Current status of foreign investment in mainland China

June 2013 | EXPERT BRIEFING | FOREIGN INVESTMENT

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The ‘Development Report on Foreign Investment in China’ (2011) pointed out that the foreign investment withdrawal risk in China has been increasing, especially in the country’s southeast coastal area.

This description concurs with our observation of foreign investment in southeast China. The southeast coastal areahas seen a considerable number of foreign investors breaking off with their originally-friendly Chinese partners by withdrawing their capital or transferring their equities. There has also been a number of joint ventures (JVs) and wholly-owned foreign enterprises (WOFEs) experiencing hard times and even bankruptcy.

Southeast regional governments are now gradually changing their previous attitude to foreign investment. They are beginning to cancel some preferential treatment already-granted to foreign investors and are more selective in their dealings with foreign investors. What is interesting is that, by contrast, inland China continues to demonstrate a strong desire to attract foreign investment by creating a friendly foreign investment environment, much as the southeast coastal area used to do. Appetite for foreign investment in inland China is most prevalent in a number of important towns in the central and western regions, such as Zhengzhou, Chengdu and Chongqing.

Digging further, we believe that Chinese economic transformation, industry upgrade and the unbalanced economic development between coastal area and inland China are the deeper cause behind this trend.

Having benefited from reform policies aimed at opening to the outside world, the economy of China’s southeast coastal area has experienced significant development over the past 30 years. Accompanying this development has been the rise of a large number of Chinese domestic enterprises in this area. While not dismissing other reasons, such as domestic financial recession, the rise of Chinese domestic enterprises is certainly a contributing factor in the withdrawal of foreign capital from mainland China.

Going back to the early years of reform, and even a few years ago, the financing channels were quite narrow for Chinese domestic enterprises, particularly Chinese private enterprises – it was hard for them to borrow money from banks as well as pool money from the public. As a result, these enterprises were eager to access foreign capital to support their development and expansion. For their part, foreign investors were hunting down opportunities to share a piece of the large pie that was mainland China’s market. In bringing these two objectives together, Chinese domestic companies and foreign investors hit it off instantly.

Of course, under the circumstance at that time, Chinese domestic companies were generally in a weak position, so they had to relinquish some of their rights to win foreign capital, the most obvious of which was a controlling interest. However, now that the honeymoon period is over, and particularly in the wake of self-enhancement, a number of domestic enterprises are trying to get rid of their foreign partners’ control and regain the rights they relinquished, which gives rise to rifts and disputes between themselves and their foreign partners. In situations where those cracks are irreparable, the cooperation of these parties comes to the end. The most common outcome is that the foreign party transfers the equity interest it held in the JV to the Sino party, whereby the JV converts into a pure domestic company.

From our observation, this transformation of the enterprise’s nature may also result in subsequent legal and financial problems, especially in terms of the preferential tax treatment enjoyed by a JV. In practice, after transformation the domestic company may face the recovery of corresponding tax by competent authorities.

As an example, around eight or nine years ago, one domestic company that ranked high on the list of security door manufacturers cooperated with a north European company to set up a JV in China. In the same way as many other domestic companies, at the outset of the initiative the Chinese party was seeking capital, more sophisticated technology and internationalisation support from its foreign partner. As provided for in the cooperation agreement, the foreign party obtained an absolute controlling interest. Notwithstanding this, due to certain underlying reasons the foreign partner wanted to distance itself from the real management (e.g., product sales and distribution) of the JV. In fact, Chinese party was in charge of manufacturing, marketing and distributing the products.

As time passed, the international financial recession took hold, hampering international distribution channels. The Chinese party gradually realised that the foreign partner actually contributed little to the improvement of technology and the internationalisation of products, since the products were still mostly sold in the domestic market. Yet the foreign partner was enjoying a large portion of the profits. Since the Chinese party believed that it contributed more to the manufacturing and distribution of products, and was now well-funded, its profit-oriented nature impelled it to seek independence from its foreign partner’s control. Amicable negotiations failed, cooperation hit the rocks and the venture finally broke up. In such circumstances, the foreign investment either transfers the shares it owns in the JV to the Chinese party or the JV goes through a bankruptcy process.

This scenario is one by-product of the rise of Chinese domestic enterprises leading to the withdrawal of foreign investment from mainland China. It is not our intention to dismiss other reasons giving rise to this trend, but only to highlight the issue to foreign investorswho may be considering making an investment in China. From our experience, we would offer some advice to foreign investors who are planning to enter the Chinese market. First, choose your Chinese partner wisely. Second, structure a clear agreement outlining each party’s rights and obligations over the course of the initiative to avoid unnecessary disputes down the line. Finally, if possible, it would be better to set up a WOFE rather than a JV.

Gary J. Gao is a partner at Duan & Duan Law Firm. He can be contacted don + 86 21 6219 1103 1742 or by email: gaojun@duanduan.com.

Gary J. Gao

Duan & Duan Law Firm