How do you assess the legal
framework in China? Do you think it
is good enough to assure existing and
potential investors?
Here is a paradox: The legal
infrastructure is underdeveloped and
corruption remains widespread in
China, but nevertheless domestic
and foreign businessmen are
investing heavily in this emerging
market. This contradicts the thesis
that the rule of law is the sine qua
non for economic development.
Owing mainly to external pressures,
the Communist Party leadership has
realized that equitable laws and their
enforcementmatter. For example, as a
member of the Word Trade
Organization (WTO), China must
comply with a set of legal standards.
As a consequence of the new
consciousness at the center, the legal
framework has improved
tremendously since the start of the
reform and opening era in 1978. But
sheer will is not enough. In the
current form of the one party state,
there are insufficient checks and
balances. Power is not meaningfully
divided. Examples include the lack of
an independent judiciary and
legislative branch, as well as the
absence of free media operating
within a certain moral framework.
What I call the “mystery of success”
and “binding trajectories” make it
impossible to leapfrog into a future
that is characterized by the
unconditional rule of law. It is very
difficult to isolate the factors that
make the legal system of a country
effective. Therefore, it is hard for
China to imitate others. Even though
laws may be copied, legal institutions
and a legal culture have to mature
over centuries. This includes training
a specialist cadre of judges and
lawyers, accumulating a body of legal
precedents, and spreading norms of
good conduct. Throughout history,legalism has been only one current of
Chinese thought. The Confucian
approach of transmitting values
through socialization to control
behavior is an alternative model.
Lacking what I call “legal absolutes”,
anchored in philosophy and religion,
China’s leaders still succumb to the
temptation to use laws as instruments
to further their interests and enforce
them selectively depending on the
circumstances. Laws are intentionally
worded in a way that allows for
multiple interpretations. Definitions
can be very vague indeed. Socialism,
for example, is what furthers the
productive forces of a society.
Capitalism thus could be regarded as
socialism, too! Multinational
companies may be attacked by the
authorities at any time, especially
when they become too successful.
The list of targets range from Nestlé,
P&G, Heinz, Lipton, General Mills,
Colgate-Palmolive, KFC, Sony, to
Dell.
Besides, the Chinese government
routinely resorts to collective
punishment of companies from a
country that has breached its
unwritten rules. Such acts of
retaliation can shatter painstakingly
developed businesses overnight.
When the German Chancellor, eager
to please the US, met the Dalai Lama,
who is regarded as a separatist leader
by the Communist Party, German
companies found it very difficult to
do business in the Middle Kingdom
afterwards. For example, securing
extensions of licenses became
extremely difficult. To add insult to
injury, the Chinese government
intentionally awarded lucrative
contracts to competitors from France,
whose leadership distinguished itself
in the eyes of the Mandarins by not
receiving the Tibetan exile. The
Chinese leaders wanted to show the
world that they have the disciplining
power to punish transgressions by
foreign states and reward global
compliance with the party line. There
is at least one additional limit that
foreigners may not overstep, that is,
the orthodox view that Taiwan is a
Chinese province.
Finally, in such a large and complex
nation as China, it is hard to firmly
root the rule of law at the local level
everywhere in the country. One
particularly pernicious problemis the
imposition of arbitrary fees (luan
shoufei) by local authorities. Similar
to the levies of the Cosa Nostra, they
are substitutes for taxes in return for
which certain services are rendered.
But it would be much better if there
were a transparent framework of
official levies, which are not subject
to the whims of corrupt local officials.
So why, despite the mentioned
legal deficiencies and pitfalls, do
businessmen invest in China?
Smaller countries, such as Singapore,
cannot afford the luxury of judicial
caprices. Instead, to attract
investment, they must be regarded as
exemplars with respect to the rule of
law. But in China, many managers
believe that the benefits of conducting
business there, such as capitalizing
on its fast growing market, outweigh
the costs associated with legal
uncertainty. A notable exception is
knowledge-intensive investment.
When valuable intellectual property
rights (IPR) cannot be adequately
protected, companies will not locate
operations that are sensitive in this
regard in China.
Since the costs of an underdeveloped
legal infrastructure are difficult to
quantify, they often do not figure in
investment appraisals. The right way
would be to adjust expected cash
flows downwards. The resulting net
present value might still be positive,
since large expected cash inflowsmay
provide the company with sufficient slack to absorb the costs resulting
fromlegal problems.Many executives
engage in mental accounting and
simply write these expenses off as
“strategic investments”.
I observed another interesting
psychological phenomenon: When
investors believe in future gains, they
ignore even a dismal track record. An
analogy is what happens after a state
defaults on sovereign debt. According
to theory, lenders will not extend
loans to the culprit anymore. But
history shows that after a while,
credits start flowing into the country
again when the creditors believe it
offers bright prospects.
Instead of blindly and passively
counting on improvements and gains
in the future, companies can use
strategy and organization to
compensate for legal uncertainty. For
example, they might build a
diversified portfolio of business
options instead of putting all eggs into
one basket. This differs from the
prescription for developed markets
with strong institutions. There, it is
better to entrust investors with
diversification. Many of them dislike
the “package deals” of conglomerates,
which may not suit their desired risk
profile.
An extensive network of trust-based
relationships, which are transferred
from incumbent managers to their
successors, can reduce the likelihood
that stakeholders use guile and thus
decrease the dependence on the
unreliable legal system. Some shrewd
investors even try to get their
corporate partners drunk, so that they
can get at the truth. This is one
sociological explanation for why
Maotai is so popular in Chinese
business settings. The same logic
applies in other institutionally
underdeveloped markets, such as
Russia where Vodka is king.
