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China's Stepped-Up War On Hot Money Shifts To M&A
After years of cross-border mergers being delayed by authorities wary of foreign firms snapping up Chinese assets too cheaply, Beijing's preoccupation with hot money may be swinging the pendulum the other way.


21 Jul 2008

SHANGHAI (Dow Jones)--After years of cross-border mergers being delayed by authorities wary of foreign firms snapping up Chinese assets too cheaply, Beijing's preoccupation with hot money may be swinging the pendulum the other way.

Now some foreign investors are being told by China's currency regulator that they're paying too much for Chinese companies.

A spike in inward foreign direct investment this year - up 46% on year in the first half, compared with a 14% rise for all of 2007 - suggests potentially volatile speculative funds are flooding into China in the form of artificially high price tags on corporate investments.

That has prompted the State Administration of Foreign Exchange in recent months to question a number of deals where the agreed purchase price was higher than the value of the assets indicated by an independent appraisal.

Under China's mergers and acquisitions rules, the Ministry of Commerce is responsible for vetting proposed foreign investments in Chinese assets, while SAFE's sole role is to sanction any currency exchange arising from the transaction. In the past, SAFE's nod has been pro forma as long as the commerce ministry approved the deal.

By getting stricter, SAFE appears to be trying to deter importers of hot cash, not drastically change M&A procedures. Not least because legitimate foreign investment injects much-needed offshore capital and expertise into an economy that is looking to become more than just the world's factory floor.

But the currency regulator's interference in recent deals - even some that had been approved by the commerce ministry - is creating additional headaches for the companies involved. It may end up scuppering some deals if the buyer, takeover target and regulator aren't willing to compromise.

What's more, it's unclear whether SAFE's meddling will yield a significant drop in the speculative funds that Beijing says are undermining its attempts to tighten its grip on money supply as China grapples with high growth rates of over 10% and inflation of over 7%.

That's because most M&A deals - where the appraisal and offer price match but which may still include speculative funds - continue getting done without any interference from SAFE. More than half the 200 foreign and Chinese firms responding to a May survey by Deutsche Bank about speculative inflows said direct investment was the easiest way to bring hot money into the country.

There are no formal figures on speculative cash inflows. A widely used calculation - looking at foreign-exchange reserves unexplained by foreign direct investment, the trade surplus or return on investments - suggests about $90 billion in such funds flowed into the economy over the first six months of the year.

That's significantly larger than the $52.39 billion in FDI that came in over the same period, a figure that economists already suspected of being padded with speculative inflows.

The Price of Transparency

Under China's M&A rules, all firms targeted for investment by a foreign entity must undergo an evaluation by a local, state-approved appraisal firm. While buyers of state-owned assets are required to pay at least 90% of the evaluation price, lawyers say there are no other official restrictions on deals.

But that doesn't mean it's all plain sailing any more.

Winston Zhao, partner-in-charge at law firm Jones Day's Shanghai office, spoke of one of his firm's deals that ran into difficulties because of SAFE's increased vigilance.

A foreign hedge fund seeking to buy a minority stake in a company based in the southern city of Shenzhen received the nod from the Ministry of Commerce but SAFE in March declined to approve the currency transaction. "SAFE had doubts about the true nature of the deal because the negotiated sale price was higher than the appraised value," Zhao said.

The deal finally got the go-ahead from SAFE in May only after the fund received a second independent appraisal that put the firm's value much closer to the proposed purchase price.

The difficulties are likely to mainly arise for those investors who eventually want to take the acquired company public or to list themselves.

In most cases, the independent appraisal is a formality resulting in an evaluation broadly in line with the purchase price already negotiated between the buyer and the seller.

"Parties usually agree to a price up front, then find an evaluator to rubber-stamp the deal," said Li Qiang, a partner with O'Melveny & Myers LLP in Shanghai, who says he hasn't had any problems with SAFE over M&As.

Valuations More Thorough, But Lower

But in cases where the companies want to go public, foreign investors make it clear they want accurate appraisals and often also hire a prominent international accounting firm to vet the appraisal report. This can result in a more thorough, but often lower, valuation of the assets.

That's because such appraisals measure only existing assets, whereas would-be buyers are often willing to pay more because they see a future value in the business. This discrepancy isn't usually an issue in developed economies where all parties understand why there may be a difference.

"When you want to go to the capital markets you'll engage a Big Four (accounting firm) to audit the (valuation) report to convince the big funds to invest," said a lawyer with a U.S. law firm in Shanghai, who had a deal turned down earlier this year.

At other times, SAFE has also objected to the payment structure for a proposed takeover.

A person at a small investment bank said a Sino-foreign joint venture deal he was working on in the southern city of Guangzhou met with SAFE opposition over concerns that it was a front for speculative money because the foreign partner wanted to pay par value for the shares but deposit a premium into a capital surplus account for future use by the joint venture.

"The informal advice we got from SAFE branches was that converting dollars into yuan would be fine for the purchase of the shares, but for anything going into capital surplus, they weren't likely to approve," he said. He added that the capital was divided that way to ensure a more favourable tax treatment.

"It's the first time I've come across SAFE being really sensitive in approving dollar-to-yuan conversions," he said. The deal ultimately failed to go ahead for other reasons that the banker declined to specify.

SAFE's increased interest in M&A deals is part of a broader campaign to choke off hot money that is somehow entering China. Other recent moves include new rules requiring exporters to park their revenue in a special bank account for auditing before they can apply to exchange it into yuan.

The currency regulator believes some exporters have been over-invoicing and parking the excess cash in mainland assets to take advantage of the yuan's appreciation. The Chinese currency has risen nearly 22% against the dollar since its revaluation in 2005, and is widely expected to rise further.