Will the 12th Five-year Plan live up to its goals?

Since 2012, central government proposals to set up funds for specific SEIs have been issued. The Shanghai government set up an Rmb3bn ($480 million) industrial development fund for SEIs in 2010, with funding from 17 venture capital enterprises. Similar funds have been established in the coastal regions of China. Some local policies require a portion of new bank loans to be extended to SEI sectors.

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Environmental policies and industrial transformation

The Plan targets specific reductions in energy consumption and emissions. Incentives for SEIs that can help achieve the targets are available in a wide variety of sectors, including biofuels, renewables, waste disposal and renewable energy vehicles, and others, such as shale gas and recycling industries, are in the process of being formulated. Consumer subsidies, such as extending the 2006 renewables subsidy programme to cover, from 2012, excess amounts paid for power supplies from renewable energy sources over the price of regular power from the public grid under the Tentative Measures for the Administration of the Collection and Use of the Renewable Energy Development Fund (可再生能源发展基金征收使用管理暂行办法), and exempting biodiesel containing at least 70% recycled oil from consumption tax (2011 Notice of the Ministry of Finance and the State Administration of Taxation on Consumption Tax Exemption regarding Pure Biodiesel Made from Waste Animal Fat or Vegetable Oil (财政部、国家税务总局关于对利用废弃的动植物油生产纯生物柴油免征消费税的通知)), may go some ways towards achieving these targets. Yet, the scale of renewables subsidies awarded since 2006 has dwarfed the renewables energy levies that finance them, and has also resulted in unproductive overcapacity, with many of the subsidised projects unable to connect to the public power grid still monopolised by state-owned enterprises (SOEs).

This shows the importance of monitoring the use and application of the incentives awarded and of reform of and cooperation between private companies and SOEs (a separate objective of the Plan). China's electricity regulator sought in its Implementing Opinions on Strengthening Regulations of Electricity and Supporting Private Capital Investment in Electricity（关于加强电力监管支持民间资本投资电力的实施意见）of June 2012 to provide private enterprises with equal access to the power grid, but its powers to ensure this in practice are arguably inadequate. In contrast, the biodiesel subsidy appears to have been a success. In May 2012, Yunhua New Energy Technologies announced the largest biodiesel project in China to date. Separately, direct subsidies and tax benefits to investors include reimbursement of investments in energy-saving technologies (announced in May 2012 by the NDRC) and tax breaks for clean technology contractors from 2011 (industry turnover doubled from Rmb63bn to Rmb128bn in the policy's first year). Looking further ahead, provincial governments are introducing exchange-traded pre-approved carbon emissions reductions. These markets will in principle be open to domestic and foreign investors, but trading on a trial basis has just begun in major cities such as Shanghai and Guangzhou and a fully operational market is not expected before 2015, so their effect on the Plan's emissions targets is uncertain.

Traditional manufacturing industries need upgrading to achieve the Plan's goals, requiring improvements in product quality and technical capability including specialised technologies in equipment manufacturing and metallurgy, LNG/LPG shipbuilding, green materials and high-technology fibres and eliminating obsolete capacity. With SOEs active in many of the industries targeted, SOE cooperation will be equally important. Specific initiatives include removing lagging technology in coking and steel industries, where draft requirements to reduce emissions and phase out high-energy consumables have been circulated by the Ministry of Industry and Information Technology (though implementation is expected to be slow, given the global economic slowdown), and technological upgrades such as, in Shanghai, substituting clean energy for 1,300 coking oil-fired boilers and generating 8m kilowatts of power using high-efficiency generators (2m of which is targeted for 2012).

The Plan also looks to outbound investment in accelerating China's industrial transformation. Investors are encouraged to build international sales networks and brands, with China's approval of Bright Food's acquisition of Weetabix a case in point. Proposed initiatives include, in the Measures for Administration of Approval of Outbound Investment Projects (Draft for Consultation) (境外投资项目核准管理办法（征求意见稿）), removing approval requirements for investments made by non-parent-funded overseas subsidiaries and ending NDRC bidder pre-selection requirements for deals below a threshold amount.

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Encouraging R&D

The Plan emphasises R&D in developing SEIs and accelerating industrial transformation. Various incentives, mainly in eastern China and varying between regions in nature and extent, are available for R&D centres. These measures complement existing favourable tax treatment for accredited high-technology enterprises, now including qualified SEI enterprises. R&D centres fulfilling certain conditions have since 2009 been entitled to tax deductions on the purchase of equipment. Approximately 350 R&D centres have been set up by multinationals in Shanghai. Under the Shanghai Municipality, Several Opinions on Encouraging Foreign Investors to Establish Research and Development Centres（上海市关于鼓励外商投资设立研发中心的若干意见), additional tax relief on technology licensing and import and R&D expenditure on state-directed projects has been made available since 2012 to foreign-funded R&D centres in the biotechnology sectors, as well as assistance with commercialisation of the resultant research. Key biotechnology companies setting up R&D centres in 2012 include Covidien, Novo Nordisk, Pfizer, Eli Lilly and DuPont. However, R&D faces constraints on growth from a shortage of engineers, analysts and other technicians as a result of recent expansion in SEI investments.

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The key to industrial transformation

The services sector, in which the Plan aims at increasing value-add from 43% to 47%, is key to domestic consumption and the necessary skills for the SEIs and industrial transformation under the Plan. Given the leading position of many foreign-service enterprises, foreign participation is critical.

Financial services

Convertibility of the renminbi and availability of renminbi investment options are the two key drivers of the Plan's financial sector reforms. Renminbi cross-border settlement was extended to more than 20 provinces in June 2010 and has been available nationwide since August 2011. In the Circular on Further Improving and Revising the Foreign Exchange Control Policy on Direct Investment (关于进一步改进和调整直接投资外汇管理政策的通知) issued by SAFE in November 2012, China further simplified formalities for inbound cross-border remittances, phasing out the approval requirements for the opening of foreign exchange bank accounts to receive and convert into renminbi inbound remittances in foreign direct investments and consideration for transfers of equity in domestic entities, replacing them with a registration system which can be operated directly by the account bank. The effect of these reforms is expected to show in mid-2013 as upgrades of existing systems complete.

Under the financial sector sub-plan, detailed reforms include cross-border financing and the opening up of capital account transactions for individuals. Capital market reforms include pricing and disclosure requirements of A share IPOs, the expansion of the over-the-counter market and new channels for issuance of private placement bonds by small and medium-sized enterprises. The establishment of the Shanghai International Board and the issue of listed preference shares will be among the proposals closely monitored. Various foreign fund managers including JPMorgan, Goldman Sachs, TPG and Blackstone have been licensed to manage renminbi under Shanghai and Beijing's new qualified foreign limited partner (QFLP) schemes. Numerous applications are reported under another recently launched pilot programme, allowing foreign private managers to raise funds from qualified domestic limited partners for investments overseas. However, an NDRC notice provides that restrictions on foreign investors continue to apply to QFLPs, showing that practical uncertainties as to the significance of the reforms remain.

Non-financial services

Service providers will benefit financially from the phased introduction of VAT, replacing business tax, enabling service providers to pass the tax cost up the value chain (following a successful roll-out in Shanghai in 2012), and local policies which give priority to service sectors in the supply of land and discounts and instalment payments in the pricing of land use rights, further tax incentives for warehouse use by logistics companies and preferential pricing policies for utilities supply. That the China portfolio of Global Logistics Properties (the largest provider of logistics facilities in Asia) has increased by 58% to 6.36m square metres and from 20 to 26 Chinese cities from 2011 to 2012 shows the success of these policies. Direct government subsidies include Shanghai's services development fund revamped in 2012 and in operation since 2009 (there have been around 200 recipients of subsidies under this fund in the past two years), and dedicated outsourcing fund (recipients include subsidiaries of Infosys and Nippon Telegraph and Telephone Corporation, in addition to PRC enterprises).

The Plan seeks to fuel domestic consumption by developing services like retail and entertainment. Public opinion on draft rules for food and beverage enterprises is being sought and IPO disclosure rules specific to food and beverage enterprises have been published, indicating that the suspension of vetting of their IPO applications, in force since 2011, may be lifted. Most provincial governments have reduced the entertainment levy from 20% to between 5% and 8% and in February 2012, seven ministries issued an opinion calling for banks to increase lending to tourism, followed in July by the first-ever loan to be secured against operating rights to a scenic tourist area in addition to construction land.

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Private enterprise: a key engine of growth

China's private enterprises have historically competed on an uneven playing field against SOEs. Central and provincial authorities now encourage financial institutions to provide more financing support to private enterprises. Government funds supporting SEIs are required to be offered to SOEs and private enterprises on an equal basis. However, private enterprises are still disadvantaged compared with SOEs in obtaining credit from domestic banks and have resorted to shadow banking and supply chain financing. This presents opportunities for foreign owned lenders.

Private enterprise investment on equal terms with SOEs is encouraged. In the logistics industry, under the Implementing Opinions on Encouraging and Guiding Private Investment into the Logistics Industry (关于鼓励和引导民间投资进入物流领域的实施意见) applications for vehicle permits are required to be awarded on an equal basis between SOEs and private enterprises, and private enterprises making new investments in logistics will receive land and vehicle permit related incentives. However, a policy opinion in June 2012 encouraging private enterprises to invest in the energy sector, the Implementing Opinions of the National Energy Bureau on Encouraging and Guiding Further Expansion of Private Investment into the Energy Sector (国家能源局关于鼓励和引导民间资本进一步扩大能源领域投资的实施意见), has not enabled private enterprises to obtain the crude oil import permits monopolised by SOEs, affecting the profitability of private investments.

The opening of the Chi-Next board, a second board of the Shenzhen Stock Exchange mainly targeted at private enterprises and technology companies in late 2009 was followed by initiatives passed in 2010 to clarify and improve its procedures for capital raising. Further challenges are in ensuring that high-quality companies are floated and maintained, however, although small steps have been made with the revisions made in April 2012 to the delisting rules of the Chi-Next board.

Balanced development

As with previous initiatives, the Plan aims to spread economic prosperity inland and from the urban to the rural population. This is key to the market for SEIs and advanced service industries in China. February 2012 saw the 12th Five-year Plan for Promoting the Economy of the Western Regions (西部大开发“十二五”规划). This targets areas in 12 lower-income provinces for consolidation into regional centres of economic activity. Specific plans include continuing its Rmb700 billion annual investment commitment in rail projects, including a direct rail network between Sichuan and Tibet as well as 18 motorways linking the eastern cities with the western regions. China regularly reviews its classification of industries for additional liberalisation and incentives to kick-start growth in Central and Western China and the regional presence of multinationals who are leading players in their industries, such as Kazakhmys and Eurasian Natural Resources Corporation in the mining sector in Xinjiang, shows regional policy's potential for China and foreign investors. Many regions already benefit from favourable land use and tax policies. The trend since 2007 is for more rapid GDP growth in central and western China than in coastal regions.

The PRC Social Insurance Law (社会保险法), effective July 2011, establishes nationwide basic pensions, medical, occupational injury, unemployment and maternity insurance schemes. The law's intention is for basic pensions to be funded and disbursed in accordance with nationally applicable standards, and for service periods for calculation of pensions, medical and unemployment benefits to be portable between regions. Detailed rules on implementation, including transition from the current systems, are awaited. The Social Insurance Law was followed by a concerted rollout of the existing New Rural Co-operative Medical Scheme（新型农村合作医疗制度）providing medical subsidies to rural residents. The scheme, now covering 800 million people and 97.5% of Chinese farmers, aims to reimburse 90% of certain medical costs of poorer patients, and to provide an annual medical insurance subsidy by 2015.

Fewer incentives and more rules needed

The strategic focus of the Plan's implementation so far has been on incentives and subsidies, with less emphasis on formulating rules to provide certainty for private investors and development of the skills supply needed to further promote the SEIs. Experience to date, as seen in the renewables sector, shows that pursuing a single set of objectives at the expense of other growth factors, such as infrastructure, support services and revenues, should be avoided. Investors in SEI sectors (each SEI has its own sub-plan) need to understand the available and potential incentives, the types of M&A targets and local partners likely to benefit from these incentives, the services and infrastructure support and the likely response by local governments and industry participants to proposed policy changes. Equally, investors in non-SEI sectors need to consider rule changes on their own financing and investment plans and regulatory compliance, including changes to the pattern of demand for their products and services as a result of specific SEI incentives.

Fang Jian, Nicola Mayo and Bryan Chan, Linklaters, Shanghai