Asiabizblog - Business and Law for China and Asia

Investment Banking

Market Overview

China's domestic stock markets, introduced in early 1990s as a cautious, controlled experiment, have quickly grown to impressive size. With a combined market capitalization of approximately $600 billion , China’s equity markets are now the Asia-Pacific's second largest after Japan and dwarf all other emerging markets in Asia, Latin America and Eastern Europe. Despite their infancy, the markets have played a unique role in China's economic transformation. They have served as catalysts for much-needed corporate restructuring, turning many chronically inefficient state-owned enterprises into modern, profit-driven corporations. More than 1,200 companies are listed on the domestic exchanges in Shanghai and Shenzhen (and another 120 or so are listed in Hong Kong and New York).

Companies of global significance such as China Mobile, Unicom and PetroChina have fundamentally altered China's corporate and investment landscape. Corporate governance, a concept totally alien to the Chinese public just a few years back, has now become the buzzword in Chinese boardrooms, the media and in the hallways of regulatory authorities. Long indulged in the "soft-budget constraint" of central planning, many of China's listed firms are for the first time under pressure to achieve a better return on equity. China has $200 billion of assets to monetize, which could mean about $10 billion a year in equity deals during the next 10 years or much more.

Although the second board for emerging companies is delayed due to the crash of NASDAQ, there are reported 450 companies waiting for listing on the Hong Kong GEM market as an alternative. Hundreds more are waiting to be listed on the Shanghai and Shenzhen markets.

Structural Problems and Constraints

However, the markets created by the central government as an alternative funding conduit from the centralized banking lending suffer from several constraints and structural defects. Many of such problems have been identified and are either corrected or in the process of being identified and rectified. It remains worthwhile to point them out as they represent both risks and opportunities for foreign players.

First, the initial quota listing system and related corruption in obtaining such quota flouted in the face of a free and efficient market place directing resources to the most efficient use. Many companies got listed not on the strength of their earning power but on political connections and ability to get approval. Therefore, initially many companies that should not have been financed were the first batch to benefit from public investment as the investment opportunities were limited in view of the quota system causing waste of social resources. This in turn has given rise to accounting irregularities those under-performing companies use to overstate their earnings and to manipulate their stocks. The China Securities Regulatory Commission (“CSRC”) has only recently abandoned the quota system.

However, it will be a few years before the skewed market restore its inherent integrity. There is a very urgent need to completely set the listing process free so that the market can operate as it should, channel limited social resources to the most efficient and deserving users. Second, the pool of listed companies does not represent the real market and is overly concentrated in a few sectors. The companies listed are largely dominated by state owned enterprises and in the manufacturing sector. This in turn gives rise to problems for asset managers in terms of risk diversification and investment choices. Third, investors’ rights are not adequately protected in terms of regulatory enforcement and private legal actions. Although the situation is improving with the recent hire by the CSRC of the head of the enforcement division of the Hong Kong Stocks and Futures Commission to spearhead its own efforts, private civil action jurisprudence is still relatively scanty. Fourth, the top management is too entrenched and often answers less to the public shareholders than to the largest shareholders who are often some state agencies. The management talent as a separate class of mobile social resources is still in the initial development process. Fifth, the illiquid shares held by legal persons and state entities. Only about 30% of the total market capitalization is liquid. The rest is locked up as shares not eligible for public circulation. This anomaly has created a very dangerous market defect by which the liquid shares have an unreasonably high liquidity premium and a large portion of social wealth is artificially trapped. Nobody can understand the rationale for the artificial creation of this anomaly. But its proposed solutions and the on-again and off-again policies by the CSRC are causing considerable market instability. The Chinese government has realized that all these trapped shares need to be freed up or they will destroy the viability of the capital market. There exist enormous potentials for foreign players in solving these problems. For example, the purchase of such restricted shares at the current steep liquidity discount may be a great bargain if selected carefully.

Legal Framework

The investment banking market was largely closed to foreign investors and banks. Prior to the commitment made under the WTO arrangement, there was only one foreign investment bank having limited operation in China. Morgan Stanley entered into a joint venture as a minority partner with China Construction Bank under the name of China International Capital Corporation (“CICC”) mainly engaged in deal origination for offshore securities offering. Only recently has CICC been issued the license to engage in domestic investment banking activities. Under the WTO agreement, China has agreed to further open up the investment banking and brokerage sector to foreign investors, allowing 33% of equity ownership to be gradually increased to 49% after three years. Many Chinese broker-dealers are looking for foreign partners in face of such opening to stay competitive and to learn the advanced investment banking technologies from international players, both in underwriting and other fields. Given the need for mergers and acquisitions and reorganization in China and the limited experience the Chinese investment banks have in this field, this should be a particular field for growth.

In keeping with China’s WTO commitment, the “Rules for the Establishment of Securities Companies with Foreign Equity Participation” (“Rules”) came into force on July 1, 2002. The rules over companies are transformed when foreign shareholders are assigned, or subscribe to, share rights in domestic securities companies and securities companies where foreign shareholders and domestic shareholders have contributed the capital and established the company jointly.

Securities companies with foreign equity participation may engage in the following types of business: distribution of shares (including ordinary Renminbi shares and foreign-investment shares) and bonds (including government bonds and corporate bonds); brokerage of foreign-investment shares; brokerage of, and dealing on one’s own behalf in, bonds (including government bonds and corporate bonds); and other business approved by the CSRC. Foreign-investment shares include foreign-investment shares listed in China (B shares) and foreign-investment shares listed abroad.

Securities companies with foreign equity participation must meet the following requirements: (I) the registered capital must comply with the provisions in the Securities Law on the registered capital of general securities companies; (ii) the shareholders must meet the qualification requirements specified in the Rules; (iii) capital contribution ratios and the forms of capital contributions must comply with the provisions of the Rules; (iv) the company must have at least 50 persons who have obtained the qualification to engage in securities business in accordance with CSRC regulations. It must also have necessary accounting, legal and computer professionals; (v) the company must have sound internal management and risk control systems. It must also have appropriate internal control technology systems for the separate administration systems for areas such as organizational structure, personnel, information and business implementation in distribution, brokerage, dealing on one’s own behalf and other such business; (vi) the company must have a place of business that meets requirements and qualified trading facilities.

A foreign shareholder of a securities company with foreign equity participation must meet the following requirements: (I) the country where the shareholder is located must have sound securities laws and regulatory systems; (ii) The country’s securities regulatory authorities and the CSRC must have concluded a memorandum of understanding on securities regulatory cooperation and must be maintaining an effective relationship of regulatory cooperation; (iii) the shareholder must have lawful securities business qualifications in the country where it is located; (iv) it must have been engaged in financial business for at least ten years and must not have been subject to major penalties from the securities regulatory authorities or the judicial authorities in the preceding three years.; (v) each risk control and monitor indicator must have met the requirements of the regulatory authorities and the provisions in the laws of the country where the shareholder is located for the preceding three years; (vi) the shareholder must have sound internal control systems; (vii) the shareholder must have a good reputation and business record in the international securities market. Foreign shareholders who buy into, or acquire equity in, wholly Chinese-owned securities companies also must meet the above requirements. .

Domestic shareholders of securities companies with foreign equity participation must meet the qualification conditions for securities company shareholders stipulated by the CSRC. At least one of the domestic shareholders of a securities company with foreign equity participation must be a wholly Chinese-owned securities company. The ratio of the foreign shareholders’ shareholding or the ratio of equity the foreign shareholders hold in a securities company with foreign equity participation may not exceed one third altogether (including direct holdings and indirect holdings). At least one wholly Chinese-owned securities company among the domestic shareholders must have a shareholding ratio or must hold an equity ratio in the securities company with foreign equity participation of not less than one third. When a wholly Chinese-owned securities company is converted into a securities company with foreign equity participation, the shareholding ratio of at least one of the wholly Chinese-owned shareholders must be not less than one third.

When applying to establish a securities company with foreign equity participation, the representative designated, or the agent appointed, by all of the shareholders jointly must submit the following documents to the CSRC: (I) an application form signed jointly by the legal representatives or authorized representatives of the domestic and foreign shareholders; (ii) drafts of the contract and articles of association concerning establishment of the securities company with foreign equity participation; (iii) application forms for qualifications to hold positions for the persons chosen to be the chairman of the board of directors, the general manager and the deputy general manger of the securities company with foreign equity participation; (iv) photocopies of the shareholders' business licenses or registration certificates and securities business qualification certificates; (v) audited financial statements of the domestic and foreign shareholders for the year preceding application; (vi) explanation letters issued by the securities regulatory authorities of the countries where the foreign shareholders are located on whether or not the foreign shareholders fulfill the conditions stipulated in subparagraphs (2) and (3) of Article 7 of the Rules (Subparagraph (2) provides that the foreign shareholder must have lawful securities business qualifications in the country where it is located; must have been engaged in financial business for at least ten years; and must not have been subject to major penalties from the securities regulatory authorities or the judicial authorities in the preceding three years. Subparagraph (3) provides that each risk control and monitor indicator must have met the requirements of the regulatory authorities and the provisions in the laws of the country where the foreign shareholder is located for the preceding three years.); (vii) and a written legal opinion issued by a law firm in China that is qualified to provide securities-related services. The CSRC will examine the above application documents in accordance with the relevant laws, administrative regulations and the Rules. It will make a decision on whether or not to approve the application within 45 working days of receiving application documents that meet the requirements and shall give written notice to the applicants. If approval is withheld, the reasons shall be explained in writing.

After approval, the shareholders must (i) pay in all of their capital contributions or provide the stipulated “cooperation conditions,” (ii) elect the directors and (iii) hire the senior management within six months of the date on which the CSRC approval document is issued. They must also apply to the industry and commerce authorities for establishment registration and obtain a business license.

Within 15 working days of the date on which the business license is issued, the chairman of the board of directors or the authorized representative of the securities company with foreign equity participation must submit the following documents to the CSRC and apply for the Permit to Engage in Securities Business: (I) a photocopy of the duplicate copy of the business license; (ii) the company articles of association; (iii) a capital verification report issued by an accounting firm in China that is qualified to provide securities-related services; (iv) a list and resumes of the directors, supervisors and senior management, a list of the primary business personnel and photocopies of their certificates of qualification to engage in securities business; (v) the text of the internal control system; and (vi) explanations concerning the status of their trading facilities and their place of business. The CSRC will examine the above application documents in accordance with the relevant laws, administrative regulations and the Rules. It will make a decision within 15 working days of receiving application documents that meet the requirements. If the specified conditions are fulfilled, a Permit to Engage in Securities Business will be issued. If the conditions are not fulfilled, the Permit to Engage in Securities Business will not be issued and the reasons shall be explained in writing. Securities companies with foreign equity participation cannot commence business or engage in securities business if they have not obtained a Permit to Engage in Securities Business issued by the CSRC.

When a wholly Chinese-owned securities company applies to convert into a securities company with foreign equity participation, it must submit the following documents to the CSRC: (I) an application form signed by the legal representative; (ii) a resolution of the shareholders meeting on conversion into a securities company with foreign equity participation; (iii) draft amendments to the company articles of association; (iv) share rights assignment agreement or capital contribution agreement (share subscription agreement); (v) a list of the persons appointed by the foreign investors that are intended to assume positions in the securities company and their resumes; (vi) photocopies of the foreign shareholders' business licenses or registration certificates and securities business qualification certificates; (vii) audited financial statements of the foreign shareholders for one year preceding application; (viii) explanation letters issued by the securities regulatory authorities of the countries where the foreign shareholders are located on whether or not the foreign shareholders fulfill the conditions stipulated in subparagraphs (2) and (3) of Article 7 of the Rules (As mentioned above, subparagraph (2) provides that the foreign shareholder must have lawful securities business qualifications in the country where it is located; must have been engaged in financial business for at least ten years; and must not have been subject to major penalties from the securities regulatory authorities or the judicial authorities in the preceding three years. Subparagraph (3) provides that each risk control and monitor indicator must have met the requirements of the regulatory authorities and the provisions in the laws of the country where the foreign shareholder is located for the preceding three years.); (ix) a liquidation proposal for the business that cannot be lawfully operated by a securities company with foreign equity participation; and (x) a written legal opinion issued by a law firm in China that is qualified to provide securities-related services. The CSRC will examine the above application documents in accordance with the relevant laws, administrative regulations and the Rules. It will make a decision on whether or not to approve the application within 30 working days of receiving application documents that meet the requirements and shall give written notice to the applying securities company.

Within six months of the date on which the CSRC approval document was issued, a securities company that has obtained approval for conversion must complete the share rights transfer or capital increase matters and must liquidate business that cannot be lawfully operated by a securities company with foreign equity participation. It must also apply to the industry and commerce authorities for change of registration and must exchange business licenses. Within 15 working days of changing the registration, a securities company that has obtained approval for conversion must submit the following documents to the CSRC and apply to exchange the Permit to Engage in Securities Business: (I) a photocopy of the duplicate copy of the business license; (ii) the articles of association of the securities company with foreign equity participation; (iii) the company’s original Permit to Engage in Securities Business and its duplicate copy; (iv) a capital verification report issued by an accounting firm in China that is qualified to provide securities-related services; (v) a liquidation work report for the business that cannot be lawfully operated by a securities company with foreign equity participation; and (vi) a written legal opinion and a verification report concerning the liquidation work mentioned in the previous bullet point issued by a law firm and an accounting firm that are qualified to provide securities-related services.

If securities companies with foreign equity participation merge or a foreign securities company with foreign equity participation merges with a wholly Chinese-owned securities company, the newly-established, or continuing, securities company must fulfill the establishment conditions for securities companies with foreign equity participation stipulated in the Rules. The company's business scope and the share rights or equity ratio held by the foreign shareholder must comply with the provisions of the Rules.

If there is a foreign shareholder among the shareholders of a securities company established after a securities company with foreign participation has been split, then the company's business scope and the share rights or equity ratio held by the foreign shareholder must comply with the provisions of the Rules.

Asset Management Industry

Market Overview

In Beijing, Shanghai and Shenzhen, more than 3,600 companies are engaged in the private funds business. Estimates are that these companies control US$84.6 billion of capital. Most of the funds are invested in the stock markets where the value of all circulating shares is approximately US$193.3 billion. In this section, we will identify the primary sources of the burgeoning demand for fund management services in China, we will outline fundamental regulations governing international fund managers in China, we will describe the operations of some of the international players in the fund management business in China today and we will list the most intractable obstacles to fund management profits in China today and in the near future. Under WTO, foreign investment banks and asset managers will be allowed to be 33% investors in domestic stock brokerage firms and fund-management companies. The threshold is scheduled to increase to 49% by December 2004.

Primary Sources of Demand for non-PRC Financial Services Firms

Open End Funds

Until recently, thirty-nine investment funds operated in China. All of them were “close-ended” funds: they issued a fixed number of shares and then traded on the market as a stock. These funds invested primarily in bank deposits and in local companies. Open ended funds, by contrast, fluctuate in price daily based on capital inflows and outflow and the underlying value of the shares herd in the fun. The new financial instruments carry a floating asset scale and investors can redeem their funds at any time. The fund therefore requires more transparency in operation and better management. Chinese companies are seeking experienced partners. Many commentators room for many foreign companies to fir into this market not just a select few.

China's first “open end” investment fund, the Hua'an Innovation Investment Fund, with five billion units, each unit with a face value of US 0.12 US cents. The funds custodian was the Bank of Communications which sold units in the Hua’an fund to retail and institutional investors through its 139 branches accross 13 cities. Since the Hua'an fund launched, additional similar funds have been launched since then.

Liberalization of the Insurance Industry

The China Insurance Regulatory Commission (CIRC) is increasingly allowing China's insurance funds to invest in securities investment funds. For example, Ping An Insurance Company of China, New China Life Insurance Company and the Manulife-Sinopec Life Insurance Co have been allowed to invest all their revenues from “premium unit-linked products” in securities funds. Unit-linked products are a category of life insurance product that emerged in 1999 product where premium income is invested and returned go to policy holders. Untilrecently, no more than thirty percent of these funds could be invested in the securities market, The bulk was invested in bank deposits, treasury bonds, corporate bonds and inter-bank loans.

Pension Funds into the Market

Government officials in China have repeatedly announced the government’s desire to upgrade the management of China’s behemoth pensions funds which manage the pensions of 150 million pensioners nationally. The funds run deficits year-after-year. The reforms, if carried out, may bring up to US$19 billion into the financial markets. Under WTO, foreign institutions would be allowed to take part in the business, to the extent that it is liberalized. The Chinese government is expected to release regulations concerning the private investment of pension funds and the participation of international firms within a few months. Reports are that the upper limit for stock investment would be around 15 per cent of any funds.

The Regulatory Framework

The “Rules for the Establishment of Fund Management Companies with Foreign Equity Participation” came into force on July 1, 2002. The rules control joint-venture investment funds. In order to operate in China, a foreign shareholder of a fund management company with foreign equity participation must meet the following conditions: (1) it must be a financial institution that is established and in good standing under the laws its home country; (2) it must not have been subject to major penalties from any regulatory authorities within three years prior to applying for a license to operate in China; (3) the securities laws and regulatory systems of its home country must be sound; (4) the home country's securities regulatory authorities and the CSRC must have concluded a memorandum of understanding regarding securities regulatory cooperation and must maintain an effective relationship of regulatory cooperation; and (5) the actual paid-in capital of the fund must not be less than the equivalent of RMB 300 million (US$ 36 million) in a freely convertible currency.

The ratio of the foreign investment shareholdings or the ratio of equity held in a fund management company with foreign equity participation cannot exceed 33% altogether (including direct holdings and indirect holdings). Within the three years following China' s entry into the WTO, the cap will be raised to 49%. The capital contributions of foreign shareholders must be made using freely convertible currencies. The chairman of the board of directors, the general manager and the deputy general manager must meet the qualification requirements stipulated by the CSRC for holding senior management positions in fund management companies.

Joint venture fund management companies must submit application materials to the CSRC. After preparation for the fund management company is completed, the domestic and foreign applicants must submit commencement of business application materials to the CSRC.

Within 30 working days after accepting the application for commencement of business, the CSRC shall decide whether to approve, defer approval of, or refuse approval for commencement of business. If commencement of business is approved, an approval document shall be issued. If the CSRC intends to defer approval or to refuse approval, it must give written notice to the applicants and explain the reasons.

Within 30 working days after obtaining the approval document from the CSRC, the shareholders of a fund management company with foreign equity participation must carry out company registration or change the company registration with the industry and commerce authorities. Where the Rules are silent regarding establishment, changes, termination, business activities, supervision or administration for fund management companies with foreign equity participation, other relevant regulations of the CSRC shall apply.

The Present Actors

With all these powerful demand forces for foreign-fund managers, it is not surprising that many have quickly moved into joint ventures even though regulations governing non-PRC firms in China have not been promulgated and are not expected. JP Morgan Fleming Asset Management has surpassed its peers, having worked closely with Shanghai-based Huaan Fund Management Co in the last two years. Two major Chinese banks, the Bank of Communications and the China Construction Bank have established strategic partnerships focusing on open-ended funds with Chase Manhattan Bank of the United States. The Bank of Montreal recently signed a contract for co-operation in mutual fund management with the Shanghai-based Fullgoal Fund Management Co. The Canadian bank has thus become the eighth foreign financial institution to have found a local partner in preparing to tap China's much-coveted mutual fund management industry. US-based Prudential Insurance announced yesterday it intends to establish a joint venture fund management company in China. Prumerica Financial, the brand name under which the Prudential Insurance Company will conduct its business in China, signed a letter of intent to establish a fund management firm with Shanghai-based Everbright Securities, one of the top 10 securities companies in the country. UBA Asset Management has singed an agreement with China's Guotai Fund Management Co. on business cooperation including the establishment of open-end mutual funds. UBS will provide technical assistance including product development while Guotai will help UBS develop its branch name and business in China. China Southern Fund Management Company Limited and HSBC Asset Management (Hong Kong) Limited on Wednesday signed agreements over full-range cooperation in fund management in Shenzhen of Guangdong Province. China Southern Fund Management Company Limited and HSBC Asset Management (Hong Kong) Limited signed agreements over full-range cooperation in fund management in Shenzhen of Guangdong Province. The cooperation will be carried out in fields such as product designing, marketing promotion, client service, business operational procedures and

investment management.

The joint venture agreements typically provide for the foreign bank to provide the Chinese bank with services and consulting on items such as open-ended fund schemes, technological support and personnel training. The Chinese banks, in turn, provide consulting and services for the foreign partner when and strategic assistance and market placement as the joint venture expands its fund business in China. Experts said the agreements will help bring the operation of China's open-ended fund business in line with international practice.

While the major players are jockeying for market position, there are many concerns over China's draft regulations governing the joint venture fund tie up in China. Foreign parties are concerned that they cannot obtain control over their investments.

Banking

Background

Over 160 foreign banks presently maintain branches or representative offices in China. Financial assets are concentrated in the banking system. China has four large banks: (i) The Industrial and Commercial Bank of China; (ii) the People's Bank of China (PBOC); (iii) the People's Construction Bank of China, and (iv) The Agricultural Bank of China. China also has three "policy" banks. (i) China Development Bank; (ii) The Agricultural Development Bank; and (iii) The Export-Import Bank of China. In addition, over 90 city commercial banks representing approximately 4-5% of the domestic banking business; urban credit cooperative with approximately 5%; and rural credit cooperative and other small institutions with approximately 9%.

With China's imminent accession to the World Trade Organization, Chinese banks are modernizing as fast as they can. The threat of increased foreign competition has forced the government, and some domestic banks, to pick up the pace of internal reform. First, the People's Bank of China, the country's central bank, has been restructured to prevent state-owned enterprises (SOEs) from getting easy money. Previously, the PBOC was organized along the same lines as other central-government agencies, which meant that nearly every level of government across China had its own central-bank branch. This has created a unique dual-control problem in China. Not only must the PBOC branches follow the policies dictated by their headquarters, they must also listen to the local government. This structural scheme makes the banks subordinated to the local government, and forces them to finance budget deficits and fund ailing SOEs. Today, however, the central bank is shaped into nine regional branches. Because the rearrangement cuts across local party lines, the People's Bank will be able to better monitor the branches of the four state banks, which also faced pressure to supply credit to inefficient local state enterprises.

Reform of the SOEs themselves is seen to have a huge bearing on China's economic future As much as 80% of the country's bank loans are to SOE. Meanwhile, the truly private sector is getting less than 5% of bank lending. Besides crowding out China's private sector from the capital market, this puts the entire financial system at risk, since a large share of these loans will never be repaid. China's banks are saddled with billions of yuan worth of bad loans to failing SOEs. The central government is trying to balance their books by transferring bad debts to asset management corporations while making its bank function along commercial lines.

Another reform move by the Chinese government involves the creation of asset-management companies to take banks' bad debts and swap them into equity. Beijing has transferred more than $200 billion in bad debt out of the banking system and onto the balance sheets of government asset management companies. Outside China, when asset-management companies (AMCs) are created to take bad loans off overburdened banks, they take them at less than face value. The 10-year bonds banks receive in exchange for accepting the swap may also prove to be worth little in the end. Regardless of the actual effect of the debt overhaul, the move at least underscores how bank reform is a priority as China prepares for entry to the WTO later this year.

Some more enterprising local banks, like the China Construction Bank and Industrial & Commercial Bank of China, are moving into fee-based businesses like insurance and fund management, seeking to sell financial products through their large branch networks. Meanwhile, state banks started to lend more to the private sector and high-tech industries, areas they have traditionally ignored. In addition, mainland banks are forming alliances with one another to sharpen competitiveness against foreign banks. Analysts said consolidation was particularly important for the dozens of medium-sized shareholding banks if they wanted to stay competitive in coming years.

The central government is taking time to lift various restrictions on foreign banks that sharply curtail their ability to conduct business. While most foreign banks' competitiveness lies in their diversification, they, like the rest of domestic banks, have been restricted to core banking businesses in China such as lending, deposit taking and transaction banking. To date, only dozens of licenses were granted to foreign banks to have local currency business, all of which are in Shanghai and Shenzhen. An even smaller group is allowed to borrow from and lend to local banks. To make things tougher, central bank officials have talked about raising foreign banks' tax rates to equalize their rates with those of local banks, claiming most foreign banks now pay half the 33% tax that local banks are charged on profits.

At present, local-currency business with Chinese clients is prohibited of foreign invested banks. Foreign-currency business limited to select cities. American financial institutions require approval, granted on a discretionary, case-by-case basis for new representative offices and branches.

American financial institutions will gain full market access within five years of accession. China will allow internal branching and provide the same rights (national treatment) for all newly permitted activities. Geographic and customer restrictions will be removed five years after accession. Foreign currency business is currently allowed without geographic restrictions. China will expand the scope and geographic opportunities for foreign banks to conduct local currency business. Local currency business with foreign clients will be permitted upon accession, with Chinese enterprises two years after accession, and with Chinese individuals five years after accession. Local currency banking will be permitted in four cities upon accession, four additional cities will be permitted each year thereafter, and nationwide access five years after accession. Financial leasing will be allowed for foreign-owned banks when allowed for domestic banks. Non-bank financial institutions will be permitted to provide auto-financing without any market access or national treatment limitations. Other financial services: for both cross border and via commercial presence, provision of financial information, data processing and advisory services (such as portfolio research and corporate restructuring) upon accession.

Joint Venture Banking

On February 1, 2002, the "Regulations on Administration of Foreign-Invested Financial Institutions" were adopted by the State Council. The regulations govern the following financial institutions established and doing business in China: (1) banks with foreign capital that have their head offices in China; (2) finance companies with foreign capital that have their head offices in China; and finance companies operated in China as equity joint ventures by foreign financial institutions and Chinese companies or enterprises. The People's Bank of China is the responsible authority for the oversight of foreign-invested financial institutions.

The minimum registered capital for wholly foreign-owned banks and joint venture banks is the equivalent of RMB 300 million in a freely convertible currency. The minimum registered capital for wholly foreign-owned finance companies and joint venture finance companies is the equivalent of RMB 200 million. The registered capital must be paid-in capital. The head office of a foreign bank branch must allocate operating funds of an amount not less than the equivalent of RMB 100 million in a freely convertible currency. The allocation must be made without requiring any compensation from the branch.

Applicants seeking establish a wholly foreign-owned bank or a wholly foreign-owned finance company, a foreign bank branch or foreign joint venture partner must meet the following requirements: (1) the applicant must have established a representative office in China for at least two years; (2) the total assets of the applicant at the end of the year preceding the application must not be less than US$ 10 billion (US $20 billion for foreign bank branches); (3) The applicant's home country must have a sound financial regulatory system and the applicant must be subject to effective regulation by the competent authorities of its home country; (4) the relevant competent authorities of the applicant's home country must consent its application; and (5) the applicant must meet other prudential requirements stipulated by the People's Bank of China.

When applying to establish a wholly foreign-owned bank, a wholly-owned finance company, establish a foreign bank branch, a joint venture bank or a joint venture finance company. the applicant must submit a written application to the People's Bank of China and must submit the following materials: (1) an application form detailing contemplated activities as well as information details of the applicant; (2) a feasibility study; (3) articles of association of the wholly foreign-owned bank or wholly foreign-owned finance company it is intended to establish; (4) a letter of opinion concerning the applicant's application and the business license issued by the competent authorities of the country or region where the applicant is from; the applicant's annual reports for the past three years; and (5) other materials that the People's Bank of China requires.

The People's Bank of China will conduct a preliminary examination of the application to establish a foreign-invested financial institution. It will make a decision on whether or not to accept the application within six months of receiving the complete application documents. If it decides to accept the application, it will issue a formal application form to the applicant. If it decides not to accept the application, it must notify the applicant in writing and explain the reasons. If there are special circumstances in which the People's Bank of China is unable to complete the preliminary examination and make its decision on whether or not to accept the application within the stipulated time limit, the time limit may be appropriately extended. The applicant must be notified. However, the time limit may not be extended by more than three months.

After the preparation work is completed, the applicant must submit the completed application form together with the following documents to the People's Bank of China together for examination and approval: (1) the names and resumes of the main responsible persons of the proposed foreign-invested financial institution; the letters of authorization for the persons whom it is intended to appoint as the main reasonsible persons of the foreign-invested financial institution; (2) a capital verification certificate issued by a statutory capital verification body; information and materials concerning preventive safety measures and other facilities related to the business; (3) for foreign bank branches, a letter of guarantee from the branch's head office undertaking liability for the taxes and debts of the branch; and other documents required by the People's Bank of China.

The People's Bank of China must make its decision on whether or not to approve the application within two months of receiving the complete formal application documents. If it decides to approve the application, it will issue a permit for the provision of financial services. If it decides not to approve the application, it must give written notice to the applicant and explain the reasons.

If approval is given for establishment of a foreign-invested financial institution, the applicant must complete registration with the industry and commerce authorities on the strength of the permit for the provision of financial services and obtain a business license. Wholly foreign-owned banks, foreign bank branches and joint venture banks may carry on the following types of business, in a lawful manner, in whole or in part in accordance with the scope of business approved by the People's Bank of China: accepting deposits from the public; making short-term, medium-term and long-term loans; accepting and discounting bills; buying and selling government bonds, financial institution debentures and securities denominated in foreign currencies other than shares; providing letter of credit services and security; carrying out domestic and international settlement; buying and selling foreign currency on one's own account or as agent; engaging in the exchange of foreign currency; engaging in interbank lending; engaging in bank card business; providing safety deposit box services; providing credit investigation and consulting services; and carrying on other business approved by the People's Bank of China.

Wholly foreign-owned finance companies and joint venture finance companies may carry on the following types of business, in a lawful manner, in whole or in part in accordance with the scope of business approved by the People's Bank of China: accepting deposits of not less than RMB 1 million per deposit or the equivalent thereof in a freely convertible currency for terms of at least three months; making short-term, medium-term and long-term loans; accepting and discounting bills; buying and selling government bonds, financial institution debentures and securities denominated in foreign currencies other than shares; providing security; buying and selling foreign currency on one's own account or as agent; engaging in interbank lending; providing credit investigation and consulting services; providing foreign currency trust services; and carrying on other business approved by the People's Bank of China.

The Regulations do not provide any detail concerning the conduct of Renminbi business by foreign-invested financial institutions. They simply provide that the People's Bank of China will fix the geographical areas and the scope of permitted clients for Renminbi services provided by foreign-invested financial institutions in accordance with the relevant regulations. China's GATS Service Schedule, however, contains more detail. It contains the following provisions concerning geographic restrictions on Renminbi business: For local currency business, the geographic restriction will be phased out as follows: Upon accession [December 11, 2001], Shanghai, Shenzhen, Tianjin and Dalian; Within one year after accession, Guangzhou, Zhuhai, Qingdao, Nanjing and Wuhan; within two years after accession, Jinan, Fuzhou, Chengdu and Chongqing; within three years after accession, Kunming, Beijing and Xiamen; Within four years after accession, Shantou, Ningbo, Shenyang and Xi'an. Within five years after accession, all geographic restrictions will be removed. It contains the following provisions concerning permitted clients for Renminbi business: For local currency business, within two years after accession, foreign financial institutions will be permitted to provide services to Chinese enterprises. Within five years after accession, foreign financial institutions will be permitted to provide services to all Chinese clients. Foreign financial institutions licensed for local currency business in one region of China may service clients in any other region that has been opened for such business.

The Regulations provide that a foreign-invested financial institution must meet the following requirements in order to carry on Renminbi business: It must have carried on business in China at least three years before the application. It must have made a profit in the two successive years preceding the application. It must meet other prudential requirements stipulated by the People's Bank of China. If a foreign-invested financial institution starts a new type of business within the scope of business approved by the People's Bank of China, it must submit a written application to the People's Bank of China before beginning the business. The People's Bank of China will make a decision on whether or not to approve the application within 60 days of receiving the written application documents. If the People's Bank of China decides not to approve the application, it must give written notice to the applicant and must explain the reasons.

A foreign-invested financial institution's interest rates for deposits and loans and the various service charge fee rates must be fixed by the foreign-invested financial institution in accordance with the relevant regulations of the People's Bank of China. If a foreign-invested financial institution provides deposit services, it must pay in deposit reserves to the branch of the People's Bank of China in the area where it is located. The ratio shall be set by the People's Bank of China and adjustments shall be made as needed.

Thirty percent of the operating funds of a foreign bank branch must be in the form of interest-bearing assets, including such assets as deposits in banks designated by the People's Bank of China. The capital adequacy ratio of wholly foreign-owned banks, joint venture banks, wholly foreign-owned finance companies and joint venture finance companies must be at least 8%. Unless otherwise approved by the People's Bank of China, the balance of credit extended to a single enterprise and its affiliates by wholly foreign-owned banks, joint venture banks, wholly foreign-owned finance companies and joint venture finance companies may not exceed 25% of its capital. The fixed assets of a wholly foreign-owned bank, joint venture bank, wholly foreign-owned finance company or joint venture finance company may not exceed 40% of its ownership interests. The Renminbi share of the capital of wholly foreign-owned banks, joint venture banks, wholly foreign-owned finance companies and joint venture companies must be at least 8%. Similarly, the Renminbi share of the risk assets of such institutions must be at least 8%. The Renminbi share of the sum of the operating funds and the reserves, etc., of a foreign bank branch must be at least 8%. The Renminbi share of the risk assets of a foreign bank branch must be at least 8%. The Renminbi proportions stipulated in this paragraph are to be gradually adjusted by the People's Bank of China in accordance with the relevant regulations.

Foreign-invested financial institutions must ensure the liquidity of their assets. The ratio between the balance of liquid assets and the balance of liquid liabilities must be at least 25%. The foreign currency deposits that a foreign-invested financial institution accepts from within China may not exceed 70% of its total foreign currency assets in China. This ratio is to be gradually adjusted by the People's Bank of China in accordance with the relevant regulations. Foreign-invested financial institutions must make allocations to dead account (bad debt) reserves in accordance with the regulations. Foreign-invested financial institutions must hire Chinese chartered accountants. Confirmation must be given from the local branch of the People's Bank of China. If one of the following situations applies to a foreign-invested financial institution, it must obtain approval from the People's Bank of China and must complete the relevant registration procedures with the industry and commerce authorities: A liaison office is established. The registered capital is adjusted or transferred or operating funds are increased or reduced. The name of the institution or the place of business is changed. The scope of business is adjusted. There is a change of shareholders that hold 10% or more of total capital or total shares. The articles of association are amended. There is a change in senior management personnel.

The People's Bank of China and its branches are authorized (i) to make periodic or unscheduled inspections, (ii) to check the circumstances of the deposits, loans, settlement and bad accounts of foreign-invested financial institutions, (iii) to require foreign-invested financial institutions to submit relevant documents, materials and written reports by stipulated time limits and (iv) to impose penalties for, and deal with, violations of laws and regulations by foreign-invested financial institutions. The People's Bank of China and its branches are also authorized to require foreign-invested financial institutions to formulate rules of operation in accordance with regulations and establish and perfect business administration, cash administration and preventive safety measures. Foreign-invested financial institutions must accept supervision and inspections from the People's Bank of China and its branches. They must truthfully submit relevant documents, materials and written reports. They may not refuse to cooperate, obstruct the said authorities or conceal matters.

If a foreign-invested financial institution ends its business activities itself, it must make an application to the People's Bank of China in writing 30 days before termination of business activities. After examination and approval by the People's Bank of China, the foreign-invested financial institution may be dissolved and liquidation may be carried out. If a foreign-invested financial institution is unable to pay its debts as they fall due, the People's Bank of China may order it to stop business and set a time limit for it to put its affairs in order. If it becomes solvent again during the period for putting its affairs in order and needs to resume business, it must apply to the People's Bank of China to resume business. If it has not become solvent again by the end of the period for putting its affairs in order, it must go into liquidation. When a foreign-invested financial institution is dissolved or terminated because it is dissolved or de-registered in accordance with the law, the relevant provisions in China's laws and regulations should be referred to for the handling of the specific liquidation matters. When the liquidation is finished, cancellation of registration should be carried out with the original registration authorities by the statutory time limit.

The Regulations contain a lengthy chapter specifying different penalties for different violations. Penalties include suppression of unauthorized foreign-invested financial institutions, pursuit of criminal liability for certain crimes, issuance of warnings, orders for rectification by specified time limits, orders to stop business for rectification, confiscation of illegal proceeds, fines of up to five times the amount of the illegal proceeds, fines of up to RMB 500,000, revocation of the permit to provide financial services and cancellation of the qualifications of senior management for their positions.

Insurance

Market Background

With a large population, fast and rapid growing economy and constant improvement of its people’s living standard, the insurance industry in China thus enjoys tremendous market potentials. Entering the 90’s, the Chinese insurance market initiated a limited opening up to the outside world with Shanghai and Guangzhou as the experimental beds in 1992. By the end of 1999, there are totally 26 insurance institutions for the whole insurance industry of China. Among them, 13 Chinese-solely-funded insurance companies 9 foreign-funded insurance companies and 4 joint ventures. The year of 1998 saw the insurance revenue of the Chinese insurance industry at 127.35 billion RMB Yuan, the 16th in the world, with insurance coverage intensity of 1.57 percent and the 77th in the world; and insurance coverage depth of 100 RMB Yuan, the 66th in the world. Thanks to the deepening reform and effort of the policy implementation of expanding the social security industry, the insurance industry of China will enjoy a faster and speedy growth. According to an estimate made by the China Insurance Supervisory Commission, the growing rate of the market size of China’s insurance industry will arrive at an annual average of 12 per cent in the coming 5 years, and the insurance revenue will reach 280 billion RMB Yuan by the end of 2005, with insurance coverage intensity of 2.3 per cent, and insurance coverage depth of 230 RMB Yuan.

On the date of the China’s accession to WTO, the PRC government granted 7 foreign insurance companies to form JVs or set up branches in China and issued them licenses to conduct various insurance businesses in this big mass market. 7 insurance licenses being issued within one day, this has never happened in China in the past and indicated the Government’s determination to realize her promises in the WTO agreement. For this moment, a number of international insurance companies have been preparing for many years. The number of foreign insurance companies operating in the China market has exceeded the domestic companies since last year. China has the potential to become the biggest market not only for life but also non-life insurance products and services. However, the situation in the China market is very complicated. The still-heavy government regulations and restraints, the big gaps between eastern and western China, different customer and organizational behavior and etc., are some examples. Foreign and domestic insurance companies need to design and develop products and services to fulfill the special needs and suit the specific environment in China. It is already not so early to make your company’s product innovations and penetration strategies for this big mass market.

China's insurance sector has registered 10 to 15 percent revenue growth for several consecutive years. Total income from premiums is likely to top US$20 billion in 2001. By 2005, the total value of insurance premiums is expected to reach $33.82 billion, constituting 2.3 percent of the total gross domestic product value. The average premium per person will be $27.78. But despite its rapid growth, the insurance industry is still only a small part of the entire economy, less than 2 percent, compared with 11 percent in Japan and 8 percent in the United States. China's insurance industry brought in $19.27 billion in premiums in 2000, an increase of 14.5 percent over 1999, according to Ma Yongwei, chairman of the China Insurance Regulatory Commission (CIRC), the country's insurance watchdog. The total assets of China's insurance companies reached $40.75 billion, an increase of 19.3 percent over 1999. Of this, $7.23 billion, or 37.5 percent, of the total premium income came from property insurance. This marks a 14.8 percent increase over 1999. A total of $3.69 billion was paid out to insured property, or 51.1 percent of property insurance premiums. Life insurance income increased 14.4 percent to $12.05 billion, accounting for 62.5 percent of the total premium income, and $2.68 billion was paid out against life insurance.

As of 2000, 17 foreign insurance companies had been granted permission to operate some form of insurance business in China, while 89 firms had set up representative offices waiting for permission to establish their own insurance operations in China. Once China is admitted to the World Trade Organization (WTO), however, this figure is expected to jump dramatically. On accession, the Chinese government has indicated it will initially approve licenses for seven European companies, two Japanese companies, one South Korean company and three United States companies. China's insurance market is characterized by its small size, a limited variety of insurance products, relatively high costs, lack of Chinese consumer education about the role of insurance, and a lack of a sound legal environment, particularly in the area of enforcement. Another limitation to the growth of the insurance industry is that China's undeveloped financial markets limit investment vehicles for insurance premiums. A second factor is China's memories of its pre-1949 experience of foreign domination and control of China's insurance industry. Analysts say foreign companies will need to do thorough due diligence before entering the market, then build up long-term relations with Chinese local governments and potential consumers. They also will need to develop business plans that prepare their companies to be long-term players.

The China Insurance Regulatory Commission estimates that in the next five years the annual growth rate of the Chinese insurance industry will be sustained at about 12 percent. The Beijing-based China Mainland Marketing Research Co in January surveyed residents of Beijing, Shanghai and 20 other cities about insurance. Almost 21 percent of those surveyed said they intended to buy insurance in 2001, and 51 percent will hold some kind of insurance policy by the end of this year. The categories of insurance policies most commonly held by the urbanites surveyed were pension insurance, medical insurance and life insurance, held by 17.4 percent, 15 percent, and 14 percent, respectively. The percentage of those with insured property was comparatively low. Only 3 percent of those surveyed held policies on personal property, and only 1.7 percent held auto insurance policies. The survey also shows a dramatic increase in the number of families in the low and average income brackets who hold insurance policies. Thirty-eight percent of families with monthly incomes lower than $120.77 and 40 percent of families with monthly incomes from $120.89 to $241.55 bought insurance in 2000. Forty-three percent of families with monthly incomes between $241.67 $362.32 bought insurance, and the figure for families with monthly incomes greater than $362.32 was 44 percent.

The People's Congress is deliberating new rules that continue the prohibition of property insurer to engage in life insurance business but with the permission of the relevant regulatroy agencies, property insureres may engage in short term medical insurance and casualty (accidental death) insurance. Insurers' funds cannot be used for equity market operations.

The Regulatory Framework

The “Regulations of the People's Republic of China on Administration of Foreign-Invested Insurance Companies ” came into force on February 1, 2002. These regulations replace the older regulations and operate in combination with the [omnibus regulation]. Where these regulations are silent regarding administration of foreign-invested insurance companies, the Law of the People's Republic of China on Insurance, as well as other relevant laws and administrative regulations and other relevant state regulations shall apply. These regulations apply to insurance companies operated in China by foreign insurance companies together with Chinese companies or enterprises on a joint equity basis; foreign-capital insurance companies in China invested in, and operated by, foreign insurance companies (“wholly foreign-owned insurance companies”); and branches in China of foreign insurance companies (“branches of foreign insurance companies”).

The China Insurance Regulatory Commission (the “CIRC”) is charged with the oversight of foreign-invested insurance companies. As required by the GATS Service Schedule on accession to WTO, foreign life and non-life insurers, and insurance brokers were be permitted to provide services in Shanghai, Guangzhou, Dalian, Shenzhen and Foshan. Within two years of accession, foreign life and non-life insurers and insurance brokers will be permitted to provide services in the following cities: Beijing, Chengdu, Chongqing, Fuzhou, Suzhou, Xiamen, Ningbo, Shenyang, Wuhan and Tianjin.

Within three years after China's accession, there will be no geographic restrictions. Foreign non-life insurers will be permitted to establish as a branch or as a joint venture with 51 per cent foreign ownership. Within two years after China's accession, foreign non-life insurers will be permitted to establish as a wholly owned-subsidiary; i.e., with no form of establishment restrictions. Upon accession, foreign life insurers will be permitted 50 per cent foreign ownership in a joint venture. According to the GATS Service Schedule internal branching for an insurance firm will be permitted as geographic restrictions phase out. The minimum registered capital for an insurance equity joint venture and a wholly foreign-owned insurance company is RMB 200 million or the equivalent in a freely convertible currency. The minimum registered capital must be actually paid in. The capital contribution of the foreign insurance company must be made using a freely convertible currency. Branches of foreign insurance companies must have operating funds of an amount equivalent to RMB 200 million in a freely convertible currency allocated by the head office without requiring compensation from the branch. The CIRC may increase the above minimum amounts based on the foreign-invested insurance company's business scope and scale of operations.

A foreign insurance company, wholly foreign-owned insurance companies, or branch of foreign insurance companies that applies to establish a foreign-invested insurance company must meet the following conditions: (I) at least thirty years of experience in carrying on insurance business; (ii) have a representative office in China that has been established for at least two years; (iii) at a minimum assets for the year preceding the application of US$ 5 billion ; (iii) the applicant must already be subject to effective regulation by the competent authorities of the applicants home country; (iv) must meet the solvency standards of the applicants home country; (v) the applicants home country authorities must agree to the application; and (vi) the applicant meets other regulations that may be introduced by the CIRC.

In order to establish a foreign-invested insurance company, the applicant must submit a written application to the CIRC as well as the following information and materials: (I) an application signed by the applicant's legal representative (if the application is for establishment of an insurance equity joint venture, the application should be jointly signed by the joint venture parties); (ii) a business license, a certificate showing that the applicant meets solvency standards and an opinion on the applicant's application issued by the competent authorities of the country or region where the foreign applicant is located; (iii) the company articles of association and the annual reports of the foreign applicant for the last three years; (iv) if the application is for establishment of an insurance equity joint venture the relevant information and materials of the Chinese applicant; (v) a feasibility study and preparation program for the proposed company; (vi) a list of the persons responsible for preparation of the proposed company, their resumes and certificates showing their qualifications to hold office; and (vii) other information and materials that the CIRC requires to be provided.

The CIRC will conduct a preliminary examination of the application to establish a foreign-invested insurance company. It must will a decision on whether or not it will accept the application within six months of receiving the complete application documents. If it decides to accept the application, it will issue a formal application form. If it decides not to accept the application, it must give written notice to the applicant and explain the reasons. The CIRC must make its decision on whether or not to approve the final application within 60 days of receiving the complete documents for the formal application. If it decides to approve the application, it will issue a permit for the provision of insurance services. If it decides not to approve the application, it must give written notice to the applicant and explain the reasons.