By Fiona Chan, Corporate Partner, Appleby, Hong Kong (31/12/2017)
Discussions over the roles that major mainland Chinese cities and Hong Kong have played in the rapid expansion of the Chinese economy have often centred on their respective legislative and regulatory frameworks and in particular their ability to attract inbound investment and to facilitate outbound investment. Shanghai, for instance, has developed into a prominent international financial centre and is one of the leading Chinese cities to act as a bridge between China and the rest of the world.
Offshore jurisdictions such as the British Virgin Islands, the Cayman Islands, Bermuda, Mauritius and the Seychelles have all been used to structure corporate, financing and wealth management transactions in Shanghai and Hong Kong. Although there has been significant growth in economic activities in Shanghai, Hong Kong still retains its prominent status as the gateway through which investments flow in and out of the mainland. Indeed, Hong Kong and Shanghai are equally expected to benefit from China’s ‘One Belt, One Road’ (OBOR) initiative and government officials in both cities have introduced various measures to seize and take advantage of this opportunity to expand their respective footings in international trade and finance.
This article will look at some of the recent trends in Asia in the bonds and funds markets to illustrate how cities such as Hong Kong and Shanghai may benefit from the use of offshore structures, particularly given the latest legal and regulatory developments.
The Impact of OBOR on the Bonds Market
China’s OBOR initiative spells out its intention to transform the world’s political and economic landscape over the coming decades andthe most frequently mentioned economic element is a Chinese commitment to invest heavily in a wide variety of infrastructure projects in order to strengthen its economic capacity and ‘connectivity’ among the nations within the OBOR area. Projects and deals of over US$490 billion in value were announced in 2016 alone, among which nearly two-thirds were investments into infrastructure developments across the OBOR region. Countries such as Thailand, Indonesia, Laos, Malaysia and the Philippines have all signed up to substantial road and railway projects with China, which will undoubtedly enhance cross-border trading and financing. These projects call for greater global capital participation despite China’s substantial pledges. Banks and enterprises in the public and private sectors have acted swiftly to seize the opportunity to contribute to these projects.
With outbound investments by Chinese banks and enterprises leading the infrastructure constructions in the developing world, international banks such as the Asian Development Bank and the World Bank and other international investors are also keen to provide funding. The vast geographical and sectoral coverage of potential projects in the OBOR region should accommodate investments of various origins and sizes. The OBOR initiative will continue to attract investments from all over the world into the region.
According to the Asia Development Bank, Asia needs to add US$770 billion of infrastructure annually from now to 2020. Commercial players and private money will also need to step into fund. It is expected that bonds and other innovative financing tools and hedging will be instrumental in spreading the risk and will be integral in attracting more global capital. Global interest rates continue to be low on a historical basis. This makes raising long-term debt to finance large-scale infrastructure projects especially opportune. Bonds are an excellent means of satisfying the demand for the financing that OBOR will generate due to their low cost and comparative high transparency and liquidity.
Given its currency and geographical proximity, the Asian bond market provides key early access points. This is likely to boost financial centres in Greater China including Hong Kong and Shanghai initially. The Chinese government’s efforts to step up financing for OBOR naturally spurs growth in Yuan denominated bonds. In addition to driving expansion in domestic bond issuance, OBOR is also seen as a vital prop for the growth of panda bond issuance by China’s key trading partners.
Hong Kong is the world’s leading offshore renminbi market and gateway for more than half of the mainland’s outward investment. Mainland companies account for more than half of the market capitalisation of Hong Kong’s stock exchange, which offers direct two-way access to exchanges in Shanghai. Further, the ‘Bond Connect’ programme, launched in July 2017, allows investors from Hong Kong and overseas to invest in Chinese onshore bonds in a much easier fashion, drawing more foreign institutional investors and significant funds inflow into China’s bond market, which has developed into the third largest in the world. Hong Kong, as one of the world’s leading financial hubs, plays a leading role in raising additional capital. Hong Kong can help companies to invest in OBOR projects, securitise debt and manage risks, and offer a natural platform for governance and arbitration.
Key offshore jurisdictions such as Bermuda, the British Virgin Islands, the Cayman Islands, Mauritius and the Seychelles are well-placed to provide the stable and neutral legal and tax background for investment in bonds catered for OBOR projects. Vehicles incorporated in these financial centres have always been popular in international transactions. Where investors are yet to gain confidence in the local legal and regulatory framework of some of the OBOR nations, these jurisdictions are perfect financial intermediaries. The use of offshore structures has been seen in many public and private bond issuances in the Hong Kong and Shanghai markets, and there’s every reason to believe that this will continue to be case.
Latest Trends in the Funds Market
Compared with the bonds market, there is much more divergence in the development of the funds market in Hong Kong and Shanghai. There is no doubt that the Asian markets have generally been regarded as the long-term growth area compared with other markets. However, the tight regulatory approval by the China Securities Regulatory Commission (CSRC) – the Chinese regulator of its securities and futures markets – has been a major obstacle for Hong Kong and other overseas funds to be sold in Mainland China.
Since the debut of the mainland–Hong Kong Mutual Recognition of Funds (MRF) initiative in 2015, only six Hong Kong funds have been approved by the CSRC to be sold in the Mainland so far, while its counterpart in Hong Kong have approved 49 Mainland funds, which encouraged Chinese investors to channel billions of RMB into Hong Kong funds so as to leverage and diversify their investment risks. It would be hard to see very active cross-border funds trading if the regulators continue to hold such a tight grip.
Similar to many other countries around the world, China is adjusting its policies and re-defining its role on the international scene in light of recent developments, such as Trump’s ‘America first’ policy and the UK’s Brexit. It seems premature to come to a consensus about the long-term effect of global political and economic changes on China as a whole. Against this background, however, international funds markets in Asia and Hong Kong are relatively volatile and vulnerable, more so than Chinese funds markets in, say, Shanghai. Investors may suffer from huge investment losses in a short period of time if risks are not assessed in full or where undue reliance is placed on track records. Investing in mainland Chinese funds market may seem to be a safer option, though the size and credibility of the market remains an obstacle to international players.
Nonetheless, tools are at hand to assist the development of the funds market, be it Hong Kong or Shanghai. For instance, an increasing number of mutual funds, hedge funds and institutional investors are utilising quantitative strategies to run statistics in a more systematic way. These ‘Fintech’ strategies are being introduced into Asian funds, and there is huge room for specialists in Hong Kong and Shanghai to collaborate and exploit the advantage of their respective funds market.
Another way in which the Hong Kong and Shanghai funds markets may further develop is via the use of offshore structures. Offshore funds are no strangers to investors in Hong Kong or Shanghai alike; though in the past we used to see Chinese investors playing a passive role as limited partners only. As Chinese investors become more sophisticated and experienced, they naturally demand greater roles in the management and operation of investment funds. The introduction of limited liability companies (LLC) in the Cayman Islands and Bermuda in 2016 rides on this trend perfectly.
LLCs are introduced in both offshore jurisdictions in response to requests made by the US financial services industry and are modelled on the Delaware LLC. Essentially the LLC is a hybrid legal vehicle that has many of the features of a partnership with separate legal personality within a corporate structure. It enjoys the flexibility of a partnership in terms of bespoke operations, management, allocation of profits and share capital accounting whilst the liability of its members remains limited. Being members of a LLC would allow investors to be more involved in the decision-making process which is traditionally reserved for general partners.
Another related development is the increasing interest in fund financing in the Asian market. Many partnerships are formed in offshore jurisdictions such as the Cayman Islands, Bermuda, Guernsey and Jersey, which in turn help drive the formation and financing of private equity funds in the Chinese funds market. The stable, legal and well-regulated regimes in these jurisdictions offer a level-playing field to all parties involved. Fund finance is expected to continue to be a fast-growing area of offshore mandates in the next few years and onward, particularly in major Asian financial hubs such as Hong Kong and Shanghai.
Although the bonds market and the funds market in Asia have generally been affected by adverse changes in the global political and economic environment, they still exhibit strong and sustainable growth owing to factors such as the strength of the Chinese economy and the concentration of private wealth in China. Moreover, the OBOR initiatives will, not only increase connectivity among the OBOR countries, but also present new opportunities for cities such as Hong Kong and Shanghai to consolidate their positions as primary financial hubs through which capital is raised and invested in cross-border transactions.
Indeed, the debate as to whether Shanghai has overtaken Hong Kong to be the number one city for outbound investments over the past decade does not appear to matter so much now – Hong Kong and Shanghai have never been in a better position to lead and facilitate economic growth through closer collaboration and exchange. With the latest legal and regulatory developments in places such as the Cayman Islands, Bermuda and the British Virgin Islands, no doubt Hong Kong and Shanghai will continue to make full use of the stable, innovative and adaptive structures offered by these jurisdictions.