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SAFE and Sound


July-August 1998


By T.K. Chang*



A conspicuous irony of the Asian financial crisis for China investors is that the general non-convertibility of the renminbi (RMB), about which foreign investors have long complained, has in fact enabled China to escape the regional turmoil relatively unscathed. Moreover, Beijing's past policy of strict foreign-exchange controls, and its dogged insistence that Sino-foreign joint ventures balance their foreign exchange and meet export quotas or targets, have helped China amass one of the world's largest reserves of foreign exchange. World leaders now look to China, and PRC Premier Zhu Rongji, to help lift Asia out of its economic doldrums.


In the aftermath of the Asian financial crisis, the PRC leadership has responded by adjusting China's policies on foreign debt and foreign direct investment (FDI), as well as its timetable for full convertibility of the RMB. Since mid-1997, Beijing has passed a number of regulations that further tighten government controls over foreign-currency debt obligations and that grant incentives aimed at attracting FDI. Among these are regulations issued by the State Administration of Foreign Exchange (SAFE) that strengthen its control over international commercial borrowings, the issuance of foreign-currency bonds, and the overall foreign-debt exposure of Chinese entities; and that tighten restrictions over collateral security provided to foreign lenders and the establishment by PRC entities of overseas foreign-exchange accounts.


Rather than take on short-term foreign debt, a primary cause of the crises in other Asian countries, China is promoting FDI. Beijing restored the tax exemption revoked in 1996 for the import by foreign-invested enterprises (FlEs) of certain types of capital equipment (see The CBR, March-April 1998, p.4). Unlike foreign debt or portfolio investment, FDI cannot be defaulted upon or accelerated, and is generally illiquid and difficult to shift quickly out of the country. PRC leaders finally seem to be realizing the increasing indispensability of FDI to China's future economic growth, and the significant role that it has already played in China's modernization.


Postponed Convertibility


Prior to Asia's financial implosion in 1997, China's leaders appeared to be targeting an aggressive timetable for making the RMB a fully convertible currency. To that end, the PRC government declared in 1996, several years ahead of the original target date, that the country's currency was convertible for current account transactions, making the RMB officially convertible for profit repatriation and trade in goods and services. PRC officials also have offered to abolish foreign-exchange balancing requirements and export quotas for FIEs in connection with the country's bid to join the World Trade Organization (WTO). Combined with the PRC's rapidly growing foreign-exchange reserves, which topped $140 billion in 1997, these moves suggested that convertibility of the RMB for capital account transactions was perhaps a realistic goal by the year 2000.


But the financial crisis halted progress on full RMB convertibility. Despite mounting bad debts and an ailing banking sector, the non-convertibility of the RMB shielded the currency from speculative attacks by world financial markets. As a result, Beijing is likely to enforce tighter foreign-exchange controls, making full convertibility of the RMB a more distant prospect.


SAFE Tightens Debt Controls


The financial problems in Indonesia, Thailand, and South Korea illustrated the dangers of uncontrolled borrowing of foreign currencies by non-sovereign borrowers. For example, Indonesia's more than $65 billion in outstanding private sector debt--a level much higher than ever previously suspected--remained hidden until more than five months after the outbreak of the financial crisis. China, on the other hand, has generally exercised caution in restricting enterprises and local entities from incurring foreign debt, primarily by requiring government approval for foreign-exchange transactions.


But a number of analysts and international organizations believe that official PRC statistics underreport the country's true level of foreign indebtedness. Official PRC statistics show utilized foreign bank commercial loans in the first 11 months of 1997 of only $904 million. Records of the Bank of International Settlements, however, indicate a debt load of $86 billion in June 1997, up from $75 billion in June 1996. According to some analysts, offshore accounts of PRC entities may also have significant foreign-debt obligations that are not reflected in official figures.


To keep a lid on China's foreign indebtedness, SAFE issued the following regulations: the Procedures for the Administration of the Borrowing of International Commercial Loans by Domestic Institutions (the International Loans Procedures), Procedures for the Administration of Foreign Currency Bonds by Domestic Institutions (the Foreign Bonds Procedures), Implementing Rules for the Statistical Monitoring of Foreign Debts (the Debt Monitoring Implementing Rules), Implementing Rules to the Procedures for the Administration of the Provision of Security to Foreign Entities by Domestic Institutions (the Foreign Security Implementing Rules), and Provisions on the Administration of Overseas Foreign Exchange Accounts (the Forex Accounts Provisions). These regulations, which took effect January 1, supersede or supplement previous regulations, and increase government control over foreign-exchange transactions, either by tightening the requirements for such transactions or by extending the coverage of the regulations over previously unregulated transactions.


International Loan Procedures


The International Loan Procedures replace the 1991 Loan Procedures issued by the State Administration of Exchange Control (SAEC), SAFE's former English name. The new procedures require all PRC enterprises to obtain central- or local-level SAFE approval before securing any international commercial loan that constitutes an obligation to a foreign financial institution or individual either inside or outside the PRC.


Compared to the 1991 Loan Procedures, the international Loan Procedures are considerably broader in scope and more restrictive. For example, the definition of "international commercial loans" now includes export financing, financing leases, foreign-exchange payments in connection with compensation trade, overseas foreign-exchange deposits (except with approved offshore banking departments of PRC banks), project finance, and trade-related finance with terms exceeding 90 days. The International Loan Procedures also set forth stringent criteria for approving requests by non-financial PRC institutions to secure international commercial loans. Such criteria include the requirements that the borrower be profitable for three years prior to seeking a loan, and that its total international loans and provision of foreign security not exceed 50 percent of its net assets or its total foreign-exchange revenues for the previous year.


Many provisions of the International Loan Procedures apply to FIES, unlike the 1991 regulations. For example, under the 1991 procedures, a PRC company with more than 25 percent of its registered capital in the form of B shares (the type of tradable share available to foreigners) qualified as an FIE and thus could secure international commercial loans without SAFE approval. But the International Loan Procedures could be interpreted to require SAFE approval for certain international loans to FlEs that relate to project finance. It remains uncertain how many of such provisions actually can apply, in practice, to FlEs, as most of them are directed at domestic PRC enterprises. Foreign investors will need to await further interpretation by SAFE before gauging the impact of the International Loan Procedures on their China ventures.


Foreign Bonds Procedures


The Foreign Bonds Procedures override the Procedures for the Administration of Bond Issues Outside the PRC by Domestic Institutions, promulgated by the People's Bank of China (PBOC) on September 28, 1987. Under the new procedures, SAFE approval is required for the issuance of all securities denominated in a foreign currency, including convertible bonds, large-denomination transferable certificates of deposit, and commercial paper. All the provisions of the Foreign Bonds Procedures apply to FIEs. Thus, FIEs and PRC companies with more than 25 percent foreign equity cannot issue any type of foreign currency bond or other security without SAFE approval, even floating-rate notes or other securities that resemble loans. The Foreign Bonds Procedures also prohibit local governments from issuing bonds outside the PRC, or applying for a credit rating issued by a foreign agency.


Debt Monitoring Implementing Rules


The Debt Monitoring Implementing Rules supersede the Implementing Rules for Foreign Debt Registration, issued by SAEC on November 10, 1989. These monitoring rules detail the legal framework for registering and tracking the total national foreign-debt exposure, including the foreign debt of enterprises and government ministries. Although most FlEs do not need SAFE approval for international commercial loans, these monitoring rules require all FlEs to report such loans to SAFE. Rigorous enforcement of the Debt Monitoring Implementing Rules will help China avoid the problems experienced by the governments of South Korea, Thailand, and Indonesia, which had vastly underestimated the foreign exchange obligations of their private sector companies.


Foreign Security Implementing Rules


The Foreign Security Implementing Rules supplement the Administrative Procedures for the Provision of Security to Foreign Entities by Domestic Institutions (the Security Procedures), which PBOC issued on September 25, 1996. The Securities Procedures and the Foreign Securities Implementing Rules aim to curtail indiscriminate guarantees and other abuses that already have resulted in the closure of a number of provincial and ministerial trust and investment corporations in the PRC (see The CBR, January-February-1997, p.16). These implementing rules, in 52 detailed articles, reinforce SAFE's authority over all types of security provided to foreign entities, including guarantees, mortgages, and pledges. The provision of such security represents a contingent foreign-exchange obligation, and requires SAFE approval. Under the Foreign Security Implementing Rules, however, the provision of security by wholly foreign-owned enterprises does not require SAFE approval.


Foreign Exchange Accounts Provisions


The Foreign Exchange Accounts Provisions replace the Provisions on the Administration of Overseas Foreign Exchange Accounts of FlEs, issued by SAEC on January 7, 1989, which applied only to FlEs. Under the Foreign Exchange Accounts Provisions, SAFE must approve the establishment of any overseas foreign-exchange accounts by domestic institutions. Because of the still imperfect legal framework in the PRC for taking security interests, such as a lien or mortgage over assets, foreign lenders in China have often had to resort to taking security over the overseas bank accounts of PRC borrowers. Under the Foreign Exchange Accounts Provisions, the establishment of overseas foreign-exchange accounts, and any change to the scope of receipts and expenditures, the maximum account balance, or the duration of such accounts, are subject to SAFE approval.


Revitalizing Foreign Investment


Beijing has also sought to bolster declining foreign investment levels by reinstating the tariff and tax exemptions in conjunction with the issuing of a revised Guiding Catalogue for Foreign Investment in Industry. China's failing FDI receipts stem, in part, from continuing economic problems in other Asian countries, which traditionally accounted for a significant portion of China's foreign-investment inflows, and the removal of foreign-investment incentives. Beijing had revoked the tariff exemptions enjoyed by FlEs because Chinese economists had argued that excessive FDI was, in part, responsible for the high inflation in the early 1990s, and that such exemptions gave FlEs an unfair advantage over PRC enterprises. The FIE exemptions prompted many PRC enterprises to cycle funds through their overseas subsidiaries and establish false FIEs to make "round-trip" investments, taking advantage of the FIE tariff exemptions.


Such arguments prompted Beijing to revoke tariff and duty exemptions for all capital imports of FlEs approved on or after April 1, 1996. Ironically, PRC officials claimed the move represented the government's commitment to honor requests by the United States and other Western members of the WTO to provide FlEs "national treatment," that is, treatment equal to that given to PRC domestic enterprises.


The effect of removing the tariff exemptions on foreign investment in China were not readily apparent in 1996, in part because foreign companies had accelerated their capital import timetables to beat the various deadline phases. But the precipitous drop--by more than a quarter--in China's contracted FDI in 1997 caught Beijing's attention. PRC leaders, realizing that already slowing foreign-investment inflows would likely drop further as a result of the Asian financial crisis, responded by restoring the tariff exemptions, effective January 1, 1998.


Although China has so far avoided the worst ravages of the Asian financial crisis, it shares many of the systemic ills of its Asian neighbors, including massive nonperforming bank portfolios, fragile financial institutions, and an overbuilt property sector. China faces potentially massive layoffs resulting from the reform of the State-owned enterprise sector. China's post-Deng leadership will perhaps need to implement more fundamental reforms to both the Chinese economy and the Chinese political system--beyond just controls on foreign debt and incentives for direct investment--to stem the tide of recession and deflation, and the accompanying societal pressures, that seem to be sweeping across Asia.


*Mr. Chang has represented SAFE as legal counsel in certain corporate finance transactions with international financial institutions.  For more information concerning Mr. Chang, please go to: