Last week, the U.S. House of Representatives approved Permanent Normal Trade Relations (PNTR) with China, and the Senate vote in a few weeks is believed to be a shoo-in. Certainly in the build up to the vote you've seen the countless waves of breathless hyperbole about access to the 1.2 billion person Chinese market and the economic boon to U.S. companies. "If each Chinese just drinks one Coca-Cola productï¿½" and so on. The thought is that normal trade relations with China will open its domestic market for U.S. companies, and the money will soon come rolling in.
Don't count on it.
I'm writing this in the Rule Maker space since Rule Makers tend to have broad international operations, and their investors rightly should be interested in seeing increased access to this potentially lucrative market. China is the second largest economy in Asia after Japan, and it is one of the United States' largest trading partners. But we shouldn't expect our $70 billion annual trade deficit to evaporate just because China has agreed generally to the openness required under the World Trade Organization (WTO). Some China experts believe that our struggles with China are going to get worse, not better, because its bureaucrats are not ready to relinquish so much control.
Coca-Cola (NYSE: KO) derives more than 68% of its revenues outside of the United States. Nokia (NYSE: NOK), the lone foreign company in our portfolio, has more than 80% of its sales outside of the U.S. For Intel (Nasdaq: INTC), the figure is 70%. What is clear is that Rule Makers are companies with globally pervasive products with universal relevance. So when one-fifth of the world's population suddenly becomes accessible to outside goods and services, we rightly believe that the Rule Makers will cover them.
To be sure, the Chinese market bears considerable promise for Western companies, but it should be remembered that in China there is only one Rule Maker: the government. Regardless of China's entrance into the WTO, genuine access is a very different beast in practice. China has previously proven to be a vexing business partner for companies, with policies and business practices designed to keep as much of their money in China as possible. Government involvement is and will remain both substantial and detrimental.
As it is, Chinese law requires that foreign companies take on a local partner in for-profit ventures in China. The official and "gray" compliance expenditures required of Western companies are huge, and the regulatory process is opaque. While PNTR will lower many of the tariff restrictions on access to the Chinese market, the non-tariff limitations (similar to those that have kept the Japanese market so prohibitive to most foreign companies over the years) will remain problematic. China has a past history of poor implementation of international agreements, and there is no reason to believe, once WTO membership has been achieved, that this time will be different.
Immediate benefits to operating in China will be largely on the supply side rather than demand. Nokia already has a production facility in China, as do Coke and Intel. These facilities are used (with the exception of Coke) for lower-cost production of goods for export. The PNTR will be good for U.S. companies not so much from an access-to-market perspective, but from an investment perspective. This is what China is counting on, and their driving reason to gain WTO membership is not out of some desire to have foreign goods more available in China, but to have more foreign money pour into China to help its economy grow.
The point is that companies eyeing China as the source of their fortunes are likely to be disappointed. The government is the Rule Maker in China, and their rules are going to remain stacked in their favor for the foreseeable future, WTO notwithstanding. Below is a list of every American company to date which has made a profit on its operations in China:
That's right, the number is zero. The large developing economies (China, Russia, and India) are very expensive places to operate. In each of these countries, corruption is rampant, regulations are unevenly applied, the commercial code is fluid or nonexistent, and legal enforcement is not guaranteed. Simply speaking, the home-court advantage is tremendous. Investors who are hitching their fortunes to the potential for certain companies to make a killing in China need to be well aware of the risks. Companies that do nothing to temper their investors' expectations for profits from China should be looked at skeptically.
China, for much of this year, has been a buzzword for companies touting their future profit potential. Perhaps the most visible (but certainly not the most blatant or exploitative) example has been Qualcomm (Nasdaq: QCOM), which signed an agreement with government-controlled China Unicom to develop a cellular network in China based on its proprietary technology. China Unicom is the second largest telecom company, and was recently forced by the Chinese government to liquidate all of its joint-venture partnerships with foreign companies -- a move quite in opposition to increased access.
The problem is that many Qualcomm shareholders have been banking on the company's prospects in China, as evidenced by the rollercoaster ride the stock has taken over the last four months -- up when something positive comes from China, down when negative news comes out. Qualcomm has, by not managing expectations for the potential importance of China, ceded a great deal of power to China Unicom, and thus the Chinese government.
China is going to become a powerful market but, in many cases, the benefit to investors will be slow in coming. As you assess the Rule Makerness of companies with large designs on this and the other growth markets, Foolishness requires that your projections of profitability from Chinese operations take into account the reality that open access to this market -- WTO or no -- is not necessarily in the best interest of the Chinese government. If these businesses are seen as a threat, rest assured they will discover who the real Rule Maker in China is.
Bill Mann, TMFOtter on the Fool Discussion Boards