Can China’s Government Procurement Market Be Cracked?

China’s preference for domestic products continues to worry foreign firms, but companies can take steps to improve their chances of succeeding in China’s government procurement market.by Jason Matechak and Brett GersonSince China first opened its gates to foreigners, US companies have sought to sell goods and services to China’s ruling government—first to the imperial dynasties and, in recent years, to the People’s Republic. China’s public procurement market, like the rest of its economy, is growing at a remarkable pace. In 2008, China’s purchases through the public procurement process totaled roughly $88 billion, more than triple the amount in 2003. The actual size of China’s government procurement market might be significantly larger than official figures indicate because of difficulties in determining which entities are state-run and which are private. Regardless of the exact figure, China’s public procurement market presents tremendous opportunities for foreign firms in a wide range of industries. By understanding recently released PRC opinions and legislation, foreign firms can form better strategies to access this vast but elusive market.

Background on government procurement in China

Foreign firms have historically had relatively few opportunities to access China’s procurement market, which is governed by the Government Procurement Law (GPL). First issued in 2002, the GPL states that PRC government agencies and entities must purchase domestic goods, works, and services except in rare circumstances when

• The required items cannot be obtained within China under “reasonable commercial terms,” defined as 20 percent more expensive than foreign products;
• The items to be procured are for use abroad; or
• Otherwise provided for by other laws or administrative regulations.

Though the GPL provides for a wide variety of avenues to procurement—including open and selective tendering, competitive negotiation, single-source procurement, and request for quotation—few foreign-invested enterprises (FIEs) have been able to compete successfully in China’s public procurement market.

In countries that have signed the World Trade Organization’s (WTO) Agreement on Government Procurement (GPA), the primary international agreement that enforces open access to domestic procurement markets, such discrimination against foreign firms is prohibited. Under the GPA, each signatory party must treat other GPA parties’ products and services “no less favorably” than it treats its domestic products and services. Furthermore, GPA parties may not treat domestic suppliers differently on the basis of degree of foreign affiliation or ownership.

China committed to joining the GPA as part of its WTO accession in 2001, but the terms of its GPA membership are still under negotiation. In December 2007, China submitted an initial offer to join the GPA. The offer, however, included high domestic content thresholds and neglected to cover procurement by sub-central government entities or in the services sector. The United States requested several changes to the offer but, much to the chagrin of FIEs seeking access to its public procurement market, China has yet to submit a revised version.

Defining “domestic”

Under the GPL, most FIEs have been unable to crack the Chinese procurement market because their goods—though manufactured or assembled in China—have not been considered “domestic” for procurement purposes. Unlike similar legislation in other countries, the GPL does not define the term “domestic,” leaving it unclear which items the PRC government considers “domestic” for procurement purposes. In June 2009, China shed some light on the issue: The National Development and Reform Commission (NDRC) and eight other PRC central agencies released Circular 1361, a key opinion on strengthening the regulation of tendering and bidding processes in construction contracts. Though the circular itself did not define “domestic,” NDRC and Ministry of Commerce (MOFCOM) spokespeople affirmed in a joint statement that products made by FIEs in China may be considered “domestic” for government procurement purposes.

Perhaps in response to calls for greater clarification, in January 2010 the PRC government issued draft implementing regulations for the GPL, which clarified the circumstances under which FIEs may compete for public procurement contracts in China. The implementing regulations define a “domestic” product as one that is “made within China’s borders and for which domestic manufacturing costs exceed a certain percentage of the final price.” (The prescribed ratio, or “domestic cost ratio,” is the difference between the product’s ex-factory price and its import price, divided by the product’s ex-factory price.) The implementing regulations do not specify a domestic content threshold, but a 1999 PRC Ministry of Finance (MOF) regulation classifies products with less than 50 percent of their value produced domestically as imports. Furthermore, Article 10 of the implementing regulations defines “domestic projects and services” as those that are provided by Chinese citizens, legal persons, or other organizations. FIEs are considered legal persons under PRC law and should thus be treated as domestic entities for the purpose of public procurement.

Because products that are not “domestic” must be imported into China, analyzing the definition of an “imported” product may help determine which foreign products are eligible for public procurement in China. In 2007, MOF imposed new procedures on PRC government agencies that seek to import products. The procedures define “imported products” as products that are made abroad and enter China after going through PRC Customs declaration, inspection, and clearance procedures. Likewise, Article 11 of the implementing regulations defines imported products as those that are manufactured overseas and enter China through Customs declaration and release procedures. The key factor in determining whether a product is domestic appears to be whether it passes through PRC Customs. Therefore, products made in China’s bonded zones using imported materials may be considered “domestic” for government procurement purposes, as long as they do not require passage through or inspection by PRC Customs.

Indigenous innovation restricts foreign competition

The preference for domestic products and services in procurement is not the only method that the PRC government uses to limit competition from foreign firms. China also promotes the procurement of “indigenous innovation products,” a policy intended to stimulate the development and sale of homegrown concepts and technologies.

In 2006, China introduced the Medium- and Long-Term National Plan for Science and Technology Development (2006-20), a national policy that directs PRC agencies and provincial governments to buy products listed in certain procurement catalogues. The catalogues include only qualified indigenous innovation products, with few exceptions. In November 2009, the PRC Ministry of Science and Technology (MOST), MOF, and NDRC jointly issued a notice announcing the National Indigenous Innovation Products Accreditation Program, which outlined the creation of a new central-level indigenous innovation product catalogue. China has yet to issue the final catalogue, but it will likely divide products into six categories: computers and related equipment, communication products, modern office equipment, software, new-energy equipment, and energy-efficient products. So far, very few products made by FIEs have qualified as indigenous innovation for procurement purposes and been listed in provincial procurement catalogues. For example, of the 523 products listed in Shanghai’s catalogue, only two are produced by FIEs, both of which are long-standing Chinese-foreign joint ventures (JVs) with a majority Chinese stake, according to a US-China Business Council (USCBC, publisher of the CBR) report.

International pushback to Chinese procurement discrimination

After the 2009 announcement of the accreditation program, a major international lobbying effort was undertaken to encourage China to soften its indigenous innovation policies. Thirty-four trade associations from Canada, the European Union, Japan, South Korea, and the United States—including USCBC—sent a letter to MOF, MOST, and NDRC, that urged the PRC ministries to delay implementation of such protectionist procurement policies. The letter argued that moving forward with the indigenous innovation policies will “restrict China’s capacity for innovation, impose onerous and discriminatory requirements on companies seeking to sell into the Chinese government procurement market, and contravene multiple commitments of China’s leadership to resist trade and investment protectionism.” Other opponents have argued that the indigenous innovation policies are designed to pressure FIEs into transferring technology, know-how, and trade secrets to their Chinese counterparts.

Some progress—but challenges remain

In a December 2009 statement, a MOFCOM spokesperson defended China’s indigenous innovation policies, pointing out that they apply equally to domestic and foreign-invested companies in China. But equal application of the policies is exactly the problem, because it eliminates too many opportunities for foreign companies.

China has made recent changes to its indigenous innovation policies that address some foreign-company concerns. Initially, to be considered “indigenous innovation,” a product must have had a trademark that was owned by a Chinese company with full ownership of the product’s intellectual property (IP) in China. In April 2010, MOST, MOF, and NDRC jointly issued a draft notice that would relax these strict requirements. Under the proposed guidelines, a product would be eligible for indigenous innovation accreditation as long as the applying party has exclusive rights to the product’s trademark in China and is licensed to use the IP in China.

Though the relaxed trademark and IP rules are welcome changes, the requirements remain onerous for many FIEs. For example, the draft notice would require that the qualifying product’s IP not have any disputes or controversies with another product’s IP. Such disputes and controversies are common for FIEs that operate in China, however, as China’s legal framework for IP protection is still developing. FIEs that seek indigenous innovation accreditation for their products may have to choose between enforcing their IP rights and seeking potential procurement opportunities.

Best practices for foreign companies in China’s procurement market

Despite assurances from PRC officials that FIEs will be treated the same as other China-based enterprises, eliminating foreign competition may be the impetus behind China’s public procurement policies. The PRC government has long been concerned that too much technology used in China has been developed abroad and that China’s unprecedented economic growth has been overly dependent on foreign products, brands, and technology. By requiring PRC agencies and ministries to procure local products and services, China aims to cultivate domestic high-tech and innovative companies.

Though many foreign companies are understandably frustrated with the lack of access to China’s procurement market, the following steps may increase their chances of successfully selling products or services to PRC entities.

• Produce goods with at least half of their value added in China  Products that contain at least 50 percent domestic content will likely be considered “domestic” for public procurement purposes.
• Consider making or assembling products that contain foreign components in special bonded zones  Goods that do not require PRC Customs inspection and release may be considered domestic for government procurement purposes.
• Offer energy-efficient and environmentally friendly products and services  Article 9 of the draft implementing regulations would require PRC agencies to give preference in procurement to energy-efficient and environmentally friendly products. Whether China will give these products preference over non-energy-efficient domestic products remains unclear, but the regulations indicate that the State Council will likely formulate procurement policies according to national economic and social development goals. Clean-energy development is high on China’s list of priorities, so an FIE may be able to improve its access to procurement opportunities by highlighting its product’s energy efficiency.
• Take advantage of provincial “buy local” provisions  Compared with other administrative functions, local agencies and ministries have a significant amount of discretion in the procurement of goods and services. The PRC central government has delegated approval authority for all foreign-invested projects below $100 million to local authorities and, by some estimates, local officials are responsible for financing 75 percent of all PRC stimulus spending. (Under the PRC Catalogue Guiding Foreign Investment in Industry, foreign investment in “restricted” industries such as chemicals and financial services are still subject to higher-level government approval.) Strengthening relationships with local partners and officials will increase foreign companies’ procurement opportunities at the provincial, county, and municipal levels.
• Highlight JV status  Since only FIEs that are part of Chinese-foreign JVs have succeeded in getting their products into indigenous innovation catalogues, foreign companies with part ownership in Chinese-foreign JVs should emphasize their JV status before and during the bidding process.
• Develop and highlight strong internal anti-bribery and anticorruption practices  Under the draft implementing regulations, entities with a history of anti-bribery or Foreign Corrupt Practices Act violations may be blacklisted for PRC procurement. Since FIEs likely face a higher level of scrutiny in the procurement process, those submitting bids for procurement should preempt close inspection by highlighting their robust internal anti-bribery and anticorruption practices.

China had not finalized the implementing regulations as CBR went to press, so how—or whether—the proposed policies will be carried out remains unclear. The international community welcomed many of the positive developments reflected in the draft implementing regulations, such as defining “domestic” goods and services in a manner that encompasses all enterprises in China, regardless of foreign ownership. Unfortunately, China’s indigenous innovation policies may still make it difficult for FIEs to crack China’s procurement market. Foreign companies that seek access to China’s immense procurement market are advised to track the evolution of the GPL and China’s indigenous innovation policies.

[author]Jason Matechak is a partner and Brett Gerson is an associate at Reed Smith LLP. They are based in Washington, DC.[/author]