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China's massive infrastructure needs, together with the tight rein on domestic investment and the desire of foreign developers and their bankers to enter the PRC market, would seem to make project finance an inevitable part of China's infrastructure development program. But Beijing so far has been wary about encouraging foreign currency debt on a large scale, even on a limited-recourse basis to build much-needed infrastructure. For many senior PRC officials, the currency crisis now affecting other Asian countries has justified and further reinforced this cautious approach, which seems unlikely to change in the near future.
There has been some progress in the development of "project finance with Chinese characteristics," though not without some frustration for would-be project sponsors. Several significant deals have been completed, including the 2x700 megawatt (MW) coal-fired Guangdong Zhuhai power station; the 2x50 MW coal-fired Tangshan cogeneration project in Hebei Province; the Dachang water project in Shanghai; and the 2x360 MW Laibin B power plant in the Guangxi Zhuang Autonomous Region. But the total number of PRC projects financed on a truly limited-recourse basis remains small. In limited-recourse projects, lenders have recourse only to sponsors for limited support for specific risks, and to project assets and revenues. A quick review of basic lender concerns indicates why (see box). Ad hoc solutions have so far been found for individual projects, particularly within the "build, operate, transfer" (BOT) program, but Beijing seems unwilling to settle such concerns conclusively by regulation.
Perhaps the two most significant project finance-related developments of 1997 were the continuing success of the BOT program (particularly the financial closing of the Laibin B project), and the issuance of the Provisional Measures on the Administration of International Project Finance (the Project Finance Measures). Interestingly, both developments enhance the power of the State Planning Commission (SPC) over infrastructure investment at a time when the central planning authority's role in approving conventional investment projects is being re-examined.
Under close supervision of the SPC, China's infant BOT program has shown skeptics within the PRC government that the BOT model can deliver infrastructure financing quickly and at an acceptable cost. Moreover, the program can meet the essential requirements of the international lending community without the erosion of national sovereignty that PRC officials feared.
The experimental program includes a number of features designed to attract foreign bidders and lenders, such as the following: a fair and transparent bidding process, supervised by the SPC; a requirement of 100 percent foreign ownership, which eliminates pressure from local utilities to retain control; credit support for offtake payments as well as generous government compensation for early termination of the concession; a "fast-track" contract negotiation and approval process that supposedly coordinates input from various departments and levels of government; and a "guarantee" of the convertibility and transferability of foreign currency for both debt service and equity returns.
Such concession-based financing offers the great advantage that the host government can assume appropriate risks contractually. For cases in which the SPC perceives such actions as necessary to conclude a deal, the concession-granting local governments h ave been encouraged to accept such risks. Also, because the SPC has been actively involved in structuring, developing, and negotiating each transaction, the likelihood that a deal would not receive final approval has been small.
In 1997, the first BOT project, Laibin B, achieved financial closure. This signaled that the program's model project documentation was fundamentally acceptable to international lenders, including a syndicate of commercial banks and COFACE, the French export credit agency. Electricite de France and GEC Alsthom, Laibin B's winning consortium, had already shown that they could meet the Chinese government's primary objective of low tariffs. While the closing was four months beyond the SPC's aggressive timetable of six months from the bid award date, it was still remarkably quick for an Asian project finance deal.
Two other projects were added to the BOT program in 1997--a second thermal power plant in Changsha, Hunan Province, and a water treatment plant in Chengdu, Sichuan Province. Bids for the Changsha project have been submitted and negotiations with the preferred bidder are under way; bids for the Chengdu water project were due in February. In these later deals, the SPC appears to be moving toward nearly standard-form documentation, in hopes of further reducing the time and costs involved in negotiations. In Changsha, the concession-granting authority was far more reluctant than the Guangxi g overnment had been in the Laibin project to accept any changes proposed by bidders to the draft project documents, or to entertain requests from lenders for additional support letters from government authorities.
The Laibin experience, however, revealed some problems. The requirement that bids incorporate final input from lenders on the project documents raised the already high cost of bid preparation. Further, the timetable for submitting tender documents, with only a few months from bid award to financial closure, was strictly enforced. Such a timetable puts tremendous pressure on the winning bidder, particularly since neither the SPC nor the concession-granting authority controls many of the approvals that must be obtained during this period. For the Laibin project, the tender documents also stipulated that the parties not sign the concession agreement until all financing conditions were met--a case of putting the cart before the horse. Nonetheless, future projects should encounter fewer of these difficulties, since each side will likely begin with a better understanding of the process.
Despite Laibin's successful financial closing and the apparently smooth bidding of the Changsha and Chengdu projects, no new projects have been announced since April 1997. A potential fourth project, a bridge near Wuhan, Hubei Province, reportedly has been under consideration for some time. Further, the release of the long-anticipated Provisional Regulations on Foreign-Invested Concession Projects, originally expected last summer to replace the brief BOT Circular, has been delayed. This apparent lull in the program suggests that PRC authorities may need more time to incorporate the lessons learned in the first set of BOT projects. Beijing also may be reconsidering the implications of requiring 100 percent foreign-currency financing of major infrastructure projects in light of the ongoing Asian currency crisis. It seems likely, however, that after these deliberations, Beijing will not only continue but also expand the program.
Though many aspects of the new project finance measures remain unclear, it is obvious that their main purpose is not to create more favorable conditions for foreign sponsors or lenders. Rather, they seem intended primarily to ensure central review and approval, for planning and foreign exchange control purposes, over the structure and financing of projects that use the project finance method.
One challenge posed by the Measures is discerning their scope of application. Experience to date with PRC officials at different levels suggests that there is not yet a clear and consistent view of what constitutes "project finance." Strictly speaking, the Project Finance Measures explicitly cover non-recourse financing, and limited-recourse financing by implication. The Measures seem to cover projects for which sponsors provide only limited support for specific risks, but seem to exclude projects involving full recourse to substantial entities, even with provisions for security over project assets and revenues.
At the same time, the regulation states that the "project finance method" is to be used mainly for certain types of infrastructure projects and other projects involving "large-scale" investment and steady and predictable long-term revenue streams. This has led to the perception that limited-recourse financing for smaller or industrial projects is not considered project finance for the purposes of the Meas ures. The SPC may not be interested in reviewing either smaller-scale projects or larger industrial projects in which risk is not allocated to a domestic offtaker. But the guidelines are broadly worded, and neither the SPC nor SAFE is expected to issue official statements that outline limitations on the regulation's scope. Whether lenders to smaller or industrial projects will be satisfied with an approval letter from the local planning commission, rather than from Beijing, remains to be seen.
Projects in China must pass through two stages of planning approval. First, the Chinese sponsor typically submits a project proposal for preliminary approval before seeking foreign investment. The PRC and foreign sponsors then jointly prepare and submit a detailed feasibility study report, on the basis of which final planning approval is granted. Traditionally, project sponsors have approached lenders only after final project approval was certain. Prior to promulgation of the Project Finance Measures, pro ject sponsors would obtain these approvals from planning authorities at the appropriate level, which was dictated by the project size and industrial sector. Under the Measures, the preliminary proposal and feasibility study for all projects that use the project finance method, regardless of size or sector, must now be approved at the central level. Though it is questionable whether the SPC really will review small projects for which investors are considering limited-recourse financing, SPC approval is clearly required under the new measures. Sponsors of projects with less than $30 million in total investment should be aware that even if local planning authorities do not consider it necessary to submit the project proposal to the SPC, potential lenders might insist on such submission for compliance purposes.
More significantly, the Measures require that feasibility studies for projects financed on a limited-recourse basis include the proposed tariff structure and adjustment formula; a statement of the "principles of risk allocation" and a "project financing plan"; commitment letters from foreign lenders; any support documents issued by Chinese entities; and the "final, unalterable drafts" of any principal project contracts that require government approval, such as power purchase contracts. Most feasibility study reports for conventional projects, on the other hand, barely mention financing issues, let alone include input from interested lenders.
SPC officials intend to review a fairly complete project package, which they can then use to assess such matters as the qualifications of prospective investors and project parties, the "appropriateness" of project risk allocation, the affordability of the tariff for local consumers, and the nature of support given by Chinese organizations. From a government point of view, this means a streamlined process from approval to financial closure. Under the Measures, this process must be completed within a year. For sponsors, however, these prerequisites may entail initial discussions of substantial issues with lenders, or even detailed contract negotiations involving lenders and their advisers, with no guarantee of final SPC approval. Project sponsors must therefore consult with lenders during the preparation of the feasibility study. Also, sponsors should be aware that lenders must sign off on the offtake agreement, the tariff structure, and the required support documents, since subsequent changes to these aspects of the deal would require re-approval.
Also new is the requirement that after the SPC has approved the project, SAFE, China's central exchange-control authority, must also endorse the project's financing conditions. Under the Project Finance Measures, SAFE must review all financing documents to determine, among other things, whether the financing conditions are sufficiently "competitive." This approval is in addition to existing foreign debt registration requirements for foreign-invested enterprises.
How intrusively SAFE will interpret this mandate remains unclear. Experience has shown, however, that PRC officials responsible for vetting complex commercial arra ngements tend to require changes, if only to demonstrate that they are doing their jobs. Foreign sponsors and lenders are understandably concerned that SAFE officials may have little experience in this area and will require amendments to negotiated loan documents simply to suit bureaucratic notions of competitiveness.
Currency convertibility Lenders are assured that for properly authorized project financings, foreign currency required for debt repayment (but not for sponsor returns) can be converted and remitted outside China. The penalty for non-compliance with the Measures is non-convertibility. This is obviously a strong incentive for lenders to ensure sponsor compliance, though less of an incentive for borrowers (especially PRC sponsors).
Tariffs Tariffs may not be calculated in foreign currency and are subject to separate price control regulations. Tariffs should "reasonably reflect" price increases (presumably prices of inputs, though the Measures are unclear on this poi nt) and exchange rate fluctuations, and "fully take into account" whether local consumers can afford them. The crucial issue of long-term enforceability of tariffs, however, is not addressed.
Guarantees The Measures prohibit domestic entities from providing payment guarantees or security, and bar domestic financial institutions from giving performance guarantees. Performance guarantees by domestic entities (other than the government or banks) and non-binding "comfort letters" from government entities remain permissible if approved by the SPC.
The problems raised by the Measures, however, are not likely to disappear as the new approval process is implemented. Given the current economic crisis in Asia, PRC authorities now have little reason to speed up the approval of foreign currency financing. Perhaps the outcome of that crisis will determine whether PRC authorities are ultimately prepared to develop a regulatory framework that will encourage and facilitate international investment in China's infrastructure.
Melissa Thomas is an attorney in the Beijing office of Freshfields.
Last Updated: 7-Mar-98