Joanna Doolan: Getting to grips with the dragon

China's Commerce Minister , Bo Xilai, and former Trade Minister Jim Sutton. Picture / Paul Estcourt

On the surface, the figures behind the state of Chinese-New Zealand trade make for auspicious reading and would tempt many to put up their shingle in China.

China is the world's fastest-growing economy, moving forward by 9.5 per cent a year. The country is also New Zealand's fourth-largest trading partner taking more than $1.6 billion of our merchandise exports and more than $1 billion of services.

The rising level of affluence, and an emerging middle class reckoned to be 100 million people and climbing, bodes well for demand for a range of "value-added" New Zealand products.

Economic forecasting suggests that as a result of a free-trade agreement with China, New Zealand exports are expected to be between 20 per cent and 39 per cent higher.

Based on this, any move that achieves preferential access for New Zealand companies must have considerable merit.

Yet it is only a little over a century ago that Rudyard Kipling passed judgment on the chasm that exists between countries of the West and those of the East. For those who don't remember his warning, "the twain will never meet".

Despite this prophecy there is evidence that some overseas business people are proving the poet wrong.

For example, venture capital investment in China has increased sharply over the past several years as existing foreign and local venture capitalists pick up the pace of investment.

In our efforts to become the first developed country to conclude a free- trade agreement with China, the recommendation is to make haste, but slowly, cautiously and responsibly.

While the potential rewards are alluring, the downside risks and scale for disaster are, like the country itself, rather large.

Based on Ernst & Young's international dealings with companies looking to enter the Chinese market, there some definite issues, challenges, and questions that will need to be faced.

Superficially sophisticated but still a touch of the Wild, Wild East

Looking at cities such as Shanghai that are burgeoning and prospering as part of China's economic insurgence, it's easy to forget that economically the country is still a tad on the wild side.

China operated under a "planned" economy for almost 40 years before it allowed market mechanisms (it is still illegal to use the world "capitalist") to burst forth in recent years.

Parallel to this, you have what was not so long ago considered an emerging economy to one now that is highly industrialised.

Consequently, many of their state-owned enterprises and companies that you might want to deal with or invest in are still operating in a hybrid business environment and system very different from what might be expected.

Needless to say, their "rules" provide potential pitfalls that need to be watched.

For example, land is owned not by individuals or companies but by the state. This may not apply so much to exporters but questions related to the transferability of land-use rights often arise during a due diligence process. Often this is the point where new ventures can come unstuck.

The state may require payments for land use before allowing any transaction to close, or changes in land rights may mean the land rights are put up for public tender.

A lack of good tax compliance is another common issue that might be faced. Many companies maintain what to us would seem as inappropriate books in order to defer, or avoid, tax. This is particularly true with "value added tax" which is China's largest form of revenue generation.

Remember also that "communal" consciousness is still very much part of the Chinese mindset.

Built around most SOEs are associated housing, hospitals, schools, restaurants and even roads - all of which are on their books.

While a particular SOE might be the desired target for an investment, acquisition or joint venture, responsibility for keeping this overall infrastructure operating may also be part of the deal.Open for ways to help close a deal: Deal-making and breaking processes and pitfalls happen in any situation and any culture. In China, however, these opportunities or impediments have a flavour of their own. Some to watch out for include:

Seek sage advice: Engage experts sooner rather than later - particularly early on in the piece and certainly before engaging in Letters of Intent. Independent parties with expertise can help to maintain momentum and achieve the result you want.

Lost in translation: Some say a little language goes a long way but it can also be a dangerous deal-breaker. Our common notion of "due diligence" translates into Chinese as "investigation" which, out of context, can take on rather sinister meanings.

Best speak in terms of "initial data-gathering to facilitate dealings" rather than the more common parlance of Western negotiation.

Similar words, different concepts: Regardless of what you call the process, the differences between Western "due diligence" and the Chinese equivalent are evidence of where the twain do not meet.

For example, because of our laws, the level of transparency in financial information is high whereas in China it is low.

Similarly, audited financial statements in New Zealand are done by usually reputable standards but similarly signed-off information in China may not be as strict.

Equally, legal enforceability in New Zealand is strong and backed by legislation whereas in China this is largely untested territory.

Know about "no": In the business milieu, and true to Eastern ways, Chinese people are not as direct as we might expect or like. Consequently, it's rare to hear the word "no" even though what they're saying is anything but "yes". To avoid being led down an unexpected path of optimistic assumption make sure you document agreements, action dates, and other important indicators of a deal taking place or progressing.

The long march: If you reach the point where you're losing sight of the business rationale for a possible deal, and want closure regardless of the consequences because you sense impatience from people in your company at the time being spent, chances are the result won't have much appeal.

Too often closing a deal in China becomes the goal in itself. The key is to have patience, manage internal expectations, and not over-commit to the benefits of a deal without fully considering the shortfalls, risks or problems. It may well have been Confucius who said: "Haste makes waste".

Go the distance: Diligence and patience are the keys to any deal-making but more so in China. Only 20 per cent to 30 per cent of Letters of Intent ultimately close there for three main reasons, namely:

* Quality of earning issues.

* Lack of transparency in the due diligence process.

* Timeline from the initial letters to closing that can stretch anywhere from six months to 18 months.


Possible models for putting together a deal

For investors, or those wanting to set up shop in China, there are a number of tried and true structures that seem to work.

Formal alliances or joint funds: Some success has come from such approaches where foreign funds and China-based funds are jointly invested in deals.

Joint co-operation: These are not formal alliances, but are situations where there is a teaming up on deal opportunities, assistance in local networks, and potentially joint investments with local funds.

Affiliate funds: These are established China-focused affiliate funds sourced from a particular home country for use in a related sector (for instance dairying or information technology).

Frequent flyers:In the early stages, making sorties into China from home base seems to be the norm.

Remember the old saying that a journey of 1000 miles begins with one step.

Take advice from people who know what they're doing, be patient, firm and realistic, and be ready to walk away if the deal turns to custard.

* Joanna Doolan is a tax director with Ernst & Young.