China’s deleveraging creates opportunity for foreign capital

After years of credit-fuelled economic growth, Beijing launched a campaign in 2016 to curb the country’s leverage by disciplining state-owned enterprises and local governments that borrowed excessively. At the same time, it clamped down on the shadow banking industry. As state-owned banks preferred to loan to SOEs and government bodies, an unregulated financial sector focused on meeting the needs of the private sector had grown across the country.

Last year, Chinese President Xi Jinping described the prevention of financial risks as one of the “three tough battles” that the authorities would need to fight to achieve high-quality economic growth. Jared Liu, leader at the project finance and PPP service at EY China, believes this tightening of regulations has translated into new greenfield and brownfield opportunities, especially in sub-sectors such as transport, utilities and renewable energy.

“Local governments are selling their shares in local SOEs and operating infrastructure projects – such as sewage, water treatment and other resources – to finance new [infrastructure] investments,” he says. “In this sense, there are some opportunities to buy operating infrastructure assets from the government.”

CICC, one of China’s largest investment banks, launched a $4.5 billion infrastructure fund in April. The fund, which has a $7.5 billion hard-cap, is targeting operational assets that are being recycled by local authorities.

A source with direct knowledge of the fundraising told us the firm had already raised $1.5 billion in 2017 for a similar strategy. Among the assets acquired by this vehicle was a stake in the rolling stock of the Jinan-Qingdao high-speed rail line in north-western China.

The authorities are exploring a range of financial structures that could allow investors to participate in the market. Yang Liu, associate director of PwC China Corporate Finance Service, says: “Local governments and state-owned enterprises are expanding financing channels, including debt financing and corporate equity transfer, and [the government] is vigorously promoting infrastructure asset securitisation. Investment opportunities for foreign investors can be found when cooperating in such activities.”

On the private side, renewables firms have also been aiming to offload assets from their balance sheets. “Many assets have been monetised to recycle capital,” says Neil Johnson, managing director at Macquarie Infrastructure and Real Assets, which in 2018 invested in China’s onshore wind and water sectors. “[This is] not only because of the deleveraging process, but also because there have been delays in receiving subsidies, particularly in the solar sector.”

Less domestic competition
China already has a well-developed infrastructure network. According to Oxford Economics, a firm focused on global economic forecasting, the country accounted for almost a third of global infrastructure investment between 2007 and 2015.

However, the consultancy adds that China will still have to spend about $1.1 trillion per year until 2040 to fulfil its infrastructure needs. In that sense, the deleveraging process and the government’s war on shadow banking have not only brought new opportunities to the market; they have also reduced the competition from domestic private equity investors.

A report published in March by financial data provider PitchBook found that in 2018 only 7 percent of funds across all asset classes were denominated in yuan, one of the lowest levels in the past decade. It attributed this to the “unwinding of domestic private-equity firms” that operate in the local currency.

“Domestic liquidity has tightened up,” says Johnson. “[This has taken] out a pool of competition from a significant number of private equity funds that emerged post-2015, which were largely funded through the shadow banking sector.

“At the same time, domestic competition from strategic players has eased up, as many companies have slowed down their M&A activity.” Infrastructure investors have taken note of the situation. A poll of 100 investors conducted in March by law firm White & Case found China to be the third-most popular market in Asia-Pacific , with around 40 percent of those surveyed saying they planned to invest in the country in 2019.

Difficult market
China has traditionally been considered a difficult market to crack, and only a handful of international firms focused on infrastructure have on-the-ground presence there.

EY’s Liu says foreign investors can face aggressive project pricing from local SOEs and private companies, and that they are often unfamiliar with bidding processes and how to deal with government. Referring to local PPP opportunities, he says: “A lot of communication, negotiations and interactions with local governments are required during the entire period of the project after the investor wins the bid.”

A placement agent from the region, who asked to remain anonymous, says the Chinese authorities still regard infrastructure as being closely linked to national security. As such, foreign firms can only access the market alongside “the right local partner”. He adds that such firms “can only expect to be passive investors”.

Yet Johnson argues that the liberalisation of the sector has been a positive development that allows foreign investors to have full ownership of their assets: “Only in more strategic sectors, such as airports or data centres, is ownership by foreign players restricted to 49 percent.”

He adds that international investors need to become more familiar with the market in order to bring their capital in. “Specifically, [you will need to know] how robust the regulatory frameworks are and whether the rule of law is sufficient to protect your interest as a private investor,” he says. “We´ve had to test our legal rights on occasions, and they have been protected as expected.”

To ease trade tensions with the US and the rest of the world, China has accelerated the opening of its markets. In March, it passed a foreign investment law that aims to level the playing field between domestic and foreign companies and create a more predictable legal framework for the latter. According to PwC’s Liu, “such opening-up policies also make it much easier for foreign investors to gain access to the Chinese infrastructure market”.

On the way out
The deleveraging campaign has been waning in recent months. The authorities have grown wary of an economic slowdown triggered by the campaign’s impact on the private sector and by the trade war with the US.

In February, Caixin, one of China’s leading business publications, reported Wang Zhaoxing, vice-chairman of the China Banking and Insurance Regulatory Commission, as saying that the country had managed to clamp down on shadow banking and companies involved in illegal financial activities. “Several kinds of financial misconduct have been effectively curbed,” Wang was quoted as saying.

The experts we spoke to believe China will keep offering opportunities in infrastructure investment, regardless of policy changes. According to Johnson: “The next phase driving investment demand will be the consolidation of certain sectors, and new capital needed to improve the quality of infrastructure.”

An investment manager based in China tells us that, ultimately, the sheer size of the market means foreign capital will become essential: “There’s an extensive need for long-term equity capital to deleverage the economy, and that capital needs to come from abroad.”