Capital Markets and Portfolio Investment

China’s leadership has stated that it seeks to build a modern, highly developed, and multi-tiered capital market. Bank loans continue to provide the majority of credit options (reportedly around 70 percent) for Chinese companies, although other sources of capital, such as corporate bonds, trust loans, equity financing, and private equity are quickly expanding their scope, reach, and sophistication. Chinese regulators regularly use administrative methods to control credit growth, although market-based tools such as interest rate policy play an increasingly important role.

The People’s Bank of China (PBOC), China’s central bank, has gradually increased flexibility for banks in setting interest rates, formally removing the floor on the lending rate in 2013 and the deposit rate cap in 2015 – but is understood to still influence bank’s interest rates through “window guidance.” Favored borrowers, particularly SOEs, benefit from greater access to capital and lower financing costs, as they can use political influence to secure bank loans, and lenders perceive these entities to have an implicit government guarantee. Small- and medium-sized enterprises, by contrast, have the most difficulty obtaining financing, often forced to rely on retained earnings or informal investment channels.

In the past year, Chinese regulators have taken measures to rein in the rapid growth of China’s “shadow banking” sector, which includes vehicles such as wealth management and trust products. These vehicles often provide private firms additional channels to obtain capital, although at higher than benchmark rates. Chinese authorities have taken steps to increase the transparency requirements and strengthen supervision of these banking activities. In 2017, worried about increasingly interconnected leverage across China’s corporate sector, President Xi Jinping declared China’s financial security to be a matter of national security, and regulators redoubled their efforts to rein in financial sector risks.

Direct financing has expanded over the last few years, including through public listings on stock exchanges, both inside and outside of China, and issuing more corporate and local government bonds. The majority of foreign portfolio investment in Chinese companies occurs on foreign exchanges, primarily in the United States and Hong Kong. In addition, China has significantly expanded quotas for certain foreign institutional investors to invest in domestic stock markets; opened up direct access for foreign investors into China’s interbank bond market; and approved a two-way, cross-border equity direct investment scheme between Shanghai and Hong Kong that allows Chinese investors to trade designated Hong Kong-listed stocks through the Shanghai Exchange, and vice versa. Direct investment by private equity and venture capital firms is also rising, although from a small base, and has faced setbacks due to China’s capital controls that complicate the repatriation of returns.

Money and Banking System

After several years of rapid credit growth, China’s banking sector faces asset quality concerns. For 2017, the China Banking Regulatory Commission reported a non-performing loans (NPL) ratio of 1.74 percent, the same NPL ratio reported the last quarter of 2016. The outstanding balance of commercial bank NPLs in 2017 reached 1.71 trillion RMB (approximately USD 270.6 billion). China’s total banking assets surpassed 252 trillion RMB (approximately USD 39.9 trillion) in December 2017, an 8.7 percent year-on-year increase. Experts estimate Chinese banking assets account for over 20 percent of global banking assets. In 2017, China’s credit and broad money supply slowed to 8.2 percent growth, slower than the nominal gross domestic product (GDP) growth rate of 11.23 percent and the lowest published rate since the PBOC first started publishing M2 money supply data in 1986.

Foreign Exchange and Remittances

Foreign Exchange Policies

While the central bank’s official position is that companies with proper documentation should be able to freely conduct business, in practice, companies have reported challenges and delays in getting foreign currency transactions approved by sub-national regulatory branches. In 2017, several foreign companies complained about administrative delays in remitting large sums of money from China, even after completing all of the documentation requirements. Such incidents come amid announcements that the State Administration of Foreign Exchange (SAFE) had issued guidance to tighten scrutiny of foreign currency outflows due to China’s rapidly decreasing foreign currency exchange. China has since announced that it will gradually reduce those controls, but market analysts expect they would be re-imposed if capital outflows accelerate again.

Under Chinese law, FIEs do not need pre-approval to open foreign exchange accounts and are allowed to retain income as foreign exchange or to convert it into RMB without quota requirements. Foreign exchange transactions related to China’s capital account activities do not require review by SAFE, but designated foreign exchange banks review and directly conduct foreign exchange settlements. Chinese officials register all commercial foreign debt and will limit foreign firms’ accumulated medium- and long-term debt from abroad to the difference between total investment and registered capital. China issued guidelines in February 2015 that allow, on a pilot basis, a more flexible approach to foreign debt within several specific geographic areas, including the Shanghai Pilot FTZ. The main change under this new approach is to allow FIEs to expand their foreign debt above the difference between total investment and registered capital, so long as they have sufficient net assets.

Chinese foreign exchange rules cap the maximum amount of RMB individuals are allowed to convert into other currencies at approximately USD 50,000 each year and restrict them from directly transferring RMB abroad without prior approval from SAFE. In 2017, authorities further restricted overseas currency withdrawals by banning sales of life insurance products and capping credit card withdrawals at USD 5,000 per transaction. SAFE has not reduced this quota, but during periods of higher than normal capital outflows, banks are reportedly instructed by SAFE to increase scrutiny over individuals’ requests for foreign currency and to require additional paperwork clarifying the intended use of the funds, with the express intent of slowing capital outflows.

China’s exchange rate regime is managed within a band that allows the currency to rise or fall by 2 percent per day from the “reference rate” set each morning. In August 2015, China announced that the reference rate would more closely reflect the previous day’s closing spot rate. Since that change, daily volatility of the RMB has at times been higher than in recent years, but for the most part, remains below what is typical for other currencies. In 2017, the PBOC took additional measures to reduce volatility, introducing a “countercyclical factor” into its daily RMB exchange rate calculation. Although the PBOC reportedly suspended the countercyclical factor in January 2018, the tool remains available to policymakers if volatility re-emerges.

Remittance Policies

The following operations do not require SAFE approval: purchase and remittance of foreign exchange as a result of capital reduction, liquidation, or early repatriation of an investment in a foreign-owned enterprise, or as a result of the transfer of equity in an FIE to a Chinese domestic entity or individual where lawful income derived in China is reinvested.

The remittance of profits and dividends by FIEs is not subject to time limitations, but FIEs need to submit a series of documents to designated banks for review and approval. The review period is not fixed, and is frequently completed within one or two working days of the submission of complete documents. In the past year, this period has lengthened during periods of higher than normal capital outflows, when the government strengthens capital controls.

Remittance policies have not changed substantially since SAFE simplified some regulations in January 2014, devolving many review and approval procedures to banks. Firms that remit profits at or below USD 50,000 dollars can do so without submitting documents to the banks for review. For remittances above USD 50,000, the firm must submit tax documents, as well as the formal decision by its management to distribute profits.

For remittance of interest and principle on private foreign debt, firms must submit an application form, a foreign debt agreement, and the notice on repayment of the principle and interest. Banks will then check if the repayment volume is within the repayable principle.

The remittance of financial lease payments falls under foreign debt management rules. There are no specific rules on the remittance of royalties and management fees. In September 2017, SAFE lowered the reserve requirement for foreign currency transactions to zero, significantly reducing the cost of foreign currency transactions. The reserve ratio was raised to 20 percent in 2016.

The Financial Action Task Force has identified China as a country of primary concern. Global Financial Integrity (GFI) estimates that over USD 1 trillion of illicit money left China between 2003 and 2012, making China the world leader in illicit capital flows. In 2013, GFI estimated that another USD 260 billion left the country.

Sovereign Wealth Funds

China officially has only one sovereign wealth fund (SWF), the China Investment Corporation (CIC). Established in 2007, CIC manages over USD 900 billion in assets (as of August 2017) and invests on a 10-year time horizon. China’s sovereign wealth is also invested by a subsidiary of SAFE, the government agency that manages China’s foreign currency reserves, and reports directly to the PBOC. The SAFE Administrator also serves concurrently as a PBOC Deputy Governor.

CIC publishes an annual report containing information on its structure, investments, and returns. CIC invests in diverse sectors like financial, consumer products, information technology, high-end manufacturing, healthcare, energy, telecommunication services, and utilities.

China also operates other funds that function in part like sovereign wealth funds, including: China’s National Social Security Fund, with an estimate USD 295 billion in assets; the China-Africa Development Fund (solely funded by the China Development Bank), with an estimated USD 5 billion; the SAFE Investment Company, with an estimated USD 441 billion; and China’s state-owned Silk Road Fund, established in December 2014 with USD 40 billion to foster investment in countries along the Belt and Road. Chinese SWFs do not report the percentage of their assets that are invested domestically.

Chinese SWFs follow the voluntary code of good practices known as the Santiago Principles and participate in the IMF-hosted International Working Group on SWFs. The Chinese government does not have any formal policies specifying that CIC invest funds consistent with industrial policies or in government-designated projects, although CIC is expected to pursue government objectives. The SWF generally adopts a “passive” role as a portfolio investor.