China after Marx: Open for business? (Fortune, 1985)

February 19, 2012, 8:00 PM UTC

Editor’s note: Every Sunday, Fortune publishes a favorite story from our magazine archives. This week we turn to a cover story from 1985, when a Communist newspaper declared Karl Marx irrelevant to China’s plans for economic expansion. Today, 27 years later, many U.S. businesses are thriving in China but the relationship between the U.S. and China is not without strife. China vice president Xi Jinping, who is expected to become the country’s next leader, visited with President Obama and business leaders last week in Washington. His tone was somewhat defensive after Vice President Joe Biden told him that the two countries will cooperate “only if the game is fair.”

Companies are horrified to discover that the People’s Republic is among the world’s most expensive places to do business. But for those willing to pay the price–and put up with the bureaucratic guff–the payoff could be worthwhile.

By Louis Kraar

China fever is easy to catch. Upbeat music from the American movie Flashdance greets arriving executives at Peking Airport. The new Great Wall Hotel, a U.S. joint venture, resembles the Hyatt Regency in Dallas. American-style blue jeans and brightly colored ski parkas are beginning to replace baggy pants and Mao jackets. Offices and factories no longer shut down for two hours at midday so that everyone can take a nap, and Chinese negotiators, long famous for haggling endlessly over every detail of a deal, now are saying things like “Time is money.”

There have been openings to China before, in fits and starts ever since Richard Nixon signed the 1972 Shanghai Communique, which established relations between the People’s Republic and the U.S. What makes this one different–and more exciting to Western businessmen–is that China’s leaders are not simply proclaiming their country open for investment, they’re eagerly appropriating a lot of capitalistic methods for use in their own sluggish economy. The Communist party newspaper has declared Karl Marx irrelevant to much of what’s going on in China today. Managers of state enterprises are fiddling with cash bonuses and other kinds of incentives, and many are confronting the need to market their products for the first time. As Chinese officials try out the profit motive on their own, they’ll have a better understanding of what Western investors are looking for. At least they’ll be talking the same language.

The People’s Republic is still far from a capitalist’s paradise. “Anyone coming here for quick gain is mistaken,” says an experienced American in Peking. For all the government’s intent to change, China remains a poor socialist economy that’s tough and expensive to crack. No one, including Deng Xiaoping, the 80-year-old leader who is orchestrating China’s swing away from doctrinaire Marxism, can be certain the new policies will stick. Deng is shrewdly installing younger men who think more or less as he does, but China has a history of sudden ideological swings.

Even with Deng in charge, the multilayered bureaucracy could thwart the economic reforms or slow their implementation. Peking recently announced that businessmen, who are often delayed at home waiting for visas, can pick them up on arrival at Chinese airports. But anyone who tries that will have a lot of time to listen to Flashdance music. Immigration officials at the airports profess ignorance of the policy. Chinese bureaucrats are also catching on to such Third World tricks as special taxes and petty bribery that make doing business costly. As a U.S. banker in Peking puts it, “Fleecing foreign capitalists is a fine art here.”

For companies willing to pay the price, put up with the bureaucratic guff, and gamble that China will stay on course for a while, the payoff could be worthwhile. Since the 19th century, when merchants dreamed of selling “oil for the lamps of China,” as the catch phrase of the time went, Westerners have been dazzled by the potentially huge Chinese market. It’s still largely out of reach for most consumer products from the West, since the average annual income of China’s more than one billion consumers is about $300. But that’s bound to change fast since the economic reforms are designed, among other things, to put cash in the pockets of ordinary Chinese.

The market for industrial goods looks even more promising. By cutting down sharply on imports in recent years, China managed to build up almost $19 billion in foreign currency reserves. Now Peking plans to spend some of that hoard to buy equipment for antiquated industries-and China needs almost everything. After a two-week visit, Alexander Trowbridge, president of the National Association of Manufacturers, declared: “China represents an excellent opportunity for the U.S. investor.”

Some Western manufacturers who missed getting into Taiwan, Singapore, and Asia’s other dynamic newly industrializing countries when they were relatively cheap to enter see China as a second chance. If Peking’s pragmatism endures, China could become a low-cost manufacturing center to rival its Asian neighbors.

The Western stake in China is still small. Peking claims that direct investment by all Western nations over the past five years has totaled some $3 billion-but that counts many pledged expenditures that may never materialize. Chinese planners want to attract $7 billion more over the next five years.

Much of the cash plunked down in China so far has come from 27 oil companies exploring in the South China Sea, the world’s last big undrilled petroleum area. Unless there is a major strike–and no one has come close yet–manufacturing investment will likely become more important in China than oil exploration. A few dozen adventurous American corporations have already plunged in, though their total direct investment commitment so far is only about $700 million, including that of 13 oil companies. R.J. Reynolds is building one of the largest cigarette factories outside the U.S. in Xiamen, southern China, a $20-million joint venture with a state tobacco company. American Motors has teamed up with a Chinese automaker to produce jeeps in Peking. Gillette is manufacturing razor blades in Manchuria. Massachusetts-based Foxboro Corp. is building industrial process control systems in Shanghai with a Chinese partner, while McDonnell Douglas plans to assemble airliners there. In a more unusual arrangement for China, 3M was allowed to go it alone. It has set up a small, wholly owned factory in Shanghai to make electrical tape and plastic electrical connectors.

IBM has put down a subsidiary in Peking. Though it doesn’t plan to manufacture there initially, IBM thinks China could rapidly develop a voracious appetite for personal computers. When programmed to handle Chinese characters, they can be particularly useful as word processors. Boeing has established a sales subsidiary to peddle airliners, and United Technologies has a similar operation for helicopters. Fueled by such deals, trade between the U.S. and China is growing again after having shrunk for several years. It may reach $7 billion this year, $1 billion more than in 1984, but that’s still only one-third of U.S. trade with the tiny island of Taiwan (pop. 19 million).

Both Japan and Europe have been reluctant investors in China, preferring to trade. Japan is China’s largest trading partner, supplying 24% of the People’s Republic’s imports in 1984, and Western Europe is No.4, behind Hong Kong and the U.S. Only West Germany’s Volkswagen has made a major investment–a joint venture to make cars for the Chinese market and engines for export. VW’s stake could total $220 million.

Many investors have had trouble in China, and as pioneers the oil companies have the most horror stories to tell. Playing on their eagerness to explore, China enticed them to ante up all the costs of offshore oil exploration. Then the Chinese piled on the expenses. Companies are forced to pay California-scale wage rates for inexperienced and often inefficient Chinese rig workers, who must give most of their salaries to the government. Then comes what the Chinese term training-expense-paid trips (including pocket money) for Chinese delegations visiting the U.S. All this boondoggling is coming back to haunt Peking–there has been no stampede of bidders for new areas the Chinese want to open for exploration.

The government used the same tactic to develop several posh joint venture hotels in Peking. American investors put together the financing, but agreed that the Chinese government would own the hotels after ten years. Like the oilmen, the investors grabbed the one-sided deal because they were eager to get into China’s room-starved hotel market. A California group led by C. B. Sung, a China-born American entrepreneur, backed the Great Wall Hotel, and the Jianguo Hotel is financed partly by San Francisco-based architect Clement Chen. While the investors struggle to get their money out in a decade, the Chinese have laid on a mounting array of taxes–some highly questionable.

China has begun to offer more reasonable terms for manufacturing projects. As a U.S. official in Peking says, “Investors won’t come to China for love but for money.” The Chinese wooed Foxboro because they clearly wanted technology from the U.S. company. Even so, the negotiations dragged on for nearly three years. A Foxboro executive recalls, “We were dealing with people who had been in commercial isolation for 30 years. They really didn’t understand how to do business or what motivated us.” The Chinese, for instance, were slow to grasp that the U.S. company had to make a profit and would get no subsidy from Washington.

Foxboro, which owns 49% of the $10-million venture, persuaded its Chinese partner to keep the labor force lean and control overhead costs by providing an existing building at a price that a Chinese rather than a foreign enterprise would pay. Begun in 1983, the joint venture is not yet profitable, but general manager Donald N. Sorterup says he’s satisfied with progress. “You don’t come to China,” he says, “unless you’re a risk taker.”

Nor has American Motors had a smooth ride. The company took four years and three months to negotiate its way into China. Then the U.S. automaker had to accept a notoriously inefficient state-owned enterprise as its partner in a $51-million joint venture. The Beijing Jeep Corp.–one-third owned by AMC–got rolling early in 1984 and by December was 20% ahead of the production schedule the government had set for it. At that point the factory ran out of materials and had to shut down for the month. Tod Clare, AMC’s vice president for international operations, says the company decided not to “try struggling” to get more steel and electricity out of the government.

Still, AMC has shown what a shot of efficiency can do for profits. The U.S. company was given an antiquated plant in which its partner was turning out a boxy local model jeep. The joint venture continued making the old jeep, which retails for $5,500, but it boosted productivity by cutting the 10,000 workers to 4,000. Though the U.S. managers who run the plant won’t confirm the number, Chinese sources say the joint venture made a $10-million pretax profit its first year. In October, Beijing Jeep plans to begin assembling a version of AMC’s Cherokee, a plush four-wheel-drive station wagon, from kits of U.S. parts: In three to four years AMC hopes that jeeps built in China with many local parts will be internationally competitive in price and quality. Chinese wage rates, averaging less than $3 a day, may help.

Companies are horrified to discover that the People’s Republic is among the world’s most expensive business centers. Maintaining a manager in Peking can easily run to $250,000 a year, roughly 40% more than it costs in London. Foreigners are charged outrageous prices. Scarce apartments rent for $6,000 monthly–and the rent has to be paid a year in advance. A spartan little room in the government-owned Beijing Hotel, which provides crude furniture and minimal service, will cost nearly $50 a day starting next month. A light meal without drinks is about $9. When they travel in China, foreigners pay more than twice as much as Chinese for plane tickets. There’s not much to do after work or on weekends at any price. Quite a few expatriates spend their free time drinking in each other’s homes while griping about conditions.

Since so little office space is available, most companies have no choice but to rent space in hotels. Last year the hotels raised rates by as much as 115%, even for tenants who already had leases at lower rates. The first Chinese office building designed for businessmen is due to open this year. It will offer space at about double the cost of prime office suites in Hong Kong and four times that in Paris.

There are a lot of little rip-offs too. The Jianguo Hotel claims it loses about 5% of the food it imports because Chinese health inspectors say they must run laboratory tests–on such products as Swiss chocolate bars. A prestigious U.S. tourist agency can get cooperation from the state-owned China Travel Service only by giving its officials Japanese cameras and other gifts.

A more serious problem for investors is getting their profits out. “Nothing in their laws says you can’t do it,” says Foxboro’s Sorterup. “If it weren’t allowed, no one would come here to invest.” The way things actually work, profits can be sent home only if the joint venture brings foreign exchange into China by exporting. AMC, for instance, won’t take home any of its profit until it starts exporting vehicles.

Volkswagen struck a more complicated deal. It formed a joint venture with the Shanghai Auto Works, which turns out a car that looks like a 1947 Dodge. (If the door of a Shanghai car doesn’t quite fit, a worker slams it with a wooden mallet.) On a nearby assembly line, Chinese workers put together the sleek, modem VW Santana from components shipped from West Germany. Alongside the 60-year-old Shanghai auto plant, Volkswagen is building an engine plant, which will send most of its output back to Europe. These exports are supposed to provide enough foreign exchange to cover VW’s share of the joint venture’s expected profits.

Problems will ease for Western businessmen if the new profit-consciousness permeates China’s system. Even if Deng is only partly successful in implementing the new economic reforms, he has already created a more rational climate for international business. The handful of Chinese managers allowed to test capitalist techniques since last spring are exhilarated by their new freedom. Says Wang Rong Sheng, 37, a Communist party member and assistant manager of Shanghai Radio Factory No. 2, “Previously the role of this factory was like a gear in the whole state machine. We didn’t care about the market, but just gave products to the state. Now we have to do market research and see if products can make a profit.”

The danger is that the inexperienced Chinese will foul up their pursuit of a market-economy. For one thing, if Peking really does allow inefficient factories to fold, it will have even more trouble in the short run than it’s having now providing jobs for millions of city dwellers. Inflation could sabotage the reform effort, too, by breeding unrest among workers. Many Chinese have already blown their savings on shopping sprees, convinced that new government policies are bound to force prices up rapidly. Chinese leaders have promised that prices will rise gradually, in sync with pay increases, a balancing act few Western nations have managed to master. Another threat to economic reform is the horde of poorly educated Communist party officials who are losing their dominance over factories to profit-minded managers. As an American specialist on business in China says, “If there isn’t a leap forward and people are thrown out of work, the party hacks will have their tum again.”

Perhaps the most hopeful sign that Peking wants to do business is the reemergence of Chinese who have commercial experience. They were banished to farms and factories during the Cultural Revolution, the decade of leftist madness that ended in 1976 and deprived China of an entire generation of educated managers. Xu Zhaolong, 67, who owned a chemical factory in Shanghai before the Communists took over, is among those who have managed a comeback. He is president of China International Trust & Investment Corp., a state-owned investment bank known as Citic that has $300 million in working capital. It often teams up with Western corporations. “Investors feel more comfortable when we participate,” says Xu. United Technologies uses a Citic subsidiary as its agent to sell helicopters in China. And Citic has a 10% share of a Beatrice Cos. joint venture that makes snacks and soft drinks in Canton. The organization is putting some money abroad, including $40 million into timberland in Washington State. Now Citic is shopping for a copper mine in Canada or Latin America to supply China. President Xu remarks, “I have a feeling we will make our way under socialism, but using methods of capitalism.”

A group of former Chinese capitalists in Shanghai act as informal consultants to foreign corporations seeking guidance through the bureaucratic maze–for a fee. (Three of them posed for the cover of this issue.) “You have to know the way and the people,” says Chen Wuqing, 62, an MIT graduate who is now general manager of Shanghai Patriotic Construction Co., a private enterprise conglomerate. It got started in 1979, when China decided to mobilize former capitalists by unfreezing their local bank accounts. Some 1,200 “subscribers” –as Chen terms investors–put about $33 million into the company, which now claims a net worth of $72 million.” We pay subscribers bank interest rates, about 8%, plus a little incentive,” says Chen, “but we don’t call it a dividend.”

Patriotic Construction built a couple of apartment buildings in Shanghai, where it also started restaurants and invested in 60 small factories. The company has seven joint ventures with Hong Kong companies to make such products as sweaters and toys. The Shanghai group even owns 25% of a cruise ship that plies between Hong Kong and Shanghai. Chen and his colleagues feel free to drive around Shanghai in foreign cars, including the Rolls on the cover and a Cadillac. Says Chen: “If there’s another period of extreme leftist policy, I think that’s the end of China. We lost ten to 15 years while countries like Singapore moved ahead.”

But even Chen warns that Western businessmen should not expect China to be as freewheeling as its Asian neighbors: “We’re moving cautiously. If we make a mistake, the open door will slam shut again.” Describing the present “open door” policy, Chen holds his hands up to indicate a slight crack. Few international businessmen trying to get into the market would argue with that cautious appraisal. At best, China is exciting because of its long-term potential–if Deng’s reforms work.