Technological Innovation in China

A CEO’s guide to innovation in China

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; here’s a road map for navigating it.

MCKINSEY QUARTERLY FEBRUARY 2012 • Gordon Orr and Erik Roth

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developments—such as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gaming—may well be escaping the notice of executives who aren’t on the ground in China.

As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage.

Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercialization—they are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.¹

Chinese companies also benefit from their government’s emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economy’s long-term health and to the global competitiveness of Chinese companies. China has already created the seeds of 22 Silicon Valley–like innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence.

But progress isn’t uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understanding—analytically, not just intuitively—what customers really want, corporate cultures that don’t support risk taking, and a scarcity of the sort of internal collaboration that’s essential for developing new ideas.

Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, “Improving the patent process”), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive in it.

China’s innovation landscape

Considerable innovation is occurring in China in both the business-to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap

When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names.

In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the picture quality and industrial design are comparable to those of high-end televisions from South Korean competitors.

We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencent’s QQ instant-messaging service and the Sina Corporation’s microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQ’s low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users.

What’s keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resources—for example, lower-cost labor, inexpensive land, and access to capital or intellectual property—that are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property–driven licensing fees if they sold their products outside China.

Successes in business to business

Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europe’s most demanding customers, such as France Télécom and Vodafone.

Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, China’s sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials.

China’s solar- and wind-power industries are also taking center stage. The country will become the world’s largest market for renewable-energy technology, and it already has some of the sector’s biggest companies, providing critical components for the industry globally. Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels.

Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectual-property requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement.

Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, China’s efforts to develop it had limited success. Since then, a mix of two policies—encouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment effort—has helped China Railways’ high-speed trains to dominate the local industry. The multinationals’ revenue in this sector has remained largely unchanged since the early 2000s.

But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the country’s scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. What’s more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?

Simultaneously, multinationals have been shaping China’s innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buick’s GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives.

In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time.

We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The government’s stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

Four priorities for innovators in China

There’s no magic formula for innovation—and that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead China’s innovation revolution and how far it goes.

 

Deeply understanding Chinese customers

Alibaba’s Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldn’t have happened without Alibaba’s deep, analytically driven understanding of customers.

Few Chinese companies have the systematic ability to develop a deep understanding of customers’ problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These “push” models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights.

Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domestic-market knowledge or relationships needed to apply them effectively. The solution—building a true domestic Chinese presence rather than an outpost—sounds obvious, but it’s difficult to carry out without commitment from the top. Too many companies fail by using “fly over” management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent

China’s universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executive-recruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge.

Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a community-like environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough.

Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate.

Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years (read about AstraZeneca’s experience in “Three snapshots of Chinese innovation”). The keys to success include a clear objective— for instance, will activity support global programs or develop China-for-China innovations?—and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking

Failure is a required element of innovation, but it isn’t the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded.

One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these “innovation work groups” to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking (read about General Motors’ approach in “Three snapshots of Chinese innovation”).

How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China (read a perspective on the evolution of its semiconductor sector in “Thee snapshots of Chinese innovation”). That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

Promoting collaboration

One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges.

Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted.

One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of cross-company collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business don’t cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasn’t yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of change—and determine who leads it.

 

Big Four in Hot Water in China

China Questions Big Four Auditors

THE MOTLEY FOOL  By Dan Radovsky  October 21, 2011

The Chinese government is sick and tired of hearing U.S. regulators question the validity of the auditing done on U.S.-listed Chinese companies. So it has done what it considers the best thing to do to squash those complaints. It has requested the world’s largest auditing firms to come in and recheck the work they did for those Chinese firms in 2010, and to do it quickly.

The Ministry of Finance and the China Securities Commission asked the “Big Four” accounting firms, KPMG, PricewaterhouseCoopers, Ernst & Young, and Deloitte, to also review the initial public offering, or IPO, work they did on behalf of Chinese companies wishing to be listed on the U.S. exchanges.

In addition, the firms have to inform the Chinese regulators whether any of the auditing work or client information was passed on to U.S. and other foreign regulators, something the Chinese government really would be upset about. The auditors have until the end of the week to complete this work.

What has brought on this desperate action by the Chinese? The get-rich-quick allure of investing in the new world of Chinese capitalism brought opportunities for many newly formed companies with little innovation and less financing to get listed on the U.S. exchanges. This made it easy, perhaps too easy, for naive investors to get in on the fun. As my Foolish colleague Alyce Lomax wrote, “The ‘Go-go’ China investment thesis made logical sense at first.”

The main problem with investing in U.S.-listed Chinese companies is the higher potential for fraudulent or inaccurate accounting. A case in point is that of Longtop Financial Technologies. At one time it had a market capitalization of more than $2 billion. But after the company was accused of fraudulent financial behavior, its auditor resigned. That auditor happened to be one of the “Big Four,” Deloitte.

According to Tim Hanson, another of my Foolish colleagues, Deloitte wrote in its letter of resignation that it found Longtop’s state-owned bank “complicit in helping Longtop deceive Deloitte and its investors.” This implied, according to Tim, that “fraudulent practices may be systemic in China’s financial system.”

This is obviously a perception that the Chinese regulators would like to change. It knows how bad publicity can negatively affect investment in China. And there are U.S.-listed Chinese stocks that certainly seem on the up-and-up (with a caveat regarding so-called variable interest entities): There’s Baidu (Nasdaq: BIDU), Country Style Cooking (NYSE: CCSC), Yongye International (Nasdaq: YONG), Guangshen Railway (NYSE: GSH), China Mobile (NYSE: CHL), and Renren (NYSE: RENN), just to name a handful.

The Big Four auditing firms are in a precarious position. Estimates put Chinese revenues for those firms at $1.5 billion for 2010, with growth at 20% over the previous year, so they can’t just ignore the Chinese regulators’ concerns.  But if they can’t do an audit of a Chinese company that would meet the standards that the U.S. regulators set, then their audits would have no credibility.

As Michael Pettis, a professor of management at Peking University, said, “I expect it is going to be a little messy.”

 

Enforcing Contracts with Chinese SOEs Still Challenging

Wall Street Journal On Line    By Andrew Galbraith   September 6, 2011

A spat over contracts between China’s biggest shipping company and foreign ship owners is calling attention to broader tension over the rise of a Chinese corporate sector that doesn’t always play by established global rules.

The move by China Cosco Holdings Ltd., the listed flagship of state-owned China Ocean Shipping (Group) Co., to halt or delay payments for vessels it leased at the height of the shipping boom in 2008 reflects in part the cyclical stresses in the global shipping industry. But some analysts, lawyers and executives in China say it also reflects a willingness among increasingly bold Chinese companies—often, like China Cosco, owned by the government—to snub existing norms of global commerce.

In recent years, foreign banks and other creditors have faced repeated difficulties getting payment on bonds or derivatives contracts with Chinese companies. In 2009, for example, China’s government encouraged state-owned airlines and shipping companies, including Cosco, to challenge losses from derivatives deals with foreign banks used to protect against sudden surges in the price of fuel. That same year, China-based Asia Aluminum Holdings Ltd. offered to buy back its debt for pennies on the dollar, eventually leading to losses for international investors.

Foreign companies that do business in China are routinely warned that contracts aren’t viewed in China with the same sort of legal sanctity that they receive in most developed economies. Jingzhou Tao, a Beijing-based lawyer with Dechert LLP, says that withholding payments is a frequent tactic used in China to force price negotiations. “A contract is not an unchangeable bible for Chinese companies,” Mr. Tao said.

Prices for leasing the cargo ships that carry commodities like coal and iron ore have plunged since 2008, when China Cosco signed the deals at issue. Industry executives say it is common for shipping companies to want to renegotiate long-term contracts as a result of economic swings. But it is unusual for financially solvent companies to unilaterally renege on contracts the way that China Cosco has done on some.

Representatives of Cosco Group and China Cosco didn’t respond to requests for comment Friday. During a conference call a week earlier after it posted a first-half loss, China Cosco Executive Director Zhang Liang called such disputes “normal” and blamed ship owners for “trying to use the media to make a bigger impact.” The company said it had renegotiated deals on 18 ships. A China Cosco official said Thursday that it plans to restructure its unprofitable dry-bulk shipping operations.

China Cosco, which has about 200 dry-bulk ships under charter and owns 234, appears to be trying to correct course. Some ship owners that had complained about the Chinese company’s failure to pay have said in recent days that they started receiving payments again.

On an earnings call Wednesday, DryShips Inc. Chief Financial Officer Ziad Nakhleh said the Greece-based company had been owed about $2.5 million by a China Cosco unit for three vessels, but that “Cosco has since resumed hire payments on all of the three vessels and we have no further issues with our counterparties.”

Angeliki Frangou, chairman and chief executive of Navios Maritime Holdings Inc., said Cosco stopped payments in July but has since met original agreements with no renegotiations. “We have been paid,” she said. “Cosco is a counterparty that we like to do business with and will continue to do business with. This was an incident that was very quickly resolved.”

But some in the industry remain frustrated and say the move could have lasting damage for Cosco’s reputation.

“They’ve paid up to date [and] I don’t want to be nasty,” said Raymond Ching, vice president at Hong Kong-based Jinhui Shipping & Transportation Ltd. “But obviously, withholding payments and giving us either no response or very, very absurd reasons—it’s just something that we won’t tolerate.”

Analysts and lawyers say big Chinese state-owned companies can be especially aggressive in dealing with foreign companies because of their government backing and the enormous clout they wield within China in industries that are often oligopolies.

“State-owned enterprises that are dominant in their own sector and in some cases more powerful than government departments are used to having things their way,” said Lester Ross, a Beijing-based partner at law firm WilmerHale. Mr. Ross said that Chinese companies in the minerals and cotton industries have a history of walking away from deals when prices move against them, and that foreign companies sometimes charge a premium for services to Chinese government companies because of the contract risks.

“These companies are only partly companies. They are also political entities,” said Carl Walter, a former Beijing-based banker for J.P. Morgan Chase & Co. who has co-authored two books about China’s state-owned enterprises. That means political imperatives, such as concerns over the value of national assets, can sometimes drive decisions by company chief executives, who at Chinese state-owned enterprises are appointed by the Communist Party. “When you do business with these major SOEs, you better make sure you make enough money to cover,” Mr. Walter said.

Arthur Bowring, managing director of the Hong Kong Shipowners Association, argues that while Cosco’s moves are worrisome for the industry, they won’t likely be that damaging to the company long term. He adds that in late 2008, Australian iron-ore producer Fortescue Metals Group Ltd. backed out of its obligations under some shipping contracts. After a period of arbitration, the company said in October that it had settled all disputes with shipping companies.

“People are now doing business with [Fortescue Chairman] Andrew Forrest again…and it’s almost like it never happened,” Mr. Bowring said.

Mr. Bowring said Cosco, which has been operating internationally for decades, is too experienced to think that it can apply Chinese rules to overseas deals. Still, he said that company relationships are viewed differently in China than in many other places. “Chinese culture will build a relationship before the contract,” he said. “The relationship is always something that can be talked about. The contract is just a set of papers that you keep in your bottom drawer.”

Buffett Backed China Battery Company Struggles

REUTERS August 23, 2011  By Alison Leung

HONG KONG (Reuters) – BYD Co’s profit warning and failure to deliver its promised electric car plan sent shares plunging to a more than two-year low, as the Chinese auto and battery maker backed by Warren Buffett struggles with steady sales declines and waning popularity of its top model.

Shares in BYD plummeted more than 14 percent on Tuesday after the company warned it could post a third-quarter loss.

The grim warning and ensuing stock drop has put a spotlight on the company’s strategy and on Buffett, whose investment in BYD has lost around $2 billion in value since taking a stake in 2009. His stake is still worth twice what he paid, though.

BYD attracted Buffett’s Berkshire Hathaway because of its battery technology, which former Berkshire executive David Sokol called a “breakthrough.” Sokol has since left the company under a cloud related to his personal investing activities.

Despite BYD’s F3 sedan being China’s best-selling car brand in 2009 and 2010, the company sold only 480 units combined of its F3DM hybrid and e6 electric model. It has also delayed the U.S. launch of its e6 until 2012.

Sales may improve in the second half with the launch of new models, BYD Chairman Wang Chuanfu said on Tuesday.

The company planned to export electric cars and buses to the United States and Europe next year and other overseas markets such as Hong Kong as early as 2011, the chairman said.

“We will start selling e6 to individual customers in China in the second half and to overseas markets next year,” Wang told reporters. “The fourth quarter is the traditional high season for car sales in China and with the new models coming to the market, our auto sales should be better in the second half than the first half.”

He expects BYD’s gross profit margin, which fell to 13.7 percent in the first half, to improve in the second half.

BYD warned Monday its net profit for the first three quarters may fall 85-95 percent due to fierce competition in China, the world’s largest auto market.

“I drove their car two years ago and I love it,” said CLSA analyst Scott Laprise, referring to BYD’s hybrid car. I thought this is the winner and I thought this could go anywhere in the world because of relatively low price.

“The premium part of the valuation is zero because they can’t deliver what they promised years ago,” Laprise said.

BUFFETT BAILING?

Buffett’s Berkshire Hathaway paid about $230 million in 2009 for 225 million shares in the company.

That stake was worth as much as $2.47 billion in October 2009 when the stock peaked at HK$85.5 each. The 9.6 percent stake is now worth about $467 million.

Wang said the company continued to maintain a good relationship with Buffett, but declined to comment on whether the U.S. investor would sell BYD shares.

Within Berkshire, the champion for the BYD investment has been Vice Chairman Charlie Munger, who held a personal stake even before the Berkshire investment and who has spoken of BYD’s Chairman Wang in glowing terms.

At investor meetings in April and July, Munger said he intended to stick with the BYD stake, which some took as a signal that Buffett would as well.

Buffett and Munger have also brushed aside concerns — raised by U.S. diplomats in cables released by WikiLeaks — that BYD has copied industrial designs from competitors. Diplomats have said that and other factors may keep BYD from releasing cars in the United States.

Buffett’s assistant did not respond to a request for comment on Tuesday.

LOWER FORECASTS, TARGETS

BYD’s guidance for a further deterioration and the forecast represented a 154 million yuan ($24 million) loss to a 90 million yuan profit for the third quarter, Bank of America Merrill Lynch said in a note.

The consensus 2011 profit forecast for the company stands at 1.7 billion yuan, according to a poll of six analysts by Thomson Reuters I/B/E/S.

Bank of America Merrill Lynch on Tuesday cut the target price on BYD shares by 15 percent to HK$17, after lowering its 2011 earnings forecast by 61 percent and its 2012 forecast by 31 percent.

BYD’s Hong Kong-listed shares, which have lost more than three-fifths of their value this year, dived 14.3 percent to close at HK$$16.18, their lowest since April 2009, compared with a 2 percent gain in the Hang Seng Index.

However, its Shenzhen-listed shares were up 1.2 percent.

The market has high expectations on BYD’s newly launched sport utility vehicle S6, and the coming G3 model, which will replace the popular F3, analysts said.

“This (profit forecast) was a surprise to the market,” said Steve Man, an analyst at Samsung Securities.

“Maybe on top of that the year-on-year comparison will be pretty easy starting from the third quarter. So people are hoping the company’s earning starts to turning around,” Man added.

Chinese Wage Inflation Causing US Manufacturer Reassment

David Griffith’s Note: China’s reputation as the manufacturer for the world is under assault as wage demands drive costs upwards and US manufacturers look to relocate to rural areas or other less developed Asian countries.

Analysis: China costs start to worry U.S. multinationals

On Friday August 12, 2011, 8:54 am EDT

By Nick Zieminski

NEW YORK (Reuters) – For years, low prices on China-sourced goods helped dampen inflation in the United States. Now China’s efforts to boost domestic consumer spending, reducing reliance on exports, are leading to higher costs for multinationals that manufacture goods there.

Eventually, China could export its inflation.

Conglomerates ranging from Emerson Electric (NYSE:EMR – News) to Honeywell International (NYSE:HON – News) feel pressure on margins from double-digit wage increases in China. So have toymaker Mattel (NasdaqGS:MAT – News), fast-food chain Yum! Brands (NYSE:YUM – News) and computer maker Dell (NasdaqGS:DELL – News), analysts and investors say.

They have plenty of options besides raising prices, such as embracing automation or moving to China’s less-developed interior. Some companies relegate China costs to the category of minor headache; others point to long-term benefits from richer Chinese consumers. But the topic has became a talking point during the earnings season now winding down.

“Input cost increases have been a steady headwind to margins for some time now,” Fairchild Semiconductor International (NYSE:FCS – News) Chief Financial Officer Mark Frey said last month. “Metals and energy pricing, forex and China wage inflation are more difficult to forecast.

Yum, the No. 1 Western restaurant brand in the world’s fastest-growing major economy, generates a third of its profit from China. It said its full-year margins will dip this year, citing labor inflation in the mid-to-high teens.

“I do believe that labor inflation will continue high for quite a while,” Yum CFO Rick Carucci said on the company’s earnings conference call. He called commodity prices another “wild card” for the company.

GO WEST, YOUNG MAN

Nearly a third of Emerson Electric’s total workforce is in China, where it employs more than 40,000 people. Amid 20 percent wage increases, the company has said it could move some production to China’s interior, and it might move 20 percent of its capacity to other Asian countries.

“The economy is going into a more costly mode,” CEO David Farr said on Emerson’s second-quarter conference call. “We are going to have to refix where we’re manufacturing.”

Emerson’s network power business was the only of its five units to show lower operating profits in the latest quarter. The company cited labor inflation among the causes.

“A lot of the wage increase is to keep civil unrest at a minimum,” said William Blair analyst Nick Heymann, who said suicides at an Apple (NasdaqGS:AAPL – News) supplier and the “Arab Spring” protests have alarmed Beijing. “These guys have watched North Africa and the Middle East with a lot of trepidation.”

A related, complicating factor is that local competitors, many state-owned and not too worried about margins, are challenging companies like Emerson on price, Heymann said.

Multinationals have figured out they cannot compete on cost: they must differentiate their products, making them smaller, faster or more energy-efficient. Then, depending on the product, they might be able to ask for higher prices.

Others, such as makers of labor-intensive shoes and toys, have to take into account a cost-conscious consumer now potentially facing a new recession. Still, Hasbro and Mattel have pushed through price increases this year, and Hasbro’s CEO has said China remains its preferred manufacturing hub.

MANUFACTURING A CONSUMER CULTURE

China this year adopted a five-year plan that calls for 7 percent growth in per-capita income, ahead of earlier targets, and fresh investment in research and development, to boost domestic consumption and modernize its economy.

Manufacturing wages are a fraction of those in the United States but are narrowing the gap, both fueling and responding to China’s inflation, now at three-year highs. Between 1978 and 2009, wages jumped almost 13 percent a year, six times the pace of U.S. wage rises, according to BernsteinResearch.

Since 2006, that growth has accelerated.

By 2015, wages around Shanghai, adjusted for productivity, will be 61 percent of those in low-cost U.S. states like Alabama, according to the Boston Consulting Group (BCG). Transport and other considerations further shrink that gap.

“Wages are getting large enough that you start to feel the difference,” said Hal Sirkin, a BCG senior partner, who said U.S. companies are looking at alternative manufacturing sites. “One of the answers is to start moving back to the U.S.”

The next few years will bring a wave of reinvestment by U.S. multinational manufacturers in their home base, as rising wages and a strong yuan currency make China a less attractive production center, BCG predicts. Its July BCG paper names 14 companies rethinking where they produce goods, including NCR (NYSE:NCR – News), Ford (NYSE:F – News), Flextronics (NasdaqGS:FLEX – News), Ashland (NYSE:ASH – News), and Jarden’s (NYSE:JAH – News) Coleman unit.

Where China once had ample labor, and supply was well balanced with demand, that equilibrium has broken down, BCG argues. The change does not mean shutting Chinese factories and firing workers; it means selectively scaling back future expansion or investment. China’s size will ensure it remains a major global player.

China’s well-developed infrastructure is an advantage over other countries such as the Philippines, Indonesia and Vietnam. And any short-term hit to margins has to be balanced against the long-term opportunity in a richer China. For many producers, costs such as oil and metals are a bigger headache than the soaring cost of labor.

“I’m not that worried about it,” Honeywell CEO Dave Cote said, referring to wage inflation. “I don’t put it up there in one of these economic perils kind of categories.”

Manufacturers including Honeywell are looking inland, where wages are lower, Cote said, or they are automating production.

“You’d look at it in the past and say, instead of a machine, it’s worth having 10 people do it,” Cote said. “Well, that may not be true anymore.”

Cote’s comment points to a crucial silver lining for some U.S. companies. If factories invest in machines, that helps Emerson and Rockwell Automation (NYSE:ROK – News). If China expands its consumer middle class, the Yums of the world benefit as families eat out more or adopt a protein-rich diet.

Ultimately, the success of that drive to shore up China’s consumer base may determine how U.S. companies perceive the risks and rewards of operating in China.

“The customer base in China is just so immense,” said Tim Hanley, Deloitte LLP U.S. Process & Industrial Products Leader. “Companies that were in China as a low-cost exporting base recognize they need to be there. That’s where demand is.”

 

Looking for Work – Consider Moving to China

China Wants to Hire You — Should You Go?

ByJoe Mont, Staff Writer , On Thursday August 4, 2011, 8:00 am EDT

BOSTON (TheStreet) — NBA players may soon follow the lead of a growing number of Americans looking for work in China.

With the upcoming basketball season jeopardized by an expiring collective bargaining agreement, several NBA superstars — among them Dwyane Wade and Carmelo Anthony — have said they would consider playing for Chinese teams, which have been growing an increasingly rabid fan base.

In looking for opportunities in the so-called Middle Kingdom, the players are not much different than others turning to China for job prospects.

Put simply, there are at least jobs to be had. Unlike the U.S, with near double-digit unemployment, there is great demand in China for skilled professions such as banking and finance. That demand shows little sign of slowing, bolstered by the fact the country had 10% growth last year and will experience nearly the same rate this year.

There has traditionally been demand for English-language teachers in China, a job niche that typically attracts young graduates enticed by the prospects of living abroad. Now U.S. companies are looking to move top managers into Chinese territories, and executives have found themselves forced to relocate. Recently, General Electric moved the headquarters for its X-ray division and top division executives to China to capitalize on growth in the Asian marketplace.

Entrepreneurs are also enticed by lower taxes, decreased regulation, cheap labor and a pipeline into the massive Asian marketplace, while Chinese companies are looking to expand globally by building their U.S. brain trust.

An exact count of how many Americans are working in China is not readily available, as neither country has a uniform process for registering such employment status.

UniGroup Worldwide, an international mover of household goods with headquarters in St. Louis and Amsterdam, used its own shipping business to gauge the trend. It found a 46.7% increase in the number of American’s relocating to China for work over the past three years.

Its international migration study, released last week, was based on more than 15,000 household goods moves completed in 2010 for major corporations. In the U.S., UniGroup is affiliated with Mayflower Transit and United Van Lines.

It shows that last year European countries topped the list of destinations for U.S. residents moving abroad, consistent with trends over the past 10 years. Asian countries, however, appear higher and more frequently on the top destinations list.

The U.K and France were the top two countries American’s were moving to, followed by China. In 2000, China wasn’t even among the top 10.

Once you get there

Adapting to local customs can be just as challenging as the logistics of moving there for a transplanted worker.

Similar to Japan, there is a ritualistic nature to rules of etiquette and even to business cards — they should be printed with English on one side, Chinese on the other; always presented and received with two hands; and momentarily studied before being carefully tucked away.

English is not as much a barrier, but interpreting subtext is crucial, given China’s stoic traditions. Hierarchy and one’s place in the “food chain” of a company can dictate nearly all interactions, and direct confrontation is considered impolite.

The website The idle Kingdom, run by expatriates Matt and Kara Banker as a resource for those planning to live or work in China, offers a rundown of some of the common types of visas China requires of all working foreigners.

The “Z” visa is for those working for an established company in China and are tied to that workplace. Businesses are issued a limited number, which typically cover only full-time employees. A Z-Dependent visa is available for a spouse and children.

The “F” visa covers foreign experts in China temporarily to work on a specified project.

Transportation, if walking or biking doesn’t meet your needs, has to be addressed.

“Purchasing a car in Beijing has become much more problematic in the last year,” says Matt Banker, who moved to Beijing to be the youth director at an international church. “To get a car you will need to win the license plate lottery, about a 1-in-5 chance, then you can purchase a car for about two to three times the cost of what you would pay in America. You’ll also need to pass the written driver’s license test, since China doesn’t recognize foreign licenses.”

The other option is to hire a driver, which will cost roughly 5,000 yuan a month, or about $777.

Another expense beyond food and housing an overseas worker or employer will need to be prepared for: securing an international health insurance policy.

For those with children, English language schooling needs to be considered. Homeschooling can range from $500 to $20,000 or more for an international school, Banker says.

Stateside expenses, such as storage of belongings, and the cost of trips back home also need to be part of a total budget.

If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income.

According to the IRS, however, you may qualify for a foreign housing deduction. Anyone who lives in China for more than a year also pays taxes to that country on their worldwide income (less than a year incurs only domestic income) at a progressive rate that ranges from 5% to 45%.

Decide fast

Despite the demand for foreign workers, the job market pendulum could eventually swing back toward America.

Within the next five years, the U.S. is expected to experience a “manufacturing renaissance” as the wage gap with China shrinks, proposes a recent analysis by Boston Consulting Group, a global management consulting firm. With U.S. wages stagnating while Chinese wages rise at about 17% per year and the value of the yuan continues to increase, the gap between U.S. and Chinese wages is narrowing rapidly.

“All over China, wages are climbing at 15% to 20% a year because of the supply-and-demand imbalance for skilled labor,” says Harold Sirkin, a BCG senior partner. “We expect net labor costs for manufacturing in China and the U.S. to converge by around 2015. As a result of the changing economics, you’re going to see a lot more products ‘Made in the USA‘ in the next five years.”

As the wage gap shrinks, once inventory and shipping costs are considered, China’s advantage may be minimal at best, BCG says. It predicts that products that require less labor, such as household appliances and construction equipment, are most likely to shift to U.S. production. Goods that are labor-intensive and produced in high volumes, such as textiles, apparel and TVs, will likely continue to be made overseas.

That trend may already be revealing itself.

NCR has flipped production of its ATMs back to domestic soil and toy manufacturer Wham-O last year returned 50% of its Frisbee production and Hula Hoop production from China and Mexico to the U.S.

 

Fake Apple Store Shows Chinese IP Enforcement Challenge

Insight: Fake Apple store cuts to core of China risk to brands

By Jason Subler | Reuters – Fri, Jul 22, 2011

SHANGHAI (Reuters) – A fake Apple store in China, made famous by a blog that said even the staff working there didn’t realize it was a bogus outlet, is probably the most audacious example to date of the risks Western companies face in the booming Chinese market.

Few products have captured the imagination of Chinese consumers quite like Apple’s iPhones and iPads. Demand is surging across the country of 1.3 billion people, even hundreds of miles away from the tech giant’s official stores in Beijing and Shanghai.

That marks a huge opportunity for Apple to sell its iconic products, but it also leaves the most valuable brand name in the world vulnerable to the sort of scam perpetrated by the fake store in Kunming, in southwestern Yunnan province.

Complete with the white Apple logo, wooden tables and cheery staff characteristic of real Apple stores worldwide, the Kunming copy left even regular industry watchers startled at the elaborate fake.

“I’m not aware that there have been actual fake stores like that before,” said Bob Poole, vice president of the China operations of the U.S.-China Business Council in Beijing.

“If your products are being sold as fakes, then your reputation goes down and people are going to be less willing to buy. We have to maintain active vigilance.”

Apple has authorized close to a thousand resellers in China to sell its goods. They are required to comply with certain standards and rules on store layout and customer service to get the rights to sell such items as Apple’s iPhones and iPad tablet computers.

The Cupertino, California-based company, which global brands agency Millward Brown says has the world’s most valuable brand worth some $153 billion, has just four official stores in China, two of them in Beijing and two in Shanghai.

In spite of the number of resell outlets, many more copycats have popped up. They often sell real Apple products, obtained from illicit channels, such as smuggling, or through the grey market via Apple agents and distributors.

The blogger who made the store an overnight online sensation said the Kunming store was a “beautiful rip-off” and the salespeople “all genuinely think they work for Apple.”

The bogus store, where staff admitted to Reuters Friday was not an authorized reseller, cuts to the core of the risk big brands take in China.

The widespread unauthorized reselling even of real consumer goods means it is more difficult for companies like Apple to manage their brands and risks undermining their longer-term plans to make inroads into the country.

“It’s becoming more of a problem I think,” said James Roy, a senior analyst with retail consultancy China Market Research in Shanghai.

“A lot of foreign brands are increasingly really seeking to set up a real retail presence in China, not just selling to resellers or through franchisees,” he said.

DIFFERENT FROM PIRACY

That China is a hotbed for piracy is nothing new. Multinational companies have long seen problems such as intellectual property theft and unclear regulations as the price of doing business in the world’s fastest-growing major economy.

The United States and Europe have persistently pressed Beijing to do a better job of enforcing intellectual property rights and stamp out the production of everything from fake DVDs to medicine.

An increasing number of U.S. companies in China say the enforcement of intellectual property rights has deteriorated in the last year, an annual survey by the American Chamber of Commerce in Shanghai released in January showed.

China has said it is cracking down, particularly on piracy, and Western companies have claimed some victories.

This week, Baidu Inc, China’s biggest search engine, agreed with top music studios to distribute licensed songs through its mp3 search service, ending a legal dispute over accusations the company encouraged piracy.

The less-publicized phenomenon of unauthorized vendors setting up shop to peddle real products has grown alongside China’s manufacturing prowess. Many of the factories that produce brand-name goods on contract have been known to do extra runs of the goods to make extra cash, analysts say.

Paul French, chief China analyst at retail consultancy Access Asia, said Apple had two choices to clamp down on fake stores.  “One is they either have to police their operations better, or two, they have to sell everything through their own stores and cancel their reseller agreements,” he said.

China’s high import duties on many goods have also encouraged the likes of the fake Apple store in Kunming, analysts suggest.

Shop owners can buy everything from computers to cosmetics at significantly lower prices overseas, smuggle them into the country, and undercut the prices of official Chinese retailers.

Vendors often turn to Chinese students studying abroad to buy products in the United States, Hong Kong, Australia and other countries.

Internet “bulletin boards” are full of advertisements soliciting interested parties, who can earn 100-200 yuan ($15-30) in fees per iPhone or iPad they manage to sneak past customs agents when returning home for the summer or winter break.

LOSS OF CONTROL

At first glance, it might appear that companies would not mind having their products bought in other countries or obtained through other means and resold in China through resellers, as it helps drive sales but with less expense and hassle over customer service.

After all, building up a retail presence in a country as vast as China takes time and is expensive. That’s why many companies have sought to expand their presence through licensees.  The problem is, any negative experiences customers have with service at unauthorized resellers can backfire on the brand because customers relate their disappointment with the product.  “People might have a bad experience, they might blame the brand,” said Roy.

Many Western brands are now opting to take back control of their operations. It may mean a more measured pace of expansion, but it gives a company greater control. Starbucks last month took back control of its retail stores in southern China, having worked in the past through a joint venture.

While the issue of unauthorized retailers has not yet garnered the same attention as piracy, China has made efforts to crack down on such activities, stepping up screening to try to catch smugglers. But if Beijing’s track record with combating piracy is any guide, analysts say, it is unlikely that fake stores — Apple or otherwise — will be stamped out anytime soon.

“China has very low penalties. It’s almost considered a good business deal to get caught, then move and set up shop again,” said Poole of the U.S.-China Business Council.

Sports-Related Domain Name Disputes in Asia

[tweetmeme]

Courtesy of Internet Business Law Services

Sports personalities and promoters can turn to the Asian Domain Name Dispute Resolution Centre (ADNDRC) for dispute resolution services regarding domain names that are claimed to infringe registered trademarks. Other remedies available to them include those pursuant to personality rights law in China, or passing off and trademark law in Hong Kong.

The Asian Domain Name Dispute Resolution Centre (ADNDRC) was formed as a joint undertaking by the China International Economic and Trade Arbitration Commission, Hong Kong International Arbitration Centre and the Korean Internet Address Dispute Resolution Committee. It was subsequently approved by the Internet Corporation for Assigned Names and Numbers (ICANN) to provide dispute resolution services in regard to Asian generic top level domain names (gTLD’s), under the Uniform Domain Name Dispute Resolution Policy(UDRP).The ADNDRC may delete or transfer the domain name under paragraph 4 UDRP if the domain name is confusingly similar to the trademark; the domain name holder had no legitimate interest; and the domain name was registered or used in bad faith. In Telstra Corporation Limited v. Domain-Broker-Labs, Case No.D2000-1789, the complainants, Australia’s leading information services company, entered into a strategic Pan-Asian Alliance with Pacific Century CyberWorks, a leading Asian communications company. They sued for and obtained transfer of the Asian respondent’s domain name, registered shortly after conclusion of the Alliance, on the grounds that the respondent did not carry on any related business, was not commonly known by any similar name, and did not act in good faith. The panel in that case held that “given the [claimant’s] reputation and goodwill in the TELSTRA PCCW name and the public announcement which… featured…prominently in South East Asia, it is hard to see how the respondent can claim to have registered the name in good faith.… [given] the lack of any adequate explanation or the denial of bad faith….” In Advance Magazine Publishers v. Shenzhen Hengtaixin Golf Utilities, CIETAC CND-200300007, respondent registered the domain name golfdigest.com.cn to provide information services concerning golf. The complainant was the owner of the trademark GOLF DIGEST for print publications in China. Article 11 of the Chinese Trademark Law and Article 49 of the Implementing Regulations of the Trademark Law provide that trademarks referring to the quality, quantity, or other features of goods may not be registered, and there is no right to prohibit others from using these terms normally. The panel ruled that the complainant could not register the trademark for information services on golf and was limited to print publications and similar goods; consequently, there was no right to prevent the respondent’s normal use of the descriptive term in its domain name. In Alibaba (China) Network Tech., Ltd. v. Jichuang Power Group Co., CIETAC CND-2003000024, the China Internet Network Information Centre (‘CNNIC’), China’s official domain names regulator and administrators of .cn TLD, refused the application of Beijing Zhengpu Science Development Company for the Chinese name ‘Alibaba’ on the grounds that the domain was reserved for a well-known Hong-Kong based online business-to-business marketplace, Alibaba.com Corporation. A Beijing Intermediate People’s Court ruled that CNNIC did not have the right to reserve Chinese domain names for well-known companies and ordered them to treat all domain applicants equally.

Are there any other sources of protection for domain names infringing identity rights of sports personalities in China?

Article 99(2) of the General Principles of the Civil Law guarantees legal persons the right to exclusive use of their personal names.  Article 120 provides, that if a legal person’s “name, portrait, reputation or honor is infringed upon, he shall have the right to demand that the infringement be stopped, his reputation rehabilitated, the ill effects eliminated and an apology made; he may also demand compensation for losses.”

How have the above legal protections been applied in practice?

In Shanghai Shenhua Football Club v. Shanghai Teleitong Trade, Gazette of the Supreme Court, vol. 69, no.1 (2001), the defendant used the name of the plaintiff, a Chinese national football champion in an advertisement.  The court held that the defendants were using the plaintiff’s identity to pursue commercial interests and required authorization for doing so.In 2004, a Fujian company registered the domain names of China’s gold medalists in the Athens Olympics,, without their authorization. After a public outcry, the company gave up the domain names. In the run-up to the Beijing Olympics, China’s General Administration of Sport preregistered most of the names of China’s Olympic athletes, giving away the domain names to the country’s gold medalists as a gift.  The rest of the domain names were returned following an appeal by the CNNIC.

Is the law the same in Hong Kong?

The Hong Kong Bill of Rights Ordinance protects private individuals from invasions of privacy by the government and public authorities, but not by private persons or organizations.  Sports personalities have to rely on the UDRP, reinforced by passing off and trade mark law, in order to obtain protection against infringement for their identities.

Related articles

• Trademark owners can block misuse in .xxx domain (infoworld.com)
• Are You Willing to Pay the Price for a Dot-Brand Domain? (greatfinds.icrossing.com)
• Should the UDRP be reformed? Don’t go there, says WIPO (ipkitten.blogspot.com)
• Welcome to the world of cybersquatting (thenextweb.com)
• Activision Files Complaint Over ModernWarfare3.com (pcworld.com)

Chinese Small Caps On NASDAQ Are Flaming Out

China‘s U.S.-Listed Stocks Are Junk

by Craig Stephen
Monday, July 11, 2011

Commentary: The flip side of Shanghai‘s growth

By now, everyone has heard of the Muddy Waters research alleging fraud at Sino-Forest that tripped up investor John Paulson.

Yet when this report arrived in my inbox last week, it was still an eye-opener, reading more like an Interpol indictment than a mosaic of analysis. It begins by asserting Sino-Forest is like Bernie Madoff, a rare fraud committed by an established institution, before estimating this Ponzi scheme overstates assets by $900 million.

Rather than being able to refute these allegations, it looks more like Sino-Forest (SNOFF – News) is just the tip of the iceberg, as more mainland Chinese companies listed in North America face questions over accounting irregularities. While Sino-Forest was listed in Toronto, numerous mainland companies listed on the Nasdaq and the NYSE have also been the subject of controversy.

Since March, at least five Chinese companies have been delisted and 15 suspended on the Nasdaq, and share prices have been hammered. Of the 52 mainland companies listed on the Nasdaq since 2010, only 8 have share-price gains this year, according to a recent Nomura report.

Why is it the once-prestigious U.S. stock exchanges appear to have listed so much mainland junk? It used to be only the best of China’s companies got to list in the U.S.

While failures by regulators and bankers will need to be examined, there is a more fundamental explanation — the emergence of China’s domestic stock markets as a major listing destination. Amid the recent clamor for China stocks, few appeared to notice that China was no longer sending its best companies to list overseas.

For a long time, the largest and better-quality mainland companies listed in Hong Kong, often with secondary overseas listings in New York or London.

That changed as Shanghai’s stock market came of age in recent years. While Hong Kong continued to get chunky dual listings with Shanghai, London and New York were largely no longer needed.

Data from Ernst & Young show how, following the Lehman Bros. financial crisis, Shanghai led the rebound in global IPOs, overtaking the NYSE in 2009, which led the world in capital raised the previous year.

In 2010, the combined $58.1 billion raised by the Shanghai and Shenzhen exchanges dwarfed the $34.7 billion raised by New York.

The Nasdaq also witnessed a change in fortunes. While it listed the first generation of mainland Internet companies, such as Netease (NTES – News) and Sina -2.51% (SINA – News), it is no longer the natural home for China tech stocks. Alibaba (ALBCF – News), for example, listed in Hong Kong, while Shenzhen started its own GEM market in 2009 for tech and growth companies.

At the same time that China began listing more of its best companies at home; it also opened its doors to foreign exchanges. Back in 2007, the Singapore, New York, London and Tokyo exchanges were given permission to open offices in China to lure mainland companies to list.

A conflict always exists between winning new business and maintaining listing standards. Could it be this new scrum of competition between exchanges for listing fodder pushed this dynamic out of balance?

Investor fascination with the China-concept investment story and the easy-money policies of the Fed likely also created conditions that allowed some questionable companies to list.

The head of the Hong Kong Stock Exchange recently remarked that the problem in the U.S. with its mainland listings did not exist in Hong Kong. Tempting fate perhaps, but there are some reasons to believe him.

Companies in Hong Kong are certainly bigger.

According to figures referenced by Nomura, the 173 Chinese companies listed on the Nasdaq have an average market cap of $700 million, while the over 600 mainland Chinese companies listed on the HKEx have an average cap of $6.3 billion.

Hong Kong is attracting more established companies, which partly comes down to differences in regulation. Perhaps the key listing requirement of Hong Kong is its three-year profit rule, which means companies must have some discipline and wait before seeking a listing payday.

Hong Kong has had its own fraudulent listings in the past, but arguably regulators have grown more wise to them. Back-door listings or reverse takeovers, for instance, that have been the core of fraud in the U.S., have been discouraged here and are now rare.

The Securities and Futures Commission also continues to push to tighten listing procedures, most recently with an initiative to hold sponsors to account if they take shifty companies to market. Trying later to go after companies or executives on the mainland is a mugs game — something U.S .regulators will find.

Another factor is the analyst community is here on the ground, rather than trying to do research from another continent. Smaller companies can also struggle to get their fair share of analyst coverage and proper scrutiny.

While these revelations suggest the U.S. has a particular problem with listing dubious mainland Chinese companies, to be fair it is not alone. Singapore is also doing some soul searching with recent press reporting more than 1 in 10 Chinese companies, or “S-chips,” having being delisted or suspended since 2008.

This often gets little publicity, as all exchanges have an interest to keep wrongdoings quiet in order to safeguard reputations. This might explain why aggressive firms like Muddy Waters have stepped into the void. Overall these developments should be positive for investors, however, as it forces mainland companies — wherever or not they are listed — to improve levels of disclosure.

Chinese Reverse Mergers – Part II (Still a Battleground)

David Griffith’s Note: Five years from now we’ll probably have a better grasp of what happened in 2010 and 2011 to the Chinese small cap stocks that went public in the US and were subjected to a withering barrage of bad news stories from fly by night American bloggers.  Unfortunately, we’ll likely find that some perfectly good companies got tarred and feathered along with the rest.

Long Strange Trip: Chinese Small Caps

THE MOTLEY FOOL By  Matt Koppenheffer May 20, 2011

I’ve been fascinated with the brouhaha that’s been going on with Chinese small-cap stocks. Of course, when I say “fascinated,” I mean fascinated like when everyone on the highway slows down to stare at a multi-car wreck.

Unless you’ve got money invested, it’s tough to figure out who to root for in the whole mess. On one side, you’ve got these apparently fast-growing Chinese companies that came into the public markets through reverse mergers — which is sort of like visiting a friend’s house by sneaking in through an open window. Most of these companies appear to be showing gangbuster growth, but at the very least their management teams have had a heck of a time clearly communicating with investors.

On the other side of the tussle, we’ve got self-styled crusaders out to crush the supposedly fraudulent companies. Many (most?) among this guerilla band short the stocks that they attack, hoping to profit as the stocks’ prices fall. While there has been some really good work done by some of the sleuths, as more and more blood enters the water it seems that anyone who can come up with a noble-looking logo is ready to take potshots at Chinese small caps that they’re shorting.

Like I said, it’s tough to wave a flag for either side.

Getting down with diligence
I was struck again by how nutty it’s gotten after covering three separate Chinese stocks yesterday that were reeling after bearish reports. Yongye International (Nasdaq: YONG  ) , Gulf Resources (Nasdaq: GFRE  ) , and China-Biotics (Nasdaq: CHBT  ) all lost more than 10% of their value after online reports surfaced questioning the veracity of the respective companies’ businesses and financials.

Of the three, it was China-Biotics’ tumble that stood out the most to me. It appeared that the stock’s decline was driven by a blog post on Seeking Alpha from an amateur investor named Gisli Eyland, who posts under the name “Sportgamma” and sums his approach as “Sports business meets value investing.”

There was really nothing wrong with Eyland’s post on China-Biotics. He notes that he’s had some concerns about the company and then details some simple diligence he tried to do to allay those concerns. Eyland apparently scoured publicly available documents for China-Biotics and then sent out a series of emails to the company and third parties to try and verify or question what he’d read. All but one of his emails — which included attempting to contact large companies like Wal-Mart and Unilever — went unanswered.

As a result, Eyland was left with the same questions he started with and a queasy feeling in his gut. He said, “I’m inconclusive whether China Biotics is indeed a fraud or a rose bud among cabbages, but what I do know is that I have a huge information disadvantage.” So he shared his decision to sell his China-Biotics shares.

Somebody’s getting greedy.  
Interestingly, in the midst of the sell-off there didn’t seem to be much notice that investor Richard Azar continues building a large stake in the company. Yesterday, the company filed a “Form 4” showing that Azar increased his stake by 178,500 shares on May 17. That follows a filing the day prior reporting a holding increase of nearly 400,000 shares. Based on his holding as of Tuesday, Azar’s stake at yesterday’s price is worth nearly $32 million.

Now who exactly is Richard Azar? Good question and one that I didn’t initially have an answer for. Interestingly, there is little information readily available about him. Based on a Facebook profile, he’s a snappy dresser and a fan of Boccelli, Shakespeare, and Charlie Rose. More importantly, it appears that he is a big-time Trinidadian investor who is a big fan of Warren Buffett. His name is even mentioned a couple of times in Roger Lowenstein‘s Buffett: The Making of an American Capitalist.

Myopia?
 Even smart investors do stupid things, and perhaps Azar is throwing good money at a bad company. However, it boggles my mind that investors in the China small-cap space are so scared out of their minds that they’d allow a stock to be knocked down more than 10% based on the musings of an amateur investor while a big fish is throwing real money at the shares.

Not that I’m all that surprised by this — to some extent it echoes the crazy sell-off in China Shen Zhou Mining (NYSE: SHZ  ) last month. In that case, it appeared that investors completely misunderstood the meaning of a statement by the company’s accountants.

If ever there were an environment of “shoot many times in the face first and maybe, possibly ask questions later,” it exists right now with Chinese small caps.

Boy, the sidelines are comfortable
I started out by saying that I’m fascinated by what’s unfolding here, and I’d bet my left arm that I’ll continue to be wowed by new developments. While I’ve considered the possibility of entering the fracas by investing in a basket of these shunned stocks — and thereby hoping that some big gainers would offset any proven-out frauds — I’m still currently enjoying the view from the sidelines, particularly since I’ve been finding good opportunities in stocks that are much easier to get my arms around.