Auto Finance Companies Finally Get the Green Light in China

Highlights of the Rules

Definition and Governing Authority

AFCs are non-bank financial legal entities chartered and regulated by the CBRC that provide loans for auto buyers and dealers in mainland China.

Requirements for the Investor

If the investor is a non-financial entity, its total assets of the previous year shall be no less than Rmb4 billion, and its annual business revenue shall be no less than Rmb2 billion. If the investor is a non-bank financial institution, it shall have a registered capital of no less than Rmb300 million. In addition, the investor must be continuously profitable for the three years prior to its application. The largest investor, who shall contribute no less than 30% of an AFC's total equity, must be an auto enterprise that manufactures or sells whole cars, or a non-bank financial institution.

Registered Capital Requirement for AFCs

The minimum registered capital of an AFC is Rmb500 million. This requirement will be subject to adjustments by the CBRC based on the development of the auto finance industry and the need for prudential supervision.

Application Procedure

The establishment of an AFC consists of two steps: application for preparation, and application for commencement of business. To apply for the preparation of an AFC, the applicant must submit the application, feasibility report, articles of association, a list of the persons responsible for the preparation and their resumes, and information of each investor, including their balance sheets, profit-and-loss statement and cash flow statement for the three previous years. Foreign non-bank financial institutions must submit written consent from their home country's supervisory authority. Non-financial entities must submit their credit rating report for the previous year.

The application will be processed within six months of its submission, after which an approval letter will be issued to the applicant to commence the preparation stage of the AFC. The preparation stage shall last no longer than six months after receipt of the approval letter unless extended for three months upon approval. If the applicant fails to apply for business commencement before expiration of the preparation stage, the approval for the AFC will automatically become void. The Procedures stipulate that the applicant cannot conduct an auto finance business during its preparation stage.

To apply for the commencement of business, the applicant must submit, before the end of the preparation stage, a report of the preparation stage, application for business commencement, capital verification report, pre-approval notice for the company name, articles of association of the AFC, a list of senior management personnel and their resumes, name and capital contribution of each shareholder, proposed business rules and internal risk control procedures, safety inspection certificates for the business premises and facilities, and other documents required by the CBRC.

Upon approval by the CBRC, the applicant will receive a licence, which it shall submit to the State Administration of Industry and Commerce in order to register and obtain a corporate legal entity business licence. The AFC shall then commence business within three months of receiving the business licence and shall not suspend operation for six consecutive months thereafter.

Limitations

There are some important restrictions on the auto finance company, the most significant of which are the following:

(i) an AFC cannot set up any branch or subsidiary in China;

(ii) the appointment of the senior managerial personnel shall be subject to qualification review by the CBRC;

(iii) an AFC cannot issue bonds or borrow funds from overseas without approval;

(iv) the capital adequacy ratio of an AFC shall be no less than 10%;

(v) a single investor cannot invest in more than one AFC;

(vi) major changes of the AFC, such as the company name, the equity structure or the business scope, are subject to approval by the CBRC; and

(vii) business transactions of the AFC involving foreign exchange shall be subject to relevant regulations yet to be published.

Scope of Business

The AFC can:

(i) take deposits with a minimum maturity of three months from its shareholders in mainland China;

(ii) extend loans for auto purchases;

(iii) extend loans to auto dealers for the purpose of purchasing automobiles or facilities for operations;

(iv) transfer and sell auto loan receivables;

(v) borrow from financial institutions;

(vi) provide guarantees for auto purchase finance;

(vii) engage in agency business related to auto finance; and

(viii) other loan business approved by the CBRC.

Reactions to the Procedures

Chinese Automobile Manufacturers

The high entry thresholds make it unlikely that domestic companies will establish AFCs in the short term. Since the significance of the Procedures lies in the opening of the Chinese auto finance market, one of the central issues is how high the entry thresholds should be. Although the Procedures have considerably lowered the total asset requirement for the investor, from Rmb8 billion in the draft to Rmb4 billion, it has not changed the minimum paid-in capital requirement of Rmb500 million.

Evidently, the capital requirement is not at all difficult to meet for the automobile giants. Shanghai Automotive Corporation (Group), First Automobile Works (FAW) Group Co. and Dong Feng Motor Co. each boast total assets of over Rmb50 billion.⁹ In addition, Shanghai Auto and FAW both control about 40% of their financial subsidiaries, SAIC Financial Affairs Co. Ltd and First Auto Finance Co. Ltd, respectively.¹⁰ The latter realized a profit of Rmb20 million in 2002.¹¹ Dong Feng has also established auto finance services via a joint venture. The "Big Three" only need to extend their existing businesses in order to establish their AFCs.

By contrast, medium to small-sized auto manufacturers will have considerable difficulty in reaching the threshold. Their lukewarm reactions to the Procedures are reflective of the grim prospects that they have for expansion in this area. When the legislation was still in draft form, Huachen Auto Co. and Qirui Auto Co. Ltd both expressed interest in entering the auto finance market.¹² However, subsequent to the issuance of the Procedures neither made specific plans to establish AFCs. Changfeng Auto Co.'s financial subsidiary used to provide auto finance services, but recently such services have been discontinued.¹³ Like these three, most of the domestic automakers are eager to establish AFCs, but limited financial resources and the high capital requirements will bar their entry into the market for the short term at least. Consequently, contrary to what some have hoped, domestic automakers will be generally unaffected by the Procedures.

Foreign Automobile Manufacturers

Big foreign players are likely to be the first to reap benefits from the Procedures, but are wary of the limitations imposed on them in the new legislation. In most markets, the auto finance market is a major source of profits. According to a study conducted by Goldman Sachs, less than 40% of an automobile's lifecycle profits is attributable to manufacturing, the remaining 60+% of the profits are generated through distribution and services.¹⁴ All of the world's largest automakers have established AFCs to support their sales worldwide. For GM and Ford, profits generated by auto finance services account for about 36% of their total profits.¹⁵ As a matter of course, these auto manufacturing giants are eager to introduce their financial services into China, which, in recent years, has become the fastest growing automobile market in the world.

In the 1990s, global auto giants sought access to China's auto finance market. In spite of market constraints, some of these foreign auto manufacturers collaborated with Chinese banks to provide auto finance services to their dealers.

Experts anticipate Ford, GM, Volkswagen, Toyota and Honda to be the first to apply for the AFC licence now that the Procedures have finally come out.

While foreign automakers have expressed much enthusiasm about the promulgation of the Procedures, their next steps are not without reservation. Limited financial resources and particular risk factors are the major sources of their tentativeness.

Pursuant to the Procedures, AFCs are limited to three sources of financing: self-possessed funds, shareholder deposits and loans from financial institutions. Although the shareholders in this case are multinational oligopolies, they have only a limited amount of renminbi generated by revenues in China. Converting foreign currencies into renminbi is both burdensome and costly. Besides, an AFC's shareholders might not be willing to allocate a large amount of renminbi as a deposit. For example, over the next few years, Volkswagen plans to invest ? billion in China, all of which will come from FAW-VW and Shanghai VW.¹⁶ Clearly, in capital allocation, priority will be given to the investment project rather than the AFC. Thus, at the commencement of business of the AFC, the only viable method to obtain renminbi will be loans from financial institutions. According to stipulations from the CBRC, the lowest interest rate an AFC can offer to a borrower is 10% less than the basic interest rate set by the central bank.¹⁷ As a consequence, the AFC will not be able to offer zero-interest loans to attract consumers, as they do in foreign markets.

Although foreign automakers have considerable experience in international auto finance markets, they need to adapt to the particularities of the Chinese market. Since China does not have an adequate credit system, risk management will be a whole new ball game for these multinationals.

Limitations of the scope of business and territory of operation are also factors that add to the risk borne by AFCs. According to the Procedures, the AFC cannot establish branches. Consequently, the Rmb500 million in registered capital will be confined to business within the province or region where the AFC is registered. In addition, an investor cannot invest in more than one AFC, further adding to the investor's risk. Also, the AFC cannot conduct any non-auto finance business, nor can it offer auto-leasing services, which are common in foreign markets. Finally, the Procedures stipulate that the capital adequacy ratio shall be no less than 10%, imposing yet another constraint on the AFC's cash flow and business operations.

Given these obstacles and the length of the application procedure, the most optimistic estimate is that foreign auto giants will successfully establish their AFCs by the end of 2004.

Chinese Banks

Chinese banks have been providing auto and real estate finance services since 1995. In 1998, upon promulgation of relevant legislation, these banks broadened their scale of auto finance services. The four major state-owned banks have since become dominant players in the auto financing market. As of July 2003, auto loans from the "Big Four" totalled Rmb140.9 billion,¹⁸ constituting 95% of China's auto financing market.¹⁹ In 2002, the balance from auto loans totalled Rmb100.36 billion²⁰ for the Big Four banks.²¹

In addition to their market dominance, the Big Four enjoy other advantages over new AFCs. To begin with, Chinese banks have abundant reserves of renminbi capital, extensive service networks throughout the country, advanced payment methods and professional expertise in finance. Second, after many years in the auto financing business, the banks have accumulated considerable client resources and credit information. Third, Chinese banks already operate in cooperation with a wide range of automakers and auto dealers.

In the short run, given their dominant position and advantages, Chinese banks are unlikely to be threatened by the entry of AFCs. Rather, experts see prospects of cooperation between AFCs and banks. For instance, instead of directly issuing loans to individual consumers, the banks can lend to AFCs. As a result, AFCs will have a secured channel of capital funds, and in return Chinese banks can be rid of the high risks in direct loans to consumers. In addition, Chinese banks and AFCs can share their credit information and risk management methods acquired both domestically and abroad.

Of course, Chinese banks are aware of the impact that the Procedures will have on their market dominance in the long run. In developed auto finance markets, AFCs are usually the dominating players. In the United States, for example, AFCs offer consumers a wide range of repair and maintenance services with which US banks cannot compete. The Chinese auto finance market will likely move towards this international norm as it matures with progressive automotive market liberalization. This prospect coincides with the legislative intent of the Procedures.

Car Dealers and Other Non-bank Financial Institutions

In the past, in the absence of auto finance legislation, many car dealers and non-bank financial institutions assumed the role of AFCs. Car dealers have often issued loans from funds raised on their own to facilitate automobile sales. For most large auto dealers, such self-issued loans often boosted annual sales by 20% to 30%.²² With the promulgation of the Procedures, such practices will be subject to regulation and fines. In Article 34 of the Procedures, it is stipulated that any auto finance business set up without the approval of the CBRC shall be closed. If these car dealers continue such practice, they will be subject to fines of up to Rmb500,000 and confiscation of illegal proceeds. Moreover, the Procedures stipulate that without the CBRC's prior approval, the inclusion of words such as "auto finance", or "auto loan" in a company's name will subject the company to a fine of Rmb1,000. In view of these provisions, most Chinese trusts, car dealers and financial leasing companies that are currently offering auto finance services will have to reconfigure their operations. Moreover, given their current business scale, most domestic non-bank financial institutions will not be able to attain the threshold of entry as stipulated in the Procedures. Nevertheless, the size of reform in the auto finance market will ultimately depend on how rigorously the Procedures are applied.

Auto Buyers

Consumers will be the ultimate beneficiaries of market liberalization. With the establishment of AFCs, auto consumers will be offered an attractive alternative to auto loans from Chinese banks. Since automobiles are movables, auto loans are considered highly risky. Recent statistics show that 30% of auto loans in China are bad loans.²³ To protect themselves against such risk, state banks have imposed stringent requirements on auto loan applicants. In China, one has to go through at least seven different organizations to take out an auto loan from a bank.²⁴ Since AFCs are specialized financial institutions, they will have a much more effective mechanism to minimize such risk. Many auto consumers anticipate that the AFCs will introduce simplified application procedures and waive the various guarantee and insurance requirements imposed by the banks.

Moreover, unlike banking institutions, AFCs will not set their focus on earning interest from auto loans. Rather, the main objective of an AFC will be to boost the sales for its affiliated auto manufacturer. Thus the new AFCs are likely to offer consumers not only lower interest rates but also comprehensive package deals in collaboration with the auto manufacturer's repair and maintenance services.

Conclusion

The promulgation of the Procedures is the first step in the gradual liberalization of the Chinese auto finance market. Its implementation will regulate existing practices while allowing entry of foreign expertise into the domestic market. The future of new AFCs will depend on four factors: the development of the auto market; the maturity of the credit system; the effectiveness of risk management; and the mentality of car buyers. As a caveat to the reader, it is still too soon to make specific predictions about how the AFCs will fare, since the CBRC has yet to unveil the relevant implementing rules for proper regulation of the auto finance market.

The authors would like to acknowledge the valuable contributions of Sha Hua, an intern in the Sidley Austin Brown & Wood Shanghai office.

Endnotes

1 "China's auto financing market must set up risk prevention mechanism," China Industrial Journal (Zhongguo Gongye Bao), August 7 2003, http://chanye.sina.net/jr/2003-08-07/175845.shtml.

2 Zhendong Liu, "Promulgation of rules, foreign giants officially begin competition for auto financing market," Economic Information Daily (Jingji Cankao Bao), October 8 2003.

3 "Auto financing company, loud thunder little rain, foreign manufacturers wait and see," Yuegang Xinxi Ribao, October 9 2003.

4 Wanquan Gu, "Auto financing, difficulty in its unveiling," Jiefang Daily, October 13 2003, www.jfdaily.com/gb/node2/node142/node144/userobjectlai298549. html.

5 "Promoting liberalization, normalizing development," Financial News (Jinrong Shibao), October 8 2003, http://www.financialnews.com.cn/jryw/200310080054.htm.

6 Feng Xu, "GM, Ford welcome new policy, division in auto financing market?" 21CN Business Herald (21 Shiji Jinji Baodao), October 13 2003.

7 http://www.china.org.cn/english/2003/Feb/55176.htm

8 See supra note 2.

9 http://www.dfmc.cn.

10 Dongping Li, "Auto financing company: Truth or myth," Caijing Zhoukan, October 12 2003, www.p5w.net/p5w/home/stime/week/200310131437.html.

11 See supra note 6.

12 Zhongqi Zhu, "Foreign giants dash to reap benefits in auto financing," Nanfang Dushi Bao, October 13 2003.

13 Ibid.

14 See supra note 7.

15 He Zhong, "Reserved optimism of foreign investors in auto financing market," International Business Daily (Guoji Shangbao), October 17 2003.

16 Zi Juan, "Auto financing companies not yet able to compete with Chinese banks," Zhongguo Zingying Bao, October 11 2003,
http://cfi.net.cn/idx/newspage.asp?200310110595.

17 Qi Xia, Xing Shen, "Banks not to contract auto financing business, 0% interest not likely," Xinkuai Bao, October 14 2003, www.cncar.net/news/shownews.asp?nid=370.

18 Of this total, Rmb49.52 billion was from the Agricultural Bank of China, Rmb36.6 billion from Bank of China, Rmb30.56 billion from the Industrial and Commercial Bank of China (ICBC), and the remaining Rmb24.21 billion was from China Construction Bank.

19 See supra note 6.

20 Rmb35 billion from the Bank of China, Rmb30 billion from the Agricultural Bank of China, Rmb21 billion from the ICBC, and Rmb14.36 billion from China Construction Bank.

21 See supra note 1.

22 See supra note 10.

23 See supra note 12.

24 Qiumei Wang, Maiqi Yang, "Loan application procedures should be simplified," Nanfang Dushi Bao, October 13 2003.