Chairman of the National Committee of the Chinese People's Political Consultative Conference Yu Zhengsheng admitted the reforms announced at the Third Plenum were "unprecedented", suggesting China is heading into a period of change  

The latest economic reforms announced at China’s most recent Third Plenum were broad and had far-reaching consequences for the world’s second-largest economy. Even top Chinese politician Yu Zhengsheng admitted that the reforms were “unprecedented”. The committee announced a wide range of changes to state-owned industry and land reforms desperately needed in China’s large agricultural sector.

The biggest news, however, was the announcement of an intention to liberalise the financial sector and continue to open the country to foreign investment. In a move that echoed the Third Plenum of 1978, in which the Chinese Government first attempted to enact market-oriented reforms, the country seems to be bringing itself ever closer to the rest of the world. The changes haven’t been pulled off without a hitch, however. Long promised and not entirely as advertised, the latest reforms have once again posed the question of just how willing Asia’s economic powerhouse is to open its borders fully and embrace foreign investment.

Investing in China has its own challenges. The atmosphere of the market is quite unlike any other. So too is the potential windfall. Despite signs that China’s growth might be slowing, the opportunity to make big gains has attracted many to the idea of investing in the country. China drew $19.3bn in foreign direct investment (FDI) in the first two months of 2014, a jump of 10.4 percent compared to the same period last year.

Despite a slight slowdown in February that officials are blaming on business closures caused by the Lunar New Year, the figures remain strong. Even so, the unique investment environment in China means there are several key issues that anyone considering FDI in China should not avoid.

Elusive reforms
First, and perhaps foremost, is the extent to which the country has actually enacted the reforms that it says it has. Although some observers hope that China is drifting towards a freer market, for now the biggest problem appears to be one of bureaucracy. The Chinese government is still extremely specific about which industries it will allow to receive foreign investment.

Although the services sector attracts the majority of the investment – $6.33bn in the first months of 2014 – China is keen to promote a wide range of industries to foreigners. Equally, though, some sectors are completely closed off from foreign interference, for a variety of reasons – some economic, most political.

The Chinese system involves four broad classifications, listed in the Catalogue for the Guidance of Foreign-Invested Industries. Industries deemed by the Chinese government to be a priority for foreign investment gain a coveted ‘encouraged’ status. This status bestows preferential tax treatment and other incentives for foreign investors, and is designed to attract technology and high-profile management to the chosen sectors. At the moment, only a few industries are encouraged – mostly hi-tech, environmental and energy – but whether the Chinese government will slowly give more industries priority treatment is unknown.

On the other side of the scale, some industries are ‘restricted’ or even ‘prohibited’ entirely. The latter category is quite specific; at the moment the Chinese Government bans any foreign investment in cultural, sports or entertainment industries. As for restricted industries, investment in financial services is still government controlled.

Under Chinese rules, foreign investors in the banking industry are not allowed to own more than 20 percent of a local bank. For commercial banks, there is a 25 percent cap on foreign ownership. Moreover, the policies restrict investors to investing in only two banks and require stringent approval checks. The Chinese government says that these policies help preserve sustainable development in the country. For foreign investors, the strict rules are perhaps not easing fast enough.

Other countries have been quicker to ease their legislation. India, for example, has recently relaxed investment restrictions in several key sectors. Last August, the government announced that the retail sector, in particular, would place fewer regulations on potential investors. India historically had strict targets regarding the percentage of goods that are locally sourced, but the severity of the measures has now been lessened. This is welcome news for those seeking to invest in the country, but across the border in China they have yet to replicate this more liberal, open market view.

Geographical considerations
In China, not only are the regulations industry-based, they are sometimes geographically based. For example, Shanghai was recently turned into the country’s first free trade zone (FTZ). The FTZ has its own problems. Policymakers are reluctant to enact policies in the zone that would have a knock-on effect across the country. For example, if interest rates were to rise in the FTZ and Chinese banks moved there en-masse, the resulting rush of money to Shanghai could have a very extreme destabilising effect on the rest of the country.

It remains to be seen whether the FTZ has worked or not, but across China certain key target areas are given special or preferential status. Now, so-called ‘Special Economic Zones’ (SEZ) and ‘Economic and Technological Development Zones’ (ETDZ) are being scattered across parts of China to attract investors. Again, the SEZs have special powers to promote foreign investment. Not only are there special tax incentives, but legislators in the SEZs themselves receive more autonomy on both their policymaking and also how they encourage international trade. Unfortunately, while new regulations are introduced centrally, the interpretation of the rules can vary from province to province.

This means more and more companies investing in China have had to adopt a region- or province-based financial model, instead of a centrally controlled one. Grant St. John Leech, the Chief Executive of C.E.O. Financial, a consultancy that runs fdiChina.com and their Wealth Management, Compliance & Risk in Asia 2014 report, agrees with this outlook.

Speaking to World Finance, Leech said that “if you are looking to sell to the domestic consumer market, you must understand that China cannot be considered a single homogeneous market. Rather, it is a patchwork of regional, disparate markets (see Fig. 1) with distinct dialects and considerable cultural differences. In terms of logistics, the distribution infrastructure is more regional than national and should therefore be taken on piece by piece [basis].”

In some ways the country is desperate for the investment as the government seeks to prevent the economy slowing down below the country’s target of 7.5 percent GDP growth per year. Although even the tiniest slice of China’s GDP growth rate would be a dream come true for most Western nations, the economy is nevertheless straining a little.

There are a myriad of contributing factors. The Chinese Government’s long-standing policy of building infrastructure to stimulate growth appears to have finally caught up with itself. Burgeoning overcapacity has drained enthusiasm for further mass construction, as more and more ‘empty cities’ spring up across the country.

Secondly, it appears that China’s demographics problem is only going to worsen in the coming years. As the ‘baby boomers’ begin to approach retirement, the effects of China’s historic One Child Policy may usher in an ugly, difficult period for the country. Analysts say that even if a Two Child Policy were enacted today, China’s population curve would not normalise for a further 20 years.

China finds itself with no choice but to open its doors to the rest of the world

All of this mounts pressure on the government, which finds itself between a rock and a hard place. Unwilling to enact the radical liberalisations that China would need to head towards a free market, but also unable to relieve domestic pressures on the economy without outside influence, China finds itself with no choice but to open its doors to the rest of the world.

Big steps have been taken with the yuan in recent months as the government continues to ease controls. Looser regulation of the currency, perhaps even heading towards permanent and full convertibility, will help investing prospects. To foster international trade, China has recently allowed direct currency trading between some of its biggest trade partners.

A recent high profile deal with New Zealand was seen as one of the first signs that China is serious about internationalising the yuan. This, coupled with the recent doubling of the currency’s daily trading band, all point to less intervention in the future. Despite this, in its recent investor outlook, PwC said that “government policies remain stringent in [their] control of foreign exchange and other transactions. This leaves treasuries engaging in much documentation and bureaucratic finessing.”

Cultural differences
Leech points out that there is also an immense cultural consideration necessary when investing in the country. “Cultural issues are very important and should be carefully managed. It is often the case that joint ventures between Western companies and their Chinese partners encounter difficulties as a result of a crucial cultural distinction: the Chinese business culture demands trust, whereas the Western business culture demands transparency. Neither viewpoint is necessarily wrong. When issues arise regarding the sharing [of] information, how this disparity in expectations is managed becomes crucial.”

There are still places to slip up for an investor though. State-owned and state-funded businesses require particular attention. Investors who find themselves contravening the very strict rules surrounding state-funded businesses can even fall foul of the law. They also have to struggle to ensure that any company invested in has suitable governance standards as outlined by the law.

For business, Leech says there are two potential strategies. “In terms of legal structures, a company can initially set up a representative office to carry out the considerable due diligence that is required. Thereafter, the choice is between establishing a ‘wholly foreign owned enterprise’ (WFOE) or opting for a joint venture with a domestic company.

“In either case, you must establish partnerships and relations with people on the ground and the choice of these partners will be a crucial determinant of success or a lack thereof. Due diligence in this regard is critical as there are myriad stories of unscrupulous partners taking advantage of naive market entrants.”

The problem is twofold, however. Not only is it difficult for an investor to gauge the suitability of a company, but they could also struggle when seeking clarification or when advancing the investment process with the government. PwC’s report says that “in seeking a successful strategy for dealing with government, foreign businesses should seek out constructive avenues of action. Investors should adopt a careful and measured approach in working with the government… they should be active in engaging relationships with government officials in order to stay informed.” Access to officials is still difficult, however, and corruption is still relatively prevalent.

Although China’s President Xi Jingping has repeatedly promised a crackdown on corruption, including going as far as to speak about it in his first speech as leader in 2012, progress is slow and murky. These issues, coupled with the continued fluidity of the investment environment, have lead many to believe that China’s reforms are simply progressing far too slowly and the country’s policymaking is struggling to keep up with the levels of FDI the country is now seeing (see Fig. 2). A rapidly forming bureaucratic backlog could be the most damaging thing for the country in the long run, especially as it continues to commit to looking outward.

Gold in a minefield
But perhaps China’s nervousness in enacting the reforms is justified. Three decades ago, it was an isolated nation that refused foreign interference. Subsequent shifts in economic policy opened up the country and accelerated growth to put China on the road towards economic supremacy.

The country’s previous administration reversed some of the progress that had been made, however, believing that liberalisation was too painful and damaging. In an article entitled Liberalisation in Reverse, economics analyst Derek Scissors writes that China’s previous government presided over a period of “renewed state intervention: price controls, the reversal of privatisation, the rollback of measures encouraging competition, and new barriers to investment.”

The current changes, then, are being promised with the anxiety and concern of a country that is still trying to retract its so-called ‘visible hand’, which historically has guided economic policy. For investors, the political machinations are frustrating, but the dream of reforms, promising. It remains to be seen how dedicated the government is to the liberalisation, but the fact that it has not let the matter fall by the wayside, as some might have expected, is reassuring.

For now, investment is still an encouraging prospect, despite the difficulties. After all, as Anthony Bolton, top fund manager at Fidelity Special Solutions, says, finding investment opportunities in China is like “looking for gold in a minefield”.