If the first decade of the 21st century will be viewed as a period in which the seemingly inevitable process of globalisation faltered, the second decade seems to be set to crown a new bi-polar world-order as China completes its metamorphosis to becoming the World’s second largest economy. But China’s export driven economy couldn’t continue to grow at the rates it achieved earlier in this millennium with the western world limping into the new decade weighed down by the concerns of double-dip recession and sovereign debt. China’s leadership has recognised this, and has begun to develop its internal markets by pushing for wage increases, thereby ensuring that its population has the disposable income to buy their own products and put deposits in domestic banks. Whilst this is a sensible and welcome strategy, it’s a tall order that wont be accomplished smoothly or quickly and there will be detrimental consequences for foreign investors.

Maintaining a competitive export led economy whilst increasing wages to stimulate internal markets is a hard equation to balance; particularly in the face of increasing US pressure to free-up the Yuan’s exchange rate. Furthermore China’s social classes are right-now broadly divided into two; the 200 million have-a-lots and 1.1 billion have-nots. The wealthy upper class would seem to have little reason for wanting change and the working class feels so disenfranchised that they dare not hope that things could be different and so, stability reigns. China’s leadership must therefore be applauded for grasping the nettle and encouraging the emergence of a middle class. Middle classes always want more, increasingly demanding many more social and economic freedoms leading to immense political pressure and fermenting social instability. In a country with the size of population and ethnic diversity of China this presents challenges that cannot be fathomed.

Foreign manufacturing companies will be hit hard. They will find themselves becoming less competitive as they inevitably bow to pressure from Beijing and employees, to increase wages at the same time that they continue to manage the associated market challenges of corruption, fraud, political risk and lack of transparency. Risks, which previously, were accepted in return for access to such large supplies of cheap labour.

Therefore, inevitabely, companies and investors must become far more sophisticated about how to operate in China if they are to survive and prosper amongst the fall out from these changes. Local corruption in business, government and the judicial system will remain the primary risk. Lack of transparency in accounting, banking practices and standards; the failure to adopt either US or international accounting standards, will create real difficulties for foreign investors trying to reliably measure financial performance. Bias in local government regulations or inconsistent or conveniently bent enforcement as a result of political pressure will continue to frustrate. The politicising of central bank operations will severely complicate financial transactions. Predatory business practices by competitors looking to move in on foreign controlled success and buoyed by instinctively xenophobic as well as corrupted court rulings will see several investors loosing control of their assets. These risks will continue to exist and grow for some time yet. Chinese officials will be most focused on social and political stability and have little reason to improve the operating environment when so many investors and potential investors have already drunk the Kool-Aid. Maintaining an un-level playing field in favour of local interests competing with foreign interests is an easy way to ameliorate local tension and that sentiment wont change until large numbers of foreign investors start to vote with their feet.

Whilst tapping into the high potential of China is quite rightly a strategic priority for almost any international business, there are serious questions to consider. Standard, Western-style due-diligence techniques will be and indeed already are inadequate in the face of the new complications. No foreign-investor plan will survive contact with the realities of operating in an environment like China. But the underlying fundamental demographics are strong and a strategy that understands the value of the right affiliations, the use of information based leverage and above all that, has a thorough appreciation for the immense challenge of social reform in China will stand a better than average chance of making a reasonable return.

 

© Diligence Inc