International companies doing business in China or with Chinese companies globally, take note: China’s shift toward protecting and promoting state-owned enterprises at the expense of private companies is raising a range of increased compliance risks which need to be understood and managed effectively.
China is changing the way it treats private and state-owned businesses
When China began its market-oriented reforms in 1978 under Deng Xiaoping, private companies—formerly illegal—began to thrive and eventually became a widespread and disproportionally large contributor to China’s employment, output, and growth, effectively enabling China to become an economic superpower.
But according to Nicholas Lardy’s new book The State Strikes Back: The End of Economic Reform in China and related comment, current President Xi Jinping’s emphasis on the importance of state-owned companies and state industrial policy is now hurting private companies, producing market inefficiencies, and holding back China’s economic growth.
State-owned enterprises have been encouraged to merge and get even bigger, and bank lending is being diverted to state companies despite their lower profitability. More than two-fifths of state companies persistently rack up losses, according to the Chinese Ministry of Finance. By comparison, private companies are three times more productive than their state counterparts. Nevertheless, Chinese bank loans to state companies have increased in recent years despite the fact that these companies’ return on assets has declined.
The fall-out for private companies and the economy has been substantial. Chinese bank lending to private companies has dropped by 80%. The share of investment undertaken by private Chinese companies has fallen, and their output is in decline. Additionally, Premier Li Keqiang officially lowered the target for GDP growth this year to 6.0-6.5 percent. This move is based on weaker domestic demand (consumption and investment) coupled with the US-China trade war. In response, the government has enacted monetary and fiscal stimulus measures, but at the same time seeks to avoid a further build-up of debt, further impacting access to credit. These developments together have contributed to a 2% decline in the annual growth of the Chinese economy, according to Lardy.
These changes are raising compliance risks for companies doing business in China or with China companies globally
Doing business in China has presented particular compliance and other risks for international companies for a long time, in areas such as corruption, quality control, and the security of trade secrets and other confidential information. Indeed, hardly a week seems to go by without reports of such problems:
- Bribery. The German dialysis products company Fresenius agreed to a $231 million settlement with the US Securities and Exchange Commission in March 2019 for paying bribes to government and health officials in China and 16 other countries to promote its business.
- Counterfeit parts. Chinese trader Ruiyang Li was sentenced to 54 months in US federal prison in February 2019 for shipping counterfeit Cisco, Hewlett-Packard, and Intel computer parts into the US.
- Risks to confidential information. The Tesla company filed suit in March 2019 against a former engineer on its Autopilot team, Guangzhi Cao, for allegedly taking sensitive “robocar” secrets to Chinese competitor Xpeng Motors. This follows similar charges against a former Apple engineer who went to work for Xpeng.
In the view of business and economic experts, the recent promotion of state-owned companies at the expense of private companies in China is likely to exacerbate such problems for a number of reasons, given past experience, economic realities, and practical considerations at play in China.
For one thing, a downturn in business of the sort that Chinese private enterprises are facing can lead to further lapses in regulatory compliance. This already seems to be becoming an issue in China.
Ernst & Young’s Global Fraud Survey found in 2012 that 46% of respondents in China believed that making cash payments to secure business would be justifiable, and that misstating financial statements would be acceptable. This response is higher than any other emerging national economy including Brazil, Russia, India, China and South Africa (BRICS). Academic scholarship and survey data suggest that there is likely to be an even greater tolerance for, or willingness to engage in, such misconduct during a business slowdown.
Moreover, a decline in business output or other economic downturn has practical effects on the budgets, programs, and staff that companies can or are willing to spend on compliance. Funding is less available for detecting or preventing non-compliance. Companies eliminate internal controls as part of staffing reductions—by as much as one-third, according to one survey. There is also anecdotal evidence that employee theft tends to increase in a recession, because “safeguards are often one of the first things to go” when a downturn hits.
Business downturns also can cause companies to cut corners in conducting due diligence on potential business risks, such as by failing to conduct in-country risk assessments, and thereby can lead to paying bribes because it simply “seems normal.”
Greater due diligence, compliance oversight with Chinese business partners is needed
Compliance risks among Chinese private companies caught in the present lending squeeze and among state companies still racking up losses are ones that companies doing business in China need to recognize and manage with renewed attention at present.
Over the years, companies have addressed a number of key corporate risks such as quality control and health and safety risks through an integrated “management systems” approach, and the benefits of such an approach for also managing compliance risks such as bribery and theft or loss of confidential information are no different.
Developing and maintaining adequate contracts, policies, procedures and records are an important first step in dealing with Chinese and other business partners, but the key is ensuring that such requirements can be and are followed in practice. Initial and ongoing risk assessment and due diligence are thus vital. Making sure that contractors and other second-tier partners are covered can help to deal with the “weakest links”. And implementing effective management responsibility and coordination, staff training, contingency/breach planning, and ongoing program measurement and improvement can go a long way toward guarding against compliance risks and breaches of the sort commonly found in China.
Perhaps, as one of the earliest commentators noted in the 1960s, the task of implementing and ensuring compliance “will never be completed”—particularly at a time when business and budgets are constrained. But over time, with continual improvements, the process of managing compliance even in countries like China can and should become one that is more effective and efficient, not only in identifying and mitigating risks but also in bringing reputational, financial and other value to the company.