Predictably, the last 11 months have seen the Chinese economic machine plough on with its constant expansion: by the end of the year, GDP is expected to have grown by over 10 percent, a figure that we have become very accustomed to hearing. Another banner year for the economy, but has it been as good a year for the foreign companies that contribute to it?

Generally foreign business has fared well, with a number of industries such as construction and the automotive sectors enjoying genuine success and some significant regulatory progress in the financial sector. On the other hand, whilst there have been no regulatory setbacks, there are some areas where progress is conspicuous in its absence.

FDI: Falling Down Indefinitely?

Confidence in the business climate is certainly evident amongst foreign businesses as shown by the European Chamber of Commerce's 2006 Business Confidence Survey, in which 92 percent of respondents expressed optimism towards their general business prospects. The survey also showed that companies are more confident with regards to their profitability: in 2005, 23 percent of respondents made a net loss, but in 2006 only 7 percent expected to make a loss. The findings don't forecast whether or not the responding companies will make a profit or not, but it does show that morale is high.

A naysayer might point out that this supposed confidence does not correlate to the trend in FDI that has been seen in 2006 - by the end of the third quarter, FDI into China was down by 1.5 percent on the same period in 2005. It might seem like an insignificant drop, and it is too early to say whether it signals a long-term trend, but in China it is easy to become used to healthy growth statistics. If confidence is so high, then why is there a dip in FDI?

"FDI numbers falling doesn't necessarily mean that everyone is having a bad time," says Paul French, director at Access Asia, a China market intelligence provider. "It probably means that some people are having a bad time, but certainly not everyone. If you're making money here and if you've expanded to a size that you're already happy with, why would you bring any more money in? A lot of people will say that the FDI numbers will keep on rising, but we think that the numbers will probably fall off." It's not just the quantity of FDI, quality is important too. When people think of FDI, they often think purely in terms of the apparatus of economic growth, such as the money that goes into factories and machinery. FDI takes into account other kinds of investments as well, such as the money that is invested in property. Over the last year, we've seen a cooling down in China's property market, which has attracted a lot of money from abroad over the last few years. This money drying up will affect the FDI figures, but that shouldn't upset anyone except for those who have been speculating on the housing market.

What will be of a more general concern for foreign companies who are deciding whether or not to invest in China is the issue of potential profits in a market that is gradually becoming more competitive.

Profiting in a mature market

A number of factors have given margins a tight squeeze. "For a lot of people, input costs have been the biggest factor this year," says French. "Some commodity prices have gone crazy, such as titanium, iron ore and gold. Then there are the higher energy costs. And also, container, freight and logistical costs have been rising. This all means that the cost to make something has gotten higher. So the costs of input are rising, but the pressure is on to keep retail and wholesale prices down."

Different industries have felt the effects of high commodity prices in varying degrees. Silas Chiow, director of business development at architectural firm Skidmore, Owings and Merrill, says, "Of course high commodities prices have had an affect on us, but the price of local building materials hasn't really risen much over the last five years."

Chiow also says that the stability in building material prices is due to a combination of increased competition amongst Chinese manufacturers, and the benefits of economies of scale due to the large quantities being produced. On the situation of construction in China, Chiow says, "My impression for the opportunities in Shanghai is that it will continue to be stable; the number of opportunities might not increase, but their quality will."

Increased competition in the industry that produces building materials is part of a more general trend. Chinese companies, through their exposure to foreign technology that joint ventures give them access to, have been able to make significant steps towards closing the technology gap in a relatively short period of time. This means that Chinese companies are becoming competitive in more technologically advanced industries. The maturation of the Chinese market has become another factor that curtails profits.

Chinese companies aren't the only companies in China able to become more competitive: something analogous has been happening to foreign companies. As foreign businesses spend more time in China, they become more adept at operating in the Chinese market. A trend that is being seen more and more often is foreign companies buying themselves out of their joint ventures because they have the confidence that they can go it alone. The most high profile example of this is Starbucks. The coffee conglomerate recently announced the purchase of Mei Da Coffee, the company that helped it enter China in 1999 and operated sixty stores in Beijing and Tianjin. Although joint ventures are a regulatory requirement in some industries, such as the automotive industry, they are becoming less of a target for investment. In August, the US-China Business Council said that 75 percent of new investment is going towards wholly foreign-owned enterprises.

The Chinese market at the end of 2006 might not seem too attractive, with increasingly competitive Chinese companies and high commodity prices that affect both manufacturing and operating costs. This ignores the fact that despite cuts in profits per unit, China still remains a place where high volumes make an operation worthwhile. Take the automotive industry for example: the cost of materials will have no doubt cut into profits, but at the same time, the market is enormous and the sale of cars has been very high. As long as companies are able to keep sales up, China will remain a profitable place to do business.

Banking on freedoms

A counterbalancing factor to profitability is freedom. A lack of the latter can dull the gleam of the former, and the nexus of regulations in China that foreign businesses have to operate within is a constant source of concern. This month will see the end of the WTO accession agreement, which, it is hoped, will bring some long-awaited opening up and regulatory easing across many sectors in China. The banking sector is one of the most regulated, and it is thus the focus of attention in the foreign business community.

The changes, which China agreed to when it joined the WTO in 2001, come in two parts. Firstly, foreign banks will now be able to engage in retail banking with Chinese citizens, thus allowing foreign banks to enter the mass market. Secondly, regional restrictions will be lifted, so that banks will be able to give out loans and take deposits from anywhere in China. Despite these reforms, getting the license to engage in retail banking is still going to be difficult. Only foreign banks that are incorporated in China will be able to offer the full range of retail services. Incorporation is a procedure that requires a lot of capital: registered capital of RMB1 billion, and a further RMB100 million of operating capital for each branch.

"The banks that are interested in retail banking will not be bothered by the charge," says Marcus Wassmuth, the China Chief Representative of the Landesbank Baden-W¨¹rttemberg and the Chair of the EUCCC's Banking Working Group. "They're going to have to set up extensive branch networks, which are going to cost a lot of money anyway. China has opened a friendly backdoor for the rest of the banks. The government has said that they can take deposits from Chinese citizens starting at about US$1 million, so they'll be able to get money from the big guys."

Different banks will be able to take advantage of these reforms in different ways. "You have two kinds of foreign banks operating in China. You have the big universal banks that want to do everything. For them it will be a big change. The other banks are those who mainly work for corporate clients from their foreign markets. For them, it won't be that big a change, except for the lifting of regional restrictions which will help everyone," says Wassmuth.

These reforms show that China is willing to open up a key industry, albeit with conditions, to foreign players. Changes in the regulatory infrastructure are never going to happen at breakneck speed. What's important about the banking reforms is that they are a step in the right direction that should instil optimism in people working in other industries who are restricted by government regulation.

IPR law enforcement

Standing in contrast to the progress in banking reform, there is the notable lack of progress in the IPR protection. In 2006, IPR has remained an issue of central importance to many foreign companies operating in China: this year's EUCCC Business Confidence Survey reported that only 9 percent of respondents have never encountered an IPR-related problem in China, and that 66 percent of respondents reported that they thought the enforcement of the existing IPR laws was ineffective. Only 14 percent described enforcement as effective.

In December 2004, the laws governing IPR protection were altered so that the threshold for criminal liability was reduced. "We still have a problem with the effectiveness and the enforcement of these laws, and on this I would say that there has been no significant improvement since last year," says Olivia Luzi, a lawyer specialising in IPR at Salans' Shanghai office. "There have been some raids and campaigns, more than there were before. The government is supporting IPR by being more willing to sue infringers. In practice, however, as soon as the raids stop, infringers will start their illegal businesses again."

One of the most high-profile IPR events of the year was the action taken against the Silk Road Market in Beijing. "They seized a number of products, mostly luxury goods. There was a civil action against the tenants of the Silk Road Market, but when you look at the amount of compensation, it's quite ridiculous," says Luzi. "They were given something like ten thousand dollars in compensation, when they make so much more in profit. There has been a lot of publicity about this raid, but when you look at it in practice, the fines are far too low to be really dissuasive. It's a good thing for the government to demonstrate that it is willing to take action, but if the judges don't impose severe penalties or criminal sanctions, then IPR infringement will remain a low risk with high rewards."

In another IPR black spot, the shutdown of Shanghai's Xiangyang Market this year wasn't because it was an illegal haven for people selling counterfeit goods, but because the land had been sold for a high price to a developer.

Things may well get better in the future. As Chinese companies climb the technology ladder they will be more likely to lose out to IPR infringement. The more Chinese companies are affected, the greater the chance that the government will become more effective in enforcing its laws. And if the future doesn't start to look promising, European companies concerned with IPR might decide to invest alternatively in one of the new low wage countries that have entered the EU. Ever since EU enlargement, countries like Romania fall under strict IPR regulations - that are enforced - and they are geographically much closer than China, thus reducing operational costs. Getting round to enforcing IPR laws is one of the best ways that China can make itself more attractive to foreign investors.

On an even keel

Despite the setbacks caused by the high price of commodities, 2006 has been a year of moderate progress. There have been no magnificent highs and no spiralling lows, but a calm year of steady improvement is always preferable to white knuckle roller coaster economics. At the same time, things aren't so good that a major setback couldn't bring a hard blow to businesses: even higher commodity prices or a drop in sales next year, could have serious consequences; so too could stagnation in regulatory reform. This could leave the market in a vulnerable position, but since there is no compelling reason to believe that any of these things will happen, the business community can rest peacefully in the expectation that 2007 will be as smooth as the year that was.