A man carrying a briefcase walks past the JPMorgan Chase & Co. headquarters.
Photograph by Ron Antonelli — Bloomberg via Getty Images
By Minxin Pei
February 20, 2015

Managing the risk of doing business in foreign countries is no walk in the park for American corporations and investors. In the case of China, with its arbitrary government, lack of transparency, and endemic corruption, political and regulatory risks are not only a fact of life, they cost U.S. businesses and investors dearly.

Three recent but unrelated incidents illustrate the need to rethink – and reprice – the risks of doing business in China.

The first one involved Alibaba, China’s high-flying e-commerce giant, which had a record U.S. IPO last September. At the end of January, a Chinese regulator – the State Administration of Industry and Commerce (SAIC) – stunned Alibaba’s acolytes when it admitted that, prior to the company’s IPO, it held a private meeting with Alibaba’s executives over several sensitive regulatory issues, in particular the sale of counterfeit goods on Alibaba’s sites. Neither Alibaba nor SAIC disclosed this event to the public before the IPO. Alibaba also failed to mention this event in its IPO filing with the U.S. Securities and Exchange Commission (SEC).

The troubling news of Alibaba’s undisclosed meeting with the SAIC coincided with the company’s fourth quarter revenue miss, sending its shares down by almost 10%. On February 13, the SEC asked Alibaba for information regarding its pre-IPO meeting with the SAIC. Several security lawsuits have also been filed against the company.

Compared to Qualcomm, the U.S. chipmaker, investors in Alibaba should consider themselves lucky. In the same week the SEC contacted Alibaba, Beijing fined the San Diego-based Qualcomm a record $975 million for violating China’s monopoly law. What was Qualcomm’s sin? It is simply too successful in the Chinese market.

Unfortunately, Qualcomm’s gain is viewed as China’s loss. Beijing aspires to become a world leader in semiconductors and reportedly has committed $170 billion in government funding to unseat American chipmakers like Qualcomm and Intel. Protectionist measures, such as anti-monopoly enforcement against foreign firms, can help build China’s champions.

Meanwhile, J.P. Morgan has seen its reputation sullied as the result of its “Sons and Daughters” hiring program in Asia. Set up to increase its investment banking business in Greater China, the program offered employment opportunities to children of Chinese officials and businessmen to gain favors with their parents (several other leading Western banks use similar tactics). The Department of Justice (DOJ) and the SEC have been investigating the U.S. banking giant’s hiring practices in China over concerns that it violated the U.S. Foreign Corrupt Practices Act. Several senior J.P. Morgan executives in Asia have left the firm. According to a recent story in The Wall Street Journal, J.P. Morgan will likely pay a fine and commit to reform its hiring practices in a settlement with the DOJ and SEC.

These three cases illustrate different risks – cronyism, arbitrariness, and corruption – that lurk in China’s business landscape.

Cronyism, the incestuous ties between Chinese authorities and well-connected businesses they are supposed to regulate, can trip up American investors who mistake regulatory partiality as business acumen. In a marketplace free of biased enforcement practices, it is impossible to conceive that an e-commerce platform like Alibaba could sell counterfeit goods without suffering severe consequences. Yet the behind-the-scenes meeting between the Chinese regulator and Alibaba reinforces the investment community’s fears that business success in China depends less on what you do than who you know.

Arbitrariness, as shown in the outsize fine against Qualcomm, has always been a concern for American firms doing business in China. Chinese authorities have a habit of interpreting and enforcing laws and rules in ways that fit their needs and interests. The only difference now is that the stakes are much higher, as the Chinese market has become a critical source of growth for American companies. Qualcomm, for instance, derives half of its revenue from China. The dependence of American firms on the Chinese market gives Chinese authorities even more leeway in imposing fines or extracting concessions.

The corruption risk, as highlighted by the J.P. Morgan case, is also well known to American businessmen. Many Chinese officials habitually demand personal benefits as a condition for approving deals. This culture of corruption puts Western firms in an impossible position. If one of them wins a deal by paying off a Chinese official, this firm will have a competitive advantage, forcing other firms to adopt the same corrupt practice. That is why many brand-name Western banks have hiring practices like J.P. Morgan’s “Sons and Daughters.”

Sadly, the risks of cronyism, arbitrariness, and corruption are not likely to go away any time soon. Western firms will need to think of ways to protect themselves. They can demand greater regulatory scrutiny of Chinese firms listed on Western exchanges to enforce transparency. They can also ask their governments to intervene on their behalf. They need to establish codes of ethical conduct against potentially corrupt practices.

As for investors, they should raise the risk premium of companies doing business in China. The market value for companies with China-based growth should be discounted to reflect their China-specific risks.

Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States

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