Dismantling the 'Great Wall' of Risk

Part One of a Two-Part Series

A growing number of lessors exhibiting cautious optimism are slowly, but successfully, knocking down the 'great wall' that separates them from turning lease financing into a mainstream financial product in China. Investing in the Chinese leasing market can be a sound decision for lessors whose customers are asking for leases there; who can effectively manage the risks; and who are equipped to deal with major differences between the United States and China, which include language, culture, and the number and nature of business regulations.

This investment, however, will require a significant and ongoing commitment. A sound exit strategy also should be a part of the investment plan, keeping in mind that China is just as aggressive about keeping foreign equity investment from leaving the country as it is about bringing it in.

This two-part article (based on a 2005 white paper issued by ELA's Equipment Leasing Foundation, 'Knocking Down (Great) Walls') will look at the key legal and regulatory issues surrounding investing in the Chinese leasing market. This installment looks at the history of this market and examines the current legal and regulatory climate.

Most international lessors with operations in China today have Chinese partners, due, in part, to the fact that a local partner was required to obtain a leasing license. With the recent availability of the Wholly Foreign-Owned Enterprise (WFOE) option and a new leasing law being considered, however, many large lessors are seeking to establish operations on their own. Smaller lessors, on the other hand, may continue to seek out partners, primarily due to the regulatory capital requirements. The second part of the series compares and contrasts the experiences of a WFOE with a partnership initiative and evaluates the pros and cons of each direction.

Leasing in China: A Brief History

During the early 1980s, China was in the initial stages of its migration from a centrally planned economy to a market-based one. To take advantage of these growth opportunities, Chinese manufacturers needed new state-of-the-art production equipment, much of which had to be imported. Since most Chinese manufacturers lacked adequate capital, several new lessors were created to provide financing to these firms. Most of these leasing companies were joint ventures between Chinese and either Japanese or Korean lessors; Deutsche Leasing was also present. All of these lessors had their plans reviewed and approved by the Peoples' Bank of China (PBOC).

By the early 1990s, the Chinese economy had expanded significantly. This expansion also made new sources of funds available to Chinese manufacturers. Most European and North American multinationals began leasing operations in China during the mid-1990s. Hewlett-Packard, IBM, Siemens, and AT&T Capital were among the companies that established small leasing operations in Beijing and Shanghai. Due to the limited credit information available and questionable legal recourse in the event of default, these lessors tended to lease primarily to other creditworthy multinationals, as well as to a small number of the larger, and better-known, Chinese companies.

Today's Market Size

While the exact number of leasing companies is not known, it is estimated that China has more than 10,000 small lessors, many or most of which are car rental companies. These lessors are in addition to the relatively small group of larger, well-capitalized lessors.

Data gathered by the Financial Leasing Committee of the China Society of Finance indicate that the total leased assets by leasing companies in China as of December 2003, was 21.36 billion renminbi (the renminbi, hereinafter 'Rmb,' is the Chinese currency), which is approximately US$2.6 billion. This figure indicates a leasing penetration rate of 0.44% of capital formation, which contrasts with the prevailing level of 30% in the United States. (That does not include hire-purchase agreements. Including hire-purchase transactions would push the rate closer to 40%.) This indicates the tremendous growth potential of the Chinese leasing industry.

The Accounting, Legal, and Regulatory Landscape

Lease Accounting

China has evolved from a centrally planned accounting system, put in place after 1949, to a comprehensive set of standards that tend to harmonize the Chinese standards with those of the International Accounting Standards Board. In 1993, with a view of aligning China's accounting and reporting practices with global standards, and supported by funding from the World Bank, China's Ministry of Finance (MOF) developed approximately 30 accounting standards that were to be applied in China's socialist market economy.

At the end of 2000, MOF released a new accounting system for business enterprises. This system is an integrated framework for accounting preparation and reporting, and its standards are more far-reaching, comprehensive, and more in line with international standards.

Chinese accounting standards, like standards in the rest of the world, recognize two types of leases. The classification of these lease types, referred to as financial and operating leases, is based on the economic substance of the transaction, rather than its form.

Leasing Law

In 2004, the National People's Congress started drafting a new leasing law that will eliminate the duplication of effort between the China Bank Regulatory Commission (CBRC) and the Ministry of Commerce (MOFCOM), which regulates all other lessors. The new leasing law (expected adoption date in early 2007) will authorize, regulate, and govern financial leasing operations. The conditions for setting up a financial leasing company will include the following:

1. Minimum registered capital of Rmb80,000,000 (equivalent to slightly less than US$10,000,000);
2. A management team with professional knowledge of financial leasing and the law;
3. Adequate organization, management, internal management systems, and systems for risk control and handling;
4. The business premise, safety measures, and other required facilities corresponding to the business operation.

The ongoing regulatory requirements for a financial leasing operation under the proposed law include the following:

1. Assets/debt ratio

2. Management of leased property. The leasing company shall set up separate accounts for leased property under sublease and entrusted lease business;

3. Cost control for leased-back property. In a sale and leaseback transaction, the acquisition cost for the leased property shall not exceed 20% of the actual value or the book value of the leased property.

Particular Challenges

Many of the risks lessors face in China are the same as those in the United States, except they are compounded by time and distance. There also are uniquely Chinese challenges that go beyond differing tax and accounting rules.

Regulatory

China's regulatory agencies (MOFCOM or CBRC) may intervene, regulate, or otherwise restrict leasing companies' activities on different grounds at any time. Because there is little or no education about leasing in certain areas, confusion or misunderstanding may trigger unfair government actions or negative regulations.

Documentation

Any time a new language is introduced into the business process, there is an opportunity for a broader range of interpretation. Furthermore, since leasing is a relatively new concept, it is important to use local counsel. Other risk factors include the recent adoption of contract law and negotiation tactics.

Collections

The concept of paying over time is relatively new in China. Along with an increased risk of nonpayment, it also creates problems in the collection process. Furthermore, the rigor as to performance and metrics is not at the same level in China as it is in the United States and Europe. Lessors will have to work very closely with local resources to understand the payment mindset and find adequate collection staff.

Repossession and Recourse

The enforceability of the lease agreement is a primary concern in China. The components necessary to enforce leasing transactions include 1) the rule of law, 2) the efficiency of the legal system, and 3) a corruption-free environment; in China, for the most part, these are still variables.

Establishing a Foothold

All foreign leasing companies in China are regulated by the government and, as such, must receive authorization to conduct business. Authorization to establish a foreign leasing company is obtained through MOFCOM. There are several structural alternatives available to foreign leasing companies, including representative offices, branches, joint ventures, and WFOEs.

The easiest way for a vendor to increase sales in China is by referring leasing opportunities to existing lessors, although this approach should not be considered as entering the market. Establishing a representative office can facilitate these referral activities. This structure allows the office to be a liaison between the foreign company and its Chinese clients. The representative office cannot perform profit-making activities such as executing sales contracts or directly billing customers. This business form does, however, allow the foreign leasing company to perform cross-border leasing, mainly for large-ticket items like aircraft, rail, power plants, etc.

China's Company Law, which has been in effect since July 1, 1994, permits the opening of branches by foreign companies but, as a policy matter, China still restricts this entry approach to selected banks, insurance companies, and accounting and law firms. [Note, the first PRC Company Law was adopted by the Standing Committee of the NPC on Dec. 29, 1993. It is effective since July 1, 1994 and was amended on Dec. 25, 1999.] While representative offices are given a registration certificate, branch offices obtain an actual operating or business license and can engage in profit-making activities. It should be noted that there are significant restrictions as to the activities representative and branch offices can conduct.

Joint ventures, another organizational option, can be formed as equity joint ventures, cooperative joint ventures, or foreign invested joint stock companies.

Historically, foreign companies were not allowed to own 100% of leasing companies in China, so joint ventures were very popular. Effective March 5, 2005, MOFCOM amended its existing rules by promulgating new measures regarding the administration of foreign investment in the leasing industry. These new rules effectively open up the leasing market to foreign investment by allowing WFOEs to operate as leasing companies. There currently are five leasing WFOEs in China ' Caterpillar Financial, GE Capital, Hitachi Capital Leasing, Siemens Finance and Leasing, and Xerox Leasing.

Even though a WFOE gives ownership control of the company to the foreign investor, the need for local alliances and know-how is critical for the success in this market. The newly created WFOEs are captive companies whose parents have years of experience in the market. Their extensive networks of local dealers and distributors let them know their end-users' behavior better than a bank-owned or independent leasing company.

Lessors seeking expansion opportunities must consider the Chinese market, given its scope and transition to a market-based economy. This is particularly true for larger lessors with ambitious growth goals. Even so, much of the infrastructure needed for a viable equipment leasing industry in China is not yet in place. As a result, it is critical that lessors be armed with adequate and accurate information regarding the opportunities and pitfalls in this market.

The next installment compares and contrasts several organizational structures, based on real-world experience.

For more information on the subject, the 'Knocking Down (Great) Walls' study may be downloaded from http://www.leasefoundation.org/.

Jonathan Fales ([email protected]) is a principal in The Alta Group (http://www.thealtagroup.com/), management consultants to the global equipment and technology leasing industry. Prior to joining The Alta Group, Fales held numerous positions around the world with IBM Credit, including general manager of Asia Pacific South Global Financing and was a member of IBM Credit General Business Customer Financing Group, which focused on marketing leases through indirect dealer channels. A member of the Equipment Leasing Association Board of Directors and Executive Committee, Fales frequently makes presentations at global leasing conferences, writes articles for leading industry magazines, and is considered an expert in vendor finance.

Part One of a Two-Part Series

A growing number of lessors exhibiting cautious optimism are slowly, but successfully, knocking down the 'great wall' that separates them from turning lease financing into a mainstream financial product in China. Investing in the Chinese leasing market can be a sound decision for lessors whose customers are asking for leases there; who can effectively manage the risks; and who are equipped to deal with major differences between the United States and China, which include language, culture, and the number and nature of business regulations.

This investment, however, will require a significant and ongoing commitment. A sound exit strategy also should be a part of the investment plan, keeping in mind that China is just as aggressive about keeping foreign equity investment from leaving the country as it is about bringing it in.

This two-part article (based on a 2005 white paper issued by ELA's Equipment Leasing Foundation, 'Knocking Down (Great) Walls') will look at the key legal and regulatory issues surrounding investing in the Chinese leasing market. This installment looks at the history of this market and examines the current legal and regulatory climate.

Most international lessors with operations in China today have Chinese partners, due, in part, to the fact that a local partner was required to obtain a leasing license. With the recent availability of the Wholly Foreign-Owned Enterprise (WFOE) option and a new leasing law being considered, however, many large lessors are seeking to establish operations on their own. Smaller lessors, on the other hand, may continue to seek out partners, primarily due to the regulatory capital requirements. The second part of the series compares and contrasts the experiences of a WFOE with a partnership initiative and evaluates the pros and cons of each direction.

Leasing in China: A Brief History

During the early 1980s, China was in the initial stages of its migration from a centrally planned economy to a market-based one. To take advantage of these growth opportunities, Chinese manufacturers needed new state-of-the-art production equipment, much of which had to be imported. Since most Chinese manufacturers lacked adequate capital, several new lessors were created to provide financing to these firms. Most of these leasing companies were joint ventures between Chinese and either Japanese or Korean lessors; Deutsche Leasing was also present. All of these lessors had their plans reviewed and approved by the Peoples' Bank of China (PBOC).

By the early 1990s, the Chinese economy had expanded significantly. This expansion also made new sources of funds available to Chinese manufacturers. Most European and North American multinationals began leasing operations in China during the mid-1990s. Hewlett-Packard, IBM, Siemens, and AT&T Capital were among the companies that established small leasing operations in Beijing and Shanghai. Due to the limited credit information available and questionable legal recourse in the event of default, these lessors tended to lease primarily to other creditworthy multinationals, as well as to a small number of the larger, and better-known, Chinese companies.

Today's Market Size

While the exact number of leasing companies is not known, it is estimated that China has more than 10,000 small lessors, many or most of which are car rental companies. These lessors are in addition to the relatively small group of larger, well-capitalized lessors.

Data gathered by the Financial Leasing Committee of the China Society of Finance indicate that the total leased assets by leasing companies in China as of December 2003, was 21.36 billion renminbi (the renminbi, hereinafter 'Rmb,' is the Chinese currency), which is approximately US$2.6 billion. This figure indicates a leasing penetration rate of 0.44% of capital formation, which contrasts with the prevailing level of 30% in the United States. (That does not include hire-purchase agreements. Including hire-purchase transactions would push the rate closer to 40%.) This indicates the tremendous growth potential of the Chinese leasing industry.

The Accounting, Legal, and Regulatory Landscape

Lease Accounting

China has evolved from a centrally planned accounting system, put in place after 1949, to a comprehensive set of standards that tend to harmonize the Chinese standards with those of the International Accounting Standards Board. In 1993, with a view of aligning China's accounting and reporting practices with global standards, and supported by funding from the World Bank, China's Ministry of Finance (MOF) developed approximately 30 accounting standards that were to be applied in China's socialist market economy.

At the end of 2000, MOF released a new accounting system for business enterprises. This system is an integrated framework for accounting preparation and reporting, and its standards are more far-reaching, comprehensive, and more in line with international standards.

Chinese accounting standards, like standards in the rest of the world, recognize two types of leases. The classification of these lease types, referred to as financial and operating leases, is based on the economic substance of the transaction, rather than its form.

Leasing Law

In 2004, the National People's Congress started drafting a new leasing law that will eliminate the duplication of effort between the China Bank Regulatory Commission (CBRC) and the Ministry of Commerce (MOFCOM), which regulates all other lessors. The new leasing law (expected adoption date in early 2007) will authorize, regulate, and govern financial leasing operations. The conditions for setting up a financial leasing company will include the following:

1. Minimum registered capital of Rmb80,000,000 (equivalent to slightly less than US$10,000,000);
2. A management team with professional knowledge of financial leasing and the law;
3. Adequate organization, management, internal management systems, and systems for risk control and handling;
4. The business premise, safety measures, and other required facilities corresponding to the business operation.

The ongoing regulatory requirements for a financial leasing operation under the proposed law include the following:

1. Assets/debt ratio

2. Management of leased property. The leasing company shall set up separate accounts for leased property under sublease and entrusted lease business;

3. Cost control for leased-back property. In a sale and leaseback transaction, the acquisition cost for the leased property shall not exceed 20% of the actual value or the book value of the leased property.

Particular Challenges

Many of the risks lessors face in China are the same as those in the United States, except they are compounded by time and distance. There also are uniquely Chinese challenges that go beyond differing tax and accounting rules.

Regulatory

China's regulatory agencies (MOFCOM or CBRC) may intervene, regulate, or otherwise restrict leasing companies' activities on different grounds at any time. Because there is little or no education about leasing in certain areas, confusion or misunderstanding may trigger unfair government actions or negative regulations.

Documentation

Any time a new language is introduced into the business process, there is an opportunity for a broader range of interpretation. Furthermore, since leasing is a relatively new concept, it is important to use local counsel. Other risk factors include the recent adoption of contract law and negotiation tactics.

Collections

The concept of paying over time is relatively new in China. Along with an increased risk of nonpayment, it also creates problems in the collection process. Furthermore, the rigor as to performance and metrics is not at the same level in China as it is in the United States and Europe. Lessors will have to work very closely with local resources to understand the payment mindset and find adequate collection staff.

Repossession and Recourse

The enforceability of the lease agreement is a primary concern in China. The components necessary to enforce leasing transactions include 1) the rule of law, 2) the efficiency of the legal system, and 3) a corruption-free environment; in China, for the most part, these are still variables.

Establishing a Foothold

All foreign leasing companies in China are regulated by the government and, as such, must receive authorization to conduct business. Authorization to establish a foreign leasing company is obtained through MOFCOM. There are several structural alternatives available to foreign leasing companies, including representative offices, branches, joint ventures, and WFOEs.

The easiest way for a vendor to increase sales in China is by referring leasing opportunities to existing lessors, although this approach should not be considered as entering the market. Establishing a representative office can facilitate these referral activities. This structure allows the office to be a liaison between the foreign company and its Chinese clients. The representative office cannot perform profit-making activities such as executing sales contracts or directly billing customers. This business form does, however, allow the foreign leasing company to perform cross-border leasing, mainly for large-ticket items like aircraft, rail, power plants, etc.

China's Company Law, which has been in effect since July 1, 1994, permits the opening of branches by foreign companies but, as a policy matter, China still restricts this entry approach to selected banks, insurance companies, and accounting and law firms. [Note, the first PRC Company Law was adopted by the Standing Committee of the NPC on Dec. 29, 1993. It is effective since July 1, 1994 and was amended on Dec. 25, 1999.] While representative offices are given a registration certificate, branch offices obtain an actual operating or business license and can engage in profit-making activities. It should be noted that there are significant restrictions as to the activities representative and branch offices can conduct.

Joint ventures, another organizational option, can be formed as equity joint ventures, cooperative joint ventures, or foreign invested joint stock companies.

Historically, foreign companies were not allowed to own 100% of leasing companies in China, so joint ventures were very popular. Effective March 5, 2005, MOFCOM amended its existing rules by promulgating new measures regarding the administration of foreign investment in the leasing industry. These new rules effectively open up the leasing market to foreign investment by allowing WFOEs to operate as leasing companies. There currently are five leasing WFOEs in China ' Caterpillar Financial, GE Capital, Hitachi Capital Leasing, Siemens Finance and Leasing, and Xerox Leasing.

Even though a WFOE gives ownership control of the company to the foreign investor, the need for local alliances and know-how is critical for the success in this market. The newly created WFOEs are captive companies whose parents have years of experience in the market. Their extensive networks of local dealers and distributors let them know their end-users' behavior better than a bank-owned or independent leasing company.

Lessors seeking expansion opportunities must consider the Chinese market, given its scope and transition to a market-based economy. This is particularly true for larger lessors with ambitious growth goals. Even so, much of the infrastructure needed for a viable equipment leasing industry in China is not yet in place. As a result, it is critical that lessors be armed with adequate and accurate information regarding the opportunities and pitfalls in this market.

The next installment compares and contrasts several organizational structures, based on real-world experience.

For more information on the subject, the 'Knocking Down (Great) Walls' study may be downloaded from http://www.leasefoundation.org/.

Jonathan Fales ([email protected]) is a principal in The Alta Group (http://www.thealtagroup.com/), management consultants to the global equipment and technology leasing industry. Prior to joining The Alta Group, Fales held numerous positions around the world with IBM Credit, including general manager of Asia Pacific South Global Financing and was a member of IBM Credit General Business Customer Financing Group, which focused on marketing leases through indirect dealer channels. A member of the Equipment Leasing Association Board of Directors and Executive Committee, Fales frequently makes presentations at global leasing conferences, writes articles for leading industry magazines, and is considered an expert in vendor finance.