Dealing with China Is Still Tricky Business

06/02/2011 2:00 pm EST

Focus: GLOBAL

Howard Gold

Founder & President, GoldenEgg Investing

Companies large and small are expanding into China, but even many of the big boys have found out the hard way that critical barriers to doing business—including corruption, piracy, and regulatory issues—still linger in China. MoneyShow.com editor-at-large Howard R. Gold explains.

Last month, shares of Yahoo (YHOO) fell nearly 11% in three trading days on news that Chinese Internet star Alibaba Group Holdings, in which Yahoo owns a 43% stake, had suddenly spun off Alipay, its lucrative third-party online payment provider, a Chinese equivalent of PayPal.

This was a very big deal. Yahoo’s holdings in Alibaba and Yahoo Japan may amount to half the company’s market value of around $16 a share. And Yahoo’s management team appeared to have been caught flat-footed by the news.

The sudden transfer of a critical asset to a separate company owned by Alibaba’s founder, Jack Ma, hit some hot buttons in a country where corruption and self-dealing are rampant. Even worse, it was prompted by new government regulations mandating local ownership of some payment processors.

The dispute apparently has been settled, and this may be more about a dysfunctional business relationship than anything else. But it raised dramatically some of the big concerns foreign businesses have about investing and doing business in China.

See related: China’s Economy May Soon Hit Brakes

Even more striking was the recent experience of Unilever (UL), the Anglo-Dutch consumer-products giant. Apparently, Unilever’s managers let it slip that they might have to raise prices a bit on soap and detergent in China, where the official inflation rate is around 5.3%. Chinese consumers scurried to hoard Unilever products ahead of the planned price hikes.

The Chinese government came down on Unilever like a ton of red bricks, fining the conglomerate over $300,000 (free registration required) for even talking about raising prices—even after the company sheepishly agreed to withdraw price increases that hadn’t happened yet.

The National Development and Reform Commission (NDRC) (don’t you just love those bureaucratic names?) said Unilever had “intensified inflationary expectations among consumers” and “seriously distorted market order.” “Severe punishment” was needed, the economic planning agency added, so other companies could “absorb the lesson.”

Last week, the NDRC partially reversed itself when an official said Unilever could raise prices (free registration required) on some items without being penalized.

And business people complain about regulatory uncertainty here?

Companies and investors still face huge barriers to doing business in China: a capricious government whose priority is social order above all else and a legal system that can be frustratingly opaque and non-responsive.

Although knowledgeable people I’ve talked to say things have improved markedly in some areas, the issues of intellectual property protection and government interference remain high hurdles.

Foreign businesses continue to flock to China because of its huge growth, far exceeding that in their home countries. But they need to keep their fingers crossed that they won’t go afoul of entrenched interests or have a product so innovative that locals decide to knock it off and sell it much cheaper in world markets.

Christian Murck, president of the American Chamber of Commerce in the People’s Republic of China (AmCham China), told me there have been big, healthy changes in China recently. “You do have recourse now,” he said. “As compared to, say, ten years ago, there is a more fleshed out and elaborate legal system.”

China has made big strides in enforcing contracts and in securities laws, I’m told, and Murck said foreign companies often win cases they bring against Chinese businesses in court.

NEXT: Why It’s Better to Be Bigger in China

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Murck conceded that it helps to be a big multinational with the clout, connections, and resources to slug it out in court. “It’s still challenging for a small US company,” he said.

Especially when alleged theft of intellectual property is involved, as a small Schenectady, NY-based chemical company learned the hard way.

The company, SI Group, makes a specialized rubber-bonding resin used in tire manufacturing. It opened a plant in Shanghai only to find that a competitor, Sino Legend Chemical Company, “hired away SI Group's Shanghai plant manager, made a virtually identical product, and eroded the US company's customer base,” SI alleged, according to The Wall Street Journal.

The Chinese company denied the allegations, and the former plant manager “said he joined Sino Legend to make more money, not to pirate a product. ‘Timing-wise, it's a coincidence,’ he said.” Right.

SI Group has spent $1 million on the lawsuit, which, the Journal reported, “was tried on a single day, but the court didn't announce a verdict.” SI has filed another suit, with new evidence for its claims, but it has so far heard nothing from a Shanghai court.

Somewhere Franz Kafka is feeling vindicated.

And it’s not just the little fish that have problems. Just last week, Steve Ballmer, chief executive officer of Microsoft (MSFT), said his company’s revenues in China would be only 5% of what it gets in the US, even though PC sales are roughly equivalent. The reason: rampant piracy.

Office and Windows go for $2 to $3 each on Chinese street corners, the Journal reported. That’s a tiny fraction of what they cost on Staples.com. And Ballmer and Bill Gates have been complaining about this for years. Despite efforts by the Chinese government to stem the flow of knock-offs, an industry survey estimated that nearly four out of five software programs installed in China were pirated.

“Civil [intellectual-property rights] litigation in China continued to grow dramatically, with a year-on-year increase of 32.96%, to 48,051 cases,” AmCham China reported in March. Incidentally, 96% of such cases in Chinese courts involved Chinese suing other Chinese, so it’s a problem for them, too.

And a recent poll of AmCham China’s members found “they’re having greater trouble obtaining business licenses, navigating murky laws and regulations and dealing with corruption…US companies are concerned about a more assertive approach in Chinese policymaking and regulatory practice that they believe benefits Chinese firms at the expense of their foreign counterparts.” Yet 83% plan to expand their business in China this year.

For instance, Intel (INTC) is sending top executive Sean Maloney to Hong Kong as its new chairman for China. Other big players have made similar moves. There were 305 multinationals with regional headquarters in Shanghai last year, the Financial Times reported (free registration required).

That’s up one third in just two years!

The legendary Steve Wynn now thinks of Wynn Resorts (WYNN) as a Chinese company because it gets such an outsized portion of its revenue from Macau, China’s gambling mecca. Wynn is preparing a big expansion there, but he knows well he must eat humble dim sum when dealing with China’s leaders.

See related: How to profit from China’s secular bear market

“You come to China with your hat in your hand,” Wynn told the Journal. “They hire outside help when they need it in this country. In my case, they wanted to broaden Macau. Well, lucky you if you happen to have what they're looking for, and they invite you and allow you to participate. I was fortunate enough to be identified as a person who could be useful.”

Big or small, you’ve got to be able to take the heat if you want to stay in China’s kitchen.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and see his commentary and videos on www.howardrgold.com. He blogs on politics at www.independentagenda.com. He does not own the securities mentioned in this column.

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