China is the agenda item no board can ignore. Whether your business is looking to cut costs or find a new market, it’s all to play for in this country of opportunity.

1 “We will slash our costs immediately by shifting manufacturing to China.”

China’s factories produce 25 per cent of the world’s washing machines, 50 per cent of the world’s cameras and 90 per cent of the world’s toys. This didn’t happen by accident. With factory wages one-tenth of those in the UK – minimum Guangdong province wages range from £30 to £50 a month – Chinese manufacturing can make pretty good sense.

But Chinese labour costs are rising, particularly in the manufacturing heartland of the Pearl River Delta. Shortages of experienced/managerial talent, and a change in sentiment that’s made Chinese graduates favour local companies rather than foreign firms, are causing salaries to rise. In September, Guangdong raised its minimum wage by 17.8 per cent. The Economist Intelligence Unit predicts ten per cent increases annually until 2010 and a 13.5 per cent hike in 2006 alone.

For UK firms, the key calculation is labour costs as a proportion of the overall cost of manufacturing. “For us,” says Paul Broadhurst, CEO at broadband and telecommunications company Technetix, “China was not so much about the savings in cost, it’s the flexibility to ramp up and down quickly.”

Another calculation is the strategic upside for your business. Margate-based Hornby outsourced production of its model trains to China in the late 1990s. Reduced manufacturing costs boosted margins and enabled the firm to add new features and increase quality. FD John Stansfield says: “We went from making a new loco every three years to annually; now we have three or four a year.”

Speak to anyone with experience of Chinese manufacturing, and they’ll stress vigilance over product quality. Stansfield says: “We don’t just send a purchase order and say, ‘could we have that in six months’ time?’ We have four Chinese people on our payroll in the factory in China who inspect the product on a perpetual basis. You don’t want to find out your product is faulty when it arrives in the UK and you’ve got a container load of it.”

2 “It’s a huge market of 1.3 billion consumers that we could be selling to.”

First, it’s not 1.3 billion. Privately, senior Chinese officials will tell you that the real population figure is closer to 1.5 billion. That said, the number of Chinese people with real disposable incomes is probably closer to 200 million. This figure is rising rapidly, driven by migration from rural areas into the cities. This, in turn, is creating huge demand for products and services, fuelling the opportunity for Western firms.

On discovering that Chinese firms preferred cheaper local versions to its top-end software, anti-virus software firm Sophos focused on multinationals operating in China. “You always know there’s gold there but sometimes you just don’t get it the first time you go,” says CEO Steve Munford.

Consulting engineer Arup is one of the UK’s most successful businesses in China. “If we were a publicly owned company, we might not still be there now,” says its chairman of global consulting John Miles. “For a long time, China didn’t wash its face. We chose to continue because it seemed inevitable that sooner or later there would be work for a firm such as ours. As a result, business has come in, including the incredible eco-city project, Dongtan, on an island off Shanghai.”

3 “We won’t get paid and we’ll be exposed to the local currency.”

China’s creaky financial system is a worry for many firms, though much has improved since China joined the World Trade Organization (WTO) in 2001. For a first-time exporter to China, the standard payment method is a documentary letter of credit. It provides security to the exporter and the importer, but this must be weighed against the costs of bank charges. Letters of credit opened by Chinese banks are readily accepted by foreign banks.

The Great Britain China Centre says that it pays to get the paperwork right as half of letters of credit are rejected on first presentation, resulting in expensive delays. Once a relationship develops, open account and bills for collection are other methods used. “The way we’ve dealt with it is to get people onto normal commercial terms, deal with payments as if they are any other supplier,” says Bryan Levine, CFO at Technetix. “In some ways, it’s easier to do business with Chinese companies than historic European companies. If you ask for something, you get it.”

Many Chinese manufacturers prefer to deal in US dollars, especially if they have experience of doing business with the US; few can quote prices in sterling. Most restrictions on repatriation of profits by foreign firms have been lifted and, if a foreign company complies with the Chinese tax authorities and has completed all the reporting obligations required by the State Administration of Foreign Exchange, it should be able to repatriate its profit smoothly. “At the same time, the Chinese government does provide incentives to encourage foreign investors to keep their profits in China. A foreign company would enjoy a 40 per cent tax refund from reinvestment of its profits,” says Jeff Jiang of US consulting firm Lurie Besikof Lapidus.

Hedging can be expensive and most of the firms interviewed by Real FD preferred to live with the currency risk. But most small and medium-sized enterprises with business in China are looking to protect themselves against moves in the sterling/dollar exchange rate through forwards and options. Paul Graydon of HSBC in London says his team has received a steep increase in firms wanting to hedge their China-related dollar exposure. “The type of approach you should use depends on timescale and cash flows. Once your foreign exchange exposure reaches about 25 per cent of turnover, it’s beginning to get significant,” says Graydon.

Hornby’s response to volatile exchange rates is to buy currency forward, six to 12 months. “We’re not trying to speculate on currency but it gives us some view to average rates. When we began, the pound was at $1.40 to $1.50 and today it’s $1.90 so that’s had a significant impact on making it much cheaper out there. The dollar has weakened much faster than labour rates have gone up – that’s for certain.”

4 “Our intellectual property rights will be flagrantly abused.”

Visit China and you’ll immediately notice the hawkers selling fake Louis Vuitton handbags and pirated software and DVDs on the street corners. Go to any China conference and a question will be posed about IP protection. “You have to accept that stuff will get copied overnight and you will have next to no redress,” says Simon Tucker, FD at Software Radio Technology, an AIM-listed technology design and licensing firm.

A recent Hong Kong poll showed that 87 per cent of its population understand the term “intellectual property”; on the mainland, familiarity is almost zero. “Nowhere in the traditional Chinese consciousness will you find mention of patents, copyrights and the like,” says Stephen Selby, director of IP for the Hong Kong government.

But with Chinese entrepreneurs complaining that local innovation is at a standstill, pressure is building on the authorities to clamp down on IP abuse. China’s entry to the WTO marked a turning point in IP protection. The country’s IP laws now largely fall in line with the body’s agreement on Trade-Related Aspects of Intellectual Property Rights. Luke Minford, head of China at law firm Rouse & Co International, says there is more patent litigation in China than any another country – and most foreign firms win their cases, according to the Intellectual Property Institute.

Technetix has dealt with half a dozen cases of IP rights infringement. In each case it has brought legal proceedings against the Europe-based importer of the Chinese-made fake component, rather than entangle itself with the country’s court system. “Don’t put undue financial pressure on your factory because it comes back to you,” says Levine. “Make sure there’s enough profit for them to operate in. You might get some better margin if you go spot buying, but it’s not very easy to get loyalty.”

Software Radio Technology’s products are a likely target for IP abuse. Its solution is to license the designs to five Chinese manufacturers and Software Radio Technology is then paid a royalty for every unit sold. “We’re basically giving our technology to customers in deepest, darkest China. What makes it work is that one component can be obtained only from us and we’ve made those unique and particularly complex.”

5 “We don’t stand a chance – China’s business culture is utterly alien.”

John Tischuk runs a small Aberdeen-based business, Tischuk International, providing risk solutions to oil plants, predominantly in the North Sea. In 2005, the firm announced that it had won a significant contract with the state-owned Chinese oil company, Sinopec. The deal, providing “risk integrity solutions” to the company, which has one million employees, is worth about £3m initially to Tischuk, potentially growing to much more.

The original email enquiry led to three years of discussions and negotiations – interspersed with months of agonising silence from his Chinese client. The final contract sat for one year in the in-tray of the individual responsible for signing it off. “Oil businesses are bureaucratic,” smiles Tischuk. “But Chinese, state-owned oil businesses take it to a new level.”

He describes his negotiating partner as a “prisoner of bureaucracy”, with the authority to sign off only a certain level of deal. Indeed, for Chinese negotiators, the process can be as important as the result. “I’d advise anyone doing business with China to take lessons in Chinese culture and the Confucian way,” says Tischuk. Saving face and patience are crucial aspects of business. “If, like us, you’re used to dealing with people who have the authority to make decisions, it’s extremely challenging.”

David Eldon, former HSBC chairman for China, sums up the power of relationships: “Building and maintaining the right connections is crucial – and challenging – for all companies doing business in China. Your relationships will need to extend to all levels of government and, depending on your line of business, through several layers of regulators as well. That said, the influence – and, thus, the potential for corruption – of individual officials is being reduced.”

China veteran Tucker took 12 months to sign Software Radio Technology’s first deal in China. “When it comes to negotiating tactics, the Chinese are masters. They will negotiate with you for a week and then, just as you have a deal and are about to fly home, they want to make changes. I went there thinking I would be there for a week, but I came back six weeks later.”

Stansfield at Hornby says: “We have four suppliers in China. People always say, ‘what kind of contract have you got?’ Well, in all honesty, we don’t have a contract. The Chinese attitude is that a lot is done on trust and a handshake. If you ask them to prove they are going to do it by putting it on a piece of paper, that’s
an insult.”

Finally, speak the language or find a trustworthy local representative who can. Philip Sturrock, chairman of London-based Continuum International Publishing, has partnerships with two Chinese publishers, which translate and distribute some of the firm’s academic titles. “You need good advice on language. A total non-Chinese speaker such as myself signing a Chinese document, I could have been signing my life away,” he says.

Katie Hunt is a former Reuters foreign exchange correspondent and a Mandarin Chinese speaker.

Matthew Rock is group editor of Caspian Publishing. He first visited China in 1982.

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