Outlook 2018: beware the watchdog's bite

Now the ruling party’s Congress has passed, it’s down to China’s regulators to steer investment flows. They are doing so, firmly.

The show is over. The time for action has begun.

With China’s 19th Communist Party Congress out of the way and President Xi Jinping entrenched as arguably the most powerful Chinese leader since Mao Zedong, it’s the job of the country’s regulators now to flesh out the priorities that will rudder China’s top-down brand of capitalism for the next few years.

For Chinese companies eager to grow outwards and commercial interests looking to strengthen their exposure to the world’s second-biggest economy, hopes are high that China-linked mergers and acquisitions will pick up anew after a hiatus. 

In broad terms they have good reason to be optimistic as the passing of China’s showpiece political event gives way to a greater clarity of purpose that shapes the country’s reforms, sharpens its ambition to build infrastructure across a vast intercontinental area, and enables more cash-rich enterprises to put money to work, albeit under greater supervision.

Policy support for fast-emerging new technologies and buying in know-how looks set to continue too, if constrained by protectionism overseas – and all the while Beijing tries to wean the economy off too much debt and promote environmentally friendly policies.

Now the political transition is behind us we can expect more in terms of reform in 2018, said Karine Hirn, partner at East Capital, an asset manager focused on emerging markets for more than 20 years. It sounds like Chinese regulators “are aware of the problems and they have a roadmap to solve these problems,” she told FinanceAsia.

The relationship between Western principles of democracy and the demands of capitalism is clearly a complicated one, but with a more certain political backdrop in China the portents are positive for both 2018 and the Year of the Dog.

Structural changes could yet yield opportunities for investors even in less fashionable areas, as the example of China Shenhua, the largest coal producer in China, has already shown. It issued a special dividend earlier this year for the first time in its history after coal prices climbed as a result of supply side reforms.

“We are seeing the beginning of a shift in the approach towards shareholder returns, as the institutionalisation of the domestic market is a clear goal,” Jing Ning, a portfolio manager at Fidelity International, wrote in a December 5 report.

“Following the 19th National Congress, the emphasis will be on ‘quality over quantity’ of economic activity in China. We are likely to see a renewed thrust on reforms across state-owned enterprises, as well as in energy pricing and pro-environmental policies,” Jing said.

QUALITY NOT QUANTITY

A similar theme is emerging with China’s outbound investment policies.

In August, the State Council listed the types of deals that the government would encourage, limit, or prohibit. 

Then the country’s top policymaker National Development and Reform Commission (NDRC) issued a set of draft guidelines on November 3, just over a week after the Congress ended. These cover Chinese companies’ overseas purchases and fleshed out the public comments and announcements made by other senior regulators in the preceding months.

Under the proposed regime even acquisitions via offshore entities that involve no cross-border flow of money would have to be registered with the NDRC. 

These were clear signs that Chinese regulators are now looking beyond issues like capital movements and at the general quality of deals.

As a result, M&A bankers and lawyers say they expect more measured and healthier outbound shopping by Chinese entities in 2018.

Compared with the previous year, 2017 has seen a clear cooling-off in mega deals, notably those that outwardly appeared to make little strategic sense – such as the football club stake purchases by Fosun, Dalian Wanda, and others.

Pan Gongsheng, head of the State Administration of Foreign Exchange (Safe), which has been leading efforts to curb cross-border transactions, told a conference on December 2 that Chinese outbound acquisitions are trending more sensibly after the crackdown to the point where regulators can ease up on extraordinary measures to curb M&A.   

China’s overseas investment had been growing by around 20% per year since 2010, except in 2016, when it leapt by more than 40% than the year before – an obviously abnormal jump, Pan said. 

While acquisitive privately owned Chinese titans have been shackled from deal-making by restrictions on cross-border capital flows and credit lending, state-controlled entities emerged as China’s largest overseas dealmakers in the first half of 2017, according to according to FinanceAsia calculations, based on PwC data. . 

The largest Chinese outbound investment in 2017 was China sovereign wealth fund China Investment Corporation’s €12.25 billion ($13.77 billion) acquisition of European warehouse firm Logicor Europe. 

SHOWING TEETH 

Chinese regulators have shown they are willing to stamp down hard on entrepreneurs’ exuberance if it threatens the national, or Party’s, interest. 

As with outbound M&A that was over leveraged and put downward pressure on the renminbi, Chinese watchdogs have bared their teeth at other parts of the economy.  

Financial regulators on November 21 banned new online micro-financing firms and limited existing firms from lending outside their home provinces. 

The move came after the unprecedented growth of Chinese online firms providing short-term unsecured loans. According to one official estimate there were 2,693 online platforms offering cash loans to close to 10 million clients as of November 19, with weak credit assessments and occasionally violent payment collection methods. 

The China Banking Regulatory Commission (CBRC) then issued new rules on December 1 to clean up the sector, defining unlicensed platforms with high lending interest rates and abusive debt collection methods as illegal. 

BELT AND ROAD

One “encouraged” area of M&A is infrastructure to aid the development of China’s Belt and Road Initiative.

This is Xi’s own pet project, his blueprint to recreate China’s ancient silk routes for the 21st century, and dealmakers have taken note. 

After privately run conglomerate HNA Group’s deal making wings were clipped its chief executive Adam Tan, for example, said in an interview published by 21st Century Business Herald on November 28 that it would not invest in industries Beijing disapproved of, but would continue deploy capital in support of Belt and Road projects.

Over the next decade, China would spend as much as $1.2 trillion on railways, roads, ports and power grids along the Belt and Road, according to investment bank Morgan Stanley.

The capital markets activity that this could give rise to is considerable. Chinese banks already are being encouraged by Beijing to issue bonds overseas to absorb international capital and to then rechannel the proceeds into loans for Belt and Road projects. 

Bank of China, for example, when issuing a landmark $3.55 billion Silk Road bond in 2015, told investors it aimed to lend $100 billion to Belt and Road-related projects over the course of three years to 2018.

No banks reach further than China’s state-run policy banks: China Development Bank, Export-Import Bank of China and the Agricultural Development Bank of China. 

The CBRC proclaimed new rules in mid-November to mitigate contingent liabilities from the policy banks' lending to social projects with low economic returns and in higher-risk countries, particularly the 60 or so countries covered by Xi’s Belt and Road blueprint.

China should look to rigorously enforce these rules, which dictate that the policy banks must strengthen capital management, corporate governance and risk controls. 

The three policy banks’ assets have grown rapidly to about 31.3% of GDP in 2016, or Rmb23.3 trillion ($3.52 trillion), from 19.2% of GDP five years earlier. 

As such, they represent a potential systemic risk – both for China and along the Belt and Road.

TECH, AND MORE TECH

Also high up among the types of deals encouraged by Beijing is investment by Chinese enterprises into overseas high-tech and advanced manufacturing companies, which is in keeping with the “Made in China 2025” scheme, a policy aimed at upgrading the country’s manufacturing capabilities. 

“The appetite for tech assets is very strong … And after the 19th National Congress, it’s more obvious,” said Jeffrey Sun, a partner at law firm Orrick who advises on Chinese firms that invest aboard. 

That said, increased scrutiny and regulatory uncertainty abroad are casting a shadow over such deals.

The Committee on Foreign Investment in the US (Cfius), in particular, which reviews transactions that would take control of a US business, has put a tail of Chinese acquisitions on hold or even killed them.

One legal source close to Cfius said that the watchdog aims to clamp down even harder on Chinese acquisitions in 2018. 

A test case will be Ant Financial’s acquisition of MoneyGram, which the Chinese fintech firm has already filed three times with Cfius for clearance. One observer said that if this acquisition fails “it’s not worth the efforts of trying at all”.

Cfius, which reviews transactions on a case-by-case basis, is short on senior appointments at the moment, exposing deals to more uncertainties.

Scott Flicker, a Paul Hastings lawyer who has dealt with Cfius matters for over 30 years, said such uncertainties are the new normal that dealmakers need to adapt to. “It’s one or the other: you either wait, or you get into the game and see whether you have some success,” Flicker said.

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