China: Where do we stand?

Author: | Published: 1 Oct 2008
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Beijing's latest glitzy multi-use real estate showpiece, "The Legation", kicked off with an inaugural contemporary Chinese art show entitled "Where Are We?" The target audience, undoubtedly those familiar with the recent meteoric rise in contemporary Chinese art prices, could immediately appreciate that this provocative title actually embodied two questions, namely: (i) how did we get here; and (ii) where are we going? Don't worry: I am not going to suggest that the fortunes of the Chinese project finance market correlate with those of contemporary art, but there are interesting parallels between the interstices being faced by both markets at this moment.

Having emerged from a relatively slow period in 2004 and 2005 following the financing of the original round of ethylene cracker projects, the Chinese projects market began ramping up again in earnest in 2006 and finished 2007 with a flourish of high profile, large private project financings including the largest ever joint venture project financing in China's history (the $4.5 billion Fujian Refining and Ethylene Project, FREP). The prospects for 2008 onward would appear to be bright if they are to be measured by deal volume and size, details of which are discussed below. Questions remain, however, as to how these deals will get done or, put in a more precisely self-interested fashion, whether there will be a role for foreign banks and/or advisers.

Mid to late nineties

It is easy to forget, given the parabolic changes in PRC projects transactions, that limited or non-recourse deals only appeared in the China market a little over a decade ago. Before that, projects were largely financed through shareholder loans backed by on balance sheet borrowing from the sponsors. Domestic bank lending models still largely reflected command economy thinking with extremely thin documentation featuring straight line amortisation schedules, only basic reps and warranties and little if any covenant protection. By contrast, the early limited recourse financings in China featured all of the bells and whistles of their European or American counterparts and then some. Some of the salient features of these financings and in particular those features that help to differentiate them from later financings are as follows.

Contractual ring-fencing

Many of the early China project financings were power projects, concessions with government offtake or both. At the time even non-concession power projects were permitted to secure a degree of offtake certainty through the negotiation of long-term power purchase agreements (PPAs) with take-or-pay provisions and sophisticated price adjustment mechanisms to permit tariffs to be adjusted to reflect changes in operating, fuel and other costs. Most of the projects were additionally managed under the terms of long-term operation and management (O&M) agreements typically with one of the foreign sponsors that provided for penalties for failure to meet target production objectives. Construction arrangements were usually structured in the form of turnkey engineering and procurement contracts (EPCs) with international contractors that, in the case of BOT projects, had their technical requirements and completion testing linked to the terms of the concession.

Under these circumstances, sponsors were able to effect paradigmatic contractual ring-fencing where the principal universe of risks likely to be encountered by the project were either addressed or at least mitigated by the contract structure. This obviated the need for lenders to gain a high degree of comfort with the market or even to an extent the jurisdiction and allowed them to concentrate instead on the strength of the terms and the enforceability of the constituent project contracts. Enforceability risk was deemed to arise in the minds of the international banks where the contractual counterpart was a PRC party (for example, in the case of the PPA and the concession agreement). These risks were in turn addressed through the provision of comfort letters from a variety of government agencies whose wording was tortuously negotiated and which in most cases turned out not to be worth the paper they were written on.

Bifurcated financings

Though by the late nineties the market began to see Sino-foreign joint venture projects financed by mixed syndicates lending on a pari passu basis, the precursors to these deals (Shandong Rhizhao and Hebei Han Feng, for example) followed a bifurcated financing approach. Under these structures the proportionate amount of debt in respect of the foreign party's investment in the project would be arranged offshore and lent to the project company on a limited or non-recourse basis. Any debt raised in respect of the Chinese party's investment was typically borrowed by the Chinese party on balance sheet from domestic banks and advanced to the project company as subordinated shareholder loans.

Foreign domination

Project financings in this period were largely the result of banks following an influx of foreign investment. Many of the projects (Laibin B, Meizhouwan and Chengdu Water Treatment, for example) were wholly foreign owned, in stark contrast to projects developed after this period, which almost invariably involved Chinese investment and often majority Chinese ownership. Bank syndicates were similarly comprised largely if not exclusively of non-Chinese lenders. Where Chinese banks were involved, they more often than not ceded negotiation control to foreign counterparts with better developed risk committees and the ability to run complex documentation. Legal advisory roles for China projects in the mid to late nineties were dominated by the magic circle firms able to capitalise on their then relatively better developed platforms in Hong Kong. Negotiations tended to be conducted in English and PRC legal advice tended to be restricted to review of Rmb facility agreements (if any), security registration and the reliability of comfort letters.

Emerging market treatment

With domestic banks having little or no say in the structuring of the financing and with stringent exchange controls and at best a nascent security regulatory regime, lenders understandably approached China as an emerging market. This was particularly evident in the formation of security packages. The inability to obtain a floating charge (now achievable under amended PRC Security Law) led to periodic security re-registration covenants during construction. The inability to obtain an account charge (still not a recognised form of security under the PRC Security Law) and concerns about remittance risk led alternatively to offshore accounts subject to separate approvals and complex account controls or artificial charges of dubious enforceability.

2000 to 2003

At the onset of the 21st century, Chinese project financing made a fairly dramatic shift away from the traditional contract ring-fencing model to a market risk structure. The principal factors contributing to this shift were concomitant changes in the regulatory, commercial and domestic banking frameworks of the time.

Regulatory change

In early 1999 the PRC State Council took action to dismantle one of the key components in the universe of contracts comprising Chinese power projects. In February of that year it issued a notice prohibiting the execution of long-term PPAs going forward and suggesting that existing PPAs with foreign invested Chinese power projects be renegotiated. In the absence of the PPA, contractual assurances regarding a project's offtake, as well as its ability to adjust pricing in the face of increased costs, were lost. Given the relatively more modest returns projected on power projects, the loss of these contractual protections effectively rendered them un-bankable on a limited recourse basis in the international marketplace.

Indeed, in the years since the issuance of the 1999 notice, very little foreign IPP activity has taken place in China and where investment has occurred it has mostly been in the area of smaller or captive projects or in renewable energy, where projects are assured preferential offtake. Meanwhile, the state-owned Gencos, spun off after a reform of the power industry which began in 2001, have themselves been struggling as increases in coal prices have only partially been passed through in electricity tariffs, reinforcing the view in the banking market that the current regulatory regime in China does not support the rational financing of most domestic power projects on a limited recourse basis.

At the same time as the Chinese government made moves to effectively impede the foreign financing of power projects in China, it appeared to come to the conclusion that it no longer had any need for foreign investment in the BOT concession programme. With Rmb interest rates dropping by the late nineties and an appetite to borrow domestically to hedge Rmb-denominated project costs, WFOE BOT projects suddenly found themselves at a significant disadvantage as the result of a prohibition on their borrowing Rmb. As a result, no further foreign invested forays into the Chinese BOT programme occurred following the pilot projects in the late nineties, striking yet another blow to the financing of China projects on the more traditional contractual ring-fenced basis.

Commercial and domestic banking changes

Happily for sponsors, advisers and banks focused on limited recourse projects in China, regulatory impediments to the pursuit of traditional project finance models came into effect at the same time as the PRC economy started to go into overdrive, triggering massive domestic demand for, among other things, speciality chemical and petrochemical products. Projects producing these products typically enjoyed more robust margins than power projects and relied on very loose offtake commitments, often from the sponsors themselves. As such they tended to be financed on a market risk basis pursuant to which the lenders rely on technical and market consultant projections to gauge the cash flow from a project rather than contractual obligations.

The shift towards a market risk focus in domestic limited recourse financing coincided with a growth in strength and competitiveness of the Chinese banks capitalising on lower Rmb lending rates, the gradual reform of their non-performing loan portfolios and, in many cases, an influx of funds from capital market listings. This trend is perhaps best illustrated by examining the structure and the syndicate mix of the three multi-billion dollar ethylene cracker projects financed during this period.

As the planning phases for all three projects roughly overlapped, considerable concern developed in the finance markets that there wasn't sufficient liquidity to bring all three projects to market. The BP/Sinopec SECCO project sought to gain first mover advantage by offering a fully guaranteed deal through the life of the project and was the first to close its financing with a syndicate dominated by foreign banks. By the time the next two projects came to market in fairly close proximity to each other, the perception of insufficient liquidity in the market had been debunked in no small part due to the voracious appetite of the Chinese banks and their willingness to lend in both dollars and Rmb. The Shell/CNOOC Nanhai project went forward on a fairly balanced syndicate basis with traditional ECA financing from US Exim and JBIC and Rmb tranches provided by the Chinese banks. The BASF/Sinopec IPS project financing was originally conceived on the same basis, but with Chinese banks eager to lend more aggressively to domestic projects and willing to provide attractive pricing, the resulting syndicate structure contained only a sliver of foreign debt.

2004 to 2007

By the end of 2003, with the growing dominance of the Chinese banks in the syndicates financing the first of the large ethylene cracker projects, foreign banks and their advisers may have been prompted to ask for the first time: where are we? The answer for many, whether rightly or wrongly, was: nowhere.

Fears abounded that Chinese banks, fueled by a perceived surfeit of liquidity and a willingness to price at seemingly irrationally low levels on dollar lending (more on this below), would effectively drive foreign banks out of the market. This sentiment was coupled with the view that Chinese banks with less experience in credit and risk assessment would revert to their command economy lending practices, obviating the need for sophisticated financial or legal advisory services. At this time, many foreign banks and law firms began to reassess their positioning in the China market and quite a few of them began downsizing or even eliminating their project teams in the region.

So what really happened? There is no question that Chinese banks dominated financings from late 2003 onward. The first Chinese bank syndicate financing of a Sino-foreign project to be done on sophisticated international standard documentation was the $1.5 billion Shanghai Isocyanates project, which closed in late 2003. This was followed in early 2004 by the first takeout refinancing by Chinese banks of a mixed syndicate when the Meizhouwan project was refinanced by a Chinese bank consortium led by BOC. The ensuing years saw a spate of financings and refinancings led, if not exclusively populated, by the Chinese banks, including all Chinese bank refinancings of all three of the original ethylene cracker projects and culminating in the record-setting $4.4 billion FREP financing, which closed in September 2007.

The real question is: what did these financings look like? Was there a reversion to the thin command economy style documentation, or did the credit approach of the domestic banks move in the direction of their foreign counterparts?

Overall structure

From a structural perspective, the early Chinese bank-led financings are a mixed bag. The overall trend in recent years has been towards a vastly more sophisticated credit approach on the part of the Chinese banks, but there have been some rough patches along the way. The look and feel of the documentation for many of these financing tracks is that which you would expect to see in more developed jurisdictions, but look more closely and you will often find that critical risk loops have not been closed. Completion support during a guarantee period may, for example, be provided by an SPV subsidiary of a sponsor with only indirect funding support at the SPV level being provided by the sponsor itself. In other cases, intercreditor loopholes may leave lenders exposed to the risk of losing access to critical shared facilities on enforcement.

Increasingly, Chinese lenders show an awareness of these risks but may be hampered in their ability to address them by frenzied competition from other domestic banks for arranger roles or syndicate position, particularly in the environment of perceived liquidity overflow that permeated 2006 and 2007. In other cases, notably in respect of the refinancings that occurred late in this period, Chinese lenders appeared to revert to a corporate lending model relying on the cash flows from a project alone to extend credit, without the need for traditional limited recourse protections in the form of a robust security and covenant package.

Overall, however, it appears that the Chinese banks have gradually assumed ownership of a reasonably sophisticated documentation model, starting with a replication of the documentation they co-lent on in the late nineties and early 21st century and culminating in a more tailored set of documents fitted to their own exigencies.


Unsurprisingly, pricing has been a significant factor in the Chinese banks' dominance of syndicates in the last several years. Their competitive advantage in this regard has more to do with regulatory constraints on the foreign banks than with the real cost of funds. Foreign banks have until recently been completely excluded from the Rmb lending market. Chinese banks responded in recent years by bidding extremely low margins on the dollar tranches, often below the real cost of funds. Unlike the foreign banks, the PRC banks had a natural margin hedge in the form of Rmb loans whose margins could not be reduced below a threshold set by the People's Bank of China (PBOC). Once blended with the healthier margin on the Rmb loans, the margins on the dollar tranches became workable.

While this formula gives rise to a competitive advantage over the foreign banks, it does not explain why uniform credit pricing decisions were made across a broad array of borrowers in this period. Nor does it explain credit lacunae such as failing to secure a pari passu prepayment of all debt tranches that occurred on a number of transactions and left PRC banks exposed to the possibility of being left with dollar lending only at unattractively low margins. While blending margins was a clear advantage to Chinese banks, the real pricing story appears to have been driven by a perception that there was significant excess liquidity in the Chinese banking system.

Market and jurisdictional risk

The rising dominance of Chinese banks in the syndicates for domestic PRC financings occurred during a period in which market risk projects were essentially the only ones that could be financed domestically on a limited recourse basis. In this environment, the Chinese banks not only embraced the market risk model but showed considerable creativity in its application to more traditional contract ring-fencing projects. Of particular note in this regard is the refinancing of the Meizhouwan project that, at the time of refinancing, retained a residual long-term PPA. The refinancing Chinese lenders recognised immediately that the PPA could not be used as a reliable means of predicting revenue from the project. Instead they relied on detailed market analysis of the base load capacity extent at the time of refinancing and predicted it to come on line during the tenor of the loans, resulting in a tailored amortisation schedule that was front end-loaded to reflect expectations of lower levels of dispatch as local base load plants became operational late in the financing term.

The Chinese banks evinced similar flexibility in deviating from traditional limited recourse models in the structuring of security packages, preferring to stay within the scope of what was permitted under the Security Law rather than attempting to recreate security structures commonly found in other jurisdictions but not recognised under PRC law.

Where are we going?

The Chinese projects market holds forth a tantalising array of very large foreign invested projects under development and expected to go to market within the next 12 to 24 months. These include, by way of example, the $9 billion Dow/Shenhua coal to chemicals project in Shaanxi Provence, the $10 billion Sasol/Shenhua coal to liquids projects in Shaanxi and Ningxia and at least three $5 billion-plus refinery and ethylene cracker projects alternatively invested by Saudi Aramco, Kuwait Petroleum Company and an African oil major. It is impossible to know with certainty how these projects will be financed, what syndicates will look like and what terms will be, but strong indications in the market suggest that the fortunes of the foreign banks may look far brighter than at any time in the preceding four years. Factors giving rise to this prediction include the following.

Debunking the liquidity surfeit

Whether the result of a deflated hubris following the realisation that Chinese banks were not truly de-coupled from the sub-prime crisis, central bank fears of inflation or a combination of these and other factors, the perception by the domestic banks that they have a surfeit of money to push out the door seems to have thoroughly dissipated. This observation is borne out by the more stringent lending quotas imposed by the central bank in 2008. Despite the growing economy, lending quotas on the state banks in 2008 were frozen at 2007 levels, with BOC in fact seeing a Rmb20 billion ($2.9 billion) decrease in its quota (contrast this with a 56% increase in the aggregate quotas from 2006 to 2007).

Importantly, it also appears that this quota is being relatively stringently enforced, with 32% of the quota remaining available after the first half of the year (seemingly quite healthy when benchmarked against quotas usurped in both 2006 and 2007 despite large year-on-year quota increases).

Given that foreign banks in China are also subject to lending quotas, the imposition of tighter quotas on the Chinese banks in 2008 relative to prior years does not put foreign lenders in a position of advantage. What it does do is suggest that domestic banks will need to be more selective in their lending decisions and in doing so are likely to move in the direction of their foreign counterparts in continuing to develop increasingly sophisticated credit and risk assessment tools that look not only at the credit condition of the borrower but the strength of the terms of the financing. In this environment, a reversion to command lending or even to the acceptance of significant risk loopholes in otherwise sound financing documents seems unlikely.


By the end of 2007, 21 foreign banks had been approved by the CBRC to establish subsidiary banks in China. These subsidiary banks are permitted to engage in the full suite of Rmb services, including Rmb lending (subject to annually approved central bank quotas). As a result, many foreign banks now find themselves on a much more even playing field with the Chinese banks when pricing project loans, as they are now permitted to blend Rmb and dollar rates in determining aggregate facility margins.

At the same time, the overall environment of fiscal tightening has resulted in internal policies at the domestic banks mandating far more rational margins, particularly on dollar debt, than were being offered in 2007. While dollar loans for large projects were being bid on by the Chinese banks sometimes at 15 to 25 basis points above Libor (often below their cost of funds), margins on long-term loans through the first half of 2008 have averaged at between 100 to 200 basis points above Libor.

So where are really we going?

The reality is that for many foreign banks the combination of perhaps a decade or more of experience of lending into China and concomitant steady growth and market economy evolution have made loans into China look far less risky than they did in the mid nineties. With an increasingly sophisticated credit approach being developed by the PRC banks, the view that foreign banks are comparatively more costly in terms of the negotiation time required to get them comfortable and more demanding in regard to financing terms is gradually easing. This, together with pricing and fiscal policies in general, has led to much greater parity between the foreign and domestic banks in terms of their attractiveness to project sponsors.

Where this ultimately will lead us is hard to tell before some of the large projects now in development actually go to market. Will we get back to the mixed syndicates of the early 21st century or even the foreign bank-dominated syndicates of the mid nineties? The only view that I can offer is anecdotal and that is that of the approximately $20 billion dollars in China projects under development on which we are advising. The objective of the sponsor's finance departments, at least on the foreign side, is to pursue a balanced Sino-foreign bank syndicate and to finance on a limited recourse basis. If their objectives are borne out, foreign bank participation in limited recourse financing in China could be more robust in the next few years than at any other time in this century.

Author biography

Andrew Ruff

Shearman & Sterling

Andrew Ruff is a partner in Shearman & Sterling's project finance group and managing partner in the Shanghai office. Andrew has over 10 years' experience of Chinese project financing covering infrastructure projects, mergers and acquisitions and direct investment.

A fluent Mandarin speaker, Andrew has recently worked on some of China's largest and most complicated projects and a number of award-winning transactions, including advising the lenders on the financing of the $4.5 billion Fujian Refining & Petrochemical Company Limited (FREP), China's first fully integrated refining and petrochemicals project with foreign participation in China and the largest ever project financing in China, Korea Electric Power Corporation (KEPCO) on its $2 billion acquisition of a portfolio of 12 power plants and nine coal assets in Shanxi province in China, the largest ever private portfolio acquisition of power projects in China, BASF-YPC Company Limited (a joint venture between BASF and Sinopec) on the $1.5 billion refinancing of an integrated petrochemical project in Nanjing, China, one of the largest Rmb takeout refinancings to be done in China to date, and Borouge (a joint venture between Abu Dhabi National Oil Company and Borealis A/S) in connection with the bidding invitation, development, construction and ownership of a 50kta capacity compounding plant in Shanghai and two logistics hubs in Guangzhou and Shanghai.

Among other distinctions, Andrew has been recognised as a Leading Individual in Project Finance in Hong Kong in the IFLR1000 Guide to the World's Leading Financial Law Firms 2008 and a Leading Individual in Corporate/M&A in China/Hong Kong by Chambers Global 2007-2008.