The history of Project Finance in China is not long, but it is rich. In the earliest days, Project Finance was used mainly in power plant deals, then later extended to water plant deals and petrochemical projects. At that time, Chinese sponsors were short of funds and experience, and Chinese banks were short of foreign exchange and caught up in bad loans. Furthermore, China's infrastructure base was very weak, and the production capability of Chinese entities was also unreliable. Therefore, the lenders in the Project Finance market were mainly foreign banks, and the loans included commercial loans, export credit, and soft loans. The loans were used mainly to import the machinery and equipment produced by the foreign producers. As well as the collateral on all project assets, the lenders also requested and were able to obtain sponsors' guaranties and even governmental guaranties for almost every project, although such arrangements are not typical under the project finance model.
Twenty years later, the Project Finance deals done by the Chinese companies and banks have developed significantly. Nowadays, two main types of deals exist within the Project Finance model, with different attributes: projects within mainland China and projects outside mainland China.
Projects within Mainland China
The attributes of the current Project Finance market in mainland China include:
- Chinese banks have now become the main, if not the only, source of funds for projects;
- The large state-owned enterprises have now accepted this model (gradually), including PetroChina and Sinopec, the biggest players with the strongest negotiating position in the market;
- With few power plant projects in action, most projects are in the petrochemical, nuclear power plant, highway, bridge and other infrastructure areas;
- All deals are subject to regulations and rules promulgated by Chinese regulators. Applicable regulations include the Guidelines for Project Finance Transactions as well as indirect rules, for example, the Provisional Measures on the Administration of Fixed Assets loans, the Provisional Measures on the Administration of Working Capital Loans, and the Guidelines for Syndication Loan Transactions, etc.
- It is largely a buyers market.
Although there is currently a contractive domestic monetary policy in China, and foreign banks are short of funds due to the global financial crisis, the borrowers under the Project Finance deals still hold a strong negotiating position and are able to request favorable loan conditions. The main reasons are because the sponsors are generally powerful, the deals are generally very big, and government support is generally strong. Some requests are raised under the current market conditions and seem strange to the general practice. For example, the borrower under a syndication loan deal sometimes requests a clause stating that if any member bank fails to grant its portion in the facility, the lead manager and other member banks should take such portion. Another example is a clause stating that if a lender or the agent fails to make the money available on time, such lender or the agent will be fined a default amount based on the default interest rate as provided in the loan agreement. We have not had such clauses in the syndication loan deal before.
Certain clauses are specific to China. For example, under the Provisional Measures on the Administration of Fixed Asset Loans and the Provisional Measures on the Administration of Working Capital Loans, the China Banking Regulatory Commission (CBRC) requests that when the disbursement fund is not a small amount (over RMB 5 million or 5% of the total investment amount), the loan must be transferred directly by the lender into the bank account of the payee rather than payer (i.e., the borrower) under the applicable commercial contract.
Sometimes, arguments may occur between the lenders and the borrower on some clauses which do not seem too material. In an infrastructure project deal, the sponsors stated that the capital they agree to contribute into the project company had been much higher than what the regulations require in proportion to the total investment amount of the project, so they insisted that no more contribution would be made even if there were cost overruns. However, the lenders stated that the ratio of the capital to the total investment amount as described in the approval of National Development and Reform Commission is a specific ratio requirement for this particular project, therefore the sponsor should contribute more capital if there were cost overruns. In fact, this point was not so important itself in that deal, and the parties just used it as a bargaining chip for benefits from other arrangements.
Normally, financial ratios are the focus of negotiations between the lenders and the borrower in a Project Finance deal. More ratios and stricter ratios mean more limitation on the borrower and more protection for the lenders. However, if the sponsors are strong enough, they will try to refuse such requirement. Debt Service Coverage Ratio is a generally accepted ratio, which means the ratio of cash available for debt service to the scheduled debt service for the relevant DSCR calculation period (i.e. the relevant period prior to the calculation date). The higher the DSCR, the better protection the lenders get.
Furthermore, the lenders normally seek to control the cash flow and the corporate activities of the borrower in a project finance deal. The lenders demand clauses in the facility documents which describe the sequence of the utilization of the funds generated during the operation of the project. Except for the amount necessary for the normal operation of the project, the lenders do not want other leaks of the funds. The lenders want to put more funds for repayment or in the repayment reserve account, while the sponsors want to get earlier and more dividends distribution. As for the borrower’s corporate activities, the lenders try to limit the borrower's business within the operation of the project. The borrower can not carry out other material business, can not make investments, can not grant loans, can not incur indebtedness, and can not provide security for others. Generally speaking, the lenders’ requirements are reasonable. The lenders' financing is based on the contemplation that the project will proceed smoothly and generate sufficient cash flow. If the borrower can do anything it wants, the lenders' right will not be effectively protected, especially in deals without recourse or with only limited recourse to the sponsors.
Projects outside Mainland China
The second type of deal relates to projects outside of mainland China with Chinese banks acting as the lenders. In the past ten years, "outbound" deals have increased rapidly, and such deals often seek the support from the Chinese banks. Among these deals, many have taken the Project Finance model and had the following features:
- Chinese banks have increasingly become leading actors in financing overseas projects. Although there are still many lessons to learn, Chinese banks have gained more experience and market influence as a result of their significant funds.
- Most of the sponsors or borrowers have a Chinese background. The lenders request collateral not only on the assets of the projects, but also request a guarantee or commitment from the Chinese holding companies.
- Most deals are in the natural resources areas.
- Due to the cross-border nature of the deals, certain rules and regulations are now applicable which otherwise would not be. For example, when the Chinese holding companies provide security to the lenders, the relevant foreign security rules will become applicable. The Chinese holding companies must get approval from and register such security with the foreign exchange regulators.
When conducting Project Finance deals outside of China, Chinese companies and banks face many unfamiliar rules and regulations. For example, many deals have failed as a result of environmental issues as well as issues related to local residents, such as compensation for destruction of their houses. The Chinese companies and banks have been accustomed to favorable environmental and other domestic requirements in China, because the local government may provide the infrastructure projects with support at the cost of the natural environment and the interests of the local residents. When Chinese companies and banks step into the international market, they may disregard the importance of these issues in the local jurisdiction. They may have made a feasibility report without considering such factors and thus arrived at a very low fee quote. When the project starts, they become aware of a large and unanticipated cost, or even potential material disputes. Stamp duty sometimes also becomes a major issue. In China, the loan agreement needs to be stamped. In some other jurisdictions, however, bank guarantees are required to be stamped with an amount calculated on the basis of a ratio of the secured amount. This additional cost normally also falls outside the Chinese companies’ and banks' initial projections, and if the financial advisor or counsel failed to make it clear in advance, this factor might render the deal unprofitable.
Foreign security is an important issue in cross-borders deals. On the one hand, during the life of the project, especially during the construction period, the lenders normally find that only the Chinese holding companies are reliable. On the other hand, the foreign exchange administration and controls are still strict in China. In the current international financial market, a stricter administration and control might be a good choice. At the same time, the regulations and rules in respect of foreign security are not very clear. What foreign security measures are included? What foreign security measures need to be approved by the regulators? How to satisfy the relevant requirements in order to provide an effective foreign security? Is the effectiveness of foreign security affected by relevant approval and registration rules? All of these issues require close attention to relevant regulations and rules.
In cross-borders deals, export credit insurance also takes a significant position. Due to the existence of various jurisdictions, the companies and banks, as commercial entities, are unable to know and deal with all risks themselves, especially political risks, outside their jurisdiction. The export credit insurance agencies are normally established by the governments. These agencies can collect information and analyze political risks of various jurisdictions, give such jurisdictions different ratings, and provide insurance under different conditions. Most important, these agencies have a strong position to make a claim against foreign entities because they are supported by their own governments. Therefore, the existence and operation of the export credit insurance agencies highly promote the development of cross-border deals. In the investment area, the export credit insurance agencies provide four main types of political risks insurance: Limitation on the exchange and transfer of foreign exchange, expropriation, war and political disruption, and government default.
A final new issue is the internationalization of the RMB. In recent years, the Chinese government has made great efforts to promote the internationalization of the RMB. It is possible now for foreign entities to borrow RMB funds from Chinese banks to facilitate the construction of infrastructure projects. However, the administration and regulation of cross-border RMB transactions is different from those over foreign exchange, including transfer of funds in and out of China, the opening of and supervision of accounts, and provision of security. This issue will likely lead to new finance and security arrangements for the overseas Project Finance deals.