A growing number of foreign and Chinese companies are accessing the renminbi (“RMB”) bond market to fund projects, enhance liquidity and improve their working capital in China. These companies can raise capital while avoiding time-consuming IPOs, rights issuances and secondary offerings. It also offers a cheaper form of RMB financing to an issuer than that raised onshore1. An RMB bond offers investors (who have few options to invest in offshore RMB) exposure to RMB. The Hong Kong RMB bond market, also known as the Dim Sum bond market, is the first offshore2 market for Chinese currency investments and has increased significantly in the past few years. This eUpdate is part 2 in a series of eUpdates on this topic. Part 1 deals with laws and regulations applicable to, and features of, an RMB bond. Part 2 discusses points that an RMB bond issuer should consider. Part 3 deals with the documentation and issue process of an RMB bond. Part 4 considers some structural issues that the Dim Sum bond market continues to face after its liberalization in 2010. Part 5 considers the competition and challenges posed by other offshore RMB markets to Hong Kong as the major offshore RMB business center.
Risks and Points for the Issuer to Consider
I. Currency Risk
The issuer must have access to sufficient funds in the currency of the bond issue to service interest payments through the life of the bonds and principal repayment on maturity. In an RMB bond issue, an issuer should consider the source of RMB for the payment of interest and principal, as the offshore swap market may not have sufficient liquidity to accommodate large conversions. An issuer could repatriate proceeds of an RMB bond issue by way of loan to its onshore subsidiary where the loan term and interest payments match those of the bonds. An issuer could use a combination of RMB dividends distributed by its onshore subsidiary and RMB obtained through cross-border trade settlement. An issuer which intends to remit the proceeds onshore for capital account purposes, or to remit funds offshore to repay bondholders, must consider PRC3 regulatory issues, though no approvals are required in Hong Kong.
The convertibility issue can also be addressed by a synthetic bond. The issuer is entitled to pay out in another currency if it is prevented from servicing the coupon or repaying the principal of its RMB bond issue due to specified events.
II. Interest Rate Risk
Global interest rates can move up or down over the life of a bond. A fixed rate of interest, especially in the current low interest rate environment, provides an issuer with an attractive rate of interest which will not change over the life of the bonds. If, however, the bond carries a floating rate of interest (e.g. a margin over LIBOR), then any increase in LIBOR rates at the beginning of each interest period for the bonds results in an increased cost for the issuer.
III. Withholding Tax
Bond issues are usually structured to enable the issuer not to be subject to deduction of domestic withholding taxes on interest and principal payments. For RMB bonds issued by Chinese companies, under the PRC Enterprise Income Tax Law and the PRC Individual Income Tax Law and implementation rules, an income tax is levied on payment of interest in respect of debt securities, including bonds sold by enterprises established within mainland China4 to non-resident enterprises (including Hong Kong enterprises) and non-resident individuals, (including Hong Kong resident individuals) resulting in an obligation on the issuer to withhold up to 10% on all interest payments. Therefore, the issuer is required to “gross-up” these payments so that the bondholders receive the full amount. Accordingly, a number of issuers have issued RMB bonds through offshore issuers, guaranteed by the PRC parent company, where the issuer group has sufficient non- PRC source revenues to service the coupon payments, thereby falling outside the withholding requirements.
IV. Offering Circular Liability
The issue of an offering circular subjects the issuer to prospectus liability if it contains any material untrue statements or omits any material facts. Accordingly, the lead manager and the lawyers conduct due diligence in meetings with the issuer’s management, and the issuer’s auditors are asked to issue a comfort letter confirming all the financial information contained in the offering circular are correctly extracted from the issuer’s financial statements and internal records. However, the legal responsibility for the accuracy and completeness of the offering circular remains with the issuer, which must dedicate the time and internal resources to ensure it is properly prepared and accurate.
V. Secured Bonds
Many first time issuers do not have a strong enough credit rating (or indeed any international credit rating) to merit an unsecured bond issue. In such cases the lead manager may require the issuer to charge assets in favour of the trustee/bondholders, which are enforceable upon an event of default under the bonds. A detailed legal analysis on the legal rights to enforce security, and whether any governmental approvals are required to grant/enforce security, must be carried out as part of the due diligence process.
The provision of security over assets in PRC by a Chinese entity to a foreign entity requires approval from the Chinese State Administration of Foreign Exchange (commonly referred to as SAFE), with some exceptions. As a consequence, a number of bond issues by PRC issuers have been secured by a pledge over the share capital of offshore subsidiaries rather than a direct pledge over physical assets in PRC.
1 “Onshore” in this article refers to the jurisdiction of the PRC.
2 “Offshore” in this article refers to the other jurisdiction areas of the PRC, in particular, Hong Kong.
3 “PRC” in this article refers to the People’s Republic of China, excluding Hong Kong, Macau and Taiwan.
4 “Mainland China” in this article refers to the geopolitical area under the jurisdiction of the PRC, excluding Hong Kong, Macau and Taiwan.