Russia China Risk Final

Group 5

XYZ Corporation Foreign Investment Risk Profile - Political Risk in China and Russia

By Anjelika Bench, Jeremy Lutes, Neal Marks, Ingo Schiller, and Jordan Young

Country Risk Analysis - ITRN 759-B01

George Mason University

Summer 2016

Introduction

We at ABC Corporation, per the request of your organization (XYZ Corporation) have

completed a comparative profile of the political risk characteristics of China and Russia, and

given our recommendation regarding the lower-risk nation to conduct a prospective investment

in the agricultural machines industry. To complete this analysis, we have used the following

definition of political risk:

“The likelihood that new major political events, including regime change, rising popular

unrest, international conflicts and disputes, legal/regulatory changes, and the imposition of

international sanctions, will negatively affect the ability of a company to operate and make

money in a given host country.”

Below, we have completed our analysis of the various aspects of political risk in

accordance with our definition above. We examine and discuss mitigation strategies for

vulnerabilities arising from the structure of the business, changes in the legal and regulatory

regimes, and the idiosyncratic and unique overall political conditions within China and Russia.

In accordance with the data derived from our analysis, we conclude that China is the lower risk

nation for your investment.

Business Structure Risks: ChinaThe World Bank’s Doing Business indicators rank China as 84th in ease of doing

business (Doing Business, 2016).  China’s regulations for foreign direct investment are complex,

opaque, suffer from arbitrary enforcement, and are overseen by various levels of government.

Foreign investment is regulated by seven laws issued by the State Council, but is also subject to

review under over 1,000 rules and regulations issued by various government ministries and

legislatures at multiple jurisdictional levels (US Department of State Investment Climate

Statements for 2016: China).  In addition, local-level governments are empowered to enact their

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own regulations on investment and business operations, compounding the complications

involved in investing in China (US Department of State, 2015).

Foreign investments are approved on a case-by-case basis following review by multiple

government agencies (see Appendix 1; US Department of State, 2015).  In January of 2015,

China’s Ministry of Commerce (MOFCOM) published a draft of a new Foreign Investment Law

for the People’s Republic of China (People’s Republic of China Ministry of Commerce, 2015).

Part of the law is the Catalogue for the Guidance of Foreign Investment in Industries, a list of

industries in which foreign investment is forbidden, restricted or encouraged.  The sector most

relevant to XYZ - agriculture or agriculture equipment manufacturing - is not prima facie

prohibited, meaning that that sector is theoretically open to foreign direct investment (Westam,

2014).

However, the process for receiving approval for investment is not transparent and it is

arbitrarily enforced.  Regulators have the flexibility to ignore the Catalogue guidelines and issue

approvals or rejections along other justifications (US Department of State, 2015).  Current

regulations may at any time be superseded by new policies issued by the government (US

Department of State, 2015).  Also, investors have voiced confusion over contradictions between

the catalogue and other existing regulations (US Department of State, 2015).  

In sum, it is difficult to predict what regulatory conditions XYZ will be faced with upon

application for investment.  According to the U.S. State Department, XYZ may be allowed to

invest, but at any point along the process the application may be rejected for reasons of national

security, violation of a separate regulation, violation of an unpublished government regulation, or

simply to protect domestic industries operating in that sector.  This uncertainty introduces

significant risk in investment; despite this, a majority of companies which apply are approved to

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conduct business in the country, leaving the industry of XYZ Corporation (Agricultural

Machinery) as unlikely to pose a problem.  

In addition to uncertainty regarding making legal investments, Chinese law may require

joint domestic-foreign equity in a venture, or require foreign investors to maintain a minority

stake (US Department of State, 2015).  Chinese law prohibits expropriation except under special

circumstance to include national security concerns and obstructions to large civil engineering

projects; however, the term is undefined, leaving open the risk of expropriation at any time (US

Department of State, 2015). For these reasons, we recommend the pursuit of a joint venture with

a Chinese company, should the decision be made to invest in China. Doing so will assist XYZ

Corporation in navigating the legal system, as well as helping to ensure that risks encountered

due to changes in investment policy for foreign companies can be minimized or eliminated

through partial Chinese ownership.

Business Structure Risks: RussiaIn 2014 President Obama authorized sanctions against certain Russian individuals and

economic sectors (energy exploration, drilling, and finance; US Department of State: Ukraine

and Russia Sanctions, 2014).  The sanctions do not prevent investment in the agricultural or

manufacturing sector.  However, in retaliation a Senator in Russia’s federation council

threatened to introduce legislation authorizing expropriation of assets, property and accounts of

EU and US companies (US Department of State Investment Climate Statements for 2016 -

Russia).  The sanctions and threats of expropriation have created significant uncertainty

regarding the security of American investments in Russia, although no expropriations have yet

occurred. Russia has no capital controls in place; companies are free to remit profits, dividends

and interest out of country. The specter of the possible escalation of sanctions creates a high

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level of uncertainty for XYZ Corporation should it decide to invest in Russia, especially if there

is no Russian ownership in the venture. It should also be noted that a lack of State Owned

Enterprises in that sector reduces the likelihood of governmental regulatory or expropriative

interference.

The World Bank’s Doing Business indicators rank Russia as 51st in the world for ease of

doing business (Doing Business, 2016).  Property rights for foreign investors are typically

protected in Russia, although there have occasionally been issues with local governments (US

Department of State Investment Climate Statements for 2016 - Russia).  Foreign and domestic

entities are enabled to enact and dispose of businesses in Russia, unlike in China where opening

a business is not a right and requires licensure from the government.

However, there are some limitations on investment.   Russia has a list of 45 “strategic

sectors” in which investment is prohibited (US Department of State Investment Climate

Statements for 2016 - Russia).  These sectors are largely confined to industries related to national

security; agriculture and manufacturing are not on the list, making it legally permissible for XYZ

to invest in Russia. Foreigners are not allowed to purchase land near national borders and are

only allowed to own 50% of an agricultural plot (US Department of State Investment Climate

Statements for 2016 - Russia). This is not expected to change in the near future. To mitigate

these risks, XYZ Corporation should hire an industry consultant to assess the likelihood of

Russian government interference.

Legal RisksBoth Russia and China share many similarities in terms of consistency when it comes to

adhering to legal framework. Corruption is a major issue in both countries which makes it

difficult for U.S. companies who are subject to compliance with the Foreign Corrupt Practices

Act.

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Despite the government’s remarks on how important foreign investment is to the success

of the economy, many foreign investors still face difficulties in making investments in Russia.

Lack of transparency is often an issue, especially since government agencies tend to change and

create new regulations relevant to their own agenda that in some cases leads to contradictory

provisions.

Russia’s regulatory system is complex and sometimes contradictory.  Regulations are

enforced inconsistently, and the law in some cases overlaps, creating legal uncertainty (US

Department of State: 2014 Investment Climate Statement - Russia, 2014).  Foreigners drafting

agreements with local entities should include contractual protection for the foreign investor to

guard against contingencies.  Furthermore, corruption is rampant in Russia judiciary system; in

some cases, commercial arbitration skews in favor of taxpaying entities, relying solely on written

documentation in lieu of witnesses (US Department of State: 2014 Investment Climate Statement

- Russia, 2014).  XYZ should be defensive when creating contracts with local partners, and it

should retain written proof for every agreement.  

According to The Economist’s Intelligence Unit, doing business in China as a foreign

investor has become easier overall, despite popular views of an increasingly difficult legislative

regime (EIU, 2016). The government has been experimenting with new regulations, causing

confusion and complications. Overall, the perception of the ease of market entry in China is

similar to that of Russia, due to specific regions and industries being closed for investment. The

Chinese government restricts foreign investment in areas that are not relevant to national interest,

or industries that would compete with state-sanctioned monopolies and “favored domestic

firms.” The U.S. State Department (2016) reported that many companies have voiced concerns

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over the fact that regulations contain vague, unclear language, and that different regulatory

bodies and localities apply certain regulations inconsistently.

Property rights protection is another area of legal framework that is rated quite poorly in

Russia. The Heritage Foundation Economic Freedom Index score for Russia’s rule of law for

property rights at 20 out of 100, meaning private property is weakly protected, the court system

is inefficient and vulnerable to political and monetary persuasion, and expropriation is a common

occurrence (Heritage Foundation, 2016). Foreigners are also subject to specific land ownership

restrictions under the Land Code. For example, foreign ownership is prohibited in some areas

specifically assigned as restricted territories, or land located in border areas. Another restriction

requires that foreign citizens or legal entities are prohibited from owning more than 50% of

agriculture plots, but can lease land for up to 49 years (U.S. Department of State, 2016). This

amount of time is usually cut short by government entities who wish to seize control of that plot.

China also scored relatively low on the Economic Freedom Index at 20 out of 100, which

similarly to Russia insinuates weak property rights protection, corrupt and inefficient courts, and

over looming threats of expropriation (Heritage Foundation, 2016). Property rights for foreigners

have expanded in recent years as rules began to change, however all land in China remains

owned by the state. Both foreign and domestic investors can apply for transferable land-use

rights for a designated number of years for a fee. While residential property rights are generally

renewed automatically, commercial property rights are only renewed if it does not “conflict with

public interest” (U.S. Department of State, 2016). In most cases foreign investors end up having

their land use right revoked due to government interests for development in that area, and

previously promised compensation for having to relocate is almost never given. Another obstacle

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foreign investors generally run into involves the aforementioned land-use leases, mortgages, and

other debtor and guarantor rights.

In the case of legal framework, whether XYZ Company invests in China or Russia they

will need to take the same precautions in one as they would the other since both countries

contain high levels of legal risk. Both countries have non-transparent systems and function off of

corrupt systems. XYZ Company must ensure that they have well-written and well-executed

contracts reviewed by trusted local sources, and should proceed with caution by including an

arbitration clause that will allow disputes to be settled outside of either country. However, if the

external arbitration clause cannot be achieved, Russia has a lower level of legal risk – while

corruption in the system is very high compared to that of China, the relative definition of Russian

laws compared to that of China indicates a lower level of uncertainty in Russia.

Political Conditions        China has enjoyed a stable (but evolving) government with no strong or large opposition

parties or groups of internal political influence. This structure is one that, while allowing more

freedom for the development of capitalist business structure maintains very strong control over

the lives of its citizens and residence. Much work is being done by the government to eliminate

corruption and abuses of power by individuals within the government with public removals and

trials of citizens and foreigners that engage in illegal or corrupt activities. This should not be

interpreted to mean that there are not examples of corruption still present in the interface

between government and commercial activities, most notably in the areas of building permits and

commercial licenses.

Russia on the other hand is working through the major change in government and

political system since the collapse of the Soviet Government in the late 1980’s. Since then the

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country and political system has become a parliamentary system with a Premier position that has

been consolidating power to the point of being likened to a dictatorship. It does have political

pressure groups but none that are so strong that they challenge the ruling party.

The introduction into commercial capitalism in Russia has been a turbulent one with

many examples of industries and commodities being effectively owned by individuals or

conglomerates with strong political pull. Similar to China, the government seeks to make

examples of those judged as guilty of corruption and other illegal activity, however there are also

entities which are exempted from the legal system and are allowed to profit from their actions.

International Conflicts

China has had a few armed skirmishes with neighboring countries in the last few decades,

but since the advent of authoritarian capitalism and the resulting economic boom of the last 20

years, the conflicts have been more symbolic. China is determined to defend all of its territorial

claims and has worked to develop and expand its military effectiveness. At the moment, China

has territorial disputes with Malaysia, Vietnam, Brunei, Taiwan, Indonesia, and the Philippines.

Despite pending arbitration in the international court system, However, due to the codependent

nature of the Chinese economy and the world’s other economies, China appears unlikely to

become a rogue state and take any military action that would draw the ire of the U.S. and the EU,

two of its largest trading partners.

Russia is involved is open military action or other conflict actions with the Ukraine,

Georgia, Chechnya, Syria and with Turkey. Some of these have inspired commercial sanctions

from the US that strongly limit commercial activity of US businesses within Russia in the wake

of the Crimean occupation. As the Russian economy does not have as many linkages with the

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world economy as a whole, other major economies are more likely to impose sanctions on Russia

when compared to China.

Internal Terrorism

China has political dissidents but does not have significant terrorist activity within its

borders. The primary source of Russian internal terrorist activity is most often associated with

the Chechnyan separatist activities. Neither of them have terrorism risk levels that would

significantly affect the investments of XYZ Corporation.

Openness

Both countries have historic issues that are points of conflict with neighboring countries

but are not expected to become heated issues or open conflicts. From the perspective of internal

government and international conflict risk, while neither country is without risk, we see the less

risky nation as China, due to U.S.-China bilateral trade composing a large proportion of the

Chinese economy, providing a safeguard against foreign aggression and an incentive to resolve

conflict through diplomatic channels; This is not the case for Russia, which has a long history of

sanctions and military conflict with the major powers of the world, especially the U.S.

Governance

The World Bank’s Worldwide Governance Indicators shows China ranked higher than

Russia in five out of six indicators in 2014, the most recent year for which data is available

(Political Stability and Absence of Violence/Terrorism; Government Effectiveness; Regulatory

Quality; Rule of Law; Control of Corruption; The World Bank Group, 2015).  Russia ranked

higher than China in only one indicator: Voice and Accountability (The World Bank Group,

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2015).  This can likely be attributed to the authoritarian system of governance utilized by the

Chinese in which it is very difficult to mobilize politically, however the Chinese dominance of

the other categories demonstrates that the lack of voice and accountability alone does not make

for low quality governance. The ability to maintain relative peace and stability while providing

low-cost production helped China to attract high levels of foreign investment in the first place.

Furthermore, China has demonstrated a commitment to building further commercial

relationships with other nations through Special Economic Zones (SEZs) which are offered the

privilege of operating largely independently from the Chinese government, a promise that has

been preserved over time. In light of this fact, XYZ Corporation making an investment in China

is significantly less risky; a further hedging strategy could be to invest in an SEZ, then to sell its

machines through a Chinese distributor in a joint venture.

China and Russia on the World StageWhen China reopened its doors to world commerce it promised to bring benefits of free-

trade, open markets, and greater individual autonomy than was present under Mao Zedong’s

oppressive regime. China has delivered on this promise, with a consistently high growth rate for

the past several decades, often exceeding 10% of GDP. As with any government at the helm of a

developing economy, the legitimacy, and control wielding by the ruling class is largely

determined by their ability to deliver economic gains for its citizenry. A large part of the

economic growth miracle that is China is due to the willingness of the government to pursue

membership in the major international commercial organizations that are responsible for

promoting free trade, ensuring fair terms of trade between nations, and providing a process for

legal proceedings against member states for those countries that do not play fairly.

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The first step for China was to reapply for membership to GATT, which it began early, in

1986. In order to win approval of the other member nations, China had to take on dramatic

reform of its economic stance toward foreign goods by dramatically reducing tariffs on foreign

goods. Domestically, it had to improve its human rights record, mostly in regards to working

conditions in its factories. Progress in these areas was gradual, but complete; and by 2001 China

was admitted into the WTO (a new body born from GATT). (Prime, 2002) Growth has continued

to be strong since this time and China has seen a dramatic rise in its middle class. This has done

much to solidify The Communist Party’s image and control over many aspects of life. While

some sources indicate unrest has become more prevalent, due to introduction of social media,

and dissatisfaction over rampant corruption, the government seems to be content to continue at

its own pace. If the economy continues to grow, and the government is willing to consider

moderate degree of social liberalization, it is unlikely that the people will be willing to mount an

effective challenge to the government’s power. They are more likely to prefer to maintain social

cohesion, unless government began to act more despotic, restricting freedoms already granted.

(Gobel, Ong, 2012). The outlook for China is relatively stable, and represents an intriguing

opportunity for potential investment.

Russia is a much newer member to the WTO, gaining membership in 2012 after

extensive negotiations over the terms of joining the organization. The US was pleased to have

Russia join for the liberalizing policies mandated for eligibility to enter the organization, and for

the increased transparency into economic affairs often shrouded in mystery. At first,

liberalization did occur and tariffs were reduced by an average of 5.9%. (Mills, 2012) Economic

growth has been weak in recent years, and in 2015 the Russian economy slid into recession on

the back of weak oil prices, down 3.75%. (IMF, 2016) The US has now begun to assert that the

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Russian government has begun enacting protectionist measures, such as import substitution and

outright bans on purchases of certain goods, which provides a boon to domestic industry and

unfairly punish foreign businesses. (USTR, 2015)

With weak economic performance since joining the WTO, coupled with on ongoing conflict

in Ukraine, which western nations have argued is fueled mostly President Putin, we believe that

the political environment in Russia has become more uncertain. The contributions of low oil

prices and a dramatically weaker ruble to an economic crisis have generated heightened political

risk, The Russian people, upset at a notoriously corrupt regime that has failed to bring consistent

growth and overtly uses crony capitalism to distribute wealth to the politically-connected, have

become increasingly vocal with their discontent. The influence of opposition leadership has been

kept in check, due to state control of the media, and even outright thuggery and brute force, has

prevented an overthrow of the current regime. We believe that stability of the current regime is

more uncertain than that of China, and therefore does not justify the costs of a potential

investment in Russia.

Conclusion

We recommend that XYZ pursue their investment in China, which in our view holds the

lower level of political risk. China, as a highly embedded state within the world economy, as

well as a state maintaining a relatively high degree of internal stability for the time being, is the

more attractive investment destination in the short term. While the future of Chinese politics is

uncertain, it is our belief that as long as the Chinese government continues to adapt to the

national political environment and China remains a cornerstone state within the international

political and economic orders, XYZ Corporation will experience lower levels of political risk.

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Furthermore, China has better demonstrated a commitment to protecting foreign enterprises

investing in the nation, through its continued establishment of Special Economic Zones, which

operate largely autonomously and provide cover from political risk in the mainland. Russia has

no such mechanism and the political economic incentives to create them, generating an

environment in which foreign companies based in the country have little to no certainty

regarding their levels of insulation from various political risks. China’s higher levels of internal

and external stability give it the edge, despite the government being known for taking actions and

instituting policies which favor SOEs in every industry. Russia lacks those same levels of

stability, and continues to openly favor its SOEs over foreign enterprise. We stand firm in our

belief that China will remain the lower risk location both in the short term and the long run.

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Appendix 1: General Approval Process for Inbound FDI in China

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Works Cited

Doing Business. Economy Rankings. World Bank Group: 2016. Web. Accessed July 22, 2016, from (http://www.doingbusiness.org/rankings)

Gobel, Christian. Ong, Lynette. 2012. Social Unrest in China. Europe China Research and Advice Network. Accessed on July 22, 2016, from (https://www.chathamhouse.org/sites/files/chathamhouse/public/Research/Asia/1012ecran_gobelong.pdf).

International Monetary Fund (IMF). Web Accessed July 23, 2016, from (http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/weorept.aspx?pr.x=72&pr.y=15&sy=2011&ey=2016&scsm=1&ssd=1&sort=country&ds=.&br=1&c=922&s=NGDP_RPCH&grp=0&a=).

LuxCSD. Investment regulation - Russia. 2014. Web. Accessed July 23, 2016, from (http://www.clearstream.com/luxcsd-en/products-and-services/market-coverage/europe-non-t2s/russia/investment-regulation---russia/8998)

Mills, Laura. 2012. Russia Joins WTO After 18 Years of Negotiation. USA Today. Web Accessed July 22, 2016, from (http://usatoday30.usatoday.com/money/economy/trade/story/2012-08-22/russia-joins-world-trade-organization/57207664/1).

Ministry of Commerce, People’s Republic of China. MOFCOM Spokesman Sun Jiwen Comments on Foreign Investment Law (Exposure Draft ) Issued for Soliciting Public Opinions. 2015. Web. Accessed 2015, from (http://english.mofcom.gov.cn/article/policyrelease/Cocoon/201501/20150100875221.shtml)

Prime, Penelope. 2002. China joins the WTO: How, Why and What Now? Business Economics, vol. XXXVII, No. 2 (April, 2002), pp.26-32. Web Accessed July 22, 2016, from (http://www.chinacenter.net/docs/WTOPrime3.pdf).

US Chamber of Commerce. China’s Approval Process for Inbound Foreign Investment: Impact on Market Access, National Treatment and Transparency. 2012. Web. Accessed July 22, 2016, from (https://www.cov.com/files/Publication/4b417f2b-ca02-4c23-b5a0-

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c9882f8f02ac/Presentation/PublicationAttachment/74c43d19-71c2-47c5-b6ce-ccb56c56d91b/China_InboundInvestment.pdf)

US Department of State. China Investment Climate Statement 2015. May 2015. Web. Accessed July 22, 2016, from (http://www.state.gov/documents/organization/241728.pdf)

US Department of State. Investment Climate Statements for 2016: Russia. Web. Accessed July 22, 2016, from (http://www.state.gov/e/eb/rls/othr/ics/2014/227933.htm)

US Department of State. Ukraine and Russia Sanctions. 2014. Web. Accessed July 22, 2016, from (http://www.state.gov/e/eb/tfs/spi/ukrainerussia/).

US Trade Representative (USTR). 2015. Report on WTO Enforcement Actions: Russia. US Trade Representative. Web Accessed July 23, 2016, from (https://ustr.gov/sites/default/files/2015-Russia-Enforcement-Report.pdf).

Westam. Forbidden, Restricted & Encouraged Activities. 2014. Web. Accessed July 22, 2016, from (http://westamgroup.com/forbidden-restricted-encouraged-activities)

The World Bank Group. Worldwide Governance Indicators. 2015. Web. Accessed July 23, 2016, from (http://info.worldbank.org/governance/wgi/index.aspx#reports). Gobel, Christian. Ong, Lynette. 2012. Social Unrest in China. Europe China Research and Advice Network. Accessed on July 22, 2016, from (https://www.chathamhouse.org/sites/files/chathamhouse/public/Research/Asia/1012ecran_gobelong.pdf).

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