Business Case Studies, Executive Interviews, Kai-Alexander Schlevogt on Emerging Markets

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Executive Interviews: Interview with Kai-Alexander Schlevogt on Emerging Markets
February 2008 - By Dr. Nagendra V Chowdary

Prof. Kai-Alexander Schlevogt
Professor of international strategy and leadership at the National University of Singapore (NUS) Business School. He serves as Program Director of the Nestle Global Leadership Program, delivered in association with London Business School.

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  • How do you assess the legal framework in China? Do you think it is good enough to assure existing and potential investors?

  • Here is a paradox: The legal infrastructure is underdeveloped and corruption remains widespread in China, but nevertheless domestic and foreign businessmen are investing heavily in this emerging market. This contradicts the thesis that the rule of law is the sine qua non for economic development.

    Owing mainly to external pressures, the Communist Party leadership has realized that equitable laws and their enforcementmatter. For example, as a member of the Word Trade Organization (WTO), China must comply with a set of legal standards. As a consequence of the new consciousness at the center, the legal framework has improved tremendously since the start of the reform and opening era in 1978. But sheer will is not enough. In the current form of the one party state, there are insufficient checks and balances. Power is not meaningfully divided. Examples include the lack of an independent judiciary and legislative branch, as well as the absence of free media operating within a certain moral framework.

    What I call the “mystery of success” and “binding trajectories” make it impossible to leapfrog into a future that is characterized by the unconditional rule of law. It is very difficult to isolate the factors that make the legal system of a country effective. Therefore, it is hard for China to imitate others. Even though laws may be copied, legal institutions and a legal culture have to mature over centuries. This includes training a specialist cadre of judges and lawyers, accumulating a body of legal precedents, and spreading norms of good conduct. Throughout history,legalism has been only one current of Chinese thought. The Confucian approach of transmitting values through socialization to control behavior is an alternative model.

    Lacking what I call “legal absolutes”, anchored in philosophy and religion, China’s leaders still succumb to the temptation to use laws as instruments to further their interests and enforce them selectively depending on the circumstances. Laws are intentionally worded in a way that allows for multiple interpretations. Definitions can be very vague indeed. Socialism, for example, is what furthers the productive forces of a society. Capitalism thus could be regarded as socialism, too! Multinational companies may be attacked by the authorities at any time, especially when they become too successful. The list of targets range from Nestlé, P&G, Heinz, Lipton, General Mills, Colgate-Palmolive, KFC, Sony, to Dell.

    Besides, the Chinese government routinely resorts to collective punishment of companies from a country that has breached its unwritten rules. Such acts of retaliation can shatter painstakingly developed businesses overnight. When the German Chancellor, eager to please the US, met the Dalai Lama, who is regarded as a separatist leader by the Communist Party, German companies found it very difficult to do business in the Middle Kingdom afterwards. For example, securing extensions of licenses became extremely difficult. To add insult to injury, the Chinese government intentionally awarded lucrative contracts to competitors from France, whose leadership distinguished itself in the eyes of the Mandarins by not receiving the Tibetan exile. The Chinese leaders wanted to show the world that they have the disciplining power to punish transgressions by foreign states and reward global compliance with the party line. There is at least one additional limit that foreigners may not overstep, that is, the orthodox view that Taiwan is a Chinese province.

    Finally, in such a large and complex nation as China, it is hard to firmly root the rule of law at the local level everywhere in the country. One particularly pernicious problemis the imposition of arbitrary fees (luan shoufei) by local authorities. Similar to the levies of the Cosa Nostra, they are substitutes for taxes in return for which certain services are rendered. But it would be much better if there were a transparent framework of official levies, which are not subject to the whims of corrupt local officials.

  • So why, despite the mentioned legal deficiencies and pitfalls, do businessmen invest in China?

  • Smaller countries, such as Singapore, cannot afford the luxury of judicial caprices. Instead, to attract investment, they must be regarded as exemplars with respect to the rule of law. But in China, many managers believe that the benefits of conducting business there, such as capitalizing on its fast growing market, outweigh the costs associated with legal uncertainty. A notable exception is knowledge-intensive investment. When valuable intellectual property rights (IPR) cannot be adequately protected, companies will not locate operations that are sensitive in this regard in China.

    Since the costs of an underdeveloped legal infrastructure are difficult to quantify, they often do not figure in investment appraisals. The right way would be to adjust expected cash flows downwards. The resulting net present value might still be positive, since large expected cash inflowsmay provide the company with sufficient slack to absorb the costs resulting fromlegal problems.Many executives engage in mental accounting and simply write these expenses off as “strategic investments”.

    I observed another interesting psychological phenomenon: When investors believe in future gains, they ignore even a dismal track record. An analogy is what happens after a state defaults on sovereign debt. According to theory, lenders will not extend loans to the culprit anymore. But history shows that after a while, credits start flowing into the country again when the creditors believe it offers bright prospects.

    Instead of blindly and passively counting on improvements and gains in the future, companies can use strategy and organization to compensate for legal uncertainty. For example, they might build a diversified portfolio of business options instead of putting all eggs into one basket. This differs from the prescription for developed markets with strong institutions. There, it is better to entrust investors with diversification. Many of them dislike the “package deals” of conglomerates, which may not suit their desired risk profile.

    An extensive network of trust-based relationships, which are transferred from incumbent managers to their successors, can reduce the likelihood that stakeholders use guile and thus decrease the dependence on the unreliable legal system. Some shrewd investors even try to get their corporate partners drunk, so that they can get at the truth. This is one sociological explanation for why Maotai is so popular in Chinese business settings. The same logic applies in other institutionally underdeveloped markets, such as Russia where Vodka is king.


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