Joint Ventures - ticking time bombs for foreign companies in China

Joint Ventures, for many companies the only way to enter numerous sectors in China, incorporate huge conflicts of interest on the Chinese side. There''s little doubt foreign companies will eventually be the losers.

In China, you get the curious juxtaposition of the world's finest, largest, and most sophisticated companies competing in one of the world's most difficult, and on a per capita basis, poorest economies.

Amongst these blue chips, the theory goes, if you're not in a JV in China you're nothing, Sure, many companies have started using the WOFEs, wholly foreign-owned joint ventures, but in China's most lucrative telecom, insurance, banking and finance sectors, the only way into the market is through a JV, with the level of permissible foreign ownership rising at regular intervals.

But rarely has the inherently flawed nature of JVs been discussed. They are accepted as a fact of life, and as a convenient hook into Chinese partners' local expertise and distribution.

Few have considered that the JV will have one extremely incestuous competitor: since JVs are new companies, co-invested by the foreign entity and the Chinese parent company, the parent company will be keeping a close eye on the progress of its infant.

This progress should be dynamic, since, so the theory goes, western know-how, financing, human resources management and customer relationship management will be twinned with the knowledge and connections of the local partner.

But what's the parent going to do, as the infant starts to overtake the bumbling, state-owned parent, mired in poor corporate governance, corruption, waste, ill-trained and divided by factionalism?

Chinese companies are aware of the inherent conflict between a JV and the parent, as the following comment by Lu Wenqing, head of brokerage at brokerage house Shenyin & Wanguo, one of the largest in China, makes clear:

"Why should we set up a JV with a foreign investment bank? It would mean cannibalising our existing customer base," he points out.

No parent likes to be overtaken by its offspring, and it's highly likely the parent will watch the infant's progress with unease, especially as the foreign company readies to buy out the whole of the Chinese partner at the end of five years, according to the WTO schedule. This could result in the foreign company, with a solid cadre of well-trained local staff with solid connections cleaning up in that particular area of business.

Is it likely the local company will watch this process with equanimity? It's far more likely the local company will fight as hard as possible to extract the benefits of the foreign presence while attempting to freeze it out of the market.

At any point, the staff the parent company has seconded to the JV could well be induced to share information with the parent company, or even to desert the JV and re-join the parent company to apply their freshly-learned expertise.

Or it could be the JV doesn't get off the ground in the first place, since it's illogical for the parent company to part with its best staff, customers and assets to help a potential competitor. The JV could well stagger along in a deadlock with the Chinese partner, as the Chinese side attempts to siphon as much cash and expertise off the foreign partner as possible giving as little as possible in return.

Still, argue foreign businessmen, many sectors in China don't even exist, so any JV would be with a conglomerate which sets up a JV with a foreign company on speculative basis, merely to test the market. For example, insurance brokers in China barely exist so if a foreign company wants to set up a JV it will go to one of China's many conglomerates and suggest setting up a business in which the parent company does not compete.

However, if the business is a success, it's clear the SOE will wonder why it should share profits with the foreign intruder. At that point it could well set up its own wholly-owned company to compete, wooing the foreign-trained locals to rejoin the mother ship.

A classic example concerned the Suzhou industrial park, set up in 1994, in which the Singaporean government invested millions as part of its efforts to enter China. The whole area was built to resemble a mini-Singapore, with independent power supplies, schooling, offices, malls and hospitals. The project was the brainchild of the great Lee Kwan-Yew himself, Singapore's senior minister.

So far so good - until the Suzhou government decided to set up its own directly competing facility. This act has already been extensively written about, but it was still an act in extremely bad faith. The poor Singaporean did not want to raise a fuss, for fear of being frozen out of other projects.

What happened was that the local government had the deep pockets and the political autonomy to offer perks and incentives which the Singaporeans simply couldn't match.

Result: the Singaporean government transfers knowhow and finances for zero gain. Never since has the Singaporean government dared to invest in such a high-profile product in China.

In 1999, the Singaporean transferred majority ownership to the Suzhou local government and to add excruciating insult to injury the new CEO, Wang Jinhua, was the former manager of the New District industrial park, which the Singaporean has accused the Suzhou local government of unfairly favouring. Under the new arrangement the city began subsidizing the joint-venture development company for shortfalls the industrial park suffers if land did not sell. And in the new $80-million science centre the city will pay the rents for up to three years in order to attract tenants.

Foreign investors both as direct partners in JVs and as stock investors in the foreign company should keep a very close eye on the whether or not the JV strategy is, in fact, as straightforward an investment vehicle as it is usually perceived.