While managing a capital outflow crisis as foreign investors cash out of the market and companies repay dollar loans amid a depreciating currency, China’s policymakers have implemented a wide array of tools since 2014 to plug the leakage, by tightening capital controls and exhausting foreign exchange (FX) reserves to defend the renminbi. An estimated $1.2 trillion has flooded out of the country since China’s shock currency devaluation in August 2015, most notably in the form of outbound M&A, fake trade invoices, and overseas insurance and property purchases.
After more than two years of market interventions and capital curbing measures, in late 2016, the PRC government substantially ramped up efforts to stem outflows. Not every single policy has been incorporated into official regulations—some are shown in public statements or take the form of “window guidance”—but the moves carry sweeping practical implications for cross-border transactions.
In late November and early December of 2016, several government agencies, including the PBOC, National Development and Reform Commission (NDRC), State Administration of Foreign Exchange (SAFE) and Ministry of Commerce (MOFCOM), issued joint statements to enhance efforts to authenticate outbound investments and crack down on fake cross-border transactions.
Certain types of outbound investments will be subject to stricter review, according to the statements. These include:
Moreover, some market observers perceive these policies to be relatively mild and actually refrain from covering a much broader range of outbound investments that are subject to tighter regulatory scrutiny in practice.
On November 26, 2016, the PBOC issued a circular strengthening the control over outbound renminbi loans extended by domestic companies to overseas entities. The new rules require the offshore borrower to be the onshore lender’s parent or subsidiary, and cap the balance amount of the outbound renminbi loan at 30% of the lender’s net asset value.
Also, in fact, a January 27, 2017 Bloomberg report indicated that the PBOC urged lenders earlier that month to issue more dollar-denominated debt offshore, in the hope that the repatriation of proceeds back to the mainland would help offset declines in the nation’s FX reserves.
The Shanghai Free Trade Zone (FTZ) is also reportedly enhancing the monitoring of capital flows to stabilize capital inflow and outflow through FTZ accounts. One consequence of this is that the advance of free-trade non-resident account loans by commercial banks (i.e. bank loans disbursed directly into these accounts opened by offshore borrowers) may face hurdles.
On December 28, 2016, the PBOC released the Measures for the Administration of the Reporting of Large Transactions and Suspicious Transactions by Financial Institutions, which require financial institutions in China to report to the PBOC any cash transactions of more than Rmb50,000 and any cross-border cash transfers of more than Rmb200,000. It is worth noting that the new threshold of Rmb50,000 for “large” transactions has been substantially lowered from the previous Rmb200,000 mark set by a 2007 regulation.
Two days later, the PBOC implemented further measures to tighten scrutiny over cash transfers by individuals. While it hasn’t lowered the annual quota of $50,000 for each citizen to move FX abroad, it has made it more difficult for individuals to pool quotas in order for one person to make large overseas investments—a method that was widely used to work around the annual limit.
SAFE then released a Q&A on December 31 outlining FX conversion restrictions and specific requirements for individuals, such as filling out a detailed form on how they plan to spend the money overseas and pledging not to use the cash to purchase overseas assets such as property or insurance investments. It also stated that violators will be put on a watch list and denied an FX quota for three years.
SAFE has also reportedly begun vetting all transfers abroad under the capital account worth $5 million or more, regardless of whether they are for outbound investments, outbound loans or other types of transactions under the capital account. Once the transfer amount reaches this threshold, banks handling cash remittances must report to SAFE, subjecting the deal to a separate review by the relevant authority (MOFCOM, NDRC, PBOC or SAFE, as the case may be) even if all the necessary government authorizations have been obtained. A similar form of “quantity control” had existed in practice throughout 2016, but this latest move drastically lowers the threshold and covers both foreign currency and renminbi.
Investors and entities looking to make outbound payments may need to present to the authority the materials evidencing or explaining the source of funds, the planned use of the funds, as well as other information relating to the underlying transaction. A board resolution or similar duly-granted internal authorization approving the contemplated overseas payment may also be required. In the meantime, it is advisable to avoid using a shell company, or a company in poor financial condition or with a history of less than one year, to invest overseas, as these circumstances are subject to much tighter regulatory scrutiny in practice.
Public statements show that the authorities will stick to the “going out” strategy and will continue to commit to facilitating authentic and legitimate outbound investments, while cracking down on violations where cash outflows are being disguised as real deals.
Given the complexity of modern day deals, however, it can be challenging to draw a clear line between genuine and fake transactions. The broad sweep of the new policy may impact a wide range of deals including those with legitimate business purposes. Normal transactional procedures may suffer from unexpected delays or other uncertainties, which could even kill a deal.
It is understood that the new policy is to address a bigger concern with respect to the loss in renminbi valuation and continuing erosion of China’s FX reserves. In 2016 the renminbi had depreciated nearly 6% against a strong U.S. dollar. China’s currency reserves also went down to a five-year low of $3.01 trillion at the end of 2016, when the renminbi posted its steepest annual slide in more than 20 years, from the peak of $3.99 trillion in mid-2014. While the nation still possesses the world’s largest FX supply, the PBOC announced on February 7 that reserves fell to $2.998 trillion, the lowest level since 2011. There is no doubt that capital outflows—both legal and illegal—have pressured the renminbi. Many people are betting on further losses in the currency’s value, which increases the outlook of capital flight. Rather than running down FX reserves to support the renminbi, restricting capital outflows—at least in the short term—may be an easier solution.
Outbound investments are facing increased uncertainties and risks. It is unclear how the PRC authorities will manage decisions around which investments to permit, and there are no published rules in this regard. Chinese investors need to carefully look into the default risks associated with the possible failure to obtain the government’s approval for a deal. Similar concerns may lead to the offshore seller demanding a higher premium or break fee as protection against deal termination caused by PRC regulatory hurdles. An uncertain outlook also affects the financing arrangement related to M&A. A blockage in cash outflow would mean a buyer may not be able to find alternative sources of funds to repay the bridge loan that was used for financing the acquisition at an earlier stage.
In the short term, investors must maintain productive communications with the Chinese authorities and their advisors to ensure that their applications for outbound investments are in full compliance with the new directives. Investors should also carefully allocate the risks of failing to obtain government approvals in the transaction documents. In the long run, investors may need to focus more on establishing offshore financing structures for overseas investments as a means of getting around the onshore capital controls.
That said, offshore financing structures bring their own set of problems, as they impact the optimization of Chinese entities’ debt structures. With a depreciating renminbi and rising expectations of a U.S. Federal Reserve interest rate hike, many Chinese companies have been taking active measures to cut their dollar-denominated debt since mid-2015. At the same time, they have found that they need to raise more overseas dollar debt to fund offshore transactions due to the tightened outflow controls. A sinking renminbi will pose greater threats to Chinese firms with high leverage and mismatched levels of currencies in their income and debt.
The surging demand for offshore financing also increases the need for a backup onshore guarantee or security. With all the capital outflow curbs, there is a growing concern among offshore lenders regarding the capability of domestic guarantors or security providers to move cash abroad when it comes to execution. Some even worry whether a bank performing its obligation under a standby letter of credit could also be subject to a quota or other transaction amount restrictions.
In sharp contrast to the control over cash outflow, the PRC authorities are implementing a series of new regulations encouraging capital inflow. Among them, the PBOC recently released the Circular on Matters Relevant to the Macroprudential Administration of the Overall Cross-border Financing on January 11, 2017 to provide domestic companies additional headroom to obtain foreign loans. While the borrowing limit was previously set at a company’s net assets, it has been doubled under the new rule. This could present opportunities for Chinese companies to leverage the enlarged space to borrow foreign debt while using part of the proceeds overseas to meet their offshore financial needs. The new rule also provides more scope for a domestic bank to provide an outbound guarantee, which is good news for offshore financing deals. It remains to be seen, however, how the Circular functions and interacts with the tightened policy over capital outflow.
With the unprecedented rate of capital outflow, the tightened controls buy the government some breathing space. But it needs to strike a delicate balance. Strict capital controls would hamper China’s efforts to make the renminbi a global rival to the dollar, and undermine the nation’s overall “going out” and opening up strategy. Even stronger measures may send negative signals regarding the state of the economy and increase the risk of panic selling of the renminbi. Transparency and predictability of regulations ensure confidence in the economy, and sacrificing these qualities may jeopardize growth. This is where the PRC policymakers must truly be cautious.
All in all, these capital controls are a temporary solution. Slight adjustments may be considered by the authorities upon execution. China has become too deeply integrated in the global economy now for it to be insulated from the rest of the world once more. The question is then how long the new policies are likely to remain in effect. The answer appears to be beyond the Chinese government’s control.
Benson Cui, Partner