Wait-and-see

The highly anticipated Shanghai Pilot Free-Trade Zone, regarded as a test bed for bigger economic reforms including convertibility of the RMB currency and further liberalisation of interest, was opened in late September.

However, those long-awaited key reform measures have not been specified by Chinese authorities even now. The already announced “negative list” is longer than expected - therefore, various industry sectors remain subject to restrictions or prohibitions from foreign investment.

All of these are acting as probable dampners to the atmosphere, especially since senior state leaders were absent at the launch ceremony.  Some may be disappointed. But officials stress the zone remains a work-in-progress.

“It’s no different from any other thing in China. Everything moves step by step,” says James Wang, partner in the Investment Funds and Asset Management Group at Han Kun Law Offices.

“There was indeed some pullback from what was previously envisioned, as the actual implementation of a reform of such a grand scale requires the daunting task of coordinating different, and often, conflicting interests and concerns of the various government constituencies involved. We cannot expect it to be accomplished overnight,” he says.

The measures have seen positive reactions in the banking sector, as many banks have already signed up to setup operations within the FTZ. But the feedback from fund investors is different. Some China-based PE firms have shown their strong interest, while some outbound activists have submitted their registration materials.

“Over the past month, my firm has been very busy helping foreign domestic and foreign clients establish a presence in the FTZ,” says Wang.

In contrast, foreign private equity firms are hesitant to take action.

“Among the PE community, we are seeing a bit of a wait-and-see attitude with the Shanghai FTZ,” says Thomas Chou, partner at Morrison & Foerster.

“It may be a little premature for PE firms to relocate or establish new funds in the FTZ.”

Waned inbound

The reason for such divisive reaction is foremost due to the lack of specific regulations to promote the establishment of private equity funds in the FTZ.Although the administration wants to have private equity launch here to make it the real financial hub, there isn’t much incentive yet.

“The good news is that there seems to be a true desire by the Shanghai FTZ officials to assist foreign companies establish in the zone and achieve their commercial objectives [to the extent not inconsistent with national law],” says Chou.

The “negative list,” a system which was hoped by many would be able to open more industry sectors to foreign investment, turned out to be much longer. Fact is that it has still kept many of the desired areas as shut as the rest of China has. Unless the negative list allowsgreater participation by foreign investors in a broader range of industries - such as an ability to arbitrage foreign investment restrictions by establishing in the FTZ -  it would not give competitive advantage in attracting investment.

“The groundwork is being laid for adoption by more PE firms, but in my opinion, they will need to go farther than the current negative list before foreign funds will be attracted en masse to the FTZ as a platform for making inbound China PE investments,” says Chou.

“I am cautiously optimistic that in 2014 and beyond, there will be more daylight for a wider range of industries to operate in the FTZ against the backdrop of a shorter negative list.”

In addition, the inactivity of foreign firms is also a result of the general environment of China investment, according to Chou. There was a period of time where a lot of the offshore PE funds were looking to establish RMB-denominated funds. Due to a number of factors, including uncertainty as to whether their investments would receive “national treatment” (i.e., exemptions from certain foreign investment restrictions), the enthusiasm among many offshore GPs to establish RMB funds has waned over the past year.

“The prospect of increased convertibility of RMB in the FTZ will not, in and of itself, materially change how GPs raise and deploy capital in China. However, increased convertibility of RMB, coupled with broader relaxation on foreign investment in additional industries, would indeed make it a more attractive destination for PE funds,” says Chou.

Fundraising for China PE funds is down significantly from 2012. A large part of these funds have been diverted to the U.S. and Europe. Additionally, many of the PE funds in China have legacy unexcited portfolio investments, and are challenged in deploying new money or raising new funds until they can exit their existing investments.

“The limited activity by PE funds to set up in the Shanghai FTZ has likely been affected, at least in the short term, by these macro fundraising constraints on China PE fund managers."

Relaxed outbound

Chinese PE firms, meanwhile, probably have found the FTZ more useful. Among the first 25 companies registered at the launch of the Shanghai FTZ, there were two private equity companies - Hony Capital, a PE firm affiliated to the Lenovo Group, and Heaven-Sent Capital Management.

“Being the first batch of companies of the FTZ will benefit the development of our cross-border investment business,” Hony CEO Zhao Linghuan was quoted as saying by the Chinese media.

One of the FTZ’s major reforms so far has been the replacement of the approval for offshore investment into projects and enterprises by a registration and filing system, which removes a number of government departments from the procedure.

Transaction delays and uncertainty of approval because of the approval procedure have been two big hurdles for Chinese companies and funds to invest abroad.

“The change of the approval regime to the registration regime for outbound investments and the significantly shortened government process are expected to pave the way for overseas investments by cash-rich Chinese companies and funds,” says Wang.

In particular, Chinese acquirers have often had to offer a larger purchase price premium in outbound biddings in the past. This is because they are subject to the regulatory approval requirements by the MOFCOM/NDRC of China which increased the execution risk caused this approval uncertainty. They must pay more in order to make their bids attractive to targets and their bankers, whereas their foreign competitors usually need not, Chou adds.

“Removing this approval requirement for Chinese companies established in the FTZ should improve the competitive profile of Chinese companies making outbound investments,” he says.

Alternative?

As the Shanghai FTZ progresses cautiously, there are other places in China trying to take their chances in bold reform.

The Qianhai Economic Zone, a coastal suburb of Shenzhen neighbouring Hong Kong, also bears hopes of experimenting critical reforms for China’s next stage development when it was set up in 2010.

“There will be competition between Shanghai and Qianhai in the long run, given both are targeted mainly at the opening up of financial services,” Liao Qun, China chief economist at Citic Bank International, tells Reuters.

Qianhai has set its focus on finance, logistics and technology. At the launch, the first batch of 22 preferential policies has been promulgated by the Central government, including eight financial reforms. So far, 16 policies have been implemented, and a lot of promotion has been done to appeal to foreign investors. But even after all this, there has been relatively little adoption by the big PEs.

“Shanghai has advanced infrastructure, but with all eyes on this world stage, each move will be highly scrutinised by the media, investment and corporate community. As a result, one would expect that liberalisation efforts will be taken deliberately and methodically, with disruptive regulatory change being unlikely,” says Chou.

On the other hand, this less noticed under-the-radar zone might be a place where more flexibility is granted and more experimentation is allowed.The smaller and relatively low-profile test petri dish in theory could foster more significant experimentation by the local authorities, according to Chou.

Qianhai’s advantage, adds Wang, lies in its geographical closeness to Hong Kong so that it could play an exceptional role by utilising Hong Kong’s offshore yuan market such as facilitating the backflow of RMB or RMB-denominated loans.

“Unfortunately, the fact that Qianhai's infrastructure is at quite an early stage suggests that this fundamental aspect needs to develop before investors can truly embrace its potential,” says Chou.

The 15-square-kilometre Qianhai zone remains a mostly dusty wasteland so far, despite its ambition of becoming a new “mini-Hong Kong.”

After all, Shanghai is still the most attractive city on the mainland for investment firms and corporations, with a deep-rooted business culture and a reputation for hosting foreign and non-state-owned investment firms and financial institutions more than anywhere else in China, says Wang.

“Shanghai’s reputation as a commercial and financial centre, its business professionalism, and its service-oriented government set an example for the rest of China,” he says.  “For Shanghai’s pilot FTZ, the key purpose is to revamp the existing government-centric regulation regime for businesses; not just taxation preference.”

Though not yet ideal, at least the policies in the Shanghai FTZ can be no worse than anywhere else. And the meaningfulness of the reform should not be denied.

“While there remain many things to be desired for the new FTZ and full capital account convertibility is still far away, there are some substantively meaningful measures for both foreign and domestic companies,” says Wang.

“In China, nothing is settled in one attempt. I am generally optimistic.”

The detailed rules for different industries are expected to come out over the coming months. As always, the devil is in the details.

“We will need to see the regulators offer more detailed regulations, implemented in a sustained and predictable manner, offering gradual but tangible liberalisation of foreign investment activity in the zone. We will also need private sector players that are willing to take the plunge to help set some positive case studies for the Shanghai FTZ,” says Chou.

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