More advanced treasury management skills like cash pooling could be used. Also, if the foreign investor has a fairly large Chinese business presence, it could consider establishing an enterprise group finance company to provide treasury management services to its Chinese affiliates. This removes the need for a bank intermediary, but the foreign investor has to set up a foreign-invested holding company.

Lastly, inter-company trades – such as advance payments by cash-rich subsidiaries, or deferred payments by cash-poor ones – are another option.

Cross-border funding is trickier. Advance or deferred payment arrangements under cross-border trades are subject to the scrutiny of China's foreign exchange regulator and quota control (10% for advance payments by a Chinese company, for example).

Since June, mainland Chinese companies have been permitted to lend overseas under stringent conditions. However, the borrowing company offshore must be an overseas subsidiary of the PRC lender, which makes upstream lending to a foreign investor by its Chinese subsidiaries impossible for the moment.

Another option exists for sizeable multinational enterprises that can meet the foreign exchange regulator's criteria. Approval could be gained for the onshore company to lend to overseas members of the multinational, including parent or sister companies, although the loans cannot exceed the unpaid profits attributable to the foreign investor and the lending companies will require sufficient foreign exchange surpluses. Multinational enterprises with treasury centres in Shanghai's Pudong district can use renminbi to purchase foreign exchange funds for such loans.

TieCheng Yang
Partner
Clifford Chance

The domestic perspective
Under the highly-regulated financial and foreign exchange regime of China, with direct inter-company lending prohibited, a number of companies face this question, along with the question of how to manage liquidity. According to our understanding of the regulatory framework and experience in the field of foreign direct investment and corporate finance, there are two approaches to optimising liquidity management in China.

The first approach involves business-related tools to realise the liquidity and operate the cash flow of related companies. Under a bilateral trade transaction, a cash-rich entity may remit the money it generated to a cash-poor entity related to it at home or abroad in the form of payment of service or royalty fees to fund the cash-poor entity and to make the most use of the money.

Aside from bilateral trade transactions, business-related tools could also be used in multilateral trade transactions to achieve the goal of liquidity management of a group of companies.

The second approach involves an entrustment loan with the services provided by banks to optimise the funds sufficient for each entity. With the banks as intermediary, an entity with excess cash may loan the money to a cash-poor entity designated by it under the terms specified by the cash-rich entity.

An entrustment loan also could be employed to improve the use of funds among multiple entities by means of a multilateral entrustment loan or cash concentration. With simplified documentation, members of a group reduce the cost of separate bilateral entrustment loans.

It is of critical importance to choose the appropriate approach to manage the liquidity of each entity, since the situations of every entity are different from each other. We continue to keep a close watch on the development of regulations in respect of liquidity management.

Julia Zhu
Partner
Grandall Legal Group

The investor's perspective
Although some bondholders who are relative newcomers to the China market may think the “cash trap” issue is a recent one that is only causing problems because of the economic times in which we are living, this is simply not the case. Those of us who have been working in China for a long time realise that this issue has severely impacted strategic investors (such as multinationals that operate cash rich operations in China trying to get “full credit” from Wall Street for the cash they hold that is trapped in China) and financial investors (such as private equity funds trying to exercise redemption rights) for more than 20 years.

Unfortunately, the solutions being discussed at bondholder meetings these days are not long-term ones. They are quick fixes that generally entail costs (additional taxes, fees, and interest paid to third parties and risk) that would not be acceptable to investors or investee companies in any situation other than one in which some investors feel pressed to realise liquidity, even if at the cost of a significant haircut, and are in turn putting pressure on investee companies to use any means available to pay amounts that are due.

Taking a step back from this discussion of immediate fixes, we should consider long-term solutions to the cash trap issue. There is no substitute for hard work at the outset of an investment. Plans for repayment of loans and the payment of redemption amounts, if required, should fully take into account foreign exchange control issues. Too many business plans simply ignore the bold line between China and the rest of the world and make assumptions about dividends and other movement of cash across that line that defy reality. Investors must dig deep, understand the impact of various regulatory restrictions on the potential for the companies in which they are investing to distribute cash and incorporate those understandings into the plans that they prepare and depend on in analysing and structuring investment opportunities.

Finally, the investment community needs to work with the Chinese government in a co-operative manner to reach the goal of reduction and eventual elimination of the foreign-exchange controls that are at the root of the cash trap issue. This process may seem to be a “two steps forward and one step back” process or even, at times, a “one step forward and two steps back” process. However, from a long-term perspective it is clear that progress has been and will be made in this area.

Marcia Ellis
Chief legal officer for Asia
D. E. Shaw group

The views expressed herein are solely those of its author and not of any entity in the D. E. Shaw group, are subject to change without notice, and may not reflect the views of any member of the D. E. Shaw group regarding Chinese foreign exchange controls.