European Firms May Shift Away From China Due To Tougher Environment – European Chamber Of Commerce Survey

Survey finds lingering challenges and uncertainty despite – and sometimes because – of new government measures.

BEIJING – China is maturing, market competition is fierce, labor costs rise constantly and the regulatory environment is still discriminatory, says a European business confidence survey. In addition, a slowdown in China's economy will further impact the bottom line of European businesses operating in China, prompting them to consider a move to other emerging markets.

Due largely to market access challenges and regulatory barriers, one in five or 22% of the European companies surveyed admitted they are considering shifting investment from China to other markets, said Davide Cucino, president of the European Chamber of Commerce in China during a press briefing in Beijing May 29.

The figure has reached an alarming level, and the Chinese government should take measures to address the regulatory challenges, Cucino said. “If I were a Chinese government official, considering recent decreasing trends in foreign direct investment [in China], the number sounds to be alarming.”

The impact is also worrisome to privately owned Chinese firms. “The lack of reform of the regulatory environment is worrying and has a disproportionate impact on foreign businesses as well as on the domestic private sector,” he added.

“There are indications from this survey that as reform continues to stall and costs rise, a previously reliable stream of FDI may slow and planned investments may be shifted to other emerging markets,” Cucino said in a statement.

Highlighting urgency, Cucino noted that as a maturing market, China could lose out to other emerging markets that offer more incentives to entice multinational firms.

Tougher Regulatory Environment

Compared to 2011, 12% of European businesses reported they experienced increasing discrimination in China, up from 9%, according to the annual survey.

One prime example is legislation on environmental protection. More than 50% of respondents said the regulation is much stricter for foreign companies than Chinese state-owned enterprises and private firms.

China’s record of intellectual property rights protection also needs further tightening, according to survey respondents, as 81% deemed China’s IPR laws and regulations inadequate, and many view a broader enforcement of laws critical to China’s future economic performance.

Earlier this month, the office of the U.S. Trade Representative released its annual special 301 report citing China for unfair treatment of U.S. patent holders (Also see "Forced Technology Transfer Hinders Innovation In China – USTR" - Scrip, 11 May, 2012.).

Indeed, survey participants listed rule of law and transparent policies as the top drivers for China’s future growth, with 72% considering it more significant than domestic consumption, labor cost, fair competition and implementation of environmental regulations.

Looking forward, companies are less optimistic about seeing a level playing field, and 13% predicted government policies will continue to discriminate against foreign-invested enterprises, up from 9% a year ago.

Ongoing regulatory obstacles have negatively impacted company revenues: more than half of Beijing- and Shanghai-based European enterprises reported missed opportunities. In particular, consumer goods and service providers were affected, with 64% reporting that the loss of opportunities accounted for more than 10% of revenues.

In terms of competition, European companies see harsher competition from privately owned enterprises (POE) than state-owned enterprises. Foreign companies were asked to rate experience with Chinese SOEs and POEs, and 48% said competition from POEs was more significant.

In addition, government relations was not viewed as critical when it comes to investment dollars. Only 9% expressed a desire to increase investment in government relations, compared to 17% for brand recognition, 30% for marketing and sales, and 44% for other areas.

Labor Costs Through The Roof

In addition to responding to a maturing China, European companies are facing rising labor costs, which have forced many to move inland and resort to other cost-cutting measures.

According to the survey, 52% stated high salary expectations as the top challenge in attracting local employees. The race over talent has put a considerable squeeze on both foreign and domestic companies, adding to operational costs, Cucino noted (Also see "Pharma Companies Offering More Perks As Race Heats Up For Top Talent In China" - Scrip, 8 May, 2012.).

Pressured by worsening inflation, only 36% were positive about profitability even though 78% of respondents were optimistic about the growth outlook in China. Seeking cheaper labor and land, companies are expanding to inland provinces as local governments offer attractive incentives to MNCs (Also see "Are China's Rising Labor Costs Good For Big Pharma?" - Scrip, 11 May, 2011.).

In addition to “Going West,” 14% of respondents said they also cut costs to cope with the changing environment, which represents a 6% increase from the previous year’s survey.

The survey found that Southwestern megacity Chongqing and coastal city Tianjin lead tier-2 markets for foreign investment. China’s central provinces Hubei and Jiangxi are also seeing business expansion due to lower operating costs.

In terms of local incentives, provinces including Anhui, Hubei, Hainan and Western Gansu were viewed as positive due to favorable loans.

In addition to “Going West,” 14% of respondents said they also cut costs to cope with the changing environment, which represents a 6% increase from the previous year’s survey. These cost-cutting measures include reducing material costs, headcount, rental expenses, subcontracting and outsourcing. Many companies are relying on cost-cutting for profitability rather than new growth, Cucino noted.

Furthermore, 59% are pessimistic about labor costs in the next two years and the picture is especially gloomy in the Pearl River Delta (75%) and Yangtze River Delta (69% for Nanjing and 61% for Shanghai).

Will China’s Policies Make A Difference?

China’s 12th Five-year Plan outlines several measures to encourage foreign investment in China, including opening up drug distribution for competition and accelerating industry consolidation (Also see "China’s New Guidelines On Foreign Investment Loosens Restrictions On Drug Distribution" - Scrip, 6 Jan, 2012.).

The survey found that many respondents are unsure of the policy's lasting impact, with 30% of respondents saying policies would have no impact compared to 11% last year.

Citing China’s huge stimulus package in 2008, Cucino said the package was a great public relations effort by putting together investment that had already been there. But in reality, only a small part of that investment went to foreign companies.

Similarly, China is also encouraging research and development to spur domestic innovation. However, many of these new policies support critical sectors identified by China as strategic growth industries, and are not directly related to R&D, Cucino noted (Also see "China Unveils Latest Five-Year Plans For Biopharma And Medical Device Industries (Part 2 of 2)" - Scrip, 26 Jan, 2012.).

In comparison, 56% of surveyed European firms have already established an R&D presence in China to develop new products and train talent, so the new policies will have a limited impact to these foreign companies, suggested the president of the European Chamber of Commerce.

The annual survey received answers from 557 respondents, 61% of which are small- and medium-sized enterprises with headcounts of 250 or less, and 77% have operated in China for more than five years.