What future for Australian manufacturing and why should you care?

The question of whether manufacturing has a future in Australia has been hotly debated for some time. This year, the debate has reached fever pitch fuelled by the usual Hanrahans spouting their own versions of “We'll all be rooned.”

The media is full of stories of failing Australian manufacturers and government bail outs. The Executive Chairman of Manufacturing Australia recently stated that, “manufacturing is severely threatened unless steps are taken to maintain global competiveness”.

But is Australian manufacturing really on a road of no return or is it merely reshaping itself, albeit not without some pain, for the 21^st century and why does it matter?
Firstly, why manufacturing matters. As Professor Roy Green has commented, Australian manufacturing is important because of the strong connection between manufacturing and developing a knowledge-based economy. True we may no longer be competitive in textiles, garments and footwear given the competition from low-wage economies. But we can be competitive in fashion and design, as well as in technical textiles and smart fabrics for industrial purposes.
That’s why it is important to preserve and assist our manufacturers. There is plenty of scope for Australia to lead the world through ingenuity and research.
Manufacturing Australia is advocating a reform agenda focused on lowering regulatory and energy costs for manufacturers and strengthening Australia’s anti-dumping system.
While these are sound reforms and may be beneficial, are they really addressing the core reasons why we need a manufacturing sector? How do these responses address the trends that are reshaping global manufacturing?
As discussed, many products previously manufactured in Australia are now being manufactured in low-wage economies like China, Thailand, Vietnam and Malaysia. Typically these are commodity products that attract relatively low margins and rely on volume to generate revenue.
The move to shift manufacturing commodity products to low cost countries is not unique to Australia and has been happening for some time as developing countries expand their industrial base. Calls for stronger anti-dumping protection will not address the underlying economic reason why these products are manufactured in these countries.
There is a more recent phenomenon occurring globally that could ultimately support more a sustainable manufacturing sector in Australia. That is, the move away from manufacturing products at an end-to-end factory located in a single country and then selling those products.
Rather, what is now occurring, particularly in developed countries, is the “unbundling” of the various manufacturing stages of a particular product across borders. Components and subsystems for a particular product are produced in two or more countries that have a comparative advantage in making those components and subsystems. They are then shipped to a third country to be assembled into the end product, which is then sold world-wide.
The benefit of “unbundling” is that each stage of the manufacturing process, including final assembly, is conducted in the country that has (theoretically) the best comparative advantage for its particular part in the process.
Large businesses, particularly multinational corporations, are not only “unbundling” and geographically dispersing the manufacture of products to reduce costs and enhance competitiveness; they are also “unbundling” and outsourcing services, such as back office administration.
What determines which country or countries have the best comparative advantage? For assembly of a product, it’s primarily access to labour at low cost. For the production of components and subsystems, it will depend on the intellectual property content in the product. Countries with strong intellectual property protection will be favoured where components and subsystems contain unique intellectual property.
Australia thus needs to focus not on the low value aspects of the production chain but rather on what Professor Green calls “our capacity to compete in knowledge-based activities worldwide as part of international markets and supply chains”.
An example of “unbundling” is the manufacture of passenger trains. Components and subsystems are manufactured in a variety of developed countries where intellectual property protection is strong. Those components and subsystems are then shipped to a developing country, where low cost labour is abundant. There they are assembled into either the finished passenger train or a partially complete passenger train. In the latter case, the partially complete train is shipped to a developed country where further high end manufacturing, such as installation of the computer and communication systems, occurs to complete the train.
Other examples using this global production technique are motor vehicles, mobile phones, computers and televisions to name but a few.
This move towards globalised manufacturing has occurred in parallel with another, related trend – the rise of preferential and free trade agreements between countries. Significantly for manufacturers, these trade agreements address more than the usual border issues such as tariffs and customs procedures. They also encompass “behind the border” issues such as investment, intellectual property and competition.
Why are these issues important? Breaking apart a manufacturing process and dispersing it across multiple jurisdictions results in a complex web of:-

• trade in components and subsystems across borders;
• investment in factories in multiple jurisdictions and associated investment in training, technology, OHS, etc; and
• infrastructure to manage the logistics involved in both the production of goods at each stage of the manufacturing process and then marketing the final product in export markets.

The threats to such a globalised manufacturing network are clear. For example, weak intellectual property and foreign investment rules in a jurisdiction will work against establishing manufacturing or assembly operations in that jurisdiction. The solution? Enter into preferential trade agreements that address those ‘behind the border’ issues and, thereby, facilitate the establishment of manufacturing operations in those jurisdictions.
In its 2011 World Trade Report the World Trade Organisation found that for cross-border production networks to operate efficiently, certain national policies (e.g. intellectual property, foreign investment, etc.) need to be harmonised and rendered mutually compatible. This generates the need for “deep” preferential agreements either on a bilateral basis or on a regional basis.
Since June 2008, Corrs has been involved in this process through (our CEO) John Denton’s role as government-appointed business representative on the regional trade and investment body, the Asia-Pacific Economic Co-operation forum and APEC's Business Advisory Council.
Corrs is eager that we shift from an old-style trade debate, where the objective is to crash through to one about economic integration. As John Denton has previously commented: “The world economic crisis has underscored just how connected markets are in an era of globalisation, yet all kinds of unhelpful nuts-and-bolts barriers remain behind borders. At the macro-level we need to flip the discussion from protection and market access to market integration”.
What does this mean for Australian manufacturing? The sector continues to be important to our collective wealth. Much can and has been done by successive governments to improve the competitive position of Australian manufacturing by moving into higher-value activities and identifying new areas of manufacturing, like manufacturing using lasers and 3D, where we have world-class scientists and a proud tradition of innovation through organisations like CSIRO and the world class work done by, amongst others, its Manufacturing, Materials & Minerals Division. At the same time we need to be vigilant in ensuring our network of trade agreements addresses any behind the border issues that might hold us back.

New SASAC rules signal greater transparency and accountability

There has been some suggestion that there is a “crackdown” by Chinese authorities on outbound foreign direct investment (OFDI) by Chinese State-owned Enterprises.

I have seen no evidence to suggest that the new rules announced by China’s State Assets Supervision and Administration Commission (SASAC) are anything more than the legitimate and reasonable wish of the Chinese government to get greater comfort about the quality of the investment decisions to maximise the benefits of the transactions. They do not signal an end or decline in OFDI which is largely driven by a readjustment of China’s economic growth model.

The new measures come into effect from May 2012. They restrict an SoE from making any OFDI in non-core business areas except in special circumstances as approved by SASAC. The measures also provide that SoEs must report to SASAC prior to making major OFDI related to their core businesses with details of an investment plan and financing sources. If an SoE breaches the rules and suffers a major loss, SASAC has reiterated that the enterprise and related persons will be held accountable.
Despite first impressions, these new rules are no more than a step in the evolution of SASAC’s current OFDI rules. Significantly, the 2011 Interim Measures require SoEs to procure feasibility studies and due diligence for all OFDI.

In particular where:

• state-owned assets located in the PRC are used as consideration for an overseas investment, an appraisal conducted by a domestic valuation institution is required; and
• an off-shore subsidiary of an SoE is to purchase overseas assets, a professional institution of sufficient expertise and reputation must be engaged to conduct a valuation or appraisal of the transaction.

The transaction price must then be based on these appraisals.
As a package, the 2011 and 2012 measures reflect a desire to strengthen the investment processes and accountability of SoEs. Statements from Chinese officials have indicated the aim of the new rules is to prevent SoEs from blindly diversifying into high risk sectors or making speculative investments abroad.

The new measures reflect a growing sophistication of Chinese authorities in managing risks associated with OFDI. They do not signal an end or decline in OFDI. Indeed, China’s accumulative OFDI is forecast to grow by 17% between 2011-15 reaching US$560 million by 2015.
Earlier this year MOFCOM reaffirmed China’s commitment to its “Going Out Policy”, stating the Government will guide and encourage local companies to enhance cooperation and invest abroad in manufacturing, energy, culture and engineering. MOFCOM has also stated that China will promote outbound investment in service sectors including finance, architecture, tourism, education and telecommunications. This reflects a logical shift in Chinese OFDI toward commercial operations in advanced economies like Australia.

The scale of businesses operated by SoEs abroad has grown exponentially as has the range of sectors in which they are investing and the complexity of the investment transactions.
While the direct effect of the new rules cannot be measured, the rules may imply a shift in the nature of Chinese OFDI in Australia with a focus on joint ventures or minority stakes in quality proven assets. This is a trend that we have already seen emerging.

The message for Australian vendors is they must understand and appreciate a SoE’s investment criteria and structuring requirements to formulate a successful deal. SoE’s will be focused on thorough due diligence, careful structuring and negotiation of the transaction to maximise synergies and benefits. Where JVs are the chosen investment method, management of relationships between the two partners will be critical to success.

I welcome SASAC’s strengthening oversight of Chinese OFDI. Ultimately, the new measures encourage accountability and transparency, two of the key principles underpinning investment by government related entities in Australia’s Foreign Investment Policy.

New rules for M&A in the PRC

Commencing 1 September 2011, China has a new ‘security review’ system for mergers and acquisitions of domestic enterprises by foreign investors.

 

Far from being a new hurdle for foreign investors to jump over, the new regime is intended to "increase the transparency and predictability of China's reviews of foreign investment and promote more ordered mergers and acquisitions in China."

Interestingly, the new procedures bear some similarities to Australia’s Foreign Investment Review Board (FIRB), which has ruled on planned Chinese investments in Australia and which can block deals it deems not to be in the national interest. FIRB advises Australia's treasurer, who has the final say.

China’s new ‘security review’ rules have established an Interdepartmental Committee system to review acquisitions of domestic enterprises.

The Interdepartmental Committee will be led day to day by the National Development and Reform Commission (NDRC) and Ministry of Commerce (MOFCOM) under the guidance of the State Council.

Like the FIRB, the Interdepartmental Committee is expected to involve other departments as required for information or to build consensus in the government but it will not necessarily invite those departments to take an active role in the review process.

National interest

Determining what is considered ’in, or not in, the national interest’ is dependent upon the way that foreign investor is controlled in China.
Under Chinese rules all foreigners and acquisitions are regulated according to industry groupings that are either encouraged, permitted, restricted or prohibited. Some economic sectors that are restricted or prohibited are analogous to areas of mandatory review under Australia's foreign interest rules (eg aviation and telecommunications) and some have no equivalent (eg the processing of traditional green tea).
In almost all cases the threshold for security review will be that the foreign investor must acquire “actual control” of the enterprise. ‘Actual control’ includes situations where any foreign investor or combination of investors will hold more than 50% of an enterprise’s equity, or where voting rights give a foreign investor significant influence over shareholder meetings or board meetings.
It seems that Chinese regulators are to be given a broad mandate when reviewing transactions. The Interdepartmental Committee will examine the transaction’s influence on national defence, economic stability, basic societal order and research and development capacity related to national security.
In the Chinese context, "national security” appears to be a more embracing and complex concept than would be typically found in a western definition, but one that is not totally inconsistent with what has been applied in Australia.
In Australia the equivalent national interest test has been described as “… something that is defined by the Australian Government and the Australian people. It is not static and cannot be defined in a mechanical way.”
Like the PRC model Australia’s foreign investment legislation does not provide a mechanical definition or guidelines against which to measure the national Interest. FIRB, as the advisory body to the Treasurer, is not obliged to reveal either how it arrived at a decision or what it recommends to the Treasurer.
It is in fact rare for the Treasurer to issue formal reasons for the approval or prohibition of transactions. Earlier this year the Treasurer took the unusual step of providing some insight into his thinking in prohibiting the acquisition of ASX by SGX. However, this is far from the norm.
In Australia the national interest includes:

• preserving of national security;
• preserving of Government revenue;
• evidence that the participant will respect Australian law and business practices;
• avoiding of inappropriate levels of competition or excessive concentration;
• consistency with Government policies; and
• the character of the investor.

Much like China the most ambiguous and difficult to predict is the national security test. This test has on occasions been applied to prohibit acquirers from purchasing mining assets that were considered too close to the Woomera prohibited area and in the SGX transaction it was considered by reference to the systemic security of Australia’s financial system.
In the SGX takeover there is no doubt the Treasurer formed the view that a takeover of ASX may have meant a loss of “full regulatory sovereignty” that might have impacted on Australian regulatory authorities’ capacity to protect the system from financial crisis.

OECD’s view

Australia’s regulatory regime sits in the mid-point of OECD countries in terms of its relative level of restrictiveness. The OECD’s FDI Regulatory Restrictiveness Index (FDI Index) measures statutory restrictions on foreign direct investment in 49 countries, including all OECD and G20 countries, and covers 22 sectors. Australia’s score is held back by the fact that the national interest test is seen as a “discriminatory screening requirement”.

Australia ranks seventh among the 34 advanced nations on an index measuring the height of the barriers countries put in front of international companies wanting to invest. This is despite Australia being decidedly pro-investment and the fact that the national interest test to reject foreign investments is rarely invoked.
The OECD’s annual Going for Growth found that screening might create uncertainties that limit foreign direct investment. Indeed the review suggested that:

Transparency would be enhanced by more information on the criteria applied in government decisions and by involving specialist agencies (e.g. national securities) in the review process of FDI approval.

China’s foreign investment regulatory regime is currently ranked as the second most restrictive on the FDI Index. However, with the introduction of a transparent set of rules and procedures governing security reviews of cross-border M&A transactions, we would hope to see China improve its score in future versions of the FDI Index.

Conclusion

Both the Australian and Chinese governments have chosen a model that allows them to retain the flexibility to be able to deal with the consequences or externalities that may arise from a foreign takeover.
As noted by the OECD there is potentially great merit in both governments providing greater transparency around the assessment process so that there is more certainty for foreign investors. Communicating how and why decisions to approve or prohibit transactions would be one way to provide transparency by which others could judge how the process operated.

A win for common sense not a blow to continuous disclosure but perhaps its time for a new way forward...

In 2004 and 2005 the Australian Securities & Investments Commission alleged Fortescue had failed to properly inform the market about contracts with a Chinese group concerning the development of rail infrastructure.
The Federal Court did not accept that proposition, later the Full Federal Court overruled that decision and now they in turn have been overruled by a unanimous decision of the High Court.
ASIC is considering the impact of the High Court's decision on the continuous disclosure requirements. It seems they are concerned that the market is unclear what companies need to disclose about the nature and content of an agreement, and “what is necessary to ensure that the market is properly informed for the purposes of making investment decisions.''
For a number of years commentators including (Greg Golding and Ronald Barusch) have expressed concern that the continuous disclosure regime was developing in a way where there was a substantial gap between what companies thought was appropriate and what the courts expected of them. The Fortescue case demonstrates that the High Court (at least) is much closer to the market’s perspective of what is required than their brothers on the Full Federal Court.
Indeed, the High Court decision suggests that directors involved in companies dealing with continuous disclosure have more scope to manage their announcements than had previously been thought. But maybe it also says something about whether ASIC is really the right body to be making decisions about market expectations concerning continuous disclosure.
The case is a win for commonsense. The 46 page judgment demonstrates the High Court’s commerciality and understanding of the nature of the cut and thrust of commercial life. But unfortunately very few of the companies or directors who need to consider their disclosure obligations are in a position to have the damning allegations of a regulator hang over them for a long period and the resources to seek the wisdom of the High Court.
Indeed, the case underscores the fact that the continuous disclosure announcements are often made in difficult circumstances where directors are trying to strike the right balance between the need to disclose too much and not enough. Justice Dyson Heydon seems to have recognised the difficulties faced by directors when he described in his separate judgment that the comments in relation to Fortescue’s contracts with Chinese China Railway Engineering Corp, China Harbour Engineering Corp and the China Metallurgical Construction Corporation were not directed to the public as a whole.

They were directed to a section of the public. It comprised superannuation funds, other large institutions, other wealthy investors, stock brokers and other financial advisers, specialised financial journalists, as well as smaller investors reliant on advice. This was not a naive audience. It was not an audience in whom the adjectives "Western Australian", "mining" and "Chinese" would excite a sudden certainty about the imminent creation of wealth beyond the dreams of avarice.

The majority decision of four judges also found that “the parties’ stated intention of making a legally binding agreement was genuinely shared by them”. In the end what we see is a judgment where the High Court has focussed on the underlying question of what is required in order for a statement not to constitute misleading or deceptive conduct. Because the High Court found there was no misleading or deceptive conduct, they did not explore other issues like directors’ obligations under the continuous disclosure laws or the application of the business judgement defence.
Clearly each case turns on its facts and the High Court was at pains to point out that its reasons in this case did not establish any general proposition to the effect that any public statement that company A has made a contract with company B necessarily conveys to its audience a message only about what the contractual document contains.
We can only hope that when the ASX and ASIC settle down to resolve the new wording of the proposed revised Guidance Note 8 that commonsense will also prevail. The meanings of words such as “immediately”, “aware” and “materiality” need to be construed with the same sensible approach as the High Court adopted and with due regard to commonsense and the environment in which the market and continuous disclosures operate.
But maybe the issue is bigger than this case. In 2002 (Making Continuous Disclosure Work – Outcomes v. Enforcement, JASSA, Spring 2002) I and others (see H Corlett, R da Silva Rosa and T Walter Corporate Executives’ Experiences of Continuous Disclosure) argued the need for our system of regulating continuous disclosure to leverage off the significant and measurable success of the Takeovers Panel and to introduce a “Disclosure Division” of that body to perform a non-judicial function related to disclosure misconduct.
Since 5 September 1994 continuous disclosure by Australian listed companies has been the foundation upon which much of our scheme for the efficient regulation of markets has been based. Our system of compulsory immediate release of information is based on an assumption that investors should be able to make investment decisions in the light of the best possible information and the powerful disinfecting quality of sunlight. That high-quality disclosure, in as near to real time as possible, will ensure that share prices better reflect value enhancing market accuracy. In that sense, the requirement of continuous disclosure is based on the market information principle, an assumption that the efficiency of a capital market depends on the amount of information available to and its distribution, among investors. But it also requires real time solutions to disclosure issues.
It is important to remember the nature of the problems that have emerged in this field. These issues are largely about the requirements of ASX Listing Rule 3.1 a provision that is somewhat aspirational in its terms. Like all the ASX Listing Rules, Rule 3.1 needs to be read (whatever its detail) by reference to the spirit, intention and purpose of the ASX Listing Rules and by looking beyond form to substance. As long ago as 1986 Young J. said:

"One falls into error if one treats the requirements of the listing rules as a technical document for construction in the same way as a statute. To my mind the listing requirements are a flexible set of guidelines for commercial people to be policed by commercial people. They are in the same category as guidelines or standards laid down by administrative bodies who are administering an Act of Parliament. These guidelines or standards are never intended to be inflexible rules, but rather principles to be administered and applied by an expert body in accordance with the prevailing ethos of those chosen to administer them.” see Fire & All Risks Insurance Co Ltd v Pioneer Concrete Services Ltd (1986) 10 ACLR 760 noted on appeal 10 ACLR 801 at 806.

Clearly the court is supporting the view that the ASX Listing Rules are not the kind of rules that ought to be enforced by a regulator like ASIC or that are traditionally associated with offences the subject of penalty notices or similar judicial processes.
While the current arrangements work satisfactorily there is scope to improve the provisions, not through penalty provisions or enforceable undertakings, but rather through the establishment of a new Disclosure Division of the Takeovers Panel.
The Disclosure Division would be designed to act with speed, it could apply a uniform standard based on experience and peer review of questions of compliance with continuous disclosure obligations. The Disclosure Division could determine whether there had been any “unacceptable disclosure practice” having regard to the spirit of the market misconduct provisions. A new approach could provide a considerable enhancement to the existing continuous disclosure regime. It may be an idea whose time has come.