Michael Komesaroff on Inefficiencies in Chinese Outbound Investment

Michael Komesaroff, principal of Urandaline Investments, a consultancy specializing in China’s capital intensive industries, and a former executive in residence at the School of International Affairs, Pennsylvania State University, has written an  excellent analysis of the operational difficulties of China's outbound investment.  Michael Komesaroff, "Screwing up in foreign climes," China Economic Quarterly 9-12 (Dec. 2010).  

 (Pix from Citi Pacific Mining)

Komesaroff starts by suggesting misdirection and waste: "When China launched its “Go Out” policy in 1999, leaders hoped state-owned enterprises (SOEs) would snap up valuable foreign assets and transform themselves into successful multinationals. In the mining sector, China’s national champions have become powerful international investors—yet they have also wasted billions of dollars on ill-conceived projects, often exacerbated by poor management. . . . Far from being exceptions, these examples of mismanagement are the rule."   (Komesaroff, "Screwing up in foreign climes," supra, 1).

This post considers insights from that essay.

Komesaroff begins with examples:

To take three examples, the cost of CITIC Pacific’s Sino Iron mine in Western Australia, which is two years behind schedule, has risen from a projected US$1.9 bn to a staggering US$7.1 billion. China Metallurgical Group Corporation (CMGC)’s US$1.5 bn Ramu nickel project in Papua New Guinea is mired in legal difficulties, largely because CMGC failed to consult local landowners. And widespread labor abuses in Zambia, where managers at China Non-Ferrous Metals Corporation’s Chambishi copper mine are accused of shooting protesting workers, have seriously damaged China’s reputation in one of Africa’s most mineral-rich countries. (Komesaroff, "Screwing up in foreign climes," supra, 1).

He suggests that there are few foreign resource based investments that can be judged both trouble free and profitable.   This pattern is odd, Komesaroff asserts, especially given the managerial prowess of Chinese executives within China.  "China’s resource companies have an enviable record at home, where projects are invariably completed well ahead of schedule and below the cost of comparable developments elsewhere." (Ibid.). 

The reason Chinese managers are unable to replicate domestic models of management and profitability outside China, Komesaroff suggests, may be a result of both inexperience in managing projects abroad, but perhaps more importantly, because of the political foundations of the Chinese "go out" policy itself.

SOEs find it hard to replicate their model outside China, partly because managers suffer from a lack of international business experience, particularly in cross-cultural management. But many foreign investments are doomed from the start, as they are often designed to serve national strategic objectives ahead of business interests. (Ibid).

With respect to what he describes as "culture shock," Komesaroff argues that a source of difficulty is that Chinese business culture is hard to translate into successful application abroad, and Chinese business people find it hard to adjust quickly enough to avoid trouble.  He divides these cultural problems into three categories:

First, approvals for domestic projects are comparatively straightforward. In foreign countries, the existence of multiple stakeholders makes the process more complicated—and, for Chinese managers, more opaque. At home, Chinese companies negotiate directly with the political elite; but abroad they must struggle with greater public scrutiny, contend with local labor unions, and comply with unfamiliar international building codes. Second, problems in many investment destinations cannot be solved by simply hiring more cheap workers, as they often are in China. Foreign governments demand that jobs go to local workers, who may be more expensive and less compliant than those back home. And third, SOEs’ domestic success depends on a network of experienced local suppliers.  Moving offshore extends supply lines and compromises this competitive advantage.

The three causes point in different directions.  The first involves a learned practice.  Officials in CHinese SOEs work in an economic and political environemtn, one that the CHinese state is quick to stress, that is built on the uniqueness of Chinese characteristics.  But that uniqueness, while contributing to Chinese internal economic progress, makes it harder for Chinese steeped in "uniqueness" either to develop empathy or to adjust to very different ways of during business.  Thsi is a temporary problem of course.  Chinese students have been going abroad in large numbers for almost a generation.  When they assume m,ore prominent roles it is likely that cultural business insularity will diminish as well. Chinese officials are not ignorant of these problems--ranging from expectations of behavior within foreign joint ventures, corporate governance that focuses on international human rights norms in ways that would be troublesome within China and bureaucracies that operate in less inefficiently than in China but in accordance to cultural norms sometimes quite different than at home--but only experience will cure this difficulty.  

 (Pix Reuters, from Peter Ford,  Why Chinese workers are getting kidnapped abroad: Kidnapped Chinese workers were freed today in Egypt, but as more Chinese workers become easy targets abroad, citizens back home are calling for action, Christian Science Monitor, Feb. 1, 2012. "Freed Chinese workers are seen in a government building in al-Arish, north of Sinai, Wednesday. Twenty-four cement workers kidnapped by Bedouin tribesmen in Egypt were freed on Tuesday night, but the fate of 29 road builders captured by rebels in the troubled region of South Kordofan in Sudan remains unknown.")

The second goes to modalities of production.  One way to overcome the strangeness of foreign investment is to bring China abroad--by using local labor sparingly and exporting not merely the business but all factors of production--capital, labor, goods, etc. and rely on local workers and goods solely for critical extraction and menial needs.  This has caused problems in the past, especially in Africa.  It is unlikely to be tolerated in developed states and is viewed increasingly with suspicion especially in countries, like Pakistan, where local xenophobia may produce risks to Chinese workers.   See, e.g., Peter Ford, Why Chinese workers are getting kidnapped abroad: Kidnapped Chinese workers were freed today in Egypt, but as more Chinese workers become easy targets abroad, citizens back home are calling for action, Christian Science Monitor, Feb. 1, 2012).

The third reminds us of the difficulties of replication in foreign environments.  Just as American and European manufacturers discovered that supply chain techniques useful in home countries would have ot be modified to survive abroad, so will the Chinese.  While it is useful top replication and rely on domestic methods for supply chain relations, unity of culture, easier to repatriate profits, tighter government control of overall objectives--in this case territory makes a difference.  So either local suppliers have to extend their operations abroad--at greater expense, or the outbound SOE must backtrack part of the supply chain back to China, at great expense, or the offshore Chinese enterprises will have to develop local suppliers.  But that gets us back to the first problem--acculturation.  These problems are not irremediable; indeed they are not.  But they will require a level of sophistication in offshore investing, and perhaps a change in basic economic policy in the "go-out" policy, that will require time to develop and even more time to implement successfully. 

For the moment, China's approach to resolving these problems is focused on the approval process for outbound investment.

In 2004, following the failure of Minmetals to acquire the Canadian mining company Noranda, they set up a formal approval system for SOEs wishing to invest aboard. The process is designed to filter projects that are risky or unlikely to succeed. SOEs must register with both the State-owned Assets Supervision and Administration Commission (Sasac) and the National Development Reform Commission (NDRC). Sasac judges potential SOE investors on a number of financial and operating performance measures, and confirms that the project at hand is within the particular SOE’s business scope. NDRC then judges whether the project is consistent with national industrial policy. Copper and iron ore have long been considered strategic acquisition targets, and bauxite and nickel were recently added to the list.
After SASAC and NDRC confirm an SOE’s registration, the SOE must carry out a feasibility study to support its proposed investment, including a financial evaluation. If the project requires extra financing, institutions like China Development Bank and Export-Import Bank of China will become involved. Managers must also submit details of their proposed risk management and auditing systems. Until 2007, SOEs used a traditional accounting approach to evaluate overseas investments. Now they use techniques like discounted cash flow, internal rate of return and payback period—all techniques that are standard in global companies. (Komesaroff, "Screwing up in foreign climes," supra, 2).

For SOEs, there is a silver lining.  Like companies in developed states that have long relied on their party advice, SOEs "embrace global best operating practices. Third-party advisors, especially foreign advisors, are also useful scapegoats when projects fail." (Ibid.).

 (Pix from Aaron Back, China Buys Overseas Assets, Wall Street Journal ("China's total overseas investments more than doubled from the year-earlier quarter, according to estimates by A Capital, a private-equity firm based in China and Paris that takes stakes in European companies alongside Chinese investors. That figure includes both mergers and acquisitions as well as so-called greenfield investments, or construction of new plants and facilities. . . . State-owned companies accounted for 98% of all deal value in the first quarter, a new high and up sharply from 53% in the first quarter of 2011, A Capital estimated in its quarterly Dragon Index on China's outbound investment. Resources and energy deals accounted for 92% of the total, up from just 24% a year earlier."))

Equally interesting is Komesaroff's discussion of the internal Chinese political to the effectiveness and profitability of outbound investment. Komesaroff notes that, like their developed state peers, Chinese SOEs have become quite sophisticated in their use and analysis of feasibility studies for investment decisions.

Project evaluation has improved as feasibility studies have taken on a more commercial orientation. This increased analytical rigor is fostering greater investment discipline. One good example was the decision by Yanzhou Coal’s Australian subsidiary to pass up an attractive opportunity after due diligence revealed that local geological conditions were not compatible with its proprietary technology. More stringent analysis is a consequence of reforms that make the management of listed SOEs more responsive to movements in their share price. Crucially, this metric is used by the Communist Party’s Organization Department to evaluate senior cadres. Recent amendments to Sasac’s regulations also make top SOE managers responsible for losses from foreign investments. (Ibid.).

But, Komesaroff suggests, because feasibility and related studies are not evaluated  solely for their financial effects, their utility is diminished, as a vehicle for determining wealth maximizing and risk minimizing action.  In the West, these arguments have acquired a certain currency, but the object of dissatisfaction is the move away from financial to social, environmental and human rights impacts analysis.  Komesaroff sees a similar problem for SOE investment decisions, but in the case of Chinese SOEs, the deviation from pure financial evaluation is political.

Yet the political dimension to corporate leadership in China means that managers have different priorities from their foreign counterparts. Because their careers are managed by the Organization Department, which regularly rotates cadres between corporate positions in SOEs and government posts, enterprise leadership need to balance corporate objectives with the demands of their political patrons. One example was Aluminum Corporation of China (Chinalco)’s stunning share raid on Rio Tinto in 2008. On a corporate basis, Chinalco probably overpaid for its 9% stake—but because the purchase blocked a possible takeover of Rio Tinto by BHP, China’s national objectives were achieved. The Chinese government was determined to prevent the emergence of a combined BHP Rio Tinto, which would have dominated the seaborne market for iron ore and gained intolerable pricing power over Chinese steel mills. (Ibid).

Komesaroff argues that the pursuit of "national objectives can seriously damage corporate interests." (Ibid.). He points to the example of the Sino Iron project at Capre Preston in Western Australia for which CITIC Pacific overpaid "after Beijing lowered the hurdle rate for foreign iron-ore projects because of their perceived strategic importance." (Ibid).  Komesaroff explains the consequence and the alternative:

Lengthy delays and cost blowouts on the Sino Iron project are a consequence of pursuing national objectives at the expense of corporate profitability. CMGC only got involved with the project at the behest of Beijing, even though it had no experience of building structures needed to withstand Western Australia’s harsh conditions, particularly cyclones. CMGC also encountered difficulty managing local employees: many contractors have resorted to the courts to recover money owed to them. Involving a global engineering company with experience in Australia as a lead design and construction partner would have prevented such problems. (Ibid).

Still, it is not as clear that the problem is the need to satisfy public policy by SOEs as it may be by incompetence in fulfilling the directives of the state. Just as wealth maximizing activity may be possible even under international soft law conditions requiring sensitivity to human rights, environmental and related impacts, so might SOE managers more intelligently comply with governmental directives.  The problem, in this case may not be that executives are overeager to produce results for Beijing, and willing to misjudge risk in that effort.  It might be that these executives might believe that somehow the government, having directed this activity, would subsidize losses for rash decisions.  To the extent that is true, the failure may be political rather than economic and falls to Beijing rather than to the SOEs. 

Komasaroff hints in this direction, though he also points the finger at the managers:

Interestingly, the failures of China’s mineral investments over the past decade or so stand in stark contrast to the handful of successful investments made early in China’s reform process. In 1987, China Metallurgical Import Export Corporation (later Sinosteel) partnered with CRA (later Rio Tinto) to develop the Channar iron-ore deposit in Western Australia. A year earlier, CITIC joined an Alcoa-led consortium to build an aluminum smelter at Portland in Australia. . . . In both cases, the lead partner was a large global company with undisputed experience in the sector—in direct contrast to most of the investments pursued since the launch of the Go Out policy.
The Channar and Portland investments occurred more than 25 years ago—well before China embraced the sophisticated financial evaluation techniques that underpin its current investment decision making. . . . These projects served a national strategic purpose, but were also sound business investments. By comparison, too many foreign investments today smack of political overreaching—a problem aggravated by managerial incompetence. (Ibid).

The issues Komesaroff raises are not new to the Chinese outbound experience.  See, e.g., Larry Catá Backer, “The Problems of Being a great Power: China and Neo-Colonialism in Africa, Law at the End of the Day, Nov. 22, 2006;  Larry Catá Backer, China and Neo-Colonialism in Africa: A Warning from South Africa, Law at the End of the Day, Dec. 15, 2006; Larry Catá Backer, Courting Africa--21st Century China Africa Investment and Cooperation Forum, Law at the End of the Day, Aug. 7, 2010. As China becomes a great power, it, like the U.S. and the U.K. and other European powers before China, will have to learn the art of projecting economic power abroad in ways that are both profitable and do not create political. cultural or economic back lash.  These may be hard lessons, and they may require substantial changes in practice and approach, but they are lessons that may be learned. But hardest of all will be to translate the characteristically close relationship between political policy and economic direction, between state and economic sectors, away from the Chinese homeland.