How to get your money out of China

Compared with the rapid expansion of renminbi settlement for imports of goods, cross-border trade in services and other current account transactions under the Pilot Scheme, the availability of renminbi settlement for exports of goods was treated with greater caution. Before February 3 2012, only those Chinese exporters which were enlisted on the trial were able to use renminbi to settle exports of goods. Initially, only 365 pilot enterprises were allowed to use renminbi to settle trading transactions involving exports of goods. Up to the opening-up of renminbi settlement for exports of goods to all Chinese exporters on February 3 2012, over 67,000 pilot enterprises were allowed to make this type of settlement.

This gradual policy may have resulted from the Chinese government's concerns over fraudulent claims for value-added tax refunds, given that the opening-up of renminbi settlement for exports of goods could expand the scope for such fraudulent claims. Since February 2012, the Chinese government has developed a mechanism to exert intensified supervision on key targets. Under this mechanism, an enterprise listed on the “List of Enterprises Subject to Intensified Supervision” (those thought to represent a higher risk of engaging in VAT refund fraud) will be subject to intensified supervision when settling cross-border trades in renminbi. The renminbi derived by them from renminbi settlements for cross-border trading transactions cannot be deposited offshore. As of June 12 2012, this list covered 9,502 enterprises.

To facilitate the Pilot Scheme, the Chinese government has, since October 2010, allowed offshore entities to open non-resident renminbi bank settlement accounts (NRAs) with onshore banks and use NRAs for lawful cross-border renminbi business. NRAs cannot be used for cash operations (except with the PBOC's approval) and the renminbi in NRAs cannot be converted into a foreign currency. The renminbi in NRAs is essentially treated as being offshore and can be remitted to offshore accounts, paid to Chinese exporters of goods or services (or Chinese payees under other current account transactions), and used for renminbi FDI purposes. NRAs provide a new settlement channel for cross-border renminbi business, and a new tool for the Chinese government to indirectly regulate offshore renminbi. However, bankers in China we have talked to who offer NRAs are finding that they are more in the nature of a transitional device to fill in the gap while foreign countries work out bilateral arrangements and create the infrastructure for having renminbi accounts in overseas countries. Once it becomes possible to have an account in renminbi in a country other than an NRA, hedged around as it is with all the restrictions on what you can and cannot do with the renminbi held in it, essentially becomes redundant, given the liberalisation and internationalisation of the renminbi as a payment currency for current account transactions.

Renminbi ODI Scheme

To promote the usage and acceptability of the renminbi offshore, the Chinese government launched a pilot renminbi overseas direct investment (ODI) scheme in January 2011 to allow Chinese companies (including FIEs) to use the renminbi to invest in projects outside China. To further support the renminbi ODI Pilot Scheme, the Chinese government has, since April 2011, started to allow Chinese non-financial sector companies to extend renminbi loans to their overseas investee companies, subject to quotas approved by the competent SAFE.

Renminbi ODI is another crucial step by the Chinese government towards renminbi internationalisation. According to many economists and market observers, before becoming a global currency, a currency must become a pricing and settlement currency for both trade and investment transactions. The launch of the renminbi ODI Pilot Scheme is also consistent with the “going out” (“走出去”) policies implemented by the Chinese government. Chinese companies have long been encouraged to diversify their asset bases and risks by investing overseas. Renminbi flowing out of China through the renminbi ODI Pilot Scheme projects also helps to alleviate the onshore liquidity surplus and to further ease inflationary pressures in China.

Renminbi FDI

With the successful implementation of the Pilot Scheme, more foreign investors now hold a sizeable amount of renminbi offshore. On the one hand, the offshore investment channels for the renminbi are limited, and need to be expanded. On the other hand, the Chinese government is concerned about the risks associated with speculation by offshore renminbi holders on future appreciation of the renminbi.

In order to widen the onshore investment channels for offshore renminbi funds and reduce the risks of currency speculation activities, the Chinese government has, since October 2011, adopted a set of new renminbi foreign direct investment (FDI) rules to allow and regulate renminbi FDI projects, with certain sectors restricted or excluded and subject to the existing law on foreign direct investments. This policy means that foreign investors who have overseas renminbi can now use that as an alternative payment currency for capital contributions to FDI projects in China, which have so far been required to have been made in foreign currency. This is a very interesting development that somewhat blurs the very clear historical distinction between foreign and Chinese investors based on the source and currency of funds contributed to Sino-foreign joint ventures, for example. Now it is possible to have a Sino-foreign JV where all parties invest using renminbi. The renminbi FDI Rules represent another important plank of the Chinese government's policy on the internationalisation of the renminbi.

Under the renminbi FDI Rules, the source of offshore renminbi used for renminbi FDI purposes must be lawful. Renminbi funds earmarked for renminbi FDI must not be used to invest in securities or financial derivative products (with limited exceptions), for arranging entrusted loans, or purchase wealth investment products or real property onshore which is not for self-use. Unless the investee FIE is a foreign-invested investment company (投资性公司), its renminbi capital or renminbi loans borrowed from offshore lenders must not be used to make any onshore reinvestments.

An investee FIE may borrow renminbi loans from its foreign shareholders, affiliates or overseas financial institutions, but the renminbi loans and non- renminbi loans borrowed will be calculated together for foreign debt administration purposes. The renminbi funds must be borrowed at interest rates independently determined by and between the lender and the borrower and must fall within a reasonable range in accordance with commercial principles (i.e. no disguised distributions of profits). It is interesting to note that this arguably resolves the age old conundrum for China lawyers as to whether renminbi borrowings should be counted for total investment amount calculation purposes. The rules state clearly that the total amount of renminbi -denominated loans (it does not mention the word “overseas” in this context) and foreign currency loans borrowed by a foreign invested enterprise shall not exceed the difference between its total investment and registered capital. In other words, they all count. Those who are in the 'No' camp will, however argue that the context is such that it is referring to renminbi loans from overseas and it is only 'foreign debt type loans' that are counted, whether in foreign currency or renminbi. The rules on renminbi borrowings by foreign-invested investment companies are that the existing rules on foreign exchange borrowing by such entities will apply to offshore renminbi-denominated loans, but the two will be aggregated for regulatory compliance measurement purposes. If its registered capital has not been duly injected as subscribed, the FIE may not borrow in renminbi from offshore lenders. Consistent with existing policy on foreign currency loans, foreign-invested real estate developers may not borrow renminbi loans from offshore lenders.

Expanding the QFII scheme

To further facilitate the flow-back of renminbi funds sitting offshore, the Chinese government kicked off a pilot RQFII program in December 2011 with an initial quota of Rmb20 billion ($3.2 billion) and later increased it to Rmb50 billion in April 2012. This allows RQFIIs to use renminbi funds raised in Hong Kong to invest in the onshore Chinese securities market to the extent of their permitted quotas and subject to the investment instrument being within the permitted scope. With the promulgation of a set of pilot rules on RQFIIs, RQFII funds can now give offshore renminbi holders access to the mainland China bond and equity markets (including the inter-bank bond and exchange-traded bond market) through an RQFII quota. This potentially expands the scope of the existing Qualified Foreign Institutional Investor Scheme which is only open to foreign institutional investors and which had previously provided the only channel for foreign institutions to lawfully get exposure to a portfolio of A shares in China as well as other equity and debt instruments authorised by the securities regulator, the China Securities Regulatory Commission (CSRC).

Currently, RQFII funds must invest primarily in renminbi bonds and bond funds issued in mainland China. Such investments must make up at least 80% of the fund's assets. RQFII funds may also invest in China A-shares and other equity investments permitted under the RQFII rules. However, such investment may not exceed 20% of the fund's assets.

So far, approved pilot RQFIIs are Hong Kong subsidiaries of qualified mainland China asset management and securities firms. Market observers believe and hope that the scope of RQFIIs and the total investment quota available to RQFIIs will be further expanded in the near future.

Hong Kong as the testing ground

With the support of the Chinese government, Hong Kong has become the largest renminbi offshore market in the world. At the end of January 2012, total renminbi deposits in Hong Kong were Rmb576 billion. From July 2009 to July 2012, the value of renminbi settlements conducted through Hong Kong's banks reached Rmb2.8 trillion, accounting for 61.3% of cumulative renminbi settlements conducted offshore. The Hong Kong market has developed various renminbi -denominated financial products such as 'dim sum' bonds, government bonds, bank bonds, shares, renminbi gold Exchange Traded Funds, deliverable forwards and deliverable renminbi futures.

According to a news report, the Guangzhou Branch of PBOC issued guidance on cross-border renminbi financing in January 2012 allowing certain qualified domestic capital companies (and FIEs which do not have a foreign debt quota) to borrow, through their subsidiaries or branches in Hong Kong, short-term renminbi loans from Hong Kong banks for their projects in Guangdong. In other words, this breaks with the long-standing prohibition on domestic capital companies being able to borrow from overseas in foreign currency except with SAFE approval (which we understand was rarely, if ever, given). It has been reported that 10 Guangdong-based companies have been approved to borrow renminbi loans in Hong Kong under this scheme. Once enacted and expanded to cover other provinces, this arrangement will provide a new and important financing channel for domestic capital companies. Market observers believe that the Chinese government will continue to use Hong Kong as a platform for testing cross-border renminbi financing.

A freely convertible currency

Free convertibility of renminbi on the capital account transactions and full renminbi internationalisation are the mid-to-long-term goals of the Chinese government. A freely convertible currency, is, in our view, brought closer as a result of the internationalisation policy, but still remains a few years away.

In the short run, according to the 12th Five-year Plan for the Development and Reform of the Financial Industry (金融业发展和改革“十二五”规划) issued by PBOC, CBRC, CSRC, China Insurance Regulatory Commission and SAFE on September 17 2012 the Chinese government will continue to make efforts to, among other things, “loosen restrictions on cross-border capital flows”. However, when a new set of rules are established (particularly when new rules are frequently issued by various government agencies with different regulatory interests and areas), there will always be problems with the interactions between different Chinese government agencies and conflicts between the existing rules and the new rules, which will take time to resolve. These types of conflicts have existed for many years and are nothing new. Regulators in China frequently tussle over approval rights over a specific industry or type of project. The classic example is the National Development and Reform Commission and the Ministry of Commerce with respect to approval rights for projects involving foreign investment.

These turf wars do not detract from the clear determination of the Chinese government to take many individually small but collectively important steps towards the internationalisation of the renminbi and, ultimately, the full convertibility of the renminbi on the capital account, which seems inevitable over the longer term, although it is difficult to say exactly when. China's main concern about full convertibility is possible attacks by speculators bringing down the currency. The size of China's reserves which are available to fight such a strategy would suggest that as of now, that would be a difficult battle for the speculators to win.

For foreign investors, the impact of the changes will be felt in many ways, including the new option of engaging in foreign direct investment in China using offshore renminbi, then using the FIE to borrow renminbi as well as foreign currency loans to finance that FIE. These options were simply not available a few years back. Foreign investors will, however, be hoping for a broader church of institutions to be allowed to become RQFIIs and perhaps a relaxation in the minefield that is the rules governing foreign related security (对外担保).

The trend is overall clearly positive and things are moving in the right direction: hopefully when China gets comfortable that the renminbi is being widely accepted overseas as both a trading settlement and a reserve currency, it will be able to make the last final step towards full convertibility that will bring an end to an area of regulation that has historically been one of the most challenging and tricky for investors and lawyers. This can only be good news for increasing foreign investment in China, and will make the investor's question on whether it can get its money out of China forever a thing of the past.

Jun Wei, Andrew McGinty, Kitty Y Zhang and Xi Liao, Hogan Lovells