No Way Out from the Middle Kingdom
You remember the movie, with Kevin Kostner as the exemplary US Navy officer-special assistant to the Secretary of Defense (Gene Hackman). The plot twists around search for a purported Russian spy in the US, codenamed Yuri, who has been able to infiltrate the Navy at the highest levels. Following several plot twists, Kostner is ultimately left with no way out – he cannot be seen in public, as he will be implicated in a murder; and he does not want to return to his homeland, which he has not seen for at least twenty years. He has no safe place to go, and no way out of his predicament.
No doubt some American businesses are in a similar predicament now, with regard to their manufacturing or distribution or licensing deals in China. Conditions have been getting more difficult for foreign businesses, particularly American businesses, for years before the tirades coming from the current occupant of the White House. Seagate closed its factory in Suzhou in 2017. Panasonic ceased all manufacturing in China in 2015. And Home Depot, L’Oreal, Revlon, and Best Buy. Microsoft moved its two China plants to Vietnam in 2015.
Xi Jinping has worked hard to promote the home advantage for Chinese companies – in 2015, Starbucks was accused by the government and the Chinese media of gouging Chinese customers Starbucks China Pricing Similar charges were leveled against Apple China's anti-Apple campaign and Yum Brands and Hewlett- Packard. In all cases, Chinese responded to the government with a large raspberry. For Starbucks and Apple, they cited the safety of the coffee and the attractiveness of the iPhone.
Those were minor skirmishes that any big company must get used to. Now companies of all sizes find themselves in the middle of a war, a trade war, conducted with spite and malice on both sides, and no clear end game. Tariffs are a tool, but the Chinese government has many other tools that can be more effective against any one company.
The tools are essentially enforcement of existing laws in a biased manner, enforcement of regulations made up on the spot, threats, and support for local businesses acting in an entirely extra-legal manner.
Differential enforcement of law and application of “special” law is a well-known tactic in the US, for persecution of blacks and other minorities. But in the US, there can be appeal to other avenues within the society – media, lawsuits, popular support, social media, engaging with legislators or regulators. These avenues are obviously restricted or non-existent for most American businesses in China – Starbucks and Apple being two that can generate widespread popular support.
But most American businesses in China are small to medium sized and without local guanxi. Those businesses trying to get factories, molds, money, and personnel out of China may be subject to a whole other level of persecution. By the way, I focus on manufacturing industries because foreign service businesses – retail, banking, finance, health care, education, real estate, insurance, media and entertainment – are highly restricted or forbidden in China. To date, foreign service businesses are not much of a factor in trade. Yes, Walmart and many chain retailers in shopping malls; but these are big companies with sufficient legal and financial wherewithal to withstand some ups and downs in the market, and American IP, personnel, and equipment are not at stake.
Dan Harris, at Harris/Bricken law firm, writes China Law Blog, by far the most useful general law blog about doing business in China. Over the years, he and co-authors have explained difficulties of doing business in China, with examples and clearly written language that provides both useful information and blatant warnings about the dark side of doing business there.
Now, Harris has reposted some of his most dire warnings, based on what he is hearing from businesses in 2018 in China and seeking to get out -
How to Leave China AND Survive September 23, 2018
The money paragraphs from this article –
Way back in 2013, in The Single Best Way To Avoid Being Taken Hostage In China, we wrote of how Chinese companies and individuals often take hostages in an effort to collect on alleged debts or to protest employee layoffs or the closing of a China facility:
As the article states, “it is not rare in China for managers to be held by workers demanding back pay or other benefits, often from their Chinese owners, though occasionally also involving foreign bosses.”
My law firm’s advice every single time to our clients who are laying off workers in China or closing a facility in China or allegedly owing money in China is to stay outside China for all negotiations. One only needs to be a regular reader of our blog to know that we took this position long ago and have never waffled:
- If you are in a debt dispute with a Chinese company, the best thing to do is not go to China at all.
- If you must go to China, think about using a bodyguard or two and think very carefully about where you stay and where you go. Most importantly, be very careful with whom you meet.
- Consider preemptively suing the alleged creditor somewhere so that you can very plausibly claim that you have been seized not because you owe a debt, but out of retaliation for having sued someone. If you are going to sue, carry proof of your lawsuit with you at all times while you are in China.
By this point many of you are probably wondering why I am writing about debt when the issue is leaving China. My answer is very simple: once the news goes out that you will be leaving China, alleged creditors will come out of the woodwork. The tax authorities will come up with taxes that you owe. Your landlord will explain why you owe it way more than you thought you did. Your suppliers will send you bills for items they never actually gave you. Your employees will demand all sorts of severance. I am not saying these sorts of things always happen, but I am saying that they often do and you need to be prepared for it.
No way out is not too strong an image. Whatever the merits of the current US complaints about Chinese business practices – and there are plenty of valid complaints, including IP theft, preferential treatment for local companies, and subsidies for exporters – China-US IP battle - the US companies love the profits earned in China, and so are between a rock and a hard place. For some companies, mostly the consumer facing companies like Starbucks or KFC, there is growing competition, but a measure of public support. CCP members drink coffee and eat KFC ice cream, too. B to B companies are out of sight, out of mind, a perfect mental location for the excesses of law or regulation that are simply another way to cheat or extort from the foreigners.
Think about it this way - is there another major American trading partner where one need fear being kidnapped over a real or imagined payment dispute? Is there another American major trading partner for which the best trade advisories scream, danger, danger, danger?
In the movie No Way Out, we don’t know what happens to Kevin Kostner. But his Russian contact is right – “Let him go. He will be back. Where else can he go?” In the tariff war, we can’t tell right now what will happen. The US has a theoretical advantage in buying more than it is selling to China, and China will soon run out of US imports to tariff; but Mr. Xi doesn’t have to stand for reelection, and Chinese, even modern Chinese, are accustomed to conceding to power. Neither Mr. Xi nor the orange haired baboon can concede without losing substantial face. The uncertainty on all sides is palpable, and uncertainty in operations is deadly scary for manufacturing businesses. (Ask any business in England right now). The American Chamber of Commerce in China (AmCham China) says that almost half of 430 member companies surveyed expect a strong negative impact from the tariff war AmCham - more pain ahead. Even though American businesses are developing strategies to move operations to Vietnam, Indonesia, Philippines, or Malaysia, it will be difficult to reproduce the infrastructure and organizational experience of having spent years in China. But at some point, companies will have to abandon the lure of profits when the cost and uncertainty become too great. China is trying to soft-pedal its formal response to the orange-haired baboon, but the indirect penalties may soon become intolerable.
High tech industries in the US face a related set of problems. In addition to traditional IP theft, Chinese companies are now innovative enough on their own to challenge world competitors, and the China market for high tech - business and consumer - is the biggest in the world. Large government subsidies and huge attractive packages for individual scientists who relocate to China are the norm. Chinese students educated in STEM fields in the US are now likely to return to China where opportunities are greater. Money alone does not drive innovation, but it is certainly a catalyst. Now American companies are feeling pressure to partner with Chinese companies on research, even as the threat of IP theft continues (even if less now than before) and loss of researcher talent continues. How to respond in this new environment, particularly one in which malice aforethought is salient? An MIT Sloan School of Management report from June of this year describes the conundrum - Changing Face of Innovation in China (limited access with sign-in). The Sloan recommendations for foreign companies in China may be all that can be done - hire more Chinese locally, learn to file patents faster in China, and "Engage in cutting-edge innovation in China when returns exceed global risks." I'm not sure what this means, but the Sloan report described it this way -
This requires both an aggressive global innovation strategy (for example, doubling down on promising R&D projects outside China and speeding up R&D outside China) and a complementary business strategy (for example, strategically patenting, engaging in more mergers and acquisitions in China and abroad, seeking greater support from home governments, and possibly shifting away from product lines increasingly dominated by Chinese companies).
Obviously, tariffs and different locations within China affect industries differently. For me, I expect those indirect costs – the unfair application of regulations and paperwork and extra-legal harassment as tools of trade war - to push a sizable chunk of American manufacturing out of China. Not major companies, but many smaller companies, looking at the short and medium term, will need to negotiate a way out. In the latest AmCham survey, 25% of American respondents said they had moved or are planning to move capacity out of China – and this survey was conducted a year ago. At that time, businesses cited labor costs, IP theft, and a “more challenging regulatory environment” as the reasons for relocation. Forty-five per cent reported flat or declining revenue in China, and only 64% reporting a profit, the lowest percentage in five years. Now comes the trade war. AmCham - businesses leaving China Larger companies may choose to reinvest elsewhere, but they too will have to bear the brunt of both sides – tariffs on imports to the US and tariffs on imports and punishment from China. The greater the role that public stockholders play in company valuation, the more difficult it will be for American companies to find a way out. Potential loss of profits and the sunk costs of capacity will be hard for stockholders to bear. But no way out can only be a short term solution. For some firms, as for Kostner in the movie, returning home - or at least, leaving China - may be the only way out.