12 February 2010
The phrase "going to China" is increasingly heard among companies looking for value and quality in their sourcing of products and services — and with good reason. Today, China’s manufacturers supply a significant and growing share of the world's products. In addition, China is pursuing an aggressive and coherent national plan designed to help it become a leading global provider of services.
Since it opened its doors to the world 30 years ago, China has been driving policies of economic development that will enable it to create a middle-class society of reasonable means. This transformation constitutes an undertaking of historic proportions. Initially, China focused its economic development on manufacturing, and the country’s success has been dramatic. Increasingly, however, the People’s Republic has concentrated its manufacturing capabilities on higher-end products and processes, including pharmaceuticals and electronics and other technologies.
Despite its remarkable success to date, however, China needs substantially more economic development. It must also deal with significant undesired impacts of its staggering growth. Notably, the PRC needs to address a rapidly urbanizing1 population and the negative environmental issues associated with its current manufacturing industries, including heavy industrial pollution and high energy consumption in low-end manufacturing.
In the face of these needs and of associated domestic and international pressures, the Chinese government has developed its current "Harmonious Society" (和谐社会) socioeconomic goal of advancing economic growth that promotes better societal balance. As part of its effort to encourage balance, China is now making a very concerted effort to grow its services industry, seeking to leverage its successes as the world's manufacturer to become the world's services provider as well.
China’s market for the sourcing of products and services is dynamic and evolving. Prospective buyers of Chinese products and services must carefully analyze the market to assess which products and services can be viably sourced from China and to determine the appropriate manner for arranging such sourcing. Approached properly for a growing number of products and services, however, China ranks as one of the world’s most attractive sourcing markets, and indications strongly suggest that this trend will continue, if not accelerate.
Fortunately, prospective buyers of China’s products and services can draw on lessons learned from many years of sourcing experience — their own and others’. Different sourcing environments inevitably present diverse and unique challenges. But the long-term accumulation of customers’ collective experience can be effectively leveraged, enabling potential buyers to approach China sourcing with significantly heightened confidence and capability. With foresight and careful planning, well-prepared customers can take advantage of current Chinese sourcing opportunities, grow and evolve their business relations in China as further opportunities develop and simultaneously mitigate their exposure to the risks inherent in such outsourcings.
The China Sourcing Environment
China’s government has embraced the notion that developing services capabilities offers significant economic benefits consistent with its Harmonious Society objectives. The need to promote its services industry is all the more urgent for China because portions of its current manufacturing base will almost certainly be eliminated by the nation’s transition to an acceptable, ecologically responsible production environment. The result has been a trend away from the PRC’s traditional dominant manufacturing focus, evidenced by a steady reduction of officially sanctioned trade incentives over the past five years and by an increasing emphasis on higher-end production and processes, including services.
With a clear eye toward India's success in its outsourcing services industry, the Chinese government has designated a number of cities as "Outsourcing Services Base Cities,"2 where it is concentrating infrastructure developments and incentives. The government has further adopted incentives — including tax incentives and liberalized work-out systems — to promote the development of services companies. These and similar efforts reflect China’s drive to encourage multinational companies to shift offshore outsourcing services to the PRC. In addition, the Chinese government is working to promote the development of large and mid-size service outsourcing enterprises, with a particular focus on software and technology-related service providers. A number of China’s regional and municipal governments, moreover, have acted independently to implement programs that will stimulate service-industry development in their areas in an effort to promote the Harmonious Society objectives.
Contract issues represent a particular challenge facing any buyer interested in sourcing from China. Significant sourcing relationships, especially those involving services, are typically dependent on complex contractual arrangements. In the context of these agreements, buyers must have reasonable confidence that their contractual rights are effective and enforceable. Impediments to contract execution or enforceability will inevitably limit the extent to which any buyer will perceive sourcing opportunities as viable, regardless of the supplier’s actual capabilities.
A supportive contractual environment depends upon two factors: (1) a level of supplier contracting capability that is sufficient to enable buyers and suppliers to negotiate and execute acceptable contracts; and (2) a legal infrastructure that affords reasonably efficient and predictable contractual enforcement. In today’s China, both these factors constitute works-in-progress. During the past 10 to 15 years, China’s adoption of laws supporting commercial transactions has been dramatic. In fact, by many estimations China now possesses a reasonably adequate base of commercial law. The real challenge facing China in this area, however, stems from its still-evolving ability to effectively enforce its laws.
The challenges associated with contracting in China are greater in services transactions than in product-sourcing transactions. Generally, service contracts are more complex than product contracts. In many ways, this distinction reflects the practical differences between services and products, including the typically more interactive relationship between buyer and supplier involved in the provision and receipt of services. Thus, as China works to build its sourcing capabilities, the measures it implements to increase its contracting capacity will be of critical importance. And as effective legal mechanisms for contract enforcement are developed, the scope of products and services seen as viable candidates for sourcing from China will almost certainly increase. In turn, the contracting capability of Chinese suppliers to support a broader range of sourcing transactions will undoubtedly grow as opportunities for such development emerge.
Other Challenges and Strengths of China Sourcing
Other challenges to sourcing from China exist that may impact whether or how a particular sourcing is undertaken. For example, do Chinese suppliers possess the level of English language skills necessary to conduct particular business activities with foreign customers? Concerns over intellectual property (IP) protection, the ability of Chinese suppliers to meet requirements of regulatory compliance and arrangements for effective dispute resolution also represent major challenges facing China’s dynamic sourcing industry today.
The level of English language skills within the People’s Republic is frequently cited as a challenge to international businesses that are considering China-based sourcing engagements. Despite the worldwide prevalence of Chinese as a spoken language (by some accounts, it is the world's most widely spoken language), English continues to be the primary language of international business.
Although a number of the services initially targeted by the Chinese government for development (for example, software services that involve common programming languages) are not wholly dependent on broad English language capabilities, English language skills within supplier organizations have a direct bearing on buyer perceptions regarding the scope and nature of sourcings that can be effectively delivered by Chinese providers.
Significant efforts are underway to increase English language capabilities within China. In 2001, for example, English language study beginning in Grade 3 became compulsory throughout the country, and larger cities such as Beijing and Shanghai have introduced English at Grade 1. Through such efforts, the significance of this issue is likely to diminish over time. In fact, some have estimated that within a few years, there may actually be more English language speakers in China than in India.
Protection of intellectual property is another concern among China’s prospective sourcing customers. Despite China's adoption of laws generally consistent with international standards of IP protection, enforcement of these rights remains a significant problem. A variety of best practices can be helpful in protecting intellectual property, including careful due diligence in human resource and business partner selection and thoughtful design, implementation and enforcement of IP compliance programs. Further, practical protections that are based in the design and control of production and performance processes may ensure effective IP protection by preventing critical intellectual property from being accessed or copied in high-risk environments. Such an approach often requires that key activities be compartmentalized or that selected parts or processes be sourced to different suppliers. In some cases, effective risk management may demand that specific parts or processes be delivered by the buyer's home organization. In cases where such arrangements are not feasible or where critical IP must necessarily be accessed or copied, the customer may determine that certain products or services will not currently be suitable for sourcing from China.
Among prospective buyers considering sourcing from China, regulatory compliance is another key area of concern. US buyers, for example, must address compliance issues associated with US export control laws, the Foreign Corrupt Practices Act and Sarbanes-Oxley obligations that might be influenced by sourcing arrangements.
Regulatory compliance, like IP protection, can be promoted through effective processes of human resource and business partner selection and through well designed and implemented compliance programs. But certain activities may simply be inappropriate for sourcing due to the regulatory risks they present. Further, care must be taken to ensure that the sourcing contract is designed to provide the flexibility necessary to address changes in applicable regulatory requirements.
Effective dispute resolution is another concern for companies that are considering sourcing from China. This issue is especially pronounced in view of the previously noted challenges associated with contract interpretation and enforcement in China. International sourcing arrangements frequently provide for a governing law other than China's and for a dispute-resolution process that does not depend upon China’s developing legal infrastructure.3
Contractual choice-of-law provisions are generally recognized in China where one contracting party is foreign, although a number of important issues remain subject to local Chinese law. These include certain issues concerning intellectual property ownership, labor laws, land ownership, insolvency and enforcement of foreign judgments or awards.
Foreign companies sourcing from China frequently prefer that, when efforts to negotiate disputes between contracting parties have failed, issues be resolved through arbitration conducted outside of China under an international alternative to arbitration in China. Such arrangements must be clearly defined in the sourcing contract. The actual enforcement of arbitral awards in China, however, presents significant challenges of its own, and these must be carefully considered in any sourcing evaluation and structure.
Sourcing Market Considerations in China
Two additional factors regarding sourcing from China present specific challenges to potential sourcing buyers: (1) China’s fragmented service provider market; and (2) the difficulties involved in performing effective due diligence on Chinese service providers and other business partners in China.
China's nascent services industry is extremely fragmented and lacks a well-defined group of leading service providers. The government's efforts to encourage growth in the services industry have been focused largely on general development in the country’s various designated base cities and have lacked a concerted emphasis on defining and promoting specific service capabilities. As a result, the services market in China is diffused and is characterized by local and regional competition that has likely impeded the development of distinct Chinese service practices or brands. While today’s China delivers a growing choice of service offerings, it has not developed a coherent pattern of practice or capability.
Ultimately, the success or failure of any product or service sourcing from China depends largely on the quality and capability of the supplier, as well as the other business consultants and partners involved in the China activities. Effective due diligence performed on Chinese parties tends to present significant challenges stemming from a variety of factors, including market fragmentation and language and cultural issues. It is very important, however, for a would-be purchaser to obtain clear understanding and adequate comfort regarding the capabilities and ethical standards of the Chinese parties with which it will deal. Effective due diligence in China often requires substantial patience, effort and expense, but its importance cannot be overestimated.
Strategies and Vehicles for Initiating Sourcing from China
China's liberalized investment rules generally allow a foreign buyer seeking to source products or services to select from a wide range of sourcing models. These models include classic third-party outsourcing arrangements in which the buyer contracts with the supplier; sourcing through joint ventures; and even sourcing through wholly owned (foreign) enterprises.
In China, as elsewhere, customers are challenged to adopt and structure the sourcing model that best meets the needs of the particular transaction. The selection process should drive to identify the most appropriate model for the particular transaction mix, based on buyer, supplier and sourcing objective. Fortunately, buyers seeking to source from China can select from among most of the strategies that have historically been used in offshore sourcing.
A buyer may initiate a China sourcing by using any one of several classic entry strategies or by combining elements of several strategies. Typical sourcing entry strategies may involve:
- Utilizing pilot programs to become familiar with and to confirm the viability of the sourcing (i.e., “testing the water”), although this approach may risk insufficient commitment on the part of one or more of the sourcing parties and may thus set the stage for failure.
- Providing an extended transition period to allow for confirmation of successful assumption of responsibility and performance by the supplier, although this approach, like the pilot program, may risk insufficient commitment, making any change-management needs associated with the sourcing more difficult to fulfill.
- Utilizing relatively short-term contracts with extension rights to allow for flexibility in substituting solutions, although this approach may be less attractive to suppliers and may nonetheless create long-term dependence on the part of the buyer, despite the shorter term.
- Limiting offshore direct reliance and exposure by utilizing a US or other home-country supplier in conjunction with Chinese capabilities, although this strategy necessarily reduces potential savings opportunities and increases risks of successful service integration.
Again, lessons learned from prior sourcing experience can and should be applied in evaluating and approaching the dynamic and evolving Chinese sourcing market.
Expectations for China Sourcing
Despite the current challenges inherent in sourcing from China, the potential benefits are compelling. As China further addresses areas of concern to international buyers, these benefits should increase as the risks decrease.
The economic stakes for China are high and the commitment to success of the government and growing ranks of suppliers is strong. Consequently, there is every reason to expect that China will remain vitally interested in developing and maintaining an economic and legal environment that will enable international buyers to source from China with increasing confidence and enthusiasm.
1. Urbanization is generally recognized both as a product of economic development and as a prerequisite for broad-based economic development. China's rate of urbanization remains significantly lower than the rates seen in other developed countries. Today, China’s leadership is promoting aggressive national policies aimed at encouraging very rapid urbanization.
2. On February 2, 2009, the PRC’s State Council directed its Ministry of Commerce to promote the development of services outsourcing in 20 pilot cities (up from 11 in 2007). The 20 pilot cities designated as Outsourcing Services Base Cities include Beijing, Changsha, Chengdu, Chongqin, Dalian, Daqing, Guangzhou, Hangzhou, Harbin, Hefei, Jinan, Nanchang, Nanjing, Schezhen, Shanghai, Suzhou, Tianjin, Wuhan, Wuxi and Xi'an.
3. Important considerations regarding the enforceability of governing law and dispute resolution contract provisions are addressed in the article "Effective Enforcement of Contract Rights in Chinese Sourcing Contracts" in this publication.