On 26 January 2017, China’s State Administration of Foreign Exchange (the “SAFE”) issued the Circular on Further Promoting the Reform of Foreign Exchange Administration and Improving the Genuineness and Compliance Review and Verification Process (国家外汇管理局关于进一步推进外汇管理改革完善真实合规性审核的通知) (the “New SAFE Rules”). The New SAFE Rules came into force immediately upon promulgation.
In connection with offshore debt financing, the New SAFE Rules allow the proceeds from Chinese companies’ offshore bond offerings backed by onshore security interests, e.g., onshore guarantees, to be repatriated onshore and used in China. Such proceeds may flow into China in the form of equity investment or loans, directly or indirectly. This represents a significant change from the rules promulgated by the SAFE in 2014. On May 19, 2014, the SAFE released the Provisions on the Administration of Foreign Exchange for Cross-Border Security (跨境担保外汇管理规定) and the Administration of Foreign Exchange for Cross-Border Security Implementation Guidelines (跨境担保外汇管理操作指引) (collectively, the “Cross-Border Security Rules”). Pursuant to the Cross-Border Security Rules, the proceeds from Chinese companies’ offshore financing secured by onshore security interests may not be remitted back to China, directly or indirectly, in the form of loans, equity investment or securities investment.
The issuance of the New SAFE Rules represents a significant policy change. Such change may have partly resulted from the continuing RMB depreciation and forex outflow. Some Chinese companies, particularly those companies that lack access to onshore financing but need capital for their onshore operations, will likely take advantage of the New SAFE Rules. It remains to be seen how much impact, if at all, this policy change may have on forex inflow.
Given that the New SAFE Rules allow a PRC onshore parent company to provide onshore guarantees to secure the issuance of offshore bonds by its offshore subsidiary issuer and permit the repatriation of the proceeds onshore, the question is whether there is still a need for such “soft” credit enhancement techniques as the keepwell deed (“Keepwell Deed”) or equity interest purchase undertaking (“EIPU”) as credit support for offshore bond offerings by Chinese issuers.
As a result of the restriction on the use of proceeds onshore under the Cross-Border Security Rules if there are onshore guarantees securing offshore bonds, issuers that need to use the proceeds onshore have used the Keepwell Deed, EIPU and other “soft” credit enhancement techniques as credit support for their offshore bond offerings. Under the Keepwell deed, the onshore parent company undertakes to ensure that its offshore subsidiary issuer remain solvent and have sufficient liquidity to service the principal and interest payments. Pursuant to the EIPU, the onshore parent company undertakes to purchase the equity interest in the onshore subsidiaries of the offshore issuer or its affiliates, and the purchase price will be used by the offshore subsidiary issuer to service the principal and interest payments. These forms of credit enhancement do not constitute guarantees, and therefore, the proceeds may flow into China under the Cross-Border Security Rules, generally in the form of loans or equity capital.
As a result of the rule change, will some issuers continue to rely on the Keepwell Deed, EIPU and other “soft” credit enhancement techniques? Onshore guarantees provide a stronger form of credit support, and thus the issuers will likely be able to get a better credit rating for its bonds as compared to bonds supported by the Keepwell Deed and/or EIPU. However, the onshore guarantees may have some impact on the issuers’ balance sheet, and therefore, some issuers may not be able to take advantage of the onshore guarantees. Other issuers (especially state-owned issuers) may see some negative reaction from their parent companies that for various reasons may be reluctant, or may not be in a position, to provide onshore guarantees. Thus, it remains to be seen how market practice will evolve under the New SAFE Rules.
On 14 September 2015, China’s National Development and Reform Commission (the “NDRC”) issued the Circular on Promoting the Reform of the Filing and Registration System for Issuance of Foreign Debt by Enterprises (the “NDRC Circular”) (国家发展改革委关于推进企业发行外债备案登记制管理改革的通知). The NDRC Circular abolished the case-by-case pre-approval requirement under the old system for issuance of offshore bonds by onshore Chinese companies, and introduced a system of registering foreign debt prior to its issuance or incurrence. The “pre-deal” registration requirement also applies to offshore bond offerings by offshore subsidiaries and branches controlled by the onshore Chinese companies. Under the NDRC Circular, the issuers have the discretion to use the proceeds onshore or offshore based on their actual business needs.
Since the NDRC Circular was released, there has been a number of direct issuance of bonds by issuers incorporated in China. Such direct issuance used to require approval by the NDRC. The NDRC Circular abolished such pre-approval requirement. One advantage of the direct issuance is that the proceeds may be brought back to and used in China. The proceeds from the offshore issuance, if secured by onshore guarantees, on the other hand, must stay offshore under the Cross-Border Security Rules. The New SAFE Rules now, however, permit the proceeds from the offshore issuance to flow back to China even if the bonds are secured by onshore guarantees. An issuer may need to take into account various factors when deciding whether to take the direct issuance approach or the offshore issuance approach. Such factors may include the issuer’s own debt-equity ratio, impact on rating, withholding tax and use of proceeds onshore or offshore.
The New SAFE Rules do not change the Cross-Border Security Rules with respect to the upstream guarantee provisions. Under the Cross-Border Security Rules, onshore operating subsidiaries may not provide upstream guarantees to their offshore parent issuers in connection with offshore bond offerings by such parent issuers. The Cross-Border Security Rules require that the onshore security interest provider must, directly or indirectly, hold equity interest in the offshore bond issuer; therefore, only an onshore parent company can provide the guarantee to secure the bonds issued by its offshore subsidiary issuer.
Some Chinese companies have used offshore holding companies to assess the offshore capital markets. Under this approach, the offshore holding companies own equity interest in PRC onshore operating subsidiaries. Given that neither the New SAFE Rules nor the Cross-Border Security Rules allow upstream guarantees to secure offshore bond offerings, Chinese companies using the offshore holding company structure will not be able to benefit from the rule change in connection with their offshore bond offerings.
We believe the New SAFE Rules will facilitate Chinese companies’ offshore bond offerings, and given that the onshore guarantee may have some positive impact on credit rating, it is likely that the New SAFE Rules will reduce funding costs for the issuers. It remains to be seen what impact the new rules have on other credit enhancement techniques, how market participants react to the new rules, and how much impact this policy change may have on forex inflow.
January 28, 2017