China, once seemingly impenetrable to all but the bravest foreign investors, has performed a remarkable transformation. First it became ‘the world’s manufacturer’ and now it is developing into one of the most interesting markets in which foreign firms look to acquire assets.
Against the background of an economy growing at an average rate of 10 per cent each year, a trade surplus that has grown to $85.71bn (£42.92bn), and a rise of 353.7 per cent on the Shanghai Stock Exchange between January 2006 and May 2007, the pace of legal change is just as breathtaking.
One catalyst for these developments was China’s entry into the World Trade Organisation (WTO) in 2001. On becoming a WTO member, China committed to a five-year plan to liberalise trade, promote transparency, fairness and predictability in business transactions, reduce tariffs and open up various industries to foreign investment.
Legislative reform has been extensive to comply with the five-year timetable, as well as to manage the impact of the pace of change on the economy, often taking an incremental approach to avoid dramatic shifts in capital flows and in the competitive environment faced by Chinese companies.
More recently, international pressure and an increasingly large current account surplus due to the growing volume of Chinese exports has led to a slight loosening of exchange rate policy, although it falls some way short of the revaluation that some have called for. Most recently policy was relaxed in May of this year when there was a slight widening of the band at which the renminbi may trade against the US dollar.
Another recent groundbreaking development came on 22 May 2007, when it was announced that the newly established State Investment Company will make a $3bn (£1.5bn) investment in Blackstone Group. The investment is in non-voting stock, giving the Chinese company a 10 per cent stake in the US private equity group. Many see this as a positive signal for the future and for a willingness to support outbound investment and to gain access to the returns generated by private equity.
In contrast, the private equity market in China has been affected by two recent changes: the M&A regulations published in August 2006 that tightened up the approval regime for establishing the offshore special-purpose vehicles (SPVs), which had been a typical feature for foreign private equity fund investment; and a paving of the way for Chinese private equity with the publication in June 2007 of a new partnership law permitting the establishment of LLPs.
Against this background it is hardly surprising that laws have been updated and new laws passed. In a survey conducted by management, 60 per cent of respondents stated that the regulatory environment was at least very significant in their decision regarding future investment choices.
Recent legal developments include the reform of China’s Company Law and the new Securities Law, which both came into effect on 1 January 2006, modernising the existing laws and in the latter case providing an improved framework for securities regulation – although it remains to be seen how the regulators will exercise some of their powers.
More recent developments include reforms under discussion such as the new Patent Law and the new Labour Contract Law. The Labour Contract Law is widely expected to be ratified very shortly. The new Property Law will come into effect in October and the new Enterprises Income Tax Law will come into effect on 1 January 2008. Under the current tax regime, foreign-invested enterprises (FIEs) pay an income tax rate of 15 per cent, while domestic enterprises are subject to a 33 per cent rate. Under the new law an enterprise income tax rate of 25 per cent will apply to both FIEs and domestic companies.
While the removal of such tax advantages for FIEs may appear contrary to China’s drive to encourage foreign investment, it agreed under its WTO commitments to apply ‘national treatment’ to foreign entities. Also, not surprisingly, there was pressure from domestic companies unhappy with the favourable treatment. The reform should also further discourage ‘fake’ foreign investment structures, under which companies are established overseas to reinvest in China as FIEs.
However, perhaps the most compelling reason is that there is an increased focus on the quality of inward investment, rather than the quantity. For example, under the new tax regime the 15 per cent rate will continue to apply to enterprises in encouraged sectors (such as infrastructure and agriculture), high-tech enterprises and enterprises located in Central and Western China, encouraging policy-driven foreign investment.
There has also been speculation that China’s first anti-monopoly law may be finalised later this year. The new law is aimed at curbing monopolistic behaviour, with the current draft prohibiting monopoly agreements and abuse of dominant market position. However, after 10 years of deliberation, it is far from certain that this new law will be brought into force in the near future. It is also worth noting that, despite the lack of any specific anti-competition law to date, China does have in place other regulations with which anticompetitive behaviour is controlled, including consumer protection laws and filing requirements for particular transactions involving foreign investors acquiring domestic companies.
Financial markets reforms
Particularly interesting is reform in the financial sector. The fifth anniversary of China’s accession to the WTO arrived in December 2006, along with the opening up of the banking and securities industries to foreign investment, one of the key industries that were part of the accession negotiations.
In the meantime, the market has had the chance to prepare itself for foreign competition. In the securities industry, permitted foreign investment is by Sino-foreign joint ventures, whereas in the domestic banking market approved foreign banks may operate through their own branches.
So far, approval of seven securities joint ventures have been announced (including ones involving Morgan Stanley, UBS and CLSA), and in March the granting of licences to four foreign banks was announced, permitting them to conduct domestic business.
Another hot topic is access for foreign investment to invest in A-shares (equities listed on the Shanghai or Shenzhen stock exchanges, which are reserved for domestic investors). Despite the cooling effect of the recent threefold increase in the rate of stamp duty on share transfers (from 0.1 per cent to 0.3 per cent), there has been much focus on the market.
In 2002 the qualified foreign institutional investors (QFII) regime was established, whereby duly approved QFIIs are able to invest in A-shares and other renminbi-denominated shares. A slight shift in focus towards attracting long-term capital has also led to further recent changes to the QFII regime that remove some of the regulatory burdens imposed under the earlier rules.
Alongside the QFII regime, in 2006 the first steps were taken for Chinese investors to invest overseas through the qualified domestic institutional investors regime. Qualifying investors such as domestic commercial banks (which could, for example, set up funds through which private investors, domestic funds, social security funds and trusts could invest) may obtain licences and quotes to invest in a limited range of overseas financial instruments.
The Chinese economy is still very much in the process of being liberalised. In the meantime, Hong Kong and China have entered into the Closer Economic Partnership Arrangement, under which all products of Hong Kong origin that are imported into mainland China enjoy tariff-free treatment. Mainland China has also agreed to provide preferential treatment to Hong Kong service providers in specified service areas, enabling such suppliers to benefit from earlier access to the mainland China market. Such measures are expected to make Hong Kong increasingly attractive to foreign investors looking for a gateway into mainland China.
It is clear that China is beginning to put a comprehensive economic legal framework in place, but such a task cannot be done in a day. Economic legislative reforms may have been constant, but many have taken years to come to fruition. In some cases new laws are discussed internally for several years before being passed (the anti-monopoly law being a good case in point). In addition, it is still uncertain whether recent reforms will prove successful.
Indeed, foreign investors are still experiencing many teething problems, most recently and publicly evidenced in the dispute between Group Danone and the Wahaha Group, Danone’s Chinese joint venture partner. However, considering the speed with which the economy is growing and the responsive approach of the legislature to control its direction, even setbacks such as those experienced by Danone are unlikely to put investors off.
•Jane Newman is a partner at Simmons & Simmons