Foreign Investors in China Feel Cold Slap of Reality

William Overholt, an American banker, was already known as one of the biggest bulls on China when he published “The Rise of China,” his business bestseller, last year.

It turned out he was leading a stampede.

Lured by stories of China’s double-digit growth and 1.2 billion potential consumers, executives rushed to the mainland and pumped billions into the Asian giant--more than into any other country save the United States.

So hungry were outsiders for their share of China that a Hong Kong stock market listing of one Chinese company attracted a staggering $10.4 billion--628 times more money than the company set out to raise.

“We are the world’s biggest market,” bragged one Chinese official. “We can choose who we want to work with.”

No longer. With jarring abruptness, the China bandwagon has hit a rut, jolting many of the investors who piled on. Wall Street firms and Japanese banks are having trouble recovering millions of dollars in obligations Chinese companies incurred. Foreign lawyers are getting tossed out for not following China’s laws.

The fast-food chain McDonald’s is being forced to vacate its busiest restaurant in the world. Now, the developer who has claimed the site can’t get permission to build his project.

Standard & Poor’s, the noted credit-rating company, has put China on notice that continued problems might affect its sovereign rating, warning, “Investment-grade countries don’t break their promises.”

“There’s not much difference between what is happening in China and Orange County,” said Huan Guocang, chief economist at J. P. Morgan. “The real difference is that Orange County knows it has to pay, while China thinks it can get away with it.”

What’s happening? A collision of expectations and reality on both sides, China watchers say. In the rush to invest, many business people forgot the precautions that they needed to take when dealing with a large bureaucratic country just emerging from communism, leading to inevitable problems.

A recent round of high-profile conflicts has caused foreign investors to rethink their strategy and has left China feeling wronged.

Even China’s biggest booster has changed his tune. “We’re going from euphoria to sobriety,” Overholt said. “And those who didn’t do their homework are going completely sour on China.”

China insists that nothing has changed, except perhaps perceptions. A senior official who met with foreign reporters last week reassured them that China’s economy remains in good shape.

“I still believe that China is a good place for direct foreign investment,” said Wang Chunzheng, vice minister and senior economic officer for the State Planning Commission.

But it will take more than that to reassure some of the companies who claim they have been burned.

Take McDonald’s, one of the earliest symbols of successful U.S. businesses in China. The government broke a 20-year lease after just two years when well-connected Hong Kong magnate Li Ka-shing wanted to redevelop the prime location. Even though it is about to reach a settlement and says it remains committed to the country, McDonald’s has come to represent the hazards of doing business in China.

Now even Li’s project has been put on hold while the government reconsiders its permission to build.

Problems like this have caused Li, among the largest investors in China and a longtime friend of senior leader Deng Xiaoping, to publicly criticize Chinese policies toward foreign investment, urging that they be made more clear, consistent and open. Topping his wish list is a mediation center to help overseas investors settle disputes.

Other deals have gone wrong. The Shanghai subsidiary of state-backed China International Trust & Investment Corp. (CITIC) refuses to pay $40 million in losses on the London Metals Exchange, claiming that the trades were unauthorized. The company dispatched officials to London to reassure traders this week.

But there are others in line ahead of them waiting to be paid. A consortium of Japanese, German and Italian banks wrote a collective letter to China’s economic czar, Zhu Rongji, begging for help retrieving $600 million in unpaid loans.

And in a case that is so closely watched that Hong Kong business people refer to it as “the O. J. Simpson trial of China investment,” Lehman Brothers Inc. is suing to recover more than $100 million in trading losses from two government-owned firms.

Minmetals Inc., one of the companies, says it will countersue, claiming that the U.S. investment bank took advantage of its traders’ ignorance.

And though four of CITIC Shanghai’s officials were arrested last week for corruption, the company’s senior adviser, Xu Shiwei, says that greedy foreign companies must share the blame. “I must regretfully point out that certain foreign counterparts have got some screws loose . . . “ Xu said. “What they have done has to some extent assisted such a thing happening intentionally or unintentionally.”

Others agree. “Foreign banks are just creating a house of cards,” said Robert Broadfoot, head of Hong Kong’s Political and Economic Risk Consultancy. “Their . . . risk assessment (in China) leaves a lot to be desired. They do what their competition does--they don’t necessarily go and see if the deal has higher risk that will require higher interest.”

After overestimating profits and underestimating problems, some foreign companies are reducing their exposure to China.

Investment bank Goldman Sachs is cutting its China staff by about 100 people, transferring about 50 to Southeast Asia and firing 50, earning it the sobriquet “Goldman Sacks.” Merrill Lynch also says it is shifting its focus to Southeast Asia.

Why now? “There’s not so much been a change in China than people’s perceptions are beginning to line up a bit more with reality,” said analyst Simon Cartledge of the Economist Intelligence Unit, which had downgraded China’s risk rating from “B” to “C” even before the latest round of conflicts. “It’s a wake-up call--China is not a place where there are pots of gold just waiting to be had.”

Like many emerging markets, China has its problems: few regulations, growing inflation, corruption and no rule of law. And with the stampede of interest in China--pledged investments rocketed from $12 billion in 1991 to $111 billion last year--hastily made deals have a high potential for coming undone.

Some foreign companies have found themselves caught in the web of domestic debts between Chinese enterprises, created when the central government tightened credit to dampen China’s growth.

The result: Chinese companies are having problems paying creditors--domestic and foreign--and some resort to risky maneuvers to increase the cash flow.

Some economists expect to see more debt problems as the economy slows next year. Growth this year has already dropped to 11.5%, down slightly from 13.4% last year. That brings up the key question of who has the right to make deals--and who has to pay when they go wrong.

Don’t look at us, the government says. As China moves toward a free market, it has cut loose many of its state-owned enterprises, forcing them to survive on their own as limited subsidiaries.

Assumptions that China would guarantee the losses of state-linked companies have proven to be wrong. A case in point: CITIC Shanghai, which lost $40 million on the London Metals Exchange, is a subsidiary of China’s flagship investment company CITIC headed by Rong Yiren--who also happens to be China’s vice president.

An American banker, who prefers not to be named because of his involvement in the case, provided an example: “CITIC Shanghai had $17 million in assets. They received $53 million in credit. If someone who has $17,000 to his name comes to you for a $53,000 loan, and you know he has a rich uncle, can you assume his uncle will pay you back? You can’t.”

But in China, where investment laws are often vague, if they exist at all, most business is done on faith and guanxi, or personal connections.

China prefers to resolve conflicts quietly and behind the scenes to save face. In the past, said one investment banker, investors have played along in the hopes of winning more business in the competitive environment.

But frustrated by slow results, many are beginning to take their complaints public.

The strategy may work. “For all the brouhaha, McDonald’s has a done deal without going through the courts,” said Richard Margolis, a managing director at Smith New Court Securities Ltd. who negotiated with Beijing as a British diplomat before becoming an investment banker. “Sometimes there comes a moment when you have to precipitate a crisis. Airing these problems in public can often help, provided you’ve gone through all the processes available.”

Lehman Brothers’ lawsuit to recover debts from the Chinese companies will be closely watched by all sides to see what results legal confrontation will bring. “The lawsuit is forcing China to come to terms with its problems and forcing everybody else to wake up,” said Overholt, the author and banker. “No question they’re doing the system a favor. It may be a while before they can do business in China again.”

But another banker added, “It may be a while before they want to.”

While the spate of conflicts and criticism adds to the perception that China is a bad place to do business, there are plenty of companies chugging quietly along, settling in for the long haul.

And because investment in new markets tends to go in boom-bust cycles, most experienced China-watchers think this cyclical dip will pass.

Beijing, though, does feel defensive as leaders work to fine-tune economic reforms and maintain the country’s so-far solid reputation for credit-worthiness.

“The fast and sustained economic development, a huge domestic market and cheap labor with steadily enhanced quality--all these conditions make China an ideal spot for attracting foreign investment,” insisted Liu Zhiben, the Foreign Trade and Economic Cooperation Ministry vice director in the official China Daily.

Besides, the Chinese have their own list of complaints: They say foreign companies exploit low-cost labor and strip assets from Chinese companies. Foreign banks, they gripe, sell complicated financial instruments carrying huge risks--an argument that may draw sympathy in Orange County.

Meantime, the attention that this first round of China disasters is getting will shake out the gold-rushers, cause deal-makers to be more cautious and leave the serious, long-term investors to get down to business, analysts say.

Overholt, for one, is looking ahead: “Markets always overreact. The serious people are going to stay in there. You can put pretty big dents in the flows of investment and not change the strategic picture. That’s the definition of strength.”