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Chinese regulator tightens control over foreign security

 

10 August 2011

In July 2010, the State Administration of Foreign Exchanges (SAFE) promulgated detailed rules that streamlined the regulatory approval process for provision of foreign security (including both guarantees and asset security) by PRC [1] entities (the 2010 Regulation) (Please click here for our e-bulletin on the 2010 Regulation).

Among other things, the 2010 Regulation has, through such streamlined regulatory approval process, facilitated the use of guarantees and security granted by PRC entities to guarantee/secure offshore indebtedness (such structure is commonly known as "nei bao wai dai 内保外贷") and made offshore funding more easily accessible to the overseas subsidiaries and affiliates of PRC corporates. The 2010 Regulation has been generally welcomed by the market.

On 29 July 2011, one year after the 2010 Regulation took effect and in response to the evolving market condition, SAFE issued another circular, the Circular on Onshore Banks’ 2011 Annual Quota for Foreign Security for Financing Purposes (the 2011 Regulation), to further regulate the provision of foreign security for financing purposes by PRC entities.

Background

By way of background, under the 2010 Regulation a distinction is drawn between foreign security for financing purpose (where the underlying debt is financial in nature, including but not limited to loans, bonds and finance leases) and foreign security for non-financing purpose (being any foreign security which is provided other than for financing purpose). Different approval process applies to foreign security for financing purpose and foreign security for non-financing purpose, and such process varies depending on whether the guarantor/security provider is a bank, a non-bank financial institution or a corporate. The table below indicates whether, for the purpose of granting foreign security, case-by-case approval by SAFE is required and if any quota system is applicable to different types of PRC entities:

Type of foreign security
Banks
Non-bank financial institutions / corporates
Foreign security for financing purpose
No separate SAFE approval is required but subject to an annual quota set by SAFE.
Subject to case-by-case approval by SAFE or (if the non-bank financial institution or corporate is able to satisfy certain financial tests) annual quota set by SAFE where none of the exceptions set out in article 14(2) of the 2010 Regulation applies.
Foreign security for non-financing purpose
No SAFE approval is required and not subject to annual quota set by SAFE.
Same as above.

The 2011 Regulation tightens SAFE's control over foreign security for financing purpose. Such tightening is in line with the general government policy to control the inflow of hot money into China (in particular into the real estate sector) and to enable SAFE to monitor, more effectively, the amount of foreign security provided by PRC entities for offshore financing transactions.

Key features of the 2011 Regulation

  1. Downsizing of the annual quota granted to banks in respect of foreign security for financing purpose

    From the 2011 Regulation one sees the downsizing of the annual quota granted by SAFE to all banks for provision of foreign security for financing purpose from the annual quota applicable in 2010. It is not clear what the exact percentage of such downsizing is, but some market sources suggest that the percentage may range between 4% to 10%. If any bank's balance of foreign security for financing purpose exceeds the 2011 quota granted to it by SAFE, such bank must bring such balance within its 2011 quota within 3 months and will not be permitted to provide any new foreign security for financing purpose until then.

  2. SAFE resumes case-by-case approval for provision of foreign security for bond issuance by an offshore entity outside of the PRC

    Bond issuance is a financing transaction. Under the 2010 Regulation, the following entities may, subject to the relevant quota granted by SAFE, provide foreign security for a bond issued by an offshore entity without obtaining any case-by-case approval from SAFE:

    (a) a bank with an annual quota; or

    (b) a non-bank financial institution or corporate that meets the financial tests under the 2010 Regulation and receives an annual quota from SAFE (where none of the exceptions set out in article 14(2) of the 2010 Regulation applies).

    Such position, however, has been changed by the 2011 Regulation. The 2011 Regulation now requires that any PRC person (whether it is a bank, a non-bank financial institution or a corporate) which wishes to provide any foreign security for a bond issued by an offshore entity outside of the PRC must obtain the case-by-case approval of Central SAFE. The 2011 Regulation also reiterates the requirement that, in the case of a non-bank financial institution or a corporate, such non-bank financial institution or corporate and the offshore entity which indebtedness is being guaranteed or secured by the foreign security in question must both meet the criteria set out in the 2010 Regulation.

  3. Suspension of approval of foreign security for offshore bond issued by real estate company's offshore subsidiary

    Amid the general tightening of credit lines and difficult operating conditions for real estate companies in the PRC, the 2011 Regulation explicitly provides that SAFE approval for provision of foreign security by any PRC real estate company to guarantee/secure bond issuance by its offshore subsidiaries outside of the PRC be temporarily suspended. Such suspension will make it more difficult for PRC real estate companies to raise funding overseas through bond issuance.

  4. Restriction on use of proceeds from financing backed by foreign security in the PRC

    The 2010 Regulation provides that the proceeds of any financing for offshore investment enterprise which is guaranteed or secured by foreign security provided by a PRC entity cannot be repatriated onshore by way of debt, equity investment or securities investment. The 2011 Regulation further clarifies this rule and specifically bans the following activities where the financing in question is backed by foreign security:

    (a) refinancing any existing debt which proceeds have been repatriated onshore by way of debt or equity investment; or

    (b) direct or indirect acquisition of shares of an offshore company which main assets are located within the PRC.

    The 2011 Regulation explicitly requires banks which conduct foreign security business for financing transactions to check the use of proceeds by the offshore borrower/issuer entity. Such requirement imposes an additional duty on the banks and may give rise to practical difficulties, as it may not always be possible for a bank to verify whether the loans or bonds to be guaranteed/secured by foreign security are to be used for refinancing any existing debt referred to in paragraph (a) above.

  5. Clarification by SAFE that foreign security denominated in Renminbi is subject to the foreign security regime

    There has been some market confusion as to whether foreign security granted to guarantee/secure any indebtedness denominated in Renminbi should be regulated in the same way by SAFE as in the case where the underlying indebtedness is denominated in a foreign currency.

    It is worth noting that in a regulation issued by the People's Bank of China (PBOC) on cross-border Renminbi in June 2011, PBOC takes the view that a guarantee denominated in Renminbi issued by a bank for offshore construction and cross-border financing is not subject to the foreign debt regime.

    SAFE, on the other hand, provides in the 2011 Regulation that "in principle" any foreign security provided by a PRC entity which is denominated in Renminbi should also be subject to the foreign security regime. In other words, Renminbi-denominated foreign security provided by a bank for financing purpose will be subject to its annual quota set by SAFE.

    It is unclear at this stage how the inconsistency between the 2011 Regulation and the regulation issued by PBOC referred to above will be resolved. One commentator takes the view that the words "in principle" in the 2011 Regulation leave some flexibility for SAFE to grant exceptional treatment on a case-by-case basis. In practice, we understand that some banks tend to take a prudent approach and will count any Renminbi-denominated foreign security provided by them for financing purpose against the relevant annual quota set by SAFE.

Impact of the 2011 Regulation on offshore bond transactions and offshore loan transactions

SAFE has placed considerable focus on regulating foreign security for offshore bond transactions in the 2011 Regulation. With the resumption of power to grant case-by-case approval for foreign security for bonds issued by an offshore entity outside of the PRC, SAFE now has another means, in addition to the existing quota system, to regulate the granting of foreign security for offshore bond transactions. In practice, it is unclear how SAFE will assess applications for such case-by-case approval, in particular where the foreign security is to be granted by a PRC bank (as the 2011 Regulation itself does not set out the relevant criteria other than, in the case of non-bank financial institutions and corporates, a reference to the criteria set out in the 2010 Regulation).

Foreign security for loan transactions, on the other hand, has not been specifically targeted for further regulation. Having said that, banks involved in offshore loan transactions utilising the "nei bao wai dai 内保外贷" structure will still be affected by the overall downsizing of the SAFE annual quota and tightened control over the use of proceeds from financing backed by foreign security in the PRC.

Since the 2011 Regulation is still relatively new, it remains to be seen how its provisions will be implemented by SAFE. We will continue to monitor any development in this regard.

[1] For the purpose of this note, PRC means the People's Republic of China but excluding Hong Kong, Macau and Taiwan.

 

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