Moving the border – PBOC issues its opinions on the Shanghai Free Trade Zone
Further to the opening in September 2013 of the China (Shanghai) Free Trade Zone (the FTZ), on 2 December 2013 the People's Bank of China (PBOC) issued the much awaited "Opinions on Supporting the Development of China (Shanghai) Free Trade Zone in the Financial Sector" (the Opinions). This note focuses on the opportunities presented by these new channels for investment and financing.
The underlying philosophy of the Opinions may be summarised as (i) removing the border between the FTZ and the offshore market and (ii) creating a new border between the FTZ and the rest of China whilst allowing some significant "permeation" through this new border.
A relatively simple accounts system will be set up for PBOC to monitor the flow and usage of funds in and through the FTZ. Residents in the FTZ may open a Resident Free Trade Account in RMB and foreign currencies (FTRA) and non-residents may open a Non-Resident Free Trade Account in RMB and foreign currencies (FTNRA).
Funds may be freely transferred between a FTRA and another FTRA, a FTNRA, a non-resident account in China but outside the FTZ, or an offshore account – hence the border between the FTZ and the offshore market is removed. As a general principle, fund transfers between a FTRA and other bank accounts in China but outside the FTZ are treated and administered as cross-border transfers – hence the new border between the FTZ and the rest of China. However, funds may be transferred between a FTRA and an onshore bank account belonging to the same entity (that is not a financial institution) for the purposes of current account business such as payment of goods and services, repayment of loans and industrial investment (and any other permitted purposes) – allowing significant "permeation" through the new border.
Interestingly, a FTNRA may only be opened with a bank having a presence in the FTZ whilst a FTRA may be opened with any financial institution in Shanghai by way of the latter setting up a FTZ segregate accounts management unit (the Segregate Unit), presumably without the need to set up a presence in the FTZ.
Investment and financing
Outbound direct investment
Conversion and remittance for outbound direct investment by an entity registered in the FTZ may be conducted directly through the banks. This is a result of the various administrative measures published by the Shanghai government which replace the existing approval of the National Development and Reform Commission and the Ministry of Commerce for outbound investment with a prior filing with the FTZ Administration Commission established by the Shanghai government, considerably simplifying the outbound approval process.
Qualified individuals employed in the FTZ may make offshore investments. Qualified foreigners employed in the FTZ may make domestic investment through a non-resident account opened with securities or futures brokers in the FTZ. The Opinions specifically refer to investment in securities, while an earlier publication by the China Securities Regulatory Commission (CSRC) (the CSRC Rules), also refers to investment in futures.
Qualified corporates, non-bank financial institutions and other entities registered in the FTZ may also invest in offshore securities and derivative products.
The Opinions themselves have not set out any of the qualification criteria. The permissions referred to above are also subject to the "relevant rules", which are yet to be published.
Opening of the capital market
Financial institutions and corporates in the FTZ may invest and trade on the securities and futures exchange in Shanghai. This may be most interesting for foreign invested entities (FIE) which, due to foreign exchange conversion restrictions, have largely been prevented from making such investments.
The offshore parent of a corporate in the FTZ may also issue RMB bonds – also known as Panda Bonds - in China. International multilateral organisations such as IFC and Asian Development Bank have previously issued Panda Bonds but there is currently no legal framework under which a foreign corporate may issue Panda Bonds in China.
Obtaining offshore financing
Corporates, non-bank financial institutions and other entities registered in the FTZ may borrow from offshore in RMB or in a foreign currency according to their business needs. Under the existing rules, a FIE may only borrow within its "headroom" and a pure domestic entity would normally need to obtain approval from the State Administration of Foreign Exchange in order to incur a foreign debt. The Opinions seem to suggest that such restrictions imposed on individual entities would be replaced by a macro-prudential overall quota for the FTZ. The Opinions also provide that, if the borrowing is in RMB, the proceeds should not be used for investment in securities or derivative products or for entrustment loans.
Corporates, non-bank financial institutions and other entities registered in the FTZ may also manage their currency or term mismatch by entering into hedging transactions with another entity in the FTZ or an offshore counterparty. Under the existing rules, any entity that is not a bank has very limited opportunity to enter into derivative transactions with an offshore counterparty.
The earlier CSRC Rules announced CSRC's support for securities and futures brokers in establishing specialised risk management subsidiaries or asset management subsidiaries in the FTZ and conducting sales of OTC commodities and financial derivatives with onshore clients. The Opinions also announced, in the context of further improving foreign exchange administration, PBOC's support for banks entering into OTC commodities derivatives with onshore clients.
How does everything work together?
Through the use of FTRAs and FTNRAs, residents in the FTZ and non-residents may conduct various innovative investment and financing activities permitted under the Opinions. There are still some uncertainties though. First, we need more information about what kind of non-residents may open a FTNRA. Would it be any foreign person or is it limited to certain types of persons? Currently, non-resident accounts are largely available only to QFIIs, RQFIIs, foreign correspondent banks for cross-border RMB settlement, foreign investors before setting up a presence in China (for pre-investment expenditures) and three specific types of offshore entities whose access of the interbank market in RMB has been approved by PBOC. Secondly, the Opinions state that a non-resident with a FTNRA may enjoy the financial services based on the principle of "pre-establishment national treatment" (which generally means that a foreign person may be treated in the same way as a national of a country before he or she establishes any presence in that country).
Does that mean, for example, a non-resident with a FTNRA may then carry out all activities permitted for, for example, the entities registered in the FTZ? Would a non-resident with a FTNRA be able to invest in the securities and futures markets based in Shanghai? Would this effectively grant "QFII" status to such non-residents?
Given the uncertainty surrounding the interpretation and implementation of the Opinions, some of the examples below are based on bold assumptions.
- A company registered in the FTZ (FTZ Co) opens an FTRA. It borrows RMB from an offshore financial institution without the need for SAFE approval (assuming it is a domestic company) or being concerned with whether there is sufficient headroom (assuming it is a FIE). The proceeds of the loan are deposited in the FTRA. The company transfers the proceeds to a normal bank account to repay its RMB loan to an onshore bank. The normal bank account may be located in or outside the FTZ and can be held by the same company or by a branch of the same company. This also works vice versa thereby allowing the company to find cheaper funding alternatives, both onshore and offshore.
- The offshore parent of a FTZ Co issues Panda Bonds and the proceeds of the issuance are deposited in a FTNRA. Then, through RMB cash pooling arrangements, it lends the proceeds to the FTZ Co which in turn uses these to refinance its onshore RMB loans.
- An offshore bank opens a FTNRA with its Chinese correspondent bank's branch in the FTZ for cross-border RMB settlement. According to the principle of pre-establishment national treatment, the offshore bank may be treated as a bank established in the FTZ. It may, for example, invest the balance of that FTNRA in the Shanghai Stock Exchange or enter into RMB derivative transactions to hedge its currency risk for providing offshore RMB services.
The Segregate Unit – for bank clients
Business conducted through a Segregate Unit should count towards the capital adequacy of the host financial institution. Its liquidity should be, in principle, self-sufficient though the upper level branch of the host financial institution may provide liquidity if necessary. Upon approval and within a certain quota, a Segregate Unit may utilise the interbank market for interbank lending or repo transactions. This seems to allow limited "permeation" through segregation into the onshore interbank liquidity pool.
Any position incurred by a financial institution for its Segregate Unit may be squared in the FTZ or an offshore counterparty. Such financial institution may also manage other risks arising from the Segregate Unit using financial derivatives on the international market. We query whether that means cross-border RMB-related derivative transactions would now be permitted.
Other significant developments
The Opinions also opened the door for a licensed third party payment entity (such as AliPay) to provide cross-border RMB settlement for internet business; expanded group companies' RMB cash pooling arrangements; envisaged issuance of certificates of deposit by qualified financial institutions in the FTZ and other measures paving the way for further interest rate liberalisation.
Although many initiatives embodied in the Opinions can be implemented only after promulgation of further rules, and there are still a lot of details to be clarified, the Opinions set a clear direction as to the end goal to be achieved. In the press Q&A, the responses of an official from PBOC Shanghai Head Quarters seemed to indicate that most of the initiatives in the Opinions will be implemented within three months and they will review the result of the reforms in six months, aiming at forming a replicable system within a year and a full rollout in Shanghai by 2020.