The liberalisation of China’s markets is offering hope to an area of finance for mainland groups that has hitherto drawn caution from investors: the keepwell deed.
Keepwell deeds are essentially a contract between a parent company and its subsidiary to maintain solvency and financial backing throughout the term set in agreement; typically involving an offshore group company issuing debt, with credit support provided by the onshore group or third-party.
These structures were arguably constructed to circumvent regulatory restrictions that prevent onshore Chinese entities from providing guarantees to offshore entities.
For the year to-date, there have been seven Chinese deals with keepwell deeds totalling more than $3.3 billion – this is almost five times more than last year’s $700 million of two transactions over the same period, according to Dealogic data.
In recent years, the increasing need for tapping capital in offshore markets has prompted mainland groups to use a variety of credit-support structures to issue bonds to boost the creditworthiness of the transaction. This is especially useful for debut issuers whose names are unfamiliar to global investors.
However, unless support is a strong guarantee or letter of credit (LC) that provides certainty of timely payment, investors will be cautious towards types of offshore deals that come to market, including those accompanied by far more complex structures such as the keepwell deed.
Unlike LCs, a keepwell requires no onshore regulatory approval, thereby making it less credible. As a result, the lack of regulatory oversight in enforcing this type of credit support prompts the potential for complexity to impede the timeliness of payment.
China’s capital and foreign exchange controls have made the functionality of such credit-support structures a lot more complicated as restricted cross-border fund flows could also affect the timeliness of payment. This is especially true when nearly all deals involve different jurisdictions and the flow of renminbi or foreign currency outside or into the mainland.
Moody’s recently highlighted in a report that “the potential impact of capital controls that remain in China must be considered carefully in respect of these transactions”; a key reason why every offshore transaction reliant on a keepwell to-date has been rated below the parent granting the credit-support structure.
In spite of the concerns that this form of credit support falls short of onshore guarantees, the structure has been popularly used to issue bonds via offshore subsidiaries owned by Chinese companies – including Gemdale and China National Petroleum Corp.
“While these forms of credit support [keepwell agreements] fall short of onshore credit guarantees, they nevertheless provide a level of comfort for investors,” said Vijay Chander, executive director for fixed-income at Asia Securities Industry & Financial Markets Association.
China’s capital control relaxation
In fact, not all is bad for such structures.
The credibility of keepwells goes positively hand-in-hand with the liberalisation of China’s capital account, implying that the support provided for offshore bonds backed by these structures will only get better with time.
This is already happening. On January 24, China’s State Administration of Foreign Exchange (Safe) released a new policy to further relax capital controls.
The new policy gives companies more flexibility to make cross-border payments. For example, onshore enterprises are now only required to register intercompany loans with Safe, instead of seeking approvals as required previously. The policy also removes the two-year limitation for the tenor of the quota for intercompany loans.
Clearly, bond investors can now be at ease as the new policy ensures that onshore companies will be able to transfer funds – if they choose to do so – in a timely manner to offshore issuers or guarantors that run into financial trouble.
Bonds – especially those with keepwell agreements attached to them – will thrive in this environment, especially if the notes rely heavily on the corporation’s onshore entities or businesses’ cash flow for interest and principal repayment.
Don’t get too comfortable
While it is reassuring to know that Chinese regulators have been making efforts to liberalise the country’s capital account, investors cannot become too complacent as the new rules still do not address the legal uncertainties associated with the keepwell deed.
Investors still need to carefully assess the standalone credit quality of the offshore issuer – if possible – and the onshore parent, as well as scrutinise the legal documentation of the keepwell structure.
Factors such as the degree of parent ownership in the offshore entity plus safety margins imposed when liquidity falls below a certain level should also be considered.
At least for now, investors can now sleep relatively soundly knowing that we are headed in the right direction and that things can only get better from here – as long as Li Keqiang promises to deliver the plans that would allow capital to move more freely in and out of China.
