Napoleon advised, "Let China sleep, for when it wakes, it will shake the world." It has awakened and we can feel the tremors. But can outsiders participate in the economic growth? China needs capital, so the answer is yes. But to do so blindly can lead to an inability to realize the expected benefits.

In 1966 Pearl Buck said, "The most dangerous element in today's world is the state of mutual ignorance which exists between the peoples of the United States and of mainland China." That ignorance persists even today. The majority of Americans focus on Europe or Africa when we talk about things international. Our cultural and historical ties point in that direction. But, to be truly global, the businessperson must include the Pacific Rim and, in particular, the People's Republic of China, whose population of 1.2 billion people is more than the U.S., the 12- nation European Community, Japan, and the former Soviet Union combined.

Since feeding on itself during the Cultural Revolution, China has been opening its doors to the outside world. It is now the world's third largest economy according to a May 1993 report of the International Monetary Fund. Since 1978 its economy has grown by an average of almost nine percent per year. In 1994 its economy became four times bigger than 1978 and within a decade will double again. China has become an economic force that is the statistical envy of the world. A survey of top Japanese companies showed that 92% of them plan to invest in China over a three-year period.

The U.S. is presently China's number one export market, and the biggest retirement funds in the U.S. have visited China to view firsthand the investment opportunities available. Morgan Stanley, the U.S. securities firm, declared China would be "The world's most profitable investment opportunity for the next 10 years."

Socioeconomic Environment

China is 12 hours ahead of us in time, but decades behind in technology, infrastructure, and environmental protection and in taking its place in world affairs. It has been out of step with the rest of the world for the majority of the last several hundred years. Long periods of darkness amidst spurts of shining light are significant in its history. An old Chinese saying puts it so well, "China's peasants plowed with iron when Europe used wood, but continued to plow with iron when Europe used steel."

The influence of the former Soviet-type economic structures with emphasis on bureaucratic methods and centralized planning has dominated China since Mao came to power in 1949. Economic reform began in 1978, but progress was slow until Deng Xiaoping's startling endorsement of the "socialist market system" by proclaiming that "to be rich is glorious."

Guangdong province with 65 million people, is an example of China's willingness to depart from the former Soviet mode because it is the largest source of tax money for Beijing. Guangdong is given considerable leeway to manage its affairs. Liberal coastal provinces such as Guangdong have fostered the development of Special Economic Zones (SEZ). They are located along the southeast coast from Shenzen in the south to past Shanghai in the north. After 1997, Shanghai will battle Hong Kong to be the hub of the Chinese financial market. Economic reform is most advanced in these SEZs and thus is more attractive for foreign investment.

Inflation and corruption remain challenges for the government. In addition, there is a growing strife between the rural peasants (75% of the population) and urban dwellers, who are the principal source of China's developing middle class.

China has the world's largest consumer market. Choices for consumer goods doubled in a six-month period, and sales volumes increased despite a 17% rate of inflation for the first half of 1993. The share of state companies of total production has been falling progressively over the past 30 years, from more than 90% of total production in the 1960s to less than 50% today as reported September 20, 1993, in the Financial Times. The government has even targeted itself for restructuring, and a 25% cut in personnel is presently taking place. Plans are for these people to be absorbed in an increasing private sector. In a nation unfamiliar with unemployment, where everyone has a job no matter how menial, the prospects are dim for a successful transition.

Commercial Law

There is a paucity of commercial law in China. The Chinese do prefer to reduce their agreements to written form even though Chinese courts do not enforce such contracts. If there is a problem, the contract is a framework for discussion and negotiation.

Taxation

Income Tax. Following the urging of the World Bank to increase its revenues, a uniform tax rate on profits of 33% on all enterprises became effective January 1, 1994. Special or coastal economic zones are allowed to establish reduced rates, often as low as 15%, on enterprises and joint ventures to attract foreign investment. Foreign investors have been encouraged by news reports that this existing preferential treatment will be grandfathered, though no specific details have yet been issued, but the need for continued foreign investment remains very strong. The planned expenditure of $140 billion (U.S.) for infrastructure improvements in the next five years, and the beginning of the world's largest construction project (a dam and power project) with a $77 billion price tag, means China must attract more foreign investment. Foreign enterprises engaged in infrastructure development with operating periods exceeding 10 years have special exemptions.

The Hong Kong Trade Development Council predicts these preferential, geographically based incentives will be phased out over time, allowing China to create a system to nurture specific industries.

Value Added Tax. Also adopted is a European-type value added tax (VAT) on production, payable at each stage of the manufacturing process. The rate of 17% applies to most goods, but other rates apply to agricultural products (13%) and small business products (6%). Credits are allowed for taxes paid in an earlier stage of the manufacturing process. The Economist Intelligence Unit has recently reported that "the system appears bewilderingly complex for a country where accounting standards are as rudimentary as they are in China."

Capital Gains Tax. A capital gains tax on property developers and stock transactions is new and likewise complex with estimated rates ranging from 45% to 60%. In a nation in need of land development, this tax appears self-defeating but booming real estate development is also covering illegally obtained funds the government wants to penalize.

Other. A new business tax on sales by service industries (instead of VAT) will range from 3% to 20%.

Regulations on all of these taxes are eagerly awaited.

Accounting

"China's accounting practices are based entirely on the former Soviet model" states Ted T. Lee, managing director of Deloitte, Touche & Tohmatsu, China, a recipient of a $3 million contract from the World Bank to design new standards. Price Waterhouse has received a contract to update rules from the Ministry of Finance that regulates the profession.

The China Daily in its Beijing edition of May 28, 1993, states "... the country's current accounting system remains an obstacle. Different types of enterprises run by different government departments have different ways of accounting." According to a report from the State Economic & Trade Commission (SETC), China now has more than 70 accounting systems. But as an official with the Ministry of Finance said, "The actual number will be far bigger if we could be capable enough to work all of them out."

As a diner grapples with chopsticks the first several times, China struggles to adopt a common accounting structure to overcome the conflicts of having multiple systems. A unified system in more than name only must be implemented; one that will correlate with the political/economic transition underway. For example, government enterprise is now profit driven. "The embracement of management expenses into enterprise costs will force them to strengthen marketing and avoid redundant persons," says one of the principal authors of the first business accounting standards that went into effect July 1, 1993. The use of a unified system will allow for performance comparability among all enterprises, heretofore lacking. Politically, the government wants to create a "private sector" with Chinese characteristics that will assume a great deal of public function and employment.

On December 29, 1993, the National People's Congress enacted a revised accounting law. This appears to be a political document promulgated by the Communist Party to emphasize the need for a unified national system and to reinforce the importance of the Ministry of Finance as the authority for the adoption of regulations. Sources indicate the Ministry of Finance expects a well-functioning system within three years. The political nature of the law is demonstrated in one "philosophical" provision of note:

"Those accounting personnel who carefully follow this law, loyal to their profession, and achieve significant accomplishments should be rewarded with spiritual or monetary recognition."

The businessperson, however, needs more practical guidance than Confucian altruism. According to very reliable sources in Hong Kong, definitive "Regulations of the People's Republic of China on the Control of Financial Affairs of Foreign Funded Enterprises" and "Accounting System of the People's Republic of China Concerning Foreign Funded Enterprises" effective July 1, 1992, are those followed at present. These can be obtained from the Economic Information Agency in Hong Kong.

Formerly the Chinese system, similar to that of the U.S.S.R., was geared toward statistics, providing data for economic planning to different ministries and tax authorities. Some deficiencies of the system include lack of consolidated financial statements, translation of foreign currency transactions at meaningless official rates, and computation of depreciation at unrealistically low rates.

The biggest change in the Chinese communist system is that ministries are now interested in profits. Managers are independent from the controlling ministry and are given control over business policy and told to make a profit. Very often the mandates from the central planners are not accompanied by government funding, leaving the ministries to their own devices. This necessitates a system of managerial accounting to control operations.

Because of the differences in accounting standards, it would be prudent for a foreign investor to reach agreement with the Chinese partner in their contract on the accounting standards to be used.

Auditing

Chinese auditing standards remain a weak point, as only vague official guidelines are in place. They are often expedited regardless of entity size and avoid the confrontation and probing style of Western audits because of Eastern ideas of "saving face" and respect for seniority. Saving face is the reason no provision is made for bad debts. Again this is an example of significant cultural clash and is a stumbling block to be overcome. In view of Beijing's expressed concern over enormous corruption at all levels, now may be the time to implement a more Western approach to auditing.

In a sharp warning to the accounting profession, eight young accountants were publicly executed recently to add dramatic emphasis that fraud, corruption, and profiteering in ministry and business management will not be tolerated.

Monetary Issues

One of the major problems in doing business in China is the repatriation of dollars. This is why patience and investing there for the long haul are prudent advice. China's economic rise is not a mirage, but its continuation is subject to many risks. Eventually the yuan will become fully convertible, but how long will the wait be?

China, a member of the International Monetary Fund, has implemented a system of centralized control over its foreign exchange receipts and payments. All foreign investment enterprises must open Renminbi (people's money - the yuan) deposit accounts and foreign exchange deposit accounts in China with the Bank of China or other banks approved by the State Administration of Exchange Control (SAEC). All foreign currency income must be deposited in these accounts, and all foreign exchange disbursements incurred in the course of normal business operation must be paid from these accounts. Payments from, and deposits to these accounts are subject to the supervision of the bank. Periodic reporting to SAEC regarding all transactions in foreign currency is mandated.

Profit repatriation must come from this foreign exchange account. A foreign investor must generate the foreign exchange for deposit in that account in the first place.

Foreign business must become familiar with swap centers to accommodate foreign exchange needs. The most significant are in Shenzhen, Siamen, Beijing, and China's financial capital, Shanghai. One cannot rely on these exclusively, however, for salary needs, imports, or profit repatriation because they, too, are under government control, or simply, supply may dwindle.

One bit of good news was the unification of the official exchange rate with the swap rate effective in 1994. Prior to that time, foreign business was required to use the lower official rate when exchanging to Renminbi, but the higher swap rate to return to foreign currency when repatriating.

The Equity Joint Venture Law (Article 10) provides the following:

The net profit which a foreign participant receives as his share after executing his obligations under the pertinent laws, agreements, and contracts; the funds he receives at the time when the joint venture terminates or winds up its operations; and his other funds may be remitted abroad in the currency or currencies specified in the contracts concerning the joint venture.

A foreign participant shah receive inducements for depositing in the Bank of China and part of foreign exchange which he is entitled to remit abroad.

There is a saving provision that allows the government to grant preferential treatment to foreign enterprises if special or urgent Chinese needs can be satisfied. The basic rule remains: the more you have to offer China, the better treatment you will receive.

Until the government either reduces monetary control or full convertibility is reached, alternative measures should be sought to bring home profit. Barter and countertrade are viable alternatives. In any event, this issue must be seriously addressed before deciding on investment in China. Information may be obtained from the commercial section of the U.S. Embassy in Beijing as well as the State Administration for Exchange Control.

Getting Started

Careful planning is critical in getting started. A definition of needs, long and short range, must be determined. Patience is necessary, for profits may not be immediate. In addition, the Chinese government's plans for its industry must be factored into the equation. A venture has more chance of backing and access to foreign exchange if it is in line with official policy.

There are alternative vehicles for direct investment in China. There are two types of joint ventures to choose from and an entity called a wholly-owned foreign enterprise. Whatever form is selected must meet government approval and registration requirements in a two-step process. The approval process starts with the Minister of Foreign Economic Relations and Trade (MOFERT). The next step is registration with the Administration of Industry and Commerce, which addresses the initial financing and reviews the debt-equity guidelines for equity joint ventures, before issuing a business license.

Preparation should begin long before meeting with these government ministries. The government insists on a feasibility study to show the foreign enterprise has thoroughly examined all essential business issues, i.e., building and energy needs, supplies, distribution, pricing foreign exchange, financing, labor, communication, transportation, taxation, and environmental protection. It is during this thorough analysis that the advantages of locating in an SEZ become apparent.

Vehicles for Direct Investment

Foreign investors should do business as a joint venture. The U.S. Embassy in Beijing reported in September 1993 that more than 2,800 joint ventures involving U.S. companies had been approved by the Chinese government. This is only a small percentage, however, of the over 75,000 joint ventures approved by the Chinese through the end of 1992. The generally recognized definition of a joint venture under the Uniform Partnership Act applies in China, except that a choice is available between an equity joint venture and a contractual joint venture. More than 70% of the joint ventures are of the equity type and are preferred by the Chinese government.

Equity Joint Ventures. Equity joint ventures are governed by the "Law on Joint Ventures Using Chinese and Foreign Investment," first enacted in 1979 and amended on April 4, 1990. This type requires the establishment of a Chinese-type corporation with limited liability that becomes the legal entity (Chinese use the term legal person) for doing business. Equity joint ventures require a minimum 25% foreign capital contribution. Profit and risk sharing is proportionate to capital investment. The subscribed capital can take the form of cash, capital goods, industrial property rights, or other assets. Investors are restricted from withdrawing registered capital during the life of the contract which may be up to a 50-year term. Ownership rights by the foreign enterprise are non-negotiable.

Contractual Joint Venture. A contractual joint venture is covered under the "Law on Chinese-Foreign Contractual Joint Ventures of 1988." This permits the venture to be organized as a business partnership, and both parties may operate as separate legal entities and bear liabilities independently. But they can take the form of a Chinese limited liability corporation. No minimum foreign contribution is required and profits and losses are divided according to the contract terms rather than their capital investment. Foreign investors may withdraw registered capital during the duration of the contract. There is greater flexibility in the structuring of the organization and its management dependency on negotiations with the Chinese partner.

Wholly-Owned Foreign Enterprise. The third possible legal vehicle is a wholly foreign-owned enterprise, created under "The Law on Enterprises Operated Exclusively with Foreign Capital" enacted in 1986. As of January 1, 1993, there were approximately 15,000 of this type approved in China with a total capital investment of just over $25 billion. This type of enterprise is restricted to those that use advanced technology and equipment or market all or most of their products outside of China. Financial accounts and records must be maintained at its principal Chinese office. Regulations require them to submit fiscal reports and statements to the financial and tax authorities for ongoing supervi- sion. A Chinese consultant well familiar with the approval process and connected to either the central or local gover ment authorities is essential. To go this route alone would be futile.

Other. In May 1992, the concept of a "company limited by shares" was introduced. It is a legal person that raises capital through issuance of shares at equal value. Shareholders have a greater role in management. A supervisory board monitors the company's managers and directors. Twenty- five percent of shares may be issued to foreigners. Little is known about the successful use of this vehicle for foreign investment, but the issue of managerial control has dampened foreign enthusiasm.

Regardless of the type used, liability of foreign investment enterprises is limited to the extent of their investment as well as the assets of the venture acquired in China.

You Have to Have Quanxi

Having "connections" in China is crucial. The Chinese word "quanxi" (pronounced QWANSHE), a pervasive network of personal relationships based on trust and mutual benefit, is not officially acknowledged but runs deep. Having quanxi working for the company is essential. This does not necessarily come at a high price. A friendly, sincere relationship established over a period of time and based on mutual respect is an integral part of Chinese culture. The foreign business person is well advised to establish such relationships.

Bribery and graft are problems, and the American businessperson should be prepared to deal with them. It is not necessary to go along, and the person who does is marked and constantly hounded. The best advice is to resist such behavior from the outset and establish the reputation of having integrity. It is important not to overreact. As recommended by Brewer Stone, an expert on this problem in China, "... a bribe brusquely refused could lead to an army of inspectors arriving at your workplace or plant to search for and find every violation imaginable. Instead, remain calm and try to articulate the practical difficulties the arrangement would create for you and your company." Familiarity with the Foreign Corrupt Practices Act is most helpful. Many businesspeople report success when making gentle references to their company's code of conduct or the FCPA as forbidding such behavior.

Another significant reason for having local know-how is to overcome the problem of determining compliance with government regulations. A freedom of information law in China is unknown. Information is precious and, at times, regulations are not published or translated. The problem is known as the "lack of transparency." Again the relevance of quanxi is apparent.

Where to Invest

Locating initially in a SEZ is the best strategy. The zones have the needed energy, skilled labor, and transportation. However, each zone has its own benefits that must be carefully analyzed before deciding to locate. Certainly these zones are not the only places to do business. It might be cheaper to establish facilities well inland, but transporting goods along inadequate highways and rail systems far offset the cost advantages of inland locations.

China's Dilemma

China is a paradox. It sees the benefits of capitalism and desires its advantages but wants the benefits in the name of communism. It cannot officially recognize in the People's Congress the advantages to privately owning property, because this runs counter to fundamental Marxism. There is still great difficulty not only in understanding these concepts, but more so in accepting them. There are significant cultural differences involved. There is enormous anxiety and uncertainty in the transition toward a market economy and property rights. China needs an enormous amount of foreign investment to achieve its potential. The lack of legal, financial, banking, and accounting standards are obstacles in attracting such investment. To date, China has lacked a comprehensive and cohesive approach to address these issues. Communism keeps getting in the way, and decision makers are hanging on to that philosophy as the nation drifts more and more from it. China disintegrating into regions is not a remote possibility. Communiques from the Communist Party Central Committee meetings continue to be short on specifics and long on abstract ideology, further evidence of internal conflict. But that is the way China has always acted. One thing is certain, the movement to an open and free market is irreversible. China beckons.

Donald J. Swanz, JD, is professor of business law at St. Bonaventure University. He spent five weeks in China in 1993 and three weeks in 1994 at the invitation of the Chinese government lecturing on international commercial law and China's membership application to GATT and now the WTO.