Identifying, Measuring, and Taking Action on the Risks of China

Thursday, September 2, 2010 6:09

Risk.  Everyone in China is exposed to it.  Some recognize it, and act on it, better than others

This was the topic of several conversations between myself and Neal Beatty (Regional Director, Global Client Services for Control Risks).  In some ways it was a followup to the interview I did of Dane Chamorro, his colleague, but this time it was over lunch and encompassed a much larger set of issues…. and given the importance nature of risk, I asked Neal if he would do All Roads readers the favor of answering a few questions about risk in China, if risks here are different than in other regions, and how good firms are at planning for and managing risk.

Below is part 1 of the interview, and with its focus on identifying the risks, and how firms work with “China” risk, there are lessons for everyone.

1. Are the risks of doing business in China any different than say in the US or EU?

Every operating environment has its own risks. What makes overseas operations more complex for multinationals is that many of the operational issues in China (kickbacks, conflict of interest, corruption, etc) are exacerbated by the very fact that they are so far from the comforts of home, and from familiar regulatory and legal environments.

When the company sets up in China, either through acquisition of a local firm, or through establishing a JV or their own facility, the operating environment is often alien. Everyone’s read the books on “doing business in China” and that’s a great start for people new to the country. But that’s just scratching the surface, and often seems to lead managers to over-emphasize or over-simplify a few features of operating environment, so for example you often hear “China is all about “guanxi”; we don’t worry about risk X because our local guys have great connections”. There’s also a tendency even these days to get carried away with the “China is different” concept, and lose sight of commercial and risk-management principles and processes the company applies elsewhere. China is different in many ways and understanding the differences is vital, but that doesn’t mean there’s some mysterious formula here that only a few people understand – like everywhere else, you need a well-informed, comprehensive and rigorously planned out approach to managing risk, not silver bullets. Few companies sit down from the very start, and map out what the risks to the business in China could really be.  They will no doubt have looked into the financial and commercial risks in some detail, but what about the operational or general business risks, not to mention the reputational risks? There is even a potential downside to hiring someone with fantastic local connections to run the business or engage as a joint venture partner, and this needs serious consideration, too.

In China, what you see is not always what you get. This can be especially true of understanding who you’re dealing with in business, whether it’s your key hires, an M&A target, or new partner or supplier. People and entities can have so many hidden interests, connections and potential conflicts that you simply can’t be sure who you’re getting into bed with unless you’ve really done your homework the right way –  specialist due diligence is essential.

2. What are the real risks of doing business in China?  What can business lose if they misjudge their environment?

Some common risk issues include:

  • Compliance & integrity issues: internal fraud (kickbacks and conflicts of interest are most common)
  • Corruption & Graft: recognized by the government in Beijing as a serious issue in China.  And now an increasingly serious issue in the US and UK with the growing impact of anti-corruption laws.
  • IP issues –  counterfeiting, internal theft of critical information, and the protection of your trade secrets are major issues
  • Business partners: Who really is your prospective JV partner? How did they accumulate their wealth? Does your partner or key staff have undeclared family or business connections to a competitor or supplier?
  • Political and regulatory risks – this is largely more of a strategic, ‘big picture’ issue, but companies who lose touch with the prevailing political pressures affecting their industry can find themselves exposed to problems or shifts that they weren’t expecting.
  • Supply Chain risks – lack of transparency and controls along the chain
  • Natural Disasters – typhoon, flood, earthquake
  • Business disputes – the concept of “illegal detention” by business partners as a means to settle a dispute over payments due; threats by disgruntled former employees.
  • Restructuring & labour disputes – closing a factory, or dealing with the disgruntled employee who seeks revenge on a manager
  • HR risks – associated with the new HR law and the complexity of hiring & firing staff.

Obviously the extent to which a particular company is exposed to these risks will depend on their specific circumstances, for example the size of the company, the location, the industry and the effectiveness of its own internal risk mitigation controls. But if you show a group of managers the list of risks above, many will admit that they have experienced several of these issues in China.

Most issues will have been dealt with and the business will have survived intact, but once in a while, something happens that has a catastrophic impact on the business, that no-one could have foreseen.

One of the most serious potential risks to any business in China is the tacit acceptance of the “This is China” approach to business ethics and compliance issues. “We can’t do business without paying the occasional bribe to win contracts” or “it’s OK to allow employees to take a few kickbacks from suppliers – that’s how business is done here”. I’ve heard similar sentiments from managers in China and I worry that they are leaving themselves exposed to more serious issues further down the line. By condoning “low level” corruption within the organization, there is a serious risk of it getting out of control and in the worst case putting the entire operation in jeopardy. A zero tolerance approach is certainly not easy, and requires time, effort and budget, but I would say it is the best way to operate in China, just as in other parts of the world. And it is essential that senior management lay down the law and set out the company culture towards such issues from the very start. The Chinese idiom 上梁不正下梁歪 (if the top beam is not straight the whole structure is crooked) is very true.

3. How much of the risk is political vs. cultural vs. commercial?

It is all three. The risks listed above could happen in any country in the world, but what makes China unique is the combination of engrained local business culture and business practices, and very patchy, often lax, legal and regulatory enforcement. This can result in people thinking there are no personal consequences to their actions.

I don’t believe Chinese people are any different in terms of morals or bad behavior than someone from Northern Ireland. But in China, there are cultural norms that sometimes conflict with the corporate expectations. For example, the concept of a conflict of interest is not understood in the same way as in the EU /US. To many Chinese people it seems perfectly reasonable to consider engaging a supplier owned by a family member or old school classmate. After all, I trust these people far more than some random supplier that approaches me at a trade fair. And if laws are unevenly enforced, then employees may never expect that their unethical, and often illegal, behavior might land them in jail.

And a kickback is often seen as nothing more that natural reward for the sales effort, something owed to the salesman, who probably doesn’t make much money anyway: no-one gets hurt, so what is the problem?

Where these three areas (political v cultural v commercial) often overlap is when doing business away from the big Tier One cities. Generally speaking, the influence of local politics on local business is more unrestrained away from the biggest cities. This can pose its own set of unique risks that can only be mitigated by a very thorough due diligence process prior to forming a business relationship in that location.

4. What are the biggest risks that you feel firms overlook when entering China?

I feel the biggest risk is not taking the time to sit back and look really seriously at “what if this doesn’t go according to plan?” or “what if this should happen?” The opportunities in China are huge, as all the business books tell you, but although most people are aware to some degree that there are very considerable risks out there, not so many are keen to think too long about the downside and address that head on when they don’t see any immediate, severe problem.

If you are new to China, whether sourcing, selling or manufacturing, the first step needs to be to ask for advice. But who to ask? Lawyers are a necessity, but as I have seen from my own experience, they do not always give you the full picture of the risks your operation may face.

So the biggest risk is actually not actively assessing and properly planning for the risks! Many firms still don’t really do this until something goes wrong.

5. Are there firms that are in denial on obvious risks?

I would have to say yes.

I once spoke to the head of a multinational R&D facility in Pudong who had first-hand experience of unaccompanied visitors strolling around their facility, with access to any number of laptops left sitting on desks. When asked whether he was concerned about competitors entering the facility to steal trade secrets, the executive replied “but why would anyone want to steal trade secrets from this facility? We have dozens of such facilities in the US, why would they come all the way over here?” The conversation on business risks didn’t go much further.

And then you have an attitude of some foreign managers who, after having worked in China for many years, feel there is no alternative to “low level” kickbacks and bribes. Leaving behind the ethical arguments for a moment, and focusing on the bottom line –it simply is not cheaper in the long run to pay bribes if you had to pay hundreds of millions of dollars in fines in the US and Europe, and you factor in the potential reputational impact.

And then there is the argument ”well, all my Chinese competitors pay bribes to win contracts, so I have to”…

6. How does the average firm’s risk profile change over the course of its china life?  can a firm run risk free?

I don’t think any company can run “risk free”, no matter what sector or what size of operation. From the largest MNC with multiple manufacturing and distribution facilities around China, to the “one-man-band” sourcing operation, everyone will face risks.

Moreover, you can never reduce risk to zero. No matter how good your risk management program, there will always be someone who does something without considering the possible outcomes and impacts thoroughly, or simply faces a problem that couldn’t be anticipated or couldn’t be prevented. And thus you need to be able to react appropriately and have contingencies in place.  But a good awareness of the risks from the very beginning, along with regular (twice a year) reviews of your level of risk exposure, will go a long way to mitigating many of your operational risks.

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7 Responses to “Identifying, Measuring, and Taking Action on the Risks of China”

  1. Kai Lukoff says:

    September 3rd, 2010 at 6:53 am

    Good piece. I agree with your general point that firms should make fully informed decisions to manage risk.

    But you dismiss the possibility that bribing is good for the bottom-line without providing significant evidence. Are all the foreign firms who do it truly making an uninformed, shortsighted decision?

    Granted, evidence is hard to come by: the busts are high-profile and the companies that succeed this way are unlikely to ‘share their stories.’ What percentage of foreign companies bribing in China are caught? 10% or 1% or 0.1% or 0.01%? What is the risk if they hire ‘outside consultants’ to handle it for them?

    How much does a ‘culture of corruption’ take away from the bottom line? Is this true for Chinese firms too? Are there not hugely successful Chinese firms with what could be termed a ‘culture of corruption’, especially in sales? Is it a money-losing proposition for foreign firms to use that model, or just riskier?

    You note that size matters. But the post seems to focus on huge MNCs, which face very high global reputational risks. This creates a a severe principal-agent problem where the China Exec is unlikely to fully internalize the global risk for the firm. The risk-reward calculus is surely different for small to medium-sized companies (Ex: sales for a machine tools firm, an operation that sources from China, etc.)

    I have no experience here whatsoever, but it strikes me as plausible that some foreign firms are taking a calculated, informed risk. I would love to hear your response–thanks!

  2. Rich says:

    September 3rd, 2010 at 10:13 pm

    Kai,

    I think part of the issue here is in terms of context, and whether or not you view paying bribes as a risk to your business (personal) security. There are certainly plenty of cases where business profited off graft, and there are certainly going to be more, but that does not necessarily make that a business model that is either sustainable or ideal.

    Which leads me to ask what is the point of building a business where you have to constantly bribe (There is never a one off), and where your business model is dependent upon those bribes? Why would anyone think that a relationship built on bribes is one that lasts? It is by its very set up a short term deal, and one that only gets more complicated as time goes on.

    as for taking a calculated, or informed risk, on bribery, I think there is only one full proof way. Don’t do it. SIEMENS thought they could get away with it, and they didn’t. Rio Tinto thought they could get away with it, and they didn’t. … and if they, with their billions invested couldn’t get away with it, no one else can really get away with anything either.

    You’ll pay one way or another.

    R

  3. Dan says:

    September 6th, 2010 at 8:59 am

    Kai/Rich,

    Kai, you ask some great questions, but in the end, I completely agree with Rich, who is, in effect, saying, is it really worth it.  That’s how I pose it to my clients. Do you really want to risk going to a U.S. or a Chinese prison so you can make a few more sales?  I also point out that once you get into the habit of paying bribes, word gets around and nearly everyone will expect it.  So if you are now paying an extra 10% on your 40 sales, is that any more profitable than paying nothing on 35 sales?  

  4. Kai Lukoff says:

    September 6th, 2010 at 7:16 pm

    Rich & Dan-

    Thank you for the thoughtful responses. I think bribing is morally wrong and personally would not want to work at a company that has a corrupt culture. I imagine it would be difficult to sleep at night out of moral reasons and for fear (even if the actual risk of being caught is tiny). If that is your calculus on a personal or corporate level, then ‘zero’ is the acceptable amount of risk: don’t bribe.

    But I remain unconvinced by the evidence that bribing is not profitable in a big way (and at an ‘acceptable’ level of risk for many). In fact, I think it’s precisely because it is that so many companies (Chinese and foreign alike) do bribe in China.

    A lot of this has to do with just how risky bribing is in China… would love to see the best available data on this point. Do you have evidence of how effective enforcement is?

    I think it’s most plausible that Siemens and Rio Tinto are the tip of iceberg, rather than evidence that no one gets away with corruption in China. The observable portion of black/grey markets (those who get busted) is usually only a tiny fraction of the total. In fact, the huge MNCs are the most likely to be busted, it’s probably far easier for small-medium sized firms to fly under the radar.

    There’s also a good conversation on this topic on the China Law Blog: “Bribery In China. Does Your Home Country Even Care?” http://www.chinalawblog.com/2010/07/bribery_in_china_does_your_home_country_even_care.html

    Barry Grossman makes a point about global enforcement there:
    “Some estimates claim that bribe payments account for up to 3% of global economic activity. We know that corruption and bribery is rampant in developing countries throughout South America, Africa and Asia. Yet in 10 years there has been less than 200 convictions under the OECD scheme world wide. That is an outrage. Are the OECD and UN schemes that target foreign corrupt practices just a hoax?

    The only message going out loud and clear is that if businesses elect to advance their interests by bribing foreign officials, they face almost no tangible risk of criminal prosecution in their own jurisdiction. Indeed, while I am no statistician, I imagine the odds of ever being prosecuted for bribing a foreign public official are smaller than the odds that radiation from our sun will cause the earth to collapse on itself in 2012.”

    I think there are three cases of corrupt foreign firms:

    1) Calculated risk-takers (largest category in my estimation)
    The risk-reward ratio is acceptable for these firms. It’s easy to counter with a hypothetical example in which the company decides that it’s worth it: for example, a small-medium sized firm may figure it faces a ~0.01% of being busted, with a 50% higher chance of getting a $10 million contract. Of course they hire middlemen and feign ignorance if caught.
    Type: small-medium foreign firms, some huge MNCs

    2) China rogue exec (principal-agent problem)
    China Exec has a lot of upside to making big profits, and does not fully internalize downside to the firm. My understanding is that foreign execs are virtually never subject to criminal prosecution in China, so absolute worst case is being fired and deportation (I’m not sure how many have been prosecuted under FCPA, but I’m guessing not very many). Global HQ may also look the other way.
    Type: medium-huge MNCs

    3) Uniformed or in denial of risks
    The firm knowingly approves bribery in China, without considering the risks. As you paraphrase, ”well, all my Chinese competitors pay bribes to win contracts, so I have to”…
    Type: all, but riskiest for huge MNCs (biggest target, highest global reputational costs)

    Finally, I think many Chinese do actually have different cultural norms about what is corrupt; the first study I found on the subject states, “In examining the attitude toward gift giving, the survey showed that an individual’s attitude toward gift giving was neither affected by their moral relativism nor by their moral idealism, which implies that gift giving is widely accepted as legal practice in business in Chinese cultural society.” http://www.springerlink.com/content/l77x5q54g256g317/

    In short, I think many firms bribe in China because it generates profits at an acceptable risk threshold. Foreign firms likely face higher risks, but it many still find that it pays. From GlobalTimes: Mu Kun, an entrepreneur in Hangzhou with a small logistics business and 20 employees, spoke openly about his past experiences with bribery. “I’ve paid off all the officials I have to deal with. The forms of bribery vary, but I have initiated them all. That’s the rule here, and everybody does it. You can’t get anywhere without giving up something first, he added. There are so many departments you have to go through; money can help.” I don’t think this is an isolated opinion in China. Link: http://world.globaltimes.cn/top-photo/2009-08/459787_2.html

    Cheers,
    Kai

  5. Caroline says:

    September 12th, 2010 at 4:32 am

    Kai,
    Do not overlook in your list the party officials and their families who have arrogated to themselves land, industry and trade. Some have even cornered entire markets, say in metals..

    The successful corrupt companies of which you speak also include those which are so deeply embedded in the culture and politics locally, regionally and/or nationally that their influence and reach is so broad and complex that the corruption has been absorbed as a norm and can’t be reached, particularly for companies owned or with other interests at the highest political levels. (As we have seen elsewhere, as in France)

  6. Kai Lukoff says:

    September 14th, 2010 at 3:38 am

    Hi Caroline,

    Thanks for the response. I’m sure there’s very high corruption and nepotism amongst party officials and their families, as is apt to happen in any system in which politicians wield enormous power but are subject to minimal public scrutiny (and also happens with regularity even in nations where there is more transparency). A number of Chinese friends have recently told me that the crackdown on corruption in China has slowed since Zhu Rongji left office; I’d be curious to hear more on that.

    And I agree with your point on sectors of the economy (real estate, minerals, and heavy industry, for instance), being dominated by the state and many corrupt practices. I think many of these areas are ostensibly off-limits for ‘state security’ reasons, but now serve to enrich many government officials and their cronies. My sense is that Rio Tinto was trying to play in that sector, but got busted (only after Rio Tinto, under pressure from the Australian government, rejected a HUGE $20 billion purchase that probably would have paid everybody off). It smacks of retribution to me, but that’s impossible to confirm. http://www.cnn.com/2010/BUSINESS/01/11/rio.tinto.china/index.html

    Bribery is certainly a risky game to play in China, and especially so for big MNCs, but that doesn’t mean that many aren’t doing so and profiting. Corruption ‘success stories’ are shared only by whistleblowers, drunken fools, and a few deathbed memoirs.

    Cheers,
    Kai

  7. Sarah says:

    November 2nd, 2010 at 1:12 am

    I completely agree with your point that making sure you are aware of the risks before you enter the Chinese market is really important. Especially in terms of protecting your IP issues there’s an interesting free starter’s guide on The China IPR SME Helpdesk (http://www.china-iprhelpdesk.eu/training%20guide.php), covering everything from what IPRs are, why you need to protect them in China, and how to develop an IP Strategy for your firm, so that you can limit the associated risks when entering the Chinese market.