How BASF Navigates China – Cover Story, Site Selection Magazine, July 2004

When BASF AG’s first quarter numbers came in, its chemical division’s sales volume had boosted net income by 17 percent. BASF Chairman Juergen Hambrecht said, “We are seeing synchronized growth in the global economy, driven by the dynamically growing economies in the Far East – especially in China – and by solid growth in North America.”         Certainly BASF is not alone in realizing the benefits of growing operations in China. But the company is also not alone in having to negotiate the perils caused by what some would call breakneck growth in the country as a whole: overloaded infrastructure, widening income disparity and changing land law, to name a few.         In this Site Selection exclusive, Thomas Glatte, Hong Kong-based manager of Asia Pacific real estate for German multinational chemical company BASF AG, provides valuable insights into what it takes to find and develop an industrial site in today’s China.

on’t miss China – words like these are spreading currently among managers all over the world. Just take a brief look at the business class occupancy of flights from Europe, North America or Japan to the major Chinese cities. This gives you a glimpse of how attractive steady growth rates between 6 percent and 10 percent in the past few years have been. It also indicates how much attention a market is given which offers 1.3 billion potential consumers and a government committed to rapidly changing the country from an agriculture-dominated developing country into one of the world’s powerhouses.

        Furthermore, China’s entry into the World Trade Organization is expected to catapult this already surging economy into another sphere of development. Most of the industrial global players already have had economic ties with China for decades, which further strengthened after the country’s opening to the world in the early 1980s. Most of these multinationals have already broken ground in China, have established production sites and have continuously grown their local organizations and portfolios.

        The world’s largest chemical company, BASF has been a committed partner to China since 1885. It is one of the biggest foreign investors in the Chinese chemical industry, and its Asian investments will total about EUR 5.6 billion (US$6.8 billion) by 2005. BASF has about 3,000 employees in China and the number is expected to double in the coming years.

        The company currently operates 10 wholly owned subsidiaries and nine joint ventures in Shanghai, Nanjing, Guangzhou, Jilin and Shenyang. In order to stay in tune with local markets, the company maintains offices in Hong Kong, Beijing, Shanghai, Guangzhou, Nanjing, Qingdao and Chengdu. In 2003, BASF achieved sales of close to EUR1.6 billion (US$1.9 billion) in Greater China.

        All foreign investors have had to learn how to deal with the specifics of doing business in China, selecting sites for offices, warehouses and production facilities as well as setting up organizations able to handle the day-to-day business locally. It is important for any kind of investor in China – as in any other country – to cultivate an understanding of the country’s business environment before finally breaking ground. This is certainly also valid for the process of site selection.

        The criteria for site selection for industrial enterprises can generally be divided into operational site factors like market, raw materials, logistics, real estate, infrastructure, energy and availability of a skilled work force, as well as functional site factors like prevailing legislation, investment regulations, taxation, customs and the financial system. It is the aim of this article to take a deeper look into China-specific challenges that overseas industrial investors have to tackle and on which issues investors should remain cautious.

There are three ways to enter the Chinese market as a foreigner: First, buy a stake in an existing company or take it over; second, form a new joint venture with an existing company; or, third, establish a new, wholly owned foreign-invested enterprise (WOFE). The first way is up to now the least desired in the industrial sector because of the lack of attractive enterprises in a market still dominated by mainly state-owned companies with inefficient structures, outdated assets or attached environmental issues. The second and third ways have been and still are the common entry options. Newcomers with no established setup in China find it still more attractive to go through the uneasy process of a joint venture formation because of the immediate availability of an existing organization. Furthermore, the network and connections of the local partner may be very helpful in smoothing the investment’s way through the country’s bureaucracy. While the first approach (entering by acquisition of a stake) basically means that one has to live with the existing site and other assets, the two other approaches normally will involve the process of site selection.

        BASF started in the 1980s with smaller joint ventures, followed in the mid-’90s by a wholly owned holding company rendering services to the local joint ventures. In 2000, with BASF Colorants and Chemicals Co. Ltd., it finally transformed a former joint venture operation into its first wholly owned enterprise. Meanwhile, the company’s main integrated production site is currently under construction in Nanjing as a joint venture with one of China’s three chemical giants, SINOPEC. Located adjacent to its joint venture partner SINOPEC Yangtzi Petrochemical Company’s existing production site, the investment of BASF-YPC Co. Ltd. amounts to about EUR 2.4

Location of Chemical Industry Parks in the People’s Republic of China

billion (US$2.9 billion). Furthermore, the company is also establishing another major petrochemical production site in Shanghai Chemical Industry Park, Shanghai-Caojing, partly as a 100-percent entity and partly in joint ventures with overseas and local partners.

As many industries are driven by the need to follow their customers, it is obviously very logical in a vast country like China to carefully check markets and clients before settling down. Traditionally, the major industries are concentrated along the country’s coastal areas, with major hubs in the Greater Shanghai area and adjacent provinces, as well as the Pearl River Delta surrounding Hong Kong with cities like Guangzhou, Shenzhen and Zhuhai. This is due to the fact that China is a country lacking sufficient natural resources to serve its own needs and, thus, relying heavily on sea-bound raw material imports like oil, gas and ore.

        Foreign investors not used to doing business in China also need to be aware of the country’s transportation network. Despite modern airports and impressive elevated road systems in Beijing, Shanghai and other eastern cities, as well as very fast infrastructure construction times, the country still has a shortage of modern airports, highways and railways to connect the coastal cities with places in the central and western provinces. This becomes even more important if one considers the surprising fact that domestic freight can sometimes cost as much as freight from other Asian hubs like Singapore.

        Low personnel cost remains an attractive investment reason, especially for labor-intensive industries. However, recent years have seen a sharp rise in income in the eastern provinces overwhelmed by investments due to their convenient logistic location, still-comparable low labor cost and the level of education, while the central, northern and western regions could not keep the same pace. This has created an increasing gap in wealth, which is a major issue to be tackled by the government in the near and mid-term future. Vice versa, the recent jumps in personnel cost have already prompted international companies to look for alternative locations beyond the major entry hubs of Shanghai, Beijing and Guangzhou.

Although China has undergone a dramatic process of opening up and trimming its economy to the market requirements, the basic set-ups of a state-controlled planning economy remain in place.

        Therefore, the decision whether a market does exist is not only subject to the investor’s own professional exploration, but depends also on a governmental approval system, distinguishing investment projects into “encouraged,” “permitted,” “restricted” and “prohibited” investment categories. There are lists available from authorities dividing the various industries according to the above scheme. A very important factor for any kind of investor is the so-called “US$30 million” threshold. While investment projects above this value normally have to receive approval from central government authorities in Beijing, projects below the threshold can be handled by local authorities, normally at a municipal level. The importance of this threshold becomes apparent once a close look is taken at the investment support on a local level.

        Since the opening up of the country in the 1980s there has been widespread establishment of larger and smaller commercial developments like industrial zones or high-tech parks. The industrial zone’s importance can be distinguished by its backing, being either a development zone at a “state level” (backed by the central government), provincial-municipal level or local/ town level, or even a privately invested development. As of today, there are some 100 such industrial parks in Shanghai Municipality alone. In Zhejiang Province, next to Shanghai, authorities have up to now approved more than 800 industrial parks, but “only” 200 are now operational. It goes without saying that all these developments – although most of them are focused on specific industries – are competing to a large extent with each other for potential investors.

        Therefore it is highly recommended to investigate thoroughly these parks’ real capabilities, as brochures and initially gathered information can be occasionally exaggerated, especially with smaller and up-country developments. Not every industrial park maintains the same service level. Larger industrial parks are of interest especially for overseas investors as they have established “one-stop agencies” whereby branch offices of the local authorities act under the roof of the industrial park’s administration. In this situation, the projects valued below the aforementioned US$30 million threshold normally can be approved by those administrations themselves. This almost guarantees a significantly less bureaucratic and quick go-ahead. Such approvals are commonly a matter of only a few weeks, while involvement of superior authorities may inflict sometimes lengthy procedures of as much as several months or even years.

As competition for investment prevails among many industrial parks and communities, many of them try to impress with a high level of “flexibility” to attract industrialists and meet their requirements. Such flexibility, although normally welcomed with much appreciation by investors from over-regulated western countries, should be treated with much caution and careful evaluation. The Chinese legal system is still undergoing a major turnaround to reflect the country’s changed circumstances. It is therefore often behind the country’s actual pace of development, and is sometimes even contradictory, leaving room for loopholes and various interpretations.

The BASF-YPC integrated production site covers 2,368 acres (220 hectares) and includes plans for a steamcracker and nine different plants. When operational in 2005, the site will produce some 1.7 million metric tons of chemicals and polymers per year – all intended for the domestic market.

        In such an environment, promises are given easily – even in writing. Their validity, however, needs very careful assessment with respect to the legislation’s current and future development, technical feasibility as well as the real authority of the respective official. The latter in particular can be very confusing for western investors and requires long experience in dealing with Chinese authorities.

        Furthermore, it is typical for China that statements and agreements are made in a rather general way. As the “devil is always in the details,” this can be a very frustrating experience for western managers who want to discuss and fix every possible scenario right from the beginning. The generality always leaves a face-saving “emergency exit” and room for subsequent, further discussion.

        It is important to know that contracts and agreements do not have the same rigid meaning and importance in China’s business environment as in the Western Hemisphere. This concept, often regarded by western investors as some kind of legal insecurity, also has advantages, as it applies to both sides: There is always room for discussion and change. In a fast-changing environment like China with many unpredictable changes and directions, this concept provides an important tool for applying necessary adjustments whenever they arise.

The above experience becomes even more clear upon first arrival at a typical Chinese industrial park – frequently in an impressive but underutilized administration building at the entrance or in the heart of the development, containing at the entrance lobby a large-scale model of the industrial park’s “future look-alike.” A field trip afterwards normally provides a different kind of picture: vast idle or agriculturally used areas, often even still occupied by plenty of farmhouses. Under such rather visionary circumstances, it is especially important for industrial investors to rely on more than just the will of development and the breath-taking pace of Chinese construction.

Right from the beginning, it should be clarified and secured which infrastructures are already available or will be available in the short term and, even more important, at what cost. It is a frequent problem that especially utility and site service infrastructures like power, railway, water supply or waste water treatment facilities will be built only many years later. Or, if already available at an early stage, they are not built for a phase-wise development, but instead are hugely over-designed and therefore resulting in uncompetitive charges.

Another very important part of establishing a site is to obtain a secure and enforceable right on the underlying property. While China does not provide a system of private land ownership and therefore all land is still owned by the state, there is an established but still developing system that allows the transfer of land use rights “for value.”

        This system of land use rights, however, requires much attention of the investor as it has undergone significant changes in the past and is still under further improvement. Furthermore, the country’s fast development has created a huge demand on construction land and, as a result of this, a tremendous rise in land prices. No wonder that, despite all government efforts, land deals are highly attractive for speculation and corruption.

        Going back to the two ways of entering the Chinese market that involve site selection issues – the joint venture formation and the new establishment of a WOFE – the real estate professional normally is confronted with two major types of land use rights provided by Chinese land legislation: the Allocated State-Owned Land Use Right (ALUR) and the Granted State-Owned Land Use Right (GLUR).

        The ALUR is typically met during formation of a joint venture with an existing or former state-owned enterprise, whereby the state has “allocated” the right to use the land to its own (“state-owned”) enterprise virtually free of charge. In return, the state-owned company was expected to develop the land at its own expense, including resettlement of former users like farmers, establishment of the required infrastructure and payment of a small annual fee to the government. As for this small fee (typically in a range of US$0.04-0.05 per sq. ft.), the state in return has the power to withdraw such right at its own discretion or increase the annual fee every three years.

        In contrast, the economic reforms of China derived in the late ’80s with the GLUR an additional form of land use rights. “Granted” by the state for a once-off payment reflecting the market value of the property for 40-70 years depending on the purpose of the investment, the GLUR currently constitutes the most secure form of land use right, as the grantee obtains it normally in the form of developed land directly from the Land Administration Bureau.

        Compensations for former users and even various infrastructures are mostly already included, and the grantee has legal protection for the stated term and can expect even compensation in case of expropriation. However, details about such compensations and included infrastructures should be carefully checked beforehand. Compensations have risen significantly in recent years. So has public awareness of shady land deals, with the subject receiving rising attention even in state-controlled media.

        As the GLUR underlies some sort of market valuation, prices differ very much from location to location. They can easily reach unit prices of well above US$10 per sq. ft. in attractive coastal high-tech industrial parks, while more remote inner country developments offer even major discounts on listed land prices below US$1.80 per sq. ft.

Although China is a vast country covering an area of 960 million hectares (2.37 billion acres), its land resources are rather limited and spread unequally over the country. An official statistic from the Ministry of Land and Natural Resources provides shares of 13.7 percent for cultivated (farm) land, 20.7 percent for forestry, 27.55 percent for pasture, 2.95 percent for construction land, 3.8 percent for water resources and 31.3 percent for unexploited land.

        Moreover, China is a hilly country with mountainous regions and hilly areas making up two thirds of its territory. Taking into account its population, China is therefore characterized by a tremendous shortage of arable land, a situation made worse by the fact that the most fertile land is concentrated in the coastal provinces with a dense population and comparably higher industrial development. This results in a massive need for construction land normally at the expense of abolishing fertile farmland. In recent years, cultivated land has been disappearing at a rate of several hundreds of thousands of hectares each year.

        The conflict between agricultural demand for land and that of urbanization and industrialization is becoming more and more significant. Excessive cultivation of grasslands, over-grazing, utilization of land by village and township enterprises, soil pollution and erosion and rapid urbanization have caused serious damage to the environment and deterioration of land resources. On the other side, the country’s deserts are expanding and reforestation programs have yet to deliver success. All of this has prompted the central government to establish a strong legal framework for the protection of farmland that shall avoid its further uncontrolled decline. This very understandable and responsible move, however, makes it much more difficult to transform land zoned as farmland into land for construction.

        An important governmental tool is the so-called land use plan, available at every administrative level (state, province, municipality, county, township), which distinguishes the land into the three main categories: agricultural land, construction land and “unused land.”Starting at the lowest administrative level, authorities annually distribute additional construction land and seek approval from their superior land administration authority.

        Based thereon, each authority level compiles a certain accumulated construction land “budget,” which in the end is approved by the central government’s State Council. Through such means the central government tries to control the construction land allocation and to avoid too excessive exploitation of this very valuable resource.

A good example for such increased awareness can be found in Shanghai. In 2002 Shanghai Municipality established a new authority responsible for the oversight of city planning and the development of a new Urban Master Plan along the river bank of Huang Pu River as part of its efforts to improve the city’s appearance prior to the world exhibition EXPO 2010. As a result of this, all investment projects along the Huang Pu River, which flows right across the city, had been put on hold and under review. Initial ideas suggested even the relocation of entire industrial developments not close to the city’s center, including main sites of some of the country’s major industrial players. This would have resulted in a multi-billion dollar undertaking as well as endangered the survival of some of the local enterprises.

        By the end of 2002, the authorities required more time to develop their own Urban Master Plan and to review many established companies’ development in light of such municipal planning. After some years of reviews and discussions, the authorities’ positions have crystallized whereby, until 2010, the activities to restructure Shanghai focus on the central and southern banks of the Huang Pu in line with EXPO locations. The river bank policy for the Northern Huang Pu area (home of many industrial enterprises) is not yet finalized. However, the preliminary scheme for the north extension part has become clear: to keep the existing industrial operations within their current premises, carefully allow certain growth and encourage the settlement of environmentally friendly operations.

        Notwithstanding this example, the conflict of interest between the intentions of the central government to control developments and competing local authorities keen to attract investors for the benefit of their communities and their own political pride can be easily seen during a cross-country ride. Developments – residential, commercial and industrial – are mushrooming across the country, and quite a number of them are questionable to the professional eye with regard to their location as well as utilization.

        In recent years, China has become the main focus for industrial investment and is expected to grow further during the coming years. The country has thereby undergone major changes in the economic, legal and administrative sectors. The site selection process and corresponding activities require much expertise and know-how of the country’s specifics, as they are often undertaken in an unsatisfactory (by western standards), unclear or less secured environment. Nonetheless, the biggest challenge for foreigners remains to follow and understand the country’s fast changes – those of the past, the present and the future.