Chairman’s Report on the AeA Trip to China
March 22-25, 2004

Dear Fellow AeA Executive:

• China’s Political Scene: Chinese President HU Jintao and Premier WEN Jiabao are seen by the Chinese public as "men of the people" and domestically-focused. Most analysts believe that China’s top leaders have not been as forthcoming with political reform as once hoped, but the Chinese leadership’s top political priority is stability. Even though there is a growing middle class, China is facing a wealth gap where the rich are getting richer and the poor are getting poorer. China is also facing a banking crisis, where the non-performing loan ratio is over 50 percent. Unemployment is becoming a problem not only among China’s farmers and state-owned enterprise workers, but also among its recent college graduates, who in some ways, are more "dangerous" because they are well-educated, ideological and organized. Taiwan also continues to vex China’s top leadership because of the democratic aspirations of the Taiwanese. Corruption has gotten worse and is systemic now among Chinese government officials. Protests have also increased in China, as citizens demand back wages, compensation for seized property, or better environmental protection. While political expectations among China’s citizens have increased, the government’s response thus far has been to tackle social inequity by decreasing taxes on farmers and instituting unemployment and medical benefits for the poor. However, meaningful democratic political reform and consistent market liberalization have been disappointing.

• China’s Workforce: Hewitt and Associates, a leading international employment practices firm in Shanghai, reported that wages for skilled workers in China increased 7.6 percent last year, while China’s inflation rate rose only 1.2 percent. Hewitt noted that "first tier" cities, like Beijing and Shanghai, have become "too expensive" for many investors and that while salaries in "second tier" cities, like Tianjin and Suzhou, are growing at a faster rate, workers’ wages in these cities are "more affordable." While China has an ample supply of skilled and unskilled labor, finding Chinese management talent is still a challenge. There is a serious shortage of professional talent with functional expertise, especially in the areas of finance, marketing, and R&D. Chinese companies themselves are being forced to hire better people, and many are poaching from multinational corporations.

• U.S.-China Relations: While we were in China, Taiwan held its presidential elections and a referendum on whether Taiwan should condemn China’s growing missile threat and its refusal to renounce the use of force against Taiwan. The referenda were voted down, while the results of the presidential election have been contested by the opposition. Of the presidential ballots cast, 37,000 were invalidated and the margin of victory for President Chen Shui-Bian was less than 30,000 votes. Protestors have taken to the streets and an appeal has been launched to force a recount. President Chen has called on the U.S. to help calm tensions between Beijing and Taipei.

• China’s WTO Compliance: While China made great initial progress in 2002 and 2003 in changing its laws and policies to conform with its World Trade Organization (WTO) accession commitments, the remaining WTO accession commitments are "getting tougher and tougher to resolve," according to Ambassador Randt, due to entrenched state-owned interests, local industry protections, and ministerial control. The Chinese government is under tremendous pressure to modernize and that pressure is driving the government to open its economy to international trade and foreign investment; however, the government remains committed to protecting those domestic industries it’s relying on to be the engine for growth of the entire Chinese economy (namely, semiconductors and software). This apparent paradox will lead to problems over the long-term, as other governments and foreign industries will lose patience with China’s protectionist ways and are likely to invoke WTO rules as a remedy.

• Semiconductors: Two days before the delegation arrived in China, the U.S. government initiated a trade case in the WTO charging that China’s value-added tax (VAT) rebate policy for integrated circuits (ICs) is discriminatory. The Chinese government imposes a VAT of 17 percent on sales of all imported and domestically-produced semiconductors and ICs; however, it rebates the amount of the VAT burden in excess of 3 percent for ICs manufactured or designed in China. While meeting with MOFCOM vice Minister LIAO Xiong, I brought this problem up and stressed the importance of its resolution between the governments as soon as possible. The Vice Minister said that China "attached great importance" to this issue and said that there would be high-level political engagement at the Joint Commission on Commerce and Trade meetings in Washington, DC, in late-April. The Chinese government is clearly aware of the growing U.S. pressure in this case, so I predict that the two governments will find a mutually face-saving way of resolving this issue and ending China’s discriminatory practice.

• Wireless LAN Encryption Standard (WAPI): Another hot policy issue between the U.S. and China is China’s unique, mandatory wireless LAN encryption standard (WAPI) that would require foreign firms to "co-produce" wireless chips with a local firm. Just prior to our visit, U.S. Secretary of Commerce Donald Evans, U.S. Secretary of State Colin Powell and U.S. Trade Representative Robert Zoellick sent a joint letter to Vice Premiers Wu Yi and Zeng Peiyan urging the Chinese government to work with the U.S. to resolve the issue. The U.S. government is negotiating a solution with the Chinese government. It is imperative that China reverse itself on this policy, because it could have set a very bad precedent for standards-setting in other areas critical to IT development in China.

• China’s Environmental Policy: "It’s not all bad news," explained Hussein Anwar, an environmental consultant in Beijing, but to hear the rest of the story, it’s difficult to understand how it’s not all bad. Every freshwater lake in China is polluted, 60 percent of China’s cities suffer from severe air pollution due to increased car emissions, 111,000 Beijingers died last year from indoor air pollution, 80 percent of the buildings in Beijing contain excessive and dangerous amounts of ammonia and formaldehyde, and enforcement of China’s environmental laws is non-existent as local officials turn a blind eye from industrial pollution in favor of economic development. The "good news" is that awareness is up, so more Chinese realize that they must do more to ensure that their grandchildren breathe fresh air and drink potable water; however, that awareness has not translated into consistent government action for, and enforcement of, environmental protection.

• China’s Energy Policy: Five of the ten largest power companies in the world are in China, according to Jim Brock, an energy expert in China. Despite the fact that China’s energy system has been legally broken up, the boards of directors of the power interests in China contain the same government players. China’s capital requirements in coal, oil, gas and power over the next seven to ten years is estimated at $30-$40 billion per year. The Chinese government has taken a sunk-cost approach to capital investment – investment is the cost of entry into the "game" – one gains by "playing the game", not by returns on the entry ticket. So, expect the Chinese to do whatever they have to within, however, the parameters of an existing system, which is socialist (meaning, ownership and management are controlled by the State), but with market-driven forces increasing (especially valuation of product by competitive forces, movement away from cost-driven valuation). There is a minimal role for foreigners’ interests, especially in policy.

• Investment Opportunities in China: China is awash in money. While the venture capital market is small, government-backed loans and private investors are flooding the economy with investment. Our delegation met with MINT, a small foreign-backed investment house that focuses on value-added telecom ventures. We also met with Linktone, an impressive mobile content company based in Shanghai that has never made a profit, but IPOed the week before we arrived and raised $84 million in one day of trading. Also in Shanghai, we met with Huateng Software, which is a 100 percent Chinese-owned software firm – successful and now outsourcing work to lower cost Chinese cities.

• Business "Dos and Don’ts" in China: Jack Perkowski, Chairman and CEO of ASIMCO, offered the delegation a rare glimpse as someone who came to China in the mid-1990s, learned many lessons, and built a successful enterprise in manufacturing car parts. China has the third largest car market in the world and is expected to overtake Japan as the second largest market by 2010. Jack advised company leaders who are looking to enter China to "leave their preconceptions at the door." Industrial development in China is at a different stage than elsewhere in the world, so China can leap-frog many technologies. Jack also stressed the need to localize company management. Chinese managers have a different, sharper focus on costs in China, and they will treat 100 RMB in China (about $12.50) like $100 in the U.S.; Chinese managers will be frugal and will know how to get to the right people to forge and maintain business relationships. Good managers are hard to find, however, so the biggest challenge is to find and develop local talent.

The delegation also met with Dave Willett, Agilent’s General Manager in Shanghai, who gave the group a very insightful presentation on how to do business in China. The greatest savings in having a manufacturing facility in China is through preferential tax incentives and less costly materials. Agilent was initially concerned about ensuring the high quality of its products made in China and has found, over time, that failure rates for its products manufactured in China are lower than the failure rates of those same products that were manufactured elsewhere. Dave said that was achieved by building a culture of quality at Agilent in China. Dave stressed that:

• Intellectual Property Rights (IPR) Protection in China: Industry estimates that 94 percent of all software in China is pirated, so protection of IPR continues to be the Achilles Heel of mature business development in China. Despite the failure of the Chinese government to adequately enforce IPR, the Shanghai Vice Mayor did stress that Shanghai has an IPR enforcement office and encouraged businesses to report IPR infractions. Moreover, officials in the Suzhou Industrial Park noted that the Park has an IPR enforcement center, staffed by five full-time employees who not only help companies in the Park apply for patents, but also investigate and enforce IPR protections within the Park. A business consultant in Shanghai recommended that to combat IPR problems, introduce a new generation of products every six months, with new features. China has a long way to go in this area, but as Chinese companies develop, they and the government are beginning to recognize the importance of not only having the proper laws in place, but also of strictly enforcing them.

• China-Singapore Suzhou Industrial Park (SIP): The SIP was established in 1994 when Chinese Vice Premier Li Lanqing and Singapore Senior Minister Lee Kuan Yew signed an Agreement on the Joint Development of Suzhou Industrial Park in Beijing. The Park covers 70 square kilometers and is being developed in three phases. The SIP has been awarded the same status as the five Special Economic Zones (SEZs) of China and Pudong New District of Shanghai. Yet as a priority park, it also has privileges of its own, which include tax incentives, easier investment approvals, special export processing and logistics, and expedited visa processing. While China was the top destination for foreign investment last year, Suzhou was the top destination within China for foreign investments.
• The corporate tax is reduced to 15 percent, compared with 30 percent in most other areas in China. The local income tax of 3 percent is exempted. Encouraged investment projects may enjoy exemption of customs duty and VAT for imported capital equipment. The Park also grants more incentives to high-tech projects.
• SIP also approves investment projects of any size, with no upper limit on the total amount of investment. SIP.
• SIP is also one of 15 experimental industrial zones that enjoy tariff exemption incentives on importing construction materials, spare parts, consumptive materials and office supplies of rational amount for their own use.
• VAT is not imposed on products produced in the Zone. Products exported to the Zone from other parts of China can enjoy VAT rebate.
• Issue business or work visa notifications to Chinese embassies and consulates for aliens-invited to enter China.

• Conclusion: You have to go to China to understand and appreciate the scale of the changes and challenges facing the country. I hope this report has given you a flavor for what it’s like. Because I can’t go into everything in this report, a number of the presentations and handout materials from the trip are available on the Members-Only side of the AeA website.  You may also view the trip itinerary.

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