Investment Climate Statement for FY 2002

INTERNATIONAL COPYRIGHT, U.S. & FOREIGN COMMERCIAL SERVICE AND U.S. DEPARTMENT OF STATE, 2001. ALL RIGHTS RESERVED OUTSIDE OF THE UNITED STATES.

A. Openness to Foreign Investment

For the past eight years, China has been the second largest recipient of foreign direct investment (FDI) in the world after the United States. According to Chinese statistics, the flow of new FDI into China slightly increased in 2000 after sharply dropping in 1998 and 1999. By the end of 2000, realized FDI in China since 1979 reached a cumulative total of just over $348 billion. The value of realized FDI flowing into China in 2000 was $40.7 billion, an increase of .9% over 1999. The value of new contractual investment, a harbinger of future investments, was $62.6 billion, an increase of 50.8% over the previous year. The United States accounted for over 10% of overall realized FDI in China in 2000, making it the second largest source of FDI behind only Hong Kong.

Government Attitude Toward Foreign Private Investment: China's investment climate has changed dramatically in 2O years of reform and opening. In the early 1980's, China restricted foreign investments to export-oriented operations and required foreign investors to form joint venture partnerships with Chinese firms in order to enter the market. Since the early 1990's, however, China has allowed foreign investors to manufacture and sell a wide variety of goods on the domestic market. In the mid-1990's, China authorized the establishment of wholly foreign-owned enterprises, now the preferred form of foreign direct investment. However, the Chinese government's emphasis on guiding FDI into manufacturing has led to market saturation and over-capacity of that sector, while leaving China's service sector highly underdeveloped.

Types of Foreign Enterprise in China: China revised significantly its laws on Wholly Foreign-Owned Enterprises (WFOEs) and Chinese Foreign Equity Joint Ventures (JVs) in 2000 and 2001. The revisions eliminated requirements for foreign exchange balancing, struck requirements for domestic sales ratios, removed or adjusted advanced technology and export performance requirements, and modified provisions on domestic procurement of raw materials.

Among the three foreign investment vehicles available to foreign investors, WFOEs are currently the most popular. Growth of WFOEs exceeded that of JVs for the first time in 2000. According to MOFTEC statistics, WFOEs accounted for 45% of total investment in 2000. Over 40% more WFOE contracts than joint venture contacts were signed, and the value of contracted investment in WFOEs was 70% more than that in joint ventures in 2000.

Encouraged versus Restricted Investment: In the past, China attempted to guide new foreign investment towards "encouraged" industries. Over the past five years, China has implemented new policies introducing new incentives for investments in high-tech industries and in the central and western parts of the country in order to stimulate development in less developed areas. In December 1997 and again in August 1999, China published revised lists (originally promulgated in July 1995) of sectors in which foreign investment would be encouraged, restricted or prohibited. MOFTEC announced in June 2001 that further revisions of the lists were expected by the end of 2001. Regulations relating to the encouraged sectors were designed to direct FDI to areas in which China could benefit from foreign assistance and/or technology, such as in the construction and operation of infrastructure facilities.

Policies relating to restricted and prohibited sectors were designed to protect domestic industries for political, economic or national security reasons. The list of restricted industries - which currently includes many service industries such as banking, insurance, and distribution - will soon dwindle to a small number, however, as China has committed itself to opening its service sector upon accession to the WTO. The production of arms and the mining and processing of certain minerals remain prohibited sectors.

Acquisition And Takeovers: China's lack of merger laws and policies and the absence of property rights guidelines have posed nearly-insurmountable obstacles for foreign mergers and acquisitions activity in China. While a simple share buy-out could occur under existing regulations, it would be subject not only to the approval of all partners in a given venture but also to the supervising Chinese government agency. The Chinese government has approved only a hand-full of such deals. Several Chinese economists are encouraging that these laws be rewritten to accommodate mergers and acquisitions. (Note: Foreigners can purchase shares in a small minority of Chinese companies listed on Chinese stock exchanges, but foreign portfolio investment is currently restricted to less than majority ownership.)

Investment Incentives: China has developed and expanded a complex system of investment incentives over the last twenty years. The Special Economic Zones of Shenzhen, Shantou, Zhuhai, Xiamen and Hainan, 14 coastal cities, hundreds of development zones and designated inland cities all promote investment with unique packages of investment and tax incentives. Chinese authorities have also established a number of free ports and bonded zones. In recent years, SEZs have sought to enhance their autonomy while officials from inland China have sought to reduce SEZ privileges. To make progress toward a consistent national trade regime as part of its WTO accession, China has indicated that it will not introduce any new SEZ investment incentives and will decrease existing incentives over time.

The vast majority of FDI is directed to China's coastal provinces. Since 1979, about 85% of cumulative FDI has gone to the 11 provinces and provincial-level cities along the eastern coast. The primary destinations in China for FDI have been the Guangdong, Fujian and Hainan provinces, accounting for about 40% of FDI since 1979. These areas were particularly targeted by Taiwan and Hong Kong-based manufacturing attracted by low labor costs. The second tier of eastern provinces for FDI include Shanghai, Jiangsu and Zhejiang, attracting about 25% of total FDI. (Note: The percentage of investment directed to Shanghai has steadily increased in recent years. End Note). The third tier includes Beijing and Tianjin municipalities and Hebei province, accounting for about 12% of total FDI.

In 1999, China announced that it would offer special investment incentives to attract foreign investors to its highly underdeveloped central and western regions. Although the government has yet to formalize concrete measures, it has proposed special tax breaks and rebates as an investment incentive. The government has also proposed giving regional governments the flexibility to specify their own "encouraged industries."

Western China continues to struggle to attract significant amounts of FDI. China has touted a high-visibility "Go West" campaign and included a variety of western development provisions in its 10th five-year plan. Most foreign investors, however, have not made significant moves in the west.

New FDI in China continues to flow overwhelmingly to the manufacturing sector. FDI in manufacturing accounted for $25.8 billion out of a total of $40.7 billion in realized FDI in 2000. By contrast, FDI in the banking and insurance sectors was limited to $79 million, mainly due to Chinese government restrictions. This ratio should dramatically shift when China phases out current barriers to foreign access to service industries as part of its Word Trade Organization (WTO) accession agreement. Foreign investors are also effectively proscribed from mergers and acquisitions (M/A). Although MOFTEC is currently studying revisions of its M/A law, officials decline to speculate about when a new law would be finalized.

There was significant growth in 2000 of foreign indirect investment (FII) as a percentage of foreign investment. In China, FII is essentially limited to foreign investors buying and selling shares of Mainland Chinese companies listed on foreign stock exchanges - primarily in New York and Hong Kong. Mainland companies raised over $22 billion in 2000, and at least another $12 billion is forecast for 2001. Chinese FII for 2001 is expected to be driven by public listings by China Telecom, Netcom, CNOOC, Bank of China, Baosteel, and Sinochem.

Foreign investors sometimes may have to negotiate incentives and benefits directly with the relevant government authorities. Some incentives and benefits may not be conferred automatically. The incentives available include significant reductions in national and local income taxes, land fees, import and export duties, and priority treatment in obtaining basic infrastructure services. Chinese authorities have also established special preferences for projects involving high-tech and export-oriented investments. Priority sectors include transportation, communications, energy, metallurgy, construction materials, machinery, chemicals, pharmaceuticals, medical equipment, environmental protection and electronics.

Under the terms of investment policies announced in 1999, foreign investment firms who produce certain types of high technology goods, or who are export-oriented, no longer pay duty on imported equipment which is not manufactured in China and which is for the enterprise's own use.

China encourages reinvestment of profits. A foreign investor may obtain a refund of 40% of taxes paid on its share of income, if the profit is reinvested in China for at least five years. Where profits are reinvested in high technology or export-oriented enterprises, the foreign investor may receive a full refund. Many foreign companies invested in China have adopted a strategic plan that reinvests profits for growth and expansion.

The tax incentive system is complicated and difficult to implement. Discrepancies between central, provincial and local government tax regulations hamper foreign investment, particularly in remote and impoverished areas. Still, initial efforts at reform are beginning to level the playing field. Collection efforts have been centralized and the responsibility for assessment and filing of returns was shifted to the taxed enterprise in late 1999. A standardized reporting and payment procedure was also implemented nationwide to reduce overpayments and loopholes.

As part of a national campaign to standardize tax treatment and increase collection rates, the State Taxation Administration began work on a planned unification of the tax system in 1998. China's weak trade performance during most of 1999, however, put this process on temporary hold. The Chinese government, in fact, increased VAT rebates for selected exports twice in 1999. This policy, however, led to large amounts of fraud as many enterprises submitted false export invoices to claim the increasingly generous VAT rebates. The authorities cracked down severely on this practice in 2000, which led to the trial, conviction, and execution of a number of individuals notably in south China's Guangdong province.

China's tax incentive system is complicated and difficult to implement. Discrepancies between central, provincial and local government tax regulations hamper foreign investment, particularly in remote and impoverished areas. Still, initial efforts at reform are beginning to level the playing field. Collection efforts have been centralized and the responsibility for assessment and filing of returns was shifted to the taxed enterprise in late 1999. A computerized standard reporting and payment procedure has been progressively expanded nationwide to reduce overpayments and loopholes.

National Treatment: China has committed to grant unconditional national treatment as part of its accession to the WTO. Not all of the thousands of government officials understand this concept, however, and implementation is likely to pose periodic problems. China has already initiated training programs to educate government officials on China's WTO obligations.

Basic Laws And Regulations Covering and/or Affecting Direct Investment: The basic laws and regulations governing foreign direct investment in China are complex. A summary of those currently enforced is provided below. The Chinese central government is currently reviewing and revising all laws, rules, regulations, and guidelines for consistency with new WTO commitments. In some instances, it is drafting new legislation to deal with issues previously unaddressed. The Chinese government acknowledges that it may take years to draft, pass, and implement all the new and revised laws, regulations, and implementing guidelines, but is publicly committed to meeting China's WTO obligations.

Laws Affecting WFOEs and JVs:

Investment in Wholly Foreign-Owned Enterprises (WFOE) is now the most popular FDI vehicle in China. The WFOE law was originally promulgated in 1986, and the law and implementing regulations have been amended five times. (Note: As Chinese laws are often drafted very broadly, implementing regulations are also approved in order to provide more detailed guidance. End Note). Most recently, the National People's Congress (NPC) approved revisions of the Law in October 2000 and subsequently approved implementing regulations in April 2001.

The 2001 revisions of the WFOE Law and implementing regulations (State Council Order No. 301) amended or deleted sixteen articles.

Under the revised WFOE law, China may reject an application to establish a WFOE for five reasons. Applications may be denied if approval would endanger China's national security or violate China's laws and regulations. Applications can be also denied under the following circumstances: (1) detriment to China's sovereignty or public interest; (2) nonconformity with the requirements of the development of China's national economy; and (3) possibility of environmental pollution.

The 1979 "Law on Chinese-Foreign Equity Joint Ventures" (JVs) had historically been the key legislation dealing with foreign investment in China. Implementing regulations issued in 1983 - which, like the joint venture law, have subsequently been amended - detailed the form and organization of equity joint ventures, ways of contributing investment, and rules on the organization of the board of directors and management. Provisions also covered acquisition of technology, the right to use land, taxes, foreign exchange control, financial affairs, and hiring and firing of workers.

Joint Ventures, however, are a less favored form of FDI since restrictions on WFOEs have been loosened in recent years. China had traditionally favored investment in JVs, as such investment was perceived as a way to rescue poorly performing domestic industries. The NPC approved revisions of the JV law in March 2001. The revisions remove the requirements that FIEs balance their foreign exchange receipts and expenditures. Many joint-venture contracts, however, still contain a clause requiring such balancing. It is unclear how the PRC will address these contractual obligations that are no longer required by law.

Regulations and periodic updates on China's investment projects and conditions can be found on MOFTEC's website: www.moftec.gov.cn.

Other laws relating to investment include:

Contract Law: China's contract law went into effect on October 1, 1999. Earlier in 1999, China's National People's Congress passed the new law to deal better with its increasing legal case load and to lay a firmer legal foundation for investment in China. The law's drafters hope that it will help prevent widespread contract fraud from consuming the nation's already overburdened court system. According to Chinese statistics, there are currently more than four billion new contracts registered with government industry and commerce bureaus each year; Chinese courts handle more than three million contract disputes annually.

The new Contract Law moves China closer to international legal norms and to greater legal transparency. It encourages stronger contractual compliance by providing legal recourse - although enforcement of judgments will continue to be a problem. However, the law's impact on the overall investment climate will be minimal, at least in the short- to medium-term. Most contracts involving foreign firms are still subject to government approval. Furthermore, domestic firms are not likely to alter their current business practices - including how they meet their contractual obligations - until penalties are enforced.

Securities Law: The Securities Law, effective on July 1, 1999, codifies and strengthens the administrative regulations that govern the underwriting and trading of corporate shares, as well as the activities of China's stock exchanges (currently in Shanghai and Shenzhen). The Securities Law does not distinguish between state-owned enterprises (SOEs) and non-SOEs. In practice, however, few non-SOEs have been allowed to sell "A" shares. "A" shares are local currency shares. As currently written, the law does not apply to the underwriting or trading of foreign currency ("B") shares. "B" shares, denominated in foreign currency, were originally for sale only to foreign legal persons and continue to be subject to separate administrative regulations. In February 2001, the authorities opened the "B" share market to Chinese citizens with legally obtained foreign currency holdings. Despite press reports indicating the "A" and "B" share markets will gradually be integrated within three years, the exact timing of this move - which would be closely linked to changes in China's foreign exchange regime - remains unclear. The Chinese authorities are considering transitional arrangements such as the designation of "qualified foreign institutional investors" which could provide foreign interests some access to the "A" share market without requiring full convertibility of the Chinese currency.

Tendering Law: Concerns over the WTO consistency of the draft tendering law led the National People's Congress, on April 9, 1999, to make a surprise announcement that it had decided to move key sections relating to government procurement into a separate law. The tendering law (which will now govern only state administered capital construction and infrastructure projects) was finalized in 1999. The new government procurement law is not expected to be implemented until 2002. Until that time, provisional regulations issued in mid-1999 remain in force.

Forms Of Foreign Ownership: In most sectors where foreign investment has been allowed, FIEs can exist as holding companies, wholly foreign-owned enterprises, equity joint ventures, contractual (or cooperative) joint ventures or foreign-invested companies limited by shares. Under China's Company Law, foreign firms can now also open branches in China.

Investment Screening Procedures: Potential investment projects usually go through a multi-tiered screening process. The first step is approval of the project proposal. The central government has delegated varying levels of approval authority to local governments. Until a few years ago, only the Special Economic Zones (SEZs) and open cities could approve projects valued at up to $30 million. Such approval authority has now been extended to all provincial capitals and a number of other cities throughout China. Most other cities and regions are limited to approving projects valued below $10 million. Projects exceeding these limits must be approved by MOFTEC and the SDPC. If an investment involves $100 million or more, it must also obtain State Council approval. MOFTEC, however, is authorized to review all projects, regardless of size. Note: Under the European Union-China bilateral WTO agreement signed in May 2000, China has agreed to raise the investment ceiling requiring central government approval from $30 million to $150 million for motor vehicle manufacturers.

The approval process for projects over $30 million has become less of an obstacle than in the past. However, government officials are still required to evaluate each project against official guidelines to determine whether it promotes exports that increase foreign currency income, introduces advanced technology, or provides technical or managerial training. Even if it meets one or more of these requirements, a project may still be rejected if the contract is considered unfair, the technology is available elsewhere in China, or China already has sufficient production capacity. Sometimes the political relationship between China and the home country of the foreign investor influences the approval process.

Research And Development: Poor links among government, university and industry researchers make it very difficult for China to efficiently utilize its many brilliant scientists and engineers. Much of China's top scientific talent is not in universities but in a government bureaucracy (the Chinese Academy of Sciences) modeled after the USSR Academy of Sciences. Young scientific and engineering talent often flows to the information industry and biotechnology sectors. Since the late 1980's, China has directed an increasing proportion of government research funds through peer review mechanisms at the National Natural Science Foundation of China (www.nsfc.gov.cn) and the Ministry of Science and Technology (www.most.gov.cn) in order to achieve better results from research funding. Some Chinese government programs such as "Torch" promote scientific research and its commercial applications yet the investment return on research and development, especially in the state sector, remains low. The central and local Chinese governments have also strongly promoted science parks which, in actuality, often just serve as low-tech assembly centers.

Despite efforts since the early 90's to push technical institutes towards the market, the political and economic structures of the old "planned economy" are still important obstacles. Inadequate intellectual property protections discourage Chinese companies from investing in research. Patent, copyright, and trademark infringement often prevent companies from recapturing their investment in product research and development. Furthermore, technology utilized by SOEs tends to lag far behind that of the growing private sector, in part, because SOEs lack incentives to conduct research and development activities. There is a broad consensus among Chinese scientists and Chinese leaders that more reforms and greater IPR protection are needed (See Section II, paras 23-26.) China continues to reform its science and technology system in order to create incentives for innovation and to link science and technology research work more closely to the needs of the market.

Foreign companies' research and development centers in China have often focused on product localization. More recently, several companies, including Microsoft and Motorola, have established research centers in China. The Chinese government has welcomed the establishment of these centers although some Chinese critics worry that the centers will create an "internal brain drain" of talent away from Chinese companies and research institutions to foreign companies.

B. Conversion and Transfer Policies

In periods when foreign currency was relatively scarce in China, profits that were not generated in foreign exchange could only be repatriated with great difficulty. Since 1994, however, China's foreign reserves have grown rapidly (exceeding $175 billion at the end of the first quarter 2001), and FIEs have generally enjoyed liberal access to foreign exchange. On December 1, 1996, China announced the full convertibility of its currency on the current account (for trade in goods, services and remittance transactions, including profits). To prevent rampant fraud, in 1998, China tightened the scrutiny of underlying documentation. Bureaucratic procedures as authorities implemented the new regulations created difficulties for many foreign and domestic companies requiring hard currency to complete their transactions. Foreign bank branches are allowed to engage in foreign currency business according to the same rules as Chinese banks and to engage in limited local currency business.

All FIEs in China are entitled to open and maintain a foreign exchange account for current account transactions. In order to do so, an FIE must first apply to China's State Administration of Foreign Exchange (SAFE) for permission. After SAFE grants permission for the account, it establishes a limit, based on the FIE's anticipated foreign exchange operational needs, beyond which foreign exchange must be converted to local currency. Foreign representative offices and individuals may also open such accounts. No limits are placed on the amount such accounts can hold, though reports for transactions involving more than $10,000 must be filed by a bank. In general, the restrictions on FIE accounts are less onerous than for wholly Chinese-owned firms. Establishing foreign exchange accounts for capital account transactions involve more complex reporting and qualification requirements.

C. Expropriation and Compensation

Chinese law forbids nationalization of joint ventures, wholly foreign-owned enterprises, and investments from Taiwan, except under "special" circumstances. The Chinese government has not defined "special" circumstances" although officials claim that "special circumstances" include national security considerations and obstacles to large civil engineering projects. Chinese law calls for compensation of expropriated foreign investments but does not define the terms of compensation.

There have been no cases of outright expropriation of foreign investment since China opened to the outside in 1979. However, the State Department believes that there are several cases that may qualify as expropriations under Section 527 of the FY94-95 Foreign Relations Authorization Act, most notably in the telecommunications sector. These apparent forced divestitures from legitimate projects raise questions about the stability of China's investment climate in telecommunications as well as other industrial sectors.

D. Dispute Settlement

Arbitration: Although China is a member of the International Center for the Settlement of Investment Disputes (ICSID) and has ratified the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (a.k.a. the New York Convention), it places strong emphasis on resolving disputes through informal conciliation and consultation. If it is necessary to employ a formal mechanism, the authorities greatly prefer arbitration through Chinese agencies. Most foreign investors consider litigation as a final option and have found it to be time-consuming and unreliable. In addition, many foreign litigants have found the Chinese government unwilling to restrain Chinese joint venture partners from asset-stripping as a case winds its way through arbitration or the courts.

Investment contracts often stipulate arbitration in Stockholm because the forum there is considered neutral. Most Chinese contracts stipulate arbitration by the China International Economic and Trade Arbitration Commission (CIETAC). During the past year, several western participants and panel members in CIETAC proceedings raised concerns about the organization's procedures and effectiveness. In one instance, a respected American member of an arbitration panel threatened to resign from CIETAC over alleged procedural irregularities during consideration a case. Another forum for resolving investment and trade disputes is the Beijing Conciliation Center (BCC), an organization affiliated with the China Council for the Promotion of International Trade (CCPIT). The BCC signed an agreement with the American Arbitration Association (AAA) in 1992 whereby the BCC and AAA would work together in joint conciliation to resolve trade and investment disputes between U.S. and Chinese parties.

Enforcement of arbitral awards is sporadic. Sometimes, even when a foreign company wins in arbitration, the People's Intermediate Court in the locality where the foreign venture is situated may fail to enforce the decision. Even when the courts do attempt to enforce a decision, local officials often ignore court decisions with impunity.

There have also been investment dispute cases in which local authorities have intervened on the part of a Chinese company in a manner considered unfair and capricious by the foreign investor. For example, local courts have occasionally intervened to prevent the sale or transfer of foreign-owned property, pending resolution of a commercial dispute between a foreign company and Chinese company. In general, most cases have been resolved through negotiation between the commercial parties and/or intervention of central authorities.

Legal System: Chinese society is in transition from rule by man to rule of law. Most laws are general; details are specified in implementing regulations. Many foreign businesses report that Communist Party officials and officials in other government departments at times interfere in court decisions. China's top leaders undoubtedly play a big role in deciding sensitive political cases. China's legal system is a mixture of common law and continental legal systems, but it places relatively less emphasis on legal precedents.

The 1979 "Organic Law of the People's Courts of the People's Republic of China" authorized establishment of economic courts at China's National Supreme Court and three levels of provincial courts. The economic courts are given jurisdiction over contract and commercial disputes between Chinese entities; trade, maritime, intellectual property and insurance; other business disputes involving foreign parties; and various economic crimes including theft, bribery, and tax evasion. In 1994, the lowest level of provincial courts started to try economic cases involving foreign parties. Foreign lawyers cannot act as attorneys in Chinese courts, but may observe proceedings informally. Over the past two years, the United States has been working with China on projects relating to commercial and economic law under the umbrella of the U.S.-China Joint Committee on Commerce and Trade.

Bankruptcy and Creditors' Rights: China's bankruptcy law, passed in December 1986, provides for creditors' meetings to discuss and adopt plans for the distribution of bankrupt property. The resolutions of creditors' meetings, which are binding on all creditors, are adopted by a majority of the attending creditors, who must account for more than half of the total amount of unsecured credit.

Even Chinese officials contemplating broad enterprise reforms recognize the inadequacy of China's current bankruptcy laws. However, debate continues over what additional legislation is needed. A major problem for Chinese commercial banks is the formal and informal constraints on liquidating the assets of non-performing state enterprise loans. Notably, local political leaders, through the ubiquitous apparatus of the Communist Party, continue to control or to influence not only the courts but also the state-owned banks themselves and can effectively block efforts to dispose of SOE assets. The failure of the Guangdong International Trust and Investment Company (GITIC) in 1998 highlighted the need to develop specialized rules for financial institutions. For the time being, however, the Office of the National Leading Group for Merger, Bankruptcy and Re-employment and the State Economic and Trade Commission (SETC) have the final say with regard to large industrial SOE bankruptcies.

In October 1995, China put into effect a new "Guarantee (Security) Law" - the first national legislation covering mortgages, liens, rules on guarantors for debt and registration of financial instruments as pledges for debt. The law defines debtor and guarantor rights and provides for mortgaging of property, including land and buildings, as well as other tangible assets such as machinery, aircraft or other types of vehicles. While some areas of the law remain unclear - such as how the transfer of property under foreclosure is effected - the law represents an important step forward. Chinese commercial banks have successfully repossessed vehicles from delinquent borrowers.

E. Performance Requirements/Incentives

China has agreed to implement the Agreement on Trade-Related Investment Measures (TRIMs) upon WTO accession. China has committed to eliminate and cease enforcing trade and foreign exchange balancing requirements and local content and performance requirements. It has also agreed not to enforce contracts imposing these requirements. China has also committed to only enforce laws or provisions relating to the transfer of technology or other know-how if they are in accordance with WTO rules on protection of intellectual property rights (IPR) and trade-related investment measures (TRIMS).

Export Performance Requirements: Export performance requirements are inconsistent with WTO principles, and Chinese law has never formally listed them. China has said it would not enforce export performance requirements in private contracts. However, in the past, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and the State Development Planning Commission (SDPC) have strongly encouraged contractual clauses stipulating export requirements.

Local Content: Chinese regulations grant foreign-funded enterprises freedom to source inputs both in China and abroad, though priority is given to Chinese products when conditions are equal. Chinese regulations forbid "unreasonable" geographical, price, or quantity restrictions on the marketing of a licensed product. The foreign venture, thus, retains the right to purchase equipment, parts, and raw materials from any source.

Chinese officials, however, still encourage localization of production. Investment contracts often call for foreign investors to commit themselves gradually to increase the%age of local content. In addition, officials carefully examine the sourcing of inputs at various stages in the approval process for FIES. Effective implementation of China's WTO commitments should affect this bias.

Technology Transfer: Most joint ventures involve the transfer of technology through a licensing agreement, the transfer of technology from a third party, or the transfer from the foreign partner as part of its capital contribution. Many regulations governing specific industries currently require such transfers. China has committed to enforce only those laws or other provisions relating to the transfer of technology or other know-how if they are in accordance with WTO provisions on protection of IPR and TRIMS. Despite these commitments, foreign investors may still encounter pressure to transfer technology.

Employment Of Host-Country Nationals: Rules for hiring Chinese nationals depend on the type of establishment. Although wholly foreign-owned companies are not required to nominate Chinese nationals to their upper management, in practice, expatriate personnel normally occupy only a small number of managerial and technical slots. In some ventures, there are no foreign personnel at all.

The amended Chinese-Foreign Equity Joint Venture Law provides that the joint venture partners will determine, by consultation, the Chairman and Vice-Chairman, leaving open the possibility for a foreign or a Chinese representative to hold either of these positions. If the foreign side assumes the chairmanship, the Chinese party must have the vice-chairmanship, and vice-versa.

While FIEs are free to recruit employees directly or through agencies, representative offices of foreign companies must hire all local employees under contract with approved "labor services companies." These foreign companies pay the contracted local employees' salary directly to the "labor services companies" that, in turn, give only a portion of the salary to the contracted employees. The employees remain technically employed by the labor services company.

F. Right to Private Ownership and Establishment

In the past, China restricted private ownership and establishment of business enterprises, particularly in the service sector. In 1999, China amended its constitution to provide a legal basis for private sector development. China has committed to reduce over time many restrictions on the private sector upon accession to the WTO. Nevertheless, some sectors - insurance, for example - will retain many restrictions.

China has agreed to grandfather all existing current market access and activities in all services sectors. This will protect existing American distribution services, financial services, professional and other service providers in China, including those operating under contractual or shareholder agreements or a license, from additional restrictions as China phases in its commitments.

G. Protection Of Property Rights

Land: Chinese law provides that all land is owned by "the public," and individuals cannot own land. However, consistent with the policies of reform and opening to the outside, individuals, including foreigners, can hold long-term leases for land use. They can also own buildings, apartments, and other structures on land, as well as own personal property.

Intellectual Property Rights: Overview

Chinese leaders have acknowledged that protection of patents, copyrights, and trademarks is needed to promote a "knowledge-based economy" in China. China has committed to full compliance with the Agreement on Trade-Related Aspects of Intellectual Property (TRIPS) upon accession to the WTO. It has completed a revised Patent Law and is now reviewing and revising its trademark, and copyright laws to ensure consistency with TRIPS requirements. In spite of steady, significant progress in improving its intellectual property legal and regulatory regime, IPR protection in China remains weak. Trademark and copyright violations are blatant and widespread. While Chinese officials are increasing enforcement efforts, IPR violations, including growing exports of counterfeit products, continue to outpace enforcement.

Membership in International IPR Organizations:

China is a member of the World Intellectual Property Organization (WIPO), the Paris Convention for the Protection of Industrial Property, the Berne Convention, the Madrid Trademark Convention, the Universal Copyright Convention, and the Geneva Phonogram Convention. The Chinese Government is still debating, however, whether China's Copyright Law will be brought into full compliance with the WIPO Copyright Treaty and the WIPO Performances and Phonograms Treaty. While China has made no commitments in this regard, the U.S. Government believes that China's signing these treaties would further indicate China's intent to provide a high level of IPR protection.

IPR Enforcement:

Inadequate enforcement of IPR laws and regulations, through either judicial or administrative means, remains a serious problem. Enforcement of existing IPR regulations is uneven and is sometimes impeded by local interests. Industry associations representing computer software, entertainment, and consumer goods industries report high levels of piracy and counterfeiting of all types of products. They also report increasing exports of IPR-infringing goods to other countries. The Business Software Alliance estimates that more than 90% of business software used in China is pirated. Consumer goods companies report that, on average, 20% of their products in the Chinese market are counterfeits. Chinese companies experience similar, or greater, problems with piracy and counterfeits. The administrative penalties for IPR violations, often no more than confiscation of the counterfeit products, are generally insufficient to deter counterfeiters. China's criminal sanctions against IPR violations are seldom used, in part, because of restrictions on types of admissible evidence and cumbersome procedures.

Combating IPR violations in China is a long-term, multifaceted undertaking. China has established special IPR courts in all provinces and major cities. Judges in Chinese courts are charged with fact-finding and have greater discretion in the adjudication of cases than those in the United States. However, the lack of legal training of many trial court judges undermines the effectiveness of these courts. The USG and U.S. companies have provided resources for training judges. Chinese authorities are attempting to address the lack of legal training of court officials by establishing IPR law centers at Beijing University, Qinqhua University, and People's University. Chinese IPR professionals are also studying in foreign countries. The United States and the European Union have made IPR - and commercial dispute resolution - a key feature of "Rule of Law" discussions with Chinese authorities.

H. Transparency of the Regulatory System

China's legal and regulatory system lacks transparency and consistent enforcement despite the promulgation of thousands of regulations, opinions, and notices affecting foreign investment. Although the Chinese government has simplified the legal and regulatory environment for foreign investors in recent years, China's laws and regulations are still often ambiguous. Foreign investors continue to rank the inconsistent and arbitrary enforcement of regulations and the lack of transparency as two major problems in China's investment climate. No prospective foreign investor should venture into the China market without due diligence.

In accordance with China's WTO commitments, the State Council's Legislation Office recently announced that all of China's foreign trade-related and foreign-investment related laws, regulations, rules, and policy measures would be published. It further announced that China would use "proper ways and means" to help other WTO members and other pertinent individuals and enterprises understand those rules and regulations. The Legislation Office acknowledged that, in the past, some departments and localities relied on their own internal documents to conduct business. Some even issued documents under their own "internal control" and resorted to "disguised forms of market blockades" and local protectionism. The State Council has announced that it is committed to stopping such practices in order to avoid international disputes.

I. Capital Markets and Portfolio Investment

The development of China's domestic capital markets has not kept pace with economic needs. Two stock exchanges have been-established in Shanghai (in November 1990) and the city of Shenzhen in southern China's booming Guangdong Province (July 1991). Other regional "securities exchange centers" were recently closed by the newly established China Securities Regulatory Commission (CSRC). After five years of debate, a Securities Law was finally passed in late 1998 and implemented in June 1999. The law includes tougher penalties for insider trading, falsifying prospectuses and financial reports, and other forms of fraud. The CSRC lacks experienced personnel and has turned to the United Kingdom and other countries for more training. China's stock markets are gradually adopting accounting standards closer to those in use in other markets.

Although, in theory, FIE's may apply for permission to raise capital directly on China's stock and bond markets, the approval process is difficult. In the case of shares, the CSRC has indicated that it plans to treat FIEs the same as domestic firms.

The state banking sector dominates China's capital markets and in the past generally channeled funds to state-owned enterprises on the basis of public policy rather than market considerations. Other domestic firms must find different sources of financing, including direct investment, gray-market sales of stock, and borrowing from other firms or non-bank institutions.

China's progress in reducing political interference in the banking system has been mixed. With the creation of three policy banks in 1994 - the Import-Export Bank of China, the China Development Bank (formerly the State Development Bank of China), and the Agricultural Development Bank - China attempted to make a clear division between policy and commercial lending. The government has directed these policy banks to lend to commercially unattractive endeavors such as infrastructure development and government agricultural procurement. The authorities, meanwhile, have encouraged China's commercial banks to improve their loan portfolios by increasing the proportion of their lending to small and medium-sized enterprises, including private firms. Lending to individuals for housing mortgages, purchase of consumer durables, and education expenses has also increased. Nevertheless, China's commercial banks, most of them state-owned, continue to carry a heavy percentage of non-performing assets. - with estimates ranging from 30-50% of the total. Large state-owned firms continue to receive preferential consideration by the commercial banks.

In 1998, the authorities - alarmed by the Asian financial crisis - took steps to reduce financial risk in the banking system. The People's Bank of China (China's central bank) reorganized its regulatory structure along regional lines, and the Communist Party created its Central Financial Work Commission primarily to oversee the selection of managerial personnel in the country's financial institutions. Both measures effectively reduced the influence of local political leaders over credit decisions, a major cause of China's abundance of non-performing loans. In 1999, the government also set up four asset-management companies to take over a portion of the bad loans issued by the main state-owned commercial banks in order to help them meet international capital adequacy standards. Most observers believe it will take many years for China to re-capitalize its banks along international lines.

Foreign firms that need working capital, whether foreign exchange or local currency, may obtain short-term loans from China's state-owned commercial banks. However, priority lending is often given to investments that bring in advanced technology or produce goods for export. Since 1998, Chinese interest rates have generally been lower than overseas, making it more attractive to explore onshore financing. Foreign-invested firms, which can keep foreign currency accounts in commercial banks, borrow funds from abroad and register all foreign loans with the State Administration for Foreign Exchange (SAFE). Along with the People's Bank of China, SAFE regulates the flow of foreign exchange into and out of China.

In 1996, qualifying foreign bank branches in the Pudong area of Shanghai were allowed to engage in local currency business for the first time although this was mainly limited to providing services to foreign-invested enterprises (FIEs). In 1998, China expanded local currency business to foreign banks based in Shenzhen and widened their client base to include several nearby provinces (Zhejiang and Jiangsu for Shanghai; Guangdong, Guangxi, and Hunan for Shenzhen). Under the terms of China's bilateral agreement with the United States on accession to the World Trade Organization, the Chinese authorities have promised to end all geographic restrictions on business by foreign banks by January 1, 2005.

Restrictions On Debt-Equity Ratios: According to regulations promulgated in March 1987, the Chinese Government restricts the debt-to-equity ratio of foreign-funded firms and sets minimum equity requirements. For investments under $3 million, debt cannot exceed 30% of the total investment. The debt/capital ratio for investments in the $3-10 million, $10-30 million, and over $30 million ranges cannot exceed 50, 60, and 70 %, respectively. Debt for investments over $60 million is limited to two-thirds of the total value of the investment.

J. Political Violence

Corruption, SOE layoffs, and economic disparities between rural and urban areas and between coastal and interior regions have fueled resentment among segments of the Chinese populace. As China continues to restructure SOEs, unemployment and other social pressures have risen. As a result, there have been a growing number of rural demonstrations and urban labor actions. Most of these have been fairly small and resolved peacefully. Some, however, including protests by 20,000 laid-off miners in China's northeast Liaoning province in early 2000, turned violent. Declining rural incomes have contributed to a similar increase in protests by farmers in rural areas, such as the demonstration by several thousand farmers in southern Jiangxi province in mid-2000. Local authorities have generally dealt with these protests in a peaceful manner and have not resorted to violence. As in years past, there were a number of isolated violent actions by disgruntled individuals who - in some cases motivated by personal, not political reasons - damaged public buses, markets, and railroad tracks.

Following NATO's mistaken bombing of China's Belgrade embassy in 1999, violent protests erupted at U.S. diplomatic facilities and a few American fast-food franchises throughout China. Soon after the bombing, government-controlled press discouraged protests or acts of violence against foreign investors. Most foreign investors in China believe that the chances of political violence are low because the government is able and willing to repress any sizeable anti-government protests.

K. Corruption

Corruption remains widespread in China. Although the government launched a high profile anti-corruption campaign, these efforts are hampered by the lack of truly independent investigative bodies. Numerous senior provincial and municipal officials came under scrutiny, but there are widespread reports that more senior officials and their family members used their connections to avoid prosecution. Banking and finance are among the sectors most afflicted by corruption, as are government procurement and construction projects. Premier Zhu Rongji has criticized corruption in the construction industry because of the safety hazards created by shoddy construction.

Offering and receiving bribes are both crimes under Chinese law, but it is unclear if giving a bribe to a foreign official in another country is a crime. Bribes cannot be deducted from taxes. Based on surveys reported in the Western media and views expressed by foreign business people and lawyers in China, it is clear that U.S. firms consider corruption in China a hindrance to FDI.

Three different government bodies and one Communist Party organ are responsible for combating corruption in China: the Supreme People's Procuratorate, the Ministry of Supervision, the Ministry of Public Security, and the Communist Party Committee for Discipline Inspection. The Procuratorate and the Ministry of Public Security are responsible for investigating criminal violations of China's anti-corruption laws, while the Ministry of Supervision and the Party Discipline Inspection Committee enforce Government ethics and Party discipline.

The United States has provided some enforcement-related anti-corruption training to Ministry of Public Security, Ministry of Supervision, and Supreme People's Procuratorate officials. NGOs such as Transparency International are also exploring opportunities for cooperative programs to reduce corruption.

L. Bilateral Investment Agreements

China has entered into bilateral investment agreements with more than 50 countries, including Japan, Germany, the United Kingdom, France, Italy, Thailand, Romania, Sweden, the Belgium-Luxembourg Economic Union, Finland, Norway, Spain, Canada, and Austria. The provisions of these agreements cover such issues as expropriation, arbitration, most-favored-nation treatment, and transfer or repatriation of proceeds.

The United States does not have a bilateral investment treaty with China. Any American investor investing in China should make sure that expropriation and arbitration are covered in the terms of the contract.

M. OPIC and Other Investment Insurance Programs

In the past, OPIC had a very active program in China. The United States has suspended OPIC's program in China since the Tiananmen Incident in June 1989, first by Executive Action, and then by the legislative sanctions that took effect in February, 1990. OPIC continues to honor outstanding political risk insurance contracts. At the end of 1990, 31 U.S. investments with approximately $300 million had OPIC political risk insurance. OPIC programs remain suspended in China due to U.S. foreign policy concerns, the terms of the sanctions legislation enacted, and the need for improved worker rights.

Although OPIC insurance is unavailable, the Multilateral Investment Guarantee Agency (MIGA), an organization affiliated with the World Bank, can provide political risk insurance for investors interested in investing in China. Some commercial insurance companies also offer political risk insurance, as does the People's Insurance Company of China (PICC).

N. Labor

Labor Availability: FIEs can integrate a joint venture partner's work force, hire through a local labor bureau or job fair, advertise in newspapers, or rely on word of mouth. Representative offices, for the most part, must hire their local employees through a labor services agency.

Skilled managers, especially those with marketing skills, are often in short supply although many companies have found an abundance of talented and highly-motivated recent university graduates. Experienced managers command salaries far greater than their counterparts in Chinese enterprises, making localization an expensive proposition for many companies. Finding and keeping engineers and technicians can also be difficult. Shortages of skilled labor are, at times, especially acute in south China due to the relative dearth of southern higher learning institutions. Many Chinese workers move rapidly from job to job within the foreign-invested and growing private sectors.

Compensation:

Workers are paid a salary, hourly wages, or piece-work wages. The provision of subsidized services, such as housing and medical care, is common, and compensation beyond the basic wage constitutes a large portion of a venture's labor expenses. With recent moves by China to reform the housing system and promote home purchases through a mortgage system, employer-provided housing has been decreasing. However, enterprises that merge with existing SOE's may still be required to provide workers dormitory housing. New enterprises, rather than providing housing, pay into a housing fund that may amount to as much as 10% of payroll. Since regulations on non-wage compensation differ by locality, investors should check the regulations in the relevant locality.

Local governments also require enterprise and worker contributions to pension and unemployment insurance funds. Tax rates for pension funds may run as high as twenty% of an enterprise's total wage bill. Employees must also contribute between three and eight% of their salary, depending on the locale. In general, FIEs ventures are free to pay whatever wage rates they choose as long as it is above the locally-designated minimum wage. In practice, income-tax laws often make it desirable to provide greater subsidies and services rather than higher wage rates. Most FIES determine their methods and calculations of salaries and benefits after observing local practice. China's national labor law also requires compensation for overtime work.

Termination Of Employment: The ability to terminate workers varies widely based on location, type, and size of enterprise. Terminating individual workers for cause is legally possible but may require prior notification/consultation with the local labor bureau and labor union. In general, it is easier to fire in south China than in the northeastern China, and in smaller enterprises than in larger ones. FIEs generally do not encounter problems letting workers hired on short-term contract go at the end of the contract period. However, enterprises that take on workers from SOE's usually find it difficult to terminate these workers. Investors should be aware that large-scale layoffs from long-established SOE's have created some tension, and prompted some demonstrations among Chinese workers, though not to a degree that threatens social stability.

Worker Rights: It is illegal under Chinese law to oppose efforts to establish officially-sanctioned unions. The Communist Party controls the country's sole officially recognized workers' organization, the All-China Federation of Trade Unions (ACFTU). Independent trade unions are illegal. China's Joint Venture Law and 1994 Labor Law require joint ventures to allow union recruitment but do not require a joint venture actually to set up the union - as required by management in SOEs. Many FIEs, including joint ventures, do not have unions although several coastal provinces have recently passed stricter regulations requiring that all FIEs have unions. In 2001, the ACFTU made it a goal to increase union representation in the private sector, including FIEs. FIEs without unions often have worker organizations that perform functions similar to Chinese unions, such as organizing social and charitable activities.

China's Labor Law provides for collective labor contracts to specify wage levels, working hours, working conditions, and insurance and welfare. In 1996, the ACFTU launched a drive to conduct collective negotiations in at least 90% of FIEs, a target which the ACFTU claims to have reached. Most collective negotiations, however, appear to be pro-forma in nature. This is because local Communist party committees, rather than the workers themselves, control the selection of the union leaders who conduct collective bargaining.

Although China is a signatory to several ILO conventions, it has not signed key ILO conventions on freedom of association and collective bargaining. In 2001, China ratified the International Covenant on Economic, Social and Cultural Rights, but reserved on the issue of freedom of association.

O. Foreign-Trade Zones/Free Ports

China's principal duty-free import/export zones are located in Dalian, Tianjin, Shanghai, Guangzhou, and Hainan. In addition to these officially-designated zones, many other free trade zones offering similar privileges exist and are incorporated into economic development zones and open cities throughout China. However, restrictions and charges often apply and can affect venture operations and business in the latter zones.

China's Customs Administration claims success in controlling the duty-free importation of production inputs into the zones, but the lack of physical barriers makes it difficult to control the flow of non-duty items out of the zones.