The dragon tucks in

Chinese companies abroad

Jun 30th 2005
From The Economist print edition

Chinese companies are becoming aggressive buyers of overseas assets. It will take longer for them to become smarter ones

“TO SPREAD the ‘China Threat’ and try to curb China's progress and starve its energy needs is not in the interest of world stability and development. Such attempts are doomed to fail.” These feisty words were uttered this week by Zhang Guobao, vice-chairman of China's National Development and Reform Commission, during a visit to an energy conference in New Orleans. He was responding to efforts by American politicians to block an $18.5 billion cash bid made on June 22nd by the China National Offshore Oil Company (CNOOC) for Unocal, a mid-sized American oil firm.

The spat over CNOOC is a symptom of the growing unease felt in developed economies, but especially in America, as more and more Chinese companies have looked abroad for expansion and technological know-how. Just days before the CNOOC bid, Haier, a white-goods maker, bid $2.25 billion for Maytag, a troubled American rival. In May IBM finalised the sale of its personal-computer arm to Lenovo, a deal that also raised political hackles in America.

Americans remember a similar period in the 1980s when Japan was accused of seeking global economic domination as its companies bought everything from Hollywood studios to paintings by Van Gogh. They seem to have forgotten that that threat proved transient, indeed was never really a threat at all. Now comes an increasingly assertive China, its companies flush with cheap cash and its government desperate to maintain its phenomenal economic momentum. As so often when politicians are involved, the truth about the overseas expansion of China's companies is much more complex than hot rhetoric suggests.

Even before the latest row over the CNOOC bid, there were clear signs of China's mounting interest in acquiring real assets abroad aside from oil and gas. The volume of transactions involving a Chinese buyer and an international target has jumped from $2 billion-3 billion in previous years to almost $23 billion for 2005 (see chart). Late last year Baosteel, China's largest steelmaker, made a big investment in Brazil, while in 2004 TCL, its leading television producer, bought most of the TV-manufacturing business of France's Thomson plus a mobile handset-making business from Alcatel. Other deals have been less visible, but no less important.

“Going overseas for Chinese companies is a prerequisite for success,” argues Gordon Orr, a consultant with McKinsey in Shanghai. Indeed, there are more deals in the pipeline. SAIC, China's leading car company, remains keen on overseas expansion following an acquisition in South Korea and a last-minute withdrawal from buying Britain's MG Rover. ZTE and Huawei, the two main producers of telecom equipment, are already serving international clients and the latter is rumoured to be interested in Marconi, a perennially troubled British rival.

Does this amount to a carefully planned assault on global assets? For all its appearance as a communist-directed monolith, China is ultimately too fragmented for that. Unlike Japan's fabled Ministry of International Trade and Industry in the 1960s and 1970s, China does not have a single agency powerful enough to be an effective co-ordinator. Nevertheless, China's acquisition spree has clear political backing. The leadership in Beijing is determined to create its own set of “global champions”—30-50 internationally competitive, yet still state-controlled, firms.

To foster rapid growth and create jobs, China deliberately opened its domestic market to foreign competition relatively early in its economic development. But the quid pro quo implicit in this strategy was that the government would support, both diplomatically and financially, Chinese companies overseas.

The state imperative is most obvious in the quest for resources being led by the mainland's big oil, metal and commodity producers. Baosteel's South American investment, for example, is a joint-venture with CVRD, the world's largest producer of iron ore, vital for steel production. Capturing scarce resources was also behind the failed attempt this year by state-owned Minmetals, China's top base-metals producer, to spend $7 billion buying Canada's Noranda, one of the world's largest zinc, nickel and copper producers.

Resources of another kind, namely the management skills, brands and market access of international firms, are driving the second type of Chinese acquisition. Haier wants the Maytag and Hoover brands because its own brands failed to break through in America. And it wants a ready-made distribution channel to help get its own branded goods on to the shelves of big global retailers. SAIC sought Rover's design and engineering expertise, not its model range or factory. Lenovo, which even more than Haier has failed to establish its name outside China, was willing to pay handsomely for IBM's blue-chip brand, which it can use for five years, even though the business is running at barely break-even in a market where prices are in free fall. And, common to all these deals, mainland managers see foreign acquisitions as a way to get their hands on the most modern internal processes, systems and strategic thinking.

Thank goodness for cheap money

Although it is clear what Chinese firms want, it is less clear that their buying spree will prove successful. In their favour, Chinese firms can contribute cheap finance, cut costs by relocating factories to China and tap their potentially vast domestic market. Of these, the first is the most compelling. For state firms—and most big companies still have government links—that do not have to make a commercial return or perhaps even repay loans from state banks, the cost of capital is very close to zero. This gives them a huge advantage when it comes to competing with private-sector firms from abroad. And there is increasing evidence that Chinese companies are routinely overpaying for assets.

CNOOC, for example, is currently offering around $2 billion more than Chevron for Unocal, despite the fact that it does not expect to make any cost savings (it promises not to fire Unocal staff), while the Americans are promising to squeeze out $325m. The Chinese bid is also entirely in cash, $3 billion of it from its own balance sheet. The only reason CNOOC can do this without ruining its financial ratios and potentially crushing its own share price is that $7 billion of the overall $20-billion deal costs (the $18.5 billion bid plus the assumption of some debt and a $500m “kill” fee to Chevron if the latter is seen off) is coming via a parent entity from its ultimate owner—the government. Another $6 billion is a loan from one of the big four state banks. Of the $7 billion, CNOOC has to pay no interest at all on $2.5 billion, and just 3.5% interest on the remaining $4.5 billion, a loan that lasts for 30 years. Since a 30-year American Treasury bond currently yields 4.2%, CNOOC is borrowing more cheaply than the American government, clearly nonsense in a world of rational economics. Given China's abundant domestic liquidity and $660 billion of foreign-exchange reserves, it is, however, a nonsense that could go on for a long time.

Successful Chinese acquirers should be able to cut costs by shifting manufacturing to mainland China—though obviously this does not apply to raw-material purchases. Haier certainly sees an opportunity at Maytag, which still has 13 of its 15 production sites in America. IBM, by contrast, already makes all of its PCs in low-cost countries, limiting gains for Lenovo. And Haier, if it wins Maytag, will face both deep resistance from the latter's strong unions and potential quality concerns among customers. Similarly, the synergies of introducing an acquisition's products into a vast domestic market may prove more ephemeral than real given that China's market is oversupplied and hugely competitive, with most global companies already present.

This is, indeed, a reason for scepticism about the current wave of foreign acquisitions: they are often motivated by a desire to escape problems at home. Certainly Lenovo, which is losing market share to Dell and Hewlett-Packard in China, fits that bill. Mary Ma, its finance director, admitted to The Economist when the IBM deal was announced: “If we just focus on China, we cannot generate returns for our shareholders.” Haier, too, is said by recent visitors to be “utterly downbeat” about falling margins and static profits at home, the result of excessive diversification and expansion. In America its company secretary recently admitted that “our brand overseas is a very minor brand”—hence the bid for Maytag.

Desperate buyers, however, run the risk of being stuck with dud assets. D'Long, a Chinese noodles-to-cement conglomerate, scooped up troubled foreign brands, including Murray lawnmowers and parts of bankrupt aircraft-maker Fairchild Dornier, before collapsing under its own debts last year. TCL is struggling to turn around the loss-making TV operations it bought from Thomson and has been left in a pickle by Alcatel after the French pulled out early from their handset joint-venture. On June 27th, Merrill Lynch downgraded its rating on TCL's TV arm, saying “the company clearly underestimated the deal complexity and the weak fundamentals of Thomson's TV business.”

Integrating foreign acquisitions can trip up even experienced acquirers. But while western executives quickly learn from their mistakes (or lose their jobs), China's political system makes its managers particularly unsuitable for running complex, global companies that demand consistent strategies. In an environment of regulatory inconsistency, corruption and political patronage, Chinese companies have tended to pursue short-term returns and excessive diversification rather than long-term technological development. And rather than build networks of suppliers and customers, they have preferred to curry favour with bureaucrats and party officials.

All of this can be unlearned, though it will take time. One encouraging sign in the latest transactions is that Chinese companies are looking outside their country for help, not just for bid targets. Both Lenovo and Haier have worked with western private-equity firms to defray some of the costs and risks of their bids, as well as to gain access to experienced managers. CNOOC is showing even more sophistication. To increase its chances of winning Unocal, it has hired local law firms, lobbyists and public-relations advisers with clout on Capitol Hill. That shows a willingness to learn that contrasts with Japan's companies when they were on their spending spree. Western financial firms are also closely involved with CNOOC's bid.

Indeed, the care being taken over the bid is a measure of China's ambitions in the sensitive energy sector. China is eager to secure energy resources that it considers essential for its future growth. So the battle over Unocal, whatever its outcome, promises to be the first of many. How America reacts will have huge ramifications on future Chinese energy policy and military strategy. The signs are not good.

The Chinese had flirted with a bid for Unocal for months, but rival Chevron swooped in with an offer back in April. Unocal's management and regulators approved the deal, although shareholders have not yet voted. So CNOOC's bid has a chance if Unocal's management is willing to jilt Chevron.

Cocking a CNOOC

Will that happen? Because CNOOC is controlled and financed largely by the Chinese government, Chevron is crying foul. Peter Robertson, its vice-chairman, declares that, if his rival is allowed to buy Unocal, then “over time, oil will be diverted to China on a non-commercial basis”—though, when pressed, he cannot explain why this is necessarily bad for America. However questionable, the claim spreads fear of China gobbling up American oil and gas, and might thereby allow Chevron to avoid having to sweeten its own offer.

Many American politicians have been receptive to Chevron's pleas. Over 40 Congressmen signed an open letter this week expressing concern about the Chinese bid. The White House rejected a request from CNOOC for an expedited review of the deal, meaning things could drag on for months. This uncertainty favours Chevron. Joe Barton, a powerful Republican congressman from Texas, even demanded that the deal simply be blocked, declaring baldly that “this transaction poses a clear threat to the energy and national security of the United States.”

Is America's energy security really at risk as politicians claim, or is this simply grandstanding? The case is hard to make. Unocal is a puny player on the world oil and gas scene. By size, it does not even rank among the top-40 global oil or gas firms. Ironically, the greater risk to America's long-term energy security may come if China reacts badly to the unseemly rush to block the deal. If purchases on the open market are thwarted, then China might seek more aggressive, and possibly hostile, paths toward its own energy-security goals. The Chinese have already grown increasingly uneasy as their tankers have brought ever more oil from the Middle East under the watchful eye of the American navy. They are mindful that they can do nothing to stop a military blockade.

Another reason to worry less about China's intentions is provided by the way oil markets have changed in recent decades. Liquid oil-futures contracts have shifted the market from one based on rigid bilateral deals to a dynamic one in which oil is a fungible, global commodity. Tom Wallin, head of the Energy Intelligence Group, an industry publisher, argues that “in a globalised market, equity oil doesn't buy you energy security because price risk is still there. If there's a big shock in Saudi Arabia, the price of West Texas oil will shoot up too.” Lee Raymond, chairman of Exxon Mobil, the world's biggest publicly listed oil firm and a powerful industry voice, sided with the free marketers last week, declaring that it would be “a big mistake” to block the CNOOC bid.

A sense of double standards over CNOOC's bid may be what rankles with the Chinese the most. When Saudi Arabia's Aramco and Venezuela's PDVSA bought American refineries and petrol stations, nobody objected. Further, when American energy firms come to China, notes Mr Zhang, they expect to be welcomed. “It's unbelievable...many US companies have investments in China, and we also think it's just a business.” The irony is that one of those American firms is Chevron, which has had a partnership to develop hydrocarbons off China's coast with CNOOC itself.

“Whatever happens with Unocal, China will continue to expand on the world stage,” argues Michelle Billig of Pira Energy, a consultancy. The roots of that expansion go back to 1993, when the country first became a net oil importer. Shortly thereafter, CNPC, another state-owned oil company, splashed out on oil acquisitions in Sudan, Kazakhstan, Venezuela and Peru. Chinese firms also used “oil diplomacy” to pursue deals, with rather less success, in Yemen, Oman, Iran and even Iraq in the late 1990s.

China has pressed hard in recent years to secure access to oil and gas in the Caspian and in Russia, hoping to bypass sea lanes that can be blockaded by America. However, its efforts have mostly been stymied, in part due to quiet diplomatic pressure from the Americans. There is talk of China developing deep-water ports in Asia along the route from the Middle East, including in Myanmar, again as a response to American control of shipping channels.

In pursuing this aggressive energy policy, China has spent tens of billions of dollars overseas on what J.P. Morgan, an investment bank, calls “strategic mercantilism”. That phrase evokes historical parallels with the rise of other great powers, such as Britain and America, and their efforts to secure energy assets overseas. Britain locked up Iran's oil wealth in the Anglo-Persian Oil Company (later BP), and America created Aramco in Saudi Arabia.

The better analogy for Chinese energy policy is probably Japan, which has been trying since the 1970s to foster a national oil company. The government's bureaucrats squandered billions of dollars on oil acquisitions and exploration licences overseas. At last, in utter disgust and failure, Japan disbanded its national oil company earlier this year. As one Asian energy guru puts it, “the best way to describe Chinese energy policy is that they are copying the Japanese example—badly.”

So, like Japanese firms in Hollywood and elsewhere in the 1980s, it seems that Chinese companies that are buying overseas now are mostly being taken in like tourists. If they overpay, resource companies will at least have something to show for their money. Many deals in other sectors look ropy, a consequence of buying poor assets. “But even if these companies suffer brutal losses, there will be plenty of others,” predicts Joe Zhang, an analyst with UBS in Hong Kong. “Thousands of not-so-ready Chinese companies are waiting in the wings.”

In terms of peacefully integrating China into the world economy, this is to be welcomed, not feared. Chinese companies will make their mistakes, and they will need to learn fast. Another wave of hopefuls is already discernible. On June 28th, Thomson of France sold the final leg of its TV operations—not to China's TCL, its partner until now, but to an Indian rival.

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