Evading the pirates

Piracy may have killed China’s consumer software sector, but the smart operators are finding money can be made where the pirates can’t reach.

China’s software sector is synonymous with IP theft and foreign designers have become accustomed to seeing their profits eroded every time a bootleg program is released to the masses.

But statistics rarely lie and Ministry of Information Industry figures show that with the right business plan there is money to be made in China’s burgeoning software sector. Since 2000, annual domestic software sales revenues have grown from just under US$7 billion to an estimated US$37 billion last year. Export revenue grew from US$410 million to an estimated US$4.7 billion in the same period.

Industry experts have a fairly good idea where the money is, and where it is not. According to Sage Brennan, managing director of media and business intelligence firm Pacific Epoch, consumer software is "ripped off", but it’s not such a big problem in enterprise-level software. "There’s a lot more skepticism than there is actual IP theft," he said.

The reason is straightforward: with enterprise-level software, firms aren’t just buying the code; they are also buying the after-sales support and business that goes with it. "Usually those projects are custom-built for a specific network architecture in some bank in the US anyway so it’s not worth much to anyone else," Brennan said.

For pirates to gain a foothold, they need to not only knock off the software, but also copy the whole back-office support structure as well. Although coding is outsourced to China, the most sensitive information is usually kept under close supervision in the home country.

Xu Jiangang, director of business development at Ufida, market leaders for enterprise level software sales to China’s domestic businesses, believes the country’s software market has huge potential. "Now software is not a big business in China but in the future it will be," he said. As a result, foreign investment is coming fast.

But while foreigners are outsourcing software development to China in increasing numbers, Xu predicts foreign entrants like Microsoft will struggle to capture domestic sales from homegrown players. "We have a long history in China’s enterprise-level software market and more experience than Microsoft. I don’t know, but from its current share in the Chinese market, for Microsoft to catch up it has a long way to go."

Jeannie Chiu, general manager of China operations for UK-based global financial and business software company Systems Union agrees, to a point. "But China is a big pie anyway," she said. "You look at the market in China and it is huge."

Global reach
Domestic companies have the edge in the small to medium-size business sector, but she believes foreign companies’ global reach, experience and reputation means they are better placed to service multinationals in China. Indeed, a lack of international expertise is proving as big a factor as piracy fear in holding back the domestic expansion needed to boost the sector as a whole.

"There are very few people in China capable of co-coordinating projects in multiple locations including China, and that is the biggest problem facing the industry," said Louise Goss-Custard, who works as an IT executive recruitment specialist at Russell Reynolds Associates.

Pacific Epoch’s Brennan points out that, while it is a challenge finding someone with sufficient technical experience to run things, identifying a candidate who can combine this with the ability to run a project management team is even more difficult.

"It isn’t easy anywhere but it’s more difficult in China where you just don’t yet have people with this kind of experience," he said. "Technically they are great but management structures are tough to set up here, and it takes time."

To this end, not only is Ufida sinking 10% of sales revenue into R&D in order to push forward product development, it is also engaged in a joint venture with Swedish developer ISS to gain access to much-needed international expertise.

Systems Union is one of the first foreign companies to see the benefits of an entire R&D set up China, responsible for everything from product development to system architecture, coding and after-sales support.

In fact, it was the lure of the domestic business market that encouraged the company to set up in China rather than India. The company is banking on a combination of its international experience and its China employees’ local knowledge to give it the edge in developing products geared for the domestic business market.

"We are very interested in the Chinese market and that is why we are here; we want to get our products really localized and geared to Chinese requirements," said Chiu.

Despite the relative immunity of some software strategies to piracy, fear of IP theft is still deterring some potential market entrants, which is unsurprising given the scale of the problem in China. Industry watchdog Business Software Alliance estimates that China’s piracy rate is a phenomenal 90%, but at the same time, China has the most to gain by cracking down on the country’s countless bootleggers. A BSA report concluded that a 10% reduction could "transform China’s US$27 billion IT sector into an engine for an additional US$87 billion of economic growth by 2009".

Questions must be asked, though, as to whether this goal is realistic enough to see the profits earned by specialists such as Ufida and Systems Union become available to players operating in the mainstream consumer sector. Bob Kwauk, managing partner of Canadian law firm Blake, Cassels and Graydon’s Beijing office is skeptical about the short-term prospects.

"Software is so valuable and it takes so little to copy it, especially in a technology savvy country like China," he explained. "You have to assume right away it is going to be knocked off and sometimes you have to swallow it and adjust your business plan accordingly."

REAL ESTATE

China REIT rush
With the success of Guangzhou’s GZI real estate investment trust, hopes are high for more offshore IPOs while China’s regulators learn to deploy a domestic equivalent.

Shanghai’s property market has endured a painful correction, but elsewhere land prices are rising and there are signs the real estate investment trust, or REIT, will play a key role in marketing mainland shopping malls and office buildings through an offshore listing.

REITs only made their mainland debut December 12, but the successful Hong Kong IPO of the GZI REIT launched by Guangzhou municipal government’s investment arm suggests that China could join in the Asian boom.

"There are 48 REITs in Asia today – from zero about five years ago – and about US$50 billion in market capitalization. That’s pretty impressive," said Antony Green, head of Asia real estate at Macquarie, which manages 13 REITs listed in Australia.

Macquarie has been in talks over the launch of a REIT in Dalian, and Green is positive about the future of the investment instrument in China, with listings likely to take place on mainland bourses in a few years. "There’s a huge asset pull there, a huge demand in China for REITs," he said.

The standard REIT is securitized property and, like a mutual fund, it allows smaller investors to enter the commercial property market. But it attracts institutional investors too, because REITs provide long-term income streams that appeal to fund managers, and they serve as easy exits from otherwise illiquid investments.

For a Hong Kong listing of China assets, the REIT must be structured around a trustee and a management company, which are responsible for the REIT’s performance. The trustee holds the assets, overseeing the management company and acting on behalf of the shareholders.

Popular investment
The institutional portion of the GZI REIT was 81 times oversubscribed while its retail tranche was 495 times oversubscribed. The flotation raised a total of US$230 million – and its success has prompted talk of other REITs. Most prominent has been the China-asset REIT involving Dalian-based Wanda Group and Macquarie Bank.

Macquarie bought a 24% stake last year in nine properties owned by Wanda. Its shopping malls house Wal-Marts and Hong Kong-listed Parkson Retail. Citigroup, arranger of the GZI REIT, was said to be fulfilling a similar role for Wanda and Macquarie. Another trust is likely to be set up by Singapore developer CapitaLand, which has bought several Chinese shopping centers.

However, a haze has been cast over this "potential vehicle" and there is a question of when, where or even if it will list. Hong Kong or Singapore remain the most likely listing spots but the slow progress might see another REIT beat it to the market. Singapore developer CapitaLand has bought several Chinese shopping centers with a view to establishing a trust.

REITs allow developers to recycle capital rather than locking assets on their books. Faced with credit tightening, combined with new anti-speculation rules, REITs also give mainland developers liquidity. "They can spin off their non-core assets and recycle the fund into more profitable development," explained Andrew Ness, executive director of CB Richard Ellis Research, Asia.

Then there is the added bonus of accessibility. Gone are the days when property market investments had to be large scale. As Macquarie’s Green explained, it is now easy for families to put a portion of their savings into property. "If you are a mum and dad, you can’t just go out and buy a shopping center," he said. "So this provides a way to enter the commercial real estate market."

In addition, REITs boost transparency as they track the market and therefore provide a good indication of what property is really worth. "We will see more REITs," said Kenny Tang, associate director of Tung Tai Securities. "Most of the China property is trading at a deep discount. If they can list as a REIT they can realize their assets’ values. Rental value goes into dividends."

Risks remain
No one denies the presence of an element of risk, though. While it can be argued that market forces will eventually iron out problems as investors are savvy enough to know the good from the bad, asset ownership remains an issue.

"China assets are difficult," Tang said. "They may get a title from the city or the provincial government, but then the central government can say it is not official. In China you do not have very clear title right. And while the occupancy rate is high, the rate of delinquency is also very high."

Agreeing, Frank Slevin, head of investment banking for Hong Kong at Citigroup advises REIT sponsors and market regulators to check titles very carefully. He also thinks investors should be wary of shopping centers without well-known tenants. "It’s one thing if your anchor tenant is Wal-Mart, but it’s completely different if it’s a local retail outlet," he said.

There are 150 REITs in the US, 50 in Australia, and 26 in Japan — where there were 11 REIT IPOs in the first 10 months of 2005. Continental Europe is still spotty, but REIT structures are being hammered out and analysts see no reason why they should not take off there too.

As for the advent of mainland-listed REITs, few expect anything soon, largely due to a restrictive China’s Securities Investment Fund Law and Beijing’s preoccupation with rectifying its capital markets.

"Five years maybe," said Tang. "There will be more [China-asset] REITs in HK markets, but China is really too focused on restructuring the stock exchange."

This view is supported by Ness of CB Richard Ellis, who points to the number of major hurdles still to be overcome. "It will take years before true REITs that invest in income-producing properties and are liquid and tradable on the exchanges start to emerge in China," he said.

While China may not yet have its REIT rules in place, the analysts agree that the long term prospects look bright. Given the unique role it plays as a means of injecting liquidity, thus opening real estate to new capital both large and small, the rise of the REIT appears unstoppable.

"I would be amazed if they saw all of China’s real estate being listed out of China and didn’t think the right place to list it is in China itself," said Macquarie’s Green.

LAW

Arbitration upgrades
While Hong Kong is more transparent than the mainland, the quality gap in PRC arbitral judgments has narrowed.

Today’s problem has more to do with enforcing awards than obtaining them.

Harsh criticism of commercial arbitration on the mainland was fair a year ago, but today even critics concede the reforms of May 2005 have brought China’s rent-a-judge system closer to world standards.

New York University law professor Jerome A. Cohen, who publicly condemned the China International Economic and Trade Arbitration Commission (CIETAC) for losing its credibility last year, now admits that a degree of progress has been made. "It’s an improvement, but they still have some way to go," he said.

Much has changed, though. Gone are restrictions on who can be an arbitrator. While the CIETAC retains a veto, the parties involved now have free choice rather than being forced to select from a set roster. A third judge can come from a country that is neither China nor the country of the contending foreign party. Also, a dissenting judge can make public his opposition to the majority.

But for the same reasons foreign parties are leery of China’s legal system, Chinese parties prefer it – it gives them the edge. "The real problem is getting the Chinese party to arbitrate anywhere else but China," said Laurie Craig, of the law firm Orrick, Herrington & Sutcliffe.

Persistent irritations
Another remaining irritant is the inability of arbitrators to set their own compensation awards. "As Jerry [Cohen] puts it, they’ll even write the award for you," said Craig. "I’ve been an arbitrator there, and I said, ‘We can do this award,’ and they said, ‘No, no, we’ll do that. Don’t worry about it.’"

Cohen remains unhappy with the ultimate CIETAC power of veto over judge selection. "In a case where there are tens of millions of dollars at stake, they may very well pressure the Chinese judges to come up with the right decision. This does not bring confidence to the process," he said.

Today’s problem is less PRC arbitration procedures than the enforcement of arbitral awards. But even this is overblown, said Christopher To, secretary general of the Hong Kong International Arbitration Center, who canvassed law firms and major players for hard numbers. "We got lots and lots of rumors, and lots and lots of complaints, but not a single solid figure."

However, in the view of top arbitration lawyer Michael Moser, of Freshfields Bruckhaus Deringer in Hong Kong, the sticking points are encountered further down the line. "It is not so much that the courts refuse to recognize arbitral awards, the problem is that by the time you get the award, the Chinese party has absconded with the assets," he said. "It is still hard to realize money."

Big players cannot abandon millions, if not billions in assets. But small-scale Chinese losers can, or face foreign winners as penniless bankrupts with little to seize. And when it comes to enforcement, it makes little difference whether the ruling came from a PRC panel or foreign tribunal. Chinese provincial courts can still dismiss a tribunal’s award and, even if courts approve, dawdling bailiffs can thwart collections.

Court to court
Once a tribunal makes an award, and the loser fails to pay, the winner must apply to a provincial court for enforcement. Should the court dismiss the application, the case can then be taken to the Intermediate People’s Court and, if necessary, all the way to the People’s Supreme Court. There is no right of review, but documents can be submitted by the plaintiff, who can be invited to informal hearings in chambers at each level.

Most practitioners agree that mainland legal practice has much improved in the last three years. Provincial courts, once accused of corrupt local protectionism, have made judges sit law exams to keep their jobs, but problems persist in remote districts where reforms have yet to bite.

"You may find people in the local [bailiff] office are more concerned about the effect of a substantial award on a company that may be the main employer in the district," said Jim James, Norton Rose’s arbitration lawyer in Beijing.

Most say Hong Kong, with its English common law, translation facilities and proximity to mainland parties, is a better place to arbitrate. A growing number of potentially contending parties who are both mainland nationals are opting for Hong Kong in arbitration contracts – seven in 2002, 14 in 2003 and 20 out of 300 last year.

But increasingly, it’s not whether Hong Kong or Beijing is better, but how much it costs. Like law firms, arbitration commissions hunger for new clients. That competition more than anything will enhance quality for all those who need to rent a judge.

MACROECONOMICS

Other people’s currency
China is on track to surpass Japan as the world’s biggest holder of foreign currency by the end of the year, generating economic concerns and adding pressure to revalue the yuan.

While a US$1 trillion cash surplus is normally cause for celebration, the news that China’s foreign exchange reserve is likely to clock up 12 zeroes in 2006 is proving to be a mixed blessing. On the face of it, the gigantic reserve, already within striking distance of Japan’s world-leading US$847 billion, gives Beijing license to embark on a spending spree. Illiquid state banks were the beneficiaries last time round to the tune of US$60 billion; 2006 could see a host of capital hungry sectors lobbying for a slice of the money.

But the very existence of this treasure trove also gives rise to some serious concerns. Despite government pledges to boost domestic consumption and reposition the economy away from export dependency, the fact that the bulk of this foreign currency was generated by exports shows how far China has to go. Meanwhile, the portion of the reserve fueled by speculative hot money may have declined last year, but its continued presence is hardly reassuring.

Above all, the ballooning reserves draw attention to China’s undervalued currency and the dark arts Beijing is said to employ in keeping its exchange rate steady. The US$1 trillion mark is a sufficiently profound psychological trigger to reignite US fervor for revaluation or retaliation in the form of trade sanctions. "This is definitely helping western countries to add pressure over the yuan," said Grace Ng, Greater China chief economist at JP Morgan.

The critics’ case is easy to put. Last year, China’s forex reserves increased by US$209 billion to US$819 billion, following a similarly large rise of US$207 billion in 2004. With foreign investment holding steady at US$60 billion in 2005 and a fall in hot money activity, responsibility for the forex boom is being placed squarely on China’s trade surplus, which more than tripled to US$102 billion in 2005.

Crying foul play
US hawks point to this, and America’s US$725-billion-plus trade deficit of which China is responsible for around US$202 billion, and cry foul play over currency. They claim that Beijing buys up the US dollars that enter the country in order to keep the yuan-dollar exchange rate down, making Chinese exports unnaturally cheap. Consequently, last July’s 2.1% appreciation of the yuan against the dollar, which has risen only 0.52% since then under a "managed float," needs to be supplemented by a whole-hearted commitment to market driven reform.

A blatant reference to China’s alleged currency manipulation found its way into the 2006 US Economic Report, which was delivered last month. The report singled out China’s inflexible exchange rate and "foreign exchange market intervention to limit currency appreciation" as contributors to America’s record trade deficit.

Few people expect Beijing to capitulate to Washington’s wishes but Jonathan Anderson, chief economist for Asia Pacific at UBS, does expect a 3% to 3.5% rise in the yuan during 2006, building up to a 7.5% increase in 2007. The implications this would have for Chinese exports, which would suddenly become relatively more expensive, are clear. A more volatile and unpredictable response could be expected from the hot money share of China’s forex.

Having tailed off in 2005, hot money is expected to pose less of a threat in 2006, though exchange rate rumblings may well see a fresh spur in speculative interest. The climate is made even more unpredictable by the influence of US interest rates – an increase in these could turn speculation on the yuan into a prohibitively expensive activity. Hot money remains a potentially disruptive, albeit declining, presence. "What we have seen in the accumulation of foreign exchange reserves suggests that there is quite a significant inflow of hot money still entering China," cautioned Peter Soo, a research analyst at Macquarie.

Calming fears
Overall, Soo believes Beijing has been effective in settling market expectations over currency appreciation and the future of its forex. This includes quashing talk of China divesting itself of dollars and diversifying its forex reserves into other currencies as a "misunderstanding." While there may be some diversification, a mass jettisoning of US dollar holdings would serve to weaken any dollar reserves retained as well as putting pressure on the yuan. "If they reduce US bonds drastically, then the RMB will appreciate against the US dollar, which China does not want," Soo said.

Nevertheless, with US$819 billion currently burning a hole in China’s pocket, there is growing speculation on where, and as what, it might end up. Following last year’s recapitalization of the banks using forex reserves, there have been calls for a continued focus on the financial sector. The country’s flagging capital markets stand out as an area greatly in need of repair. But throwing money at these problems won’t necessarily solve them – nurturing effective regulation is the key.

Others favor an increase in gold stocks as a means of boosting the low risk element of China’s financial holdings. Most countries hold an average 10% of money reserves in gold; the precious metal accounts for only 1.1% of Beijing’s reserves. Teng Tai, an economist at China’s largest brokerage, Beijing-based China Galaxy Securities, recently recommended boosting the country’s gold holdings from 600 tonnes to 2,500 tonnes. He backed increasing this to 3,000 tonnes in the long term.

Going for gold
The Russian central bank announcement in November bolstered such views when it said it was considering doubling its gold reserve. Central banks, mainly in the US and Europe, hold almost a fifth of the world’s gold, using it as an insurance policy against any type of disruptive risk. Deutsche Bank has the central banks of China, Singapore, Taiwan, Thailand, Ukraine and Nigeria on its watch list as gold buyers, and predicts gold may rise 28% year-on-year to US$570 an ounce.

For Tai Hui, an economist with Standard Chartered Bank, oil is the answer, with China’s planned strategic oil reserve a likely destination for a relatively small proportion of the forex holdings. "They are talking 100 million barrels and, using US$60 [per barrel] as an assumption, they can afford it," he said. "Multiply that by US$60 and you get US$6 billion against US$800 billion in reserves, which would only be a small dent."

Speaking at the World Economic Forum in January, Zhou Xiaochuan, governor of the People’s Bank of China, said the government planned to slow down the accumulation of foreign currency holdings by positioning domestic consumption as the driver for economic growth in place of the trade dependent model. Beijing could also do with loosening its grip on both its exchange rate and currency outflows.

But even then, China’s foreign exchange juggernaut might continue to plow its way forward at a considerable pace. "I expect foreign exchange will grow as China relaxes constraints on foreigners to buy the A-shares," said Macquarie’s Soo. "Overseas companies are buying listed banks’ A-shares, and with the Bank of China IPO [in Hong Kong], that money will be repatriated, and these are billions of dollars."

TOURISM

Springing out

Overseas destinations are
becoming more popular among Chinese tourists who have the money and motivation to celebrate the lunar new year in style.

More than 78 million Chinese people hit the roads, railways and airlines during the one-week Spring Festival holiday at the end of January, according to official figures. This mass movement of the country’s population sent ticket prices soaring and saw tourist attractions across the country packed to bursting point. There were even reports of a boom in adult diaper sales in some areas as people prepared for limited toilet access during lengthy journeys on crowded trains.

But a sustained rise in disposable income over the last 15 years, driven on in recent times by incredibly strong economic growth, means an increasing number of China’s urban professionals are able to seek exotic thrills beyond their borders. From Hong Kong shopping malls to sunny beaches in the Maldives to South Korea’s ski slopes, Chinese tourists were there this Spring Festival.

"At this time of year, most places in China are so cold. The few destinations with a pleasant climate like Yunnan and Hainan we’ve all seen before," said Zhang Wenjing, an accountant who made a trip to warm Cambodia during the holiday.

Outbound tourist numbers grew 43% in 2004 to 29 million and CLSA expects this figure to reach 115 million by 2020, making China the world’s largest source of departures. The majority of these relatively inexperienced travelers choose to stick close to home. According to a survey carried out last November by the International Forum on Chinese Outbound Tourism, 90.4% don’t travel outside Asia, with eight of the top 10 outbound destinations located in the home continent.

However, this month a further five countries will be added to the current total of 76 destinations accessible to Chinese tourists – up from 27 in 2003 and zero pre-1983 – and as result people’s travel plans are gradually becoming more adventurous.

"Hong Kong, Macau and the Southast Asian islands are still very popular, while the most sought-after destinations this year are Australia and New Zealand," said a representative of Beijing-based China Comfort Travel (CCT). The representative pointed out that the importance of Spring Festival means many people take time off in addition to the official seven-day holiday, thereby allowing them to travel further afield.

Other travel agents report similar areas of interest among customers. Mr Yue, manager of the Shanghai China Travel International (SCTI) outbound travel department, flagged the popularity of package trips to South Africa and Egypt as well as Australia. Often, relatives from different cities meet at a resort for a family holiday.

"The highlight of Spring Festival travel is going with the extended family," he said. "This not only satisfies people’s emotional need for a family reunion at the traditional festival, but is also a good way for them to express their love and thankfulness to parents, which is a time-honored virtue amongst Chinese people."

Shopaholics
While Chinese tourists typically go for low to mid-range hotels and eat cheap meals, they spare no expense when it comes to shopping. According to a study jointly conducted by ACNielsen and Tax Free World Association (TFWA), Chinese travelers spend an average of US$987 shopping each time they take a trip out of China, making them the world’s biggest spenders.

"When you’re abroad, you make the most of the opportunity to buy something unavailable in China," said Johnson Zheng, an advertising sales executive who spent US$1,240 in Japan during Spring Festival. Although he can stay in five-star hotels and eat delicacies from across the globe in Shanghai, he explained that luxury goods are still limited in China compared with Japan, Hong Kong or European countries.

But retail fever should be balanced out by increased expenditure on food and hotels in the long-term. There are already signs that Chinese tourists are following the Japanese pattern and placing more emphasis on the quality of their experience.

"Chinese people are cost-conscious. They usually choose packages priced at no more than RMB4,000 (US$496) for outbound travel, but more and more people are focusing on quality", said Tang Qiting, assistant marketing manager of Guangzhou’s GZL International Travel Service, citing the growing popularity of GZL’s six-day US$620 luxury Thailand package over the US$248 package as evidence of this trend.

"The purpose of outbound travel has shifted from sightseeing to relaxation and leisure," said the CCT representative. "Therefore, products priced around RMB6,000 (US$744) that offer accommodation in four- or five-star hotels are much favored this year."

All these package trips offer a berth in a tour group. This isn’t an issue for most Chinese, with an estimated four in five choosing a group trip first time up. While this is partly because visas are sometimes only given for group tours, the lower cost of group travel is also a factor.

Safety first
The accountant Ms. Zhang went to Cambodia with a group. "A self-help tour may cost twice as much during the Spring Festival when the transportation fees are skyrocketing," she said. "Besides, it’s safer and easier as a group in a country like Cambodia, where the tourism industry is not so well developed."

While inadequate transportation infrastructures, complicated visa application procedures and limited access to local information scare many people, going solo is expected to become more popular.

"Individual travel is expected to grow very fast, with rising disposable incomes and easy government policies the key drivers" said CLSA analyst Aaron Fischer. "As people gain more experience in traveling, they become more adventurous and are more comfortable with exploring new places on their own."