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China's manufacturing industry has taken the world by storm. Some industry analysts estimate that China now produces 50% of the world's cameras, 30% of the air conditioners and televisions, 25% of the washing machines and 20% of the refrigerators. Driving this trend are big multinationals, like General Electric and Toyota, which are building or expanding their manufacturing units. Technology giants such as Intel, which is now shipping Pentium 4 chips from a $500 million Shanghai plant, have also done their part. But there are signs--plenty of stories, if not hard statistics--indicating that many smaller firms, with sales in the $100 million to $1 billion range, are heading to China as well.

Virginia Kamsky, a New York-based consultant, helps U.S. businesses start up operations in China. These days, she sees a new sense of urgency among her clients: It's not so much that they want to go East; they feel that they have no choice. Kamsky says. "Their business has evolved such that they must be in China. It's not a question of if, but a question of how."

Unmatched Opportunities

It's easy to see why China is attractive right now to foreign firms large and small. It offers a mix of opportunities no other nation can match: Low labor costs, an enormous domestic market, rapid growth, good infrastructure, a well-trained workforce and a business-friendly government. Its GDP growth is estimated at around 8%, far above the recent near-stagnant rates in Europe, Japan and the United States.

With growth has come a rising standard of living, as well as a consumer thirst for new products. Twenty years ago, China was a country where a wealthy household had a sewing machine, a bicycle, and a wristwatch. Today, more than half of the purchases of automobiles are personal.

The cell phone industry in China is a good example of how China's domestic market, even more than its export opportunities, has been a draw for foreign firms. Neil Mawston, a U.K.-based analyst with the market research firm Strategy Analytics, notes that the big multinational handset makers, such as Nokia and Motorola, set up manufacturing in China to be close to where their products were sold. "The majority of phones manufactured in China are for the Chinese market," he says. "China only became a net exporter of mobile phones [in 2002]."

Despite this rising prosperity, China still has a vast pool of cheap labor from rural areas, where nine out of ten in the workforce are either unemployed or underemployed. At the same time, the Chinese manufacturing infrastructure has reached a high level of technical sophistication. "The entire electronic food chain has migrated to China," says Samuel Wang, president of SMIC Americas, a Chinese firm that Wang describes as the nation's first pure play in semi-conductor wafer manufacturing. At a plant in the Shanghai area, where it started up in August 2002, the company now has over 3,200 employees and delivers 35,000 wafers a month. Its technology has moved from .35 micron down to .18.

SMIC is backed by venture capital from the United States. A few years back, a company like this might have built its factory in Silicon Valley or somewhere else in the U.S. Now, China is the logical place for suppliers of high-tech materials and components. Their OEM customers have migrated there to tap the Chinese market and, as Wang notes, "They want their suppliers to be nearby."

In short, there are plenty of good reasons to have a manufacturing presence in China. But the move does carry some risks, though many of these can be avoided by getting sound advice from people who are experienced in dealing with Chinese authorities and can truly represent the foreign company's interests.

Much of the potential trouble springs from the fact that China's capitalist system is still a work in progress. Foreign firms are welcome, but they still need government approval to operate. Rules and regulations are changing and are not always consistent. Protecting intellectual property (IP) rights can be difficult in China's courts, which are just starting to build the sort of legal framework that businesses take for granted in the United States. Terry McCarthy, a TMT tax partner in Deloitte & Touche's Chinese Services Group, says the court system is improving, but "there's no case law per se .... You can't go in and find a series of cases you depend on." McCarthy adds, "China's relatively weak protection of IP seems to be a near-universal complaint, and it has led some foreign companies to keep sensitive elements of their production process outside the country."

China's currency, the Renminbi (Rmb), is not fully convertible and the flow of funds out of the country is restricted. "Every time you move money in and out of China, you need approval," explains McCarthy.

Tax Traps

Taxes can also trap the unwary in several ways. First, they can vary widely, with various provinces offering breaks such as tax-free incentive zones or subsidies. One danger is that a U.S. company will miss out on one of these deals and needlessly pay the highest tax rate. Or a local official might offer the company a break that's not allowed under national law. The company might also get a great legal tax break and still get a bad deal overall. Taxes are just one aspect of operating costs, says Lili Zheng, a Deloitte & Touche TMT international tax partner in charge of the Northern California Chinese Services Group. What's gained from lower taxes or subsidies that could be eaten up by other expenses in the area? "Look at the operational logistics, the convenience and the total operating costs before considering the tax incentives," she advises.

Zheng says U.S. firms sometimes lose money by failing to account for the value-added tax (VAT), which is charged on goods sold within China but not on exports. "A lot of companies make the mistake of thinking they only want to manufacture and then export," Zheng says. "Later they realize they need to sell in China. Then they have the choice of paying a stiff VAT (generally about 17%) or shipping goods outside the country to be re-imported. We've seen big companies pay $6 million in transportation costs, a quarter to avoid the VAT," she says.

China's march to economic freedom hasn't been matched on the political side. That fact is of concern to the whole world, not just businesses. What kind of country will this giant ultimately become? If it becomes a democracy, will the transformation be peaceful? And will it remain at peace with the United States? These are all questions that businesses need to consider. Technology firms have to be especially wary of downdrafts in United States-China relations, because Washington might bar them from transferring sensitive technology to your Chinese operation if things turn sour.

The Chinese government, getting its house in order--which includes doing a better job of collecting and sharing data and being more candid at home and abroad. Deloitte Touche Tohmatsu TMT Asia Pacific Country Leader, Alfred Tang, based in Hong Kong, says China's leaders have realized that they must play by global rules. "They sort of learned a big lesson in the sense that, if you want to join the world economy, you have to join the economy on every issue," Tang says. The coming years will tell if they've truly taken such lessons to heart, and if the United States firms now going to China will have a long and happy future there.

www.deloitte.com

RELATED ARTICLE: A Tip on Exit Strategies

Making money in China is one thing. Getting it out is another matter. Here are some things to consider when repatriating profits:

* China controls its currency, the Renminbi, at a fixed rate to the U.S. dollar by restricting the outflow of funds. Know this going in, and plan for it.

* There are minimum capital requirements for different types of companies in different industries.

* Capitalize your Chinese company using debt rather than equity. It is generally simpler to repatriate money through debt repayment than to pull out profits from an enterprise you own.

* Be prepared to make (and document) your case. China requires that firms have sufficient capital to pay creditors and fund obligations, such as pensions, before they can send profits outside the country. Compliance with these rules isn't assumed; companies have to prove it.

* Plan your exit before your entry. The licenses, royalties, loans and other aspects of an investment in China should be structured from the start with an eye toward repatriation of funds. And be sure to register the relevant contracts with the authorities.

Source: Terry McCarthy, Deloitte & Touche Chinese Services Group

George Koo is the director, Chinese Services Group, U.S.A., Deloitte & Touche (New York, NY)

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