Google, Rio Tinto and the rule of law in China - Emerging Market Red Light

What happens when Communist party insiders control your competitor, your supplier, your customer and the legal system set up to resolve your disputes?

Recent headlines have highlighted China's alleged cyberattack on Google and China's indictment of four employees of Rio Tinto, one of the world's largest mining companies, for accepting bribes and stealing trade secrets. Both cases should remind investors that there is more to emerging markets than growth. The cyberattack came as Google struggled with censorship and accessibility issues in China while competing with a Chinese imitator. It led to Google's withdrawal of censored search service in China. Rio Tinto was involved in heated negotiations to supply iron ore to Chinese steel companies, at prices Chinese officials considered unfair. The Google and Rio Tinto incidents are not directly connected, but they raise some common questions on the sustainability of foreign investment in China and, in very broad terms, the sustainability of any large system that combines a market economy with political control by a privileged group not subject to democratic selection. Just how committed to the rule of law is China, how nervous should companies (and their shareholders) with extensive business in China be about this issue and what should they do about it.

From the outside (and Justmeans Sustainable Finance is looking forward to an inside view on China from Johanna Hoopes) some broad trends seem reasonably clear. First, the shift towards a market economy combined with the retention of strict political control by the Communist party is allowing party officials and business owners with close ties to the party to build personal wealth through control of assets, information and access that once belonged to the state. It's a less flamboyant version of the plutocrat creation decade in Russia, but with no pretense of democracy. Second, although China honors the rule of law in theory (both historically and currently the Chinese legal system is quite interesting and in many ways advanced), in practice Communist Party leaders will still control the outcome of any dispute that threatens a significant interest of the party. Sometimes the party considers the pocketbooks of its officials and their friends to be a significant interest of the party. Ouch, that's right, once in a while your Chinese competition might make the rules and own the referee. Rio Tinto officials are professing innocence in response to the recent indictments, but don't bet on the Chinese courts to agree. The issue is not unique to China or communism, many emerging market countries, especially those run by an unelected elite, have revealed some cracks when a growing economy creates friction the legal system can't handle.

Non-Chinese businesses recognize the issue, but they are desperate to get involved, and stay involved, with a market that will be the world's largest. Often they count on close relationships with Chinese stakeholders (sometimes co-owners, but also key employees, consultants, suppliers or customers) to keep them on the party's good side. As a safety measure, they can limit exposure of intellectual property in China and minimize non-removable investments like bricks and mortar construction on Chinese soil. Few will take a Chinese problem head on, with open defiance. Google's technical and financial might, and the moral courage its management eventually showed on censorship, are a combination we won't see often.

What should a business, an investor, or anyone else do to foster the rule of law in China? Probably start by recognizing that lectures will be counterproductive and Western democracies don't have an ideal record on this issue. Even in the US Federal system, where I believe the vast majority of judges are competent and honest, money is an extraordinary advantage, especially if you consider rule making (and the expensive lobbying that surrounds legislation and regulation) as part of the system. Then maybe give some credit to the companies that are willing to take a stand, even when it costs them. Attaboy Sergei. If you're an investor, look at China as more than just a rosy opportunity, what would happen if that hot stock you are considering suddenly found itself on the wrong side of a dispute with a company in China that was seriously connected to the party. Would the same thing happen even if the “dispute” was just a pretext for the competitor to gain at the expense of your suddenly not so hot stock? Finally, if you are doing business in or with China, then, with patience and diplomacy, whine about rule of law whenever you can, especially on Chinese web sites. China's leaders aren't democratic, but they monitor public opinion, especially on the Inter net. Each time concern about how the rules are made and enforced forecloses or modifies your opportunities in China, let your Chinese stakeholders know directly. In the long run, a judicial system that values the rule of law over party connections is important to the Chinese, not just the foreign investor.

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