Walking Through Chinese Walls, published Financier Worldwide

Published in Financier Worldwide magazine

When the Chinese State Administration of Foreign Exchange (Safe) released a circular dealing with foreign exchange controls at the beginning of this year, it set off a number of alarm bells among both national Chinese and foreign investors.

While the measures in the circular have yet to be officially made law, it is already being enforced by Safe and the alarm bells are growing ever louder.

Officially known as The Circular on Certain Issues of Improving Administration of Foreign Exchange in Connection with Mergers and Acquisitions by Foreign Investors, the circular limits the ability of Chinese nationals to take money overseas. For the first time, Chinese mainland-based individuals and companies will have to seek Safe approval in order to make overseas investments.

According to tax and finance experts in China, the circular's principle aims are three: to prevent wealthy Chinese people taking their assets out of the country (even though these people still intend to remain in China), by setting up companies in places such as the Cayman Islands; to prevent 'capital flight' by individuals aiming to leave China altogether; and to put a stop to 'round-tripping', where Chinese companies take money out of the country and then re-invest it in China in order to benefit from tax breaks and other incentives which are only available to foreign investors.

The circular extends the limits of earlier legislation, which already limited repatriation of hard currency by foreign-invested enterprises in China and regulated foreign investments by securities, pension and insurance funds. This new circular extends these controls to foreign investments by private individuals.

The difficulty for foreign investors is that the circular, if fully implemented, could have an enormous impact on all M&A activity in China. "This could impact every single deal in the pipeline," as Robert Woll, managing partner of the Hong Kong office of law firm Morrison & Foerster puts it. "It may have unintended collateral damage."

For some years, Chinese businesspeople have pursued exit strategies for their companies through M&As or public listings, typically establishing an offshore holding company to circumvent Chinese laws forbidding the direct listing of Chinese companies on foreign stock exchanges. These companies include such giants as China Telecom, China Unicom and China Mobile, all listed on the New York stock exchange.

Companies who might wish to follow this example may now find themselves blocked by Safe, according to Robert Woll. Many new approval attempts for investments in offshore companies have been turned away by Safe in the past few months. This blockage may lead to a closedown of much M&A activity in China, as access to capital becomes progressively harder.

China's domestic stock exchanges are nowhere near advanced enough to support the country's commercial growth: every company that lists on the national bourses must have a 'legal person', normally the CEO or chairman of the company, who must hold around one-third of the shares in the company, which cannot be traded. "Because of the liquidity factor, you must have an offshore company or you're stuck with illiquid shares," points out Woll. "That would be a complete catastrophe for a private equity investor."

Tellingly, neither the Ministry of Commerce or the China Securities Regulatory Commission have endorsed the circular, leading China watchers to speculate that there has been some rift, or at least a breakdown in communication, between different parts of the governmental administration. The government itself has warmly welcomed investment from foreign venture capital funds, seeing them as crucial to the stimulation of technical innovation. A number of Chinese high-tech firms have already listed on Nasdaq, with no demur from Beijing.

What continues to alarm experts in China, however, is the absence of real implementation guidance: "The details of the circular are very badly spelt out," says Walker Wallace at law firm O'Melveny & Myers in Shanghai. "So the whole business community has been left in limbo. Some local firms think the measure won't be implemented, but others think that it represents a very significant risk. If you start a company and three years down the line you want to do an IPO or sell the company, there could be regulations saying 'we're going to make your life very difficult'."

Wallace can see the logic of preventing capital flight and clamping down on 'round-tripping', but he takes issue with the aim of thwarting successful Chinese businesspeople from investing overseas. "They seem not to acknowledge that these individuals have created world class companies and created value to help the Chinese economy," he says.

Along with the rest of the Chinese investment community, Wallace is in no doubt that the circular has caused a delay in deals progressing. "People are trying to get to grips with it," he says. "It's had a major effect on transactions. People have been forced to go back to more primitive structures."

It is possible that there are some silver linings to the situation, from foreign investors' points of view. Since the circular is so limiting on Chinese individuals, foreigners may find that they can increase their leverage in M&A transactions. But for the Chinese entrepreneur, "This is a terrible situation," says Wallace. "They may be forced to give up control of their companies or not invest at all."

Curiously, the 'circular' was not in fact circulated to businesses or the legal profession ahead of its release, but simply issued in late January this year. Experts in China believe the measure was in part a 'knee jerk' response to the over-heating economy, to the fact that so many people have grown very wealthy in a short time and that many companies' affairs have become obscure to the authorities, through setting up offshore companies and listing overseas. "The government seems to feel that things are spinning out of control because people are making so much money," says Wallace. "There is a sense of insecurity to do with money going offshore."

Along with many other interested parties, Wallace's company is lobbying the state tax bureau and other arms of the government to clarify the situation. The Chinese venture capital association is particularly vocal in its querying of how the circular is to be implemented.

Some believe that the clampdown on foreign investment is part of a wider Chinese movement to assert the country's national identity, in line with the recent protests from China regarding Japan's state publication of a history textbook downplaying Japanese atrocities during the occupation of China in the 1930s and 40s, alongside China's opposition to Japan gaining a permanent seat on the UN Security Council.

Certainly, as China's GDP increases each year to levels closer to developed countries, there are bound to be new tensions and conflicts over how this wealth is allocated. The pace of the changes and the influx of money appears to have taken the Chinese regulatory authorities by surprise. For example, there remain grey areas over issues as fundamental as the sale of a property or company. "There is still no clear statement on the exact point at which equity changes hands and when risk changes hands," says Walker Wallace. "This is an awkward point and the approval regime continues to be a drag on commercial life."

In other areas of the Chinese economy, meanwhile, business has continued to flourish. The high tech sector remains buoyant, with Chinese and foreign-owned companies taking an ever greater slice of the world's IT manufacturing cake and domestic demand for computers, mobile phones and other devices reaching new peaks. "Investment in IT and real estate is certainly helping to bring liquidity to the market," says Wallace. Multinational corporations such as GE, Unilever and Proctor & Gamble are all investing heavily in China and Chinese operations. Companies of this size have little to fear from the recent investment circular since their conditions of business have long been established.

Real estate investment has been another growth area so far this year, with cities outside the two main locations of Beijing and Shanghai beginning to benefit from serious development funding and a series of joint ventures forming between Western and Chinese companies.

This sense of opportunity and freedom to create commercial structures in Chinese real estate comes against a backdrop of legislative controls, some of which appear daunting. The Value Added Land Tax, for example, remains on the statute books and can mean sellers of property paying between 30 and 60 per cent of any rise in value. Yet the tax has 'officially' been suspended and Western companies make their commercial predictions assuming that it will not be levied. Nevertheless, there have been recent examples of the tax being applied, where local authorities wish to 'shake down' a certain company.

There may in time be parallels drawn between this (generally neglected) tax and the foreign investment circular. Certainly there are some observers in China who argue that the circular is more of a warning shot to Chinese nationals trying to shift their assets overseas and will not be enforced to the point where it stifles inward investment.

But this is more of a hope than a belief. The mere fact of its existence and the fears it has raised of the iron hand of the Communist state returning to restrict commercial activity has already had a profound effect on investor sentiment. For the moment, the investment community is casting around for means of circumventing the measure, presuming that it will be fully enforced.

But those such as Robert Woll at law firm Morrison & Foerster who have studied the progress of similar Chinese legislation are optimistic that the benefits to China of an open and free-flowing trade system will outweigh their anxieties over outgoing finances. "I'm confident that the regulators will pursue an enlightened path, because they are increasingly sophisticated and understand the importance of this technology ecosystem to China's economic development," he says.

This article was originally published in Financier Worldwide and can be viewed here.