ASSIGNMENT 01

CLOSING THE DOOR ON THE DRAGON Should Chinese global investments be constrained or no?

MBA/11/2751

R.M.SIDATH .T BANDARA

Course : MBA 503: Business Communication Instructor : Prof. Uditha Liyanage Co Instructor : Ms. Shyam Hettiarachchi Term/Semester 01 (January March 2011)

TABLE OF CONTENTS

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INTRODUCTION...02 CHINA'S FOREIGN INVESTMENTS, CAPITALISM'S FUTURE.....04 CHINESE TAKEOVERS...05 POWER BEHIND THE CHAIR.....06 THE CHINESE WAY.07 THE CUSTOMER WHO BUYS UP THE STORE....07 WHY CHINA IS DIFFERENT (THE PROs & THE CONs).08 CONCLUSION...09 BIBILIOGRAPHY..11

INTRODUCTION Can it be true? Has China become a capitalistic country? In this paper I look at the history of the transition of China's economic system. I will then explore how China uses its new-found economic power and wealth to exert influence over other countries, including the U.S and the catastrophic consequences that may follow if its investments are not restricted. The Cultural Revolution in China ushered in a decade of social, political, and economic upheaval between 1966 and 1976. It officially ended with the death of Mae Zedong, chairman of the Communist Party. After Mao's death in 1976, forces within the party that opposed the Cultural Revolution, led by Deng Xiaoping, gained prominence, and most of the political, economic, and educational reforms associated with the Cultural Revolution and its excesses were abandoned by 1978. The Cultural Revolution has been treated officially as a negative phenomenon ever since. The people involved in instituting the policies of the Cultural Revolution were prosecuted including Mao, Lin Biao and the "Gang of Four." In China, the traditional State-owned enterprise (SOE) has been undergoing a process of corporatization since 1984 when these enterprises were encouraged to expand production and earn profits. The traditional model of state-owned and state-managed enterprises became two-fold: state ownership of property with management rights in SOEs separated out. Compared with traditional SOEs, the ownership structure of SOEcorporatized corporations includes better defined shareholder rights than its traditional counterpart along with increased efficiency and accountability. The modern corporate model presents more sophisticated and difficult governance issues as China continues to transition from a planned economy to a market economy. The Chinese government controls about 70 percent of the stakes of publicly listed companies on stock exchanges with the largest exchange in Shanghai. The government still exerts considerable influence over the operations of Chinese companies even as the country moves toward a western form of capitalism. Companies that seek a listing on a stock exchange are required to adopt sound corporate governance practices, such as the inclusion of independent directors on the board of directors. Indeed, China has been influenced by corporate governance policies developed in the UK in the aftermath of scandals at companies such as Barings Bank that was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost 827 million ($1.3 billion) speculating primarily on future contracts. The scandals in the U.S., including at Enron and WorldCom, and the passage of the Sarbanes-Oxley Act also have led to governance improvements and increased transparency in the Chinese economic system. Still, it has a long way to go to overcome years of secrecy. One problem with the current Chinese economic system -- SOE-corporatized corporations -- is the influence of the state shareholder in managing Chinese enterprises. The government champions the state-owned firms and a truly market-oriented economy

may by years off in the future. However, the achievements of a more western style economic model in China cannot be overstated given that it is the second largest economy in the world and, in my opinion, will surpass the U.S in the near future. CHINA'S FOREIGN INVESTMENTS, CAPITALISM'S FUTURE "The notion that capitalists should allow communists to buy their companies is, some argue, taking economic liberalism to an absurd extreme. But that is just what they should do, for the spread of Chinese capital should bring benefits to its recipients, and the world as a whole." "China buys up the world," The Economist, November 11th The Economist November 11th 2010, includes a full-page leader plus a separate threepage article about China's increasing importance as an acquirer of businesses elsewhere. Pointing out that China's share of Foreign Direct Investment today is only 6%, compared to 45% for Britain in 1914 and 50% for the US at its peak in 1967, the magazine argues persuasively that China's growing interconnection with the rest of the world is a good thing, and that "to reject China's advances would thus be a disservice to future generations, as well as a deeply pessimistic statement about capitalism's confidence in itself." We'd wonder if capitalism maybe has too much confidence in itself or at least in its current form. All systems evolve, and capitalism will not stand forever unchanged. Today's form of capitalism grew out of a particular environment. The technologies of the industrial revolution demanded large-scale operations steel mills, for example, rather than anvils and that created a new need to aggregate, well, capital. That's not today's problem. With scarcity of capital no longer the constraining factor on global growth, and nations ranging from Party-controlled China to the market-crazed United States trading together, the world needs an economic system that drives and disseminates innovation globally, and does not privilege capital as if it were still scarce. (Today's financial services industry, in fact, was the mechanism for reducing the excess returns to land as the leading economies switched from agriculture to industry.) The Economist still places its confidence in capitalism as is, apparently. That shows up in its "to be sure" paragraph allowing that no one should desire too much Chinese ownership: "The idea that an opaque government might come to dominate global capitalism is unappealing. Resources would be allocated by officials, not the market. Politics, not profit, might drive decisions." Let's put two objections on the table to that phrasing: 1. Are we so certain that profit, not politics, should drive all decisions? To refuse to question that, we think, is to cling to a dying Washington Consensus. In theory, of course, it is legitimate to see profit as the measure of value creation for society but that would be true in practice only if externalities were all fully priced, antitrust were thoroughly enforced, and regulation wholly protected the interests of the population. In real-world 4

market-based economies, profit as the sole yardstick leads to transfers of value from individuals to corporations. If you want an economy to serve the best interests of flesh and blood participants not just paper ones the profit motive needs to be accompanied by priorities placed on common goods like social justice, sustainability, or health. 2. Is it necessarily true that in profit-driven economies, politics is excluded by the perfect working of the market? This is another Washington Consensus tenet. But stop and consider for a moment the subsidies paid to the corn industry in the United States (let alone the demand for corn ethanol), or the oil depletion allowance, the decision to prosecute or protect Microsoft, or the structure of the financial services industry. Is it possible to claim these are not driven by politics? We're not trying to take the opposite position from The Economist and claim that the global economy should be dominated by a Beijing Consensus of state-directed capitalism. Our point is simply that state vs. market is a false dichotomy. The decisions taken by Chinese companies don't all emanate from Beijing. As The Economist documents, they respond to markets in many ways. And US companies don't strive for perfect competition. Meanwhile, in Singapore, a different kind of state-dominated capitalism has made different tradeoffs. What we see is a spectrum of roles for governments, companies, and markets around the world and we don't expect that to narrow. Sit within any system and you tend to consider the others heretical. But adopt a new vantage point, as Copernicus did when he "stood on the sun", and you see the jostling of legitimate models against one another in a global marketplace. And you recognize that as the environment to which the next capitalism will be adapted. CHINESE TAKEOVERS Last year (2010) buyers based in China and Hong Kong have accounted for a tenth of global deals by value, including investments in oil and landmark takeovers in industry, such as Geelys purchase of Volvo, a Swedish carmaker. A decade ago China urged its companies to expand under the slogan go out. Now it is really happening. More deals are inevitable, given Chinas rise. Control of the worlds stock of foreign direct investment (FDI), which includes takeovers and companies greenfield investments, tends to reflect a countrys economic muscle. Britain owned 45% of the worlds FDI in 1914; Americas share peaked at 50% in 1967. Today China, including Hong Kong and Macau, has a share of just 6%. Listed Chinese firms, which are largely state-controlled, are already some of the worlds biggest, and account for over a tenth of global stockmarket value. Most are still mainly domestic outfits. Chinas high savings will also spur deals. Companies often have surplus cash and banks surplus deposits. Today those savings are recycled into rich countries via sovereignwealth funds and the central bank, which act as portfolio investors, buying mainly bonds.

But China may and probably should diversify. That shift will be accelerated by Chinas political aims: to acquire inputs, such as raw materials, labour and land; to build up technical and commercial expertise; and to gain access to foreign markets. Public announcements of such deals are something of a charade. Wooden Chinese executives insist they are acting on purely commercial grounds. Western bosses hail a new era of co-operation. Yet these transactions are tricky partly because of cultural differences and partly because of the role of the Chinese state. There have been fiascos. In 2005 CNOOC, a Chinese oil firm, withdrew a bid for Unocal, a Californian producer, after American politicians kicked up a stink. In 2009 Rio Tinto, an Anglo-Australian mining firm, withdrew from a deal to sell a series of minority stakes to Chinalco, a Chinese metals firm. Rios shareholders opposed the sale but many reckon that the Australian government did, too. Chinese companies power structure is a bit of a mystery to outsiders, even the handful of Westerners on the boards of big state-backed companies. A popular theory is that they are controlled by a parallel hierarchy of Communist Party officials. The most senior party man in a firm, the general secretary, is not necessarily the most senior executive. Although one Western executive says this distinction was evident (There were party people and people who did stuff), most are just overwhelmed by the volume of bodies. One arrived, alone, in London to be faced with 30-40 people from the Chinese side. I was shocked, he laughs. Meetings in China can be attended by vast audiences, with people coming in and out continually. A core of people ask good questions, but even they, many visitors say, seem to lack the authority, or desire, to make decisions. POWER BEHIND THE CHAIR Chinas state-backed system also has disadvantages. One is that foreign governments are becoming increasingly wary of Chinese takeovers. These include those of Canada and Australia, previously two of the most open markets for corporate control in the world. Another is more subtle: that the style of decision-making can lead Chinese companies to overpay and to struggle to integrate their purchases. Chinese firms also risk political fallout if they fail. Their sense of mission makes them transparent, says one European executive of his experience selling a firm. They cannot take the chance to lose the deal. Another European boss says his Chinese suitor struggled to deal with Western stockmarkets. Their disclosure rules mean slip-ups are made public, and disparate institutional investors are unpredictable. As a result Chinese buyers prefer targets with a single big shareholder who can negotiate bilaterally. However, buying such firms can be costly because they command a scarcity premium. The price China pays is often dismissed as inconsequential: what are a few billion in the grand scheme of things? But even for rich countries, systematically overpaying for foreign assets is a bad idea. After a binge in the late 1980s and early 1990s, Japanese firms retrenched.

THE CHINESE WAY Does any of this matter? After all, Western takeovers can be brutal, too, and a buyer is by and large entitled to do as it pleases. Several mining and oil bosses also argue that a healthy process is at work, in which China buys firms and the capital and skilled people thus released are recycled into new start-up companies. Yet from Chinese firms perspective an inability to retain staff is a problem. Technical and local expertise accounts for much of a companys value. And as China moves beyond digging stuff out of the groundat which it is fairly adeptto more complex consumer industries, let alone creative ones, better management will be essential. In this, companies from other emerging markets, such as India and Brazil, have the advantage of private-sector credentials and more cosmopolitan cultures. The most durable multinational firms, such as Nestl or Unilever, often transcend nationality. A pessimistic view is that China will have to find other ways of going out. It could make passive equity investments through China Investment Corporation, a sovereignwealth fund. Executives from two firms attest that its representatives take a back seat at board meetings. Joint ventures are another option. The boss of an oil firm with a Chinese partner says that its motivation is not to take control and that the relationship is harmonious. Alternatively, Chinese companies could grow without buying. Until the wave of crossborder deals in the 1980s most firms went global by building operations from the ground up. Chinese firms are becoming good at this. One of them, COSCO, has a concession to run part of Greeces biggest port. Chinese construction firms have won contracts across Africa and eastern Europe. Huawei has developed without making large acquisitions. For all that, it is hard to believe that Chinas companies and politicians want to operate with one arm tied behind their backs. And although many of the countrys big firms may never resemble Western ones, with diffuse private shareholders and independence from the state, they may have to edge more towards this template in order to succeed at large cross-border deals. In a speech this month a senior Chinese official emphasised the role abroad of Chinas private firms, which typically have less overt state direction. To address other countries concerns about political control, China may also have to loosen its hold on its giant state-owned companies and ensure that their power structure is more transparent. THE CUSTOMER WHO BUYS UP THE STORE IN THEORY, the ownership of a business in a capitalist economy is irrelevant. In practice, it is often controversial. From Japanese firms wave of purchases in America in the 1980s and Vodafones takeover of Germanys Mannesmann in 2000 to the more recent antics of private-equity firms, acquisitions have often prompted bouts of national angst.

Such concerns are likely to intensify over the next few years, for Chinas state-owned firms are on a shopping spree. Chinese buyersmostly opaque, often run by the Communist Party and sometimes driven by politics as well as profithave accounted for a tenth of cross-border deals by value this year, bidding for everything from American gas and Brazilian electricity grids to a Swedish car company, Volvo. There is, understandably, rising opposition to this trend. The notion that capitalists should allow communists to buy their companies is, some argue, taking economic liberalism to an absurd extreme. But that is just what they should do, for the spread of Chinese capital should bring benefits to its recipients, and the world as a whole. WHY CHINA IS DIFFERENT (THE PROs & THE CONs) Not so long ago, government-controlled companies were regarded as half-formed creatures destined for full privatisation. But a combination of factorshuge savings in the emerging world, oil wealth and a loss of confidence in the free-market modelhas led to a resurgence of state capitalism. About a fifth of global stockmarket value now sits in such firms, more than twice the level ten years ago. The rich world has tolerated the rise of mercantilist economies before: think of South Koreas state-led development or Singapores state-controlled firms, which are active acquirers abroad. Yet China is different. It is already the worlds second-biggest economy, and in time is likely to overtake America. Its firms are giants that until now have been inward-looking but are starting to use their vast resources abroad. Chinese firms own just 6% of global investment in international business. Historically, top dogs have had a far bigger share than that. Both Britain and America peaked with a share of about 50%, in 1914 and 1967 respectively. Chinas natural rise could be turbocharged by its vast pool of savings. Today this is largely invested in rich countries government bonds; tomorrow it could be used to buy companies and protect China against rich countries devaluations and possible defaults. Chinese firms are going global for the usual reasons: to acquire raw materials, get technical know-how and gain access to foreign markets. But they are under the guidance of a state that many countries consider a strategic competitor, not an ally. As our briefing explains, it often appoints executives, directs deals and finances them through state banks. Once bought, natural-resource firms can become captive suppliers of the Middle Kingdom. Some believe China Inc can be more sinister than that: for example, America thinks that Chinese telecoms-equipment firms pose a threat to its national security. Private companies have played a big part in delivering the benefits of globalisation. They span the planet, allocating resources as they see fit and competing to win customers. The idea that an opaque government might come to dominate global capitalism is unappealing. Resources would be allocated by officials, not the market. Politics, not profit, might drive decisions. Such concerns are being voiced with increasing fervour. Australia and Canada, once open markets for takeovers, are creating hurdles for Chinas

state-backed firms, particularly in natural resources, and it is easy to see other countries becoming less welcoming too. That would be a mistake. China is miles away from posing this kind of threat: most of its firms are only just finding their feet abroad. Even in natural resources, where it has been most active in dealmaking, it is not close to controlling enough supply to rig the market for most commodities. Nor is Chinas system as monolithic as foreigners often assume. State companies compete at home and their decision-making is consensual rather than dictatorial. When abroad they may have mixed motives, and some sectorsdefence and strategic infrastructure, for instanceare too sensitive to allow them in. But such areas are relatively few. What if Chinese state-owned companies run their acquisitions for politics, not profit? So long as other firms could satisfy consumers needs, it would not matter. Chinese companies could safely be allowed to own energy firms, for instance, in a competitive market where customers could turn to other suppliers. And if Chinese firms throw subsidised capital around the world, thats fine. America and Europe could use the money. The danger that cheap Chinese capital might undermine rivals can be better dealt with by beefing up competition law than by keeping investment out. Not all Chinese companies are state-directed. Some are largely independent and mainly interested in profits. Often these firms are making the running abroad. Take Volvos new owner, Geely. Volvo should now be able to sell more cars in China; without the deal its future was bleak. Chinese firms can bring new energy and capital to flagging companies around the world; but influence will not just flow one way. To succeed abroad, Chinese companies will have to adapt. That means hiring local managers, investing in local research and placating local concernsfor example by listing subsidiaries locally. Indian and Brazilian firms have an advantage abroad thanks to their private-sector DNA and more open cultures. That has not been lost on Chinese managers. Chinas advance may bring benefits beyond the narrowly commercial. As it invests in the global economy, so its interests will become increasingly aligned with the rest of the worlds; and as that happens its enthusiasm for international co-operation may grow. To reject Chinas advances would thus be a disservice to future generations, as well as a deeply pessimistic statement about capitalisms confidence in itself. CONCLUSION As described in the Introduction where I have spoken about the transition of the Chinese economic system from a state-owned and controlled model to a more western style freemarket economy. Under this heading I shall explore the implications of an everexpanding Chinese economy for the U.S.

In a sense the Chinese government uses the free-market model to get what it wants -- an ever-expanding economic influence around the world and growing political force to be reckoned with. The increasing power of the Chinese economy equates with increasing state power, and it is essential to maintain stability and growth thereby ensuring continued Communist party rule. A question that has been frequently raised in the past few years is whether China is playing by the rules of the game or exploiting government policies to keep the Yuan (Chinese currency) artificially low to enable Chinese exports to be unrealistically low in price while making the imports of other countries relatively expensive. Such practices are permitted only when the government has a major role in running corporatized stateowned-enterprises (SOEs). The rest of the world allows its currencies to freely float on the foreign exchange market. Western critics claim that China's practices are a form of mercantilism aimed at piling up wealth by manipulating trade. They point to China's $2.6 trillion in foreign-exchange reserves. So, what is China doing with the enormous amount of foreign reserves? Today, it is largely invested by sovereign-wealth funds and by purchasing rich countries' (read U.S.) government bonds. Tomorrow, it could be used to buy companies and protect China against possible devaluations and defaults of wealthy countries. Chinese firms own just 6% of global investment in international business compared to the peak ownership of 50% by the U.S. in 1967. Some countries fear China's moves to acquire natural resources to ensure its continued economic growth and development. The nationalistic fervor in response to such deals has killed a few of them. Most notably in 2005, CNOOC, a Chinese oil firm, withdrew a bid for Unocal, a Californian producer, after American politicians weighed in on the worrisome loss of national control over the country's own resources. In 2009 Rio Tinto, an Anglo-American mining firm, withdrew from a deal to sell a series of minority stakes to Chinalco, a Chinese metals firm, after Rio's shareholders (and some claim the Australian government) opposed the sale. So, should we fear the Chinese or welcome it with open arms? It's not an easy question to answer. On the one hand, where would the world be today without China buying up the government debt and financing the deficit of USA? On the other hand, what happens if China sells off their investment in U.S. government securities or uses it as a stick to exert more and more influence over the US economy? Given America's appetite for imported goods including those from China, would it be a good thing for the American consumer if Chinese goods were made more expensive by "forcing" the Chinese to loosen its controls over the YUAN? Do we really think China would import more from the U.S. and other countries, if the value of the dollar were to weaken in relation to the Yuan? The fact is the Chinese have us just where they want us. We need them more than they need us. It's not China's fault. We're to blame because of our attitude of spend, spend, spend that existed prior to the financial crisis of 2008 in the Western World. The US can be blamed because of its ever-expanding entitlement programs and involvement in two wars that has mushroomed the national debt. Finally, we wanted and supported the Chinese in its

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movement towards a more market-oriented economy. We shouldn't blame them because they have been beating us at our own game. BIBLIOGRAPHY The Economist (Nov 11th 2010 edition) UNCTAD; Multinational Enterprises and the Global Economy by J.H Dunning Company Reports (ICBC, China Construction Bank, China Development Bank, Bank of China and China Eximbank.

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