FT SPECIAL REPORT

Doing Business in Chinawww.ft.com/reports | @ftreportsTuesday November 4 2014

Inside

Bribes just one maladyin healthcare systemAchieving affordabilityand quality of care isproving to be a strugglePage 2

Driving the car crazeAntitrust fines have awider agenda: to lowerprices of vehiclesPage 3

Hong Kong protestsBeijings plans forelectoral reform sparkfears of long-termimpact on business hubPage 4

Financial system in forshort-term shocksLiberalisation plans aimto foster longer-termgrowthPage 5

The Chinese flag was flyingover the New York StockExchange in late Septemberas a grinning, elflike formerEnglish teacherwatchedhis

ecommerce company smash the recordfor the worlds largest ever initial publicoffering.

Alibabas $25bn share sale made JackMa the richest man in China, but italso provided the kind of moment thatsymbolises historic shifts in the globallandscape.

Fromoutside,Chinasrisingeconomicand political power appears unstoppa-bleandrelentless.

Chinese are now the biggest purchas-ers of expensive properties in London,New York and Sydney, and Chineseinvestorsarebuyingupeverything fromItalian utility companies to the WaldorfAstoriaHotel inNewYorkCity.

Chinas increasingly assertive Com-munist leaders seem to want their ownversion of the United States 19th cen-turys Monroe Doctrine for their ownbackyardofAsia.

This policy stated that any interven-tion by external powers in the politics ofthe Americas was seen as a potentialhostileact.

At the same time, Beijings risinginfluence can be seen around the globe,fromSierraLeonetoSoPaulo.

As he revelled in his companys suc-cessful debut in New York, Mr Madeclared that Alibaba was a companythat had already shaped the worldand said he wanted it to be bigger thanWalmartas itexpandsoutside itshomemarket.

US capitalist investors lapped it upand appeared to have bought into the newest Chinese dream. Alibaba shares

ended their first trading day up nearly40 per cent and the company wasvalued at more than Facebook, Ama-zon, JPMorganorProcter&Gamble.

Alibaba is not the only Chinese com-panywithdreamsofworlddomination.

As growth continues to slow at home,many Chinese companies are lookingabroad to make investments, enter for-eign markets and acquire valuable tech-nologyandbrands.

But this interest in overseas corporateexpansion is increasing just as foreign

Slowdown ispart of neweconomicnarrativeJamil Anderlini says shifts in investment patternsand internal problems signal end to strong growth

direct investment (FDI) into China isslowing sharply. In recent months, it hasfallen at the steepest rate since theheight of the global financial crisis, witha drop of 14 per cent in August and a 17per cent fall in July from the samemonthsayearearlier.

Apart fromadropduringthefinancialcrisis, FDI inflows to China have grownsteadily since the country joined theWorld Trade Organisation in 2001 andreached a record $118bn in 2013, com-

Continuedonpage2

Internet giants trainsights on killer appsMobile gatewaydevelopers become toptargets for acquisitionsPage 6

High stakes: Alibabas New YorkIPOmade Jack Ma ChinasrichestmanAndrew Burton/Getty Images

Even themost optimisticforecasters believe Chinawill keep slowing

Order a childs Halloween costume inChina ($3.44 for pirate hat, eye patchand black cape) and it will arrive at yourdoor the next day, with a mere $1.60 inshippingcostsadded. If thesupplier is inyourcity,youget it thesamedayfree.

This consumer bonanza is increas-ingly a problem for local and foreigncompanies selling in China, where risingenergy, transport and labour costs aresqueezing profits, not just for manufac-turers but for the growing number ofbrandstargetingChineseconsumers.

For years, the price of labour has beenrising, especially for managers, butoverall costs were still so low comparedwith the prices foreign customers wouldpaythat itsexport industrythrived.

By contrast, brands that market tocost-conscious Chinese buyers not onlyhave to manage their manufacturingcostsbutalsocontendwithshippingandretail costs inside the country. And thatin turn means high energy costs are tak-ingadoubletoll.

Energy costs are so high in China, itsbecoming a concern, says Shaun Rein,author of The End of Cheap China andmanaging director of China MarketResearchGroup.

Those high costs can show up in unex-pected ways as Chinas business land-scape changes. Sales have moved sodecidedly from bricks and mortar toonline that transport is really a prob-lem,MrReinsays.

For retailers still selling the old fash-ioned way, the shift from tiny store-fronts to malls or box stores has meanthigher power costs for air conditioningandlighting,aswellasrisingrent.

Much of the problem lies in Chinasindustrial structure. There is not muchtransparency in how authorities setdomestic oil prices and a good system ofsupervision is not in place, says DongZhengwei, a lawyer and veteran cam-paigner against state-owned mono-polies. The government wants to pro-tect the interestsof largeoil companies.

International oil prices dropped bynearly a quarter between late June andmid-October; but Chinese retail petrol

and diesel prices fell by only half thatamount, or 11-12 per cent. The govern-ment, which adjusts prices on an irregu-lar basis, is allowing oil companies torecoup some revenues denied themwhen oil prices were higher. That putsChinese retail petrol prices about 20 percent above US prices and diesel pricesabout9percenthigher.

Relatively few manufacturers rely onnatural gas in China, but those that dohavealsobeenfacingrisingprices.

Increases in the state-set natural gasprice were designed to offset importlosses for state oil companies andencourage them to produce more gas,but the price rises have deterred indus-trial customers. Its one of the few mar-kets in the world where industrial gasprices are higher than residential

prices, says Kim Woodard, an invest-mentadviser inBeijing.

Most of Chinas industrial sector stillrelies directly on coal, the cheapest fuelaround, but by 2010, 28 per cent of Chi-nese industrys energy needs were metby electricity, surpassing the level ofindustrial electrification in the US. Theswitch has helped mitigate noxious coalpollution in wealthier cities but mademanaging energy costs more compli-catedforChinesecompanies.

This is important, because power canaccount for up to 90 per cent of a fac-toryscost,dependingonthe industry.

First Financial Daily, a Shanghai-based newspaper, tried to analyse

Chinas electricity rates last year andconcluded there were at least 1,000 tar-iffs across the country, with 314 in Bei-jingalone.

The result is so confusing it creates abusiness opportunity. Taryn Sullivan,an American, founded EEx, a consul-tancy that is helping Chinese factoriescut electricity costs by 10 -20 per cent.EExs entry-level service is helping cli-entsmakesenseof theirelectricitybills.

Chinese labour costs are rising stead-ily as the workforce shrinks, but wagesare still well below those in the US,Europe or Japan. The labour-intensivetextile industry has already moved tolower-cost markets such as Vietnam orBangladesh, but for many other indus-tries, especially electronics, Chinasports, roads and clusters of supplier fac-toriesmakeitunattractivetomove.

Minimum wages are $2.50 an hour inthe manufacturing hub of Guangdong(versus $7.25 in the US), although manyworkers earn more for overtime workduringpeakorderseason.

The introduction of social security,medical insurance and other pro-grammes has raised costs, althoughmany factories skimp on these legallyrequiredpaymentsordeductother,ran-dom fees, from salaries. They also hireinterns through vocational schoolswhocanlegallybepaidmuchless.

There is one labour cost that factoriesarenotable tododge.

Management salaries in China haveseen a large increase in the past decade,says David Alexander, whose Florida-based company BaySource Globaladvises companies on offshoring.Where a mid-level manager may havebeen paid $20,000 about 10 years ago,thatposition isdoublethatnow.

Additional reportingbyOwenGuo

Rising energy, transport andlabour costs squeeze profitsCheap China

Local consumers are notprepared to pay the pricesthat foreign customers will,reports Lucy Hornby

Going up: move from tiny storefronts to malls has increased overheads Bloomberg

Its one of the fewmarketsin theworldwhere industrialgas prices are higher thanresidential prices

2 FINANCIAL TIMES Tuesday 4 November 2014

DoingBusiness in China

merceministry figuresshow.But inbound FDI is not expected to

reach that level again this year andaccelerating outbound investment,which hit $108bn in 2013, according tothecommerceministry, is likely toover-take inbound investment within thenextyearortwo.

This trend of rising outbound and fall-ing inbound investment suggests a dif-ferent narrative from the dominantinternational impression of a relent-lesslyrisingChina.

Charles Wolf, a China expert and dis-tinguished chair in international eco-nomics at the Rand Corporation think-tank, argues that shifts in investmentpatterns are important for judging eco-nomicprospects inagivenmarket.

If we look at inbound and outboundFDI in China and we examine the ratesof change, we can see that outboundChinese investment to Europe and theUS is extremely positive, while inboundFDI from those markets and elsewheretoChina isnowquitenegative,hesays.

This shift is indicative of expecta-tions regarding market opportunitiesandGDPgrowth,headds.

In fact, from Beijings viewpoint, glo-bal perceptions of indomitable Chinesestrengthseemsomewhat far-fetched.

The countrys borrowing-to-GDPratio continues to rise rapidly, even asgrowthcontinuestoslow.

The worlds second-largest economyis almost certain this year to report itsweakest annual expansion rate since1990, when the country still faced inter-national sanctions in the wake of theTiananmenSquaremassacre.

Owing to the stimulus measures Bei-jing introduced in the wake of the finan-cial crisis, debt relative to GDP hasexpanded from about 130 per cent in2008 to more than 250 per cent by themiddleof thisyear.

No economy in history has experi-enced credit growth of that speed andscale without suffering a financial crisisandaprotractedperiodof lowgrowth.

Chinas expansion is also beingdragged down by a prolonged correc-tion in the property market, which hasbeenthesinglemost importantdriverofthe economy for much of the past dec-ade.

Even the most optimistic forecasters

Continued frompage1

believe China will keep slowing in thenext few years, even if it is able fully toimplement a range of reforms intendedto rebalance growth away from an over-reliance on investment towards con-sumption,particularlyofservices.

China faces double-digit wageincreases and indeed rising costs acrossthe board that are making the countryless and less attractive as the worldsworkshop.

But it is also becoming less attractiveas a market for global businesses andnot just because of the falling growthrate.

Over the past year, many multina-tional companies have been hit by awave of state media attacks and opaqueregulatory investigations that have

sometimesresulted inhefty fines.Many of the worlds largest carmak-

ers, household names from the world oftechnology, such as Microsoft and Qual-comm, and a host of others from sectorsas varied as pharmaceuticals and babymilk formula makers, have been inves-tigated for alleged price fixing andmonopolisticactivities.

The US and EU Chambers ofCommerce in China have stronglycriticised the heavy-handed intimida-tion tactics of the discriminatorygovernment campaign against theirmembers. They have warned that theseactions could violate commitments thatChina made when it joined the WorldTradeOrganisation.

Jacob Lew, the US treasury secretary,

sent a letter to Chinas leaders sayingsuch tactics could have serious implica-tions forbroaderSino-USrelations.

Shaken by the criticism, Chinese pre-mier Li Keqiang responded by sayingforeign companies have only beeninvolved in 10 per cent of the anti-mo-nopoly cases brought under the currentcampaign.

No other statistics are publicly availa-ble and the claim has been met by deepscepticism among multinational execu-tives, who point out that none of thecountrys large state-owned monopo-lies, which dominate most big indus-tries,havebeentargeted.

Experts on Chinas investment poli-ciesbelievethe investigationsarepartofa broader trend that has developed asthe country has shifted from being acash-starved importer of capital to anexporterofcapital.

Lei Li, a Beijing-based partner withthe law firm Sidley Austin and a formerofficial in the legal department ofChinas ministry of commerce, declares:I can remember the good old days adecade ago, when the Chinese authori-ties, particularly local governments,welcomed almost any kind of foreigninvestment.

However, Mr Li says that since 2009the government has become muchmoreselectiveabout thekindsof invest-ment itwants:

It has imposed more and more con-ditions on foreign investment and hasactively discouraged certain kinds, suchaspolluting, low-endmanufacturing.

Decades from now, the Alibaba IPOwill definitely be remembered as a his-toric symbol of changing fortunes andshiftingeconomicrealities.

However, those shifts may not goentirely in the direction most peopleassumetheyareheadingtoday.

Slowdown ispart of neweconomicnarrative

$108bnChinas outboundinvestmentlast year

250%Chinas debtrelative to GDP, upfrom 130% in 2008

Top of the world: Jack Mas Alibaba was the largest ever IPO Andrew Burton/Getty Images

Doing business in Chinabecame that bit moreunpredictable when a courthit UK pharmaceuticalcompany GlaxoSmithKline

with the largest bribery fine everimposed on a foreign company in China,while GSKs British head in China, MarkReilly, received a suspended three-yearprisonsentence.

Four Chinese managers got sentencesof two to three years in a verdict handeddown in September. Their sentenceswere also suspended, but the messagewas clear, drug industry analysts andinsiders say. Foreign drug companies inChina can no longer turn a blind eye (orworse) to sales staff who offer bribes todoctors and hospitals that buy theirproducts.

SoonafterChinesepolicebeganinves-tigating GSK in 2013, the companystopped using individual sales targets asa basis for calculating staff bonuses, glo-bally as well as in China. Other multina-tional pharmaceutical companies inChina have not been so categorical, butindustry and legal sources say they haveall re-examined their compliance pro-cedures to make sure they are not set-ting unrealistic sales targets that canonly be achieved through what areeuphemistically known locally as com-missions.

But punishing one foreign drug com-pany will hardly solve corruption in theChinese healthcare system, which haseroded public trust in doctors and theobjectivityof their treatmentchoices.

Drug industry analysts, doctors andhospital officials all say that localgeneric companies are more profligatewith kickbacks than foreign companies,and that the underfunded hospital sys-temcannot functionwithout them.

Local suppliers are still very depend-ent on such payments, despite the anti-

corruption campaigns efforts to pre-ventbriberyofstaffathospitals.

Many doctors say they cannot makeends meet or live a lifestyle commen-surate with being a medical professional without accepting gifts from drugcompanies, so their incentive to takecommissions will remain strong,whatevertherisk.

But bribes to doctors are far from theonly problem facing a medical systemthat must serve 1.4bn increasinglysophisticated, urbanised, demanding and elderly patients. Chinas leadershave ambitious plans to improve boththe quality and affordability of medicalcare, through complicated reforms ofthe healthcare system including drugprice controls and a radical transforma-tion of health insurance. However, noneof thiswillhappenswiftly.

Beijing is certainly willing to spendmoney on the problem, but in 2013healthcare still accounted for only 6 percent of gross domestic product, accord-ing to national statistics, compared with10-12 per cent in western Europe and15-17 per cent in the US and far less percapita,accordingtoMcKinsey.

The government promised in 2009 toprovide universal, low-cost healthcarewithin three years. Since then, 95 percent of the population has been givenbasic health insurance. However, thecoverage is so limited that many fami-lies facecripplingcosts.

While public dissatisfaction is high,Beijing sees improving healthcare ascritical to maintaining social harmony.However, many interactions betweenhealthcare staff and patients are farfrom agreeable, with hundreds ofattacks on healthcare workers everymonth. Many doctors say the last thingthey want their children to do is studymedicine.

Beijing hopes to ease the pressures onthe public system by doubling the shareof private hospitals to 20 per cent by2015 and private investors are eager tojump on that bandwagon. Privateinvestment in the mainland healthcaresector rose to an all-time high, withdeals worth $10bn last year, nearly fivetimes the 2006 figure, according to sta-tistics from Dealogic. So far this year,therehavebeenanother$7bnindeals.

But public distrust of private hospi-tals is a hurdle, and they struggle toattract top-quality doctors, who preferthe prestigious state system. Investorsmay battle to identify potentially profit-able deals in a sector where corruptionisrifeandhospital financesareopaque.

Additionally, privatisation will notsolve the problems of corruption, over-work, low salaries and conflict in thestate hospital system where most ofChina will continue to receive its medi-cal treatment.

Additional reportingbyZhangYan

Corruption a symptom of healthcare illsMedical system Beijingplans to improve carefor its 1.4bn citizens, butdistrust of privatehospitals is a hurdle,writes PattiWaldmeir

Healthcare shortfall

Source: China National Health and Family Planning Commission

1.5

2.0

2.5

4

6

8

2004 05 06 07 08 09 10 11 12 13

Number of licensed doctors forevery 1,000 people

Number of outpatient visits(bn)

2013: June 28 Police in Changshaannounce that GSK companyofficials are under investigation foralleged economic crimes.

July 2 The National Developmentand Reform Commission, Chinasmain economic planning agency,announces a probe into the costs ofmedicines at 60 domestic andinternational drugmakers.

July 11 The Public Security Ministryissues a statement accusing GSK ofbribing doctors to prescribe theirdrugs and concocting a hugescheme to raise drug prices.

July 15Police say GSKmade illegaltransfers. Gao Feng, head of theeconomic crimes investigation unit,says four senior Chinese executivesfrom GSK have been held.

Aug 15 Chinas State Administrationfor Industry and Commerce says itis investigating possible bribery,fraud and anti-competitivepractices in a range of sectors,including the drugs industry.

Dec 16 GSK says it is to scrapindividual sales targets forcommercial staff and will insteadlink pay to improved patient careand company-wide performance.

2014: Feb 4 GSK says sales ofmedicines and vaccines in China fell18 per cent in the fourth quarter of2013, year on year, after falling 61per cent in the third quarter.

May 14 Chinese police say theirinvestigation shows that GSK as acompany and individuals engagedin bribery on a massive scale.

June 29 GSK says senior executiveshad been sent a secretly filmed sextape of the companys top managerin China shortly before Beijingopened its bribery investigation.

Sep 19 GSK says its Chinese unitwill pay a fine of about 300m afterit is found guilty of bribery.

GSKCase timeline

New start: pharmaceutical multinationals have re-examined their complianceprocedures after GlaxoSmithKline was found guilty of bribery Alexander F Yuan/AP

Tuesday 4 November 2014 FINANCIAL TIMES 3

DoingBusiness in China

For multinational car compa-nies operating in China, theeuphoria fromthebiggesteverautomotiveboominindustrialhistory is finally being tem-

pered by some unexpected risks, mostnotably a controversial investigation bythe National Development and ReformCommission (NDRC) into allegedlyanti-competitive behaviour by Audi,Mercedes-Benzandotherbrands.

The investigations have so farresulted in fines that are peanuts incomparison to the vast profits that for-eign automakers have enjoyed overrecentyearsandcontinuetoenjoy.

In July, a joint venture betweenVolkswagen unit Audi and state-ownedFirst Auto Works was ordered to pay$41m for alleged violations of Chinas2008 Anti-Monopoly Law. This com-pares with reported operating profits of$12.2bn for VWs joint ventures in China(itsotheriswithSAICMotor)lastyear.

Fiat unit Chrysler was also hit with asmall fine this summer, while Daimlersjoint venture with BAIC Motor, whichmakes Mercedes-Benz saloons, is stillawaiting the outcome of an NDRC inves-tigation after one of its Shanghai salesofficeswasraidedinJuly.

These fines are the byproduct of awide-ranging investigation that appearsto have a much larger aim forcing carcompanies, regardless of whether theyare in fact guilty of anti-competitivepractices, to lower the prices of theirvehicles, sparepartsandservices.

According to one industry executive,the head of a multinational companysChina operations has told visiting boardmembers that, in view of the NDRCsoffensive, his biggest fear is of a suddenshift in government policy. Its bad forbusiness, the executive says of the

investigation. It has made the invest-mentenvironmentveryuncertain.

Ifpeoplecanaffordthecars, theycanafford the spare parts and after-salesservice, he adds. Its not like the NDCRis lowering the price of medical care ormakingfoodcheaper.

Foreign automobile executives arguethat the relatively high prices asked forcars especially premium vehicles thatcan be almost twice as expensive inChinaas theyare intheUS isa functionof unprecedented demand, even foroverseas models subject to expensiveimport taxes.

Chinas car craze began in earnest in2008-09, during the depths of the globalfinancial crisis, when it overtook the USastheworlds largestcarmarket.

Demand from entire generations offirst-time drivers soared in the worldssecond-largest economy, just as pur-chasing power collapsed in the US andEurope a nadir symbolically markedby Washingtons bailout of GeneralMotors inDecember2008.

Over the ensuing half decade, foreigncarmakers in China, especially longestablished ones such as VolkswagenandGM,hadalicencetoprintmoney.

Even last year, when double-digitannual growth was finally expected totaper, annual sales grew by about 15 percent to 18m passenger cars 10 times asmanyasweresold inIndia.

This year began in similar fashion,especially for foreign brands and theirChinese joint venture companies. Salesof Chinese brands, however, began tofall sharply and their share of the pas-senger car market tumbled from 27 percent to23percent.

The precipitous fall-off in sales oflocal brands and slower economicgrowth has forced the China Associationof Automobile Manufacturers to lowerits projection of an 8.3 per cent increasein year-on-year sales this year to 4.6 percent two-thirdsdownonlastyear.

In the first quarter, Geely, the privatesector carmaker most famous for itspurchase of Volvo Cars from Ford, sawsales of its own-brand vehicles fall by asmuch as 40 per cent over the sameperiodayearearlier.

This was despite a gradual improve-ment in the quality of local-brand carsin China, according to Geoff Broderickat JD Power, which publishes an annualcustomer survey of 212 models across62 brands. The domestic brands aredoing exactly what they should be doing focusing on quality, Mr Brodericksays. But as we see the quality gap clos-ing, were not seeing a pick-up in [localbrands]marketshare.

One reason for the fall has been acounterintuitive NDRC requirementthat foreign-invested joint venturesdevelop a local brand for the China mar-ket, such as the Baojun saloon manufac-tured by GM, SAIC and Wuling. Many ofthese new entrants are priced to com-pete against domestic rivals, especiallyin smaller cities where car ownershipratesarerelatively low.

I dont understand what the Chinesegovernments objective was in encour-aging foreign companies to create localbrands, says Bill Russo, a Shanghai-basedindustryconsultant.

It only cannibalises already dis-tressed sales of local brands. I think theintent was for more technology to beshared by the foreign companies. Butthe unintended consequence is to takevolumefromlocalcarmakersproducingsimilarproducts,headds.

At the other end of the spectrum, for-eigncarmakerscontinuetothrive insat-urated markets such as Beijing andShanghai, where premium brands suchas Audi, BMW and Mercedes-Benzaccount foraquarterof themarket.

Even now, limits on expensive newlicence plates to combat congestion andpollution are spurring their sales, asexistingplateholders tradeup.

As cities implement plate restric-tions, people gravitate towards pre-mium foreign brands, says Mr Russo.They want to put their expensiveplates on the best piece of automotivetechnologythat theycan.

Antitrust finesfor foreign carcompanies failto stall growthSales drive Price probehas not dented profits,reportsTomMitchell

ContributorsJamil AnderliniBeijing bureau chief

Lucy HornbyChina correspondent

Patti WaldmeirShanghai correspondent

Gabriel WildauShanghai correspondent

Charles CloverBeijing correspondent

Tom MitchellChina correspondent

Demetri SevastopuloSouth China correspondent

Jrg WuttkePresident of the EU Chamber ofCommerce in China

Adam JezardCommissioning editor

Steven BirdDesigner

Andy MearsPicture Editor

For advertising details, contact:Maralyn Ho +852 2905 5580; email:maralyn.ho@ft.com,or your usual FT representative.All FT Reports are available on FT.com atft.com/reports.Follow us on Twitter @ftreports.

Chinese antitrust fines

Source: China Central Television, NDRC

Largest fines, Rmb million

Sumitomo Electric and nine other parts suppliers (Japan)

Audi JV and dealerships (Germany)

Maotai (China)

Mead Johnson (US)

Wuliangye (China)

Danone Dumex (France)

Biostime (China)

LG (Korea)

Samsung (Korea)

1,240

278

247

304

202

172

163

118

101Total: Rmb 3,043.6m

648.6mPaid by Chinese

companies

2,394.9mPaid by foreign

companies

Fines paidRmb

Investigations have sofar resulted in fines thatare peanuts in comparisonto the vast profits thatforeign automakerscontinue to enjoy

Trading up: premium vehicles costalmost twice as much as in the US

4 FINANCIAL TIMES Tuesday 4 November 2014

DoingBusiness in China

Luxury goods were the currency ofChinese corruption for decades, untilBeijing stepped in two years ago to blockthe flow of fine baubles into the hands ofgovernment officials and stem theflood of profits into the coffers of luxurygoodscompanies.

Herms, the luxury dynasty bestknown for its sought-after Birkin andKelly handbags, is one of the few luxurybrands that has prospered despite Bei-jingsabstemiousnesscampaign.

So far we havent seen any impact onourfigures,saysAxelDumas,chiefexec-utive of Herms and scion of the found-ingfamily.

The French company does not breakout mainland sales, but sales in Asia(excluding Japan) rose 17 per cent in thefirsthalfof2014,while first-half sales forits rival LVMH in Asia (excluding Japan)wereuponly3percent.

And despite the generally gloomyatmosphere around luxury in Chinathese days, in September Hermsopened its first mainland maison, inShanghai, to complement those in Paris,NewYork,TokyoandSeoul.

Itmightseemliketheworst timetodosuch a thing, but Mr Dumas is not in theleast bit worried. That could just be theself-confidence that comes with repre-senting the sixth generation of the com-panys founding family. But it is morelikely that his optimism reflects a moreimportant underlying fact about whytheFrench luxurygroupcontinues todowell in the middle kingdom, despite themost challenging luxury market condi-tions inadecade.

Herms represents what Chinaaspires to be: not just another nouveauriche nation with more money thantaste, but a country of sophisticatedaffluence and understated extrava-gance.

Mr Dumas thinks time is on the com-panys side, as Chinese consumers out-grow their tendency to show off withluxury brands and develop an appetiteforsavouringthem.

Most retail analysts agree: Chineseconsumers are growing keener on niche

top-level brands such as Herms andless fond of logo-laden, mass luxuryrivalssuchasLVMHandGucci.

Torsten Stocker, retail partner atconsultancy AT Kearney in Hong Kong,says: Herms more classic style fitswell with the high-end Chineseconsumers shift to less ostentatiousitems. Cao Weiming, Herms head inChina, agrees: Two to three years ago,we started to see some changes, even

before the anti-corruption campaignbegan, as the market moved naturallytoward greater sophistication, whereconsumers are more brand-knowledge-able thanshow-off.

That transformation will take time;but that is one thing the French houseprides itselfonhaving.

It takes many years to train its crafts-men. It takes forever to get through thewaiting list to buy a Birkin bag. It even

took seven years to build the Shanghaimaison.

Mr Dumas points out that his familysconnection with China stretches a longway back: his grandmother, who wasborn in the early 20th century, whenmany French writers and artistsindulged a passion for the far east, wasafanofmah-jong.

Gestures toward that Chinese herit-age pepper the Beijing store, includinghorse-themed dinnerware for the cur-rent lunaryearof thehorse.

Indeed, Herms is so keen on winningover this market that four years ago itlaunched its own Chinese luxury brand,Shang Xia one of the few mainlandbrands that celebrates its Chineseness,ratherthanapologising for it.

Everything in the Shang Xia collec-tion of clothing, jewellery, furniture andobjets dart has a story: a cashmere feltcoat is inspired by the wool felt saddleblankets used by Mongolian horsemen;a jade ladder to heaven necklace ech-oes the bamboo undergarments worn inimperial China to keep heavy ceremo-nial fabricsawayfromsweatyskin.

It is the first Chinese lifestyle brandbuilt from the ground by a leading Euro-pean luxury house. Making it a successwill taketime,evendecades.

Additional reportingbyZhangYan

Herms takes long view to feedappetite for understated styleLuxury case study

Even as Beijing cracks downon extravagance, brand holdsits appeal for sophisticates,writes Patti Waldmeir

Lap of luxury: Herms Shanghaimaison took seven years to build

Herms represents whatChina aspires to be: not justanother nouveau richenationwithmoremoneythan taste, but a country ofunderstated affluence

Beijingis notpreparedto give thepublic a rolein choosingthecandidates

Hong Kong has witnessedthe most heated debateabout its political futuresince Britain handed theterritory back to China in

1997.From the end of September, tens of

thousands of students and other pro-de-mocracy demonstrators took to thestreets to oppose a controversial Chi-nese plan for electoral reform in theformerBritishcolony.

The protesters were so successful inblocking traffic in a crucial commercialdistrict that they sparked concernsabout the impact on the economy andthe citys reputation as a leading finan-cialcentre.

The Occupy movement evenprompted a rare intervention from LiKa-shing, Asias richest man, who urgedthestudents toreturnhome.

We understand student passion, butyour pursuit needs to be guided by wis-dom, the Hong Kong tycoon saidrecently.ItwouldbeHongKongsgreat-estsorrowiftheruleoflawbreaksdown.

So far, few protesters appear to havelistened, partly because one of their

main concerns is that the Chinese planallows the elites who wield power inHong Kong to retain far too much influ-ence at the expense of the public.

In August, China followed through ona promise to introduce universal suf-frage one person, one vote for theelection of Hong Kong chief executive,the toppolitical job, in2017. Ithasurgedpeople inHongKongtosupport theplan which requires approval from HongKongs legislature on the grounds thatit provides them with a greater politicalvoice than was available during the Brit-ishcolonialperiod.

But critics say tough conditions thatBeijing included in the plan mean itamounts to nothing more than shamdemocracy. Those concerns morphedinto thephysicalprotests that forcedtheclosure of traffic arteries in the Admi-ralty district and other shopping andentertainment areas in what has beendubbed the umbrella revolution afterdemonstrators huddled under umbrel-lasduringdownpours.

While many business people say pri-vatelytheprotestscoulddolastingdam-age to the citys reputation, few have

been willing to speak out. Some are con-cerned about generating anger amongthe protesters that might be directed attheirbusinesses.

Following a visit to Hong Kong,Stephen Roach, a senior fellow at YaleUniversitys Jackson Institute for GlobalAffairs and a former Morgan StanleyAsia economist, said that while the pro-tests were still causing a little inconven-ience, they were not a big deal intermsofeconomic impact.

MrRoachsaidthebiggerquestionwaswhether there would be any long-termimpact on Hong Kongs reputation as abusiness hub. At the height of the pro-tests when masses of people were dem-onstrating on the streets, he said therewere signs multinationals might start tolook at places such as Singapore as analternative, but now that the intensityhas diminished, I dont think it is goingto be a significant factor. He added thatas long as the confrontation did not leadto extreme police action, the reputa-tional impactwillbeminimal.

Some people who are sympathetic tothe protesters fear that speaking pub-licly would earn them the wrath of

China, on which they increasingly relyfor business deals. For example, JimmyLai, the Hong Kong media tycoon whoowns the anti-Beijing Apple Daily news-paper, has accused the Hong Kong gov-ernment of persecuting him in the wakeof a move by the anti-graft agency toinvestigate payments he made to demo-cratic lawmakers who are critical of Bei-jing.AppleDailyhasalsoaccusedStand-ard Chartered and HSBC of pullingadvertising because of pressure fromBeijing,claimsbothbankshavedenied.

Even before China unveiled its con-troversial plan, a Chinese official speak-ing in Hong Kong gave an unusual warn-ing for a senior Communist partymember that the territorys famedcapitalist system could come underthreat if protesters followed through ontheir threat tooccupythecity.

Under the current electoral system,an elite committee of 1,200 people whoare mostly loyal to Beijing, elect thechief executive. Beijing is prepared to let5m people in Hong Kong vote for theirleader, but is not prepared to give thepublicarole inchoosingthecandidates.

The leaders of the democracy move-

Power of Beijinglooms large interritorys future

Hong Kong Fears grow over impact on business ofelectoral reformplans, reportsDemetri Sevastopulo

Tide of opinion:while manyHong Kongpeople aresympathetictowards theprotesters, fewhave beenwilling to speakout publicly AFP

ment in Hong Kong argue that, as aresult, the plan on offer does notamounttogenuineuniversal suffrage.

China has also ruled that potentialcandidates must secure support of amajority of a nominating committeethat is expected to resemble closely thecurrent 1,200-member election com-mittee. At present, candidates need sup-port of only one-eighth of committeemembers a formula that has allowedopponents of the Communist partytwice to get on the ballot. Critics say thenew proposal would be more restrictive,giving Beijing even more scope to ensureitscriticscouldnotrunforelection.

At a rally on the day that Chinaunveiled its electoral reform plan, Mar-tin Lee, the founder of Hong KongsDemocratic party, summed up the con-cerns of critics when he said the peopleof Hong Kong wanted genuine univer-sal suffrage and not democracy withChinese characteristics. Hong Kongpeople will have one person, one vote,but Beijing will select all the candidates puppets, he said. What is the differ-ence between a rotten apple, a rottenorangeandarottenbanana?

Tuesday 4 November 2014 FINANCIAL TIMES 5

A year after the launch of the Shanghaifree trade zone, hailed as a laboratoryfor ambitious economic and financialreforms, many investors are disap-pointedat theslowpaceofchange.

However, while critics rightly notethat precious few business and invest-ment activities are currently permittedin the zone (known as the FTZ) that arenot also allowed in the rest of China, it istooearlytodismiss itasa failure.

Thegovernmenthasused its firstyearto establish a regulatory framework forfurther liberalisation of rules on foreigndirect investmentandcross-bordercap-ital flows.

Meaningful deregulation under thisframework has been slow, but with thebasic infrastructure now in place, thegovernment could proceed quickly toloosen capital controls or open to for-eign investment industries that werepreviouslyoff-limits.

We still hold the view that the Shang-hai FTZ and other [similar zones] willbe an important test ground for Chinascapital account convertibility, says JuWang, senior foreign exchange strate-gistatHSBC.

Over time, we can expect companiesand individuals within the zone to beable to conduct free borrowing andlending activities as well as portfolioinvestments.

Full convertibility would enableinvestors to exchange renminbifreely for foreign currency for thepurpose of either portfolio or directinvestment, without being subject toquotas and onerous administrativeapprovals.

Last December, the central banksShanghai branch issued rules establish-ing a system of special FTZ bankaccounts. Moving funds between theseand offshore accounts is already possi-ble with few restrictions, buttransfers between FTZ

accounts and the rest of China remaintightlycontrolled.

Yet, with the FTZ account system nowin place, the ground is prepared for fur-ther opening up of the system. Officialshave said they are preparing stress teststo gauge the impact of freer capital-ac-count flows.

Nonetheless, investors should beunder no illusion that the authoritieswill allow unfettered flows for financialinvestmentanytimesoon.

Han Zheng, Shanghai CommunistParty secretary, said recently: Convert-ibility under the capital account doesnot equate to full convertibility underthe capital account. These are differentconcepts.

He added: We are opening up capitalaccount operations directly serving thereal economic growth, instead offinancefor thefinancessake.

Another example of the governmentscautious approach to reforms in thezone is the much-touted negative list.For years, China has regulated foreigndirect investment by publishing a cata-logue that categorises each sector of theeconomy as either encouraged,restrictedorprohibited.

The FTZ has established a mirror-image system for regulation of foreigninvestment. All industries not includedin the negative list are permitted for for-eign investment.

Like the FTZ bank account system,the negative list has delivered few prac-tical resultsso far.

The initial version of the list con-tained190items,making foreign invest-ment in the zone barely less restrictivethanintherestofChina.

In late June, the government trimmed51 items from the list, opening sectorsincluding real estate, oil explorationtechnology, and chemicals. Officials saythat the negative list is likely to be short-enedfurther inthecomingyears.

Yang Xiong, Shanghais mayor, hassaid: It is not a matter of two or

three years. Many thingsneed to be done. Butfrom a long-term per-spective, it is the rightpath.

Authorities are taking a cautiousapproach to Shanghai test groundTrade zone

Critics are disappointed,one year on, at the slow paceof change in this importanttest area for reforms,writes Gabriel Wildau

Han Zheng:no finance forfinances sake

DoingBusiness in China

Global financial institutionsare hoping that Chinaspledge to liberalise itsfinancial system will bringopportunities in a market

that has long stymied their efforts togainafoothold.

Their hopes for swift progress may bedashed, however, as risks from within the system are likely to encourage pol-icy makers to apply the brakes onreform. Last November, Communistparty leaders approved a landmarkagenda that included pledges to deregu-late interest rates and liberalise the flowof investment funds in and out of thecountry.

Their goal was to improve the alloca-tion of financial resources and correctdistortions in the economy, putting thecountry on a secure footing for severalmore decades of rapid growth. Forinstance,acaponbankdeposit rateshasencouraged excessive investment ininfrastructure and manufacturing bykeepingborrowingcostsartificially low.

Meanwhile,overinvestmenthas ledtorampant overcapacity in sectors such assteel, cement and non-ferrous metals,creating a host of unprofitable firms andimperilling the financial sector, as loss-makingcompanies fail torepaydebt.

At the same time, restrictive capitalcontrols preventing Chinese citizensfrom moving funds abroad havetrapped savings inside the nations bor-ders, further contributing to wastefuldomestic investment. This liquidity hasalso helped inflate a housing bubble, assavers prevented from buying foreignassets and wary of the casino-likedomestic stockmarkethaveembracedbricks and mortar as an investmentratherthanjustaplaceto live.

Deregulation of rates, when it finallyoccurs, should play to the advantage offoreign banks and joint-venture broker-

ages operating in China, which are expe-rienced at managing interest-rate andforeign-exchange risk. They should alsobe able to earn profits dealing in deriva-tives to help clients manage such risks.Freer capital flows would also createopportunities for foreigners, especiallyoverseas asset managers that will enjoyincreased access to mainland capitalmarkets. But such freedom may still beyearsaway.

Currently, foreign investors areallowed to buy only into Chinas domes-ticstockandbondmarketsunderastrictquotasystemthatseverelylimitsaccess.

By comparison, direct investment,which involves buying an overseas com-pany outright or starting an enterprisefrom scratch, is relatively more open,but still subject to governmentapproval.

John Greenwood, chief economist atInvesco, a UK-based fund manager,says: The gradual relaxation of capitalcontrols should bring multiple opportu-nities to asset managers, but we must

accept that these changes will be slow incoming. Nevertheless, since the Chinesemarket has huge potential, it is worth-whilebeingpatient.

The problem is that such reforms,while they will aid long-term growth,are likely to be destabilising in the shortterm. That is a problem for Chinas

stability-obsessed leadership, which istherefore likely to implement themmore slowly than the most zealousadvocatesofreformwouldprefer.

Once banks are forced to compete fordepositors funds, interest rates willrise. That will be painful, given the largeincrease in corporate and local govern-

ment debt since the global financial cri-sis. Rising rates will also increase thecost of servicing debt, potentially spark-ingawaveofdefaults.

Freer capital flows will open the doorto capital flight if investors lose confi-dence in the economy. Such a scenario isall the more likely if rising interest ratesspark a wave of defaults among highly-indebtedcorporateborrowers.

To be sure, China has already takencautious steps to open its financial sys-tem. A new programme will allow HongKong and Chinese investors to buy intoeachothers stockmarkets.

However, this scheme is subject to astrict quota, and authorities have madeit clear that capital-account converti-bility the technical term for freeingcross-border investment flows doesnot mean it is open season for specula-tive capital to slosh in and out of theterritories. A rapid opening up could behighly destabilising for the economy, sowe understand the caution of theauthorities,saysMrGreenwood.

Liberalisation threatens stability in the short termFinance Policymakersset sights on long-termgrowth and patientinvestors will findplenty of opportunities,writesGabrielWildau

Patience pays:investorsmonitor stockprices inShanghai Qilai Shen/Bloomberg

Freer capitalflowswillopen thedoor tocapital flightif investorsloseconfidencein theeconomy

Chinas rising debt load

Source: CEIC

Total social financing stock by type, as a % of GDP

0

50

100

150

200

2002 03 04 05 06 07 08 09 10 11 12 13

Bank and trust loans to corporates, households Bank and trust loans to local governments Entrusted loans, corporate bonds, nonfinancial equities, and others

Simplified company registration:a one-stop shop for all steps inthe process. Approach to foreign investment.All industries not on the negativelist are open to foreigners. Investment in sectors not on thelist via a simple registration system;no advance approvals necessary. Simplified procedures and lessred tape for customs, shipping andlogistics to make merchandisetrade more convenient. Unrestricted transfer of fundsbetween FTZ bank accounts andoffshore accounts. Suspension of 14-year ban ongames consoles, which can beproduced in the zone and soldthroughout China.

Preferential policiesin the zone

It is not amatter of two orthree years: many thingsneed to be done

6 FINANCIAL TIMES Tuesday 4 November 2014

Ukraine will undoubtedly be the mainforeign policy focus for the EuropeanCommissions newly appointed leaders.The importance of this immediateneighbour to the east is obvious. ButJean-Claude Juncker and hisadministration should place equal ifnot greater emphasis on a countrythis lies even further east.

With the EU exclusively responsiblefor foreign trade and investmentmatters since the entry into force of theLisbon Treaty in late 2009, the blocsrelations with China should beprioritised to reflect the countrys sizeand its restrictive investmentenvironment.

China has contributed substantiallymore to the worlds economic growththan any other country since the globaleconomic crisis and it has become itslargest economy in purchasing powerparity terms. Yet China has longadopted an idiosyncratic approach toforeign investment.

Unlike the EU, which does not evenhave a term for classifying investmentwithin its borders as foreign, Chinaretains a distinction between externaland domestic investment. In doing so,it places conditionality on the openingof its marketplace by prescriptivelylaying out conditions that acceptforeign investment only where it isperceived to serve specific domesticindustrial policies.

The vast reform agenda outlined ayear ago in the so-called Decision of theCommunist Party Central Committeesthird plenary session was thereforewelcomed by European industry inChina for its breadth and boldness. Ifimplemented resolutely, its emphasison further opening up of its marketscould rebalance Chinas increasinglyprecarious economy and level theplaying field for European and otherforeign companies. While thisdemonstrates the political will ofChinas leaders to push reforms,these will not come intoforce overnight.

The recent spate of investigationsinto antitrust violations indicates thatproblems will continue to arise. One ishow China investigates tax collection,particularly among foreign companies.The EUs leaders should be mindful ofthese difficulties when working outhow to engage with China.

Foreign businesses have developed ajustified wariness of speaking out oncontroversial topics.

So, when the European chamberbecame the first association to expressconcern openly about the opacity andlack of due process in Chinasenforcement of its competition lawover the past year and a half, it waspraised for being courageous.

Foreign industry needed to voice itsconcern, for reasons that go wellbeyond todays investigations. But this

should not be done to disparage Chinasefforts to improve how it applies itslaws. Chinas antimonopoly law is oneof the cornerstones for strengtheningexactly those conditions that arerequired to rebalance and upgrade theeconomy.

However, non-adherence to legal dueprocesses in antimonopolyinvestigations risks a situation wherebyadministrative power not onlyperversely distorts competition but, ina wider context, endangers thecredibility of Chinas attempts to bemore open and its ability to let thewider market place have a bigger rolein the economy.

China improved the positive

sentiment among foreign companies toan all-time high following the thirdplenary session last year. It would be ashame if the praise it has earned forthis important policy direction isundermined by poor execution.

The antimonopoly investigationsshow that the EUs political leadershipmust be ready to engage head on withChina on politically prickly trade andinvestment issues. Such a strategymust be built on a deep and studiedunderstanding of the countrysbusiness environment. The Europeanparliament ought to look closely (andregularly) at Beijings trade policiesand actions as happens in the US inorder to make the informed decisionsneeded to engage with China.

At stake are millions of Europeanjobs, a substantial contribution toeconomic growth, our ability toinnovate and the multiple benefits ourrelationship with China has brought.

As China is now an economicsuperpower that increasingly shapesglobal practices and invests overseas, itis high time that engagement with thecountry commands the priority itmerits across all the EUs institutionsand member states.

This means that the Europeanparliament, the 28 member states andthe European Commission speak withone voice and avoid temptations tobow down to Chinas economic mightin return for short-term gains at theexpense of a unified and results-orientated strategy.

Europes change in leadershipprovides an opportunity for thisreadjustment of its strategy with China.The opportunity within thatopportunity is the EUs continuingnegotiation of an ambitious bilateralinvestment agreement (BIA) withChina. The negotiations represent themost important engagement withChina on trade and investment policysince Chinas accession to the WorldTrade Organisation in 2001.

They also present the EU with aprime opportunity to set the tone for aconstructive engagement with China.As explained in the EU-China 2020Strategic Agenda for Cooperation,the successful conclusion of a

comprehensive BIA would conveyChinas willingness to engage in a

deep and comprehensive tradeagreement with the EU.

The writer is president of the EUChamber of Commerce in China

China needs to be placed at the top ofthe EuropeanCommissions to do list

Jean-Claude Juncker:setting tone for futureengagement

DoingBusiness in China

The listing of Alibaba in NewYork in September createdthe worlds second-largestinternet company by mar-ket capitalisation, behind

Google. This did not happen by acci-dent. Of the top10 internet companiesin the world, ranked by market cap,three are Chinese, and the rest are fromtheUS.

Together, Baidu, Alibaba and Tencentform what is know in China as BAT.These economic juggernauts that havecome to dominate the internet in Chinaare operating almost along the lines ofJapans keiretsu, which are alliances ofbusinesses with similar interests or thathave shareholdings in one another.They are also rapidly branching out intooffline sectors, such as transport, travel,retailandbanking.

Whether the rapid growth of the Chi-nese internet is just a bubble or a stabletrend is open to question. However, forthe time being at least, BAT has becomethe nucleus of an internet industry thatis starting to rival the US, creating what

is essentially a US-China duopoly. Thethree Chinese companies also benefitfrom what has become known as theGreat Firewall, as most of the top UScompanies, such as Google, Facebookand Twitter, are excluded from operat-ing inChina.

However, no Chinese internet com-pany has yet made the leap from Chinato become a global brand. For now, it isenough for them be dominant in China,which had 632m internet users as ofJune, 527m of whom go online usingmobile devices. The potential of theforecast consumption boom, as Chinamovesfromaninvestment-drivenecon-omy to a consumption-driven one, isenough to attract investments such asthe $25bn sunk into Alibaba in its initialpublicoffering, the largestever.

The internet is the most dynamic partof Chinas budding private sector,though it remains solidly under the con-trol of the state. Foreigners hold large shareholdings in Alibaba, Tencent andBaidu and dozens of other internet com-panies.Butthesestakesare largelytheo-

retical at best and owned via variableinterest entities, or VIEs, which guar-antee a payment stream from, but notownership of, the licence-holding vehi-cles in China. These VIEs are techni-cally illegal, though Chinese courts turna blind eye to the practice, and ownersknow their large holding only existsthankstothetacitconsentof thestate.

Nimble private internet companies,able to dance circles around the ineffi-cient state-owned enterprises, havebegun impromptu liberalising of wholesectors such as financial services. Ali-babas fund company Yue Bao is Chinasbiggest online money market fund, withRmb574bn($93.8bn)worthofassets

The internet is a phenomenal wealthgenerator. Five of the 10 richest men inChina are tech moguls, up from nonethree years ago, according to the HurunChina Rich List, which tracks wealthyindividuals. In September, Alibabafounder Jack Ma joined the list in firstplace and became one of the wealthiestmen in the world, with a 7.8 per centstake ina$230bncompany.

Competition between internet com-panies is fierce, however. With theentire industry switching from desktopdevices to mobile ones, many compa-nies risk being left behind if they donthave a killer app that will act as a gate-wayformobileusers.

Alibaba has been searching for justsuch a feature to challenge the currentlyundisputed leadership of Tencent,whose WeChat instant messenger has350m monthly users. WeChat and Ten-cents other messenger, QQ, are the twomost popular mobile apps in China,according to iResearch, a Beijing-basedinternetresearchfirm.

In June, Alibaba bought UCWeb, apopular mobile browser company, andthe two have developed Shenme, amobile search engine. They are alsoworking with Quixey, a US-based com-pany in which Alibaba has invested, todesign a mobile gateway using Quixeysapp search engine. Francis Bea of Papa-yaMobile, a Chinese mobile technologycompany, says Alibaba is attempting tomirror Tencents success with WeChat.

He says: In as highly competitive amarket as China, there is potential forthe mobile internet to disrupt estab-lished internet players if they dontmanage the transition from desktop tomobile.

Alibaba has spent an estimated$6bn-$8bn in the space of a year on fullacquisitions of, or investments in, com-panies including mobile providers,chain stores, an internet TV company, amaker of electrical appliances, a movieproducer, a digital broadcaster and aprofessionalChinese football team.

While attention has focused on Ali-babas acquisitions, Tencent and Baiduhave been on similar spending sprees.Baidu is betting that its stake in Qunar,Chinas top travel website by users, andmobile app store 91Wireless.com, willcomplement its popular search engineto carry it into the mobile age. Tencenthas taken a stake in JD.com, Chinas sec-ond-largest ecommerce platform, andmobile-friendly companies such as res-taurant review site Dianping and SouthKoreasCJGames.

Internet titansfocus on stayingahead of mobilerevolution

Technology Charles Clover says search for gatewayapps is driving acquisitions in a dynamic industry

Changing times:of the 632minternet users inChina, 527m goonline usingmobile devicesEd Jones/AFP/Getty Images

There ispotential forthemobileinternet todisrupt theestablishedinternetplayers

OPINION

JrgWuttke

China isnowaneconomicsuperpower thathelpsshapeglobalpracticesand investsoverseas

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