Foreign Currency Debt and Conversion Controls Tightened for Strong RMB Era

The amount of foreign debt permitted to an FIE was tightened in principle from March 1 2003 by requiring that most³ "short-term"⁴ debts, along with medium⁵ and long-term⁶ debts, be kept within the difference between the FIE's registered capital⁷ and its approved "total investment".⁸ This change was set out in the Foreign Debt Administration Tentative Procedures (the 2003 Debt Procedures).⁹ But the 2003 Debt Procedures did not spell out implementation mechanisms, and SAFE deferred implementation while waiting for the issuance of implementing rules. 15 months later, no formal implementing rules have been issued, but the 2004 Debt Circular contains sufficient guidance to enable at least partial implementation of the 2003 Debt Procedures, and SAFE has indicated informally that it will now attempt to begin implementation.

Mandatory Funds Repatriation

The most dramatic new requirement is for excess foreign debt funds of an FIE to be returned through the original remittance channel, by the bank holding the funds, acting at the direction of the local SAFE Bureau (Section 3 of the 2004 Debt Circular). But most excess foreign loan proceeds have not remained in their original bank accounts, and instead have been spent or invested into fixed assets. They may have been converted into RMB for use in domestic expenditures or investments, or may have been paid out directly as foreign currency to foreign suppliers of goods, services and/or capital assets. They may also have been converted into RMB for the purpose of direct injection into the FIE's reserve fund, expansion fund or employee welfare fund, but it is more likely that these "three funds" have been funded from retained RMB operating profits.

The question of whether or how an FIE should be compelled to raise funds to be repatriated is not addressed in the 2004 Debt Circular. In theory, foreign currency funds could be raised directly, e.g., by making foreign sales of goods, services and/or capital assets, or indirectly, e.g., by making domestic sales of goods, services and/or capital assets to raise RMB to be converted into foreign currency and then remitted outward back through the original channel of inward remittance. But there is no published basis for any of these approaches.

Approvals for Increases

An FIE may apply to the local foreign investment authorities for examination and approval of an increase of its total investment to the level necessary to cover its excess foreign debts. The local SAFE bureau can extend a three month grace period to an FIE that is applying for this increase (Section 3 of the 2004 Debt Circular).

But approvals of increased total investment may be difficult to obtain. No special arrangements have been made for the handling of such applications by local or central foreign investment authorities or the local registration authorities. Neither foreign investment nor registration authorities were involved in issuing the 2003 Debt Procedures or the 2004 Debt Circular.

Where the needed increase would move an FIE above the limit of the local approval authority, making it subject to central MOFCOM approval,¹⁰ particular complexities may arise. Where an FIE had been purposefully kept under this limit in order to enable local approval, perhaps because of anticipated difficulties to obtain central approval, local authorities are likely to resist sending an application for an increase to the central level.

Where an increase would not exceed the local approval limit, local authorities are likely to issue approvals easily, especially where the FIE has simply omitted to request the maximum amount of total investment corresponding to its registered capital, or where the FIE voluntarily applies to increase its registered capital and total investment in tandem. But many FIEs have purposefully kept their registered capital at the lowest possible level,¹¹ and will not apply for an increase unless they are compelled to do so.

Enforcement

Where an FIE with excess foreign debts, and without funds available for repatriation, does not voluntarily apply to increase its total investment, it is difficult to see how PRC government authorities might seek to compel FIE compliance with the clean-up procedures contemplated by the 2004 Debt Circular. The most extreme sanction would be to cancel an FIE's business licence, possession of which is the basic precondition of a company's ability to do business and to have its existence recognized. Such cancellation would have to be implemented by the local Administration of Industry and Commerce (AIC), presumably acting under the instructions of the foreign investment authorities that had originally approved the FIE's establishment. But no mechanism exists at present for coordinating such procedures.

The most logical potential sanction would be the most difficult to adopt, because it would be complex and would require a high level of coordination between different government networks, but might be attractive to government authorities where the FIE is a wholly foreign-owned enterprise. This sanction would be to deem a portion of loans received from an FIE's investor to be converted into capital contributions. Such a conversion on a voluntary basis, with government approval, is already a recognized procedure. This approach would normally result in the converted funds being stuck in the FIE until the FIE's liquidation. Rather than generating interest payable at agreed times from the FIE's free cash flow, the converted funds could only generate profit distributions to be made after the FIE had earned an operating profit for a full year, made up previous years' losses, paid taxes and made contributions to internal funds.

Most likely, enforcement will be passive and incomplete. First, the local SAFE branch will reject applications for new registrations of agreements for excess foreign loans, including rollovers of previous loans. Second, a local SAFE bureau might reject applications for conversion of RMB and remittance of foreign currency as payment of interest on excess foreign debts. Thereafter, SAFE may not be in any hurry to determine when, how, or if the foreign lender would still be entitled to receive interest and principal on unregistered foreign debts. This would leave foreign lenders uncertain of whether their claims would eventually have priority equal to that of other loans, or that of contributed capital, or would have even lower priority, or perhaps be completely extinguished.

Trade Credit?

The above uncertainty gives FIEs an incentive to avoid overtly breaching the new restrictions, and also deters FIEs from excessively exploiting the "trade credit loophole". Trade credit of less than 90 days is not within the prevailing definition of "short-term debts" for purposes of an FIE's debt-equity ratio. There is no apparent barrier to an FIE receiving unlimited amounts of financing through the mechanism of trade credit (with a stated term of 89 days or less), including from its parent company. There is also no apparent barrier to an FIE failing for an indefinite period to pay off its trade credit, and thereby effectively converting it into longer-term debt. But visible exploitation of this loophole would annoy the local SAFE bureau and could encourage local authorities to adopt the more onerous enforcement approaches discussed above.

An Increased Role for RMB Financing

The above risks might be avoided by an FIE promptly borrowing RMB and applying to convert the RMB into foreign currency to repay excess foreign debts. Although in principle an FIE's RMB debts are also (in the aggregate with foreign debts) not permitted to exceed the difference between registered capital and total investment, there is no government department with direct responsibility for enforcing compliance. RMB debts of FIEs are not within the responsibility of SAFE and are not directly affected by the either the 2003 Debt Procedures or the 2004 Debt Circular. No serious concern about this issue has been displayed by MOFCOM or by bank regulators under the Ministry of Finance. Under present circumstances, an increase in RMB debts appears to be the path of least resistance to enable an FIE to comply with the 2004 Debt Circular without an undesired increase in its registered capital.

To increase RMB borrowings will entail meeting the creditworthiness and/or security requirements of RMB lenders, which have been toughened. But this toughening can make FIEs appear to lenders as more attractive borrowers than domestically owned companies. An FIE with a creditworthy foreign affiliate or banking relationship can further increase its attractiveness by arranging for a foreign guarantee to be provided in favour of an RMB lender.

Some FIEs will have no choice but to reorganize their RMB lending and to increase their reliance on parent company guarantees. Among the excess foreign loan funds likely to be repatriated under the 2004 Debt Circular are foreign currency funds held in bank accounts serving as collateral for RMB loans. This was a common financing structure in the era when FIEs sought to hedge against an expected devaluation of the RMB. If the foreign currency funds are repatriated, the lender is likely to call in repayment of the secured RMB loan, unless the FIE can arrange substitute security, such as a foreign guarantee.

FIEs will need to rely more heavily on domestically owned lenders of RMB, because foreign-invested PRC banks and foreign bank branches will have their RMB lending capacity constrained by new restrictions on (i) annual quota issuance, (ii) verification of short, medium and long-term foreign borrowings, and (iii) exchanges between RMB and foreign currencies.¹² These restrictions also appear to be part of the broader policy of toughening control over flows into RMB.

Usage of Foreign Funds

FIEs' usage of foreign funds from any source are also further restricted in the 2004 Debt Circular, as follows:

¡P First, where more than US$200,000 of foreign currency is covered by a single application for conversion into RMB, the converting bank is not permitted to deposit the RMB funds into the FIE's account, but must instead remit the RMB funds directly to the party to whom the FIE is obligated to make payment. (Presumably the bank will be required to reject any attempts to separate a larger transaction into multiple applications that are each below US$200,000.) The application for such conversion and remittance must be supported by documents showing the payment obligation and the details of the payee (2004 Debt Circular, Section 1).

¡P Second, where foreign currency is converted into RMB for an enterprise's small payments for wages, fund reserves, or foreign exchange settlements with an amount less than US$200,000, the converting bank may deposit the RMB funds into the FIE's account, but the FIE must document its usage of these funds and attach the documentation to its subsequent application for conversion of additional funds (2004 Debt Circular, Section 1).

¡P Third, foreign currency must not be converted for the purpose of paying off RMB loans (2004 Debt Circular, Section 2). (One can only speculate whether this prohibition could be interpreted to prevent any attempt by an RMB lending bank to enforce its security interest over a foreign currency bank deposit.)

Conclusion

Fund inflows are the main target of SAFE's recent changes. This reflects the government's recent concern that "hot money" inflows into RMB are stoking domestic inflation and potentially turning RMB revaluation rumours into a self-fulfilling prophecy. It was not many years ago that SAFE's restrictions and scrutiny reflected a primary concern to prevent "capital flight" outflows from RMB. This change reflects a fundamental strengthening in international markets' confidence in China's economy. Some FIEs will lament the loss of opportunities to hedge against or to bet on an RMB revaluation, but many will enjoy a countervailing benefit if China's inflation can be controlled.

We expect that most FIEs will not need increased capital contributions from their investors, but the transition now getting underway may be disruptive, especially for FIEs that take no action until they are faced with enforcement procedures. The smoothest transition will be enjoyed by those FIEs that proactively update their financial structures.

Endnotes

1 Hot money inflows appear to raise two primary concerns. The first is the upward pressure on domestic inflation and the value of the RMB. The second is their vulnerability to sudden large-scale repatriation, as occurred in Thailand in 1997, and is widely considered to have triggered the 1997-1998 Asian currency and financial crisis. The PRC was not directly affected by that crisis, in large part because of restrictions on currency conversion and repatriation, and the government is determined not to allow its deregulation programme to increase vulnerability in this area.

2 Capital flight outflows have become less of a concern in recent years, as confidence in the RMB and interest in PRC investment opportunities has grown. This has been reflected in a series of liberalizing steps, including substantially deregulating FIEs' outward remittances for current account items, and loosening restrictions on domestic PRC companies' ability to make investments, acquisitions and expenditures abroad.

3 The "balance" of existing short-term foreign debts will be covered. This undefined term appears to mean the net amount of short-term debts after deducting short-term creditor claims held by the FIE. It is not clear whether the calculation will include the FIE's short-term trade credit to customers, or other accounts receivable, which of course fluctuate frequently. Logically, all debts, claims, accounts receivable and accounts payable with a term between 90 days and one year should be included in this calculation. Previously, it was the unwritten policy of SAFE to exempt from applicable borrowing limits short-term foreign borrowings for the purpose of funding an FIE's liquid capital for operational expenses.

4 "Short-term" borrowings are borrowings with a term of one year or less. See Article 2, Lending General Provisions, issued by the People's Bank of China and effective August 1 1996.

5 "Medium-term" borrowings are borrowings with a term of more than one year and less than five years (including five years). See idem.

6 "Long-term" borrowings are borrowings with a term of more than five years. See idem.

7 "Registered capital" primarily means the capital of an FIE or other company that is subscribed to and then contributed by investors (see Article 18 of the PRC Sino-foreign Equity Joint Venture Law Implementing Regulations, last amended in 2001), although the same phrase is also used to describe the investors' ownership interest in the company.

8 "Total Investment" in effect means the sum of (a) registered capital, and (b) permitted debt (other than exempted debt), although it is formally defined as "all funds for construction [investment in capital assets such as purchase of land, buildings and equipment] and production working capital [liquid capital for operational expenses such as personnel, raw materials, components, inventory and lease of land, buildings and equipment]" of an FIE. See Article 17 of the Equity Joint Venture Law Implementing Regulations.

9 The 2003 Debt Procedures, issued by the State Development and Planning Commission and the Ministry of Finance along with SAFE, are analyzed in Yin, Stender and Kong, "FIE Financing and the New Foreign Debt Procedures", China Law & Practice, March 2003, 17(2), pp. 71-73.

10 US$30 million of total investment is generally the limit of the approval authority at the level of provinces and major municipalities.

11 Incentives for a foreign investor to minimize registered capital contributions include the requirement that registered capital be contributed within a limited time period, and the effective prohibition on registered capital being withdrawn before the FIE's termination, even if the FIE's capital assets have been depreciated to a level where the FIE's capital needs are lower. But these incentives have been weakened now that a profitable FIE is permitted to invest part of its registered capital by establishing or acquiring ownership in other companies, including wholly owned subsidiaries or joint ventures.

12 See the Foreign Debt Administration of Foreign-invested Banks in China Procedures, issued by SAFE on May 27 2004 and effective 30 days thereafter.