Inside China: Are International Firms Destined to Fail?

In part 1, we re-acquainted investors with the Red Dragon in the East. We discussed the nation's rapid economic growth, resurgent middle class, and related companies to watch. To read the previous section, click here.

A Very Lucrative Market

The rise of China's middle class has not only brought economic prosperity, but the creation of a consumer pool larger than the entire US population with a significant amount of capital to spend. This increased strength in the Chinese consumer market has driven an enhanced business environment for players in the region. But although domestic firms are seeing exponential growth, most foreign enterprises have had difficulty penetrating the market.

While this is partially a function of the region's variation in consumer preferences, it is more so the result of stringent government regulation, along with other artificial barriers to entry. The Chinese government is very aware that its constituents represent a significant business opportunity, and as such continues to issue an ever-growing list of demands that firms must bend over backwards to satisfy.

Surveying the Business Climate

In January, the American Chamber of Commerce and Bain & Company published the 2018 edition of their annual report on the Chinese Business Climate. The report was based on 411 surveys from individuals working in AmCham member companies of all scales and industries, with nearly two-thirds of responses coming from senior-level management. The results point to a blend of optimism and caution in the face of uniquely challenging economic and global trends.

36% of survey respondents believe that US-China relations will improve, and another 48% expect them to remain the same. While this may not seem like a particularly positive outlook, it marks a notable contrast from the 2017 report's 17% positive and 50% neutral levels. Moreover, 46% feel that the Chinese government is more committed to opening its market to foreign investment, compared to 34% the year before.

But before drawing too one-sided a conclusion, investors should note that survey responses were collected from late October to late November 2017, a period during which President Trump himself visited Beijing. While foreign business entities may genuinely hold a more optimistic outlook, expectations could have also been somewhat inflated by the event, a concern echoed by the authors of the report.

Regulation continues to serve as a major hurdle for member companies, with 75% of respondents feeling less welcome in China than they have in the past. Still, business for the year has been solid, with 64% of member companies reporting revenue growth in 2017, compared to 58% and 55% in 2016 and 2015, respectively. But these businesses remain threatened by lopsided "quid pro quo" arrangements with Chinese companies.

Domestic Interests Always Come First

One of the largest contributors to operational struggles in China is the government's continued preferential treatment of homegrown businesses to foreign ventures. The bias appears to be most prevalent in technology and other R&D-intensive industries, where 59% of firms stated that they are treated unfairly compared to local entities. While not as extreme, this sentiment has been echoed by companies in the services (46%), industrial (42%), and consumer (37%) industries as well.

The Chinese business environment is also not conducive to the protection of foreign data and intellectual property rights. Over 50% of member companies believe that threats in intellectual property theft and data security are more prevalent in China than elsewhere. In another response, 27% wrote that they believe the lack of IP protection measures is causing major setbacks to innovation efforts.

Last June, China enacted a new cybersecurity law that, among numerous other stipulations, requires foreign enterprises and organizations to store all "sensitive data" domestically. As a result, Apple AAPL reluctantly agreed to store the iCloud data of its mainland Chinese customers in a state-owned data center in southern China. It was not the only giant forced to bend the knee, as Amazon's AMZN Web Services division was made to sell its hardware to a local Chinese partner.

Most businesses can only expand to China through a joint venture with a local partner, in which the latter holds the majority stake. But in many cases, these agreements involve the required turnover of all related IP information to their counterparts. Local partners then use that information to create knockoffs, and to further their own research. Investors should note that this practice of forced technology transfer was confirmed through a six-month investigation from the US Trade Representative's Office.

China also operates the so-called "Great Firewall," an online censorship initiative which actively blocks many international services in China. Alphabet GOOGL , Facebook FB , Twitter TWTR , and Snap SNAP are among the array of companies whose services are rendered inaccessible by the firewall. Thanks to this, Tencent's TCEHY WeChat messaging application and Sina's SINA Facebook-like Weibo platform sprung up as replacements and now dominate the Chinese social media market.

Looking Ahead

Over half of member companies see inconsistent regulatory interpretation, unclear laws, and rising labor costs as the biggest challenges in 2018. Moreover, 73% hold either a neutral or negative two-year business outlook on the nation's regulatory environment. But at the same time, firms are feeling more confident that with time, China's market will become more transparent and open to foreign investment.

Even in the face of all the difficulties, a growing number of companies and interests rate China as a major investment priority. Firms in the consumer market will see the most opportunity moving forward, as China continues its transition from an industrial powerhouse to a consumption-based economy.

While there are reasons for cautious optimism, investors must also closely watch developments in the trade war between the US and China. A prolonged back-and-forth conflict could bring small and large-scale businesses alike into the crosshairs and jeopardize various initiatives in the region.

The key takeaway from these findings is that the US is not going to remain the best destination for business growth forever. While China still leaves much to be desired in terms of transparency and fair practice, it is home to what will likely become the most influential consumer market of the 21 st century. Now is the time for investors to take notice and start paying more attention to the ancient giant.

Up Next

Next, we will look outward and explore how China is exercising its new power through extensive foreign investment activity. It could potentially redefine trade in the Eastern hemisphere.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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