Commercial Legal System in China - Coursework Example

Commercial Legal System in China 2008 Introduction Since 1978, when China transformed itself from a strictly command economy to a more liberalized one, while maintaining its conservative political policies, the country has grown at an average rate of about 9 percent per annum (Hill, 2005). In 2007, real Gross Domestic Product (GDP) grew at 11 percent over the previous year, demonstrating the fastest growth among all economies in the world (CIA). Much of the growth has actually happened over the last decade. In terms of purchasing power parity, China was the second country, after the United States, in 2007 although in terms of per capita, it continues to be categorized as a middle-income country (CIA). Over the years, China, with the fastest growth of Gross Domestic Product (GDP) in the world, has not only become the most important country in the Asia Pacific region for international trade but also in the world. Primarily because of the low cost labor pool in China, almost all multinational companies in all industries have offshore facilities here. As a result, China has emerged as the largest trading partner of the United States as well as of many European countries. Besides, much of the international trade in the Asia Pacific is routed through China. This means that China is a major net importer from other south east Asian countries and a net exporter to the western world. At the same time, much of the movement of foreign direct investments in the world is directed towards China to cater to the huge market. In 2007, 21 percent of China’s exports were destined for the US while 7.5 percent of its imports were from Japan, making it a net exporter to the US. In contrast, with European countries, China has a more balanced trade (CIA). Hence, it would not be unjustified to claim that China, over the last quarter of a century, and particularly over the last decade, has emerged as the most important destination for global capital, both as an attractive market as well as a low-cost production base for the global market. In terms of acquisition of technology and capital, China is in the process of “catching-up” with the west, like Japan and South Korea did in the 1970s and 1980s through export-oriented policies (Deloitte, 2005). While much of the investment in the infrastructure sectors of China has been in the state-owned enterprises, which are not too efficient, FDI that has been efficiently used are in the production of consumer products. In this paper, I will discuss the legal and political system and the business culture in China in the context of growing foreign direct investment and trading relations. Foreign Direct Investment in China China receives foreign direct investment (FDI) of about $75 billion annually, the largest in the Asia Pacific region (CIA). At the end of 2007, there were 5,000 multinational companies, from 172 countries in all parts of the world, operating in China. The same year, the country had a stock of FDI of an estimated $758.9 billion from almost nil in the late 1970s (CIA, IMF). By the 1990s, China became the largest recipient of FDI in the world, contributing 25-30 percent of the FDI directed towards all emerging economies. It must be acknowledged, though, that a part of the FDI in China represents return of disguised capital inflows from the Chinese that originate from China through Hing Kong and other south eastern countries because of tax, tariff and other issues (IMF, 2002). Some of the FDI is also really borrowings on account of infrastructure development. Even discounting these issues, though, there is a significant amount of FDI inflows into China as a result of entry of MNCs into the country since the 1990s. As much as 60 percent of total FDI inflows into China are directed towards the manufacturing sector, followed by real estate (24 percent) and distribution including transport, wholesale and trading (6 percent). Within manufacturing, half is in labor-intensive sectors like textiles and apparel, food processing and furniture. The rest of the FDI inflows are shared equally by technology-intensive sectors like pharmaceuticals, electrical machinery and equipment and electronics and capital-intensive like petroleum refining and chemicals (IMF, 2002). Most of the FDI inflows have been through subsidiaries of MNCs or through joint ventures between MNCs and Chinese companies. In the early years of liberalization, MNCs were allowed into China only through joint ventures but since 1986, MNCs are allowed to have wholly owned subsidiaries in China (IMF, 2002). Much of the FDI inflows into China are intra-regional, that is from Japan and south east Asian countries. Such trade has grown faster that global trade, from 35 percent in the 1980s to 55 percent in 2006 (Kawai, 2007). The share of east Asia in world trade increased from 25,2 percent in 1990 to 26 percent in 2006 and in FDI as percentage of global FDI flows, it increased from 18.9 percent to 33.7 percent. This shift is both a result of rapid economic growth in China and production chains and supply networks by MNCs for which production facilities in this region has assumed crucial importance. Most western MNCs have located sub-processes in the production chain in Asia to take advantage of cost differences and have re-integrated them with the primary chain. Hence, much of the east-west trade is on account of that between Asian affiliates of global MNCs to the host and other markets in parts, components, semi-finished and finished products. Trading System FDI inflows in China has been boosted by reduced tariff rates, which fell by over 50 percent in the 1980s, and was around an average 15 percent in the early 2000s, encouraging imports of intermediate products and raw materials for domestic production and for the export market. Such export-oriented trade policies transformed China and made it the most crucial economy in the Asia Pacific region, replacing the erstwhile “Asian Tigers” – South Korea, Thailand, Indonesia and Hong Kong – in terms of importance to the western world. China has attracted such huge FDI inflows because of the potential of the huge growing market as well as export-oriented production enabled by the large pool of low-cost skilled and semi-skilled workforce. Low wage costs in China have given it a distinct advantage over other countries in Asia Pacific. Besides, the improvements in infrastructure, particularly on the eastern coast, have made it an attractive destination for MNC production facilities. The development of Export Processing Zones (EPZs), which were provided with infrastructure at par with the western world and also fiscal incentives, has become the major recipient of FDI inflows. China’s accession to the World Trade Organization in 2001 was accompanied with a number of commitments with regard to market access to global capital, reduced tariff and non-tariff barriers, reducing geographical restrictions (for automobiles), increasing foreign ownership limits in telecommunication, life insurance, distribution and retailing and securities, and full entry to foreign banks (IMF, 2002). As a result of China’s accession to the WTO in 2001, the import tariff rates have gone down For example, tariffs on pharmaceutical products have been reduced to 4.2 percent (Price Waterhouse Coopers, 2006). Since 2004, MNCs are allowed to distribute their products across the entire geographical area. However, non-tariff and regulatory barriers exist as do corruption and problems with the distribution mechanism that is inevitably linked to the hospital network, which is largely state-controlled. Most MNCs distribute drug products through a dealer network comprised of an estimated 6,000-8,000 wholesalers. About 80 percent of the drugs are sold through hospitals and clinics while the rest is sold through pharmacies. Although some global pharmacy chains and medical equipment manufacturers are exploring ways to enter the market, this is still in a nascent stage. Hospitals and clinics, which purchase drugs through a bidding process, generally prefer locally produced drugs. Because of pervading corruption, MNCs have to cough up significant amounts of money bribing middlemen in the pharma distribution chain. The government is attempting to develop the retail pharmacy network in order to control over-prescription by hospitals and clinics as well as over-invoicing on drugs. Since the 1990s, China has become a major hub of the global automobile manufacturing industry, a position that was occupied by Japan in the 1970s and by South Korea in the 1980s. In 2004, China was the 4th largest automobile and auto component manufacturer in the world, after the United States, Germany and Japan. In 2006, China overtook Japan to become the third-largest car manufacturer in the world, and being the second in terms of market for US car manufacturers. By 2010, automobile manufacturing will contribute 5 percent of China’s gross domestic product (GDP) while auto and auto component exports will cross $50 billion, as stated in the Five Year Plan, 2005-10. Over 1994 to 2004, share of sales of vehicles in the Chinese market has risen from 2.5 percent to 8.1 percent (Ernst & Young). However, the penetration of automobiles is still meager, at 5.2 per 1,000 persons, so there is considerable scope for growth yet. Further, with increase in disposable incomes and fall in car prices as a result of lowering of tariffs on components since 2006 is further expected to boost car sales in China. Political and Legal System Despite the economic liberalization of China, the political system in China continues to be rigid. The law enforcement system is weak as is the enforcement of intellectual property rights and property rights. As much as 40 percent of economic activity is controlled by the state enterprises and the financial markets are weak. This is one reason why the Shanghai Stock Exchange declined over the years that the economy boomed. The state controls the direction of investments. Performance and productivity of organizations are affected by the level of control. Even private companies are affected by guanxi, or informal business relations (Hutton, 2007). The political system is omnipresent and is involved in all business relations. As President Hu Jintao says, the Party "takes a dominant role and coordinates all sectors. Party members and party organisations in government departments should be brought into full play so as to realise the party's leadership over state affairs" (quoted in Hutton, 2007) As a result of high concentration of power, the Party has also become embroiled in corruption. High level politicians have been arrested for fund embezzlements and accepting bribes for business deals. The commercial law system in China is increasingly being strengthened since the mid 1990s, incorporating European and Asian civil law elements in the socialist system. Over 1979 to 1983, 4,119 laws were promulgated, 37,775 laws over 1996 to 2000 and 94,288 over 2001 to 2004. In 1981, there were only 6,218 lawyers in China. By 2005, there were 114, 471 lawyers (Dickinson, 2007). However, many judges in China still do not have professional qualifications. The media is controlled by the state so it cannot fulfill its role as a watchdog (Hutton, 2007). Business Culture The term guanxi, though defined in general as social connections for the purpose of business, is a complex phenomenon. In Chinese, the word is a combination of two concepts – guan, which means a gate or a hurdle, and xi, which means relationship or connection. Thus, the word literally means to pass the gate in order to build connections. It originates from the Confucian culture, which is based on collectivism rather than individualism. The main relationships in the Confucian society are the emperor-subject, father-son, husband-wife and friend. In the Chinese society, hierarchies are very important such that the subject is always lower than the emperor or the government, the son is lower than the father and the wife is lower than the husband although friends are usually considered equal. The Confucian society, rather than relating individually to God as in the traditional western society, is related collectively to each other and the social hierarchies are critical for the power structure. The relationships are maintained in concentric circles, beginning with family at the core, extending to relatives and then to friends, with strong and intimate ties. In the closed communist regime prior to 1978, although it was not based on Confucianism, the autocratic rule was such that the local governments favored individuals and groups on the basis of guanxi. The term became all the more popular since the 1980s when foreign businesses began to enter the country in large numbers and faced the hurdle, that is the guan. More recently, scholars like Fan (2002) have identified more guanxi bases, like the family (kin and in-laws), relationship by nature (same town, classmate, etc.) or professional relationships (friends, acquaintances, colleagues) (Lee and Anderson, 2007). Scholars have variedly defined the term guanxi. Definitions range from “tight, close networks” to (Yeung and Tung, 1996, cited in Dunffe and Warren, 2001), “interpersonal connections (Xin and Pearce, 1996, Leung et al, 1996, cited in Duffe and Warren, 2001) or “gate or pass” (Yeung and Tung, 1996, cited in Dunffe and Warren, 2001). Bain (1994, cited in Dunffe and Warren 2001) proposed three alternative definitions for guanxi: “(a) the existence of a relationship between people who share a group status or are related to a common person, b) actual connections with and frequent contact between people and c) a contact person with little direct interaction”. The basic idea of guanxi, therefore, is building relationships for the purpose of gaining a favor. Such phenomena are prevalent in many societies – examples can be found in “blat, bakshish and relationship marketing” in the eastern societies or “networking, reciprocity and nepotism” in the western world (Dunffe and Warren, 2001). Guanxi is therefore the opposite of impartiality and objective merit according to western values. The building up of the guanxi begins from the “guangxi base”, which originates from being schoolmates, neighbors or past colleagues. Individuals within the group interacts, visit each others’ homes or office, exchange gifts, entertain, hire each other’s relatives in businesses and over time develop trust and credibility to demand obligations in return. Guanxi has traditionally prevalent in the Chinese society as part of the values as also to bypass the restrictions of the communist regime. For businesses, particularly those that do not have government tie-ups, guanxi functions as strategic ties. Private companies use guanxi effectively and multinational companies are increasingly using guanxi to enter into new businesses in China (Dunfee and Warren, 2001). Guanxi with government officials can be used to gain contracts, import and export licenses, get new customers and contracts while that with individuals in the private sector may be used to get customers and business relationships. However, with the increasing global integration and foreign investments into China, businesses are getting privatized and western business norms are beginning to alter the business environment in the country. The rule of the law is returning after the legal profession after banned in 1979 (Dunfee and Warren, 2001). This has resulted in a situation that is increasing seeing disagreements being settled through the court rather than through unofficial mediation through the guanxi. Increase in the importance of the legal system is expected to reduce the importance of guanxi (Guthrie, 1998 cited in Dunfee and Warren, 2001). On the other hand, other scholars like Garten (1998, cited in Dunfee and Warren, 2001) argues that “for decades to come, the structure of China’s government will be far less important to businesses than the officials who are in charge. More than any other large country, it will be a system not of laws and institutions but of people and relationships”. Lovett et al (1999 cited in Dunfee and Warren, 2001) even argue that guanxi will in fact increase in importance in international transactions, being more potent than legal contracts. Although little research has been made on Chinese entrepreneurship, guanxi is considered to be the key to business relations. The fundamental element of such relationships is trustworthiness on the basis of which all exchanges are made. Apart from this, reciprocal obligation is the other important element of guanxi. If a person gifts another or provides some sort of help, it is customary that he expects to be returned in reciprocation. Fulfilling one’s obligations (renqing) is essential not only in the Confucian system but also in the modern business structure although the western ethical culture may not be able to sufficiently appreciate this. The establishment of guanxi, that is a relationship, between two individuals or enterprises also mean that the reciprocal obligations are fulfilled. Guanxi is not a static relationship nor is its number limited but needs to be continuously developed to incorporate more members. Besides, one guanxi may lead to more relationships, quite like the in a internet-based social networking site but based on a far greater degree of trust and obligations (Lee and Anderson, 2007). In the initial years of liberalization, that is, through the decades of 1980s and 1990s, the Chinese private economy was unorganized and guanxi played a major role then. Most private business enterprises then did not have proven track record hence most of the licenses and contracts were awarded on the basis of guanxi that is through connections based on family, kinship and social acquaintances. However, the economy has now become more sophisticated, partly because of the prolonged interaction with western companies, and the importance of guanxi has greatly reduced (Yuxun, 2008). However, personal guanxi within organizations have remained, as has been seen on a study of employees from various industries in terms of leadership-employee relationships. Leader-employee relationships were found to be the basis of job assignments and promotions. Typically, foreign managers employ the local knowledge and the personal guanxi of employees in order to pursue business interests in China. This in turn result in some employees being favored over others depending on their guanxi strength (Chen and Tjosvold, 2007). Problems China’s fast growth in comparison to the global economy has created a disbalance in global financial flows. In particular, China has been facing a growing trade surplus vis-à-vis the United States, the largest economy in the world, as a result of massive exports of manufactured goods from China to the US. China has been supporting the US trade deficit through purchases of US Treasury Bonds. Hence, interest rates have remained low in the US for long, forcing investors to invest in markets like China. This has been aided by the low value of China’s currency, yen, that the government has maintained. As a result of increased money flows into China, liquidity remained high, pushing up inflation. This is particularly problematic for China since the fast economic growth has also been accompanied by growing economic inequalities. To tackle this overheating of the economy, the Chinese government has tightened credit flows by imposing curbs on the banking sector. Further, China’s financial sector is inefficient and banks lend large amount of credit on the basis of guanxi relations without taking into consideration economic implications. The government is trying to make the financial sector productive by making the legal framework stronger (economicshelp). Conclusion Thus, China has been growing fast on the basis of foreign direct investment and international trade. The economy has been in the process of liberalization over the last two decades. Yet, the state continues to wield considerable power in the business environment. Not only does the state determine the direction of investment, politicians influence business deals to the great extent although tariff and investment barriers have formally been lifted to encourage foreign investors. Informal business relations, or guanxi, forms the fundamental basis of business culture in China. Along with this, lack of law enforcement for property and intellectual property rights make it difficult for foreign companies to operate in China. 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