Pre-investment capital planning for China’s currency control
In China, companies, banks and individuals must comply with a “closed” capital account policy. This means that money can not move freely inside or outside the country unless it complies with the strict exchange rules.
China made promises to liberalize its foreign exchange market by accessing the World Trade Organization (WTO), but changes are gradually being introduced. Currently, the government is using the China Free Trade Area Pilot (Shanghai) to test the full convertibility of the currency and new liberalizations for foreign investors. If successful, regulators are likely to expand liberalization nationally.
Currency exchange system of China
The main bodies responsible for overseeing the flow of foreign currency are the State Administration of Foreign Exchange (SAFE) and the People’s Bank of China (PBOC), the central bank. SAFE is the administrative agency responsible for the management of foreign exchange activities in China, the establishment of relevant regulations and the management of China’s foreign exchange reserves. SAFE approval or filing of records is required for a variety of transactions involving inbound and outbound foreign exchange payments.
In the Chinese exchange system, there are two main accounts: the current account and the capital account. The current account is applied to ordinary recurring commercial transactions, including receipts and payments of operations, payment of interest on the external debt and the repatriation of profits and dividends after taxes, among other transactions.
The capital account, on the other hand, deals with imports and exports of capital, direct investments and loans and securities, including the repayment of the principal of the external debt, investments abroad, investment in FIE, and plus.
China Currency Exchange System
According to the SAFE rules, companies with incorporated foreign investment (FIE) are subject to a debt-to-general capital ratio requirement. This means that of the total investment of an FIE, a certain percentage must be composed of the capital contributed by the investors.
Previously, SAFE required that all foreign investment companies present a statement of assets of foreign investors to clarify and demonstrate the outflow and entry of proposed foreign currency. In addition, an authorized national CPA firm had to issue an Annual Foreign Currency Inspection Report.
However, with the publication of the Notification on simplifying and further improving foreign exchange management policies for direct investment on June 1, 2015, the annual foreign exchange inspection for foreign investors was canceled. Instead, investors must submit an “existing Right Register” before September 30 of each year.
If the FIE does not comply with the SAFE requirements, the foreign exchange offices can take care of the capital account information, and the banks will refuse to process any currency business in the FIE capital account. In addition, if the FIE does not comply with the conditions of SAFE, the banks will not allow the FIE to distribute the benefits to foreign shareholders.
Common challenges for foreign companies
Given China’s restrictions on foreign currency exchange, companies have to be strategic with respect to their financing plans at the beginning of the pre-investment stage.
Running out of funds
A common pitfall for foreign companies is to underestimate their costs and overestimate their profits, leading to a capital shortfall.
In one case, Company A was optimistically established in China with a smaller amount of registered capital on the assumption that it could generate revenue quickly. The assumption was based on an agreement with an important client whereby the customer would place a considerable order and settle the payment within 90 days. However, the payment was delayed and the company was unable to meet its cash flow objective. Company A incurred substantial startup costs, including rent in the warehouse, raw material expenses and salary commitments.
To cover the costs, the parent company abroad initiated the steps to inject more registered capital, but it would be weeks before the entire process could be completed. Meanwhile, company A could not pay its employees and did not comply with the compulsory social security contributions.
overseas investments, investment in FIEs, and more.