enforceability of contracts within the Chinese legal system. This (justified) lack of faith meant these contract-based approaches to doing business in China were not considered feasible. China’s dramatically improving legal system (at least with respect to contract enforcement where it is now ranked 19th in the world) has made it possible to shift to contract-based approaches to doing business in China. As with WFOEs, many foreign SMEs and their lawyers are not aware of this improvement in the legal system and continue to make their decisions about their China investments based on outdated, 2003 conditions.