China Takes Major Step to Ease Capital Controls

The Chinese government is continuing to dismantle capital controls, with a new policy taking effect next month granting stronger protection to offshore bond-holders.
"The new policy, which is effective on 1 June and is largely the same as the draft version on which the State Administration of Foreign Exchange (SAFE) solicited public comments in February, is a major step toward the relaxation of capital controls in China," says Kai Hu, a Moody's Vice President and Senior Credit Officer.
"As Moody's stated when SAFE proposed the policy changes earlier this year, an explicit guarantee can provide stronger protection for offshore bondholders than keepwell agreements and other credit support mechanisms," says Hu.
"This guarantee should enable the offshore subsidiary to obtain lower funding costs than they could without a guarantee and, by facilitating offshore bond issuance; the new policy should also advance the growth of offshore bond markets," says Hu.
Chinese corporates will also be able to capture acquisition opportunities in a more timely manner.
However, there are conditions for the use of proceeds raised under cross-border guarantees, including:
(1) The guaranteed offshore funds cannot be moved onshore through loans or equity investments to support onshore operations or debt refinancing, unless approved by SAFE.
(2) The funds can be used only for the offshore subsidiaries' normal business scope, not for speculative transactions and pure arbitrage trades that take advantage of differences in interest rates or foreign exchange rates.
As such, Moody's says the policy change will not immediately benefit companies such as property developers that raise offshore funds primarily for their onshore business.
Specifically for offshore bonds issued under guarantees, the offshore bond issuer that is covered by the guarantee will have equity linkage with the onshore guarantor and can use the proceeds only for projects that have been approved by relevant authorities responsible for approval of overseas investments.
The final policy also includes some changes from the draft, and it is important for offshore bond investors to validate the purpose of the bonds, the final registration of the cross-border guarantee, and the relevant parties' track record of compliance with foreign exchange regulations.
In addition, the policy makes clear that other cross-border undertakings that are not legally binding, such as keepwell agreements, do not fall within the scope of cross-border guarantees.
Thus, an onshore company cannot make cross-border payments in the name of a guarantee when it has to honor such undertakings. As such, investors need to examine carefully other cross-border payment channels the onshore company would have to execute the cross-border payments.
This approach is also consistent with Moody's view that a keepwell agreement is not equivalent to a guarantee.

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