Inside China: avoiding the twin towers asset bubble

Author: | Published: 24 Apr 2013
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One of the deleterious results of the artificially imposed constraints on meetings between Chinese renminbi (RMB) sellers and foreign RMB buyers is the ceaseless accumulation of the twin towers asset bubble: the Chinese real-estate and A share markets. These constraints are exchange controls, as exercised by the State Administration of Foreign Exchange (SAFE) and the Ministry of Commerce's (MOC) foreign investment approval requirements.

There are a number of official channels by which such meetings can be approved. These include: overseas listings of domestically-incorporated companies; overseas investments and acquisitions by Chinese persons; foreign investments in and acquisitions of Chinese companies (inbound M&A); and special asset acquisitions by foreigners. This last category would include, for example, qualified foreign institutional investments in publicly-traded securities, permitted investments in non-performing loans, and investments in limited partnership interests in certain private equity funds, and their respective special 'R' channels for overseas RMB arising from trade account settlement in RMB. Yet it is structurally difficult for foreign acquirers to use Inbound M&A to build up the scale required to compete (except on quality) with market-leading domestic companies. Inbound M&A is meant to encourage the establishment of beachheads, but there is no designated path to systematic expansion beyond such beachheads.

Inbound M&A challenges

First, there is the Catalogue of Foreign Investment, which lists only certain industries as permitting more than 50% and up to 100% foreign ownership in companies.

Second, central MOC approval (which is always time-consuming and sometimes ultimately elusive) is required for certain types of significant inbound M&A. There are four triggers for central MOC review:

  • deal size of $300million or more (or 50mm or more in a 'restricted' industry);
  • the target operates in an industry such that change of control could impact 'national economic security' or entail loss of control of a famous national trademark;
  • the acquisition currency includes foreign equity; or,
  • the acquisition is by a foreign entity that is controlled by the original domestic founder/owner of the target.

Third, expansion of the capital base by domestic initial public offerings (IPO) has, a priori, been shut down by the China Securities Regulatory Commission (CSRC) for the past 15 months as the CSRC has stopped reviewing listing applications. A posteriori, it is difficult for foreign-owned targets to meet the listing requirements of stand-alone supply and distribution chains. This is because acquiring these chains entails an investment of time and funds and connections, which the onshore operation will likely not have. In practice, operating subsidiaries of foreign companies must remain what's deemed single children (and such foreign companies cannot use any such subsidiary to acquire and hold other subsidiaries). This is unless such subsidiaries are consolidated under – and such acquisition and holding is done by – a so-called foreign-owned holding company (FOHC), since by regulation such operating subsidiaries may use no source of funds other than operating profits for any such acquisition. Moreover, an FOHC is prohibited from borrowing money from onshore banks to fund such acquisitions. The result is that a prohibitive amount of capital is required for a foreign party to create the type of integrated supply chain and distribution network needed to list in China.

These factors mean that the cross-border exchange of RMB in the capital account is meant only to occur in regulated, calibrated doses. None of these doses, individually or in aggregate, can hope to solve the twin tower problem, at least not immediately or in isolation. Thus, there is no effective hedge or negative feedback mechanic to pose against continuous reinvestment into the twin towers. The twin towers become too big to fail, because there is no alternative channel for Chinese savings and investable wealth of meaningful scale. When macroeconomic or so-called animal-spirit factors cast doubt on the fundamentals, a crash ensues unless the government steps in. Sound familiar? Like the banking system in western countries (which intertwines all financial intermediaries following the erosion of Glass-Steagall, including the pension system), the twin towers in China lie at the nexus of the economy and financial markets. This is due to the mutual dependencies of the Chinese corporate economy, employment, listed company stock prices, and the real-estate market (the construction, development and usage of which fuels a large proportion of Chinese employment). In each case, whether due to mission creep/engulfment of alternative uses of funds, or due to lack of alternatives, that use of funds which is left standing cannot be allowed to fail absent structural, or at least behavioral, change that precedes such failure.

Other options

Behavioral change in China may be the catalyst necessary to increase access to underdeveloped, underpriced investment alternatives to the twin towers. These remain largely untapped due to the belief that these carefully calibrated valves of exchange exhaust the possibilities, and a lack of domestic capability necessary to catalyse the market-making and formation of capital in these alternative investment markets. Although tentative, admirable efforts have begun, they have gained limited traction due to a lack of experience and the inertia that accompanies the tradition of local and central government support for the twin towers. Inexperience is apparent in two areas: asset class identification and valuation, and the mechanics for origination and trading of such asset class.

These asset classes include: small-to-medium sized enterprises (SMEs) and households (a subclass of which had previously been in the form of financing of certain so-called red chip companies); corporate and financial receivables; futures and options (both commodity and financial); insurance risk; and credit risk. These mechanics include the ability to capture: data on customer/market participant decisions; losses and mortality (through use of cutting edge software, the internet, and access to governmental statistics); and the ability to take and transfer positions in these asset classes (whether or not with leverage), preferably on an organised physical or electronic trading platform. FenXun Partners has advised clients on several such arrangements, including the origination and secondary trading of small loan and SME corporate receivables in western China. That platform follows, to a certain degree the, the New Orleans Receivables Exchange model, while taking into account some of the special characteristics of Chinese regulation and data collection.

None of these asset classes is provided a specified channel for foreign access. The only valves are indirect, for example through qualified foreign institutional investors (QFIIs) that can trade specified fixed income instruments. Another example is investment in domestic entities that trade such asset classes – including direct investments in banks, insurers, small loan companies, financial leasing companies, credit guarantee companies and other financial intermediaries with special licences to originate and trade financial assets. Another indirect valve is the limited amount of qualified foreign limited partnership interests in, and partially foreign-owned general partners of, RMB funds. Of these channels, only property and casualty insurance, credit guarantee and financial leasing companies are explicitly permitted by national laws to be 100% acquired by a foreign persons. Small loan companies may also be so acquired pursuant to the regulations of only certain provinces. Funding for these operations is generally based on capital and privately placed/quasi 144A-style traded securitisation. These entities will be regulated as to capital and assets. These valves purposely limit the amount of foreign capital to be allowed, singly and in the aggregate. This is not contained in writing, but rather in the discretion vested in the administrative bodies charged with implementing the applicable laws and regulations.

An alternative way for a foreign party to access these asset classes may be to employ a combination of the nominee/Variable Interest Entity (VIE) structure and a split hedge for capitalisation purposes. This allows:

  • the foreign party to utilise its own 100% PRC subsidiary in retaining and employing proprietary technology in the pricing, origination and trading of these asset classes; while,
  • providing funding for a Chinese contractual counterparty by way of loan from PRC bank (the offshore affiliate of which takes a deposit from the foreign party in the same amount); with,
  • the counterparty making periodic payments to the subsidiary in consideration of services rendered by such subsidiary pursuant to a services agreement that effectively vests operational control of the onshore enterprise in the subsidiary.

The funding is for the capital expenditures needed to make the onshore enterprise viable and scaleable. The PRC counterparty is not subject to MOC or SAFE strictures against buying, selling or holding RMB-denominated exposures to one or more of these asset classes. In some cases, the PRC counterparty will be, or will trade with another PRC entity that is, licensed by a central administrative organ (CSRC, China Banking Regulatory Commission, or China Insurance Regulatory Commission) or by an arm of provincial or local government (the applicable Financial Assets Office). However, the PRC counterparty itself will not be a market maker, intermediary or exchange member in the core commodity, equity, money or credit (bond or depository institution loan) markets in China.

The PRC counterparty will be able to attract funds away from the twin towers through market-driven efforts. These market-driven efforts will be based on the expertise and IT necessary to realise the yields inherent in holding and/or trading these alternative asset classes. As a wider range of asset classes develop depth and liquidity, prices will normalise across the twin towers, reducing the need for fiscal and monetary resources to stabilise prices to prevent crashes and/or bail out the banking system. Foreign capital (much of which will be domestic savings re-channeled back into China), rather than playing the bogeyman role of hot money, can have the opposite effect. A nascent alternative investment management industry will acquire the behavioural catalysts necessary to become more than just the aspiration that is latent in recent amendments to China's laws and regulations governing the mutual funds and private funds. In particular, the CSRC's amendment, in late 2012, of the Pilot Measures on Asset Management Business of Fund Management Companies for Specified Customers now allows public mutual fund managers (which CSRC regulates) to set up subsidiaries to engage in private equity and alternative investments management. The purpose of this and other recent regulatory developments affecting the fund management industry is to open up competition for institutional investor funds.

Inside China
Inside China, written by FenXun Partners’ Yang Xusheng and Fred Chang, is an insight into aspects of the China market that elude the naked eye. Yang is a specialist in China’s financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Fred has worked for buy-side clients buying companies, positions in companies’ capital structure, and positions in markets since 1986 in New York, Hong Kong, Singapore and most recently Beijing. The first three articles of the series focused on legal developments in the PRC capital markets, audit issues and the asset management industry. Future topics include debt capital markets, securitisation, and derivatives.

Red Line Zones

The Alipay-Yahoo affair and the Longtop audit controversies showed that there are certain red lines that such arrangements should not cross. These red lines demarcate the unique domain of Chinese political authority – payment systems and more broadly the stability of the financial markets, the A share market, real-estate market, large employee ecosystems such as state-owned enterprises, and any industry that bears material significance for a very broadly construed definition of national security (Red Line Zones). While these red lines are Heisenbergian in nature, probabilities suggest that industries and operations steering wide of Red Line Zones are highly unlikely to attract displeasure.

The question for these arrangements, therefore, is not legality but enforceability and their ability to unwind. Even if a PRC court would hesitate in enforcing the substantive arrangements, there should and can be call/mandatory transfer (to another PRC person nominated by the foreign party) provisions, and collateral (preferably offshore as well as onshore controlled bank accounts) mechanisms to secure the PRC party's transfer and other obligations. Equally or more important, the alignment of interests (profit allocation) between foreign and PRC parties should be a disincentive to contractual breaches. Perhaps most importantly, in the event that the PRC party (whether on its own or due to government intervention) fails to perform (or the foreign party otherwise wishes to terminate the arrangement), the foreign party will want comfort that unwinding the arrangement is practicable, without unnecessary loss to its proprietary franchise.

A partially-owned subsidiary can be sold or (with some difficulty under PRC law) liquidated by a foreign parent, but only after intangible capital (including know-how) would have been contributed to such subsidiary by the parent. However unwinding a contractual arrangement enables the wholly-owned subsidiary of the foreign entity to retain its franchise intact. For example, under the service agreement with the PRC counterparty, the subsidiary's key personnel could be seconded to the PRC counterparty in lieu of outright employment by the latter. In turn, these personnel hold the key to unlocking the deepest secrets of any IT that will be used in the enterprise, and clients in the PRC will very much look to these key personnel as their account managers.

By Fred Chang of FenXun Partners