russia china risk final
TRANSCRIPT
Group 5
XYZ Corporation Foreign Investment Risk Profile - Political Risk in China and Russia
By Anjelika Bench, Jeremy Lutes, Neal Marks, Ingo Schiller, and Jordan Young
Country Risk Analysis - ITRN 759-B01
George Mason University
Summer 2016
Introduction
We at ABC Corporation, per the request of your organization (XYZ Corporation) have
completed a comparative profile of the political risk characteristics of China and Russia, and
given our recommendation regarding the lower-risk nation to conduct a prospective investment
in the agricultural machines industry. To complete this analysis, we have used the following
definition of political risk:
“The likelihood that new major political events, including regime change, rising popular
unrest, international conflicts and disputes, legal/regulatory changes, and the imposition of
international sanctions, will negatively affect the ability of a company to operate and make
money in a given host country.”
Below, we have completed our analysis of the various aspects of political risk in
accordance with our definition above. We examine and discuss mitigation strategies for
vulnerabilities arising from the structure of the business, changes in the legal and regulatory
regimes, and the idiosyncratic and unique overall political conditions within China and Russia.
In accordance with the data derived from our analysis, we conclude that China is the lower risk
nation for your investment.
Business Structure Risks: ChinaThe World Bank’s Doing Business indicators rank China as 84th in ease of doing
business (Doing Business, 2016). China’s regulations for foreign direct investment are complex,
opaque, suffer from arbitrary enforcement, and are overseen by various levels of government.
Foreign investment is regulated by seven laws issued by the State Council, but is also subject to
review under over 1,000 rules and regulations issued by various government ministries and
legislatures at multiple jurisdictional levels (US Department of State Investment Climate
Statements for 2016: China). In addition, local-level governments are empowered to enact their
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own regulations on investment and business operations, compounding the complications
involved in investing in China (US Department of State, 2015).
Foreign investments are approved on a case-by-case basis following review by multiple
government agencies (see Appendix 1; US Department of State, 2015). In January of 2015,
China’s Ministry of Commerce (MOFCOM) published a draft of a new Foreign Investment Law
for the People’s Republic of China (People’s Republic of China Ministry of Commerce, 2015).
Part of the law is the Catalogue for the Guidance of Foreign Investment in Industries, a list of
industries in which foreign investment is forbidden, restricted or encouraged. The sector most
relevant to XYZ - agriculture or agriculture equipment manufacturing - is not prima facie
prohibited, meaning that that sector is theoretically open to foreign direct investment (Westam,
2014).
However, the process for receiving approval for investment is not transparent and it is
arbitrarily enforced. Regulators have the flexibility to ignore the Catalogue guidelines and issue
approvals or rejections along other justifications (US Department of State, 2015). Current
regulations may at any time be superseded by new policies issued by the government (US
Department of State, 2015). Also, investors have voiced confusion over contradictions between
the catalogue and other existing regulations (US Department of State, 2015).
In sum, it is difficult to predict what regulatory conditions XYZ will be faced with upon
application for investment. According to the U.S. State Department, XYZ may be allowed to
invest, but at any point along the process the application may be rejected for reasons of national
security, violation of a separate regulation, violation of an unpublished government regulation, or
simply to protect domestic industries operating in that sector. This uncertainty introduces
significant risk in investment; despite this, a majority of companies which apply are approved to
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conduct business in the country, leaving the industry of XYZ Corporation (Agricultural
Machinery) as unlikely to pose a problem.
In addition to uncertainty regarding making legal investments, Chinese law may require
joint domestic-foreign equity in a venture, or require foreign investors to maintain a minority
stake (US Department of State, 2015). Chinese law prohibits expropriation except under special
circumstance to include national security concerns and obstructions to large civil engineering
projects; however, the term is undefined, leaving open the risk of expropriation at any time (US
Department of State, 2015). For these reasons, we recommend the pursuit of a joint venture with
a Chinese company, should the decision be made to invest in China. Doing so will assist XYZ
Corporation in navigating the legal system, as well as helping to ensure that risks encountered
due to changes in investment policy for foreign companies can be minimized or eliminated
through partial Chinese ownership.
Business Structure Risks: RussiaIn 2014 President Obama authorized sanctions against certain Russian individuals and
economic sectors (energy exploration, drilling, and finance; US Department of State: Ukraine
and Russia Sanctions, 2014). The sanctions do not prevent investment in the agricultural or
manufacturing sector. However, in retaliation a Senator in Russia’s federation council
threatened to introduce legislation authorizing expropriation of assets, property and accounts of
EU and US companies (US Department of State Investment Climate Statements for 2016 -
Russia). The sanctions and threats of expropriation have created significant uncertainty
regarding the security of American investments in Russia, although no expropriations have yet
occurred. Russia has no capital controls in place; companies are free to remit profits, dividends
and interest out of country. The specter of the possible escalation of sanctions creates a high
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level of uncertainty for XYZ Corporation should it decide to invest in Russia, especially if there
is no Russian ownership in the venture. It should also be noted that a lack of State Owned
Enterprises in that sector reduces the likelihood of governmental regulatory or expropriative
interference.
The World Bank’s Doing Business indicators rank Russia as 51st in the world for ease of
doing business (Doing Business, 2016). Property rights for foreign investors are typically
protected in Russia, although there have occasionally been issues with local governments (US
Department of State Investment Climate Statements for 2016 - Russia). Foreign and domestic
entities are enabled to enact and dispose of businesses in Russia, unlike in China where opening
a business is not a right and requires licensure from the government.
However, there are some limitations on investment. Russia has a list of 45 “strategic
sectors” in which investment is prohibited (US Department of State Investment Climate
Statements for 2016 - Russia). These sectors are largely confined to industries related to national
security; agriculture and manufacturing are not on the list, making it legally permissible for XYZ
to invest in Russia. Foreigners are not allowed to purchase land near national borders and are
only allowed to own 50% of an agricultural plot (US Department of State Investment Climate
Statements for 2016 - Russia). This is not expected to change in the near future. To mitigate
these risks, XYZ Corporation should hire an industry consultant to assess the likelihood of
Russian government interference.
Legal RisksBoth Russia and China share many similarities in terms of consistency when it comes to
adhering to legal framework. Corruption is a major issue in both countries which makes it
difficult for U.S. companies who are subject to compliance with the Foreign Corrupt Practices
Act.
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Despite the government’s remarks on how important foreign investment is to the success
of the economy, many foreign investors still face difficulties in making investments in Russia.
Lack of transparency is often an issue, especially since government agencies tend to change and
create new regulations relevant to their own agenda that in some cases leads to contradictory
provisions.
Russia’s regulatory system is complex and sometimes contradictory. Regulations are
enforced inconsistently, and the law in some cases overlaps, creating legal uncertainty (US
Department of State: 2014 Investment Climate Statement - Russia, 2014). Foreigners drafting
agreements with local entities should include contractual protection for the foreign investor to
guard against contingencies. Furthermore, corruption is rampant in Russia judiciary system; in
some cases, commercial arbitration skews in favor of taxpaying entities, relying solely on written
documentation in lieu of witnesses (US Department of State: 2014 Investment Climate Statement
- Russia, 2014). XYZ should be defensive when creating contracts with local partners, and it
should retain written proof for every agreement.
According to The Economist’s Intelligence Unit, doing business in China as a foreign
investor has become easier overall, despite popular views of an increasingly difficult legislative
regime (EIU, 2016). The government has been experimenting with new regulations, causing
confusion and complications. Overall, the perception of the ease of market entry in China is
similar to that of Russia, due to specific regions and industries being closed for investment. The
Chinese government restricts foreign investment in areas that are not relevant to national interest,
or industries that would compete with state-sanctioned monopolies and “favored domestic
firms.” The U.S. State Department (2016) reported that many companies have voiced concerns
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over the fact that regulations contain vague, unclear language, and that different regulatory
bodies and localities apply certain regulations inconsistently.
Property rights protection is another area of legal framework that is rated quite poorly in
Russia. The Heritage Foundation Economic Freedom Index score for Russia’s rule of law for
property rights at 20 out of 100, meaning private property is weakly protected, the court system
is inefficient and vulnerable to political and monetary persuasion, and expropriation is a common
occurrence (Heritage Foundation, 2016). Foreigners are also subject to specific land ownership
restrictions under the Land Code. For example, foreign ownership is prohibited in some areas
specifically assigned as restricted territories, or land located in border areas. Another restriction
requires that foreign citizens or legal entities are prohibited from owning more than 50% of
agriculture plots, but can lease land for up to 49 years (U.S. Department of State, 2016). This
amount of time is usually cut short by government entities who wish to seize control of that plot.
China also scored relatively low on the Economic Freedom Index at 20 out of 100, which
similarly to Russia insinuates weak property rights protection, corrupt and inefficient courts, and
over looming threats of expropriation (Heritage Foundation, 2016). Property rights for foreigners
have expanded in recent years as rules began to change, however all land in China remains
owned by the state. Both foreign and domestic investors can apply for transferable land-use
rights for a designated number of years for a fee. While residential property rights are generally
renewed automatically, commercial property rights are only renewed if it does not “conflict with
public interest” (U.S. Department of State, 2016). In most cases foreign investors end up having
their land use right revoked due to government interests for development in that area, and
previously promised compensation for having to relocate is almost never given. Another obstacle
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foreign investors generally run into involves the aforementioned land-use leases, mortgages, and
other debtor and guarantor rights.
In the case of legal framework, whether XYZ Company invests in China or Russia they
will need to take the same precautions in one as they would the other since both countries
contain high levels of legal risk. Both countries have non-transparent systems and function off of
corrupt systems. XYZ Company must ensure that they have well-written and well-executed
contracts reviewed by trusted local sources, and should proceed with caution by including an
arbitration clause that will allow disputes to be settled outside of either country. However, if the
external arbitration clause cannot be achieved, Russia has a lower level of legal risk – while
corruption in the system is very high compared to that of China, the relative definition of Russian
laws compared to that of China indicates a lower level of uncertainty in Russia.
Political Conditions China has enjoyed a stable (but evolving) government with no strong or large opposition
parties or groups of internal political influence. This structure is one that, while allowing more
freedom for the development of capitalist business structure maintains very strong control over
the lives of its citizens and residence. Much work is being done by the government to eliminate
corruption and abuses of power by individuals within the government with public removals and
trials of citizens and foreigners that engage in illegal or corrupt activities. This should not be
interpreted to mean that there are not examples of corruption still present in the interface
between government and commercial activities, most notably in the areas of building permits and
commercial licenses.
Russia on the other hand is working through the major change in government and
political system since the collapse of the Soviet Government in the late 1980’s. Since then the
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country and political system has become a parliamentary system with a Premier position that has
been consolidating power to the point of being likened to a dictatorship. It does have political
pressure groups but none that are so strong that they challenge the ruling party.
The introduction into commercial capitalism in Russia has been a turbulent one with
many examples of industries and commodities being effectively owned by individuals or
conglomerates with strong political pull. Similar to China, the government seeks to make
examples of those judged as guilty of corruption and other illegal activity, however there are also
entities which are exempted from the legal system and are allowed to profit from their actions.
International Conflicts
China has had a few armed skirmishes with neighboring countries in the last few decades,
but since the advent of authoritarian capitalism and the resulting economic boom of the last 20
years, the conflicts have been more symbolic. China is determined to defend all of its territorial
claims and has worked to develop and expand its military effectiveness. At the moment, China
has territorial disputes with Malaysia, Vietnam, Brunei, Taiwan, Indonesia, and the Philippines.
Despite pending arbitration in the international court system, However, due to the codependent
nature of the Chinese economy and the world’s other economies, China appears unlikely to
become a rogue state and take any military action that would draw the ire of the U.S. and the EU,
two of its largest trading partners.
Russia is involved is open military action or other conflict actions with the Ukraine,
Georgia, Chechnya, Syria and with Turkey. Some of these have inspired commercial sanctions
from the US that strongly limit commercial activity of US businesses within Russia in the wake
of the Crimean occupation. As the Russian economy does not have as many linkages with the
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world economy as a whole, other major economies are more likely to impose sanctions on Russia
when compared to China.
Internal Terrorism
China has political dissidents but does not have significant terrorist activity within its
borders. The primary source of Russian internal terrorist activity is most often associated with
the Chechnyan separatist activities. Neither of them have terrorism risk levels that would
significantly affect the investments of XYZ Corporation.
Openness
Both countries have historic issues that are points of conflict with neighboring countries
but are not expected to become heated issues or open conflicts. From the perspective of internal
government and international conflict risk, while neither country is without risk, we see the less
risky nation as China, due to U.S.-China bilateral trade composing a large proportion of the
Chinese economy, providing a safeguard against foreign aggression and an incentive to resolve
conflict through diplomatic channels; This is not the case for Russia, which has a long history of
sanctions and military conflict with the major powers of the world, especially the U.S.
Governance
The World Bank’s Worldwide Governance Indicators shows China ranked higher than
Russia in five out of six indicators in 2014, the most recent year for which data is available
(Political Stability and Absence of Violence/Terrorism; Government Effectiveness; Regulatory
Quality; Rule of Law; Control of Corruption; The World Bank Group, 2015). Russia ranked
higher than China in only one indicator: Voice and Accountability (The World Bank Group,
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2015). This can likely be attributed to the authoritarian system of governance utilized by the
Chinese in which it is very difficult to mobilize politically, however the Chinese dominance of
the other categories demonstrates that the lack of voice and accountability alone does not make
for low quality governance. The ability to maintain relative peace and stability while providing
low-cost production helped China to attract high levels of foreign investment in the first place.
Furthermore, China has demonstrated a commitment to building further commercial
relationships with other nations through Special Economic Zones (SEZs) which are offered the
privilege of operating largely independently from the Chinese government, a promise that has
been preserved over time. In light of this fact, XYZ Corporation making an investment in China
is significantly less risky; a further hedging strategy could be to invest in an SEZ, then to sell its
machines through a Chinese distributor in a joint venture.
China and Russia on the World StageWhen China reopened its doors to world commerce it promised to bring benefits of free-
trade, open markets, and greater individual autonomy than was present under Mao Zedong’s
oppressive regime. China has delivered on this promise, with a consistently high growth rate for
the past several decades, often exceeding 10% of GDP. As with any government at the helm of a
developing economy, the legitimacy, and control wielding by the ruling class is largely
determined by their ability to deliver economic gains for its citizenry. A large part of the
economic growth miracle that is China is due to the willingness of the government to pursue
membership in the major international commercial organizations that are responsible for
promoting free trade, ensuring fair terms of trade between nations, and providing a process for
legal proceedings against member states for those countries that do not play fairly.
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The first step for China was to reapply for membership to GATT, which it began early, in
1986. In order to win approval of the other member nations, China had to take on dramatic
reform of its economic stance toward foreign goods by dramatically reducing tariffs on foreign
goods. Domestically, it had to improve its human rights record, mostly in regards to working
conditions in its factories. Progress in these areas was gradual, but complete; and by 2001 China
was admitted into the WTO (a new body born from GATT). (Prime, 2002) Growth has continued
to be strong since this time and China has seen a dramatic rise in its middle class. This has done
much to solidify The Communist Party’s image and control over many aspects of life. While
some sources indicate unrest has become more prevalent, due to introduction of social media,
and dissatisfaction over rampant corruption, the government seems to be content to continue at
its own pace. If the economy continues to grow, and the government is willing to consider
moderate degree of social liberalization, it is unlikely that the people will be willing to mount an
effective challenge to the government’s power. They are more likely to prefer to maintain social
cohesion, unless government began to act more despotic, restricting freedoms already granted.
(Gobel, Ong, 2012). The outlook for China is relatively stable, and represents an intriguing
opportunity for potential investment.
Russia is a much newer member to the WTO, gaining membership in 2012 after
extensive negotiations over the terms of joining the organization. The US was pleased to have
Russia join for the liberalizing policies mandated for eligibility to enter the organization, and for
the increased transparency into economic affairs often shrouded in mystery. At first,
liberalization did occur and tariffs were reduced by an average of 5.9%. (Mills, 2012) Economic
growth has been weak in recent years, and in 2015 the Russian economy slid into recession on
the back of weak oil prices, down 3.75%. (IMF, 2016) The US has now begun to assert that the
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Russian government has begun enacting protectionist measures, such as import substitution and
outright bans on purchases of certain goods, which provides a boon to domestic industry and
unfairly punish foreign businesses. (USTR, 2015)
With weak economic performance since joining the WTO, coupled with on ongoing conflict
in Ukraine, which western nations have argued is fueled mostly President Putin, we believe that
the political environment in Russia has become more uncertain. The contributions of low oil
prices and a dramatically weaker ruble to an economic crisis have generated heightened political
risk, The Russian people, upset at a notoriously corrupt regime that has failed to bring consistent
growth and overtly uses crony capitalism to distribute wealth to the politically-connected, have
become increasingly vocal with their discontent. The influence of opposition leadership has been
kept in check, due to state control of the media, and even outright thuggery and brute force, has
prevented an overthrow of the current regime. We believe that stability of the current regime is
more uncertain than that of China, and therefore does not justify the costs of a potential
investment in Russia.
Conclusion
We recommend that XYZ pursue their investment in China, which in our view holds the
lower level of political risk. China, as a highly embedded state within the world economy, as
well as a state maintaining a relatively high degree of internal stability for the time being, is the
more attractive investment destination in the short term. While the future of Chinese politics is
uncertain, it is our belief that as long as the Chinese government continues to adapt to the
national political environment and China remains a cornerstone state within the international
political and economic orders, XYZ Corporation will experience lower levels of political risk.
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Furthermore, China has better demonstrated a commitment to protecting foreign enterprises
investing in the nation, through its continued establishment of Special Economic Zones, which
operate largely autonomously and provide cover from political risk in the mainland. Russia has
no such mechanism and the political economic incentives to create them, generating an
environment in which foreign companies based in the country have little to no certainty
regarding their levels of insulation from various political risks. China’s higher levels of internal
and external stability give it the edge, despite the government being known for taking actions and
instituting policies which favor SOEs in every industry. Russia lacks those same levels of
stability, and continues to openly favor its SOEs over foreign enterprise. We stand firm in our
belief that China will remain the lower risk location both in the short term and the long run.
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Appendix 1: General Approval Process for Inbound FDI in China
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Works Cited
Doing Business. Economy Rankings. World Bank Group: 2016. Web. Accessed July 22, 2016, from (http://www.doingbusiness.org/rankings)
Gobel, Christian. Ong, Lynette. 2012. Social Unrest in China. Europe China Research and Advice Network. Accessed on July 22, 2016, from (https://www.chathamhouse.org/sites/files/chathamhouse/public/Research/Asia/1012ecran_gobelong.pdf).
International Monetary Fund (IMF). Web Accessed July 23, 2016, from (http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/weorept.aspx?pr.x=72&pr.y=15&sy=2011&ey=2016&scsm=1&ssd=1&sort=country&ds=.&br=1&c=922&s=NGDP_RPCH&grp=0&a=).
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Mills, Laura. 2012. Russia Joins WTO After 18 Years of Negotiation. USA Today. Web Accessed July 22, 2016, from (http://usatoday30.usatoday.com/money/economy/trade/story/2012-08-22/russia-joins-world-trade-organization/57207664/1).
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Prime, Penelope. 2002. China joins the WTO: How, Why and What Now? Business Economics, vol. XXXVII, No. 2 (April, 2002), pp.26-32. Web Accessed July 22, 2016, from (http://www.chinacenter.net/docs/WTOPrime3.pdf).
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c9882f8f02ac/Presentation/PublicationAttachment/74c43d19-71c2-47c5-b6ce-ccb56c56d91b/China_InboundInvestment.pdf)
US Department of State. China Investment Climate Statement 2015. May 2015. Web. Accessed July 22, 2016, from (http://www.state.gov/documents/organization/241728.pdf)
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