Hong Kong China Business

1. Hong Kong China Business Problem-based Learning : Question 1 (Group X) • Chan Po Yan 0033874d • Chan Yin Ting 00295162d • Ho Hiu Nuen 00295227d • Wu Kar Yee 00916560d • Wong Wing Lam 00201434D • Or Shek Chung 00302965D

2. Problem No.1 (Group X) Mr. David Green is the CEO of an American company that produces electrical components for motor vehicles. The product range includes windscreen wiper assemblies, small electric motors and electronic banking system. The company spends $US50m per year on research and developing new products. It has overseas operations in 20 countries, including most of the European Union, India, Russia and Japan.

3. Problem No.1 (Group X) The President of the company has decided that a manufacturing operation in Mainland China must be established within the next 3 years, in order to serve the domestic Chinese market. He has told Mr. Green to provide a recommendation to the Board of Directors on whether to enter the China market through a joint venture or a wholly-owned subsidiary. Mr. Green has asked you to prepare a report on that decision, setting out and justifying the recommended strategy.

4. Different Entry Modes • Equity Joint Ventures (EJVs) • Contractual (or cooperative) Joint Venture (CJVs) • Wholly Foreign Owned Enterprises (WFOEs)

5. Equity Joint Ventures (EJVs) Background Information • Involves the creation of limited liability companies with equity and management shared in negotiated proportions by foreign and Chinese partners • Most common form in past -- accounted for 37.56 % of the total contractual amount of FDI in 1997 • Each partner contributes cash, facilities, equipments, materials ,intellectual property rights, labor or land-use rights. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

6. Equity Joint Ventures (EJVs) Characteristics Advantages • Synergies:risk reduction, economies of scale and scope, production utilization, convergence of technologies, or improved local acceptance • Long-term connections to the Chinese market: ability to sell through the local partner’s established marketing channels seems especially attractive to manufacturers hoping to penetrate the domestic market Chinese approval authorities generally encourage these extension • Favoured by Chinese government: • significant technology transfer • more likely to receive special access to utilities and critical input than those utilizing other entry modes such as WFOEs • Imported tax exemptions:exempt from the paying transfer taxes and duties on imported equipment used as part of foreign partner’s investment in the enterprise Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

7. Equity Joint Ventures (EJVs) Characteristics Disadvantages • Hard to sustain: • relatively stable environment in US and Europe hard to sustain • Investment in China is more difficult • country is vast and varied, • culture and traditions are profoundly different form those of the west • social, governmental and economic systems are particularly complex • Negotiations can be lengthy and complicated: • Negotiations usually last for several months • Difficult to calculate each party’s contribution  Chinese side: contribute non-cash items such as land use and existing buildings and construction materials  it is easier for them to overstate their contribution • foreign investors should have assessments made by independent professional consulting or accounting firms Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

8. Contractual Joint Ventures (CJVs) Background Information • an investment vehicle in which profits and other responsibilities are assigned to each party according to the joint venture contract. (not necessarily in accordance with the % of each partner’s share of total investment) • partner cooperate in joint projects or other business activities according to the terms and conditions stipulated in a venture agreements • accounted for 21.86%of the total contractual amount of FDI in 1997 Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

9. Contractual Joint Ventures (CJVs) Characteristics • Advantages and Disadvantages are similar to EJVs • Each party cooperates as a separate legal entity and bears its own liabilities Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

10. Wholly Foreign Owned Enterprises (WFOEs) Background Information • The enterprise manages its operations independently and is responsible for all risks, gains and losses • according to China’s Law on WFOEs, promulgated in April 1986, the WFOE is organized by a foreign company using its own capital, technology, and management. • accounted for 32 % of the total contractual amount of FDI in 1997 Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

11. Wholly Foreign Owned Enterprises (WFOEs) Characteristics Advantages Easy to set up • WFOEs take less time to establish than EJVs • WFOEs : 30days; EJVs: years to negotiate High flexibility and control • Allow managers to expand as quickly as they want and where they want without the burden of an uncooperative partner • Allow foreign investors to set up and protect their own processes and procedures, which leads to more careful strategic and operational oversight  established more quickly than EJVs  excellent fit with China’s competitive situation deliver efficiency and effectiveness to an economic system Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

12. Wholly Foreign Owned Enterprises (WFOEs) Characteristics Disadvantages China is a more competitive market -- Chinese complexities double the challenges. Since foreign investors have little knowledge about the China’s market, they may find difficult to survive in China. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

13. Wholly Foreign Owned Enterprises (WFOEs) Characteristics Disadvantages Lack of government support • As offering little in the way of technology transfer or other benefit to the economy government may not like to support WOFE • foreign investors need to rely on Chinese agents to make liaisons on their behalf and to help procure land, materials and services. • not allowed to invest and operate in certain industries that are vital to the Chinese economy • Without the control of a Chinese partner, investment approval authorities often hold them to higher standards such as stricter foreign exchange balance requirements. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

14. Wholly Foreign Owned Enterprises (WFOEs) Characteristics Disadvantages Vulnerable to criticism relating to cultural & economic sovereignty • Chinese do not want foreign companies taking advantage of their country • Solutions localize production by buying as many parts and component as possible from local Chinese suppliers  active in socially responsible project such as financing schools, sports events Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

15. Wholly Foreign Owned Enterprises (WFOEs)  many disadvantages arisen from Government role  Government attitude towards WFOEs is gradually changed: WFOEs help to stimulate economic growth, generate foreign exchange earnings and reduce the unemployment rate Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

16. Entrant Firm Characteristic American company produce electrical components for motor vehicles Size: very large Large amount of R&D spending (US50million /year) Rich multinational experience (oversea operations in 20 countries)

17. The US Automotive Industry ~ Highly R&D technology intensive ~ Require high innovation, such as ABS braking system and new engine technology ~ Require model-specific tooling and production facilities, esp the high complexity modern vehicles favor high control entry strategy so as to avoid creating a competitor

18. 2 nd Highest

19. 2 nd Highest ~ Market leader Therefore higher bargaining power  favor to set up a wholly owned subsidiary

20. Home Country Characteristics (USA) • Low power distance • power distance refers to the degree of inequality among people that is view as being equitable • Society that is in low power distance do not tolerate relatively high social inequalities such as the income difference • Flexible and fewer rules in the hierarchy • Keegan,2002

21. Home Country Characteristics (USA) • Low uncertainty avoidance • How management deals with uncertainty situations and establishes predictability of out comes (Hofstede 1994) • Do not prefer risk sharing arrangements such as forming alliances with other foreign firms as compared with those with higher uncertainty avoidance ( Tse, Pan 1997) • =>support WFOEs • Keegan,2002

22. Uncertainty Avoidance 100 Japan Germany Power distance 0 Netherlands 100 USA Britain HK 0 • Keegan,2002

23. China’s automotive Firms characteristics Average size: relative smaller Less spending on R&D Mainly focus on domestic market Largely depend on Foreign technology Limited multinational experience

24. Host Industry Characteristic Eclectic theory: High Potential of host country EOS Long term market presence Long-term profit Low resource commitments Questionable potential Source : Foreign Market Entry Strategies: Intrgratuve Framework, Critical Review And Future Directions, September29, 1998, Deepak K.Datta, Pol Herrmann and Abdul M.A. Rasheed

25. China automotive Industry Characteristic Potential of China: 10 - 15 years after - biggest market in the world ~ biggest motor consumption country ~ biggest motor production country Low production cost - low labor and capital cost High potential and good for long-term profit Wholly Owned Source : TB,專家對中國汽車業有三個預言,新華社,25/10/2002

26. China automotive Industry Characteristic

27. Host country characteristics(China) • Higher uncertainty avoidance than USA • Higher Power distance than USA • If use JV, more rules will need to be negotiate and thus take a longer time to establish the firm • More quarrel may also result • => Wholly owned • Keegan,2002

28. Host country characteristics(China) US-China WTO agreement 2000- Feb 16th China agreed to eliminate barriers which have encumbered specific US industries just as auto industry China has agreed to an Unilateral reduction in its trade barriers while US industries remain protected Knollenberg 2000

29. Host country characteristics(China) • Guanxi is quite important • Guanxi may not be cost effective sometimes • China’s partners’ guanxi may be limited sometimes • Less government restriction after entrance to WTO (Source: Wilfried. 1997)

30. Host country characteristics(China) • Technology spillover: • Chinese companies want as much info as possible from the foreign partners • Many constraints of the Chinese system • WFOEs allow managers to expand as quickly as the foreign investors want and where they want without the burden of an uncooperative partner

31. Venture Characteristics It is related project-level factors Venture orientation In our case: produces electrical components for motor vehicles  The project is technological advanced. wholly owned subsidiary  protect its know-how technological knowledge.

32. Venture Characteristics 2. Contractual risks and costs associated with this project • If: • perceived risk of dissipation of knowledge high and costs of writing and enforcing contracts are high  wholly owned subsidiary to reduce dissemination risk and economize on the transaction. (Hill, Hwang and Kim 1990. )

33. Venture Characteristics • Finding support: • An air-con business company has about 10 joint- ventures. • a lot of differences between company mission and Chinese partners. • different approaches to the market and different perspectives on the same issue. Source: www.chamber.org.hk/mbc/organizing71_body.htm Hong Kong General Chamber of commerce report

34. Venture Characteristics • 2. Contractual risks and costs associated with this project • If: • contractual risks are low,  a firm may be more willing to share its specialized knowledge.  Joint Venture

35. Venture Characteristics • 2. Contractual risks and costs associated with this project • In our case: • spends $US 50m per year on R&D new products. (great R&D intensity) • ability to develop own ability and knowledge  no need to share the knowledge on this project  wholly owned subsidiary reduce dissemination risk

36. Venture Characteristics • Finding support: • research with 187 U.S. manufacturing firms in six countries greater R&D intensity, are associated with less importance of Joint Venture. Stopford & Wells (1972) • research with 20,000 subsidiaries of 187 U.S. multinationals over the period 1900-1975.  wholly owned subsidiaries are preferred when MNCS possess significant R&D skills. Gomes-Casseres (1989)

37. Venture Characteristics • 3. The availability of proper Chinese partners for a particular project • ability to establish a joint venture depends on the availability of capable, trustworthy partners. • absence of acceptable local partner, the MNC may be forced to establish a wholly owned subsidiary.

38. Global conditions • Related to world overall condition: Hot topic: World Terrorism • Since 911 event, Terrorism threatens not only lives but also economies. • A stable and revitalized world economy is indispensable in building a world that does not yield to terrorism. • Terrorism may have an impact on the JV/WOFE decision.

39. Global conditions • Terrorism disseminate to Asia countries • e.g. Terrorist bombings in Bali, Indonesia • Firms more likely take partners to share the uncertainty risk and become more circumspect when considering an entry mode.

40. Global conditions • compare with other developing countries • China has a relatively stable and harmony political environment • less grudge with those terrorist association • still a peaceful place for firm to entry the market directly.

41. Wholly-owned subsidiary

42. Implementation

43. Estimate the performance • By observing data from a research of 48 randomly selected sample EJVs with 48 sample WFOEs with regard to several key financial variables: • profitability, • liquidity, • efficiency and • growth opportunity. • Get a general idea of the future performance by comparing the figures of WFOEs and EJVs Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

44. Variable EJVs WFOEs Return on asset before tax 0.21 0.18 Return on asset after tax 0.15 0.14 Gross profit margin 0.71 0.69 Operations profit margin 0.23 0.26 Profitability • ROA • but it does not take operating expense into account. • all operating expense are considered, the operating profit margin can reflect WFOEs’ profitability. • Operating profit margin • WFOEs (i.e. 0.26) higher than EJVs • WFOEs are profitable than EJVs. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

45. Efficiency • Receivable turnover and inventory turnover • WFOEs have higher level of receivable turnover and inventory turnover. • These show WFOEs are more efficiency than EJVs. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

46. Liquidity • Current ratio & cash liquidity • EJVs have higher level of cash liquidity than WFOEs • it seems that EJVs enjoy higher liquidity • EJVs have a better relationship with Chinese banker by involving a Chinese partner • Debt ratio • But, also this makes EJVs have a larger debt from the bankers  higher debt ratio. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

47. Growth opportunity • Local sales growth & export growth • EJVs can have better performance on local sales growth and WFOEs perform better on export growth. • EJVs have better connection to Chinese market • WFOEs have better knowledge of their home country, easy to export • It may afraid that WFOEs can perform well in doing local business. But the figure shows that the local sale growth is 0.17 just 0.01 lower than 0.18 of EJVs. • It implies that WFOEs also can perform well in local sales. Source: Luo, Yadong, How to Enter China: Choices and Lessons, Ann Arbor, MI: University of Michigan Press, 2000

48. Conclusion • Base on profitability ,liquidity, efficiency and growth opportunity, we can believe that the Company can perform well in the Mainland China by setting wholly-owned subsidiary.

49. Reference http://education.yahoo.com/reference/factbook/us/econom.html Keegan,. Warren J, 2002, Global marketing management ,Upper Saddle River, N.J. : Prentice Hall, 7th ed. Tse. David K., Pan Yigan, and Au, Kevin Y 1997. How MNCs choose entry models and form alliances : the China experience. Journal of International Business Studies 4, 779-805 Vanhonacker, Wilfried. 1997 Entering China : An unconventional approach. Harvard Business Review (March/ April) 130-140 Luo Yadong, How to Enter China: Choices and Lessons, Ann Arbor, M1: University of Michigan Press 2000 Luo, Yadong. Partnering with Chinese Firms: Lessons for International Managers Aldershot :Ashgate, c 2000Press, 2000 Foreign Market Entry Strategies: Intrgratuve Framework, Critical Review And Future Directions, September29, 1998, Deepak K.Datta, Pol Herrmann and Abdul M.A. Rasheed

50. Reference • TB,專家對中國汽車業有三個預言,新華社,25/10/2002 • Just-auto.com (2000)