China investment regulation: Context clues

When China’s Ministry of Commerce (MofCom) and National Development & Reform Commission (NDRC) announced the latest revisions to the country’s national negative investment list earlier this year, the private equity reaction was muted. Compared with the introduction of the national list in 2016, which amounted to a fundamental overhaul of the existing regulatory framework, the lifting of investment restrictions in eight subsectors sparked little comment.

Industry observers believe this was precisely the non-reaction China’s government was looking for. More excitement could have implied that foreign investors believe the regulatory environment is still stacked against them; the business-as-usual response has been seen as a quiet endorsement of the current trajectory.

“The changes to infrastructure, oil and gas, and energy are certainly good for investors in those areas,” says Lorna Chen, a partner and head of Greater China at Shearman & Sterling. “But for PE firms that are not that specialized, this doesn’t look like such a big change. Sectors like consumer products and technology, new energy, and things like that have already been opened up through previous revisions to the list.”

For many investors, the greatest value of the new negative list is in its lack of surprises. However, observers are also clear that the project of transformation in China is far from over. Clarity is still lacking in how authorities will ensure consistent implementation of the new policies nationwide, and national security measures have raised concerns that the government is less than fully committed to fair treatment. Regulators have a lot of work left to reassure investors that they can do business in peace.

Viewed in tandem

PE investors could be forgiven for paying little attention to the latest revisions, which landed in June while the industry was still digesting the passage of the Foreign Investment Law (FIL) in April. The measures eliminated bans on overseas investment in some categories, such as mining, and removed the 49% shareholding caps for overseas investors in others including construction and operation of cinemas and urban gas pipelines, domestic shipping agencies, and value-added telecommunications.

These moves are widely regarded as positive but far from earthshaking when placed alongside the FIL, which cleared the way for foreign and domestic investors to be treated essentially the same. But both the FIL and the negative list have a key role to play in encouraging foreign direct investment (FDI) in China, which has historically been characterized by spikes and troughs. 

Last year is a prime example. According to data from CEIC, total FDI went from nearly $80 billion in the last quarter of 2017 to just over $25 billion in the same quarter of 2018. These swings have made regulators understandably nervous.

“The Chinese economy is changing from lower-end, labor-intensive manufacturing to a mid to high-end market, and we’ve seen some foreign investors withdraw from their investments in the country,” says Sherry Yin, a partner at Morrison & Foerster’s Beijing office. “At the same time, China has a big demand for investments in foreign currency due to the drop in currency reserves. So there are some key economic drivers for this opening up as well.”

The FIL and the negative list serve this purpose from different ends, with the law establishing the principle that foreign investors should be treated like their local counterparts, in a form that will be difficult to change later. In turn, the negative list is part of a regulatory framework that can be updated as needed. Notably, the FIL gave the negative list official standing, three years after it was introduced as an expansion of policy in China’s free trade zones.

Much remains to be worked out in terms of on-the-ground enforcement. Notably, local governments retain significant say over how policies are carried out on a day to day basis, and they continue to raise difficulties for foreign investors. Exceptions do exist, as with Tesla, which broke ground on a factory in January that was allowed to bypass the normal requirement of 50% Chinese shareholding. However, these are far from the norm.

“You do hear complaints that the environment hasn’t changed much in terms of leveling the playing field,” says John Gu, head of China advisory and M&A tax at KPMG. “On the other hand, we’ve seen that if China wants to open up a sector through a special deal with one particular player, it can do so very quickly, like Shanghai did with Tesla.”

Unreliable entities

Another complication for overseas investors is China’s unreliable entities list, which was announced by MofCom in June as a means of banning foreign companies accused of violating contracts or damaging Chinese companies for non-business reasons. 

Reactions to the unreliable entities list, seen as a warning shot in reaction to recent US actions against Huawei Technologies, has been mixed. A sizeable portion of observers consider it largely a bluff, but the lack of specifics about how companies may be put on the list and what punishments they face could have chilling effects for investors who cannot afford uncertainty.

“We don’t know how the list will be organized in the end, but there are some concerns on the part of investors about whether this will result in a lack of transparency or even abuse of the blacklist,” says Lucy Lu, a partner at Morrison & Foerster. “Some people are worried that if an entity is put on the list and it has affiliated companies in China, those companies may be affected too. For now, we need to wait and see.”

For some investors, the fact that such interventions are even a consideration shows that China has a long way to go before overseas players can feel truly secure. However, most industry professionals are confident that regulators are committed to taking the country in the right direction.

“On a national level the law is there, but sometimes you’ve got to deal with different interpretations and procedures that are imposed by the local governments. That’s the most common complaint we hear about China’s opening up,” says KPMG’s Gu. “But I think big picture-wise they’re moving in the right direction with simplifying the approval processes, and over time these things will work themselves out.” 

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• Topics
• Greater China
• Regulation
• Investments
• China
• KPMG