The Insightful Trader

Archive for January, 2011

China, Where Foreign Owned Companies Go to Die

by on Jan.20, 2011, under Editorials

Corporate America thinks that China is the future, the place to make a fortune. They are dead wrong. China strongly prefers that Chinese, not foreigners, make money in China. The country’s usual practice is to require foreign firms to transfer valuable technology to Chinese partners, and then make life difficult for the foreign firm if not take over its business.

While some high profile US companies like Apple (AAPL) and Coke (KO) do well in China, at least for now, they are exceptions. Most firms looking to produce in China should remember this: casinos need some lucky winners to lure in the suckers.

China rolled out its trade policy in the Nineties when it established a modern aviation industry at the expense of McDonnell Douglas (remember them?). It’s a story worth recalling because the McDonnell disaster – or smashing victory, from China’s viewpoint – has been the template for the China “trade” ever since.

The McDonnell Douglas Disaster

When the US and China renewed their contacts in the Seventies, China coveted a world class aircraft industry. China’s own aviation technology was horrendously backward then. They even made airplanes out of steel.

Under Deng and then Li Peng, the Chinese planned to catch up. They would play the Western firms off against each other and get them to hand over to China a century’s worth of aviation know-how for the chance – just the chance – to compete for the “limitless” Chinese market.

Neither Airbus nor Boeing caved, even though each was afraid that the other might give up enough to get an inside track in China. There was a third, weaker player, though, which would give the Chinese what they asked for in exchange for one last shot at corporate survival: McDonnell Douglas, whose storied history had included the world’s first real commercial airliner, the DC-3, and the F-15, which for decades helped assure America’s air superiority.

McDonnell had already fallen behind Boeing to a weak number two position in the US when McDonnell Douglas China began producing airliners in 1985. Through the Eighties and early Nineties China dangled the possibility of big sales that McDonnell could make to Chinese customers. The deal between McDonnell and its Chinese joint venture partner went through several iterations as negotiations continued.

In the end McDonnell Douglas China produced a total of 35 planes between 1985 and 1994. And China got what it wanted: McDonnell taught the Chinese to build advanced commercial airplanes. Considering the amount of sales McDonnell got out of the venture, that deal was an absolute steal for China.

China had no compunction about squeezing McDonnell ruthlessly for even stiffer terms, though. China demanded, and got, a $5 million side letter under which McDonnell exported to China in 1994 a number of machine tools that fell under the category of sensitive military technology. Under the export license granted by the Commerce and State Departments, the tools were to be used to make only civil aircraft at Shanghai, but, in an episode one might characterize as James Bond meets Keystone Kops, things turned out rather differently. (Then again, who were we kidding when we exported such things to anyone other than a longtime ally?)

The tools ended up in factories located 800 miles southwest of Shanghai. The tools were so large they would not fit through factory doors; buildings had to be built around them. Not the sort of item that is easily misplaced. The Chinese went to that trouble for a reason.

According to a federal indictment handed up in 1999, McDonnell knew that China National Aero Import Export Corporation (CATIC) would divert the machine tools purchased from McDonnell to plants producing advanced weapons such as Silkworm missiles. A CATIC division pleaded no contest to charges of violating US export laws in 2001.

After the 1994 machine tools purchase, McDonnell Douglas China sputtered; nothing came of the “firm” order for 20 more planes McDonnell announced at the 1995 Paris Air Show. The paltry sales from the joint venture proved far too few to make a difference to McDonnell. Boeing acquired McDonnell – or what was left of it — in 1996. Even then China had the gall to protest the merger, saying it didn’t want a Boeing-McDonnell combination that would “exert market power” over the aviation industry.

The McDonnell Treatment as Standard Chinese Policy

The Chinese have used similar tactics ever since McDonnell got sold; no need for them to change a winning game plan.  Some headlines from just the last three months:

  • Train Makers Rail Against China’s High Speed Designs WSJ, November 17.  A virtual rerun of the McDonnell saga. China “invites” Japanese and European companies, into its high speed rail market, apparently misappropriates their technology, then gives the big contracts to domestic manufacturers.
  • China Wins in Wind Power, By Its Own Rules NYT, December 14. Foreign wind power generation equipment makers with plants in China slowly getting squeezed out of the market after having given their know-how to Chinese companies.
  • Then there’s the White House Fact Sheet on Commercial Relations (h/t Taylor Marsh) prepared for Hu’s state visit. It is a list of deals that will supposedly make money for Americans in China. The great bulk of them are agreements to transfer US technology to China in exchange for sales in China. Our President naively or cynically trumpets these deals as accomplishments for the United States. Just how do we expect those to turn out?

Some readers have told me that foreign companies “should transfer technology to China as a condition of market access, otherwise it is neocolonialism.” On the other hand, China is now the world’s largest economy when measured by purchasing power parity. It is itself arguably a colonial power by virtue of its Southern Hemisphere mineral reserve purchases. And China aspires, not just to power, but pre-eminence as it angles for the yuan to get reserve currency status. Why should China still receive the coddling customarily given to weak developing countries?

The Lesson for Investors

For investors the lesson is simple. Companies that manufacture in China risk their intellectual property and even their whole business. While China looks like a wonderful customer on the surface, in reality the Chinese play a very long game and the short term profits China offers to foreign suppliers can come with nasty surprises on the tail end. The “market access” they offer in exchange for technology transfer can prove to be as elusive as that green light Gatsby could never reach.

The NYT article details just how much trouble wind energy equipment makers got into when they went to China because they “just had to be there.” No, they didn’t. As McDonnell and countless others have learned, it may well be that “there’s no there, there.” Except if you are Chinese.

Disclosure: Avoiding companies that manufacture in China in favor of natural resource companies that sell to China.

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