China and the WTO: Perspectives on a Changing Environment

This is not surprising, as 25 years of progressive decentralization of economic decision-making to the local level has empowered local governments to operate largely autonomously in attracting foreign-invested projects to set up in their area, while at the same time protecting their own business interests by keeping out any enterprises conceived as competitors. Within broad policy goals, local governments have been largely left to themselves to implement their local development plans.

Another factor is that the WTO commitments on market access have been handled differently by the different ministries responsible for their implementation, and interpreted differently at the local level across China. There is frequent debate in Beijing as to whether a particular change or opening is good for the country as a whole, but not for a particular ministry that is involved, and vice versa. The different impulses stemming from narrowly bureaucratic and more broadly based national interests are among the key dynamics determining how the WTO commitments are approached.

Given these facts, we might better understand how the WTO impacts China by viewing WTO membership as a work in progress that interacts with the changes brought on by China's uneasy integration into international commerce and the domestic pressures that have reacted to new economic circumstances. The impact of the WTO commitments is thus only part of the story of economic development in China.

The Business Ethos

In China, practitioners, and their clients, are faced with discrete situations and immediate problems that may or may not be related to WTO issues.

General attitudes about investment are more bullish than ever. "What we have seen is that all big international conglomerates have really decided that now is the time to seriously commit to China because China is now mature enough. In the past, they would put a bit in here and there in joint ventures or specific projects," says Andreas Lauffs, a partner at Baker & McKenzie in Hong Kong. He elaborates with a specific example: "One conglomerate we have heard of has decided that each division must invest US$1 billion in China within two years, and division managers must justify the case where they haven't invested all of the money. As a result, they are sending out investment bankers and troops of people trying to nail down targets in a specific area. But they have gotten to a particular place and discovered that there are three or four like-minded individuals already there, either other conglomerates in their industry or private equity funds."

And in the large coastal cities where most business is done, the municipal officials are keenly attuned to what the WTO entails and how China's economic landscape is changing: "In Shanghai and the surrounding provinces, we haven't seen any footdragging or attempts to avoid WTO commitments," comments Owen Nee, a partner at Coudert Brothers in New York, and managing partner of the firm's Shanghai office until the end of 2004.

Business in China is booming, and seeking solutions to immediate problems is the main issue. Being aware of WTO requirements is now only one of many constituent factors that form the complexity of working in China. David Livdahl, the managing partner of Paul, Hastings' Beijing office, expresses this point in terms of the firm's considerable Japanese client base: "They see China as a difficult place to work in any case. The bureaucracy is difficult to deal with, and even just getting forms and applications together can be time consuming. None of this is a plot to make things difficult, but just a fact of working here. In travel, hotel consulting and franchising, which is a lot of our work, at the same time that WTO has brought certain opening measures (that are not yet completed, such as the remaining restriction on ticketing), we are also seeing an improved effort by certain local officials to expedite review and approval of new ventures. We often deal with Chaoyang district (in Beijing), and those officials are trying to improve the business environment at the local level."

Perceptions of the Business Environment

The US-China Business Council conducts an annual survey of its members in China of the business environment and opinions about WTO compliance to date. In the survey results reported in September 2004, 92% of respondents reported that WTO implementation affects their business, and 80% said they were "significantly" affected by WTO implementation.

The survey conducted in 2004 resulted in roughly the same numbers of respondents citing WTO implementation as affecting their businesses in China as in the previous survey from 2003. The council noted, however, in its report for 2004 that a number of members declined to respond, which indicates that WTO issues have lost some of their importance over the past year as members become more attuned to the business environment and as business practices in China evolve to become more predictable. The council also notes that 19% of respondents in 2004 stated explicitly that the WTO either does not address their industry or that they have evolved strategies to deal with problems in China. At the same time, the council noted that China in the third year after accession made considerable progress in implementing its commitments, and that the overall assessment by members was more positive than in 2003.¹

Changing Attitudes, Changing Laws

At the same time that foreign businesses have largely taken a practical approach to working in China, local officials across China have become more sophisticated in their outlooks and attitudes.

This is especially true in the area of big projects. In intra-provincial business arrangements, for example, practitioners report that they haven't encountered serious obstacles to significant new projects. Winston Zhao, a partner at Jones Day in Shanghai, says although investors have to be sensitive to local political arrangements, in his experience no real obstructionism has been encountered. An example is the West-East natural gas pipeline, one of China's largest infrastructure projects. Users may now be asked to accept the take or pay arrangement that has been adopted in the west-east gas supply contract. This will impact all downstream users of natural gas. "This is a part of the ongoing changes in China. People start being exposed to certain project finance concepts in their gas purchase contracts with upstream gas suppliers. This was never the case before. From western China to Shanghai, the rules will likely be pushed to apply to most of the users in a contractual arrangement. A few years ago, this didn't even exist," Zhao explains. The government plays a role in setting basic natural gas prices through a complicated hearing process, which of necessity must be participatory. "Natural gas distributors now go to local governments and say that they want to increase the price. Local governments instead would require a public hearing process to determine the merit of such a price increase request and publish the results thereafter. We now see such new price setting mechanisms becoming increasingly common," Zhao says.

An important legal dimension to the way that business practices have changed is the fact that adhering to WTO requirements has involved numerous changes to Chinese law. As a result, these changes have been absorbed by Chinese law, and now key issues revolve over Chinese law arguments. "The original impetus (i.e., WTO) for changes to the law has been forgotten by some people, and goes into the background. In daily life, the WTO doesn't really come up; it is just one argument among many others. You have to deal with Chinese officials and laws first," says Lauffs.

This practical business attitude is probably the main reason that foreign companies working in China haven't made more of a fuss about WTO non-compliance. In most cases, people seek to solve problems quickly and realize that in China they are dealing with a developing economy and a changing legal system. Also, political and economic realities have kept formal recourse to the WTO dispute resolution mechanism at a minimum in the case of China. "With China, you have introduced a huge player into the club (i.e., the WTO). A question that comes up is how much pressure you want to put on China over compliance issues. You still need China's engagement in the entire regime to get the next stage of negotiations going. There has been a sense that everyone wants to go easy on formal disputes and use instead the annual transitional review mechanism," says Eugene Lim, a lawyer with Baker & McKenzie in Hong Kong. Additionally, governments have to make formal inquiries and complaints, and it takes considerable proof to launch a solid case.

China has shown that it is generally committed to playing by the international rules when it has been challenged on possible WTO violations. A prime example is the discriminatory VAT policies that were used to protect domestic semiconductors against potential competition from imports. The VAT rebates were challenged by the United States, which was prepared to initiate a formal dispute resolution claim with the WTO on the grounds that the rebates violated the GATT agreement. The US and China reached an agreement in April 2004 before such a step was necessary, and China ended the rebates.

Business Strategies in a Changing Economy

Three years after WTO membership, it has become apparent that strict adherence to a market access schedule is not the pot of gold at the end of the rainbow for companies in China. Gaining wider access to the Chinese economy is important as China develops, of course, but a business strategy must take account of the economic realities that people face once the legal framework is established.

An example of this is in the banking industry. Access to China's savings base offers lucrative opportunities for foreign commercial banks that have already developed networks in many Asian countries and now see China as the last untapped market. Per the market access schedule for banking, geographic restrictions on foreign business have gradually been relaxed and the number of cities where foreign banks can provide services has grown.

Instead of a rush to try their luck and take up new business in China, foreign banks have taken small strategic stakes in Chinese banks. Most banks have come to the realization that they cannot compete with the comprehensive branch networks of the leading domestic banks and their familiarity to Chinese customers.

"No matter what you negotiate, the reality of the market is what dictates the outcome (of your venture). Three years ago, banks were pounding on the door (to gain market access); now they say, well we got what we wanted, but maybe we should do it in a different way. I don't think that local banks feel under a great deal of pressure from foreign competition," Nee says.

It should be noted that opinions are mixed as to the extent of compliance with the spirit of the WTO in opening the banking sector. Some stipulations brought into law in recent years governing foreign commercial banking operations have arguably been WTO non-compliant. The 2002 PRC Administration of Foreign-invested Financial Institutions Regulations stipulated that foreign banks could not apply to open more than one branch office per year, and imposed excessively high capital requirements for opening new offices. The latter requirement was expressed through requirement of a separate registered capital amount for each of four main types of licence: restricted foreign currency; unrestricted foreign currency; restricted renminbi licences; and unrestricted renminbi licences. The one-year interval for applying to open offices was abolished in the Implementing Regulations for the foreign-invested financial institution regulations, but the registered capital requirements largely remain, with some changes.²

Trading and Distribution: A Potential Stumbling Block

A potential problem area that comes up when reactions to China's fulfilment of its WTO commitments are solicited is in the rights to trading and distribution. Trading and distribution rights are an instrumental part of China's commitments. Liberalization in these areas will have a far reaching impact on the economy, and the complexities in their implementation reflect many of the dynamics of WTO-inspired developments and their interaction with local factors.

Under China's WTO commitments, distribution rights are defined as the ability to engage in four main areas of business: commission agents services; wholesaling; retailing; and franchising. Distribution rights are often discussed in tandem with trading rights, but in fact the two are treated separately under the terms of China's WTO accession. Trading refers principally to import and export rights. China agreed to allow minority-held foreign-invested enterprises full rights to trade one year after WTO accession. In the second year after accession, majority-held FIEs were to be granted full trading rights throughout China for all types of goods except some state-traded monopoly goods.³

In its 2004 report, the US-China Business Council noted that up until the time of the report (September 2004), foreign-invested joint ventures continued to face difficulties and delays in registering for trading rights.⁴ The PRC government issued a revised version of the PRC Foreign Trade Law (中华人民共和国对外贸易法)with effect from July 1 2004. It was the first revision to the law since 1994, and in some key ways brought China's foreign trade regime into closer agreement with its WTO obligations. At the same time, however, the law allows the Ministry of Commerce considerable discretion to determine issues such as limiting access to trade in a particular sector, instituting safeguards in particular cases and limiting technology imports or exports.⁵

Landmark legislation became effective on June 1 2004 that spelled out how foreign access to China's distribution sector would unfold. The Ministry of Commerce issued the Administration of Foreign Investment in the Commercial Sector Procedures as fulfilment of WTO obligations to open the distribution sector to foreign participation according to the agreed upon timetable. Among other things, the 2004 rules allowed wholly foreign-owned operations in the distribution sector by December 11 2004, and allowed retailers to operate free of geographic restrictions as of the same date. Additionally, wholesale operators are not subject to geographic limits, and franchising operations have been largely allowed.⁶

The 2004 Procedures were seen as a triumph for the foreign investment community that had long sought to promote expansion of their opportunities in the commercial sector as a win-win situation for both foreign companies and Chinese consumers, and as a key method to encourage further economic reform. Unarguably, liberalizing the matrix of domestic commercial distribution networks will be one of the most significant outcomes of WTO membership. The 2004 Procedures will have a significant impact on the domestic economy.

Initial dismay over the restrictions imposed in a draft version of the law turned to relief when the final version of the law was promulgated. Many onerous restrictions on the commercial sector activities of foreign investors were eliminated in the final version. In a tug of war between reformist and progressive elements and reactionary groups in determining the contours of commercial sector reform, the reformists appear to have won.

"The foreign-invested commercial enterprises law turned out to be a pleasant surprise. It appears to be possible to open distribution to all comers except in certain businesses (access in pharmaceuticals and petroleum products distribution have been extended to six years). In all other areas, the Shanghai municipal government has been quite helpful in counselling companies how to apply," says Nee of Coudert Brothers.

Applications for setting up wholly foreign-owned enterprises (WFOEs) in distribution from all over China must be approved in Beijing, however. This is where some of the reality of dealing with Chinese bureaucracy meets the optimistic predictions of WTO market access. To date, no WFOE distribution companies have been approved. Additionally, key implementing legislation for the 2004 Procedures that would spell out some ambiguous areas have not been issued.

The problem might be strictly a bureaucratic hurdle that will be overcome in time. "MOFCOM has four people examining applications for WFOEs in distribution. It seems that the staffing issue is more of a concern than that there is any concerted effort to block market access in this area," Lauffs says.

Regarding the implementing regulations, it is possible that Beijing doesn't see them as particularly crucial. Nee states: "Beijing seems to be saying that they aren't needed, as the existing rules stipulate all of the areas that are required. (A foreign-invested company) asks to set up a WFOE and stipulate the areas of business, etc. It might be a problem in that Beijing will reject an application because without more detailed rules the authorities have much more discretion. They might raise issues such as insufficient capital, or a plan to set up too many stores."

Some practitioners report that getting local administrations of commerce to process applications has been ineffective, since the municipalities and localities say they haven't received instructions from Beijing on how to proceed. This is where the implementing regulations are perhaps most crucial, in decentralizing decision-making power over applications to local commerce departments. An additional area of concern that needs to be clarified in implementing regulations is whether existing companies will be required to set up subsidiaries to distribute products that fall outside their business scope.

This latter issue focuses on the key question of whether manufacturing FIEs that already conduct business in China are allowed to undertake the distribution of products that they haven't made themselves, and thus expand their business scope. The question remains unaddressed directly in the legislative framework, although it seems to be theoretically possible under the 2004 Procedures. "The ministry (of commerce) has made it clear that this would be sorted out under the detailed implementing rules. To our knowledge, some individual applications have already been filed, but it remains to be seen what the outcomes will be," states Zhao of Jones Day. "It is likely that such applications would be handled on a case-by-case basis by the ministry. The question is what criteria will be applied in the approval process."

In the meantime, the role of private, domestic distribution and trading businesses are transforming the sector.

In the area of trading, for example, growing numbers of domestic companies have taken up the opportunities offered by more liberalized business environments and have obtained trading rights that were once the exclusive preserve of state import and export trading companies. "We have seen a developing cadre of domestic companies that are handling foreign goods trading. So, although it isn't entirely clear what is happening with FIEs (in terms of trading rights at the local level), this domestic dynamic is taking place," Nee comments. In WTO terms, this dynamic is based on the third-year commitment that all domestic and foreign trading companies would be allowed full trading rights in China with the exception of certain state trading monopolies.

In distribution, although many foreign companies are eager to set up their own wholly foreign-owned companies, many have worked out arrangements with private Chinese companies to handle distribution for them.

The Limits of WTO: The Mixed Blessing of Localism

It was hoped that membership in the WTO would usher in a new spirit of openness and transparency in the legal and regulatory environments, and would result in introduction of a trickle-down rule of law ethos that would make business and investment relations at the local level much more uniform and less susceptible to the vagaries of local decision makers and officials with their own agendas. This has not happened.

The main national challenge in implementing WTO commitments that reflect national policy is the structural asymmetry between, on the one hand, the WTO commitments and, on the other, local economic interests. How China can create a more balanced situation between WTO-inspired laws and regulations and economic incentives at the local level, and how implementation of commitments on the ground can actually be enforced uniformly are two questions that beg answers.

"Local incentives continue to drive investment. It's still a messy situation, and not at all transparent. In each situation, you're still dealing with local rules, local policies, and the way that these are handled at the local level, as they have been for the past 25 years," Lauffs says.

Local governments have implemented an array of local investment policies and offered incentives that often stand in a dubious relation to national laws and regulations. Local investment incentives and policies both seek to protect some local industries while at the same giving foreign investors the opportunity to shop around China for extremely lucrative investment deals.

An example of how WTO commitments and the planned maturation of the investment environment should play out is in the aforementioned distribution business. But taking into account the preferential treatment offered foreign companies, it is difficult to reconcile the different policies and incentives in China.

For example, supposing a manufacturer now has the option to manufacture their products in their home country and have a distribution company in China that imports and sells in the PRC. The company could well find that it makes more economic sense for its representatives to travel around China to different investment zones and find an extremely lucrative deal replete with tax breaks and rebates for set up of a PRC manufacturing centre. Two-year tax exemptions and three-year 50% reductions in tax are legal and widely used methods to attract foreign investment. But in an effort to get FIEs to set up in a locality (rather than, for example, only importing their product to China and distributing domestically) local governments are giving extended tax-free periods, for example five years at 50% off the tax rate, or rebates of local portions of value-added tax, or giving expatriate managers lower individual income tax rates, or rebates for individual income tax that is paid.

These practices amount to illegal investment subsidies, and are contrary to WTO principles. "No one is complaining about this, however, and foreign companies seek out such deals and treatment. So, localism works both ways. It is appearing in this sense as localities are giving even more incentives for foreigners to invest, and not just set up a company to distribute. In addition to tax, they give back fees that they charge," Nee comments.

The central government periodically sends out harshly worded directives that attempt to restrain local governments from contravening national laws, but has had only limited success in restraining such practices. A long anticipated national unified income tax law, which will end preferential tax laws, is the best way to end abuse. But enforcing the law at the local level is the key challenge.

There is a "disconnect" between the central government and the local level, and tax is a prime example. "I don't see the local incentives to attract foreign investment going away anytime soon. It is a very delicate issue. Will they grandfather the preferential tax treatment? If the government maintains the status quo, how will they reconcile this with the national treatment issue under China's WTO commitments? If they don't, how could they then live up to the promises that have been given to and relied upon by foreign investors? I think local governments would continue to subsidize foreign investment one way or another. But they will at times also have to comply with national government rules," says Zhao.

Customs practices, which fall within the GATT portion of the WTO agreement, are another area where national rules are interpreted in different ways by particular officials, partly because of rent-seeking activities and partly because the rules are open to interpretation. "China has national rules on customs, but the difficulty is that you have local customs officials who have different interpretations of the rules. I don't think they do this deliberately, but it is rather that China is a big country and it can be difficult to ensure that all customs officials uniformly interpret the rules. Also, in customs there is a lot of pressure to enforce the rules that boost revenue. In part, this is because customs officials often have to meet revenue-raising targets as part of their performance requirements," say Lim of Baker & McKenzie.

The Limits of WTO: Transparency in Legislation

Among WTO issues, the issue of transparency in the legislative process figures prominently.

The US-China Business Council in its 2004 report noted that much progress has been made by the Chinese government, and especially the Ministry of Commerce, in boosting the transparency of the rule-making process. At the same time, many US-China Business Council members reported in response to the council's 2004 survey that generally insufficient time is offered for feedback on pending legislation that is circulated for comment.

"Often a new draft law is put on a ministry's website, but no one is told about it, and then the consultation period is closed after seven days," comments a senior commercial official at a foreign embassy in Beijing. Although this is an improvement over the days of neibu (internal, i.e., non-disclosable) documents, "(the ministries) should give people a substantive amount of time to comment, and should make announcements when new draft laws are posted on a website," he adds.

Trouble commenting on rules in time, given translation issues and the analysis that is often required to understand the legislative intent, has a tendency to result in poor legislation being issued. "Without sufficient input, vigorous debate and open compromise in the legislative process, a resulting common problem is the confusing ex post facto patchwork of notices, regulations, circulars, etc. Courts and ministries then have a very difficult time figuring out the original intent (of legislation). All of the secondary legislation has to be issued to try and address the shortfalls of the original legislation, but this results in an exceedingly complex situation," the commercial official explains.

Although the government has made progress in attempting to adhere to WTO standards on transparency in rule promulgation, it is very difficult to enforce across the board. Ministries draft rules very carefully to meet their own needs, and to balance the pull of competing interests. As a result, throwing the drafting process open to public comment is not in their interests.

The Limits of WTO: IPR

Widespread intellectual property rights violations continue to rank as probably the most important WTO non-compliance issue that foreign investors and businesses raise about China. The government has made tackling IPR violations a national priority, with Vice Premier Wu Yi in September 2004 announcing an intensive campaign to coordinate government efforts to address the problem.

The problem remains acute, however. In addition to rampant trademark and copyright piracy and counterfeiting, domestic Chinese companies have become very aggressive in pursuing foreign IP rights holders who haven't yet filed their intellectual property in China.

There have been many cases where Chinese entrepreneurs have registered trademarks or patents that are held by foreign companies overseas. "They have then actively pursued the real owner for infringement in China, as the foreign parties haven't registered their IPR in here. We have seen this especially in model patents, for example in automotive model patents, but also in trademarks at the local level. These entrepreneurs have used IPR laws in an extremely predatory manner," explains the foreign commercial official.

Managing Bureaucracies

An excessively narrow interpretation of WTO commitments has been displayed in some recent legislation as well. The construction and engineering sectors have been highlighted in this regard. An additional problem is the exploitation of ambiguities and loopholes in the WTO agreements. "This goes on all the time. An example is WAPI and the standards used in technology. Another example is in construction; the standards and licensing requirements (for foreign-invested construction and design companies, for example) maybe are WTO compliant, but in effect they keep out many foreign companies. The ministries know the WTO very well, look at practices in other countries, and look at the letter of the WTO and meet it, but in a way to minimize disruption to local industry. It isn't unusual, but it is being done in a clever way," comments the commercial official.

The difficulty in evaluating WTO performance in general is that different approaches are taken by different ministries, and there are different evaluations of the "what is good for the ministry, what is good for the country" debate that surrounds all legislation. The Civil Aviation Administration of China, as an example of national interests trumping specific bureaucratic or industry ones, signed a series of open skies agreements with foreign parties that will badly hurt Chinese airlines and freight carriers, but will in the long-term be good for China. Liberalization is an effective tool to develop different sectors of the economy, but carries painful immediate consequences for domestic industries and companies in hitherto heavily protected sectors. And the attitudes about when to push through liberalization vary. Some actors in the legislative process act on the belief that an open market in a particular industry is in the best interests of the country, while others don't. And even with seemingly pro-reform, progressive bureaucracies, like the China Banking Regulatory Commission, it is hard to untangle the interests that are making their voices heard in the legislation that is passed. The implementing regulations for foreign-invested financial institutions that were discussed above seem to reflect both the international orientation of the CBRC's western-educated technocrats and a very cautious and conservative approach to introducing reforms that will substantially alter the face of the banking sector.

Excepting perhaps intellectual property protection, most people are satisfied with China's WTO compliance three years after accession. But how the pressures of economic growth will create new dynamics and demands on the legislative framework is an open question. "We have seen a great deal of improvement (in general transparency and the attitudes and practices surrounding WTO issues), but today the stakes are so much higher, and there is so much more investment and trade, that many more problems become apparent. Many of them are not covered by WTO and cannot be solved by WTO," comments the trade official.

Some of the most crucial issues that WTO membership will not influence are those that loom largest in China's unfolding attempts to move to a more competitive, consumption-driven economy that is largely in private hands. These include state ownership of much of the economy, banking sector reform, handling the non-performing loans issue and corruption. Within business law, some of the biggest issues, such as M&A law, bankruptcy law or facilitating the simple creation of nationwide corporate structures are not WTO issues. Debates over how China is handling WTO issues are important for an understanding of how the economy is evolving, but only to a point. Beyond that, complex structural issues, the intricacies of political and bureaucratic behaviour and the influence of local issues take over.

Endnotes

1 See The US-China Business Council, "China's WTO Implementation: An Assessment of China's Third Year of WTO Membership." Written testimony prepared on September 7 2004. Also see The US-China Business Council, "Membership Priorities Survey," September 7 2004. Both available at http://www.uschina.org.

2 For a discussion of changes to the banking rules and the impetus for reform, see Harner, "Looking at New Implementing Rules for Foreign Financial Institutions," China Law & Practice, September 2004, 18(7), pp. 31-33.

3 State-traded imports include: vegetable oils, processed oil, sugar, tobacco, chemical fertilizers and cotton. Exports that are state monopolies include: tea; rice; soybeans; corn; silk; cotton; crude and processed oil; and various mineral products such as tungsten ore, antimony ores and products, ammonium paratungstates, and tungstate products.

4 See the US-China Business Council's written testimony report, p. 2.

5 For a translation of the law see China Law & Practice, May 2004, 18(4), pp. 34-47. Also see a discussion of the law by Stender et al in ibid, pp. 14-16.

6 For a translation of the law see ibid, pp. 24-33. Also see the discussion by Xu and Peerenboom in ibid, pp. 12-13.