In 2016, the value of RMB depreciated over 6% against the US dollar and China’s foreign exchange reserves dropped sharply. Such depreciation of RMB and the continuous capital outflow at extraordinary levels have caused the Chinese Government concern.  Among different types of capital outflow, China’s outbound direct investment (ODI) continues to surge, with a 55.3% increase on a year-on-year basis in the period between January and November.  Recently, there has been widespread media coverage of China’s new restrictions on outbound investments by Chinese companies.  While so far no new laws or regulations have been officially promulgated, public statements by Chinese government officials and our recent experience in on-going transactions both suggest that such new measures have been implemented in practice.  In recent cross-border transactions, we are seeing outbound investments by Chinese companies, certain foreign direct investment activities, and even the overseas repatriations of foreign invested enterprises (FIEs) being affected.  Domestic companies, FIEs, and foreign companies need to be aware of the change of the atmosphere and to be prepared for the changes.

New Restrictions on Outbound Direct Investment

Since 29 November 2016, news media outlets have widely reported that China has been implementing new measures to tighten outbound transaction approval under the pressure of capital outflow and RMB depreciation.  

It has been reported that, as an interim measure to stem capital outflow, the Chinese Government is effectively implementing stricter scrutiny over six types of outbound investments:

1. Extra-large outbound investments, including:
   •outbound real property acquisitions or developments by state-owned enterprises with an investment value of US$1bn or above;
   •outbound investments of more than US$1bn outside of the core business of a Chinese buyer; and
   •extra-large outbound investments valued at US$10bn or more;
2. ODI by limited partnership.
3. Minority investments in listed companies: ODI involving the acquisition of 10% or less of the shares in an overseas listed company;
4. “Small parent, big subsidiary”: ODI where the size of the target is substantially larger than the size of the Chinese buyer or where the Chinese buyer makes the investment shortly after its establishment;
5. Privatisation: participation in the delisting of overseas listed companies which are ultimately controlled by Chinese companies or individuals; and
6. High risk/low return transactions: ODI into an overseas target resulting in a high-debt to asset ratio and a low return on equity.

In a recent press conference, officials from the People’s Bank of China (PBOC), the State Administration of Foreign Exchange (SAFE), the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) reiterated the Chinese Government’s continued support for the “Going Out Policy” and the “One Belt, One Road” initiative, but emphasized the importance of monitoring irrational outbound investments by Chinese companies.  Sectors including real estate, hotels and hospitality, cinemas, entertainment and sports clubs were specifically mentioned.

Tightening Control over Outbound Remittance

Apart from tightening supervision on outbound investments, it is reported that measures have been taken to control outbound payments:

1.Banks are now required to report any overseas transfer of US$5m or more under any capital account item (covering both foreign currency and RMB) per transaction to Beijing SAFE. Such overseas transfers can only be made after the Chinese regulators have re‑examined the underlying transaction of the requested transfer to verify its authenticity and compliance with relevant regulations.

2.SAFE also tightened controls over ODI with a capital outflow of US$50m or more. Such fund transfers will only be made after re-examination of the underlying transaction for authenticity and compliance with relevant regulations. 

3.The rules for cross-border RMB lending by Chinese companies (which used to be more relaxed than the regime for cross-border lending in foreign currency) has also been modified by the PBOC recently.  The cross-border lending limit (which is below 30% of the lender’s total equity) and shareholding requirement (that the lender and the borrower must have a shareholding relationship) which previously applied only to foreign currency lending now also applies to cross-border RMB lending.  In addition, the rules now make it clear that such cross-border RMB lending by Chinese companies need to be registered with SAFE.

Observations

As of the date of this bulletin, no official rules have yet been promulgated by the regulators in relation to the measures outlined above, although various sources suggest that PBOC and SAFE have given the so-called “window guidance” to local foreign exchange bureaus and local banks to implement such measures.  Such measures have already affected a number of cross-border transactions.

In outbound transactions, for example, an on-going outbound investment project informally endorsed by local NDRC was rejected by the central NDRC, while before the measures were out, the central NDRC would grant the approval for such case.  For some outbound deals in the planning stage, the parties are either considering postponing the transactions or seeking alternative solutions to circumvent the restrictions.

As to FIEs already established in China, foreign investors started to worry about whether the dividend distributions can be remitted offshore in a timely manner.  Transactions involving the transfer of equities or assets by a foreign investor of their PRC invested target to a Chinese buyer whereby the purchase price needs to be remitted from China across the border also became problematic.  

Practical Pointers and Outlook

People generally hold the view that the new restrictions, issued due to the pressure of capital outflow and RMB depreciation, are not an attempt to stop the “Going Out Policy” that the Chinese Government has been promoting in recent years, but to improve the quality of such transactions, to inject some discipline and to prevent “hot money” capital flight.  Of concern were attempts by Chinese companies to acquire targets in industries where they had no underlying competence, were as a result of a desire to purchase trophy assets or for reasons of moving funds offshore.  Noting this, caution should be paid when engaging in cross-border transactions in China or with China investors with an awareness of these issues.

•As the inherent regulatory risk in outbound transactions has increased significantly, it is important to import mechanisms that can fairly allocate such risks.  For example, foreign vendors may consider adopting measures such as break fees, deposits or an appropriate adjustment in valuation for risk alleviation noting that some of these mechanisms may not be so easy for the Chinese investors to accept.  Transactional documents must be carefully negotiated to allocate regulatory risks properly.

•In an auction setting, a foreign vendor should firstly be very careful in selecting Chinese buyers.  Chinese buyers in the form of limited partnerships, with limited assets, or being established recently, will have greater regulatory risks than others as they are under stricter scrutiny by Chinese regulators, thus, should be avoided if possible.  It is advisable to choose buyers that have substantive operations and with a considerable scale of assets.  Another important point to consider is whether the payment, even denominated in RMB, can be transferred out of China.  The general perception is that China will impose the same level of control over cross-border transfer of funds in RMB as that in foreign currency.  Chinese buyers could no longer take advantage of the more lenient RMB regime to transfer a “large sum” of funds in RMB offshore without similarly stringent formalities.

•Parties should be cautious when engaging in outbound investments in business specifically mentioned by Chinese government officials, namely real estate, hotels and hospitality, cinemas, entertainment and sports clubs.  It is anticipated that the approval for outbound investments in the above-mentioned business will be difficult to obtain due to the stricter scrutiny imposed.

•Timely communication with Chinese regulators is important under the current situation.  Chinese buyers are encouraged to apply for approval or record-filing as early as possible and to actively communicate with the Chinese regulators for the purpose of facilitating the regulatory procedure.  FIEs with a dividend distribution plan in large amounts should consult the banks and local SAFE at the earliest to understand the current best practice for overseas repatriations.

•The measures will increase the difficulty of outbound fund transfers. A Chinese buyer may consider alternative plans such as using offshore funding to avoid fund flow from China to overseas, noting that this option is subject to the Chinese buyer’s overseas financing ability.  For outbound investment deals that are able to complete filings with NDRC and MOFOM, parties will need to budget additional time for deal closing as fund transfers may take much longer due to the newly-imposed controls.

•The measures will have an impact on the timetable for any event-driven financing.  At this stage, it is unclear whether the measures will affect the financing structures, including the registration by SAFE of any guarantee granted by the PRC parent in support of the offshore acquisition financing obtained by its subsidiary under the “Neibaowaidai” structure.  It would be prudent for any PRC company which intends to provide a guarantee for such acquisition financing to enquire with local SAFE in advance.

It is rumoured that the restrictions on ODI will stay in place until September 2017 and the restrictions on outbound remittance will continue at least until February 2017.  We will continue to monitor the development and provide another update in due course.