Risk Management in China
BRG Principal Steven Parker, leader of the firm’s Financial Investigations and Regulatory Compliance practice in the APAC region, joins us on this episode, which was recorded in anticipation of the Phase One trade deal with China. Steven discussed the evolving regulatory environment on mainland China and what it could mean for future joint ventures in the country. He also spoke about the increased focus on risk management for companies looking to invest in the region.
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TRANSCRIPT
S1 00:08 [music] Welcome to BRG's ThinkSet podcast. I'm your host, Eddie Newland. BRG is a global consulting firm that helps leading organizations advance in three key areas: disputes and investigations, corporate finance, and strategy and operations. Headquartered in California with offices around the world, we are an integrated group of experts, industry leaders, academics, data scientists, and professionals working beyond borders and disciplines. We harness our collective expertise to deliver the inspired insights and practical strategies our clients need to stay ahead of what's next. For more information, please visit thinkbrg.com.
On today's episode of the ThinkSet podcast, we'll be speaking with BRG Principal Steven Parker. Steven leads BRG's financial investigations and regulatory compliance practice in the APAC region. He has more than twenty-five years of experience in Asia between Mainland China and Hong Kong. He specializes in forensic accounting investigations, litigation support, risk management, and regulatory compliance.
We spoke with Steven in anticipation of the finalization of the United States Phase One trade deal with China. Steven talked about the evolving regulatory environment, the future of joint ventures, and his increased focus on risk management for companies looking to invest in the region. And with that, let's get started.
Well, Steven, thank you so much for joining us on the ThinkSet podcast. How are you doing today?
S2 01:43 Very well, thanks.
S1 01:44 Right now you're stationed out of Hong Kong. Can you give us a little bit of background of how you came to be there?
S2 01:49 Sure. So I first came to Hong Kong to establish the consulting practice for a global risk advisory consulting firm. So I served as the MD for Asia–Pacific for that company for quite a number of years. This was around 2007 or so. So I've been here since that time.
Prior to that, I worked in China for more than fifteen years. I originally moved to China to assist an American sanitary waste company to undertake the due diligence for a potential joint venture partners in China. Hard to remember that was 1992. So the China of 1992 and the China of 2019 are very, very different places. And part of the work experience I had in China, I also worked for one of the Big Four as a managing director for its consulting practice, as well as CFO for a US-based global FMCG. So that's kind of how I came there. Originally from Missouri, so, yeah, I've been living here in—we'll call it Greater China, China and Hong Kong—for over twenty-five years.
S1 02:45 Phase one of a new trade deal with China has recently been agreed to. What's your take on the significance of that step?
S2 02:52 So if you look at the phase one—as they're calling this trade agreement—I call it crisis averted, instead of is it really an all-encompassing trade deal. So, really, it just stopped the new tariffs and about 160 billion of Chinese products, and it kind of reduced the existing import tariffs that the US had put on a lot of the Chinese imports—was 15 percent so it goes back to 7.5 percent. So what happens is that it really isn't the kind of getting rid of the tariff set; some of the tariffs that are in place, it's just reducing them back to a level that they ratchet up from. The US is still going to impose 25 percent import taxes on 250 billion of Chinese imports, so it's not like the trade agreement kind of did away with all the tariffs that US has imposed.
The big thing about it was—I called it agricultural in nature, so if you look at it about 40 billion a year in US agricultural products are supposed to be purchased by the Chinese over the next two years, so look at 2020, 2021. The issue here is that US agricultural exports to China, it really never exceeded 25 or 26 billion in a year. So, therefore, supposedly we're going to believe that China is now going to increase its purchase of agricultural products from the US by more than 50 percent in the next two years. Given that China also expanded their supply chains over the agricultural products they used to get from the United States—previously soybean, corn, and things like that—this looks pretty optimistic. So we'll have to see if this actually comes to fruition.
And I think the other key part of this trade friction and some of this agreement was that China is going to discontinue the practice of pressuring companies to transfer technology as part of gaining market access to China.
As you said, having been in China since 1992 until 2020, this was one of the major facets of doing business in China. I mean, one of the key things was that the transfer of technology from yourself to the partner. Because you have to remember is that, back in 1992 you couldn't have a wholly owned foreign enterprise, so we caught a whiff where you had to basically create a joint venture between yourself and a Chinese company. And so part of that access to the Chinese market was also the technology transfer. So that's been a big issue not only for the United States, but I think of also other countries as well, be that Japan, European countries, whoever. So this is part of this disagreement was: okay that's going to be discontinued.
That's such a long-standing practice that had been going on since China first opened up in the '80s. Is it really going to happen? So I guess the real proof would be how it actually comes to pass. And, like I said, this trade agreement is quite limited, and the question is did it really address the key fundamental issues in the trade relationship: namely the protection of intellectual property rights, IP protection. The US kind of fundamental believes that the Chinese government provides unfair subsidies to Chinese state-owned enterprises which in so doing it allows them to compete unfairly in the global marketplace. That's quite a serious issue, right.
And so that's, again, issues that not only United States has, but other countries have with China, as well. And so the issue here that the US kind of has acted relatively unilaterally in terms of trying to set up this trade agreement, while they had some common issues with Chinese trade, that's common among other countries, they're kind of trying to do it on their own in terms of how they're actually doing this. Is that the best approach or not? Tough to say.
And also the question is how to manage the mix of capitalism and state control that's modern China. I mean, I think this is what's really unique about China compared to other countries in the world is that it's a unique mix of very capitalist market tenets as well as major tenets of state control. That's a question of how do you actually manage and deal with that as a trading entity.
And also about enhancing access to markets in China that both had tariff and non-tariff barriers. It kind of seems more like a cessation of trade hostilities than a comprehensive agreement.
So, really, the question is going to be what's going to happen in the phase two agreements? So that's where you're going to be critical over the next twelve to twenty-four months of saying, how is the phase one trading implemented and what are going to be the major components of the phase two trade deal. So that's really something that, I think, is going to impact the ongoing trade relationship between the two countries in the foreseeable future.
S1 06:54 Great. So, Steven, there's a lot to unpack there. Where I want to start is: you mentioned the US is acting unilaterally as compared to working with, say, Europe and the UK and other traditional trade partners when negotiating with China. When you speak amongst the expat community and the folks that you've developed relationships with in Hong Kong and China over the years, is this something that's unprecedented?
S2 07:18 That's pretty much the US's major modus operandi in a lot of cases. I mean, traditionally, because China has such a large economy, and the future of its economy is only going to continue to grow—the concerns that the US has are the same concerns that other countries has. The question is what is going to be better to work with like-minded partners to try to resolve these issues rather than trying to do it unilaterally.
So the question is how is that going to work itself out. I would believe that had the United States kind of tried to work with major partners with similar issues, say the EU, say Japan, say any other country that might have similar trade issues with China, maybe it would have been better to kind of have more of a multilateral, multifaceted approach. But, as we said, we won't know that until we see with the phase two trade agreement really looks like.
S1 08:11 What is the timeline, in your understanding, right now for phase two?
S2 08:14 China tends and the US, as well, tries to, tends to move things at more of a moderate pace rather than trying to push things like it over-reaching trade agreement very quickly. So in terms of the phase two timing, I don't think there's been any kind of timeline set in stone.
S1 08:27 Another thing that you mentioned was wholly owned corporations that traditionally anybody that wanted to enter China they would have to not only abdicate their IP rights and transfer the technology and the information behind the business, but that they would never be able to own 51 percent of the company—that at least 50 percent of the company had to be owned on Mainland China. Because I understand that that's changing now, right?
S2 08:50 China's reformed a lot. So what happens is that as, first when we went into China, you could actually own more than 50 percent, the problem is it couldn't be wholly owned, so it couldn't be 100 percent owned by a foreign entity. There had to be some type of ownership from a partner—from a Chinese partner side. So whether that was 50–50, 51–49, 60–40, something like that. So there had to be some kind of Chinese ownership, then some kind of equity interest from the Chinese side in it.
That was changed. The way they reform it's very systematic. So what happens, is over time they open things up, wholly owned foreign enterprises could own 100 percent of their entity, not have to have a Chinese partner. Some industries like you mentioned—like financial services—were more heavily regulated where you couldn't actually do that. Automotive was something that's quite similar to that.
And so, now, the last couple of years, the Chinese government has enacted additional reforms. And part of this phase one trade agreement is those other areas where, as US demanded, foreign companies could have better access to the markets, which means that they could actually own 100 percent of their entities. So, as you mentioned, a lot of the banks, a lot of the foreign financial institutions have now eventually had a joint venture but now looking to kind of buy out the joint venture partner and have 100 percent equity stake of the organization itself in China. So that's a big change.
S1 10:05 Because I imagine a lot of businesses and entities would have stayed out of China just because the inability to own everything that was there. So are there any particular industries or maybe countries where the companies are coming from that have done a good job of positioning themselves to be patient now that these reforms have come, they're able to take advantage?
S2 10:26 I think I used to look at a lot of the financial institutions that have kind of waited. They understood the size of the market, the potential of the Chinese market. They understood what the financial regulations were, and they just understood that over time China is going to reform those with the ability to increase ownership with potentially having 100 percent ownership stake of that. And so I think most of the financial institutions—whether those are US based, European based, Japanese, wherever they are, Australian—they were the very smart ones that said, "Hey. This is an important market to us. We understand what the regulations are, and we know that those regulations are going to be reformed over time." So it's kind of they took a wait attitude thing, "We're going to get into the market. We're going to understand the market. And then when those financial regulations come through, we're going to adapt to make changes that we think are necessary to be able to succeed in that marketplace."
S1 11:15 So a lot of these changes to coming out of China are coming as their economic growth is finally starting to slow. Though it's well ahead of most standards for fully formed industrialized nations. It's still well ahead of the curve. What do you see as the biggest factors behind that? I hear a lot of people talking about it becoming a consumer economy as opposed to an exporter economy. But as you see that day to day in your interactions, how does that really manifest itself?
S2 11:42 Having been in China since the early '90s to today, the increase in the economic output and the well-being of the population is unprecedented. I mean, you really can't understate what a massive economic progression that country has made in thirty years. So if you look at the 1990s, China's economy is growing now 10 [percent], 12 percent in that decade with some years being 12 [percent] or even high as 14 percent. That's incredible economic growth.
Look at the 2000s, it was just as good, right, and China's economic growth was around 9 [percent], 10 percent. And even during the 2008 financial crisis, the economy was still growing at 6 percent clip. In fact, after the financial crisis, China was essentially the economic engine of the world for a year or two after that.
And so look at the 2010s, China economy became a little bit more mature as a result of the economy growing at, say, 8 [percent], 8.5 percent average. That's still phenomenal.
And so what we're seeing in 2019, the economy is now growing at 6 percent. Let's not kid ourselves, 6 percent is still pretty good, but it's certainly half of what the heady days were in the 1990s and the 2000s. Really, it's the slowest growth we've seen in nearly three decades. So the question is why? What has happened in the Chinese economy where you had growth averaging 10 [percent], 12 percent for ten, fifteen, twenty years.
And so, one, I think that were big factors is the seventeen-month trade war with the US. That's one pretty important factor.
As you mentioned, the realignment of an export-led economy to domestic consumption economic model. That's a big thing in China—is that if you look at 1990s and 2000s, the economic precipice. So the economic model that China was built upon was completely export led, and so now there's been some realignment in the last ten some-odd years are saying, "How do we move from more of an export-led economic model to a domestic consumption model." That's a big change.
And another thing about it is that the 2008 financial crisis kicked off around the stimulus in China that went on for about seven or eight years, right, roughly about 2008 to 2015 or 2016. And along with this whole set of financial reforms, including the growth of shadow banking and informal lending that came about. And so we've seen in, since about 2016, 2017, there's been a credit downturn.
So what happens in 2016, most of the financial reforms are discontinued. So this resulted in a pretty significant drop for the last two or three years in credit availability. Credit was cheap in China after the financial crisis for the next seven years, knowing companies were gobbling up cheap credit. And so what happens is suddenly they said, "Okay. We're going to need to reduce the credit availability." And so the reduction in credit availability is particularly pronounced in the private sector, particularly. And notably in medium and smaller-sized enterprises. And this has had a significant and material impact throughout the economy. Less asset investment, less hiring, wages aren't rising as fast, or maybe they're actually stagnant. All of these kind of factors are leading to a reduction in consumption.
S1 14:49 So one trend that I've heard you speak about is decoupling, where companies are moving their operations beyond China. Can you explain a little bit about how that fits in?
S2 14:58 We've only really been hearing of this decoupling trend for the last fifteen or so months mostly as an outcome of the trade war. And so I think as a result of the protracted trade issues, and in many instance in an effort to avoid US tariffs and minimize risks associated with the supply chains, businesses—those public or private—have begun moving their operations beyond China, or at least begin to assess the feasibility in doing so.
So if you look at in July 2019, more than fifty MNCs were reportedly investigating relocation of manufacturing operations to Southeast Asia, where in some cases we're catering their operations in supply chains. The ultimate decoupling may end up being limited in scope, because those Chinese supply chains are so deep. But I think now we've seen, as this trade war kind of has shown, there seems to be kind of the idea of, "Okay. Maybe we have to. Maybe the US economy wants to have less reliance on some of these Chinese supply chains." And at the same time, Chinese are saying they believe we'd have less reliance in terms of our revenue and our sales output as a function of sales to the United States. So they can maybe be called a mutual decoupling in a way.
S1 16:07 What does this combination of factors mean for entities by foreign-mainland joint ventures going forward?
S2 16:13 There is an ongoing debt crisis in China, as well. So what happens is that as the credit expanded in 2008 after the financial crisis until about, I guess, in 2016 or so, there was a lot of cheap credit. And so what you've seen is a lot of this credit is now coming due, and there's been some serious defaults on that, right?
So in this perfect storm of events, all warning signs continue to flash red. So all the red flags you see, potential issues the market are kind of flying now. And so if you look at what those red flags are, those usually kind of relate to instances of fraud, bribery, and corruption. When you have economic conditions like you're having in China today, you see the instances for fraudulent activity, kickback schemes, bribery, those kinds of issues increase exponentially. It's the ongoing trade conflict with the United States, the slowing domestic economy, transition from an export-led to a consumer-driven economy, increasing corporate debt, a highly competitive marketplace that is slowing growth to rates not seen since thirty years. So you look at the combination of these events as of the scene for increased issues affecting foreign investments in China, especially related to fraud, bribery, corruption known to rise, and not only to rise but to rise pretty rapidly. So the need, therefore, for companies to review their exposure to monitor and assess risks related to fraud, bribery, and corruption are now more than ever kind of critical.
And so what you're seeing now in China, it might be occurrences of financial statement fraud, asset misappropriation, bribery, kickback scheme, customers and suppliers; anything that, one, could make the balance sheet and the income statement look better or, two, to get asset malfeasance from employees there. Take, for example, firms that are facing tightening liquidity and facing potential insolvency to instances of fraud and corruption become amplified in those kind of situations. So looking at risks ranging from financial statement fraud to improper financing, improper utilization of funds to asset misappropriation; those become much more common and frequent in this kind of environment.
It's critical that companies understand and monitor major changes to its financial statements, to its cash flows, to its working capital. So financial statements from Chinese business partners also should be scrutinized in more detail. For firms that are reviewing and assessing their China operations when they're downsizing, rationalizing, type of this decoupling process which are related to asset misappropriation, siphoning of funds, employee malfeasance, which become much more elevated, right? If you're working in a company and you know, "Hey. They're going to leave China or they're going to kind of move the operation to a different country," and nobody's hiding that fact, and studies are ongoing, everybody in the company knows that—don't be surprised when you see issues related to asset misappropriation, siphoning of funds. Things like that happen.
S1 19:00 Has the government reacted in any way yet or do you see down the line that that might be something that they'll need to address with reforms?
S2 19:07 China has been very active in terms of the space, right? They have laws set up for anti-bribery. They have laws governing corruption and things like that. So it's something that they understand.
And I have to say, having worked in China for twenty-five-plus years, I mean, in countless investigations related to fraud and asset misappropriation there, the situation has improved dramatically. And the government has taken tacit steps to improve the overall business environment there. So I think they'll continue to do that, but you can't put all of that on the government. I mean, it really becomes the responsibility of the firm itself to ensure that, "Hey. What kind of internal controls do we have?" The companies must enhance the risk assessments and do their due diligence, ensure its internal controls and its government structures are not only in place but are effective.
And this applies not only to their own operations but also to the key partners, agents, customers, suppliers, and other significant third parties.
It's also imperative to understand major changes in the financial statements. A sudden or explained changes in the financing are typically red flags, and so undertaking a risk assessment that identifies, assesses, and prioritizes corruption risks is a key element to mitigating those risks. The risk assessment should consider country risks as well as risks related to its industry, customer and supplier mix, product and services risk, third-party relationships, as well as actual financial transactions.
One other thing that's important: that organizations all seem to have an effective whistleblower mechanism. You need to have an effective governance framework and internal controls in place that will identify and mitigate instances of fraud, bribery, and corruption.
One of the things about it is most times, how is fraud detected? Well, typically, it's two ways. It's one through it's a whistleblower where it's through internal audits. So if you don't actually have an effective and comprehensive internal audit compliance program, as well as the effective whistleblower mechanism, then the ability to kind of detect that fraud is reduced significantly.
Additionally, the organization has to be proactive when it comes to internal investigations of allegations of fraud, lest they find themselves under ever-increasing regulatory scrutiny. So properly executed risk assessment exercise provides management with the foundation for the formulation of good, strong, robust governance program. So if we look ahead and saying, "What does this mean for companies in China today, and do we think if we look ahead in the next, say, twelve to twenty-four months, will the red flags disappear?" Well, I think, actually, we're going to see is that, no. I think the issue we see in China today, in twelve months and twenty-four months is going to be quite similar. Now, the trade war, like I said, it's not been resolved, but maybe it's been the cessation of these trade hostilities. But I think the red flag can continue to fly in full mast for the foreseeable future.
S1 21:54 Picking up on what you just described about the next twelve to twenty-four months, what part of risk assessment will take center stage?
S2 22:00 Good question. The most important part will be an effective and robust governance framework structure. Something that one starts with the tone at the top of the senior management and goes all the way to the process, the procedures, the internal controls, the training program to make sure that any instances related to fraud, corruption, and bribery are not only monitored and understood but also can be mitigated.
S1 22:25 Steven, thank you so much for joining us today. It's not always easy to sync up around the globe, but we really appreciate, and we'll look forward to connecting with you down the line.
S2 22:32 Thank you, Eddie.
S1 22:35 [music] This ThinkSet podcast is brought to you by BRG. You can subscribe to the podcast and access other content from ThinkSet magazine by going to thinksetmag.com. Don't forget to rate and review on iTunes, as well. I'm Eddie Newland, and thanks for listening.
The views and opinions expressed in this podcast are those of the participants and do not necessarily reflect the opinions, position or policy of Berkeley Research Group or its other employees and affiliates.