China overhauls cross-border financing regime

The PRC banking system still trails in terms of flexibility and maturity compared with those in western jurisdictions. Onshore lenders have traditionally been more willing to sign off on debt to large state-owned firms, while small- and medium-sized enterprises (SMEs) have had to shop around more intensely and pay higher interest rates.

“Privately run companies and SMEs have long found it difficult to obtain NDRC [National Development and Reform Commission] approval for offshore funding,” said Stanley Zhou, a partner at King & Wood Mallesons in Shanghai. The NDRC is the agency responsible for managing China's macroeconomy.

Amending the previous policy was necessary to aid the country's private sector, said JunHe partner Bing (Benson) Cui. This regime allows domestic-funded companies to convert their foreign borrowings to renminbi for onshore use, whereas getting clearance on this was extremely tough earlier, he added.

It's worth noting that the purpose of using this debt is limited to an entity's registered business scope, meaning borrowers are only permitted to spend the money on fixed assets, operations and for working capital. Using the cash to repay outstanding loans is not allowed, and neither is securities trading or project/acquisition financing, unless the business scope includes equity investment (i.e. hedge funds and private equity firms).

The new scheme excludes real estate enterprises and local government financing vehicles (LGFVs). The reasoning here is most likely that the property market still needs time to cool down, while LGFVs have been slammed by global investors for having piled up high levels of debt amid increasing default risks.

Figures from Bloomberg show that outstanding bonds issued by LGFVs—often criticized as opaque—were at Rmb4 trillion at the end of March. Local government debt, as a ratio of regional tax revenue, swelled to 195% in 2015 from 153% in 2013.

Complex calculations

The macroprudential management system put forward by the Circular involves weighing the risk ratios of an enterprise's cross-border financing limit and outstanding debt amount. Companies need to ensure that the balance does not exceed the cap.

The new formula is quite complicated and takes into account factors such as the term and currency of the loan, said Zhou. (Articles 3 and 6 show the calculation methods for the risk weighted balance and limit.)

This is in contrast to the current regime for FIEs, which uses a straightforward equation for determining whether the company has adequate headroom within its borrowing gap—calculated as the difference between its registered capital and total investment—to undertake the required foreign debt registration.

This method of using only two input figures has been criticized for being too black and white, and unable to reflect a borrower's real risk exposure.

“The new scheme, which is a net asset-based calculation, offers more flexibility and allows FIEs that are in good financial and operational standing to borrow more money than those that aren't doing so well,” Zhou said.

Cashflow & currency considerations

Practitioners also highlighted that plugging different tenors and currency denominations into the formula results in varying foreign debt limits, with Zhou saying that the PBOC appears to be encouraging companies to seek mid- and long-term offshore debt in renminbi.

“For example, the new equation makes it so that if a company's borrowing limit is Rmb1.5 million, it can borrow that much in renminbi,” he said. “But if it wants to borrow in U.S. dollars, it'll be able to get the U.S. dollar equivalent of Rmb1 million. Similarly, a limit of Rmb1.5 million for a long-term loan would be Rmb1 million for a short-term one.”

This facet is aimed at contributing to the internationalization of China's currency, with the PBOC pushing its global usage as the renminbi prepares to enter the IMF's Special Drawing Rights in October.

The Chinese central bank's focus on shorter-term financing could be the result of recent volatility in the offshore renminbi market. The PBOC had to burn through hundreds of billions of dollars of its foreign exchange (FX) reserves late last year and early in 2016 to defend its currency as speculators shorted the renminbi to take advantage of the difference in onshore and offshore rates. The resulting volatility pushed up the overnight renminbi interbank rate in Hong Kong to an improbable 67% on January 12.

Long-term loan transactions are more stable, and the PBOC and SAFE [State Administration of Foreign Exchange] are looking to steady the PRC balance sheet. China has been experiencing significant capital outflows since the second half of 2015 amid both national and international expectations that the renminbi will continue to depreciate.

The FX specifics of the new scheme have been highlighted in the Circular on Further Promoting Convenient Trade and Investment Procedures and Improving Reviews on Genuineness (国家外汇管理局关于进一步促进贸易投资便利化完善真实性审核的通知) (SAFE Circular), issued by SAFE on April 26.

The huge pressure of capital outflows has prompted the FX regulator to strengthen authenticity reviews on cross-border transactions and crack down on illegal and fake money transfers. Banks must now follow stricter standards of scrutiny and parties are required to submit more documentary evidence of compliance.

“The SAFE Circular makes it clear that all cross-border cash flows must be based on real trade,” said JunHe's Cui. “For instance, while previously banks only needed to review the board resolution for handling dividend and profit distributions, they are now required to examine the tax filing sheet and the most recent financial statement of the onshore entity as well.”

SAFE will also look for any serious imbalance between the cross-border flow of cash and goods, Cui said, adding that any company that fails to explain its uneven levels in a satisfactory manner will be downgraded. Lower-grade enterprises' cross-border deals will be subject to greater scrutiny.

On June 9, SAFE issued the Circular on Reforming and Regulating the Policy for the Control of the Conversion of Foreign Exchange on the Capital Account, which clarified FX conversion methods for the foreign debt proceeds of both Chinese companies and FIEs.*

The road ahead for FIEs

FIEs now face the option of following the new regime or sticking with the existing framework for obtaining foreign debt, and must submit their decision to the PBOC and SAFE. The Circular provides a transition period, though according to a Clifford Chance client briefing, the length of this period remains unclear, as does which financing regime will permanently apply to FIEs after it's over.

It may be possible for FIEs to borrow more money using the new formula under certain circumstances, said Clifford Chance's Yang. That said, the greater number of parameters set by the PBOC will require companies to consider many more elements, and depending on the business nature, financing structure and asset status of an FIE, some may prefer to use the old method, he added.

An Allen & Overy alert compared the new and existing schemes: “On the one hand, calculation under the new regime may more accurately reflect the actual leverage (instead of the previous regime where the long-term debt will permanently consume the headroom) of an FIE as the quota is determined with reference to the amount of actual outstanding foreign debt and current net assets or capital. On the other hand, the new regime may potentially reduce the amount of foreign debt which may be borrowed by an FIE with insufficient net asset value (e.g. those engaged in greenfield development may need to rely on the headroom to incur foreign debt for the purpose of developing a project). This may, in turn, have the effect of limiting the ability of a foreign shareholder of an FIE to manage the capital structure of that FIE by putting in shareholder loans within the headroom, which would be limited by the net asset value of that FIE under the new regime.”

Reporting lines & conflicts with NDRC

The Circular sets out the roles the PBOC and SAFE play in regulating cross-border financing. The former will govern 27 registered banks (see the Attachment at the end of the Circular), while the latter will handle filings of all other financial institutions and corporates (excluding real estate firms and LGFVs), both domestic and foreign.

Corporates must file with SAFE after signing a cross-border financing agreement and at least three days prior to drawdown of the debt. Financial institutions must file their debt limit and remaining quota with the PBOC or SAFE and then again when the agreement is signed. All borrowers also need to make post-filings and update the authorities as required. Both agencies will impose penalties for violations and suspensions on any foreign debt business for serious breaches.

Yang pointed out that there were some inconsistencies that need to be resolved: “The reporting lines to the PBOC and SAFE are clear, but the Circular doesn't refer to NDRC filing. The NDRC issued Circular 2044 on September 14 last year that set a ceiling at a national level for debt with a tenor of more than one year, in contrast to the PBOC which has put forth a formula that produces individual quotas.”

The NDRC also said it would give favorable treatment to companies investing as part of the One Belt, One Road initiative, and set a filing requirement for any loan with a term over a year as a pre-condition for drawdown, which is absent in the PBOC Circular, said Cui. The national registration system gave the NDRC control over the country's foreign debt size.

Follow-up questions

King & Wood Mallesons' Zhou said he is interested in how cross-border asset transfers—specifically, domestic non-performing loans (NPLs) invested in by overseas parties—will be affected. The Circular permits onshore borrowers to owe debt to offshore lenders within the borrowing limit and post-filing, and commercial investors interested in NPLs may wish to understand how they can take part in the scheme, he said.

On the whole, the Circular will make executing transactions smoother.

“Because it was difficult for locally-funded companies to borrow cash from offshore firms, we usually advised them to obtain funding from an onshore entity backed by a cross-border security or guarantee, which was complicated and, in most cases, is still subject to the borrower's net asset volume,” said Cui. “But this new regime allows for direct financing and much more simplified deal structures.”

Table 1

Balance calculation (Article 3)

Cross-border financing risk weighted balance = Σ renminbi and foreign currency denominated cross-border financing balance × maturity risk conversion factor × type risk conversion factor + Σ foreign currency denominated cross-border financing balance × exchange risk conversion factor

Maturity risk conversion factor: 1 for medium- and long-term cross-border financing with a repayment term of more than one year, and 1.5 for short-term cross-border financing with a repayment term of up to one year.

Type risk conversion factor: 1 for on-balance-sheet financing, and provisionally set at 1 for off-balance-sheet financing (contingent liabilities).

Exchange risk conversion factor: 0.5.

Limit calculation (Article 6)

Upper limit of the cross-border financing risk weighted balance = capital or net assets × cross-border financing leverage ratio × macroprudential adjustment parameter.

Capital or net assets: calculated by an enterprise based on its net assets, by a banking financial institution (including policy banks, commercial banks, rural cooperative banks, urban credit cooperatives, rural credit cooperatives and foreign-funded banks) based on its tier 1 capital and by a non-bank financial institution based on its capital (paid-in capital or share capital + capital reserve) with its most recent audited financial report governing.

Cross-border financing leverage ratio: 1 for an enterprise or non-bank financial institution, and 0.8 for a banking financial institution.

Macroprudential adjustment parameter: 1.

Table 2