August 1 2005 by Rick Newman
Four years ago, the German electronics giant Siemens was facing relentless pressure to cut costs and lower prices on its mobile phones. So it did what hundreds of other companies have done: It sent a task force to China to see about opening a research facility there. The delegation found there was a large supply of talented engineers in China, available on a pay scale far below that in Germany or the United States. Government agencies were prepared to help recruit the best applicants. And a Chinese R&D operation, while helping to lower costs globally, would also give Siemens a foothold in the world’s biggest market for cell phones. So in 2001 Siemens built a state-of-the-art R&D campus in Beijing, which quickly grew to several hundred Chinese employees.
There were headaches from the start, though. Language and cultural barriers made some of the engineers “almost impossible to work with,” says Wolfgang Klebsch, senior vice president for mobile devices. Siemens’ German managers found that they had to adapt to their Chinese employees, instead of the other way around. The bureaucratic welcome mat suddenly disappeared, too: Overlapping government agencies began to invoke a confusing array of rules, often contradicting each other. And it was difficult getting prototype phones developed in German labs-often containing proprietary, cutting-edge technology-to the right people in China. The prototypes were subject to unusual taxes, and Chinese authorities often insisted on seeing sensitive design plans. Some of the phones never arrived at all-most likely pirated by black marketeers adept at fencing Western technology.
Such are the complexities of doing business in China. The Chinese are putting pressure on Western chief executives to transfer more technology and conduct more research in China, yet protection for intellectual property is scarce. Corruption and fraud are a constant concern, particularly at a time when American companies are required under the Sarbanes-Oxley Act to have extensive internal controls in place for all their operations, including supply chains in China. And the rules of operating in China are shifting: China’s accession to the World Trade Organization in 2001 requires it to adopt hundreds of reforms meant to establish predictable and transparent legal, regulatory and banking systems. That’s good, but it introduces another element of uncertainty.
Despite the generally pro-business agenda of the national government in Beijing, local and provincial governments, often dominated by powerful apparatchiks, can be far less accommodating. Western firms often make deals with local companies that are still controlled by local governments and run as patronage operations, which makes it difficult to sell assets, reduce bloated staff and even produce clean balance sheets. What worries Western executives most of all is lax-some would say nonexistent-enforcement of laws protecting trade secrets, proprietary technology and other intellectual property. “Anybody who invests in China must be very, very careful,” says Philip Swan, IBM’s chief economist. “It’s very competitive, and some things have not caught up with the West.”
This means that how a CEO structures and staffs a Chinese subsidiary is critical, the experts say. As more Western companies crowd into big cities like Beijing and Shanghai, the hunt for top Chinese managers, who know local markets and have key connections, has intensified. Candidates are scarce. During the Cultural Revolution of the 1960s and 1970s, the Communist Party shuttered most universities, which has left a severe shortage of homegrown managers. Thousands of ethnic Chinese who studied or worked abroad have been returning, but they are far too few to fill the need.
“There is nowhere near enough senior-level managerial and technical talent to satisfy the demands of all the companies hoping to grow in China,” wrote Joy Chen and Madelaine Pfau of Heidrick & Struggles, the executive search firm, in a recent white paper. “And the problem will get worse before it gets better.”
Western companies that have been in China the longest have found that a blend of their own top managers and lower-level Chinese employees, many of whom they train themselves, works best. Most big multinationals-firms like Siemens, Citigroup, General Electric and AIG-have assigned long-time in-house executives to oversee their China subsidiaries. Among other things, this assures close supervision of business practices that might otherwise stray from the company’s standard operating procedures.
But these CEOs of China subsidiaries tend to staff their operations with as many locals as they can find, from the bottom up. At General Electric’s China Technology Center, a research facility in Shanghai, nearly all of the 800 employees are Chinese. But the company still has to look elsewhere to fill some key jobs. “At the entry level, the quality of university graduates is every bit as good as in other countries,” says Bijan Dorri, managing director of the facility. “At the experienced level, not so much. If we’re stopping anything, it’s because we can’t get the people.”
Hiring locally can also make or break profitability. When PricewaterhouseCoopers opened its first office in Shanghai in 1992, virtually all of its accountants were expatriates from the West, since accounting had been an obscure, unnecessary profession in China up until then. The firm quickly realized that dozens of expatriate salaries were too expensive, so it took advantage of China’s strong mathematical schooling and started training young university grads in accounting. Today, several of the partners in its Shanghai office are homegrown, a competitive advantage that has helped lower costs and also has given the firm senior-level talent that is innately familiar with the local language and culture. A sure sign of success: PwC must routinely fend off competing offers from multinationals eager to poach its well-trained accountants.
Overall, the challenges of succeeding in China today are greater in some ways than when Western brands like Gillette and Coca-Cola first arrived in the 1980s. Few Chinese consumers had any money to spend. The companies that did come to China mainly wanted to take advantage of low-paid assembly line workers. And the Chinese government had little to offer besides joint ventures with antiquated state enterprises and access to a huge, but still poor, population. Persuading foreign firms to invest in China-and share some of their business acumen with homegrown enterprises-was a tough sell.
Bring Us Your Secrets
But the balance of power has shifted. Offering to set up a manufacturing operation and bring hundreds, or even thousands, of low-paying jobs to China no longer impresses the nation’s economic gurus. Instead, China now insists on being treated as a source of technological innovation, much as South Korea, Singapore or other Asian countries are. “There’s a saying in China,” says Yiping Yao, people and organization director for Novozymes China, a Danish biotechnology firm. “If you sell in China, you are China’s friend. If you produce in China, you are China’s good friend. If you do R&D in China, you are citizens of China.”
Chinese “citizenship,” however, can be costly. Virtually every foreign venture in China has experienced some kind of piracy, and as foreign operations have become more sophisticated, so have the knockoffs. Originally, China’s black markets filled with pirated batteries, watches, CDs and other inexpensive, easy-to-copy consumer goods.
Now, some of the most complex and expensive name-brand products on the market face pirated equivalents, usually costing much less. The Gartner Group estimates that more than 90 percent of all copies of Microsoft Windows running computers in China are fakes. Western pharmaceutical companies have tested bootleg versions of leading prescription drugs and found them to be remarkably similar to the originals. General Motors claims that a local automaker named Chery heisted the design plans for its Chevrolet Spark compact car and used them to build the nearly identical QQ, which sells for about 30 percent less. “There’s a very lively trade in industrial secrets-blueprints, client lists, patent info,” says Peter Humphrey, managing director of ChinaWhys, a Singapore-based investigative firm. “And it’s getting exponentially worse, not better.”
That’s because the kinds of commitments China expects from foreign companies these days are higher. The potential for industrial espionage has therefore skyrocketed. Most people think of counterfeits as low-quality goods manufactured at shadowy sweatshops meant to copy the look and functionality of recognized products, with a slapped-on label that can pass for the real thing.
But increasingly in China, knockoffs come straight from the victim company’s own databases, laboratories and assembly lines. Humphrey’s firm, ChinaWhys, investigated one large Western consumer-goods manufacturer and found that Chinese staffers in virtually every department colluded with a counterfeiting syndicate that was duplicating a wide range of the company’s products. The Western firm’s R&D chief was a secret shareholder in the syndicate, which even managed to market the phony goods through the company’s own distribution channels. In another case, the top Chinese sales manager for an international auto parts maker secretly formed a competing company run by his brother, and fed it technical and management know-how for 10 years until he quit to run the family firm himself.
Due Diligence Required
China’s loose intellectual property laws may encourage such borrowing, but many companies also unwittingly leave the door open. “Victims tend to be those not closely monitoring the business,” says Tony Parton of PricewaterhouseCoopers in Hong Kong, whose forensic accounting practice has nearly quadrupled in the last two years. “What you don’t know is what’s being taken out the back door.” Humphrey advises clients to make sure field operations follow the same due diligence standards practiced at the home office, with extra attention paid to screening employees, partners and suppliers for any history of fraud or piracy. The fewer middlemen the better. And operations should be tightly compartmentalized, to limit the wholesale duplication of a supply chain.
Preventing problems in China is crucial, because it’s not clear what to do if there’s a dispute. In Europe and the U.S., decades of case law and established legal systems usually produce decisive, if costly, outcomes. In China, however, the legal system has been taking root for only a decade or so, and it is still not independent of the Communist Party. “There’s no judge in China who’s going to go against the government,” says Marc Lasry, whose investment firm, Avenue Capital Group, securitizes nonperforming loans purchased from Chinese state banks.
While most Western executives arrive in China with some awareness of the piracy problem, many are surprised by what’s considered legal in China. Last year, a group of Chinese pharmaceutical companies banded together and filed the equivalent of a civil lawsuit seeking to invalidate Pfizer’s patent protection for the popular drug Viagra, so they could produce cheaper knockoffs. The local companies won, producing alarm in Western boardrooms.
Still, long-term China watchers see progress between the setbacks. “The conventional wisdom is, there is no intellectual property protection,” says Mitch Dudek, a partner in the Shanghai office of Paul, Hastings, Janofsky & Walker, the New York-based law firm. “But I’d argue the opposite. The fact that the Pfizer case went to court shows the system is working. The chief judge even cited a case from Europe.”
Some Western executives in China are encouraged by the emerging need for Chinese firms to protect their own innovations and intellectual property. “One good sign is Chinese companies suing Chinese companies,” says Dorri of GE. “Once you get into that, then it’s the right direction.”
Still, there’s no shortage of irregularities forcing Western CEOs to change their expectations in China. Companies that form partnerships with Chinese companies often discover that “gifts” to favored partners or suppliers-the equivalent of kickbacks or bribes, often involving considerable sums of cash-are an accepted cost of doing business and largely overlooked by authorities. And accounting in China is a relatively new concept, which can cause grave consternation when a partner’s balance sheet doesn’t add up-which is often. “We know the figures presented at first are not going to be correct,” says an executive at one U.S. accounting firm. “They are not produced to measure performance. A lot of things are just not known.”
The Long Term Is Very Long
As in the U.S. and Europe, the right connections-guanxi in Mandarin-can help open doors and forestall a lot of problems. But it takes work and time. “Creating an office with a small staff and flying executives in and out is not good enough,” says Dion Wiggins, research director of the Gartner Group.
With legions of business people and official trade delegations making pilgrimages to Beijing, Shanghai and numerous other cities, it takes big commitments to get the attention of Chinese officials. Hank Greenberg, longtime chairman of insurance giant AIG prior to his resignation earlier this year, traveled to China for 20 years before AIG obtained a license to operate in the country, in 1992. It’s become much easier to set up shop in China these days, but that has lured virtually every company in the world with international growth plans, a new kind of obstacle to getting noticed.
Even the favored entrants face challenges. AIG, which is known as AIA in China, began selling insurance in Shanghai when most consumers there didn’t even know what insurance was. Demand grew as AIA marketed its products, and an increasingly prosperous middle class began seeking life and property protection to safeguard their families and their new possessions.
Today, AIA is the premier insurance brand in China-yet the payoff still seems a long way off. So far, AIA has only been able to gain licenses to operate in eight cities, and it’s only allowed to sell life and property policies to individual consumers, not more lucrative group policies to companies. Small local insurance outfits, many with no experience, spring up regularly and often copy AIA’s policies word for word, while offering premiums at far lower costs. A few have fleeced consumers and disappeared, souring the public on insurance in general.
Revenues from China represent less than 1 percent of AIG’s top line, yet senior executives have learned to practice Confucian patience when it comes to China. “The future potential is huge for all of our businesses,” insists Vice Chairman Edmund Tse. “Our investment in China will give a very good return in the long term.”
Maybe so. But achieving great results over the long term means being able to manage prickly problems in the short term. CEOs who are mesmerized by the size of China’s 1.3 billion-person market or smitten by the low cost of manufacturing-and don’t keep a weather eye on the details of day-to-day operations-almost certainly are in for rude awakenings.