August 23 2002

China's entry into the World Trade Organisation last December has inspired a new wave of foreign multinationals to enter the China market. But how many of them really know what they're getting into?

The recent travails of Pepsi in Sichuan province are a sobering reminder that WTO membership is no substitute for the rule of law.

A few years after every China investment boom, a fresh batch of horror stories inevitably emerges. One common tale goes something like this. A Western company sets up a joint-venture factory to manufacture its product for the domestic market. All goes well until it notices its local partner has stolen its technology and set up an identical factory next door.

The multinational not only finds that its brand has been compromised by cheap, counterfeit products flooding from next door. When troubleshooters fly down from Beijing, they find that the venture's bank account has been cleaned out, and the local workers turned against them. Legal recourse is impossible because the renegade partner is best friends with the mayor, police chief and district court judge. Bigger companies faced with this situation seek heavy-duty help from their embassy. Smaller ones usually walk away from their losses.

Pepsi's China story is a classic of the genre. It has invested $US500 million ($A918 million) in the country over the past 20 years, and has yet to make a profit. The company says it hopes to break even in the next few years. Elsewhere that would be called madness, but in China it's known as "long-term investing".

Pepsi set up its Sichuan joint venture back in 1994, in the days when the government provided joint-venture partners for big projects. That's how it teamed up with a most unlikely soft drinks partner - the local bureau of the State Administration of Film, Radio and Television, the ministry that regulates China's media.

Now Pepsi alleges that the venture's chairman, Hu Fengxian, expensed luxury cars and European vacations without its approval. It also suspects that funds were skimmed off by inflating the costs of marketing campaigns. Mr Hu denies the accusations. But the dispute has become so bitter that local company employees threatened Pepsi officials trying to visit the plant and inspect its financial records.

Because China's courts are often corrupt, most Western companies insist that their contracts with Chinese partners and clients include a provision for international arbitration. Pepsi is no exception, and it has now taken the Sichuan case to a panel in Stockholm. But even if the arbitrators favour the American company, it will still have to go to the local courts to get the judgment enforced. And even if that happens, Mr Hu may not comply, in which case Pepsi will be at the mercy of another Chinese judge.

Some multinationals entering China are now trying to avoid the pitfalls of dishonest joint-venture partners by setting up wholly owned foreign enterprises, known as "woofies". But getting land for a factory is difficult without a local partner. Government bureaus that provide essential inputs often try to gouge a newcomer. Smaller and less China-savvy multinationals may still find it easier to look for a local partner.

Much has been made about the importance of "guanxi", or connections, to get around the lawlessness of China. But a special kind of guanxi is needed to find a partner that is going to play it straight. One consultant who specialises in this field once told us that the only reliable method is to start with someone you know is honest, and ask if he would vouch for the honesty of a potential partner. It's not fool-proof, but in an environment where the default is to mistrust everybody, it's the only way to find somebody to trust.

After its dispute in Sichuan is resolved, Pepsi hopes to find a new partnership based on "observing law and order, mutual trust and transparent decision making". But two decades of experience in China should have taught Pepsi that such partners are thin on the ground. China's courts often protect rather than punish fraudsters. Without a thorough reform of the judiciary, we expect that in three or four years' time there will be stories of multinationals who piled into China in 2002, having their hopes dashed by a marketplace in which the most basic rules needed to conduct business are only sporadically enforced.

- Dow Jones