In our recent research, How does market entry mode affect the performance of FDI into China, we evaluated the chosen FDI market entry mode of US, UK and German multinational enterprises (MNEs) in China. Our research focused particularly on:

• establishing the reasons Western investors give for selecting the chosen market entry mode;
• evaluating their FDI in China and their chosen market entry mode; and
• analysing the relationship between market entry mode and performance by examining the return on investment (ROI) achieved by the foreign investors surveyed.

Opening up to FDI

Equity joint ventures were originally the only avenue open to foreign MNEs wishing to conduct FDI business in China. The introduction of the Act of Joint Venture Enterprises in 1979 reopened China to FDI. The Act stipulated that foreign firms take a minimum equity share of 25% in foreign-invested enterprises but did not prescribe a maximum (although, since by definition the Chinese partner has to own an equity stake, the theoretical limit must be 99%). Originally, foreign investment was limited to four special economic zones (SEZs): Shantou, Shenzhen, Xiamen and Zhuhai. A fifth SEZ, Hainan, was added in 1988.

A wholly foreign-owned enterprise (WFOE) is a foreign-owned Chinese company. It can be owned either by a foreign company or by foreign shareholders. Mainland Chinese nationals are not allowed to own shares in a WFOE, and the rules for establishing a WFOE state that one of the following conditions must be met:

• More than 50% of the value of products produced by the WFOE each year must be exported, and a foreign exchange balance or surplus must be achieved.
• The WFOE must develop new products, use advanced technology, save raw materials and energy, and replace existing products that can be a replacement for imports.1

It is very difficult to establish a WFOE for a service industry because the rules restrict this type of structure to the manufacturing, processing and assembly sectors. However, some free trade zones have taken a very liberalised attitude and permit the establishment of WFOEs for service industries.

Strategic market The strategic importance of the Chinese market is clearly on the radar screens of most MNEs. The demographics of China, coupled with its rapid industrialisation, have created a market potential so immense that most MNEs feel compelled to have a presence. The World Bank predicts that China will become the largest economy in the world if it continues with its current growth trajectory.2

Over the past decade, GDP growth in China has averaged more than 7%, far outstripping growth rates in developed nations.3 China already acts as an engine for global growth. According to a conference in 1998 sponsored by McKinsey & Company and the Canada-China Business Council, China was responsible for 46% of global GDP growth when GDP was calculated using purchasing power parity (PPP). Measuring GDP using PPP rather than exchange rates already firmly places China as the second biggest economy in the world.

Open door policy

Ever since China instigated its “open door” policy in 1979, the amount of FDI flowing into China has been increasing rapidly. In 1993, China became the second largest recipient of FDI in the world and has remained at number two ever since. Cumulative contractual FDI in China had reached $757bn by the end of February 2002. The number of investment ventures had grown to 393,900 and actual utilised investment stood at $401bn.

The continuing resilient nature of the Chinese market is evident from its ability to attract FDI in spite of unfavourable worldwide economic conditions – despite the collapse in 2001 of worldwide FDI flows from $1400bn to $700bn, China’s share increased by 15%4.

China’s entry into the WTO on December 11, 2001 should ensure it will continue to attract large amounts of FDI.

WTO rules stipulate barrier-free access to each member’s domestic market. China, along with most transitional economies, has grace periods for certain industries before barriers must be relaxed and finally eliminated.

Despite the massive potential of the Chinese market, there are a number of issues highlighted in academic and business studies which MNEs need to weigh up carefully before embarking on an FDI strategy. Many MNEs have suffered huge losses as a result of entering the Chinese market – Whirlpool is one often-cited example, where losses ran into many millions of dollars.

MNEs often fail to appreciate fully the complexities of the Chinese market. Many are unfamiliar with, or underestimate, the socio-cultural differences between Asian and Western societies. The FDI environment within China is often difficult to understand initially, and the fluid nature of FDI policies, together with bureaucratic infighting, make itdifficult to keep abreast of the changing priorities of the central government.

Missing markets

Some MNEs that have established themselves in China have discovered that the burgeoning consumer markets on which their investment assumptions were based have failed to materialise. The increase in retail sales has actually fallen from an average of 25% a year in the 1985-1995 time period to 7% in 1999, and this was from a small base to begin with.

While the increase in China’s GDP during the past decade has arguably been the highest in the world, the high growth figures achieved throughout the 1990s are misleading because GDP per head was only $330 in 1990. According to Chinese government figures for the end of 2002, GDP per capita had risen to $1,450.5

Car trouble

Certain industries seem to have been especially susceptible to over-estimation of potential market growth. The automobile industry is a prime example. In 1994, sales of domestically made cars in China were 250,000 units, yet MNEs were planning on building 2.7 million units of annual manufacturing capacity. Although the Chinese authorities ultimately issued licences to manufacture only 1.3 million vehicles, automobile overcapacity now stands at approximately 100%6. Even with annual GDP growth averaging more than 7% since 1994, the logic behind the projection by the government and some MNEs of a domestic market for one to three million vehicles a year by 2000 seems highly questionable.

Another consequence of the euphoria surrounding the Chinese market can be seen in the ‘herd mentality’ of many MNEs and the corresponding hyper-competitive market conditions that now afflict many industries. For example, Whirlpool’s losses totalled in the hundreds of million dollars after a disastrous investment in the white goods sector. The massive over-investments in this sector by many MNEs have resulted in utilisation rates for refrigerators and washing machines of only 50.4% and 43.3% respectively.

Previous research has shown that cumulative FDI relative to cumulative domestic investment has a negative impact on new FDI. The logical conclusion that can be drawn from this research suggests that MNEs should invest in provinces with fewer FDI competitors or in industries with fewer competitors.

A further symptom of the hyper-competitive environment is the lack of profitability of most FDI projects. Although data on the ROI of FDI projects is scarce, that which is available makes sobering reading for the head of any MNE. For example, a survey carried out by the Financial Times (October 2, 1998) found that more than half of MNEs fail to make a profit on FDI projects in China. A similar survey carried out by management consultants AT Kearney showed that only 38% of all MNE manufacturers in China were covering their operating expenses.

MNEs entering the Chinese market also face the decision as to which entry mode to utilise. The entry mode chosen is a critical determinant for achieving overall success. Firm-specific consideration and the motivation behind FDI will also heavily influence this decision.

Another important consideration that might influence entry mode decisions in provinces that have already attracted large amounts of foreign MNE investments is first mover advantage. Research on profitability of Japanese FDI in China showed that first mover advantage was very important and allowed companies to instigate barriers to entry. The projected length of time of an investment might also influence entry mode decisions.

One of the major problems in investing in China is the lack of exit strategies. Investment regulations in China favour long-term investors and permit only limited avenues for disposal of investments for cash returns.

Questions raised

Figures compiled from secondary data showed that FDI flows into China continues to increase and set a record of $52.7bn in 2002. A 57% increase in the first quarter of 2003 saw China surpassing the US as the world’s largest recipient of FDI (Merrill Lynch 2003).

However, the literature also highlighted some discontent among economists regarding the accuracy of official Chinese FDI figures. For example, Guy Pfeffermann, an economist at the International Finance Corporation (a World Bank affiliate), gave a presentation in mid-2002 in which he said China’s net FDI inflows would be around $20bn instead of the official $40bn for 1999 and 2000 if round-tripping of capital was taken into consideration.7

Economists in Singapore’s ministry of trade & industry commented: “FDI flows to China are not as large as official figures show because a significant percentage of it – 25% or higher – consists of round-tripping of funds that originate from mainland commercial entities.”

The data from the questionnaire raised some paradoxical results. The most intriguing and, arguably most important one for MNEs entering China for the first time, was that 70% of new FDI takes the form of WFOEs even though the superior profitability of EJVs compared with other types of entry mode has been observed by different empirical studies. The data from the questionnaire and previous studies provided some explanations for this seemingly counter-intuitive observation.

The reasons cited by foreign investors for choosing their entry mode were multifaceted. One of the reasons included regulatory restrictions that dictated the mode employed. However, other questions that aimed to establish the logic behind entry mode decisions produced both consistent and inconsistent comparisons with reasons provided by FDI entry mode theories.

For example, answers provide by companies that dealt with opportunities being closed to them because of their foreign status showed that MNEs that had entered China using a WFOE were far more optimistic than MNEs utilising other types of entry modes. This is consistent with the generally higher levels of optimism shown by WFOEs.

However, the natural advantages cited in the literature (for example, local contacts and access) that EJVs – and, to a lesser extent, EJVs and WFOE combinations – should have over purely WFOE entities is mostly absent from the results.

The questions that dealt with foreign MNEs evaluating their performance and foreign entry mode produced some contradictory results.

The data from the questionnaire showed that, on average, EJVs had a 2% higher ROI target goal than WFOEs and 4.4% higher than companies utilising both WFOEs and EJVs. EJVs also expected to achieve their stated ROI goal a year quicker than either WFOEs or MNEs utilising both WFOEs and EJVs.

Over-optimism

However, the data from the questionnaire also showed that EJVs’ time expectations for reaching their ROI goals are over-optimistic. A cross tabulation of the data shows that it took on average 3.6 years for EJVs to achieve a positive ROI, which is exactly the same length of time reported by WFOEs. MNEs using both WFOEs and EJVs were able to achieve a positive ROI a year earlier than companies using other forms of entry mode.

The results from the analysis also showed that 40% of EJVs and 11% of MNEs using both WFOEs and EJVs said in retrospect that they would have used a different entry mode. This compared with no WFOE companies saying that they would have used a different entry mode.

The intriguing point raised here is that 50% of EJVs and of companies using both WFOEs and EJVs had achieved their stated ROI goals.

The findings from this study are consistent with earlier research that noted the relationship between entry mode and performance, and the advantages of being first mover. EJVs were shown to enjoy a higher overall rate for achieving both a positive ROI and for reaching their stated ROI goals. Since EJVs were the first available legal structure for foreign MNEs entering China, coupled with the advantages previously mentioned concerning being an early mover, it is not surprising that, on average, EJVs are more likely to have achieved profitability and have a higher ROA than WFOEs.

Pros and cons

This report evaluated the entry modes chosen by MNEs entering China using both quantitative and qualitative data, which provided respondents with opportunities to voice ‘real world’ scenarios encountered by them. The data showed that there are advantages and disadvantages with each type of entry mode chosen. EJVs have historically produced the best rates of profitability, and are more likely to lead to achieving overall ROI goals compared to other forms of entry.

However, there is a very strong relationship between length of time that an MNE has been operating in China and the likelihood of profitability. MNEs entering China for the first time should be aware that the market conditions that were prevalent when EJVs first entered are very different now and entry mode decisions should, therefore, not be based on the past performance of EJVs. This is especially relevant if EJVs are currently in a transitional state because of the peculiarities of the Chinese market.

The difficulties of managing relationships with Chinese partners are clearly evident from the literature and from the experiences of the respondents. The fact that 70% of all new FDI into China takes the form of WFOEs indicates either that there are perceived problems with EJVs by new MNEs entering China, or that the operational advantages of WFOEs cited in the literature and questionnaire outweigh any advantages that EJVs may possess.

The large percentage of companies opting to use WFOEs is not the result of FDI through merger and acquisition activities. The implications of China’s entry into the WTO are going to create valuable opportunities for foreign MNEs. The data from the questionnaire showed that market orientation was a key determinant of profitability. MNEs with operations aimed at the domestic market were much more likely to achieve their ROI goals than those aimed primarily at the export market.

The removal of the remaining restrictions on establishing WFOEs within the service sector will potentially open up the massive Chinese market to foreign MNEs. However, MNEs should be aware of the problems with distribution networks, which effectively stop a pan-country strategy that works in other countries.

All strategic decisions need careful evaluation. FDI is no exception. There is ‘no one size fits all’ solution on the type of entry mode. Despite the negative publicity that managing cross-cultural relationships often receives, there are obviously a lot of joint ventures that work well. The issues raised in this report highlight most of the important considerations for choosing an entry mode strategy. The ultimate decision on entry mode should probably be based on whatever mode best aligns itself to the overall corporate strategy.

Martin Scullion is a recent MBA graduate and Lorraine Watkins-Mathys is head of school business strategy & operation, at the UK’s Kingston Business School

email:

martin_scullion@hotmail.com;

l.watkins@kingston.ac.uk

Notes

The findings were based on primary data that was collected using a questionnaire from 40 German, UK and US MNEs with a combined total of 122 equity joint ventures (EJVs) and wholly foreign-owned enterprises (WFOE) investment projects in China, which range in size from Fortune 500 companies to enterprises with less than $100m in turnover.

1 Source: Dezan Shira & Associates www.china-briefing.com

2 See www.worldbank.org

3 China National Bureau of Statistics

4 China Dream, Far Eastern Economic Review

5 Source: CFA magazine July/August 2003

6 Studwell, 2002

7 China’s FDI merry-go-round, fDi, April 2003