China’s ABS market has pulled off a remarkable recovery since the pandemic, but the real estate credit crunch and other economic risks have forced businesses to seek new avenues for financing, writes Sophia Luo
Amid the twists and turns of pandemic-ravaged 2020, China’s asset-backed securities (ABS) market managed to continue its growth trajectory following a U-shaped recovery.
The market has shown no signs of losing momentum in the first half of this year, with offerings totalling RMB1.3 trillion (USD202 billion), up 45% from the same period last year. Specifically, credit ABS more than doubled in the past year – with 105% year-on-year growth thanks to a low base because of slower issuances during the pandemic in 2020 – making up 31% of total ABS issuances this year.
ABS backed by corporate debt increased by 20% compared with the same period last year, accounting for 50% of the total, while asset-backed medium-term notes (ABNs) jumped by 53% from the first half of 2020, contributing to 19% of total issuances.
The issuance of standardised ABS products amounted to nearly RMB2.9 trillion last year, representing a 23% year-on-year increase. The market inventory by the end of 2020 reached about RMB5.2 trillion, translating into growth of 24% compared with the previous year, according to the 2020 Asset Securitisation Development Report published by China Central Depository & Clearing (CCDC).
Since the launch of the Administrative Measures for the Pilot Securitisation of Credit Assets in 2005, China’s ABS market has taken a hard road to becoming the world’s second-largest.
Time period: 1 September 2020 − 31 August 2021
Unit: RMB100 million
Time period: 1 September 2020 – 31 August 2021
Time period: 1 September 2020 – 31 August 2021
Time period: 1 September 2020 – 31 August 2021
Li Mingyue, a partner at Tian Yuan Law Firm’s Beijing office, says the conventional business of asset securitisation has hit a bottleneck in the post-pandemic era for two main reasons. On the one hand, China’s overall economy has grown at a slower pace in the past two years due to the deadly virus and an unstable international investment climate. Financing demand from the real economy, including the needs of the ABS market, has experienced a deceleration in growth.
On the other hand, the rise in debt defaults has become a regular thing in the bond markets, which has had an impact on the risk appetite of investors and the investment side of the ABS market.
Add to this the real estate industry, which takes a lion’s share of underlying assets of the ABS market and has borne the brunt of unprecedented regulatory tightening. The securitisation of real estate assets involving individual house mortgage loans has been inevitably affected by total issuances’ downward trajectory compared with the previous year.
However, Li stresses that, compared with countries and regions known for their established and sophisticated ABS markets, asset securitisation in China is still in its early days. The new round of industry-wide transformation and exploration is well underway, and corresponding short-term challenges can hardly be avoided. “We cannot jump to the conclusion that the industry has reached the limit of growth at the current stage,” she says.
Riding high on nationwide undertakings to strengthen the ability of financing to serve the wider economy, Li says there is potentially huge financing demand from the real economy to be unlocked. Many companies, especially private enterprises with other financial channels subject to certain restrictions, will seek to raise funds from the ABS market. When choosing the investment targets, investors will also switch their focus further from corporate credit rating to the quality of underlying assets.
“Meanwhile, as the transition period for the implementation of new asset management rules comes to an end, conventional credit business, non-standard financing and ‘channel business’ – which refers to when asset management companies temporarily take over bank assets and later sell them – are further restricted,” says Li.
“With the arrival of the inventory era, and under the broad context of ‘deleveraging’, asset securitisation, as a standardised financing channel with easy access and the ability to activate the inventory assets in an effective manner, is actively encouraged by policymakers,” she says. “Asset-backed securitisation financing, banking on industries with competitive edges and high-quality assets, has what it takes to offer an industrial breakthrough and become a major driving force for growth.”
Payne Huang, senior partner and director at the Shenzhen office of Hui Ye Law Firm, explains that only when the quality of underlying assets becomes the real criterion, and the interest of investors stands as the driving factor, will the country’s asset securitisation – particularly the traditional underlying assets-backed securitization – be able to create a new growth curve for long-term development.
“We are also looking forward to more and more high-quality assets with a weak business profile of issuers seizing the chance to make a big difference in China’s ABS market,” he adds.
Pan Xinggao, a Beijing-based partner at Commerce & Finance Law Offices, believes that fields such as technology and innovation, sustainability and environmental protection, as well as high-end manufacturing, which are all currently encouraged by policymakers, are where the new growth opportunities will emerge.
In April last year, the China Securities Regulatory Commission (CSRC) and the National Development and Reform Commission (NDRC) jointly issued the Notice on Work in Relation to Advancing the Pilot Project for Infrastructure Real Estate Investment Trusts (REITs). On the same day, the CSRC followed with the Guidelines for Public Offered Infrastructure Securities Investment Funds (for Trial Implementation) (Draft for Comment). Since then, nine infrastructure REITs have made their debuts in Shanghai and Shenzhen stock exchanges as of June 2021.
Huang notes that the most notable drawback in China’s commercial property market lies in the fact that a real closed loop has yet to come into being. The existing quasi-REITs, or other means of asset securitization, still base investments on the creditor’s rights.
The product, by its nature, is a single securitised product with a specific financing purpose, says Huang, more like a means of financing than a winning co-operation, and lacking a financial exit of the sort that gives consideration to long-term investments.
Pandemic-induced uncertainty has also temporarily led to a high level of risk aversion from Commercial Mortgage-Backed Security (CMBS) investors. “Today, the secondary market of asset securitisation is still beset with limited liquidity, the level of securitisation of non-performing loans remains low, and the default risks of underlying assets are confined to the internal system of commercial banks,” says Huang. “Looking ahead, infrastructure REITs, Residential Mortgage-Backed Securities (RMBS), as well as supply chain financing ABS and other types of ABS, are where the industry is heading.”
Matthew Ching, a partner at Jingtian & Gongcheng’s Shanghai office, says that unlike conventional asset-backed securitised products represented by credit ABS, ABS backed by corporate debt, and ABN – which are in essence debts with maturity dates – infrastructure REITs are equity-based, where one can cash in via the actual sale of assets, and the corresponding risks and benefits lie somewhere between that of equities and debts.
“In light of the core difference, it can be said that infrastructure REITs carve out a new path for fast-developing asset securitisation in China,” says Ching. “In terms of the investment and financing of infrastructure included in the pilot schemes, the publicly offered REITs have iteration-based advantages over asset securitisation.”
Chen Sheng, a partner at Tian Yuan Law Firm’s Beijing office, says that the choice of making infrastructure projects, rather than commercial properties, in the experimental field of publicly offered REITs is in line with local conditions and the specific context of China.
Pan, from Commerce & Finance Law Offices, adds: “This is a historic opportunity for infrastructure REITs. In the post-pandemic era, with local government debts on the rise, there is financing demand from large projects. A range of real estate, including some industrial parks that have been upgraded, has also generated demand for asset securitisation.
“Moreover, as policymakers have introduced a whole set of policies in the past two years to tighten the grip on internet finance and shadow banks, the pent-up market demand has driven the development of infrastructure REITs,” says Pan.
Huang, from Hui Ye Law Firm, says the batch of well-chosen infrastructure-related instruments includes REITs that own property rights in underlying infrastructure projects like modern logistics and warehousing, and industrial parks, as well as REITs that hold franchise rights in underlying infrastructure projects such as highways, sewage treatment and power generation.
Proceeds raised by the nine REITs will be mainly invested in disadvantaged infrastructure sectors, and the pilot infrastructure REITs programme will be carried out across key geographic areas such as the Beijing-Tianjin-Hebei Economic Zone, Guangdong-Hong Kong-Macau Greater Bay Area (GBA), the Yangtze River Delta, and the Yangtze River Economic Belt.
In the past 12 months, infrastructure REITs have grown from nothing and, given that the pilot schemes are just the initial stage, Pan says the immediate problem still lies in the selection of high-quality underlying infrastructure assets.
“The developed eastern regions have relatively more projects that are expected to generate higher and more stable cash flows to choose from, while for the less-developed central and western areas, the cash flows generated by some infrastructure assets will hardly support the financing demand from REITs,” says Pan.
“Our advice is to strictly comply with the rules to select the best-qualified REITs, and avoid pressing ahead with the scheme like a swarm of bees – blind followers as well as high-profile campaigners.”
Ching, from Jingtian & Gongcheng, says the first batch of infrastructure REITs’ average dividend yield could be as high as 6%, but the threshold for underlying assets also remains high, which makes a lack of market willingness to ensure the supply of high-quality assets almost inevitable.
Chen, from Tian Yuan, says: “Based on the transaction data in nearly three months since the market debuts, what we can see is a process where the publicly offered REITs markets, in a progressive manner, are switching to trade on value from pure emotion, with the overheated market showing signs of cooling down and stabilising. In the end, it is the underlying assets themselves, and the stability of their cash flows, that remain the area of concern for the markets.”
The NDRC has recently gone a step further to require originators to be able to issue new shares, whose total assets under management (AUM) that can be used for the issuance of infrastructure REITs shall be in principle no less than two times the AUM that supports the would-be IPO of the infrastructure REITs.
“In order to liquidise the inventory assets and create a virtuous circle in investment, the infrastructure REITs are not designed as one-off financing products for a certain infrastructure project,” says Liu Borong, equity partner at Zhong Lun Law Firm’s Beijing office. “Instead, the funds should constantly expand the assets under their management, based on the evolving market conditions, to realise sustainable development.”
Besides the NDRC, the CSRC and Shanghai and Shenzhen stock exchanges have also added fundamental provisions on the required capabilities of listed infrastructure REITs to issue new shares.
By Fang Yan, DeHeng Law Offices
By Fang Rong, Han Kun Law Offices
By Chen Xiuli, V&T Law Firm
By Luan Jianhai, Commerce & Finance Law Offices
By Ye Fei and Xie Yuhao, Jincheng Tongda & Neal
The principle that houses are for living in, not for speculation, has been widely accepted, and the establishment of a housing system that encourages both rental and purchase has what it takes to become the next big trend, with affordable rental housing certainly part and parcel of such a system.
A circular from the NDRC in July – the Notice of Further Effectively Completing the Work of the Pilot Programme of REITs in the Infrastructure Field – confirmed that affordable rental housing will be promoted as a sector suitable for REITs.
On 18 August, the country’s first public rental housing REITs product – China Development Bank-Beijing Public Housing Centre public rental housing asset-backed special programme – was successfully issued, opening a new chapter for public rental housing private REITs.
This is a well-prepared and well-timed exploration. Chen, from Tian Yuan, says that before this it was estimated that there had been roughly 40 rental housing-related quasi-REITs launched in the mainland Chinese market, therefore offering some practical experience to lay the foundation for further exploration.
Zhang Zhixiao, a partner at V&T Law Firm in Beijing, says that affordable rental housing is a typical type of real estate project that targets long-term returns, which fits in well with the characteristics of REITs. But Zhang underlines that there are at least a pair of problems ahead.
“One is whether the rate of return can meet the standard,” he says. “The other issue is with respect to asset management, which results from the fact that mutual funds today are the main body for the setup of REITs, and are known for their lack of experience in managing properties. This also stands as a common problem facing the REIT industry as a whole for the moment.”
Pan, from Commerce & Finance, summarises developments in the rental housing industry as “three highs and one low”, namely high asset prices, high financing costs, high tax burden, and low yield.
Huang, from Hui Ye, adds that, compared with the common ABS programmes, affordable rental housing publicly offered REITs are required to pay dividends on a regular basis and therefore need more stable cash flows. Affordable rental housing REITs deliver a lower return and hence rely more on property operation and management.
Public rental houses, thanks to lower rents, are usually in high demand with their high occupancies. However, the imbalance in rental prices that result from the difference between new and old rental housing projects, as well as the districts where they are located, make the underlying assets less profitable.
Wang Lihong, a Beijing-based senior partner at Dentons’ Banking and Finance Practice Group, says that the affordable rental housing REITs pilot programme has been limited to four centrally administered municipalities and 29 major cities with a net inflow of population, including Beijing, Shanghai and Shenzhen. There is a stable demand for affordable housing in these cities, coupled with dispersed and stable cash flows, and return on assets being less affected by economic cycles and market fluctuations.
With the opening up of China’s capital markets well underway, a growing number of foreign financial institutions have been making inroads into the market, creating a historic opportunity for cross-border securitisation.
Karen Lam, a Hong Kong-based structured finance and derivatives partner at Linklaters, says that despite the internationalisation of the renminbi, the channels for cross-border capital flow – essential in any structure for cross-border securitisation – remain limited.
“Restrictions on foreign ownership of onshore assets also contribute to the scarcity of direct cross-border securitisation,” she says.
Lam says that although it is technically possible for some assets to be transferred to an offshore securitisation vehicle, the formalities required for such a transfer (such as registration with the relevant authorities) make it impracticable. For these reasons, market participants are actively exploring other indirect routes such as the qualified foreign institutional investor (QFII) and bond connect schemes.
According to Lam, in a typical indirect securitisation structure, the onshore assets are acquired by offshore eligible investors (including QFIIs and RQFIIs), and an offshore special purpose vehicle (SPV) will issue notes with payment flow backed by the cash flow generated by the onshore assets.
The notes will typically be secured over the SPV’s rights and interest in respect of the offshore custodian/manager of the onshore assets, as opposed to directly over the onshore assets, thus bypassing complications under PRC law.
Such offshore security and custody account structures provide more comfort to offshore investors as they bear more resemblance to the structures in an offshore securitisation.
Huang, from Hui Ye, says that the steady development of cross-border asset securitisation will have a profound influence on many areas. Taking account receivables as an example, he says the biggest difference between cross-border asset securitisation and securitisation backed by account receivables lies in the fact that the debtors of the underlying assets that can generate cash flows in the future are physically outside the border.
Hence, cross-border asset securitisation should fall into the category of foreign-related business. No matter whether asset securitisation is carried on in domestic or offshore markets, approval and support is required from cross-border regulators with rules and laws abroad.
“For the business area of trade financing, it is no doubt a major innovation and breakthrough,” says Huang. “If the pilot programme goes well, it will blaze a new financing trail in capital markets for the country’s export and import enterprises, as well as commercial banks.”