Investing in mainland China usually involves an element of risk, but with an intelligent risk management framework in place, foreign firms can make risk work in their favour, says Prof. Kai-Alexander Schlevogt.
Many companies are attracted by China's great market potential, but are deterred by the perceived risk of doing business there. For example, despite excellent market opportunities for their often highly specialised products, few small or medium-sized firms from Germany enter China, because they believe it to be too volatile. At best, such firms tend to act as late movers, following in the footsteps of larger market pioneers.
Others, by contrast, trust in the long term and invest large sums in moves that contain a significant element of risk. General Motors, for instance, invested US$750m in cash for a 50 per cent stake in a Shanghai joint venture auto assembly plant, before China's accession to the World Trade Organisation. This was more than twice the amount it paid for 100 per cent acquisitions of plants in Poland and Argentina.
Visionaries gamble on their foresight and move first into unknown territory. Mochtar Riady, head of Indonesia's Lippo Group, invested heavily in Fujian province, betting on the opening of direct links with Taiwan when he decided to establish an industrial park in Putian and a convention centre and tourist attraction on nearby Meizhou island. When their visions are not realised within a short period of time, such players are likely to retreat or scale down their investment, as was the case with Goldman Sachs, which slashed the number of its Hong Kong staff in the mid-1990s after failed investments in the mainland's power and property sectors.
Both these approaches can prove harmful, since companies are likely to invest either too little or risk too much. Instead, managers should try to assess and handle risk in China systematically. The following four-step framework reduces the residual risk that a company has to bear after the 'raw risk' in the market has been reduced.
1. Understanding risk
Risk seems to be the only certainty in China. Anything can happen, including political turmoil, financial crises and labour unrest. However, acting on the basis of such generalisations will lead to the wrong conclusions. In many cases, risk results simply from ignorance. Because of knowledge differentials, commercial banks close to China, in places like Hong Kong, often offer lower rates for credits than banks that are removed from the region, even when they are denominated in the same currency. Foreign banks that are less involved in China charge a 'risk premium' to compensate for their ignorance.
Companies need to understand the difference between uncertainty and risk. In an uncertain world, the future is completely unpredictable. In a risky world, subjective probabilities can be placed on various foreseeable outcomes.
Most of the turbulence in China consists of risk, not uncertainty. Specific risk can be defined as the product of three factors: the expected overall damage that a potential event may cause multiplied by the likelihood of it occurring multiplied by the impact it exerts on the company. For example, trade sanctions imposed against China may bar access to overseas markets. But how large is the potential overall damage of these events and what is the probability of them occurring? And even if they happen, would they necessarily be bad for your industrial sector and your company, which may primarily serve the domestic market? If any of the three dimensions is reduced to zero, risk disappears. The dimensions of risk can be analysed using the following procedures.
SEGMENTING RISK Risks can be classified into different groups, which need to be adjusted for each individual project: general country risk (such as political and currency risk) and project-specific risk (such as financing, approval, operating and competitive risk). Each risk needs to be defined further. For example, one key aspect of country risk is the danger that, once an investment is made, the original bargain with the government may become obsolete. When a company has made a large, asset-specific investment that cannot easily be moved elsewhere, it is especially vulnerable to a government reneging on its promises.
Likewise, demand risk (which is a part of operating risk) needs to be analysed for different customer segments. It helps to analyse comparable trends and experiences in other countries, which might later manifest themselves in China. Pingan Insurance in Shenzhen, for example, studied how a British insurance company pressed its customers to take out life insurance with sums insured that exceeded their financial means. This inevitably led to high cancellation rates and prevented the company from recuperating the high commissions it had paid to its agents.
When categorising risk, it is important to predict changes over time and as a result of your future action. For example, an Ameri- be jeopardised by a possible future attack on China by the US. But there may be forces at work, such as China's rapid military buildup, that will slowly change the power equation and reduce the likelihood of conflict.
IDENTIFY DRIVERS OF GENERIC RISK Companies need to look below the surface and determine what causes an event and how likely it is to occur. For example, by studying which areas the Chinese government promotes, it is possible to discover future competitive threats. Companies such as Lafarge, in the cement industry, assess demand risk by analysing its key drivers at different levels, such as government investment in infrastructure and building activity in the office and residential sector. They can then construct scenarios around these drivers and prepare responses for each case.
One key factor in many risks, which is often overlooked, is the part played by individuals. For example, when Singapore created Suzhou Industrial Park in its own image in co-operation with the local government, it did not foresee that the city's mayor had a great incentive to build a competing park.
DETERMINE POTENTIAL IMPACT ON YOUR COMPANY An event may appear very harmful in general, but may not significantly affect an industry or a company operating within it. It may even prove beneficial. Companies need to look for risks that have a positive relation with company success. However unlikely, a peasant revolt in China might mean more emphasis being put on the countryside. This may increase returns for those involved in the agricultural sector. Likewise, new trade barriers might destroy international competitors that focus on exports. A war could benefit producers of military equipment, while an earthquake might stimulate excavator sales.
2. Shaping the environment
Companies should not treat the environment as a given. Instead, managers need to take into account all stakeholders and their interests – especially in China, where a great many different institutions and individuals wield influence. Shaping this open system, for example through network building, may decrease the likelihood of an event occurring and the potential damage it may cause, even when the subjective probabilities cannot be assessed.
For example, the risks associated with gaining construction permits endanger many promising real estate projects in China. For a single building, developers often need more than 100 permits. Building a complete city from scratch, and linking it by a new highway to a provincial capital, might therefore appear far-fetched. But by spotting opportunities in the stakeholder configuration and shaping the environment through networking, Hebei-based Zhuoda Group reduced this risk. It understood one of the key needs of the Chinese government, which is to reduce unemployment, especially in rural areas. Since 'Sun City' (outside the city of Shijiazhuang) is a major project that will create jobs and increase economic growth in the countryside, the government strongly supports the planned project and has issued all permits speedily.
Bringing partners you know to China and thus recreating a familiar environment may reduce many risks. For example, Coca-Cola brought experienced bottlers into China, giving it an edge over PepsiCo, which preferred to take stakes in local companies.
Shaping the internal environment also helps. Pingan Insurance, for example, is trying to achieve significant company size, so that even if it were to encounter financial trouble, the government would be likely to support it to avoid large-scale redundancies.
It helps to mould the company according to proven business models and best practice, as Hainan Airlines did when it trained its crew to copy the refined manners of Singapore Airlines stewardesses, such as kneeling down when talking to passengers in order to avoid to look down on them while speaking. Through excellent training, it reduced the people risk. Technology, such as highly structured online ordering systems, can also standardise procedures and thus reduce human error.
Some shaping strategies can reduce holdup risk. For example, a company can disintegrate its value chain and spread the activities throughout Asia. It could source raw materials and major components from abroad. If it were to be nationalised, the Chinese government would be left with an isolated asset (such as an assembly plant), which would be worthless without the whole system and the economies of scale, scope and learning that it affords. Besides, if the operation of the asset is complex (such as an R&D centre), the government may not be able to manage it and thus be deterred from expropriating it.
Decreasing the amount of fixed investment (which makes it less attractive for the government to capture the business) and increasing the weight of invisible assets also helps. The risk of 'time inconsistency' also decreases if a company exports a large part of its production, because foreign customers would probably react negatively to nationalisation. Good corporate citizenship may deter the Chinese government from taking action against industries it considers socially important for a large number of people, such as food and electricity.
If at all possible, excessively high margins should be avoided, for example through skilful transfer pricing, in order not to tempt the government to seize an attractive asset. Investment schemes should also be shaped to avoid large sunk investment and a long period of large cash-inflows to recuperate it, because such a pattern also entices a government to renege on prior bargains once the investment has been committed and only the profits of the business are visible. Partnering companies from powerful countries or with international institutions, such as the World Bank, also reduces the hold-up risk, because China will fear for its reputation.
Companies can also devise shaping strategies that decrease the risk stemming from competitive attacks. For example, preemptive investments may prevent competitors from entering the same territory. Coca- Cola and Pepsi were both quick to occupy shelf space and lock capital-intensive bottling companies into exclusive arrangements.
3. Transferring risk
Besides shaping the environment and thus reducing or eliminating risk, managers may transfer risk. To do this, they need to go through all the known risks and identify institutions or people who have a comparative advantage in bearing them – perhaps because of economies of scale, scope or learning. Indeed, underwriters believe that any risk can be insured at the right price. In the extreme, a company that invests in China may just become a network integrator with a core competence in selecting companies to which it transfers risks.
Country risk in China is a type of unique risk, which means that it does not fluctuate with a well-diversified global portfolio. It can be transferred to outside shareholders. Those who hold a balanced portfolio diversify away the unique risk. For example, American Standard, the manufacturer of plumbing fixtures, found outside investors to take significant stakes in its China venture. Outside stakes of this sort can be bought back subsequently. Despite the appreciation of the equity, companies may still be able to make a profit by using their expertise to add value that others could not create.
Another aspect of country risk is how to deal with currency risk. For most companies, currency speculation is a risk best handled by financial markets through hedging. Pharmaceutical giant Novartis, for example, prevented huge losses by hedging before the Asian financial crisis stuck.
Financing risk – the risk of not finding enough investors – can be transferred to investment banks. American Standard engaged Peregrine, which privately placed about 70 per cent of its shares to outsiders. In China, approval risk can be allocated to retired government officials acting as consultants. They may leverage their former connections to obtain permits speedily. Construction risk can be borne by specialised construction companies with experience in other emerging markets.
Through risk transfer, even demand risk may be reduced. For example, a power generator investing in China may transfer demand risk to a power distributor by concluding long-term contracts, obliging it to purchase all output at cost-plus rates. Shaping to reduce hold-up risk is a prerequisite, since in recent years there have been several instances where the Chinese government has reneged on purchase agreements with power plants. For example, in March 2002 government officials in Fujian province ordered two stations to sell power at a steep discount because of oversupply. One of the plants was Meizhou Wan, once considered a model for foreign investment in the power sector and which included Lippo China Resources and the Asian Development Bank among its shareholders.
To manage demand risk, Chinese real estate companies routinely sell apartments before starting construction. A Chinese film producer may first sell the rights to a film to raise cash for production. Mercedes-Benz may in future extend its successful online selling of second-hand cars from its corporate fleet to China. In this case, it could transfer the warranty risk to outside insurance companies, such as Real Garant Versicherung, which it engages in Germany to protect itself against this risk.
4. Governing captive risk Even captive risk that cannot be transferred can be mitigated through effective coping strategies. These help a company to shield itself from unwanted surprises.
SIMULATING To prepare for possible events in China, managers can engage in simulated negotiations, which teach them the right responses in different scenarios.
SEEDBEDDING A company can hold a diversified portfolio of options with different risk and return characteristics, such as 'safety ropes', 'no regrets' and 'gambles'. Some options may promise relatively stable, but low, cashflow levels. Others might boost growth significantly but at higher risk. This can be compared to putting a small stake on the zero in roulette: if you do not invest too much, you will not regret a loss.
In the area of consultancy, McKinsey & Co has a stable set of international clients in China. At the same time, media reported that the firm has experimented with domestic companies in a variety of sectors such as Wangfujing Department Store, Shanghai Tyre & Rubber, Pingan Insurance and Huayi.
Alternatively, a company may hold small equity stakes in a number of different enterprises. For example, a diversified technology multinational company, which is renowned for its innovation and practical solutions, provided seed money for many independent start-ups in Asia that pursued a variety of research and development programmes. When one of these ventures succeeded, such as by registering a promising patent, the sponsoring company starved it of funds. This caused financial distress at the start-up, which made it possible for the sponsor to take it over, together with is intellectual capital. Even though effective, this approach is questionable from an ethical point of view.
STRATEGIC PROBING Companies may also invest on a much smaller scale – perhaps in small units, in a limited geographic territory or in selected consumer segments. If it succeeds, the investment can be rolled out on a larger scale. For example, to assess credit risk, banks can first manage a small number of trial debts and perform regression analysis to detect the factors that increase the likelihood of default. Hope Group, the Chinese animal feed producer, expanded from its home base in Chengdu by first opening a pilot site outside Sichuan province and then applying its newly gained knowledge to expand throughout China.
Strategic probing even helps to cope with uncertainty and can be quicker and more effective than hunting for the 'best' solution, which may not anyway exist. Prompt movement on a clearly defined and manageable battleground can prove vital in generating cashflows. For example, a consortium comprising the German government, Siemens and Thyssen Krupp was able to complete the Transrapid magnetic levitation train railway in Pudong within 20 months. This facilitated early service of debt and gained it credibility, which may lower the market acceptance risk and lead to further business opportunities. It thus had a risk profile that differed significantly from comparable construction projects in Germany, where cumbersome decision-making procedures mean they would take years to realise.
ADAPTIVE CONTROL SYSTEMS After the first implementation step has been taken, a company needs to track performance, such as the achievement of certain milestones, like the number of new stores or restaurants opened). Pingan Insurance used a set of key performance indicators that took account of previous failures to serve as a warning system. When the red flags go up, the company needs to take corrective action.
To conclude, risk can be seen as an opportunity, since it helps companies to differentiate themselves through a core competence in managing it. In a stable environment, companies are unable to showcase or exploit such a strength, in the same way that a jeep cannot demonstrate its full range of capabilities on a flat road. Core competence in risk management can help to achieve above average returns. It also helps a company to discover and exploit profitable niches that others do not see or shy away from.
An enlightened approach
Smart risk management is more than just undertaking educated risks, since it involves actually reducingrisk. In fact, any risk can be handled, if appropriate strategies and safeguards can be devised. With such knowledge, companies can engage in 'enlightened' investment appraisal for their China projects. It is important that the remaining 'pocket risk' should not be reflected in a 'risk premium'for the project. Otherwise, all future cash flows will be penalised even though the risk may decline over time, for example, through lessons learned.
Investors, too, will profit from a risk management framework. One question they may want to ask about a potential investment target is how well it manages risk. A key factor behind the success of any company in China is usually excellent risk management.
Proper risk management avoids simply taking chances (a lottery mentality) and instead means taking control. This implies that even the worst-case scenario will still be acceptable, which is the key rule for a cautious manager to go ahead with an investment. It pays to heed the advice of the ancient Chinese warfare strategist Sun Tzu, who wrote: "In war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory."
This article was written by Prof. Dr. Kai- Alexander Schlevogt (D. Phil. Oxford), president of the Schlevogt Business School in Germany, which focuses on China, and a visiting professor at the Henley Management College (UK). After serving at McKinsey & Co. and Harvard University, he became the first permanent foreign professor in China (at Peking University) and a senior faculty member at the Australian Graduate School of Management. Website: http://www.schlevogt.com Email: firstname.lastname@example.org