Fresh Openings in China's Retail and Wholesale Markets

International law firm Freshfields examines new regulations on commercial enterprises which may encourage more foreign investors to take a stab at the country's tremendous consumer markets.

For foreign investors seeking to break into the Chinese market, commercial distribution has long been a thorn in the side of their business operations. To prevent multinational companies from dominating the retail or wholesale links in the chain of supply from manufacturer to end-user, the central government in Beijing has constructed a complex web of domestic distributors through which to channel foreign and domestic goods. This situation may be set to change, however. One recent regulatory move may give foreign investors the breathing room they need to operate more competitively in China's vast commercial sector.

On June 25, 1999, the Ministry of Foreign and Economic Co-operation (MOFTEC) and the State Economic and Trade Commission (SETC) promulgated the Experimental Measures On Commercial Foreign-invested Enterprises (the Commercial Measures; for a digest of this and other new regulations, click here), significantly opening China's retail and wholesale markets to foreign investment. At first glance, the concessions granted under these new Measures appear extraordinary - and with good reason.

Although the PRC government took its first steps towards opening the retail sector to real foreign participation in 1992, the activities of foreign-invested retailers remained subject to tight regulation. A pilot program restricted Sino-foreign retail joint ventures to 11 cities, with only two such ventures allowed in each pilot site. The establishment of retail joint ventures required the approval of the highest organ of the Chinese government, the State Council, in addition to a panoply of government ministries. Foreign investment in the wholesale market was completely barred.

Government policy further demanded that the Chinese party to a such a venture be granted majority control. In practice, however, cash-poor Chinese partners were often unable to fund a majority stake. This, combined with the enthusiasm of local governments for projects which might generate employment opportunities, meant that Beijing's rules were often creatively bent. Local governments proved willing to approve a variety of Sino-foreign retail operations, above the numerical limits and often without Chinese majority shareholder status. Last year, Beijing responded with a crackdown, ordering the closure or restructuring of nearly 200 foreign-invested retail firms, particularly targeting foreign retailers holding an unauthorized majority stake. The new regulations issued this Summer suggest yet another policy shift in Beijing. As with such concessions in most sectors of China, though, this liberalization is of a mixed nature. The Measures legalize a number of previously forbidden practices that have proven quite difficult to control in practice. At the same time, they draw another set of lines in the sand, marking Beijing's determination to maintain strict control over foreign investment in the commercial sector.

Broader Scope For Foreign Investment
The Measures increase both the permitted operational and geographical scope of Sino-foreign commercial joint venture operations. Most notably, they abandon the prohibition on foreign investment in the wholesale market. Geographically, the areas open to foreign investment increase from the initial 11 cities to include Beijing, Tianjin, Shanghai, Chongqing, all special economic zones, and all provincial or autonomous region capitals.

The Measures do not specify a numerical restriction on the number of joint ventures to be approved under the new application process. Nonetheless, government officials have hinted that the actual application process might follow prior practice, with approval granted only to a select number of experimental joint ventures in each individual locale.

More favorable treatment is extended to joint ventures seeking to operate in China's central and western provinces. This concession will be viewed by many investors as a valuable opportunity for retailers to break into the inland market. From a practical viewpoint, enterprises established in these less developed areas benefit from lower starting capital requirements and longer operating terms than those elsewhere.

Restrictions Remain
Despite significant advances presented in the Measures, foreign investment in the retail and wholesale sectors remains subject to considerable restrictions. Investment in either the wholesale or retail sector is required to take the form of equity or cooperative joint ventures; wholly foreign-owned investments are expressly forbidden.

Further, only large, well-developed multinational companies will be able to secure such joint venture arrangements. Those seeking to enter the retail sector must possess at least US$200 million in assets, with an average annual sales turnover of at least US$2 billion over the preceding three-year period. For the wholesale trade, the requirements are even more strict: US$300 million in assets and an annual sales turnover of US$2.5 billion.

Commercial operations must take the form of chain stores which the joint venture directly invests in and operates. Franchise or voluntary chains, where the joint venture maintains less direct management of the stores, are still prohibited.

In keeping with prior practice, the Measures also demonstrate an intent to discourage the use of Sino-foreign joint ventures as distribution outlets for goods produced abroad. To this end, the new rules state that annual joint venture imports may not exceed 30 percent of the annual sales volume. Further, contemplating that foreign companies might try to seize this opportunity to engage in lucrative foreign trade business, the Measures state explicitly that a joint venture may only import or export commodities dealt in by itself or export domestically produced products; acting as foreign trade agents on behalf of third parties is strictly prohibited.

With regard to equity ratio, Beijing has only modestly relaxed the Chinese majority stake requirement which it failed to enforce effectively in prior efforts. Foreign investors can now secure a controlling share only under a limited set of circumstances. For example, retailers operating three or fewer stores or opening certain types of commercial outlets, such as convenience or specialty stores, may earn a foreign party share of as high as 65 percent. In contrast, for larger retail or wholesale joint ventures, the Chinese party almost always must be the majority shareholder. Similarly, commercial ventures engaged in wholesaling must maintain 51-percent Chinese ownership.

Satisfying Beijing's policy objectives might give a foreign retailer some breathing room. For example, a large retail operator might be awarded a majority stake if the foreign party pledges to procure a large quantity of products in China and successfully expand exports of domestically-produced goods through its international marketing network. What constitutes fulfillment of these criteria, however, is a moot point. Moreover, any foreign investor looking to secure a controlling share based on such a pledge will have to reckon with the State Council, which retains approval authority on this determination.

Shifting policy gears
The new Measures nonetheless substantially simplify the approval process for establishing foreign-invested commercial enterprises. Most notably, no longer is State Council consent required for each joint venture application; its involvement is only necessary in certain limited circumstances (such as deciding on a foreign majority stake). Rather, the Measures charge MOFTEC and SETC with the joint responsibility of approving new ventures in the retail and wholesale sectors. Significantly, the central authorities need only be consulted for an established joint venture that wishes to enter the retail or wholesale market.

Many observers see this legislative development as an uncharacteristically liberal move by the central government, and a welcome one, too. As of mid-August 1999, MOFTEC had already announced the approval of one new foreign-invested commercial project, a joint venture involving a well-known U.S. wholesaler. Further, the Ministry has also indicated that it has set a timetable for the approval of roughly one dozen additional projects in the near future, though the details and time frame are unclear.

Beijing's new policy framework as spelled out in the Measures has yet to be interpreted in practice. Whether this framework will hold given the tendencies of local governments to disregard central controls remains to be seen. Nevertheless, given the perpetual concern of a crackdown on creative commercial arrangements, the new rules should provide more guidance and greater security to foreign retailers and wholesalers operating or seeking to operate in the PRC market.

© Virtual China Inc. 1999