A quiet revolution in China’s capital markets
Reforms that attracted little attention in the Western world mark a major step forward in the modernization of China’s capital markets.
James Ahn and David Cogman
(McKinsey Quarterly) When China first began privatizing its state-owned enterprises in the 1990s, the intent resembled that of other privatization programs around the world: to use capital market pressures to improve the performance of a large number of state-owned companies, many of which had weak balance sheets and were not as commercially focused as publicly held companies elsewhere. However, the government wanted to retain substantial shareholdings in and influence over these companies, which precluded the full privatization of state assets. To allow such companies to raise capital in that context, a two-tier ownership structure was put in place. Essentially, the original equity remained legally distinct from the new equity and formed a separate class of shares held by the existing state-linked owners. Although both classes had the same theoretical rights to profits and votes, the nontradable shares could not be sold on the public markets.
As Chinese companies have grown in scale and complexity, this system has faced several challenges. With a two-tier equity structure to manage, state-owned enterprises understandably concentrated on their most important stakeholders: the government and one or two of their largest holders of nontradable shares. Smaller holders of nontradable shares and public-market shareholders had very limited influence either on the governance of these companies or their investment decisions. This arrangement had a negative effect on the development of the Shanghai stock market. After falling from its peak in 2001, when the first wave of IPOs was complete, it progressively declined until mid-2005, losing more than half of its value. Although the two-tier share structure did not cause the slump, the uncertainties it created prevented the market from recovering over the following five years, and it also affected the overall credibility of Chinese stock markets, both as a source of capital and as a vehicle for investment.
Now a second-wave reform effort that does away with the two-tier structure is showing signs that it could spark a revolution in China’s capital markets by affecting M&A activity, the equity markets, and corporate governance. Two years ago, the government instituted new policies requiring companies to merge the two classes of shareholdings—in essence, making the nontradable shares liquid. As of this spring, more than 90 percent of state-owned enterprises had already completed plans to that effect; shareholders at the last few companies are expected to finalize their reform plans this year.
This seemingly technical reform received little attention outside China at the time but will have a profound impact on the structure of its capital markets if implementation proceeds as planned. Depending on the specific agreements negotiated between shareholder classes at each company, over the next five years, all shares in China’s state-owned enterprises will become fully tradable (Exhibit 1)—thousands of majority and large-minority stakes, spread across the entire economy. In several sectors, they account for up to two-thirds of the equity of all listed companies (Exhibit 2). These reforms will also encourage the development of the country’s M&A market by allowing industries to consolidate, improving corporate governance at state-owned enterprises, and expanding the capital markets.
Already, investors who lost significant wealth in previous years have returned to the market en masse, sparking an 18-month rally that has already reversed the decline of the previous five years—and continues at the time of writing. Although the market’s performance still attracts considerable attention from investors and the media, as well as the interest and concern of policy makers, we believe that the longer-term implications of the latest round of reforms are potentially far more significant.
Setting the stage for reform
As the reforms of the 1990s ran into challenges, the government put forward several different plans for merging the two kinds of shareholdings and making the nontradable shares tradable. None of these early trial runs won the support of the companies and shareholders involved. Public shareholders—in the minority—worried about what would happen to them if the two-tier equity structure were dismantled. Many feared that shareholder value would be massively diluted or that the market would be flooded with more new equity than it could absorb, thus structurally depressing prices.
Owners of nontradable shares had their own concerns. Deals involving nontradable stakes achieved relatively low valuations and faced considerable regulatory difficulty. Transactions involving the nontradable shares required approval from the State-Owned Assets Supervision and Administration Commission of the State Council1 (SASAC), a government department created to oversee and supervise listed and unlisted state-owned enterprises, and the valuations for such deals were typically quite low—during 2003 and 2004, around a third of the value of the traded shares, on average. Moreover, approval requires an assessment by SASAC that the valuation is “fair”—a determination based on the implied premium or discount to the estimated net asset value in the deal rather than on market-based notions of valuation. Because this approach often created large disparities between the valuations offered by strategic investors and the prices that companies could accept, it prevented deals from going through.
In 2005 China’s State Council, the country’s chief administrative authority, asked SASAC and the China Securities Regulatory Commission (CSRC), which regulates stock markets, to come up with a def initive scheme to end the two-tier equity structure. The two entities put in place reforms requiring all companies to implement plans to merge shareholdings. Although the companies themselves could determine the specific form and implementation of the plans, every plan had to include two key elements. First, no more than 5 percent of the previously nontradable shares could be sold in the first year following the accommodate’ approval of an integration plan and no more than 10 percent in the next year. Thereafter, companies could specify longer, voluntary lockup periods, but for most there would be no mandated restriction on the sale of shares in public markets. This measure spreads the impact of the reforms over several years: the first wave of companies to pass a reform plan will see their shares become tradable only in late 2007 and early 2008.
Second, the plans had to involve some compensation paid by the holders of nontradable shares to the owners of tradable ones. A consensus quickly emerged that holders of tradable shares should receive a bonus worth 30 percent of their premerger stake. Most plans approved bonuses to be paid in equity, though many combined it with cash and options. This compensation was a high price for the holders of nontradable shares to pay in order to make their shares tradable. The reforms therefore represented a gamble that eliminating the two-tier structure would attract enough liquidity to make the price worthwhile.
Negotiations over these plans involved instances of shareholder activism that would have been inconceivable in China when state-owned enterprises were first privatized. Under the reforms, each plan had to gain the support of a two-thirds majority of the nontradable shares in a vote and, separately, a two-thirds majority of the tradable shares. Almost all the public debate around share reform centered on compensation for the latter. In several high-profile cases, when companies made offers that were viewed as too low, public figures organized to vote down the plans and forced the companies to make more generous proposals.
M&A market development
These reforms are an important enabler for the development of the domestic M&A market. Many people suppose that the state shareholding SASAC oversees is a single, monolithic block. In fact it is a complex web of different types of shareholders—different layers of government, other state-owned enterprises, banks, and investment companies—often with very different intentions. Around 20 percent of the non-tradable equity is in sectors viewed by the government as strategic, where investment is closely controlled. Slightly more than 55 percent is held by strategic investors with a long-term interest in the companies: for instance, those in an upstream or downstream industry or local governments that have invested because the companies are major employers in the local economy. The remaining 25 percent represents shareholdings primarily by state-owned financial investors. Of their holdings, more than 75 percent of the equity (by value) is in sectors open to foreign investment.
As the reform plans go into effect, these financial investors in nontradable shares will for the first time be able to rationalize their noncore investments—a development that could create a wave of M&A activity. That would provide a powerful stimulus for the longer-term development of China’s domestic M&A market by forcing companies to develop a sorely lacking experience and confidence in doing deals. The domestic M&A market and cross-border investment in China may well grow too.
The biggest winners will be some of the more aggressive domestic companies looking to consolidate their sectors. What’s more, many executives of state-owned enterprises we’ve spoken with view the reform as an opportunity to manage their shareholder base more actively by encouraging the departure of passive, nonstrategic investors and bringing in new strategic ones, often foreign companies, that can help them develop their capabilities—for instance, in accessing new markets or technologies. Astute foreign companies seeking to expand their footprint in China will no doubt use the “unfreezing” of ownership structures to find strategic partners of their own.
Uncertainties remain. First, the government also recently instituted a new policy to create a transparent environment for M&A. The policy extensively revises the framework for foreign companies investing in China, specifying which industries are considered strategic and thus not open to 100 percent ownership by private or foreign investors. Many details on the policy’s application are unclear, and the definition of “strategic” is so flexible as to accommodate a number of interpretations. Second, SASAC’s role will continue to be critical in M&A activity involving state-owned enterprises. Historically, it has acted as custodian of the state-linked portfolio. Although the commission will still be responsible for overseeing state-owned shares, it has signaled interest in concentrating its efforts on the subset of truly strategic companies and progressively opening the rest to market forces. However, it is hard to say how quickly it will proceed down this path.
Capital market expansion
By allowing formerly nontradable shares to be sold, share reform creates a huge pool of equity potentially seeking liquidity—nearly twice the capitalization of the market today and far greater than the new liquidity seen in recent years. The risk of a massive inflow of new shares was a major concern prior to reform. Yet the supply of liquidity into the domestic equity market could grow even more. By the time the last of the nontradable shares becomes fully tradable, in 2012, current plans to reform the pension system and social security, if implemented, will have generated new funds for investment into the equity market. Those funds will be worth two-thirds of the value of all nontradable equity, or around 75 percent excluding sectors with investment restrictions.
This increase will greatly enlarge the base of domestic institutional investors, which today account for only 10 percent of all investors. That huge shift will create a professional-investor segment with holdings that exceed the capitalization of China’s domestic equity market today. Indeed, McKinsey research suggests that from 2005 to 2015 the funds under management of China’s asset-management industry could grow by as much as 24 percent a year. A professional, organized investor base would also be a powerful force in advancing best-practice governance.
Furthermore, as Chinese middle-class investors gain greater confidence in the equity market, they could generate enormous amounts of new liquidity by shifting their assets to shares from their present low-yielding bank deposits, which now account for almost three-quarters of China’s financial assets, compared with around 20 percent in the United States. (Diana Farrell and Susan Lund, Putting China’s Capital to Work: The Value of Financial System Reform, McKinsey Global Institute, May 2006, available free of charge online.) Because of exchange controls on China’s currency, the renminbi, this capital is concentrated within the country. The level of investment activity in recent years in real estate, art, and equities suggests a desire for viable domestic investment opportunities. In that case, domestic stock exchanges would become much more attractive for listing. Already, some high-profile Chinese companies that had scheduled IPOs in Hong Kong have changed their plans, deciding instead to pursue a Shanghai listing. Aside from currently favorable pricing, this move has considerable public-relations value.
Over time, a healthy, liquid equity market will also take pressure off the banking system, which today is the principal allocator of capital. A gradual shift from bank debt to equity as the primary source of funding for companies would improve the allocation of capital, make the ability to produce profits more important, and reduce the economy’s reliance on the banking system.
The development of domestic equity markets might also make foreign companies with significant operations in China consider the strategic merits of a Shanghai IPO of minority stakes in their Chinese holding companies. Indeed, a few joint ventures have already started to explore this possibility. Although a Shanghai listing would be complex, it has potential strategic benefits: it could mitigate the implicit foreign-exchange risk in funding and send a very strong signal of commitment to China and of success in localizing foreign businesses.
One major uncertainty that remains is how access to the equity markets will be managed. Historically, a government committee approved IPOs, and state-owned enterprises found it far easier to gain approval than did China’s emerging private-sector companies. With the recent explosive growth of the Shanghai stock market, companies have become much more interested in new IPOs. Greater access to the capital markets would make private-sector companies less reliant on debt financing, reducing the risks both for them and for the banking system in the event of an economic downturn. It would also allow private enterprise to play a greater role in accelerating the consolidation of many industries.
The reform of China’s capital markets still faces significant obstacles. China must further improve the accounting, legal, and regulatory framework needed for equity markets to reach their full potential. Although the government implemented a completely new set of accounting and auditing standards earlier this year, there are simply not enough Chinese-speaking accountants to meet the needs of every listed state-owned enterprise; accounting firms cannot hire and train people fast enough. Similarly, although the legal framework is well designed, enforcement and support—courts, arbitration procedures, experienced lawyers—are still lacking or inconsistent. Finally, effective market regulation typically requires independence and objectivity, but in today’s China no government department really enjoys them.
Corporate governance
Currently, China is sailing in uncharted waters as it explores ways to develop its own approach to improving corporate governance.2 One of SASAC’s most heavily publicized initiatives is aimed at encouraging the companies it supervises to upgrade the quality and transparency of their governance. Under the two-tier equity structure, even companies that wanted to implement corporate-governance systems more inclusive of the holders of tradable shares found it extremely difficult to do so. The reforms facilitate a number of important changes. Companies are now allowed to implement share-incentive schemes to align the interests of managers and all groups of shareholders. With the legal distinction between investor classes removed, the importance of the public-market investors will increase and so will the role of the equity markets in allocating capital. Companies will feel pressure for greater transparency in their decision-making processes and will focus on generating returns for all equity investors.
It may be too early to say how the development of corporate-governance standards will affect overseas investors, but we are cautiously optimistic. In recent years many industries in China have seen intense competition to build production capacity, partly because mechanisms for allocating capital rewarded companies for top-line growth rather than generating returns on capital. These problems were most noticeable in commodity industries (such as steel, cement, and paper), several of which now have structural overcapacity in China and are destabilizing export markets. A greater role for equity shareholders and better governance will increasingly push management teams to run companies for profitability and not just growth.
Implementing high-quality governance will be a long, challenging process. China will need to address a serious shortage of executives in the mainland with the skill and independence to be competent board members. Because many state-owned enterprises are at an early stage of installing best-practice governance, executives and potential board members will need time to translate their academic understanding of it into practice.
Over the past 25 years, China’s market reforms have delivered impressive results in developing product and labor markets. This latest round of privatization lays the foundation for similarly dramatic changes in the country’s capital markets and the market for corporate control.
Showing posts with label china. Show all posts
Showing posts with label china. Show all posts
Monday, September 24, 2007
Friday, August 17, 2007
Some notes on Leveraged Financing in China
White & Case
China: Future of Leveraged Transactions in China
25 February 2007
Article by Fred Chang
Leverage Not Taboo
The requirement for a high level of leverage to finance a project is neither unusual nor taboo in China, and there has in the past been no shortage of willing borrowers, lenders and (most importantly) approval authorities keen to execute leveraged transactions.
However, most of this activity has been in the context of transactions generating tangible assets such as new plant and infrastructure. This is now being extended—with the enthusiasm of all concerned—to the consummation of structured financing transactions designed to finance the origination and carrying of financial assets such as loans, rentals and trade receivables. So does a thriving economy continue to expand.
In China, however, the exuberance for leverage has not so far extended to corporate takeovers. It is one thing for the government partially to divest its holdings in state owned enterprises, accompanied by injections of new equity capital into the SOEs to fund capital expansion, in IPOs and strategic investment transactions. It is another thing for the government to acquiesce in the change in control of Chinese companies where the would-be acquirer (particularly if it is a foreign entity) has one of two motives (in the mind of the government): housecleaning or exit. The government would rather have it both ways. The existing personnel and business should be what remains at the end of the day and the acquirer should increase the going-concern value of the company by "reforming" both those people and the business that it acquires1. For these purposes, the word "acquirer" refers to a foreign-organized acquirer of more than 50% of the voting stock of a Chinese company that is (or is the largest shareholder in) a listed2 Chinese company, and "takeover" refers to a transaction which leads to that result.
This article examines, in relation to listed companies: (a) the reasons in favor of at least some types of takeovers, and; (b) the methods by which takeovers can utilize leverage to enhance the acquirer’s incentives. Being an area that has not yet been tested, leveraged takeovers in China present a set of risks which this article briefly analyzes and attempts to quantify.
Takeovers Not Considered Intrinsically Valuable
A takeover for its own sake lacks appeal to the Chinese policy-makers, since no asset is created. Indeed, where the company is state-owned, simply to give the government funds in exchange for control of the company begs (in the view of the government) the twin questions of: (a) how to reform the company, and; (b) how to define the government’s ongoing role in the economy.
Company boards owe a fiduciary duty to their shareholders. There are certain types of company, however, that owe fiduciary duties to other constituencies as well. For example, financial institutions that take Other People’s Money, at least when Other People means the retail public, owe fiduciary duties to depositors, policy-owners, and brokerage and fund investors. In the shiny world of theory, the State as owner of a financial institution has the best interests of all its citizens, including the Other People whose Money such financial institution controls, at heart. But this theory culminates in the concept of financial institution as shadow tax collector.
It creates conflicts between the purely financial motivations of the people whose residual income is placed in financial institutions and the fiscal (or less salutary) motivations of the central and local governments that are the owners of such financial institutions. Although the Guangdong Development Bank ("GDB") transaction could not be approved as a takeover, there is nothing to say that this situation could not change in the future. Indeed, the financial services sector is an area that, a priori, is best run professionally rather than by the state. However, such a development is likely to unfold as an iterative process, as the provision of credit is a highly sensitive industry where: (a) the alternative methods of capital raising, such as bond and stock markets as well as private placements, are still embryonic, and; (b) the need to fund capital expenditures is still critical.
A second area where takeovers may be welcome is for companies in distress (yet, for purposes of leveraged takeovers, have positive book net worth). It is important to bear in mind that the shareholders of the target company will be likely to include as a majority various governmental entities, and that for the foreseeable future, the motivations of such shareholders are not those typically prevalent in Western economies. The conventional wisdom of having a three-pronged arsenal to mitigate the risk of fundamental disagreement with management (proxy battles, derivative suits and the ability to exit positions in the stock market) is not very relevant in China—for the foreseeable future it is these governmental entities that will be left holding the bag for failed management of significant enterprises, whether as stockholders or otherwise. The pool of management talent that understands how to sell goods and services in China is not yet deep enough to support a full-blown market for corporate control. There is little interest, as yet, in having debates about corporate policy play out in the Chinese securities markets. Rather, it is when there is nothing left to debate, as in the case of a chronically unprofitable company, that a takeover begins to make sense, a posteriori.
A third area is street sales. These must be approved, or taken up in a purchase, by a majority of the other shareholders—by a controlling shareholder in a company that is not state-owned, such as street sales of interests in Sino-foreign joint ventures or in privately owned enterprises for purposes of converting to "FIE" status (generally, a tax-favored domestic enterprise with 25% or greater foreign ownership). This has been an active market of late, but because this article is concerned with changes in control involving listed companies, it is not further discussed here3
Perhaps most fundamentally, there may be some industries in which, far from wanting more plant and infrastructure creation, the policy makers would like to see less—i.e. a corporate consolidation and weaning process that is the cauldron out of which national champions in such industries may be born.
Foreign Takeovers Legally Possible
The two leading precedents are the pending acquisitions (not "takeovers") of Guangdong Development Bank ("GDB") and Xugong Group Construction Machinery Co Ltd ("Xugong"). That they are not takeovers should not be disheartening for acquirers. These targets displayed only some and not all of the optimum conditions for permitting a takeover. While they are both companies in need of improved competitiveness, in "bedrock" industries (banking and construction machinery) as a whole that are also in need of improved competitiveness: (a) GDB is in an industry in which conversion to "foreign invested" status (greater than 25% foreign ownership) entails certain legal consequences which the banking regulator (the China Banking Regulatory Commission, or CBRC) would consider ‘prudentially’4 unacceptable, and; (b) Xugong5 is in an industry considered6 (rightly or wrongly) by observers to be sensitive to national security. In other words, these and any other proposed takeovers of companies in industries which do not forbid majority foreign ownership as a matter of law under the post-WTO accession rules may only be stopped at the discretion of the approval authorities.
What a Leveraged Buy-Out ("LBO") by a Foreign Sponsor Might Look Like
We turn to the methods by which it may be possible to enhance the acquirer’s financial incentives through the use of leverage. A high degree of leverage is typically not available on arms length commercially reasonable terms unless the leverage provider is contractually or structurally senior to general unsecured creditors of the owners of the most valuable corporate assets. The challenge of LBOs lies in the fact that the acquirer typically owns only stock and can only own valuable collateral by way of mergers, and absent such mergers, the acquired company and its subsidiaries must approve the grant of security to the leverage provider. We contemplate the following hypothetical situation, which similar in some but not all respects to what is known publicly about the Xugong transaction:
The target is an unlisted PRC incorporated company ("Target") that owns (among other things) a substantial though not necessarily majority stake in another PRC incorporated company ("Listco Sub") that has A shares listed in China, as well as other unlisted subsidiaries in China (collectively, "Target Group"). Target is indirectly majority owned by the government by virtue of the government’s ownership of the majority owner ("Parent") of Target. Target operates in an industry which, post-WTO accession, does not prohibit majority foreign-owned companies. The acquirer is ultimately owned by a highly creditworthy foreign entity that meets the qualifications applicable to foreign strategic investors in listed companies set out in the Strategic Investor Rules, but neither the acquirer nor such foreign entity is, or is affiliated with, a QFII. Neither the acquirer nor the foreign entity has appreciable sales in China. Target Group has steady revenues primarily from domestic sales, and has little financial indebtedness relative to the book value of its assets (or at least would remain solvent after giving effect to indebtedness incurred by Target Group members in connection with the takeover). Target Group has substantial assets comprised of plant, property and equipment, inventory, trade receivables, and/or bank accounts.
Acquirer and Parent agree that acquirer will acquire X% of the fully diluted equity (the "Stock") of Target from Parent for a price of RMB equivalent of $A (the "Acquisition Price"). Under the CSRC’s Administrative Procedures for the Acquisition of Listed Companies (effective September 1, 2006) (the "Offer Rules"), unless an exemption is granted by the CSRC, the maximum interest in a listed company’s "issued shares" that can be acquired (directly, or indirectly by acquisition of the Stock) by negotiated purchase is 30%. Any excess over 30% must be obtained by means of a general or partial (i.e. for 5% or more) tender offer. See Articles 47 and 61.
Alternative Structure A: 80% of the Acquisition Price will be funded by a loan ("Loan") from a bank ("Bank")7 booking through one of its offshore offices, that has a branch (or subsidiary) ("Branch") in China.
Acquirer, foreign entity, Parent, Target Group members, and Bank and Branch enter into a participation agreement ("PA"). The key provision of the PA is the agreement of the parties that: (a) the Acquisition Price is paid to Parent and Parent will hold the Stock "in trust" for the acquirer (which remains the exclusive beneficiary of all indicia of economic ownership including dividends (after all required debt service), voting rights and the right to transfer the Stock); (b) disbursement by Branch, at the instruction of the acquirer, of the proceeds of the Loan (to the Parent) and other drawdowns under a secured credit facility ("Secured Facility") between Branch and Target Group members (to Target Group members) is consideration for the grant of security over the assets and cross-guarantees of the payment obligations of various members of Target Group in favor of Branch; (c) payment to Branch by Target Group members is good discharge, to the extent of such payment, of required debt service on the Loan and other indebtedness under the Secured Facility; (d) there is no recourse to Parent for any obligations under the Secured Facility, except that the Parent indemnifies Branch against any losses suffered as a result of the deliberate violation of covenants8 under the "trust" arrangement, and; (e) the foreign entity agrees to pay Bank the difference between required debt service under the Secured Facility and amounts actually received by Branch from free cash flow of Target Group (as well as after enforcement of rights), unless that difference is due to the deliberate breach of Parent’s obligations under the trust arrangement.
The key role in this transaction is that of Branch. Branch must be willing and able to carry the amount of the exposure under the Secured Facility (a RMB asset) on its books, with or without funding from Bank. There is also a currency mismatch between the Branch’s loan assets and the "investment" in the Branch by Bank in such amount.
Alternative Structure B: 70% of the Acquisition Price is funded by an unsecured USD bridge loan to the acquirer (guaranteed by the foreign entity9) from one or more offshore lenders. This loan is refinanced ("Prepayment") by a dual currency (USD/RMB) loan facility from one or more domestic lenders (the "Secured Facility"), under which Target (as surviving corporation in a merger (the "Merger") by acquirer into Target that marks the termination of the bridge facility and of the effectiveness of the Secured Facility) and other Target Group members may draw, which is cross-guaranteed by all Target Group members, and which is secured by all Target Group assets. The Target draws an amount equal to the Prepayment under the Secured Facility, while other Target Group members draw on the Secured Facility from time to time for working capital needs. Funds might also be available to make payments necessary to cash out certain shareholders of Target Group members as discussed in "CSRC Risks" and "Risks Under Company Law" below, to the extent such cash outs (as conditions precedent to drawdown/release from escrow) are not funded by internal cash.
In Structure B, the foreign entity remains on record as ultimate owner of Target and Listco Sub, and there may be significant upfront cross-border debt service flow (the Prepayment) and the potential for complex inter-creditor negotiations in connection with the Merger (see discussion in "Risks Under Company Law" below). The refinancing and Merger10 are for the purpose of avoiding concerns about using domestic bank funds to acquire Stock, and banking law and corporate benefit concerns if the borrower of the domestic bank funds is a foreign entity that is not a Target Group member. Structure A avoids these potentially troublesome aspects, subject to the risks discussed in the last paragraph of this article.
Risks: The Lenders’ post-drawdown risks in these structures can be summarized as follows:
CSRC Risk: This is the risk that the CSRC do not waive the requirement that acquirer must make a partial or general offer for any part of the shares of Listco Sub indirectly to be acquired that constitutes an excess over 30% of the issued shares. In this event, since acquirer itself has no power to purchase and own A shares in its own name, it would have to "entrust" a party, such as Target, to make the offer and hold the A shares in trust for acquirer.
Risk Arising from Conversion to FIE Status: By virtue of the takeover, Target has (at least under Structure B and probably A as well) become an FIE, a conversion which requires approvals from a host of regulatory bodies—the NDRC, MOC, SASAC, SAIC, SAFE and the Tax Bureau, at either central or local levels depending on the transaction—and while these approvals are generally given so long as the formal requirements for investment and documentation are complied with, the MOC in particular retains discretionary authority to disapprove transactions on various grounds such as national/economic security and harm to competition. However, most of these approvals can be made conditions precedent either to drawdown or to release of funds from escrow, with the exception that 20% of any additional equity contribution to Target in relation to Target’s conversion to FIE status (if acquirer subscribes to an increase in capital of Target) is required before a business license will be issued to the FIE, and certain tax procedures required to permit dividends to flow offshore cannot be finalized until the monies are released to the Target or Parent.
Bankruptcy and Perfection Risk: If a Target Group member becomes insolvent within one year after its grant of security, that grant could be rejected to the extent given for inadequate value, under Article 31 of the Bankruptcy Law, with the result that in relation to the obligations of that Target Group member, the lenders would hold only general unsecured claims. The perfection of security interests in rights and in bank accounts is also uncertain. However, registration is possible at the local notary public in relation to the former (per a ruling of the Ministry of Justice), and the consent of the account debtor (in the case of the former) and acknowledgement of the account bank (in the case of the latter) would pre-empt rival claims of other creditors absent deliberate breach by the account debtor or account bank (in which event a claim would arise against those parties).
Risks Under Company Law: Subject to the possibility of cashing and or merging out dissident shareholders of any given Target Group member security grantor, (A) the use of corporate assets to secure the borrowing by upstream entities (as opposed to own borrowings) must be approved by a majority11 of shareholders (exclusive of shareholders that are the borrowers) present at a shareholder meeting of each Target Group member providing collateral. These approvals should, if possible, be made conditions precedent to drawdown; and (B) for the Merger, in addition to approval of two thirds of the shareholders present at a shareholder meeting, the non-objection (within the later of 30 days after actual notice or 45 days after publication in a newspaper) of creditors of Target is a condition to the effectiveness of the Merger. Objecting creditors have a right to prepayment or equal and ratable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through draws on the Secured Facility as a condition subsequent. Whether or not a cash-out is necessary, the all-in costs of the financing would rise, either to pay the guaranteeing companies some consideration (e.g. guarantee fee) or to increase the amount of group stock being purchased.
Risks Under Banking Law: This is the risk that the Secured Facility in Structure B would be recharacterized as a loan extended to finance the acquisition of shares, which is prohibited.
Liquidity, Currency and Political Risks Relating to Branch Investment: This is exacerbated by the recent State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective December 11, 2006), which requires branches of foreign banks wishing to engage in either credit card or retail RMB-denominated business to re-incorporate in China. Whereas in the past Bank and Branch were one accounting entity (regardless of the Bank’s internal policies on quantifying the political/inconvertibility risk of its capital in China and regardless of Chinese banking laws requiring each branch of a foreign bank to adhere to capital requirements on a standalone basis), banks that wish to engage in such businesses can no longer be so. Bank’s overall cost of capital will increase (if it intends to engage in such businesses) compared to what it would have cost to maintain a similar asset in the branch prior to the effectiveness of the new law. Presumably this will be charged through in the interest rate on the Secured Facility.
Risk that Entrustment Arrangements not Enforceable Against Entrusted Party: Generally, under the PRC Contract Law, a contract (including its remedial provisions) will be enforceable against the obligor thereunder so long as adequate consideration has been given for the obligation and the performance of that obligation does not violate law. Since the Parent received the proceeds of the Loan, adequate consideration for its obligations under the PA would have been given. The question is whether the acquisition, financed by domestic bank loans, of control of the Target and, indirectly, Listco Sub and other Target Group members, by a foreign entity would be considered a violation of PRC law. Given the hypothesis of non-prohibition under the Catalogue of Foreign Investment, and the formal features of Structure A, in which it is not the acquirer that is the actual borrower of domestic bank funds but other parties, such an argument by Parent and Target seeking to abrogate the trust arrangement, either in a distress situation or due to fraud/willful breach, should not succeed12 However, the risks of fraudulent preference, failure to close necessary post-drawdown corporate approvals (as for cash outs of dissidents or post-drawdown mergers), or failure of the foreign invested enterprise to obtain required licenses and approval for continued operation could be further mitigated through an escrow of the Acquisition Price—unlike the case of the LBO of a public company, which would be mechanically impossible to unwind, it would not be mechanically difficult to unwind the escrow of Parent’s funds.
As can be seen from this brief analysis, potential structures exist for leveraged takeovers within China. Associated with these is a set of risks that, in the main, are both identifiable and quantifiable and which can be addressed in the deal structure. These should not in this writer’s view, in principle, discourage those considering a more fundamental level of participation in the mainland economy through the use of LBOs.
The author gratefully acknowledges the assistance of Zhao Ying and Li Yongyi. Ying is a lawyer in White & Case’s Beijing office and Yongyi will join White & Case’s New York office in September.
© 2007 White & Case LLP
China: Future of Leveraged Transactions in China
25 February 2007
Article by Fred Chang
Leverage Not Taboo
The requirement for a high level of leverage to finance a project is neither unusual nor taboo in China, and there has in the past been no shortage of willing borrowers, lenders and (most importantly) approval authorities keen to execute leveraged transactions.
However, most of this activity has been in the context of transactions generating tangible assets such as new plant and infrastructure. This is now being extended—with the enthusiasm of all concerned—to the consummation of structured financing transactions designed to finance the origination and carrying of financial assets such as loans, rentals and trade receivables. So does a thriving economy continue to expand.
In China, however, the exuberance for leverage has not so far extended to corporate takeovers. It is one thing for the government partially to divest its holdings in state owned enterprises, accompanied by injections of new equity capital into the SOEs to fund capital expansion, in IPOs and strategic investment transactions. It is another thing for the government to acquiesce in the change in control of Chinese companies where the would-be acquirer (particularly if it is a foreign entity) has one of two motives (in the mind of the government): housecleaning or exit. The government would rather have it both ways. The existing personnel and business should be what remains at the end of the day and the acquirer should increase the going-concern value of the company by "reforming" both those people and the business that it acquires1. For these purposes, the word "acquirer" refers to a foreign-organized acquirer of more than 50% of the voting stock of a Chinese company that is (or is the largest shareholder in) a listed2 Chinese company, and "takeover" refers to a transaction which leads to that result.
This article examines, in relation to listed companies: (a) the reasons in favor of at least some types of takeovers, and; (b) the methods by which takeovers can utilize leverage to enhance the acquirer’s incentives. Being an area that has not yet been tested, leveraged takeovers in China present a set of risks which this article briefly analyzes and attempts to quantify.
Takeovers Not Considered Intrinsically Valuable
A takeover for its own sake lacks appeal to the Chinese policy-makers, since no asset is created. Indeed, where the company is state-owned, simply to give the government funds in exchange for control of the company begs (in the view of the government) the twin questions of: (a) how to reform the company, and; (b) how to define the government’s ongoing role in the economy.
Company boards owe a fiduciary duty to their shareholders. There are certain types of company, however, that owe fiduciary duties to other constituencies as well. For example, financial institutions that take Other People’s Money, at least when Other People means the retail public, owe fiduciary duties to depositors, policy-owners, and brokerage and fund investors. In the shiny world of theory, the State as owner of a financial institution has the best interests of all its citizens, including the Other People whose Money such financial institution controls, at heart. But this theory culminates in the concept of financial institution as shadow tax collector.
It creates conflicts between the purely financial motivations of the people whose residual income is placed in financial institutions and the fiscal (or less salutary) motivations of the central and local governments that are the owners of such financial institutions. Although the Guangdong Development Bank ("GDB") transaction could not be approved as a takeover, there is nothing to say that this situation could not change in the future. Indeed, the financial services sector is an area that, a priori, is best run professionally rather than by the state. However, such a development is likely to unfold as an iterative process, as the provision of credit is a highly sensitive industry where: (a) the alternative methods of capital raising, such as bond and stock markets as well as private placements, are still embryonic, and; (b) the need to fund capital expenditures is still critical.
A second area where takeovers may be welcome is for companies in distress (yet, for purposes of leveraged takeovers, have positive book net worth). It is important to bear in mind that the shareholders of the target company will be likely to include as a majority various governmental entities, and that for the foreseeable future, the motivations of such shareholders are not those typically prevalent in Western economies. The conventional wisdom of having a three-pronged arsenal to mitigate the risk of fundamental disagreement with management (proxy battles, derivative suits and the ability to exit positions in the stock market) is not very relevant in China—for the foreseeable future it is these governmental entities that will be left holding the bag for failed management of significant enterprises, whether as stockholders or otherwise. The pool of management talent that understands how to sell goods and services in China is not yet deep enough to support a full-blown market for corporate control. There is little interest, as yet, in having debates about corporate policy play out in the Chinese securities markets. Rather, it is when there is nothing left to debate, as in the case of a chronically unprofitable company, that a takeover begins to make sense, a posteriori.
A third area is street sales. These must be approved, or taken up in a purchase, by a majority of the other shareholders—by a controlling shareholder in a company that is not state-owned, such as street sales of interests in Sino-foreign joint ventures or in privately owned enterprises for purposes of converting to "FIE" status (generally, a tax-favored domestic enterprise with 25% or greater foreign ownership). This has been an active market of late, but because this article is concerned with changes in control involving listed companies, it is not further discussed here3
Perhaps most fundamentally, there may be some industries in which, far from wanting more plant and infrastructure creation, the policy makers would like to see less—i.e. a corporate consolidation and weaning process that is the cauldron out of which national champions in such industries may be born.
Foreign Takeovers Legally Possible
The two leading precedents are the pending acquisitions (not "takeovers") of Guangdong Development Bank ("GDB") and Xugong Group Construction Machinery Co Ltd ("Xugong"). That they are not takeovers should not be disheartening for acquirers. These targets displayed only some and not all of the optimum conditions for permitting a takeover. While they are both companies in need of improved competitiveness, in "bedrock" industries (banking and construction machinery) as a whole that are also in need of improved competitiveness: (a) GDB is in an industry in which conversion to "foreign invested" status (greater than 25% foreign ownership) entails certain legal consequences which the banking regulator (the China Banking Regulatory Commission, or CBRC) would consider ‘prudentially’4 unacceptable, and; (b) Xugong5 is in an industry considered6 (rightly or wrongly) by observers to be sensitive to national security. In other words, these and any other proposed takeovers of companies in industries which do not forbid majority foreign ownership as a matter of law under the post-WTO accession rules may only be stopped at the discretion of the approval authorities.
What a Leveraged Buy-Out ("LBO") by a Foreign Sponsor Might Look Like
We turn to the methods by which it may be possible to enhance the acquirer’s financial incentives through the use of leverage. A high degree of leverage is typically not available on arms length commercially reasonable terms unless the leverage provider is contractually or structurally senior to general unsecured creditors of the owners of the most valuable corporate assets. The challenge of LBOs lies in the fact that the acquirer typically owns only stock and can only own valuable collateral by way of mergers, and absent such mergers, the acquired company and its subsidiaries must approve the grant of security to the leverage provider. We contemplate the following hypothetical situation, which similar in some but not all respects to what is known publicly about the Xugong transaction:
The target is an unlisted PRC incorporated company ("Target") that owns (among other things) a substantial though not necessarily majority stake in another PRC incorporated company ("Listco Sub") that has A shares listed in China, as well as other unlisted subsidiaries in China (collectively, "Target Group"). Target is indirectly majority owned by the government by virtue of the government’s ownership of the majority owner ("Parent") of Target. Target operates in an industry which, post-WTO accession, does not prohibit majority foreign-owned companies. The acquirer is ultimately owned by a highly creditworthy foreign entity that meets the qualifications applicable to foreign strategic investors in listed companies set out in the Strategic Investor Rules, but neither the acquirer nor such foreign entity is, or is affiliated with, a QFII. Neither the acquirer nor the foreign entity has appreciable sales in China. Target Group has steady revenues primarily from domestic sales, and has little financial indebtedness relative to the book value of its assets (or at least would remain solvent after giving effect to indebtedness incurred by Target Group members in connection with the takeover). Target Group has substantial assets comprised of plant, property and equipment, inventory, trade receivables, and/or bank accounts.
Acquirer and Parent agree that acquirer will acquire X% of the fully diluted equity (the "Stock") of Target from Parent for a price of RMB equivalent of $A (the "Acquisition Price"). Under the CSRC’s Administrative Procedures for the Acquisition of Listed Companies (effective September 1, 2006) (the "Offer Rules"), unless an exemption is granted by the CSRC, the maximum interest in a listed company’s "issued shares" that can be acquired (directly, or indirectly by acquisition of the Stock) by negotiated purchase is 30%. Any excess over 30% must be obtained by means of a general or partial (i.e. for 5% or more) tender offer. See Articles 47 and 61.
Alternative Structure A: 80% of the Acquisition Price will be funded by a loan ("Loan") from a bank ("Bank")7 booking through one of its offshore offices, that has a branch (or subsidiary) ("Branch") in China.
Acquirer, foreign entity, Parent, Target Group members, and Bank and Branch enter into a participation agreement ("PA"). The key provision of the PA is the agreement of the parties that: (a) the Acquisition Price is paid to Parent and Parent will hold the Stock "in trust" for the acquirer (which remains the exclusive beneficiary of all indicia of economic ownership including dividends (after all required debt service), voting rights and the right to transfer the Stock); (b) disbursement by Branch, at the instruction of the acquirer, of the proceeds of the Loan (to the Parent) and other drawdowns under a secured credit facility ("Secured Facility") between Branch and Target Group members (to Target Group members) is consideration for the grant of security over the assets and cross-guarantees of the payment obligations of various members of Target Group in favor of Branch; (c) payment to Branch by Target Group members is good discharge, to the extent of such payment, of required debt service on the Loan and other indebtedness under the Secured Facility; (d) there is no recourse to Parent for any obligations under the Secured Facility, except that the Parent indemnifies Branch against any losses suffered as a result of the deliberate violation of covenants8 under the "trust" arrangement, and; (e) the foreign entity agrees to pay Bank the difference between required debt service under the Secured Facility and amounts actually received by Branch from free cash flow of Target Group (as well as after enforcement of rights), unless that difference is due to the deliberate breach of Parent’s obligations under the trust arrangement.
The key role in this transaction is that of Branch. Branch must be willing and able to carry the amount of the exposure under the Secured Facility (a RMB asset) on its books, with or without funding from Bank. There is also a currency mismatch between the Branch’s loan assets and the "investment" in the Branch by Bank in such amount.
Alternative Structure B: 70% of the Acquisition Price is funded by an unsecured USD bridge loan to the acquirer (guaranteed by the foreign entity9) from one or more offshore lenders. This loan is refinanced ("Prepayment") by a dual currency (USD/RMB) loan facility from one or more domestic lenders (the "Secured Facility"), under which Target (as surviving corporation in a merger (the "Merger") by acquirer into Target that marks the termination of the bridge facility and of the effectiveness of the Secured Facility) and other Target Group members may draw, which is cross-guaranteed by all Target Group members, and which is secured by all Target Group assets. The Target draws an amount equal to the Prepayment under the Secured Facility, while other Target Group members draw on the Secured Facility from time to time for working capital needs. Funds might also be available to make payments necessary to cash out certain shareholders of Target Group members as discussed in "CSRC Risks" and "Risks Under Company Law" below, to the extent such cash outs (as conditions precedent to drawdown/release from escrow) are not funded by internal cash.
In Structure B, the foreign entity remains on record as ultimate owner of Target and Listco Sub, and there may be significant upfront cross-border debt service flow (the Prepayment) and the potential for complex inter-creditor negotiations in connection with the Merger (see discussion in "Risks Under Company Law" below). The refinancing and Merger10 are for the purpose of avoiding concerns about using domestic bank funds to acquire Stock, and banking law and corporate benefit concerns if the borrower of the domestic bank funds is a foreign entity that is not a Target Group member. Structure A avoids these potentially troublesome aspects, subject to the risks discussed in the last paragraph of this article.
Risks: The Lenders’ post-drawdown risks in these structures can be summarized as follows:
CSRC Risk: This is the risk that the CSRC do not waive the requirement that acquirer must make a partial or general offer for any part of the shares of Listco Sub indirectly to be acquired that constitutes an excess over 30% of the issued shares. In this event, since acquirer itself has no power to purchase and own A shares in its own name, it would have to "entrust" a party, such as Target, to make the offer and hold the A shares in trust for acquirer.
Risk Arising from Conversion to FIE Status: By virtue of the takeover, Target has (at least under Structure B and probably A as well) become an FIE, a conversion which requires approvals from a host of regulatory bodies—the NDRC, MOC, SASAC, SAIC, SAFE and the Tax Bureau, at either central or local levels depending on the transaction—and while these approvals are generally given so long as the formal requirements for investment and documentation are complied with, the MOC in particular retains discretionary authority to disapprove transactions on various grounds such as national/economic security and harm to competition. However, most of these approvals can be made conditions precedent either to drawdown or to release of funds from escrow, with the exception that 20% of any additional equity contribution to Target in relation to Target’s conversion to FIE status (if acquirer subscribes to an increase in capital of Target) is required before a business license will be issued to the FIE, and certain tax procedures required to permit dividends to flow offshore cannot be finalized until the monies are released to the Target or Parent.
Bankruptcy and Perfection Risk: If a Target Group member becomes insolvent within one year after its grant of security, that grant could be rejected to the extent given for inadequate value, under Article 31 of the Bankruptcy Law, with the result that in relation to the obligations of that Target Group member, the lenders would hold only general unsecured claims. The perfection of security interests in rights and in bank accounts is also uncertain. However, registration is possible at the local notary public in relation to the former (per a ruling of the Ministry of Justice), and the consent of the account debtor (in the case of the former) and acknowledgement of the account bank (in the case of the latter) would pre-empt rival claims of other creditors absent deliberate breach by the account debtor or account bank (in which event a claim would arise against those parties).
Risks Under Company Law: Subject to the possibility of cashing and or merging out dissident shareholders of any given Target Group member security grantor, (A) the use of corporate assets to secure the borrowing by upstream entities (as opposed to own borrowings) must be approved by a majority11 of shareholders (exclusive of shareholders that are the borrowers) present at a shareholder meeting of each Target Group member providing collateral. These approvals should, if possible, be made conditions precedent to drawdown; and (B) for the Merger, in addition to approval of two thirds of the shareholders present at a shareholder meeting, the non-objection (within the later of 30 days after actual notice or 45 days after publication in a newspaper) of creditors of Target is a condition to the effectiveness of the Merger. Objecting creditors have a right to prepayment or equal and ratable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through draws on the Secured Facility as a condition subsequent. Whether or not a cash-out is necessary, the all-in costs of the financing would rise, either to pay the guaranteeing companies some consideration (e.g. guarantee fee) or to increase the amount of group stock being purchased.
Risks Under Banking Law: This is the risk that the Secured Facility in Structure B would be recharacterized as a loan extended to finance the acquisition of shares, which is prohibited.
Liquidity, Currency and Political Risks Relating to Branch Investment: This is exacerbated by the recent State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective December 11, 2006), which requires branches of foreign banks wishing to engage in either credit card or retail RMB-denominated business to re-incorporate in China. Whereas in the past Bank and Branch were one accounting entity (regardless of the Bank’s internal policies on quantifying the political/inconvertibility risk of its capital in China and regardless of Chinese banking laws requiring each branch of a foreign bank to adhere to capital requirements on a standalone basis), banks that wish to engage in such businesses can no longer be so. Bank’s overall cost of capital will increase (if it intends to engage in such businesses) compared to what it would have cost to maintain a similar asset in the branch prior to the effectiveness of the new law. Presumably this will be charged through in the interest rate on the Secured Facility.
Risk that Entrustment Arrangements not Enforceable Against Entrusted Party: Generally, under the PRC Contract Law, a contract (including its remedial provisions) will be enforceable against the obligor thereunder so long as adequate consideration has been given for the obligation and the performance of that obligation does not violate law. Since the Parent received the proceeds of the Loan, adequate consideration for its obligations under the PA would have been given. The question is whether the acquisition, financed by domestic bank loans, of control of the Target and, indirectly, Listco Sub and other Target Group members, by a foreign entity would be considered a violation of PRC law. Given the hypothesis of non-prohibition under the Catalogue of Foreign Investment, and the formal features of Structure A, in which it is not the acquirer that is the actual borrower of domestic bank funds but other parties, such an argument by Parent and Target seeking to abrogate the trust arrangement, either in a distress situation or due to fraud/willful breach, should not succeed12 However, the risks of fraudulent preference, failure to close necessary post-drawdown corporate approvals (as for cash outs of dissidents or post-drawdown mergers), or failure of the foreign invested enterprise to obtain required licenses and approval for continued operation could be further mitigated through an escrow of the Acquisition Price—unlike the case of the LBO of a public company, which would be mechanically impossible to unwind, it would not be mechanically difficult to unwind the escrow of Parent’s funds.
As can be seen from this brief analysis, potential structures exist for leveraged takeovers within China. Associated with these is a set of risks that, in the main, are both identifiable and quantifiable and which can be addressed in the deal structure. These should not in this writer’s view, in principle, discourage those considering a more fundamental level of participation in the mainland economy through the use of LBOs.
The author gratefully acknowledges the assistance of Zhao Ying and Li Yongyi. Ying is a lawyer in White & Case’s Beijing office and Yongyi will join White & Case’s New York office in September.
© 2007 White & Case LLP
Friday, July 13, 2007
Energy demand in China
Energy for China
Jul 12th 2007
From the Economist Intelligence Unit ViewsWire
More diversity of supply, but demand is growing fast
China's energy challenges are monumental. The economy is in the midst of a highly energy-intensive stage of growth, but domestic reserves—especially of oil—are far from adequate to meet burgeoning demand. As a result, the government faces a series of policy challenges: to expand supply while increasing efficiency, to allow fuel prices to increase and risk more social unrest, and to acquire energy assets overseas while China's international conduct is under close scrutiny. If the government fails in any of these delicate tasks, in the medium to long term the resulting energy crunch could pose a serious threat to China's economic growth and political stability—and hence to the global economy as well.
The good news is that the government is focusing on energy issues and that progress is likely to be steady, if halting, on several fronts--from fuel-price liberalisation to diversifying energy sources and expanding imports. In the longer term, moreover, the maturation of the economy will help to enhance efficiency and ease the pressure to secure ever-greater supplies.
What is the issue?
Many countries are experiencing rapid economic growth, industrialisation and urbanisation. But China's sizzling pace of growth and its huge population make its energy needs particularly challenging. After two decades of rapid economic growth, China is now the world's second largest energy consumer (behind the US). Total energy consumption has risen by an annual average of more than 11% during the past five years, reaching 1.7bn tonnes of oil equivalent in 2006.
China is well on its way to becoming the world's biggest energy consumer. Its per-capita energy use remains relatively small—only around one-third that of Japan and one-seventh that of the US—and the potential market for cars, air-conditioners and other energy-guzzling machines is vast. The Economist Intelligence Unit estimates that China's energy consumption will continue to increase by at least 6% annually for the next several years—a more moderate rate than in some recent years, but one that will nevertheless require huge increases in supply as a consequence of China's massive size.
China's energy crunch is exacerbated by the country's high energy intensity (the ratio of energy use to economic output). This is partly due to the large share of industry in the economy, but it is also because many sectors—such as steel and cement—are plagued by over-production, waste and inefficiency. China's overwhelming reliance on coal for the bulk of its energy—around 70%—also poses problems. Coal is relatively dirty, inefficient and difficult to transport, but it is by far the most abundant energy resource in China.
China's energy needs are also having geopolitical repercussions, as the country's relative paucity of domestic oil reserves prompts efforts to expand imports and secure supplies abroad. For example, energy competition is a factor in China's territorial disputes with its neighbours, particularly in the East China Sea (with Japan) and the South China Sea (with eight South-east Asian countries). Large potential reserves of oil and natural gas are at stake in these disputes. China's energy security concerns also bolster its determination to develop its naval power, and to impose its rule on Taiwan, a de facto US ally that is adjacent to the shipping lanes to northern China.
Why is it critical?
Acute energy shortages in China would have serious economic and political consequences both at home and abroad. (This was illustrated clearly in 2004 when severe energy shortages at home resulted in a sharp increase in China's demand for imported oil, causing international energy prices to soar to 20-year highs.) Access to adequate supplies of energy is necessary for China's continued economic expansion. This is especially the case with oil and natural gas, but it is also an issue for the electricity sector more broadly. Even though generating capacity has been successfully bolstered following the recent power shortages, keeping pace with demand remains a long-term challenge.
China's political stability, in turn, depends on sustained economic growth. The ruling Chinese Communist Party (CCP) has staked its legitimacy on its ability to deliver ever-wider prosperity. As a result, the government's focus on energy security is not merely an economic necessity--it is also a fight for political survival.
A Chinese economic slowdown, combined with potential political instability, would send shockwaves rippling through the global economy. The sheer size of China's economy, as well as its increasingly important role in the global economy, ensures that the effects of a serious energy-supply disruption or power shortage would be severe.
What the government is doing
To sustain rapid economic growth, the overarching priority of the government is to meet soaring demand for energy. Given China's limited domestic reserves of most fuels except coal, this will inevitably require a steady expansion of imports--imports of oil, in particular, are set to surge as industrial demand expands and sales of vehicles boom. China's widening dependence on imports, coupled with an awareness of the environmental challenges posed by soaring hydrocarbon consumption, is in turn motivating a drive to reduce energy intensity.
Reforming the pricing system is a top focus. Although domestic energy and electricity prices have started to converge with global prices, they are still distorted by subsidies, quotas and other forms of state control. For example, retail fuel subsidies have worsened energy shortages in the past by prompting refining firms to cut back domestic sales in favour of the more lucrative international market.
Artificially low energy prices also encourage waste and weaken incentives for domestic exploration and production. Recognising this, the government is slowly but systematically removing price ceilings, eliminating subsidies and opening retail-fuel markets.
An ambitious programme of investment in domestic exploration and production is also under way. Some returns on the government's investments have already been forthcoming. In May 2007 state-owned China National Petroleum Corporation announced the discovery of a 1bn-tonne offshore oilfield in Bohai Bay. If the oil is entirely recoverable, this would boost China's reserves by around 50%. However, notwithstanding discoveries like these, China is unlikely to manage to expand its domestic production fast enough to meet demand. The country even became a net importer of coal in April 2007, and coal imports—especially from Australia and South America—are set to continue to expand. Furthermore, despite the abundance of China's coal reserves, the lack of adequate internal infrastructure makes it difficult to transport coal between northern and southern China—implying that parts of the country will remain highly dependent on imported coal.
Another policy priority is the expansion and diversification of the country's energy sources, with an emphasis on hydropower, nuclear power and natural gas. For example, the government aims to raise the use of natural gas from just 2.9% of primary energy consumption in 2005 to 10% in 2020. Since China has just 1.3% of the world's natural gas reserves, meeting this target will require a big increase in imports. China is building a series of terminals on its southern coast to handle the anticipated surge in shipments from abroad.
As China's dependence on foreign oil and gas rises, efforts to secure access to multiple sources of imports will continue. Already, China has actively sought to diversify its foreign supplies, focusing not only on the Middle East and Central Asia, but also increasingly on Africa, South-east Asia and Latin America. By 2025, according to the US Energy Information Administration, foreign supplies will account for a dizzying 77% of China's total oil consumption, compared to the current level of less than 50%. Still, given the controversy created by the failed bid by China National Offshore Oil Corporation for US-based Unocal in 2005, and the limited amount of oil that can be secured through acquisitions of foreign energy companies, the emphasis is likely to remain on securing long-term supply contracts. The government is also building up strategic oil reserves, but these will be small by international standards and filling them will be a very long process—especially if international oil prices remain high.
Meanwhile, China has embarked on a massive campaign to augment its domestic power-generation capacity. An estimated 81 gw of new capacity was added in 2006, and the government plans to invest a further Rmb600bn (around US$79bn) in new power plants during 2007-12, with the goal of reaching 1,000 gw of generating capacity. The vast bulk of this—around 600 gw—will still be coal-based, but the contributions of nuclear, gas and alternative energy are targeted to rise sharply. In January 2006 a law was passed specifically to promote the solar, wind, geothermal, biofuel and hydropower sectors. Scores of dams are under construction on the upper reaches of the Yellow River in Qinghai and Ningxia, and on the Jinsha River spanning Sichuan and Yunnan. Eight nuclear power reactors are under construction in Zhejiang, Guangdong and Fujian, with another 22 on the drawing board. Large amounts of maize are also being converted into biofuels such as ethanol, although the government will remain wary of jeopardising food security.
The EIU view
China's energy policymakers face several policy dilemmas that will complicate their efforts to keep pace with demand over the next several years. For one thing, the need to maintain political stability limits the government's ability to improve efficiency. There is plenty of room for improvement—China uses around three times as much energy per unit of GDP as the US, and nine times as much as Japan—but the goal of engineering a "harmonious society" ensures that economic growth targets will almost always trump efforts to cut energy consumption. Efficiency gains are also limited by the inability of the central government fully to impose its will on local leaders.
Worries about political unrest also underscore the government's cautious approach to price liberalisation. Higher fuel prices could exacerbate rural poverty and accelerate the flood of migrants to the cities, while costing the CCP a measure of popular support among urban dwellers. In the past government efforts to increase resource prices have led to protests. These political concerns are one reason why China seems set to miss its energy-intensity targets by a long shot; the government aims to reduce energy intensity by 20% in 2005-10 but achieved a reduction of only 1.2% in 2006. Even this figure may be exaggerated, however, given the expansion of the metals and cement industries in 2006. Ultimately the key to reducing energy intensity will be a move away from investment-led economic growth—a long-term transition that is unlikely to have made much headway by 2010.
Policymakers must also juggle the aims of energy independence and energy efficiency. China's most abundant domestic energy resource (coal) is highly polluting and relatively inefficient, yet diversification into more efficient, less polluting sources of energy will require expanded imports. Price reforms could also increase import-dependence as domestic energy becomes more expensive. Plans to increase the use of natural gas will depend on reducing its current high cost.
China's import-dependence will in turn continue to undermine its efforts to be seen as a responsible stakeholder in the international system. As a relative latecomer to the global scramble to secure energy supplies, China's overseas investment options are limited. Its involvement in pariah states such as Sudan (where oil reserves are still relatively untapped) will expand, as the fear of the domestic political consequences of an economic slowdown—as well as the commercial interests of China's state-owned energy firms—will continue to trump the desire to avoid international opprobrium.
Given China's apprehensions about import-dependence and its colossal pollution problems, the prospects for China's fledgling alternative energy industry should be bright. In reality, however, the government's targets will be difficult to achieve, and the industry faces so many impediments that even its most ardent advocates are at best only cautiously optimistic about its future. The main hurdle continues to be cost. Although technologies needed to generate electricity from alternative energy sources are getting cheaper and more efficient in China, production remains relatively expensive, particularly when compared with coal-based energy.
The government's target for hydroelectricity—240 gw by 2020—looks particularly problematic, as it would require the construction of the equivalent of the huge Three Gorges dam project every two years. The target for nuclear-generated electricity looks similarly daunting, implying the need to invest more than US$3bn annually for the next 20 years. Meanwhile, the central government will continue to face difficulties preventing local authorities and township enterprises from building cheap, inefficient coal-fired power plants.
Despite these challenges, China is likely to make steady progress towards its energy goals. We expect energy consumption growth to slow to around 6% a year by 2010, down from 16% as recently as 2004. Meeting this lower level of demand growth will be no small feat, and a heavy dependence on energy imports seems inevitable. However, looking beyond the government's immediate policy dilemmas, China's energy crunch is set to ease as the economy matures. In the long run, structural changes already under way—such as price liberalisation, the consolidation of inefficient industries, the expansion of the services sector and the transition from investment-driven to consumption-driven growth—should help to moderate the energy intensity of the economy.
Jul 12th 2007
From the Economist Intelligence Unit ViewsWire
More diversity of supply, but demand is growing fast
China's energy challenges are monumental. The economy is in the midst of a highly energy-intensive stage of growth, but domestic reserves—especially of oil—are far from adequate to meet burgeoning demand. As a result, the government faces a series of policy challenges: to expand supply while increasing efficiency, to allow fuel prices to increase and risk more social unrest, and to acquire energy assets overseas while China's international conduct is under close scrutiny. If the government fails in any of these delicate tasks, in the medium to long term the resulting energy crunch could pose a serious threat to China's economic growth and political stability—and hence to the global economy as well.
The good news is that the government is focusing on energy issues and that progress is likely to be steady, if halting, on several fronts--from fuel-price liberalisation to diversifying energy sources and expanding imports. In the longer term, moreover, the maturation of the economy will help to enhance efficiency and ease the pressure to secure ever-greater supplies.
What is the issue?
Many countries are experiencing rapid economic growth, industrialisation and urbanisation. But China's sizzling pace of growth and its huge population make its energy needs particularly challenging. After two decades of rapid economic growth, China is now the world's second largest energy consumer (behind the US). Total energy consumption has risen by an annual average of more than 11% during the past five years, reaching 1.7bn tonnes of oil equivalent in 2006.
China is well on its way to becoming the world's biggest energy consumer. Its per-capita energy use remains relatively small—only around one-third that of Japan and one-seventh that of the US—and the potential market for cars, air-conditioners and other energy-guzzling machines is vast. The Economist Intelligence Unit estimates that China's energy consumption will continue to increase by at least 6% annually for the next several years—a more moderate rate than in some recent years, but one that will nevertheless require huge increases in supply as a consequence of China's massive size.
China's energy crunch is exacerbated by the country's high energy intensity (the ratio of energy use to economic output). This is partly due to the large share of industry in the economy, but it is also because many sectors—such as steel and cement—are plagued by over-production, waste and inefficiency. China's overwhelming reliance on coal for the bulk of its energy—around 70%—also poses problems. Coal is relatively dirty, inefficient and difficult to transport, but it is by far the most abundant energy resource in China.
China's energy needs are also having geopolitical repercussions, as the country's relative paucity of domestic oil reserves prompts efforts to expand imports and secure supplies abroad. For example, energy competition is a factor in China's territorial disputes with its neighbours, particularly in the East China Sea (with Japan) and the South China Sea (with eight South-east Asian countries). Large potential reserves of oil and natural gas are at stake in these disputes. China's energy security concerns also bolster its determination to develop its naval power, and to impose its rule on Taiwan, a de facto US ally that is adjacent to the shipping lanes to northern China.
Why is it critical?
Acute energy shortages in China would have serious economic and political consequences both at home and abroad. (This was illustrated clearly in 2004 when severe energy shortages at home resulted in a sharp increase in China's demand for imported oil, causing international energy prices to soar to 20-year highs.) Access to adequate supplies of energy is necessary for China's continued economic expansion. This is especially the case with oil and natural gas, but it is also an issue for the electricity sector more broadly. Even though generating capacity has been successfully bolstered following the recent power shortages, keeping pace with demand remains a long-term challenge.
China's political stability, in turn, depends on sustained economic growth. The ruling Chinese Communist Party (CCP) has staked its legitimacy on its ability to deliver ever-wider prosperity. As a result, the government's focus on energy security is not merely an economic necessity--it is also a fight for political survival.
A Chinese economic slowdown, combined with potential political instability, would send shockwaves rippling through the global economy. The sheer size of China's economy, as well as its increasingly important role in the global economy, ensures that the effects of a serious energy-supply disruption or power shortage would be severe.
What the government is doing
To sustain rapid economic growth, the overarching priority of the government is to meet soaring demand for energy. Given China's limited domestic reserves of most fuels except coal, this will inevitably require a steady expansion of imports--imports of oil, in particular, are set to surge as industrial demand expands and sales of vehicles boom. China's widening dependence on imports, coupled with an awareness of the environmental challenges posed by soaring hydrocarbon consumption, is in turn motivating a drive to reduce energy intensity.
Reforming the pricing system is a top focus. Although domestic energy and electricity prices have started to converge with global prices, they are still distorted by subsidies, quotas and other forms of state control. For example, retail fuel subsidies have worsened energy shortages in the past by prompting refining firms to cut back domestic sales in favour of the more lucrative international market.
Artificially low energy prices also encourage waste and weaken incentives for domestic exploration and production. Recognising this, the government is slowly but systematically removing price ceilings, eliminating subsidies and opening retail-fuel markets.
An ambitious programme of investment in domestic exploration and production is also under way. Some returns on the government's investments have already been forthcoming. In May 2007 state-owned China National Petroleum Corporation announced the discovery of a 1bn-tonne offshore oilfield in Bohai Bay. If the oil is entirely recoverable, this would boost China's reserves by around 50%. However, notwithstanding discoveries like these, China is unlikely to manage to expand its domestic production fast enough to meet demand. The country even became a net importer of coal in April 2007, and coal imports—especially from Australia and South America—are set to continue to expand. Furthermore, despite the abundance of China's coal reserves, the lack of adequate internal infrastructure makes it difficult to transport coal between northern and southern China—implying that parts of the country will remain highly dependent on imported coal.
Another policy priority is the expansion and diversification of the country's energy sources, with an emphasis on hydropower, nuclear power and natural gas. For example, the government aims to raise the use of natural gas from just 2.9% of primary energy consumption in 2005 to 10% in 2020. Since China has just 1.3% of the world's natural gas reserves, meeting this target will require a big increase in imports. China is building a series of terminals on its southern coast to handle the anticipated surge in shipments from abroad.
As China's dependence on foreign oil and gas rises, efforts to secure access to multiple sources of imports will continue. Already, China has actively sought to diversify its foreign supplies, focusing not only on the Middle East and Central Asia, but also increasingly on Africa, South-east Asia and Latin America. By 2025, according to the US Energy Information Administration, foreign supplies will account for a dizzying 77% of China's total oil consumption, compared to the current level of less than 50%. Still, given the controversy created by the failed bid by China National Offshore Oil Corporation for US-based Unocal in 2005, and the limited amount of oil that can be secured through acquisitions of foreign energy companies, the emphasis is likely to remain on securing long-term supply contracts. The government is also building up strategic oil reserves, but these will be small by international standards and filling them will be a very long process—especially if international oil prices remain high.
Meanwhile, China has embarked on a massive campaign to augment its domestic power-generation capacity. An estimated 81 gw of new capacity was added in 2006, and the government plans to invest a further Rmb600bn (around US$79bn) in new power plants during 2007-12, with the goal of reaching 1,000 gw of generating capacity. The vast bulk of this—around 600 gw—will still be coal-based, but the contributions of nuclear, gas and alternative energy are targeted to rise sharply. In January 2006 a law was passed specifically to promote the solar, wind, geothermal, biofuel and hydropower sectors. Scores of dams are under construction on the upper reaches of the Yellow River in Qinghai and Ningxia, and on the Jinsha River spanning Sichuan and Yunnan. Eight nuclear power reactors are under construction in Zhejiang, Guangdong and Fujian, with another 22 on the drawing board. Large amounts of maize are also being converted into biofuels such as ethanol, although the government will remain wary of jeopardising food security.
The EIU view
China's energy policymakers face several policy dilemmas that will complicate their efforts to keep pace with demand over the next several years. For one thing, the need to maintain political stability limits the government's ability to improve efficiency. There is plenty of room for improvement—China uses around three times as much energy per unit of GDP as the US, and nine times as much as Japan—but the goal of engineering a "harmonious society" ensures that economic growth targets will almost always trump efforts to cut energy consumption. Efficiency gains are also limited by the inability of the central government fully to impose its will on local leaders.
Worries about political unrest also underscore the government's cautious approach to price liberalisation. Higher fuel prices could exacerbate rural poverty and accelerate the flood of migrants to the cities, while costing the CCP a measure of popular support among urban dwellers. In the past government efforts to increase resource prices have led to protests. These political concerns are one reason why China seems set to miss its energy-intensity targets by a long shot; the government aims to reduce energy intensity by 20% in 2005-10 but achieved a reduction of only 1.2% in 2006. Even this figure may be exaggerated, however, given the expansion of the metals and cement industries in 2006. Ultimately the key to reducing energy intensity will be a move away from investment-led economic growth—a long-term transition that is unlikely to have made much headway by 2010.
Policymakers must also juggle the aims of energy independence and energy efficiency. China's most abundant domestic energy resource (coal) is highly polluting and relatively inefficient, yet diversification into more efficient, less polluting sources of energy will require expanded imports. Price reforms could also increase import-dependence as domestic energy becomes more expensive. Plans to increase the use of natural gas will depend on reducing its current high cost.
China's import-dependence will in turn continue to undermine its efforts to be seen as a responsible stakeholder in the international system. As a relative latecomer to the global scramble to secure energy supplies, China's overseas investment options are limited. Its involvement in pariah states such as Sudan (where oil reserves are still relatively untapped) will expand, as the fear of the domestic political consequences of an economic slowdown—as well as the commercial interests of China's state-owned energy firms—will continue to trump the desire to avoid international opprobrium.
Given China's apprehensions about import-dependence and its colossal pollution problems, the prospects for China's fledgling alternative energy industry should be bright. In reality, however, the government's targets will be difficult to achieve, and the industry faces so many impediments that even its most ardent advocates are at best only cautiously optimistic about its future. The main hurdle continues to be cost. Although technologies needed to generate electricity from alternative energy sources are getting cheaper and more efficient in China, production remains relatively expensive, particularly when compared with coal-based energy.
The government's target for hydroelectricity—240 gw by 2020—looks particularly problematic, as it would require the construction of the equivalent of the huge Three Gorges dam project every two years. The target for nuclear-generated electricity looks similarly daunting, implying the need to invest more than US$3bn annually for the next 20 years. Meanwhile, the central government will continue to face difficulties preventing local authorities and township enterprises from building cheap, inefficient coal-fired power plants.
Despite these challenges, China is likely to make steady progress towards its energy goals. We expect energy consumption growth to slow to around 6% a year by 2010, down from 16% as recently as 2004. Meeting this lower level of demand growth will be no small feat, and a heavy dependence on energy imports seems inevitable. However, looking beyond the government's immediate policy dilemmas, China's energy crunch is set to ease as the economy matures. In the long run, structural changes already under way—such as price liberalisation, the consolidation of inefficient industries, the expansion of the services sector and the transition from investment-driven to consumption-driven growth—should help to moderate the energy intensity of the economy.
Wednesday, July 4, 2007
Yuan strengthening on rumours of tightening monetary policy
Yuan Rises Past 7.6 for First Time Since July 2005; Bonds Fall
By Christina Soon and Belinda Cao
July 3 (Bloomberg) -- The yuan rose past 7.60 to the dollar for the first time since the end of a link in 2005 on speculation the central bank is using the currency's gain as one of the tools to cool economic growth. Bonds dropped.
The currency strengthened by the most in two weeks also on speculation the central bank will sell dollars as China sets up a fund to manage the country's $1.2 trillion foreign-exchange reserves. The government on June 29 approved a 1.55 trillion yuan ($204 billion) sale of government bonds to establish the new asset-management company, which will seek to boost returns.
``The central bank is likely to accelerate the pace of yuan gains to help resolve the economic problems,'' said Jeffrey Tan, a treasury dealer at Maybank Shanghai. ``There has been talk that China's selling dollars, affecting the U.S. currency's performance in global markets.''
The yuan climbed 0.14 percent to 7.5944 against the dollar as of 5:30 p.m. in Shanghai. The currency has risen 9 percent since China dropped a fixed exchange rate to the dollar in July 2005. It may rise as much as 7 percent this year, said Tan from Maybank, a unit of Malayan Banking Bhd., Malaysia's biggest lender.
China is the world's second-biggest holder of U.S. Treasuries after Japan, with $414 billion compared with Japan's $615 billion, according to the Treasury Department. A weaker dollar reduces the returns.
The central bank on May 10 said it won't slash holdings of dollar assets while diversifying its record reserves.
All but three of the 10 most-actively traded Asia currencies rose against the dollar today and 14 of 16 of the world's major currencies gained.
The People's Bank of China reiterated pledges to continue its exchange-rate reform and to give the market a bigger role in setting the yuan's rate, the central bank said today.
New Stock Sales
The trade surplus in China climbed 73 percent to $22.5 billion in May after reaching an all-time high last year. Gross domestic product may increase 10.8 percent in 2007, according to a report by economists at the People's Bank of China's research department, the Beijing-based China Securities Journal reported on June 29. That would be the fastest in 12 years.
China's government bonds declined as new stock issues this week attracted funds away from the bond market.
``The yields on short-term bills are still rising,'' said Li Gang, a Beijing-based bond trader at the Agricultural Bank of China.
The yield on the three-year bond rose 5 basis points to 3.6 percent, according to the China interbank bond market. The price of the 2.66 percent security due August 2010 declined 0.14, or 1.4 yuan per 1,000 yuan face amount, to 97.26. One basis point is 0.01 percentage point. Yields move reversely to bond prices.
By Christina Soon and Belinda Cao
July 3 (Bloomberg) -- The yuan rose past 7.60 to the dollar for the first time since the end of a link in 2005 on speculation the central bank is using the currency's gain as one of the tools to cool economic growth. Bonds dropped.
The currency strengthened by the most in two weeks also on speculation the central bank will sell dollars as China sets up a fund to manage the country's $1.2 trillion foreign-exchange reserves. The government on June 29 approved a 1.55 trillion yuan ($204 billion) sale of government bonds to establish the new asset-management company, which will seek to boost returns.
``The central bank is likely to accelerate the pace of yuan gains to help resolve the economic problems,'' said Jeffrey Tan, a treasury dealer at Maybank Shanghai. ``There has been talk that China's selling dollars, affecting the U.S. currency's performance in global markets.''
The yuan climbed 0.14 percent to 7.5944 against the dollar as of 5:30 p.m. in Shanghai. The currency has risen 9 percent since China dropped a fixed exchange rate to the dollar in July 2005. It may rise as much as 7 percent this year, said Tan from Maybank, a unit of Malayan Banking Bhd., Malaysia's biggest lender.
China is the world's second-biggest holder of U.S. Treasuries after Japan, with $414 billion compared with Japan's $615 billion, according to the Treasury Department. A weaker dollar reduces the returns.
The central bank on May 10 said it won't slash holdings of dollar assets while diversifying its record reserves.
All but three of the 10 most-actively traded Asia currencies rose against the dollar today and 14 of 16 of the world's major currencies gained.
The People's Bank of China reiterated pledges to continue its exchange-rate reform and to give the market a bigger role in setting the yuan's rate, the central bank said today.
New Stock Sales
The trade surplus in China climbed 73 percent to $22.5 billion in May after reaching an all-time high last year. Gross domestic product may increase 10.8 percent in 2007, according to a report by economists at the People's Bank of China's research department, the Beijing-based China Securities Journal reported on June 29. That would be the fastest in 12 years.
China's government bonds declined as new stock issues this week attracted funds away from the bond market.
``The yields on short-term bills are still rising,'' said Li Gang, a Beijing-based bond trader at the Agricultural Bank of China.
The yield on the three-year bond rose 5 basis points to 3.6 percent, according to the China interbank bond market. The price of the 2.66 percent security due August 2010 declined 0.14, or 1.4 yuan per 1,000 yuan face amount, to 97.26. One basis point is 0.01 percentage point. Yields move reversely to bond prices.
Subscribe to:
Posts (Atom)