Commercial distribution has long been a thorn in the side of foreign investors operating in China. Rather than allow substantial foreign control of the retail or wholesale links in the chain of supply from manufacturer to consumer, Beijing's regulatory authorities have consistently attempted to channel goods through a complex web of domestic distributors. This may be set to change. Recently released regulations may give foreign investors the scope to operate more competitively in the commercial sector.
Although China's commercial sector has been open to foreign investors since 1992, their activities remained subject to tight regulations. A pilot programme restricted retail joint ventures to 11 cities, with only two allowed in each city. The establishment of retail joint ventures required the approval of the highest organ of the Chinese government, the State Council, in addition to a panoply of government ministries. Regulations further demanded that the Chinese party to such a venture be granted majority control. Foreign investment in the wholesale market was barred completely.
In practice, however, cash-poor Chinese partners were often unable to fund a majority stake. This, combined with the enthusiasm of local governments for projects which might generate employment, meant that the central government rules were often bent. Local governments proved willing to approve a variety of Sino-foreign retail operations, above the numerical limits and often without Chinese majority shareholder status.
Last year Beijing responded with a crackdown, ordering the closure or restructuring of nearly 200 foreign-invested retail firms. Particularly targeted were those firms in which the foreign investor had taken a majority stake.
New regulations issued on July 8, 1999, the Experimental Measures On Commercial Foreign Investment Enterprises, suggest yet another policy shift in Beijing. Promulgated by the Ministry of Foreign and Economic Cooperation (Moftec) and the State Economic and Trade Commission (SETC), the measures significantly open the Chinese commercial sector to foreign investment. As with such concessions in most sectors of China, though, this liberalisation is of a mixed nature. The measures legalise a number of previously forbidden practices that have proven quite difficult to control in practice. But they also draw another set of lines in the sand, marking Beijing's determination to maintain strict control over foreign investment in the commercial sector.
The new regulations increase the permitted operational and geographical scope of Sino-foreign commercial joint venture operations. Most notably, the new rules abandon the prohibition on foreign investment in the wholesale market. Geographically, the areas open to foreign investment increase from the initial 11 cities to include Beijing, Tianjin, Shanghai, Chongqing, all special economic zones, and all provincial or autonomous region capitals.
The measures do not place a restriction on the number of joint ventures to be approved. Nonetheless, government officials have hinted that the actual application process might follow prior practice, with approval granted only to a select number of experimental joint ventures in a given area.
In general, more favourable treatment is extended to joint ventures seeking to operate in the central and western regions of China. Enterprises established in these less developed areas benefit from lower starting capital requirements and longer operating terms than those elsewhere.
Foreign investment in the retail and whole sale sectors remains subject to significant restrictions. For example, investment is required to take the form of equity or cooperative joint ventures – wholly-owned foreign enterprises are expressly forbidden.
Only large, well-developed foreign companies will be allowed to enter into joint venture arrangements. Those seeking to enter the retail sector must possess at least US$200m in assets, with an average annual sales turnover of at least US$2bn over the preceding three-year period. For the wholesale trade, the requirements are stricter – US$300m in assets and an annual sales turnover of US$2.5bn.
Commercial operations must take the form of chain stores which the joint venture directly invests in and operates. Franchise or voluntary chains, where the joint venture maintains less direct management of the stores, are prohibited.
With regard to the Sino-foreign equity ratio in the joint venture, Beijing has acknowledged the failure of prior efforts to unilaterally require a Chinese majority stake. Under the new rules, for retail operations of three or fewer stores, the equity share of the Chinese party may be set as low as 35 percent. In contrast, for larger retail or wholesale joint ventures the Chinese party must be the majority shareholder.
The measures offer a special incentive to those joint ventures which satisfy Beijing's policy objectives. Foreign majority shareholder status can be granted even in large retail operations, provided that the joint venture has procured large amounts of domestically produced goods and successfully expanded Chinese exports. It is up to the State Council to decide whether this relatively vague criterion has been satisfied.
The regulations also suggest that preferential status will be given to foreign investment in particular types of commercial outlets in the form of convenience or speciality stores. Large retail operations which fall into either of these two categories can apparently be established with a 35 percent Chinese equity share.
In keeping with prior practice, the measures demonstrate an intent to discourage the use of Sino-foreign joint ventures as distribution outlets for goods produced abroad. For example, annual joint venture imports may not exceed 30 percent of the annual sales volume and joint ventures may not act as foreign trade agents on behalf of third parties.
Under the new rules, the application process is somewhat decentralised and simplified. No longer is State Council consent required for each joint venture application. Rather, the measures charge both Moftec and SETC with the responsibility of approving joint venture operations in the retail and wholesale sector. While only the central authorities need be consulted for an established joint venture that wishes to enter the retail or wholesale market, the decision to found a new joint venture requires the involvement of local Moftec and SETC authorities as well.
The interplay of Beijing's new approach with the real business world has yet to be determined. Though relatively less restrictive than previous policies, the measures institute a controlled framework within which foreign investment is to be contained. Whether this framework will hold, given the tendency of local governments to disregard central controls, remains to be seen. Nonetheless, the new rules should encourage foreign investors seeking to operate in China's wholesale and retail markets.
Freshfields 1999. Freshfields is an international law firm. Most of its offices throughout Asia, Europe and North America include China specialists. For further details, contact Lucille Barale in Hong Kong (tel: +852 2846 3400) or by email (email@example.com) or Matthew Cosans in London (tel: +44 171 936 4000) or by email (firstname.lastname@example.org).