After the gold rush

If SMEs have a strong selling point, especially at the hi-tech end, China is still worth looking at.

FIFTEEN miles from the historic centre of Nanjing, close to China's eastern coast, lies a surprising reminder of the UK. At the centre of a vast, dusty industrial estate, Chinese workers dressed in powder-blue overalls emblazoned with the MG logo shuffle down streets named after famous British towns. They gather around a 100ft tower, on which a giant MG logo glistens in the sun.

They work for Nanjing Automobile, the Chinese firm which bought MG Rover when it fell into administration in 2005. Nanjing Automobile has built an 800,000 square metre plant minutes away from the Yangtze river, which on Tuesday will send through its gates the first MG sports cars produced since the closure of MG Rover's main plant at Longbridge, Birmingham.

The MG TF two-seater car will also roll off production lines in the UK from August 1, reviving a small number of the 6,500 jobs that were lost when MG Rover went under.

Standing proudly next to a red MG TF during a preview for foreign media, Yang Junhu, vice general manager of MG in Nanjing, is keen to emphasise the importance of Chinese and British collaboration. He talks of the company's great "respect" for the British brand and the important role British technicians have played in helping to get MG back on its feet.

MG is an example of the kind of ties that Westminster and Holyrood have been falling over themselves to forge with the Far East in the past few years.

With China tipped to become one of the world's dominant economies by 2050, along with Brazil, India and Russia, both Gordon Brown's and Alex Salmond's governments are eager to build greater economic relations with China. In particular they are keen for UK businesses to tap into China's booming economy and take advantage of its growing consumer thirst.

Only last week, Scotland on Sunday revealed that Salmond wants to set up an independent 'Scottish embassy' in China to further economic and diplomatic interaction between Beijing and Holyrood. From August, up to 200 Scottish schoolchildren will study towards a national qualification in Mandarin and Cantonese in the hope that they will help Scottish companies to access the Chinese market in future.

Scotland also has a specific China 'strategy' which states that more businesses should follow the example of Royal Bank of Scotland, whisky producer Edrington and Edinburgh-based boutique investment firm Martin Currie in building a strong presence there.

"It is an important place for businesses to be," said Scottish Enterprise chief executive Jack Perry after he returned from a trade mission to China and Japan.

However, as Government officials including the likes of Chancellor Alistair Darling – who visited Beijing in April – zealously promote its virtues to UK companies over here, a very different picture is emerging on the ground in China. Economists based in cities such as Shanghai and Nanjing, the capital of Jiangsu Province, are warning that the gold rush for foreign companies investing in China may already be over. With the Chinese government withdrawing tax incentives and introducing severe restrictions on some industries, questions are arising as to whether UK Government policies on China might be too little, too late.

According to Dominic Phinn, general manager at the European Union Chamber of Commerce in China's (EUCCC) Nanjing bureau, foreign companies are finding it increasingly difficult to break into the market. Those that have been there for several years are also facing growing difficulties in turning a profit.

In the past six months, the Chinese government has reformed tax and other incentive schemes for foreign firms seeking to take advantage of the country's lower labour and manufacturing costs, and many companies are not finding the conditions they had been led to expect.

Phinn said: "There used to be a lot of incentives: VAT rebates, tax incentives and so on. The rebates that used to exist don't exist any more, particularly in manufacturing for export. It's not so feasible any more."

The EUCCC's latest business confidence survey shows that between 2006 and 2007, the number of foreign firms making a loss in cities such as Shanghai and Beijing increased by 5%. Two-fifths admitted they had lower than average profitability in China – a stark contrast to what many policymakers would have foreign companies believe.

Accountants in Asia warn that with the raft of changes introduced by the Chinese government since last November, these statistics are in danger of getting worse.

On January 1, for instance, Chinese authorities scrapped the separate tax rates for foreign and domestic firms – which previously saw many international companies enjoy a reduced 15% rate in order to encourage direct foreign investment – in favour of a uniform 25% corporate tax to be phased in over the next five years. Since the start of the year, foreign firms and joint foreign-Chinese ventures have been forced to pay land-use tax, which was previously restricted to domestic firms only.

At the end of 2007, the grading system for foreign investment was also reformed and several key industries were downgraded from a 'permitted' status to 'restricted' or 'prohibited'. Particularly hard hit by the changes are international companies that want to set up low-cost manufacturing plants in China in order to export their goods. Manufacturers are now required to produce goods for the Chinese market as well as for export – a dramatic change in policy which previously allowed international firms to set up cheap factories and ship products en masse to international markets.

Similarly, the Chinese government now restricts foreign investment in industries which it believes the country has already mastered, such as toy and clothing manufacture. The rules relating to foreign investment in commercial property were also tightened.

"The government has been trying to cool the property market," explains Nick Thomas, of the China-Britain Business Council (CBBC) in Shanghai.

According to Stéphane Vernay, a partner at the international law firm Gide Loyrette Nouel, the Chinese government intends to create a climate where domestic firms can compete on a level playing field with multi-nationals. Whereas previously it encouraged foreign investment so that Chinese workers and industries could benefit from the new technology and business know-how introduced by international groups, it has shifted the focus to promoting Chinese companies and brands.

"This is part of a much broader reform in the Chinese legal environment aimed at enhancing the competitiveness of domestic industry, creating worldwide Chinese leaders and brands, and bringing domestic players to the same levels of practice as foreign players," she warned foreign investors in the EICCC's latest journal.

Phinn argues that eventually the Chinese government will put a stop to the country's reliance on foreign investment altogether. "The plan is at some point to stop relying on foreign companies."

He asserts that it'll be increasingly difficult for small and medium-sized firms in particular to make a profit in China, especially if they plan to manufacture there. "For an SME which isn't going to be producing huge amounts, the margins are slim," he says.

According to Ken Craig, a specialist in international trade between the UK and China at HSBC, companies seeking to maximise their profits in the Far East might now be better off looking at other developing Asian countries. With the rise in labour costs and tax changes in China, UK businesses may find better opportunities in countries such as Indonesia and Vietnam, he says. "You should be looking at South East Asia as a region in general, not just China."

Fu Chi Shan, executive director of CB Media, which publishes the China Economist magazine, points out that the boom days of China's economy are also in doubt. While Chinese economic growth still rapidly outpaces developed countries such as the UK and North America, the economy is not without its challenges. And the World Bank has forecast that Chinese growth will slow this year. "Inflation was at 20% over the past few months," he says.

But according to Nick Thomas of the CBBC in Shanghai, although the climate has changed, not all foreign firms should turn their backs on China just yet. He argues that there are still opportunities for small and medium-sized Scottish companies in particular, given Scotland's growing might in technology, life sciences and other areas such as environmental clean technologies, which the Chinese government is keen to promote. "What we'd say to (Scottish] SMEs is if they have a strong, unique selling point, especially at the high tech end, China is certainly worth looking at," he says.

The CBBC is encouraging UK firms to look beyond the usual destinations of Beijing and Shanghai. Derek Wang, who works for the council in Nanjing, suggests Scottish companies are likely to find opportunities in cities such as his, which specialises in IT and high tech industries.

Some investors in China also point to less developed cities in the west of the country, which they say offer similar opportunities to Shanghai and Beijing 10 or 15 years ago. According to the German airline Lufthansa, UK businesses are already starting to explore alternative industry bases in China. It has reported heightened interest in destinations off the beaten track, and has introduced flights from Edinburgh and London to other industrial cities such as Nanjing and Shenyang.

With China now boasting the second largest number of billionaires of any country, the airline expects businesses focused on its burgeoning middle class to grow their activity over the next few years.

"There are 310,000 US dollar millionaires based in China so they clearly have money to spend," argues Arved von zur Muehlen, managing director for Lufthansa in Greater China.

The EUCCC's Phinn agrees. He says the best chance many UK firms now have of capitalising on China's growth is by targeting its consumers, whose thirst for luxury goods is strong . "That's the reason to be here now. You have to look at the domestic market," he says.