China has been growing at approximately 9% per year since the adoption of its liberalization policy, and is expected to grow at a 7% annual rate going forward. Historically, the 300,000 or so State-Owned Enterprises (SOE) formed the economic backbone of the economy. This system is increasingly being replaced by a more dynamic and growing private sector, currently with an estimated 1.3 million firms. Moreover, since the liberalization, more than 350,000 foreign companies have invested over 300 billion USD in China, with new contracted investment entering at a rate of 50 billion USD per year in recent years and increasing. Growth in trade is also compelling. At the end of 2000, China was the United States' fourth largest trading partner.

The phenomenal changes that are underway in China are accompanied by extreme displacements. One of the areas where this tension is most directly felt is in the rules and traditional practices by which China conducts trade. A rarely discussed challenge is the absence of a set of generally accepted business practices, as well as a business system based on trust and credit.

Communist Legacy and the Implications to Personal Property Rights

In 1949, Mao Tze-Deng introduced a radical Marxist-Leninist brand of Communism to China. As a result, state planning, rather than market requirements, dictated employment, investment, and trade policy. Private property rights, as Westerners know them, were abolished, and property, as a matter of law, belonged to the State. As a result, business transactions in China became ambiguous. Purchase transactions became merely planned transfers on the government account with no actual rights transferred. This created an especially interesting scenario when one business defaulted on another.

During the 1990's, as China's leaders moved to liberalize the economy, private property rights began to be recognized. Homes, automobiles, bank accounts and even shares in companies can now, under certain conditions, be owned personally in China. Although these ownership rights now exist, it is not always clear how or by what authority they are to be enforced. Such ambiguity renders commercial disputes between parties in China extremely difficult matters to resolve.

Cultural Elements of Chinese Business Practice

Two cultural aspects stand out in making Chinese business practices unique - "guanxi," and "face."

"Guanxi"
The concept of guanxi, or "social connections," is probably the single most important element in doing business in China. To understand guanxi, consider the saying "it's not what you know, but who you know." In China, personal relationships represented through guanxi are instrumental in all aspects of business and are frequently used to influence the outcome of business decisions.

A product of Chinese culture, the extension of guanxi into the area of business stems from a lack of trust and objective credit procedures - including data about buyer creditworthiness. When trust and credit are missing, the only way to sustain business is by reverting to existing and familiar patterns such as guanxi and hoping that your guanxi, and that of your friends and relatives, can deliver.

There are signs that even the Chinese regard guanxi as an insufficient basis on which to conduct commercial relations. Chinese businessmen will admit that they have deliberately refrained from pursuing many opportunities for growth for fear of not being able to collect. Until a reliable system to protect these Chinese firms as creditors and provide them an avenue to collect is in place, reliance on guanxi will remain the foremost means of building trust in a buyer's willingness and ability to honor his obligations.

"Loss of Face"

Another cultural aspect surrounding Chinese business dealings is "loss of face." "Face" can be understood as the need to be respected and have one's voice heard. Fear of "losing face" is one of the principal reasons credit management is a unique challenge in China.

Loss of face, especially in a close guanxi relationship, makes traditional Chinese less likely to initiate default. However, this statement must be interpreted with caution. Having lived under the communist system and lacking a capitalist understanding of property rights, the concept of a corporate default may be interpreted differently. Also, if the common practice is paying in 120 days, paying your suppliers beyond terms will not lead to a loss of face.

The fear of loss of face can lead firms to conceal losses. This instinct, together with lax accounting practices, makes the detection of default risks more difficult for analysts. In many cases, the scale of the potential loss and its implication is not even well understood by the firm itself.

Building a Credit Infrastructure in China

Having a predictable, systematic approach to credit and receivable management is only recently understood as necessary in China.

Credit and Information Management Tools

One way China is seeking to open and modernize its economy is through the establishment of credit management tools that have long been available outside the country. In early 2001, the People's Bank of China (China's Central Bank) promulgated the "Measure on Bank Credit Registration and Information Management (Trial)," designed to implement a "national bank credit registration and information management system." This measure requires institutions such as banks, co-operatives, trust and investment companies, and financing companies to provide information on individuals' banking transactions, as well as information on companies' disputes, defaults, and securities issuances.

Surrounding this initiative is the recognition by the private sector that they, too, can play a role in establishing safeguards and remedies for people seeking to trade more predictably. Chinese credit insurers and some of their European counterparts are active in the China market and are establishing resources in China to improve domestic and export credit risk assessment.

Guarantee and Contract Laws

On October 1, 1995, the Guarantee Law was enacted "to promote capital accommodation and commodity circulation, and ensure the realization of creditors' rights. The Law governs guarantee (guarantee and guarantor, guarantee contract and guarantee mode and guarantee responsibility), mortgage (mortgage and things mortgaged, mortgage contract and registration of things mortgaged, force of mortgage, realization of mortgage and mortgage of maximum amount), pledge of movables and rights, lien, and earnest." (www.sinolaw.com.cn) This law was a realization by the government that private property rights needed an official and stable basis of recognition and enforcement.

A more recent step in support of property and contractual rights was the enactment of the Contract Law on October 1, 1999. This law recognizes such recourse as rights of assignment, subrogation and transfer of debts from first-party to third-party debt-holders. These rights enhance the ability of organizations to pursue collection, and coincide with the establishment of official "Asset Management Companies," opened by the Chinese Government and banks to consolidate bad loans and debts for active disposition.

Bankruptcy

Bankruptcy, as understood in western economies, is a relatively recent phenomenon in China. As Dr. Li Shuguang notes in "Bankruptcy Law in China: Lessons of the Past 12 Years", appearing in Harvard Asia Quarterly, Winter 2001, "The concept of 'bankruptcy' was not formally recognized in Chinese law until the first bankruptcy law was introduced in 1906, during the late Qing Dynasty. Until that time, the role of bankruptcy law was filled by the legal and ethical tradition that, 'the son pays for the debts of his father'... In the early 1980's, Chinese economists, legal experts, and government officials began to realize the drawbacks in the way that the planned economic system dealt with insolvent enterprises, and advocated the promulgation of a law of enterprise insolvency." New laws finally came into effect on November 1, 1988.

Recovering Debts In China

In light of difficulties in interpreting and enforcing contractual and property rights, proving and recovering debts in China is often problematic.

Arbitration

The most widely practiced official remedy for recovering debt in China is Commercial Arbitration. Arbitration, as a mechanism for resolving foreign trade disputes, was implemented in 1956. The Arbitration Law of the People's Republic of China, adopted on August 31, 1994, set the framework for how arbitration is performed today. The main body governing arbitration is the China International Economic and Trade Arbitration Commission, or CIETAC. CIETAC's rules, amended effective October 1, 2000, provide the jurisdiction and procedures for commercial arbitration. Firms selling in China are strongly advised to include an arbitration provision in their sales contracts, in order to insure any subsequent trade disputes will fall within the jurisdiction of CIETAC. The following model arbitration clause is recommended by CIETAC:

"Any dispute arising from or in connection with this Contract shall be submitted to China International Economic and Trade Arbitration Commission for arbitration, which shall be conducted in accordance with the Commission's arbitration rules in effect at the time of applying for arbitration. The arbitral award is final and binding upon both parties." (Visit the CIETAC website at www.cietac.org.cn for additional information.)

Use of Lawyers

Aside from arbitration, the use of lawyers to litigate claims is growing in China. The judicial system, consisting of four levels of courts functioning throughout the country, has jurisdiction to adjudicate commercial disputes. Chinese, as well as some of the leading Western law firms, now practice extensively throughout the country, representing Chinese and foreign clients on a variety of legal matters. The judicial process in China, however, is slow and expensive. It is also marked by corruption, a condition top government officials recognize and pledge to confront.

Collection Agencies

Traditional debt collection by lay organizations, which is the customary way of conducting third party collection in developed markets, is "illegal" in China. Collection agencies, per se, are banned under regulations issued by the State Administration for Industry and Commerce and the National Public Security Bureau in 1995. There remains a perception that "debt collection agency" means criminal undertaking, as it has been taken to mean in other Asian markets, such as Japan and Hong Kong. It is the case, however, that consulting and other business service firms, acting in co-operation with Chinese partners, are operating in China for the purpose of helping Chinese organizations pursue debts owed to Chinese creditors from debtors outside of China, thereby promoting China's interest in managing the country's balance of payment and foreign exchange levels. These organizations also have an interest, along with a growing capability and need, in advising Chinese exporters on how to limit credit risks and exposures, and how to remedy collection problems should they occur.

Conclusions

In view of the rapid growth of the Chinese economy, the country's attempts at reform as it enters the World Trade Organization, and the prevalence of foreign-owned firms and practices in the market, principles of credit management as understood in the developed world are bound ultimately to be embraced in China. Currently, the authors believe the number one risk of doing business in China is the inability to collect. This risk not only applies to MNCs (multinational corporations), but also to domestic firms. In fact, if China can build a business system based on sound credit practices and risk control, its own domestic sector can flourish.

For commerce to take off in China, as portrayed by many commentators and observers, China needs to develop trust and credit in its business practices. An important part of this approach includes accounting and financial information reform. Recent efforts by the Chinese Government to begin such measures are clearly steps in the right direction. However, in practice, protection truly comes about in the form of the systematic adoption and use of credit procedures and remedies by all parties, people and institutions. With a culture built and still largely based on "guanxi" and "face", there are significant challenges to the adoption of the concept of credit risk control, let alone the full systematic implementation of credit practices.

As it now stands, foreign-based MNCs can take various positions regarding their involvement in the Chinese market. They can choose not to be part of this economy until a more sophisticated credit management orientation is established. They can take part aggressively and without much information or protection against credit and related risks. Or, they can take part not only in selling to the country, but also helping to build a credit practice and culture there. Such active participation, in the long term, could be the most advantageous way to favorably position an entrant in this large, fast moving, and ancient economy.

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Dr. Ronald K. Chung is a partner of Equity Consulting Company, a corporate consulting and training company with offices in China, Hong Kong and the U.S. Dr. Chung specializes in international corporate strategy and finance.

David I. Herer is Chief Executive Officer of The ABC Companies, Inc., parent of ABC-Amega Inc. ABC-Amega provides international receivable management and debt collection services for exporters to more than 200 countries including the People's Republic of China.

This article represents an abridged version of the article that initially appeared in the First Quarter 2002 issue of The Credit and Financial Management Review. Complete reprints are available upon request by contacting: editor@abc-amega.com.