Special Report China - Part of Your 2007 Strategic Plan

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					S P E C I A L         R E P O R T                                 Second Quarter 2006

Part of Your 2007 Strategic Plan?
China is presenting new opportunities as well as risks.
U.S. companies need to be strategically positioned to succeed.
China is quickly emerging as a global economic powerhouse. As a result, it is likely to
become the world’s fourth largest economy by 2010, according to the Organisation for
Economic Co-operation and Development. Its economy could exceed the United States’
by 2039, a Goldman Sachs report says. U.S. companies strategically positioned stand to
benefit significantly. Those unprepared, however, will enter a more competitive business
environment filled with considerable risk.

A number of factors are responsible for driving Chinese growth. However, its manufactur-
ing sector is believed to be the overwhelming force behind the country’s economic
strength. In turn, China is becoming the world’s largest manufacturer for an increasing
number of products. In order to take advantage of this, U.S. producers are teaming up
with Chinese manufacturers to create more attractive goods for global consumption.

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The tremendous growth of the Chinese manufacturing sector, as well as the Chinese
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economy as a whole, is nothing new. China’s gross domestic product (GDP) growth has

been among the highest in the world, hovering around 10% annually in recent years. Much
of this growth has been achieved as a result of China's recent adoption of market reforms.   Treasury Spotlight

In December 2001, after 15 years of negotiations, China became the 143rd member of the
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World Trade Organization (WTO). As part of its accession agreement, China committed to
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                                 a fairly extensive trade liberalization and reform schedule. Since then, it has significantly
                                 opened its markets, slashed import tariffs, eliminated import licenses and quotas, and
                                 relaxed ownership restrictions.

More than half of Chinese        The result: From 2000 through 2005, U.S. exports to China rose nearly 160%, while U.S.
                                 exports to the rest of the world rose by just over 15%, according to the U.S. Census
                                 Bureau. This has benefited many American companies, including producers of machinery,
                                 aircraft, software, agrochemicals and integrated circuits, as well as telecommunications,
                                 optical, photographic and medical equipment. Although many of China’s WTO commit-
firms are expected to increase
                                 ments have been met, many have not. This, in addition to other factors, especially the
                                 enormous trade deficit with China, is causing anxiety in many boardrooms as well as in
spending on information

                                 The Benefits
technology in 2006.              The U.S.-China Business Council has identified a variety of U.S. benefits resulting from
                                 trade with China. It concludes, for example, that from 2001 through 2010, U.S.-China
                                 trade and investment will effectively boost U.S. GDP growth 0.7%, while pushing U.S.
                                 prices down 0.8%. Together, the study says this equates to an annual increase in real U.S.
                                 household disposable income of $1,000.

                                                      Chinese imports offer American consumers greater choices, a wider
                                                      range of quality and access to lower-cost goods and services. Since
                                                      they allow the American family to purchase more goods for less
                                                      money—stretching the dollar—more disposable income is available
                                                      for education, health care, mortgages, vacations, etc. Imports also
                                                      help keep inflation down, which is one of the most important factors in
                                                      raising the standard of living. Importantly, through the availability of
                                                      lower-cost imported components and materials, U.S. producers are
                                                      more globally competitive.

                                                      U.S. imports, however, also cause U.S. job dislocations. How many?
                                                      According to the Progressive Policy Institute, a Washington, DC-
                                                      based think tank, total U.S. imports account for as many as 5% of lay-
                                                      offs, and more likely between 2% and 3%.

                                                      Small companies also benefit from U.S.-China trade and investment.
                                                      In fact, the latest available data shows 89% of all U.S. exporters to
                                                      China in 2003 were small and medium sized companies. This is up
                                                      from 77% in 2002, according to the U.S. Department of Commerce.
                                                      Nearly half of these exporting firms had fewer than 20 employees.

                                                      What sectors hold promise? According to Forrester Research, an
                                                      independent technology and market research firm, more than half of
                                                      Chinese firms are expected to increase spending on information tech-
                                                      nology in 2006. A survey of Chinese companies indicates they are
                                 focusing on IT investments in new server hardware, infrastructure hardware, business
                                 applications and systems integration services.

                                 Some of the largest opportunities for both U.S. exporters and investors, according to the
                                 U.S. Department of Commerce, are in agrochemicals, air traffic management services and
                                 equipment, coal mining equipment, banking technology, education and training, and fran-
                                 chising, as well as goods and services for safety and security, automotive components,
                                 construction equipment and credit card markets.

                                 The Numbers
                                 Chinese world trade has increased rapidly. From just 2000 through 2004, Chinese world
                                 exports rose almost 140%—from $249 billion to $593 billion, according to the WTO. On
                                 the other hand, China’s world imports increased almost 150%, jumping from $225 billion to
                                 $561 billion. Due to its thirst for imports, China has become one of the world’s primary

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locomotives of economic growth, helping to pull many countries out of recession. In turn,
China became the world’s third largest importer and exporter of merchandise trade in
2004, selling and buying $28 billion and $106 billion more, respectively, than Japan.

U.S.-China trade also has risen significantly, making China the United States’ second            An increasing amount of
largest trading partner in 2005. Although U.S. exports to China reached $41.8 billion last
year, they were overshadowed by $243.5 billion in Chinese imports (Customs basis),
resulting in a U.S. trade deficit of $201.6 billion. Interestingly, as U.S. imports from China
continue to rise, U.S. imports from the rest of Asia have flattened. This reflects a new trad-
                                                                                                 investment is going into
ing pattern that puts China at the center of an emerging Asian trade bloc.

China’s world trade in service also is quickly growing. According to the WTO, China’s
                                                                                                 higher value-added sectors,
world service exports and imports reached $62 billion and $72 billion, respectively, in
2004. In contrast, U.S. Census Bureau data indicates U.S. world service exports and
imports were $344 billion and $296 billion that year, and jumped to $379 billion and $322        as well as research and
billion in 2005.

Investment Goes High Tech
After three years of decline, world foreign direct investment (FDI) flows slightly rose in
2004 to reach $648 billion, according to the United Nations (UN). But
while inflows into developing countries jumped a whopping 40%,
inflows into developed countries dropped 14%. China, the largest
developing country recipient, received $60.6 billion. Overall, China
placed third after the United States and United Kingdom.

The majority of China’s inbound FDI originated in neighboring coun-
tries, including Hong Kong, South Korea, Japan and Taiwan.
According to the U.S. Bureau of Economic Analysis, U.S. FDI directed
to China exceeded $4 billion.

The largest portion of Chinese bound FDI is directed into its manufac-
turing sector. In order to secure a position in China’s rapidly expand-
ing domestic supply chain, a growing number of foreign component
suppliers are establishing facilities there. In turn, this is contributing to
China’s supply chain effectiveness—another important factor influenc-
ing manufacturing FDI decisions.

Surprising to many, an increasing amount of investment is going into
higher value-added sectors, as well as research and development
(R&D). This is a departure from the past.

Traditionally, transnational corporations typically invested their R&D in
home country facilities. In recent years, however, they have been
establishing R&D facilities in developing countries—and not for the
exclusive purpose of serving host country markets.

For example, in 1993, Motorola established the first foreign-owned R&D facility in China,
according to the UN. Since then, the number of foreign R&D units in China has climbed to
approximately 700.

American companies are not alone in their efforts to establish R&D units in developing
countries. According to a UN investment survey, 90% of Japanese and 61% of European
companies plan to increase investment in foreign R&D. For the period of 2005 through
2009, China is identified as the most popular R&D destination, followed by the United
States, India, Japan and the United Kingdom.

For many, this trend was not anticipated for a variety of reasons. For one, R&D functions
have traditionally been considered the least fragmentable of all economic activities since
they involve strategic knowledge. Secondly, R&D activity demands a seamless supply of

                                                                                             ¯                                 3
higher-skilled and very knowledgeable professionals, as well as an appropriate support
infrastructure that often is not available in developing nations. This second point may
affect China’s long-term ability to attract R&D investment.

Labor Shortage                                                                                    China appears to have
China appears to have broken the mold in terms of its ability to attract global R&D invest-
ment. Looking forward, it simply may no longer be a recipient of technology transfer, but a
creator of it. Yet is China’s talent pool large enough to satisfy the broad long-term interests
of foreign multinationals?
                                                                                                  broken the mold in terms

“We estimate that given the global aspirations of many Chinese companies, over the next
10 to 15 years they will need 75,000 leaders who can work effectively in global environ-
                                                                                                  of its ability to attract global
ments; today they have only 3,000 to 5,000,” says a McKinsey Global Institute report.
Unless China graduates more students “fit for employment in world-class companies …
our research points to a looming shortage of homegrown talent, with serious implications          R&D investment.
for multinationals now in China and for the growing number of Chinese companies with
global ambitions,” the report concludes.

To fill the gap, the Chinese government has engaged in a massive effort to educate the
nation’s next generation of managers. Nevertheless, the problem has
less to do with the number of graduates, which exceeds 3 million
annually, and more to do with their ability to function at higher levels
demanded by the world’s multinationals.

Shortages among highly skilled workers are not the only problem.
Shortages among lower skilled factory workers also have become an
issue in several export-driven Chinese provinces. If this problem con-
tinues, higher demanded wages could erode China’s position as the
world’s dominant low cost producer—a scenario that would benefit
India, Vietnam, Cambodia and other low cost producers.

Issues Causing Tension
A number of issues continue to cause U.S.-Chinese friction. These
include China’s accelerated military buildup, its desire to bring
Taiwan—the so called “renegade province”—under Chinese control,
human rights violations, and slowness to implement distribution rights
to foreign companies. Issues creating the most tension in the United
States Congress today involve the U.S. trade deficit, China’s currency
policies and intellectual property violations.

According to the U.S. Trade Representative, China has done a rela-
tively good job of overhauling its legal regime. However, it has been
less successful in enforcing its laws and ensuring effective intellectual
property rights enforcement. As a result, the frequent theft of intellec-
tual property has made foreign investors cautious.

Worldwide piracy is estimated to cost U.S. businesses $250 billion annually. Consequently,
a number of companies have withheld their trade secrets from China and have chosen to
keep their cutting-edge research at home. To better combat piracy and safeguard intellec-
tual property rights, China recently announced the creation of a special court to prosecute
intellectual property theft in hope of impacting the rising illegal copying of American
movies, music, software and other goods.

Anecdotal evidence, however, suggests international business executives do not have a
great deal of confidence in China’s ability to curb violations in the short term. Instead,
many say the best defense against piracy is the establishment of a genuine personal rela-
tionship with Chinese partners. In fact, business of any consequence is rarely conducted
without it. A strong personal relationship is so important that it often substitutes for legal
agreements. This is not well understood in the West.

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                            A more pressing issue causing friction in the United States is China’s practice of not allow-
                            ing its currency, the yuan, also known as the renminbi, to float freely. For more than a
                            decade, China pegged the yuan to the U.S. dollar. This provided financial stability and
China is approaching its    helped China to weather the Asian financial crisis in 1997 and 1998.

                            On July 21, 2005, the Chinese government announced a change in its exchange rate
                            regime from the fixed peg close to 8.28 per U.S. dollar to a managed float based on a
                            basket of currencies. Since then, however, the value of the yuan has moved little and con-
WTO deadline to open its
                            tinues to be considerably undervalued. If freed, it is widely believed that the yuan will rise
service sector to foreign   in value.

                            On the other hand, some economists believe that if the yuan were allowed to float freely, it
                            may become volatile due to China’s fragile financial sector, instability associated with the
companies.                  country’s transition to a market economy and difficult economic adjustments associated
                            with WTO-mandated reforms. In turn, a widely fluctuating yuan could have a destabilizing
                            effect leading to a financial crisis. Nevertheless, economists generally agree that if the
                            yuan did rise in value, it would have little impact on the U.S. trade deficit since U.S. com-
                            panies would continue to seek low cost imports from other developing countries.

                                                 Reform Continues
                                                 Some within China continue to advocate against economic liberaliza-
                                                 tion, resort to industrial policies that limit foreign market access and
                                                 try to decelerate the pace of change. These factions, which also tend
                                                 to resist free enterprise, transparency and the rule of law, likely will
                                                 lose influence as China continues to integrate into the world trading
                                                 system. With this in mind, China is approaching its WTO deadline to
                                                 open its service sector to foreign companies. This year the focus is on

                                                 If China implements its financial sector reforms on schedule, foreign-
                                                 invested banks should see all geographic and customer restrictions
                                                 on their local currency businesses removed. This combined with other
                                                 measures will allow wholly foreign-owned banks to provide local cur-
                                                 rency services to any Chinese client in any city, according to the U.S.-
                                                 China Business Council.

                                                 Additionally, implementation rules detail procedures for existing for-
                                                 eign-invested banks to expand their business scope and open new
                                                 branches. Although only a few international banks plan to establish
                                                 branch networks throughout China after December 2006, many are
                                                 expected to grow in various ways, including the buying of minority
                                                 stakes in domestic banks. Thus, as China continues to open its finan-
                                                 cial sector, greater stability and efficiency are predicted.

                            The Wealth Gap
                            Lifting hundreds of millions of people out of poverty is one of China’s proudest achieve-
                            ments. However, as China presses ahead with reforms—which are accelerating political,
                            social and technological changes—an income gap is becoming increasingly evident
                            between the urban haves and rural have-nots. The result: Twenty-five years ago Chinese
                            income distribution was among the most equal; today, it is among the most unequal.

                            By some estimates there were nearly 90,000 public order disturbances—sit-ins, riots,
                            strikes and demonstrations—in 2005. Clashes between villagers and police have increas-
                            ingly occurred over the confiscation of farmland by local governments for use in industrial
                            and real estate projects. Additionally, corrupt local Communist Party officials, who by some
                            accounts are delivering fewer basic services through poorly managed support systems,
                            are causing rural frustration to rise. Combined, these problems are creating tensions not
                            seen since the protests in Tiananmen Square in 1989.

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In an attempt to better satisfy the needs of rural peasants and quell protests, the
Communist Party’s National People’s Congress recently approved an increase in funding
for rural services, the elimination of educational fees for students receiving compulsory
education, the scrapping of an agricultural tax, and the expansion of an experimental            China is not only becoming a
healthcare plan. Discussions continue over rules governing state requisitions of farmers’
lands and how to determine fair compensation.

Nevertheless, as Chinese authorities attempt to improve rural living conditions, migration
                                                                                                 source of higher technology
to the cities continues to occur at an alarming rate, putting tremendous stress on urban
infrastructures. Although estimates differ, the Chinese government claims 543 million peo-
ple lived in urban areas in 2004. This has increased the demand for urban-based employ-
                                                                                                 goods, but also an enormous
ment—a primary component necessary to maintain social order.

However, as new jobs emerge, those at many state-owned factories have declined. In fact,         consumer.
over the past decade a tremendous number of workers have lost their jobs as authorities
closed unprofitable factories. Consequently, China has a very difficult task: to move from a
centrally planned economy to a market-based system at a rate that balances both the
needs and interests of its urban and rural populations.

Strategies for Success
China is not only becoming a source of higher technology goods, but
also an enormous consumer. Its thirst for commodities, semi-finished
merchandise and higher technology goods continues to rise. With a
population of 1.3 billion—and an emerging middle class of 200 million
to 300 million consumers with considerable purchasing power—
Chinese markets offer tremendous opportunities for both U.S.
exporters and investors. On the other hand, more efficient and sophis-
ticated Chinese firms are becoming increasingly competitive, creating
new challenges.

To succeed in this dynamic environment, U.S. companies need to
have an accurate understanding of Chinese culture, be very familiar
with successful methods of doing business there, and have the ability to quickly adapt to
changing Chinese needs and tastes. Companies that are accustomed to an inflexible busi-
ness model and not willing to consider new options may find it gradually more difficult to

Importantly, in order to seize opportunities offered by China and minimize risks it presents,
it is vital for U.S. firms to devise strategies that address both short- and long-term goals.
China’s strength as a low cost producer is likely to remain for some time. However, this
should not be confused with what China is quickly becoming: an increasingly sophisticated
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