China Adopts Fundamental Changes in Foreign Exchange Control

May 20, 2014

After a public consultation period of three months, the PRC State Administration of Foreign Exchange (“SAFE“), China’s foreign exchange control authority, issued the Foreign Exchange Administration Rules on Cross-border Guarantees (the “New Rules“) on May 19, 2014. The New Rules represent an important step towards fully liberalizing governmental control over foreign exchange.

While China boasts of a foreign exchange reserve larger than any other country, it still has one of the tightest foreign exchange control regimes in the world. Prior to 1994, practically all transactions involving foreign exchange had to be approved. Since then, China has adopted a dual regulatory system: while prior approval from SAFE is not required for current account transactions (such as payables for international trade or repatriation of dividends), such approval is required for capital account transactions (such as investing in or providing a loan to a Chinese company or return of capital investment). This system has largely remained unchanged during the last two decades, even though some measures have been adopted to loosen control over certain capital account transactions in recent years.

Under the existing regime, capital account transactions also include cross-border guarantees (including guaranties, pledges and mortgages). Specifically, without SAFE approval, a PRC entity (other than a PRC bank) generally cannot provide guarantees to an offshore entity for the obligations (financial or otherwise) of another offshore entity, nor can an offshore entity provide guarantee to a PRC entity for the obligations of another PRC entity. While a PRC bank is allowed to provide guarantees to an offshore entity, it can only do so under a tight quota issued annually by SAFE. In addition, it is virtually impossible for PRC individuals to obtain SAFE approval to provide guarantees to offshore entities. Such restrictions are imposed on cross-border guarantees because, in each of these cases, assets would need to cross the border either from China to outside of China or from outside of China to China if the beneficiary enforces its rights under such guarantees.

It is this cross-border guarantee arrangement that the New Rules have tried to change and, in doing so, the New Rules have introduced a big opening in the rules that have been regulating capital flow to and from China ever since the establishment of the People’s Republic.

Under the New Rules, cross-border guarantees are divided into three categories: onshore guarantee/offshore lending, offshore guarantee/onshore lending and other cross-border guarantees.

The onshore guarantee/offshore lending arrangement refers to a situation where the guarantor is a PRC entity and the beneficiary and guaranteed party are offshore entities, as is the case when a PRC entity provides a guarantee for a loan made by an offshore bank to an offshore borrower. With respect to such arrangement, the New Rules provide that:

PRC financial institutions, non-financial institutions and individuals can all provide onshore guarantees in connection with offshore lending. Only filing with or reporting to SAFE (instead of prior approval) will be required. This is a fundamental change from the current regime.
PRC financial institutions are no longer subject to any SAFE issued quotas when providing cross-border guarantees.
The offshore borrower may not use the proceeds of the offshore loan to engage in businesses outside its normal business scope and the proceeds may not be remitted into China for equity, debt or other investments.

By contrast, under an offshore guarantee/onshore lending arrangement, the guarantor is an offshore entity and the beneficiary and the guaranteed party are both PRC entities. This would be the case where a foreign bank provides a guarantee for a loan made by a PRC bank to a PRC borrower. With respect to such arrangement, the New Rules provide that:

A PRC company can obtain a guarantee from an offshore entity for its onshore debts only if the lender of the onshore debt is a PRC financial institution. Such onshore debts must be bank loans or binding commitments to make bank loans made by a PRC financial institution.
With respect to the debt owed by the PRC borrower to the offshore guarantor resulting from the enforcement of the offshore guarantee, the amount of such debt may not exceed such borrower’s audited net assets for the preceding year.

As for cross-border guarantees which are neither onshore guarantee/offshore lending or offshore guarantee/onshore lending, the New Rules provide that no filings with or reporting to SAFE are required unless otherwise expressly required by SAFE.

It appears that the New Rules are more restrictive with respect to offshore guarantee/onshore lending than onshore guarantee/offshore lending, which would make it easier for foreign exchange to go outside of China than to come into China. This is a major departure from China’s traditional foreign exchange control system, which has always focused on trying to keep foreign exchange within the country. Still, it should not be a surprising development because even according to the Chinese official press China’s huge foreign reserve has become something of a burden to the country’s economy.

The New Rules will take effect on June 1, 2014 and are expected to have a profound impact on future cross-border capital flows in China.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about this development. Please contact the Gibson Dunn lawyer with whom you usually work or the following:

Yi Zhang – Hong Kong (+852 2214 3988, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Hongtao Lu – Hong Kong (+852 2214 3711, [email protected])

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