It wasn't 30 years ago that the prospect of a foreign investor buying a Chinese firm was politically abhorrent to Beijing and a low-priority pipedream to multinational planners. Since then, while foreign direct investment (FDI) in China has soared, cross-border M&A remains minimal. When China became the world's leading FDI destination in 2003, accounting for 9.6% of global flows, its cross-border M&A sales made up just 1.3% of the global total. It was only in the late 1990s that a legal framework was put in place enabling cross-border M&A. Despite the creation of these rules, it's still no cakewalk for foreign investors in China. The regulations remain inconsistent, highlighted by a lack of clarity over which sectors are ring-fenced. Overseas players are also faced with complex accounts and valuations that don't conform to international norms. When the government asked the Organization for Economic Cooperation and Development (OECD) for ideas on regenerating the industrial northeast, it chose to focus on China's policy towards cross-border M&A. Ken Davies, senior economist for the investment division of the OECD's directorate for financial and enterprise affairs, told CHINA ECONOMIC REVIEW what needs to be done.
Q: Why does M&A make up such a small proportion of the total foreign investment entering China?
A: It's quite normal for investment in greenfield FDI to be sought by governments in developing countries and it's also normal for companies to use it as a first step when they enter a country. It also depends on the structure of the country in question. India, for example, has well-developed stock markets so equity investment is quite realistic. In China, the A-share market was until recently completely closed to foreigners, so greenfield FDI was the main form of investment. If you look at what investment was actually doing in China to begin with – some of it in joint venture hotels, some in textile factories – it was generally involved in creating new facilities rather than in taking over old capacity. That doesn't mean to say China didn't have any industry – it was just off-limits to foreigners because everything was state-owned. All along it's been a case of gradually opening up to foreign investment.
Q: What are the advantages for Chinese companies of cross-border M&A over joint ventures with foreign partners?
A: One form of M&A is a foreign joint venture partner buying out its Chinese partner. The Chinese partner has very often provided land, perhaps an old factory, and labor – if it agrees to sell these, it gets to realize its investment in cash. You also get Chinese enterprises that simply need more capital. A company may have to pay off some debts and this might be a worthwhile thing to do, particularly if it is restructuring and becoming more efficient and profitable. It may then need new technology, more management help or assistance in restructuring financial deals in order to launch an IPO. When I went to the northeast of China last April I found quite a lot of these firms. In Changchun, for example, I was given a list of 100 companies that were seeking foreign partners for cross-border M&A. They generally were not doing well – most of them had huge debts and increasing losses.
Q: Much has been made of opposition to foreign investment from traditionalists in the Communist Party. To what extent has this been an obstacle?
A: It is a live debate in China but it's also a live debate in other countries. We had a round table at the OECD on June 21 on the relationship between legitimate national security interests and investment protectionism as we are concerned that these issues are being raised in OECD member countries. At the moment it seems to be mostly a case of rhetoric rather than obstacles. In China it's the same thing – and even if you just look at the rhetoric, it's not all bad. We had the head of the foreign investment administration say at the China M&A Association conference that China will continue to open up to foreign investment. He rejected the idea that sectors of Chinese industry have been dominated by foreign investors, saying that the Ministry of Commerce had done its own study of all sectors and they couldn't find one dominated by foreign investors. The debate has been quite a lively one in China but to say it has been won by the liberalizers is probably premature. It depends what happens in the world as a whole. If the rest of the world turns out to be a very cold and inhospitable place then China might also feel that is has to do more to protect itself.
Q: If China were to open up its industries to more cross-border M&A, would this help the next time it tries to buy an oil company in the US?
A: Not on its own. One of the problems with the China National Offshore Oil Corp (CNOOC)-Unocal deal was that the perception of CNOOC by practically everyone in the US was different from its own perception. The idea that it was an off-shoot of the state and had bottomless pockets and therefore wasn't working in a commercial, market-driven way wasn't well understood in China. I think that by participating in the sort of discussions we're having in the OECD on investment protectionism, China will understand these worries and try to assuage them. One way to do that is by having more transparency, especially about financials. Companies need to open up their books and show that they're separate from the government.
Q: It is often argued that the sectors off-limits to foreign investors are poorly defined. Can the government really just turn round and say: "This is a strategic asset; you can't buy it"?
A: That's basically the problem. If they say something is a strategic asset just because it belongs to China, then that is ludicrous. One of the aims of these regulations is to protect state property because originally all assets belonged to the government. During the management buy-outs of a few years ago, in some cases the discounts went up to about 80% of estimated value. This was due to corrupt activity on the part of enterprise managers buying their own companies and privatizing them basically by stealing them. The government was worried about this so they stopped it; they were also worried about foreigners coming in and buying things on the cheap.
Q: What other obstacles do foreign companies face when trying to do M&A deals in China?
A: They have a valuation method which is based on the net asset value of a company at historic cost: so if a company has bought some machinery a few years ago at high prices, even if that machinery is no longer useful, that company is worth a lot of money. According to the law, it cannot be sold for less than 90% of the official valuation. The foreign investors do their own due diligence and might conclude that the company has a lot of shiny machines but these are not making anything that anybody wants. It may also be inefficient, have bad management and a poorly trained workforce. The foreign investor doesn't think it will make any money and walk away. As a result, the domestic company would probably just be closed down so both the Chinese people and the state have lost out. Then take another case where you've decided to value the company on its assets but it doesn't have any machines, just a few people with bright ideas. It probably has very low net asset value but somebody coming in and looking at it may estimate that it could make huge amounts of profit in the future. They'll buy it at the official price because this price is too low and so the Chinese state has really lost out.
Q: What will be the impact of listed companies switching from historical value to real value in their accounting? Is this a sign of progress?
A: Yes, if they can implement it. With the big companies it's not a problem as they've already been working on both systems for some time. But some of the smaller companies will probably say they can't do it because they haven't got the staff.
Q: What can be done to improve the enforcement of regulations?
A: You may have to allocate more officials to it and do more lightning checks. Also, when you actually find people to be violating the laws, they should be punished: when fines are not enforced, they should be chased up. One of the problems – especially with cases such as intellectual property violations – is that people either aren't prosecuted or, if they are, the local authorities say they have far more important things to do like chasing murderers. There is a serious problem with rule of law: there aren't enough courts, there aren't enough lawyers and there aren't enough judges. Specialist courts like tribunals tend only to exist in big cities like Beijing and Shanghai. The judges are so unqualified in many areas, particularly away from big cities, they have no choice but to ask advice from local officials. If those local officials are involved in the cases in any way, the advice is likely to be a bit tainted.
Q: If you compare China to other countries at similar developmental points, are these problems typical or China-nuanced?
A: First of all, they are typical because many developing countries do not have functioning court systems, and if you look at the various corruption indices, China has comparable levels to other transition economies such as Russia. The particular problems in China result from having had a particularly strict central planning regime which excluded many of the institutions you need for a functioning market economy. Rather than have these developing over a period of centuries or even decades, China had to come up with these when it decided to go for economic reform at the end of 1978. The court system was virtually destroyed during the Cultural Revolution and, when rebuilt in the 1970s, it wasn't done so very effectively; the educational system was closed down for a while; the statistical system was destroyed in the Great Leap Forward, partly rehabilitated in the 1960s and then destroyed again in the Cultural Revolution. There wasn't even a state-owned enterprise system until the early 1980s – before that all enterprises had effectively just been part of the government. You have all these building blocks, throw them together and expect them to be a house, but it takes time to develop them properly.
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