Counterparty Risk in China: A Potential Deal Breaker?

At the risk of repeating ourselves, we want to make it perfectly clear that ChinaFund.com is in no way here to “pitch” China as the perfect jurisdiction. In fact, there are countless articles which revolve around the exact opposite, the fact that there are significant drawbacks associated with launching a business in China, working with Chinese companies, investing in Chinese assets and so on.

However, a common denominator does tend to be represented by the fact that despite the various drawbacks which inevitably exist (and we do our best to cover them thoroughly), the pros oftentimes more than make up for it.

Pick your poison, at the end of the day.

For example, those interested in legislative predictability more so than anything else most definitely have far better choices than China, for example most Western jurisdictions. If the same investors, however, are also after career-altering return potential, then we have a bit of a problem because whenever investors chase after the best of both worlds, chances are they will secure neither.

To put it differently, consider it a “China 101” quasi-axiom that higher returns come with a greater degree of risk. As appealing as the idea of a jurisdiction where low-hanging fruit abound but where everything is at Western standards may be, it is nothing more than a mirage: compromising is, at the end of the day, a must.

The same principle applies to the counterparty risk dimension.

As the name suggests, it’s ultimately all a matter of understanding that when it comes to pretty much any transaction/project, there is a certain degree of risk which revolves around the possibility or probability that the other party may not hold his or her end of the deal.

Is this dimension jurisdiction-dependent?

Most definitely.

For reasons which range from cultural ones to aspects pertaining to the legislative landscape and/or especially the law enforcement one, you as an investor who is interested in China need to come to terms with the fact that opportunities pertaining to China almost inevitably come with a greater degree of risk, including… yes, counterparty risk.

For example:

1. When choosing to work with a Chinese supplier, possibilities such as the company in question ultimately working with a competitor who out-bids you despite what seemed to be a rock-solid contract between the two of you needs to be taken into consideration, for reasons which have to primarily due with the fact that contract enforcement tends to be quite a bit more difficult in China than let’s say the United States or a EU nation
2. When choosing to invest in a Chinese company in one way or another, from companies such as the over 100 Chinese businesses listed on formal exchanges such as NASDAQ to reverse mergers and a wide range of other options, it is paramount to come to terms with the fact that the less strict the “watchdog” in question is, the more at risk you are. For example, companies listed on formal exchanges need to meet requirements in terms of let’s say reporting accuracy that tend to be on the strict side, whereas perhaps companies more in the realm of OTC opportunities are multiple orders of magnitude more lax in that department. Speaking of reverse mergers for example, there have even been Netflix shows dedicated to (in)famous examples of Chinese companies that looked great on paper but in reality, were decaying rather than well-functioning businesses
3. The other party might end up unable to hold its end of the bargain for reasons that are beyond its control, in light of the fact that the legislative landscape is anything but predictable in China and companies can literally be one change away from having to essentially close up shop
4. The other party might end up unable to hold its end of the bargain for malicious reasons and in light of the fact that you are a foreigner, the business in question might decide that the potential risk to reward ratio associated with not delivering in one way or another is too attractive to say no to… definitely far more attractive than scenarios involving Chinese companies defrauding Chinese companies or individuals, where enforcement is can be quite a bit stricter
5. The other party might end up unable to hold its end of the bargain not for legislative reasons, nor for malicious reasons but rather for reasons which have to do with the fact that the Chinese economy is more volatile than most Western ones. As such, there are always risks associated with the market potentially deciding to “shun” China for one reason or another, choking its economy and with it, the ability of the counterparty in question to deliver… despite perhaps its very best of intentions

The situation is what it is.

Those who decide to gain exposure to “all things China” but are not willing to accept the cons associated with this jurisdiction after a thorough due diligence process will most likely end up less than satisfied with their results, with the temptation of blaming external factors (forces other than yourself) being hard to resist. Perhaps the Communist Party of China will be blamed, maybe cultural aspects will be in the spotlight or it may very well be the domestic economy if China which will be considered to be “at fault” by a misguided Western investor.

Leaving scapegoats aside, in a depressingly high number of instances, the truth tends to be more than obvious by simply looking in the mirror. By asking yourself whether or not your expectations were in tune with reality, by trying to figure out what could and should have been done better in terms of research and the list could go on and on. Should you be in need of assistance when it comes to just that, the ChinaFund.com team would be happy to put its real-world experience (which spans a double-digit number of years) in China at your disposal in a win-win manner: simply visit the Consulting page of our website to find out what we can do for you, the About Us one to read a bit about who we are and the Contact section to get in touch.