Distrust Between Multinationals and China’s Government Can Be Deadly

(Originally published on Quartz.com, October 23, 2012)

China’s industrial policies have created a climate of fear among Western multinationals. Concerned that China’s innovation policies are a mandate for technology theft, but dependent on the China market, multinationals often “blackbox” their technology—meaning protect it from copycats—and the consequences may prove devastating.

Mutually Assured Deception

China’s mercantilist technology and industrial policies and the global economic downturn have combined to create a damned-if-you-do, damned-if-you-don’t dilemma for many foreign businesses in China.

Leading technology and industrial companies can’t afford to stay away from China, as it is the world’s principal growth market. As “China 2030,” the report jointly published by the state agency Development Research Center and the World Bank, puts it: “Perhaps the most important global megatrend is the rise of China itself. No other country is poised to have as much impact on the global economy over the next two decades. Even if China’s growth rate slows as projected, it would still replace the United States as the world’s largest economy by 2030,” and China’s “share in world trade could be twice as high” as the US share.

It’s no wonder, then, that the CEOs of many multinationals believe that failure to succeed in China could result in the eventual downfall of their companies on a global scale. But these CEOs are also aware that access to the China market often requires handing over their technology to a Chinese state owned-enterprise partner—one that could be expected to go global and compete against the same foreign company that provided the technology. “For many of us, the China market is a matter of survival,” said a former China CEO of a leading industrial multinational. “So when it comes to implementation, the foreign companies find ways to protect themselves by taking advantage of confusing terms and conditions in the contracts and doing whatever we can to not transfer the complete technology.”

This CEO and others describe a process that begins with mutual distrust between Chinese and foreigners at the outset of contract negotiations. It is common for the Chinese RFP (request for proposal) to require detailed technology specifications and demand that 100% of the technology be handed over by the end of the contract. The foreign bidders try to protect themselves by littering their proposals and final contracts with wiggle-room wording and conflicting language to circumvent the most serious technology-transfer requirements. Once the actual business cooperation begins, this distrust quickly shifts to a game of mutually assured deception. When it’s time to transfer their know-how to the joint venture, the foreign companies often “black-box” their most valuable technology. This is done by withholding technical design details and packaging their components or systems in ways that are difficult to dissect and reverse-engineer.

The result may be as dangerous as these partnerships are disingenuous.

During a lightning storm in July 2011, two high-speed trains collided near the city of Wenzhou in Zhejiang Province. Forty people were killed and at least 192 injured. In a 50-page report published in December following public outrage over the crash, the State Council blamed the crash on a signaling system that was supposed to prevent train collisions. The report concluded that poor system design in combination with lightning strikes was responsible.

Outside of official government circles, however, the black-boxing of technology is believed to have been a contributing factor to the crash.

The signaling system was assembled by Beijing-based Hollysys Automation Technologies Ltd., a Nasdaq-listed company that was once part of the Ministry of Electronics. Hollysys, one of the three companies China’s Ministry of Railways (MOR) had approved to do such work, received more than $100 million in high-speed rail signaling contracts in 2010, according to a Wall Street Journal investigation. “An examination of China’s use of foreign technology in its bullet-train signal systems highlights deep international distrust over China’s industrial model,” the Journal said. The Hollysys signaling technology contained circuitry tailor-made by Hitachi Ltd. of Japan. Worried about losing its technology, Hitachi provided black-boxed components with the inner workings concealed from Hollysys. A senior Hitachi executive told the Journal that Chinese engineers probably couldn’t fully comprehend the technology as Hitachi withheld the technical blueprints. “It’s still generally a mystery how a company like Hollysys could integrate our equipment into a broader safety-signaling system without intimate knowledge of our know-how,” the Hitachi executive told the Journal in October last year.

Hitachi had good reason to be wary. Foreign companies are forbidden from bidding on China’s high-speed rail contracts. Their only option is to partner with Chinese state-owned enterprises that plan to become their global competitors. But the help these foreign companies offer to China is rewarded with shrinking market share. Industry figures show that foreign companies account for 15 to 20% of China’s investment in the rail sector, with their earnings roughly the same as eight years ago.

Black-boxing to protect proprietary technology could have implications beyond high-speed rail. To realize its nuclear power ambitions, not to mention its desire to build its own commercial airliner, the C919, China needs to depend on foreign technology. The only way for foreign companies to participate in these sectors, however, is through joint ventures and technology sharing with a Chinese partner.

In the nuclear sector, China is adopting technologies from France, Canada, Russia, and the United States. This has scientists worried about China’s ability to master and continually improve all of these complex technologies. “It is extremely dangerous—in terms of standardization of design, operational safety, and ease of maintenance—for any nation to run so many different types of reactor simultaneously,” a Carnegie Endowment for International Peace researcher wrote. “China’s leaders should immediately limit further diversification of nuclear reactors and concentrate the nuclear sector’s human and financial resources on the research, development and commercialization of just one or two types of standardized design.”

Unsafe at Any Speed

The State Council said corruption also likely contributed to the July 2011 train crash. It occurred a half year after the arrest of Railways Minister Liu Zhijun, known as “Great Leap Liu” for seeking to build the world’s fastest trains in the shortest time possible. Chinese media reports claimed Liu had 18 mistresses and had skimmed tens of millions of dollars from rail projects.

Caixin Media’s Century Weekly Magazine reported that 80% of all high-speed rail projects were awarded to two state-owned enterprise contractors: China Railway Group and China Railway Construction Corp. Executives at two suppliers of high-speed rail equipment said that until 2011, MOR used an “expert review” system for choosing contractors in which middlemen paved the way for contracts.

MOR accrued colossal debt during Liu’s eight-year tenure as minister. By the end of 2010, according to Century Weekly, MOR had accrued RMB 1.25 trillion (almost $200 billion) in outstanding loans. Industry analysts estimate that debt payment plus interest were set to hit RMB 250 billion in 2011, while MOR cash flow from operations would not exceed RMB 200 billion.82 The Beijing-Shanghai high-speed railway was initially estimated at $1.96 billion. In the end, it cost $3.4 billion. Cost of the Guangzhou South Station escalated to RMB 14.8 billion from an initial estimate of a couple billion RMB. “This is because every project is contracted, subcontracted and subcontracted again,” a contractor told the magazine. “If you want to profit from the plan, you have to continuously modify the plan.”

In March this year, a 300-yard section of high-speed rail track collapsed on a line under construction in central China—after having passed inspection and test runs. The People’s Daily reported that the contractor had cut costs by packing dirt instead of gravel under the tracks. A Fujian Province rail contractor told the New York Times that bribes to government officials erase profits un- less savings can be found. “You are constantly being forced to cut corners, or else you cannot make a profit,” the contractor said. “Everyone does this.”

Excerpted from No Ancient Wisdom, No Followers: The Challenges of Chinese Authoritarian Capitalism. Published by Prospecta Press, 2012. 

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About James McGregor
James McGregor is an American author, journalist and businessman who has lived in China for more than 25 years. Currently, he is chairman of APCO Worldwide, Greater China. A professional speaker and commentator who specializes in China’s business, politics and society, he regularly appears in the media to discuss China-related topics. McGregor is the author of the books "No Ancient Wisdom, No Followers: The Challenges of Chinese Authoritarian Capitalism" (2012) and "One Billion Customers: Lessons from the Front Lines of Doing Business in China" (2005). He also wrote the 2010 report "China’s Drive for ‘Indigenous Innovation’ – A Web of Industrial Policies." From 1987 to 1990 McGregor served as The Wall Street Journal’s bureau chief in Taiwan, and from 1990 to 1994 as the paper’s bureau chief in Mainland China. From 1994 to 2000, he was chief executive of Dow Jones & Company in China. After leaving Dow Jones, he was China managing partner for GIV Venture Partners, a $140 million venture capital fund specializing in the Chinese Internet and technology outsourcing. In 1996, McGregor was elected as chairman of the American Chamber of Commerce in China. He also served for a decade as a governor of that organization. He is a member of the Atlantic Council, Council on Foreign Relations, National Committee on US-China Relations and International Council of the Asia Society. He serves on a variety of China-related advisory boards.

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