Wcg china survey 2015

ASSET FINANCE INTERNATIONAL IN ASSOCIATION WITH WHITE CLARKE GROUP

China ASSET & AUTO FINANCE COUNTRY SURVEY 2015

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

White Clarke Group White Clarke Group is the market leader in software solutions and business consultancy to the automotive and asset finance sector for retail, fleet and wholesale. White Clarke Group solutions enable endto-end credit processing and administration to streamline business practice, cut operational cost and deliver outstanding customer service. White Clarke Group has a 23-year track record of leadership and innovation in finance technology, consultancy and new market entry. Clients value White Clarke Group's industry knowledge, market intelligence and innovation. The company employs some 600 finance and technology professionals, with offices in the UK, USA, Canada, China, Australia, Austria and Germany.

White Clarke Group publish the Global Leasing Report, which is part of The World Leasing Yearbook. To download a copy please go to: www.whiteclarkegroup.com/knowledge-centre

Acknowledgements Don Chan, director, IAA-Advisory; David Chen, head of Sales & Marketing, Société Générale Equipment Finance Greater China; Jeff WZ Chen, DFS program manager, Dell DFSi China; Paul Errington, chief executive officer, Connaught Finance Investments; Colin Fleischmann, director, White Clarke Group; Brendan Gleeson, group executive vice president, White Clarke Group; Alan Leesmith, international director, IAA-Advisory; Simon Liu, partner, KPMG in China; Yanping Shi, program director, Lease Research Centre; and professor in Finance, University of International Business and Economics, Beijing; Joh Sim Khuang, partner, LehmanBrown International Accountants, Beijing; Diwakar Singhal, senior vice president, Genpact; Richard Taylor, chief executive officer, Siemens Finance Services in China; Conrad Turley, senior manager, KPMG in China; Markus Weinseiss, president, CIT Asia; Lachlan Wolfers, partner, KPMG in China; Haitian Yang, chairman, China Leasing Alliance Institute of Tianjin Finance Lease.

http://www.whiteclarkegroup.com/ http://www.assetfinanceinternational.com

Publisher: Edward Peck Editor: Brian Rogerson Author: Nigel Carn Asset Finance International Ltd. 39 Manor Way, London SE3 9XG UNITED KINGDOM Telephone: +44 (0) 207 617 7830 Photo credit page 5: openbuildings.com © Asset Finance International, 2015, All rights reserved No part of this publication may be reproduced or used in any form or by any means – graphic; electronic; or mechanical, including photocopying, recording, taping or information storage and retrieval systems – without the written permission from the publishers.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

Contents China at a glance

5

The leasing market in China

7

Recent growth trends Auto sector leasing Alternatively-fuelled vehicles

7 9 11

Economic overview – the new normal

12

Stimulus measures Growth factors Performance levels Economic competitiveness Business climate

12 13 14 14 16

The Chinese captive market

18

Leaders’ insights

21

Leasing market performance Performance trends Challenges for lessors Portfolio and credit quality New market entrants Opportunities for captives Market forecasts Renewable energy Government incentives Leasing regulation Taxation update on leasing in China Direct taxes Indirect taxes

21 21 23 25 25 27 28 28 29 30 31 31 33

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

Accounting for leases in China Classification of leases Accounting treatments of lessees in finance leases Accounting treatments of lessors in finance leases Accounting treatments of lessees in operating leases Accounting treatments of lessors in operating leases

36 36 36 38 38 38

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

China at a glance This Asset Finance International country survey aims to provide a balanced assessment of the equipment and auto finance and leasing market in China. Key areas covered and principal findings include:

• China’s leasing market has grown at a near-exponential rate since

2007, although the introduction of tighter monetary controls in 2011 and a temporary change in VAT regulation in 2013 briefly slowed the rate of growth.

• This upward growth trend has not been adversely affected by the

recent downturn in China’s overall economic growth, and there are no signs of a change in this situation.

• There are no definitive figures for market size and performance.

However, sources put the number of leasing companies at over 2,000 with a total leasing portfolio at the end of 2014 of CNY3,200 billion (US$520 billion). This represents a portfolio increase of over 50% on the previous year.

• New business volume (NBV) in 2014 is estimated at around

US$500 billion, an increase of nearly 50% on 2013. Nearly half of NBV is contributed by 30 financial leasing firms.

• Market penetration is relatively low, at around 5% compared with • In the auto sector, China is the world’s largest car market and sales volume continues to rise, driven by a burgeoning, wealthy middle class with an appetite for conspicuous consumption of luxury items.

• However, whilst awareness of leasing is relatively high, uptake of leasing as a financing option is very low, as ownership remains a powerful status symbol.

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nearer 20% in more developed markets, so the scope for further growth is huge.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

• Sales of alternatively-fuelled vehicles are gathering pace, and China is now the world’s second largest market for electric vehicles.

• Regarding China’s economy, the current downturn marks a shift

to a lower but still relatively rapid growth path. This is likely to be more sustainable than the recent breakneck rate, and has been termed the ‘new normal’.

• Growth will remain driven largely by investment, but rapid bank

and non-bank credit growth has fuelled financial stability concerns.

In terms of value added, the share of services has now overtaken that of manufacturing, but a pick-up in productivity in all sectors is needed.

• Opportunities for entrepreneurship and innovation are improving, but problems remain in the financial sector and access to loans remains difficult for a large number of SMEs.

• A special article looks at captive and vendor finance in China, from its origins and growth to the key factors and decisions that affect foreign investors entering this potentially lucrative market.

• For this country survey, a wide range of industry leaders in

equipment and auto leasing in China provide their views of the market, its recent performance and future growth trends, and the opportunities and challenges it faces in the near and medium term.

• Opinions are given on areas of topical interest, such as: -- Leasing portfolio and credit quality; -- The opportunities for new foreign lessors looking to enter

the Chinese market, including establishing captive finance operations;

-- Which leasing sectors offer the best prospects for growth

in the coming year, including debate on the outlook for the renewable energy sector; and

-- The effectiveness of government incentives on the market,

both for foreign invested lessors and for Chinese institutions expanding overseas.

• This country survey concludes with two specially commissioned

articles from experts in their field. The first provides a timely update on leasing taxation, and how China’s direct and indirect taxation regimes are evolving in line with the rapid expansion of asset leasing in the country. a necessary classification of leases and describing accounting treatments of both lessees and lessors in finance and operating leases.

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• The final article concerns accounting for leases in China, providing

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

The leasing market in China The leasing industry in China has grown from nowhere in an exceptionally short number of years, with the market being steadily opened up after China joined the World Trade Organization in 2001, which was followed by the government’s opening of the market to domestic investment in 2005, and the China Banking Regulatory Commission (CBRC) allowing domestic bank involvement in 2007.

Since then, the leasing market has grown at a near-exponential rate.

There have been setbacks, the first coming in 2011 as a reaction to the global financial crisis, when China introduced tighter monetary controls, making it harder for both domestic and foreign investors to get loans from banks, whilst at the same time regulators introduced new legislation regarding Business Tax and VAT. The market suffered a further regulatory obstacle in May 2013, when the introduction of an unfavourable VAT reform led to a slight decline during the second half of the year. That policy was considerably redesigned at the end of the year, and the market returned to strong growth.

This growth trend has noticeably not been adversely affected by the recent downturn in overall economic growth, and there are no signs of a change in this situation.

There is no overall system of regulation of leasing companies, with licences being provided by the CBRC and the Ministry of Commerce (MOFCOM). The CBRC covers the so-called non-bank financial institutions (NBFIs), while MOFCOM covers foreign-invested leasing companies – either joint ventures (JVs) or wholly foreign-owned companies – and domestic leasing companies.

Recent growth trends In a market that is relatively young and vibrant, but where there is no overall regulatory system, it is not surprising that there are no hardand-fast industry statistics. However, whichever way the market is viewed, the figures involved are large and rising. In currency terms, the totals in Chinese yuan (CNY) have been converted to US dollars using the average annual exchange rate for the year in question.

The following figures are available from the latest China Leasing Industry survey, published by the China Leasing Alliance Institute of Tianjin Finance Lease, and are widely accepted in the industry:

• The number of outstanding lessors at the end of 2014 was 2,202 • Lessors licensed by MOFCOM include 152 that are owned by

Chinese companies, with the great majority being foreign-owned or JVs. However, it should be noted that, of those 2,050 foreignowned and JV operations, the majority are in fact Chinese companies using their Hong Kong businesses as foreign partners.

Most Chinese companies own an operating entity in Hong Kong – so in practice, over 90% of ‘foreign’ lessors including JVs that have been established in the past five years are Chinese-related.

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compared with 1,026 at the end of 2013. Of these 30 are licensed by the CBRC and the remaining are licensed by MOFCOM.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

• New business volume (NBV) increased to US$500 billion in 2014, up by 47% from US$340 billion in 2013.

• The 30 bank-owned lessors are hugely important: although they

represent only 1.4% of the total number of leasing companies, they accounted for 40.6% of NBV, while foreign lessors including JVs represent 91.7% of leasing companies but accounted for just 28.1% of NBV.

• The average capitalization of bank-owned lessors was US$300 million, with the highest capitalization being for ICBC Leasing at US$1.8 billion.

• The average capitalization of foreign-owned lessors was US$20 million, with the highest capitalization being for Far Eastern International at US$1.4 billion.

These figures correlate reasonably closely with research undertaken by the highly respected team at the University of International Business and Economics (UIBE), Beijing, headed by Professor Yanping Shi. Dr Shi told Asset Finance International that the UIBE research revealed the following information about the market in 2014:

• According to MOFCOM, the total number of leasing companies at the year-end was more than 1,800 and the total registered capital of these firms amounted to nearly CNY580 billion (US$95 billion).

• According to the CBRC, NBV from the 30 financial leasing

companies under its supervision amounted to CNY548.6 billion (US$90 billion) and total asset size of these firms amounted to CNY1,276.8 billion (US$208 billion) at the end of 2014.

• These 30 financial leasing companies (around 1.7% of the 1,800 total) contributed nearly half of total NBV for the whole leasing industry in China in 2014.

• According to UIBE calculations, of all new leasing volumes, sale and leaseback amounted to more than 75%, although that was down from 83% in 2013.

• UIBE calculations show that leasing penetration including sale and leaseback is around 4.5−5.0% and leasing penetration for new equipment, not including sale and leaseback, is nearly 1.5%.

Some degree of tolerance must be allowed for the figures, which can and do vary. Sources indicate that the total leasing portfolio in China reached CNY3,200 billion at the end of 2014 (US$520 billion), an increase of 52% on the total of CNY2,100 billion at year-end 2013 (US$340 billion). It should be noted that an estimated 35% of the total leasing market is real estate, which is probably one of the sectors that is least easy to regulate and have accurate data on.

Even allowing for an element of over-estimation, the progress shown in the chart is spectacular. Given the relatively low penetration rate of around 5% compared with nearer 20% in more developed markets, the scope for further growth is huge. Predictions of the total leasing market exceeding CNY10 trillion in 2020 are not far-fetched.

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These last market penetration figures fit with the consensus view, and opinion is unanimous that they are rising.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY China total leasing market 100

3,500

90

3,000

80

2,500

70 60

2,000

50 1,500

40 30

1,000

20

500

10

0

0 End–2009

End–2010

End–2011 CNY bn

End–2012

End–2013

End–2014

% change y-o-y

Source: Asset Finance International, based on data from China Leasing Blue Book, ResearchInChina

In the first quarter of 2015, the total portfolio is reported to have increased to CNY3,420 billion (US$555 billion); however, the growth rate for the quarter of just under 7% is less than the rate of nearly 12% growth in Q1 2014.

China financial leasing enterprises, as of March 2015 Total number

NBV (CNY bn)

NBV as % of total

Financial leasing enterprises

30

1,390

40.6

Domestic-funded enterprises

191

1,070

31.3

Foreign-funded enterprises

2,440

960

28.1

Total

2,661

3,420

100.0

Source: ResearchInChina

The figures certainly agree on the proportion of the total provided by NBFIs, at over 40% in 2014. This proportion was maintained between March 2014 and March 2015, according to ResearchInChina figures, in line with the rapid increase in the overall market, at CNY950 billion (US$155 billion) out of CNY2,350 billion (US$380 billion) in March 2014 and CNY1,390 billion (US$225 billion) out of CNY3,420 billion (US$555 billion) in March 2015.

China has been the world’s largest car market for several years now, and although the rate of growth has slowed recently, the volume is still rising, driven by a burgeoning, wealthy middle class with an appetite for conspicuous consumption of luxury items.

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Auto sector leasing

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Passenger vehicle and commercial vehicle sales in China, 2008–April 2015 (000 units) 25000

18 16

20000

14 12

15000

10 8

10000

6 4

5000

2 0

2011

2010

Passenger cars

2012

2013

Commercial vehicles

2014

Jan–Apr 2015

0

% change y-o-y (PC)

Source: Asset Finance International, Chinese Association of Automobile Manufacturers

Traditionally, the desire for ownership and the rise in disposable income meant the majority of new vehicle purchases were cash transactions and the use of credit has been relatively limited. In 2013, loans accounted for only around 20% of vehicle purchases, with just 1% of financing being through leasing (Source: PwC Autofacts Analysis).

A recent study by professional services firm PwC revealed that, while awareness of leasing as a car financing option was high (91%), only 3% had leased or planned to lease a car, with 47% of respondents stating they preferred to own their vehicle – demonstrating that ownership remains a powerful status symbol. (Source: PwC, The shift from ownership to access, 2015.)

Auto finance preferences 80% 70% 60% 50% 40%

76%

30% 20% 21%

10%

3%

0% Loan

Lease

Source: PwC, ‘The shift from ownership to access’

However, rapid expansion of the auto market has massively increased congestion and pollution. This has led to various government and municipal initiatives to reduce vehicle usage and emissions, and to encourage car-sharing and leasing – concepts that are gaining in popularity among the younger generation.

Attitudes towards leasing are becoming more positive, and the benefits of a strong auto finance market are recognized by the authorities. To aid this, government is promoting the development of 10

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Cash

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY the used car market and awareness of financial leasing. There are also moves under consideration to relax regulatory requirements regarding obtaining a finance licence from the CBRC. It is predicted that the auto leasing market will grow at a combined annual growth rate of 25% over the next five years, although this is of course starting from a low base (Source: 21st Century Business Herald).

This softening of attitudes should help all lessors, particularly captive finance providers in the short term as they can use their experience of leasing in established markets.

A further boost is likely to come from the uptake of social media, especially by the younger generation of consumers, but use of social platforms and smartphones to research and interact is increasing rapidly across the demographic spectrum.

The appetite for new technology (the Chinese love gadgets) means the concept of changing cars more frequently has greater appeal as vehicle technology expands, which increases the attraction of leasing.

Lessors will also benefit from the volume of data that will become available to them.

Alternatively-fuelled vehicles Another area where attitudes are changing, and more positively than in many developed markets, is the alternatively-fuelled vehicle market – in particular, electric vehicles (EVs).

China is now the world’s second largest EV market after the US, with 23% of the global total and total sales in 2014 of 74,763 units, which represents an increase of 220% on the previous year. The sector can be divided into two segments: battery electric vehicles (BEVs) and plug-in hybrid electric vehicles (PHEVs).

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BEV passenger car sales totalled nearly 34,000 in 2014, an increase of 190% year-on-year. Sales of PHEVs totalled 17,500, rising from next to nothing the year before. (Source: ResearchInChina.)

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

Economic overview – the new normal The consensus view of the state of China’s economy is that, after a sustained period of extraordinary economic development, the country’s current downturn heralds a shift to a lower but still relatively rapid growth path, which is likely to be more sustainable than the recent breakneck rate. This situation has been termed the ‘new normal’.

The new normal is something businesses and investors in China and the rest of the world will need to get used to. In a statement to the International Monetary Fund (IMF) in April 2015, Zhou Xiaochuan, Governor of the central bank, the People’s Bank of China (PBOC), described the slowdown thus: “The Chinese economy is transiting toward its new normal. Amidst continued structural adjustments and absorption of the post-crisis stimulus effects, the real GDP growth rate edged down from 7.7% in 2013 to more sustainable rates of 7.4% in 2014 and 7.0% in the first quarter of 2015.”

In its March 2015 China Economic Survey, the Organisation for Economic Cooperation and Development (OECD) predicted growth would remain “moderate in 2015−16 by recent historical standards,” but added that such a level would still be high by international comparison.

The survey noted that the reason for the reduction in official targets for growth is the unwinding of imbalances in the property and some heavy industry sectors.

China − Macroeconomic indicators and projections 12

10.4

10

9.3 7.7

7.7

7.4

7.0

6.9

2013

2014

2015

2016

8 6 4 2 0 2010

2011

2012

Real GDP (% change y-o-y)

Source: OECD China Economic Survey, March 2015

The IMF itself has forecast the rate of real GDP growth in China will slow to 6.8% in 2015, followed by a further drop to 6.3% in 2016 (source: IMF World Economic outlook, April 2015).

A slowdown that is sharper than forecast is likely to have an adverse effect on global confidence. Recent efforts by the PBOC, such as reducing interest rates, have been made to act as a stimulus to investment and to counter potential unease. By mid-May, the PBOC had cut the benchmark one-year lending rate three times in six months, the latest reduction of 25 basis points taking it to 5.1%.

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Stimulus measures

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY In an additional monetary easing measure, in April the PBOC reduced its so-called reserve requirement ratio (RRR) for all commercial banks by an unexpectedly high 1 percentage point to 18.1%. This reduces the portion that must be held on reserve at the PBOC, thereby making more available for loans and investment. Such a move was deemed necessary as slowing economic growth has reduced the volume of capital inflows from foreign sources into China.

Mr Zhou noted that inflationary pressure remains contained, with the consumer price index (CPI) inflation rate dropping from 2.6% in 2013 to 2.0% in 2014 and 1.2% in the first quarter of 2015, attributing this to falling food and oil prices – although the rate has in fact been creeping up again slowly through this year.

Inflation and interest rates 7 6 5 4 3 2 1 -15

15

-15

r-

ay M

Ap

ar

-15

-15 M

b Fe

n

-14

CPI inflation (% change y-o-y)

Ja

c De

ov

-14

-14 N

ct

-14

-14 O

p Se

14

Au g

lJu

-14 n

Ju

M

ay

-14

0

Benchmark interest rate (%)

Source: National Bureau of Statistics, PBOC

Mr Zhou stated that, despite a rise in non-performing loans, the PBOC views the banking sector as being “in good shape”, adding that “the Chinese government will stay vigilant on non-bank financing, which will be supported by continued efforts to enhance the regulatory framework, and deploy macroprudential measures, as appropriate, so as to guard against systemic financial risks.”

The OECD survey observed that growth will remain driven largely by investment, but that a renewed pick-up in productivity will be necessary. It stated: “State-owned enterprises enjoy implicit government guarantees and easy access to cheap credit, which make it hard to reduce excess capacity and deter the construction of new overcapacity. Rapid bank and non-bank credit growth has fuelled financial stability concerns.”

An important marker has been passed in that, in terms of value added, the share of services has now overtaken that of manufacturing. This share will rise further as China becomes richer and urbanization progresses. “However,” the survey comments, “productivity in the service sector is held down by the fact that the playing field is not level for all firms.”

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Growth factors

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY One outcome of the boom in services is that some 13 million new urban jobs were created in 2014. Pledges to implement administrative reform by cutting red tape and easing the burden on private companies have been welcomed, and indeed the registration of new private enterprises grew to 3.6 million in 2014.

However, there is a need to reform small businesses’ reporting and disclosure requirements, as their access to credit would be enhanced if such requirements were made more rigorous.

Performance levels Business performance levels have varied over recent months. In the manufacturing sector, the National Bureau of Statistics (NBS) Manufacturing Purchasing Manager Index (PMI) measures the sector’s performance from a survey of private sector companies regarding factors such as orders and output. A reading above 50 indicates expansion compared to the previous month; below 50 indicates contraction; while 50 means no change.

In the period since the last Asset Finance International survey on China in 2013, the Manufacturing PMI has been above 50 for all but two months – those being in January and February 2015, following a steady decline over the second half of 2014. Performance picked up enough that March and April both registered 50.1, although this level is close to static.

The main measure of performance in Services is the HSBC Markit Services PMI, and this has been much more positive over the last two years, registering above 50 continuously and standing at 52.9 in April 2015 – the third consecutive monthly increase.

Since the previous AFI survey, the main international ratings agencies have kept China’s investment-grade sovereign long-term credit rating, and all affirm the outlook as ‘stable’.

Economic competitiveness Reform is key to managing the economic slowdown, and although the authorities have promised more, progress needs to be seen.

In its latest Global Competitiveness Report for 2014−2015, the WEF observes: “Trends are largely positive, but now is not the time for China to be complacent. The country is no longer an inexpensive location for labour-intensive activities and is losing manufacturing jobs to less developed countries and even to some more advanced economies.

China must now create the high-value jobs that will sustain the increasing standards of living.”

The WEF ranks China in 28th position out of 144 economies in its Global Competitiveness Index (GCI) – a marginal improvement of one place over the previous two years, but still leading the BRICS economies by a wide margin − well ahead of Russia (53rd), South Africa (56th), Brazil (57th), and India (71st).

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In the view of the World Economic Forum (WEF), more reforms and liberalization are needed in China to improve market efficiency, increase competition and encourage a more optimal allocation of financial resources.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY In its market commentary the report notes that “small gains in most pillars of the GCI contribute to creating a more conducive ecosystem for entrepreneurship and innovation,” citing higher education and training, business sophistication and the technological readiness pillar (which is China’s weakest showing in the GCI) as areas of improvement.

However, the report stresses that problems remain in the critically important financial sector, which is weakened by the relative fragility of the banking industry, and adds that access to loans remains very difficult for a large number of SMEs. It highlights improvements in the functioning of the market (goods market efficiency, up five places at 56th), but warns that “various limiting measures and barriers to entry, along with investment rules, greatly limit competition.” The report also notes that “China is becoming more innovative (32nd), but it is not yet an innovation powerhouse.”

China’s ranking in the Global Competitiveness Index Rank (out of 144)

Score (1–7)

GCI 2014–2015

28

4.9

GCI 2013–2014 (out of 148)

29

4.8

GCI 2012–2013 (out of 144)

29

4.8

GCI 2011–2012 (out of 142)

26

4.9

Basic requirements (40.0%)

28

5.3

Institutions

47

4.2

Infrastructure

46

4.7

Macroeconomic environment

10

6.4

Health and primary education

46

6.1

Efficiency enhancers (50.0%)

30

4.7

Higher education and training

65

4.4

Godds market efficiency

56

4.4

Labour market efficiency

37

4.6

Financial market development

54

4.3

Technological readiness

83

3.5

2

6.9

33

4.1

Market size Innovation and sophistication 10.0%) Business sophistication

43

4.4

Innovation

32

3.9

Stage of development Transition 1–2

1 Factor driven

Transition 2–3

2 Efficiency driven

3 Innovation driven

Institutions 7

Innovation

Infrastructure

6 5

Business sophistication

Macroeconomic environment

4 3 2

Health and primary education

1

Market size

Higher education and training

Technological readiness

Goods market efficiency

Financial market development Labor market efficiency China

Emerging and Developing Asia

Each year, respondents to the Global Competitiveness Report list the most problematic factors for conducting business. A selection of most cited factors over the last three reports shows that access to financing has been consistently ranked top, with corruption being another common concern. Worryingly, the percentage of respondents citing these two factors is increasing, whilst others vary.

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Source: Global Competitiveness Report 2014-2015, World Economic Forum, Switzerland

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Most problematic factors for doing business in China % of responses 0

2

4

6

8

10

12

14

16

18

Access to financing Corruption Tax regulations Inadequate infrastructure Government bureaucracy Inflation Policy instability Tax rates Lack of capacity to innovate

2014–15

2013–14

2012–13

Source: Asset Finance International, based on Global Competitiveness Reports, World Economic Forum, Switzerland

Public sector corruption is an ongoing concern and cannot be ignored. According to Transparency International’s 2014 Corruption Perceptions Index, which ranks countries on how corrupt the public sector is perceived to be, China was ranked in 100th position out of 175 countries. Scores are graded from 0 (highly corrupt) to 100 (very clean), and China scored 36. Unfortunately, this shows no real improvement since 2012, when China ranked 80 out of 176 countries, but with a score of 39.

Business climate

China’s current ranking places it on a par with the regional average (92), but it struggles in comparison with most of what the WB considers ‘comparator economies’ – the US (7), Japan (29) and even Russia (62) − although it remains comfortably ahead of India (142).

Since the last Asset Finance International China survey in 2013, the ease of doing business has only improved to any degree in three WB topics: starting a business (up to 128 from 151), registering property (up to 37 from 44) and resolving insolvency (up to 53 from 82). The chart below shows the full range of topics and where China ranks globally.

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In the 2015 edition of Doing Business, produced by the World Bank (WB), China was ranked overall in 90th place out of a total of 189 countries. The WB’s quantitative indicators concerning regulation give a profile of the business environment and allow useful comparison with other selected economies, as well as against the ‘regional average’ (in China’s case, East Asia & Pacific). The nearer a country is to number one in the ranking, the more conducive the regulatory environment is to operating a business.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY China’s ranking on Doing Business topics

Source: Asset Finance International, based on Doing Business database

Although access to credit is a constant issue, China’s Doing Business ranking is at least better than the regional average (71 compared with 80) and is in fact level with that of Japan. Also, reforms have been instigated: concerning financing, China improved its credit information system by introducing credit information industry regulations, which guarantee the right of borrowers to inspect their data.

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Elsewhere, China has made starting a business easier by eliminating both the minimum capital requirement and the requirement to obtain a capital verification report from an auditing firm.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

The Chinese captive market

By Don Chan and Alan Leesmith

Don Chan

Alan Leesmith

Leasing in China commenced in early 1980 with a joint venture (JV) between Orix and CITIC. Other JVs followed, financing imports of equipment needed by developing low-tech factories in eastern coastal areas. Early JVs were mainly between European or Japanese lessors and Chinese banks. By the early 1990s most had suffered major losses and ceased to operate. As a result, the Government prohibited Chinese banks from investing in leasing.

In mid/late 1990s, captives led the development of today’s leasing industry when AT&T Capital (of which Don Chan was the founding CEO), HPFS, IGF and GE Capital formed leasing operations to support their parent’s equipment sales.

The success of this development can be seen in the construction sector, where the leasing penetration rate in construction machinery went from 0% in 2005 to around 50% by 2013. This surprisingly high penetration rate can be attributed to the fact that since the introduction of construction machinery leasing by Caterpillar in 2005, all construction manufacturers, both foreign and Chinese, have established their own captive arms in order to compete. The Chinese captives are becoming very aggressive, reducing down payments and easing credit underwriting standards. In addition, almost all independent lessors, including foreign-owned ones such as Soc-Gen, UniCredit and Siemens, are also offering construction machinery leasing.

In 2007, Chinese banks were allowed to re-enter the leasing market. Since then, major Chinese banks such as Bank of China, ICBC, China Construction Bank and China Development Bank have formed leasing entities to finance big ticket items like aircraft, vessels, infrastructure projects, subway train networks and power plants.

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As a concession for entry into the World Trade Organization (WTO), China agreed to allow 100% foreign-owned leasing companies.

Around 2004, captives again led the way when Caterpillar Financial Services and GE Capital were the first 100% foreign lessors. Others such as Siemens, DLL, Soc-Gen, Hitachi and Cisco followed.

Car manufacturers like Mercedes-Benz, Volkswagen and GM, established 100%-owned auto finance companies offering loans, but not leases, to customers. Chinese manufacturers, like Sany, a leading construction company, and state-owned enterprises like SinoChem, established leasing entities, mainly financing medical equipment and construction machinery.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY With these changes the leasing market went from US$1 billion annually with 30 lessors, to around US$500 billion with over 2,000 lessors by the end of 2014 (source: China Leasing Alliance Institute of Tianjin Finance Lease). This significant growth considerably increased awareness of leasing in China. Importantly the Premier of China has openly supported China’s leasing industry and its ability to provide alternative financing to SMEs, farmers and export finance. Even with such high growth, the lease penetration rate is still relatively low at less than 10%. Looking at the overall market, the main reasons are following:

• The majority of leases are structured as sale and leaseback without limitation to the remaining economic life of the equipment.

• Although bank lessors accounted for 1.4% of registered leasing

companies, they accounted for 40.6% of annual lease volume, mainly focusing on big ticket, such as aircraft, vessel, power plant, metro etc. Excluding sale and leaseback and large tickets, the lease penetration rate, other than for construction and medical equipment, is less than 5%.

For captives and vendors, key factors currently are:

• Very few Chinese lessors offer formal vendor programs. The basic reason being a lack of real understanding of vendor finance.

• Domestic and bank-owned lessors have more credit appetite,

but they are reluctant to make the investment required to properly conduct vendor business. They only consider financing it on a wholesale approach, with full recourse to vendors.

• Foreign lessors, who do understand vendor programs, can be

reluctant to expand their vendor business due to lack of formal registration, which prevents lessors from perfecting their title on leased equipment. Additionally, they are often constrained by the parent’s high underwriting standards.

• Most foreign lessors, but not all, have been successful, but

are still liable to suffer some delinquencies with the current slowdown.

Looking forward five years, leasing should see healthy development due to the following:

• Rapid increase of new entrants means Chinese lessors

• Compared to performance criteria required of foreign lessors, Chinese lessors can aggressively grow business from the perspective of rates, credit risk and lower down payments.

• Chinese lessors are expanding rapidly in cross-border leasing, supporting export of big ticket capital equipment such as rail, construction, port & logistics, drilling platform, vessel, power plant, etc.

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generally need to identify alternative lease offerings by diversifying away from sale and leaseback in order to improve margin and risk profile.

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• Other than construction and medical sectors, asset classes such as IT, vehicles, agriculture, energy, logistic, etc. are underdeveloped.

• Foreign captives have potential to expand, but many face

country concentration risk as far as parents are concerned.

They could benefit from finding local sources of funding without recourse.

• Chinese captives look to scale up volumes with new classes of assets beyond their parent’s equipment, whereas foreign captives are there to serve only their parent. This limits their comparative growth.

• Increasingly, private equity is interested in investing in the

leasing sector. More importantly, professional managers are attracted to lessors with private equity investors due to the availability of equity compensation packages.

• Chinese captives can more easily find state-owned entities to

support them, but they must diversify, gain scale and spread risk. Construction lessor Sany (established 2004) achieving 50% penetration, found its captive impacting the group balance sheet. The problem was solved by transferring majority captive ownership to a state-owned energy company. They will now diversify into classes of equipment, such as solar power.

In summary, the Chinese leasing industry is highly competitive with many new entrants. The number of lessors grew from 1,000 in 2013 to over 2,000 in 2014. Annual volumes increased from US$340 billion in 2013 to US$500 billion in 2014. Market potential remains significant, especially in asset classes with penetration rates below 5%, (i.e. outside construction and medical). Vendor business is underdeveloped. With the right vendor business model, foreign lessors can cultivate a large pool of vendors both Chinese and foreign.

Don Chan was founder and CEO of AT&T Capital China in the 1990s. He has remained working in China since then, making him one of the longest serving practitioners in the Chinese leasing industry. Don is a Director of IAA-Advisory and along with his fellow directors advises both foreign and Chinese lessors, manufacturers, banks and investors.

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Alan Leesmith, FCA, FCT, is International Director of IAA-Advisory and Secretary General of the Captives Forum in Europe.

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Leaders’ insights Asset Finance International sought the views of industry leaders in the equipment and auto finance and leasing market in China in order to provide a view of the current state of the market, the opportunities and challenges it faces in the near and medium term, and the direction of market trends.

Leasing market performance With regard to the performance of the market over the previous 12 months, there was universal agreement that it had performed better than expected. As detailed earlier in this survey, business volumes grew year-on-year by around 50% in 2014.

Opinion was summed up by David Chen of Société Générale Equipment Finance Greater China, who said: “All indicators show the rapid growth of equipment finance in China, and annual performance is significantly better than expectations, especially during a period when China’s GDP growth rate has slowed to the ‘new normal’ (i.e. 7%).”

Apart from the strong market growth rate, Diwakar Singhal of Genpact was enthusiastic about other positive sentiment, stating: “China has the potential to become the largest leasing market in the world. The last 12−18 months have certainly seen many positive steps taken in that direction.”

David Chen

He pointed to two particular areas. First, leadership support, on which Singhal commented: “Over the years, Chinese policy initiatives for developing the financial leasing industry have been helpful in the development of the leasing sector. Leasing can play a critical role in supporting agricultural development and foreign trade.”

The second area of note for Singhal is the steps to be taken towards clarity of policy. He said: “Legal clarity on interpretations on a range of issues related to disputes over financial leasing contracts needs to be further addressed to create a pro-leasing environment.”

Performance trends The panel of experts was also unanimous in the view that the market will continue to grow in the coming year.

Jeff Chen of Dell Financial Services China predicted that performance will continue to improve, saying: “The shift in China’s economic growth engine from export and investment led to consumption led will be further enhanced by actions taken by the government to reform the financial and other markets. For example, interest rate liberalization

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An important longer-term trend was pointed out by Richard Taylor of Siemens Financial Services (SFS) in China, who remarked on the growth in investment in assets, stating: “China’s leasing industry has grown steadily since 2000, reflecting the growth in the economy and the significant increase in capital expenditure over the last decade.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY and plans to encourage more non-banking financial institutions to enter into the financial service market are the catalyst which will have a positive effect on the market.”

Markus Weinseiss of CIT Asia noted that, by helping manufacturers to quickly increase market share and drive customer retention, leasing “is an optimal bridge between equipment manufacturing industry and finance” and is becoming a more important way of financing, he added: “Bank loans are still hard to obtain despite the central government's push on the banks to increase Markus Weinseiss lending. As a result, leasing has been a welcome alternative source of funding.”

With market growth, awareness of the potential of leasing is growing, although actual uptake is still low, as Weinseiss reported from CIT’s own experience: “We recently conducted a joint study with the Shanghai Leasing Trade Association (STLA) that found that the medical equipment industry in China has seen sales increase to more than CNY188 billion in the past decade. However, only 6% of the local companies surveyed are utilizing financial leasing services, while 72% hope to learn more or use financial leasing services in the future.”

The upside of this, he concluded, is that “there is huge potential for financial leasing services among local Chinese medical device manufacturers.”

David Chen agreed, noting that a slowing down in investment may impact negatively on industry equipment demand. However, he added: “On the other hand, in order to keep the Registered Urban Unemployment Index (an key indicator for central government, the other is CPI) at a reasonable level and thereby avoid social issues, central government is closely monitoring and fine-tuning China’s economic engine proactively – twice there have been reductions in PBOC bench rates and reserve ratios respectively in the last 12 months, demonstrating the government’s desire to take quick action.”

Reduced demand due to the economic slowdown need not affect an increase in leasing, observed Richard Taylor: “Demand for new machinery and equipment in the industrial sector has slowed, reflecting the reduced production requirements. However, with relatively low penetration rates, leasing is continuing to grow in popularity among manufacturers investing in assets to maintain competitiveness, both in the local and global economy.”

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Compared with the slowdown in the Chinese economy, the leasing market grew disproportionately in 2014, but it may prove difficult to maintain such growth levels in the near future. Brendan Gleeson of software solutions and consulting services provider White Clarke Group commented: “The Chinese government is striving to soften the slowdown in order to make sure GDP growth Brendan Gleeson remains healthy over the medium term, and to get everyone used to the ‘new normal’ of that slower rate of growth.

This may well have an adverse effect on investment in the near term.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY For Diwakar Singhal, given the limited penetration of leasing as a product, it should continue to see good growth. He highlighted the outlook for certain sectors such as auto leasing, which is forecast to have double-digit growth rates over the next five years.

He elaborated on this potential for the market, stating: “In general, leasing penetration in China is around 5%, far behind the developed economies in the West, where it stands at around 20−30%, hence overall there is very large room for growth.”

However, the situation for smaller businesses and the difficulty for them to access finance could still pose problems. Singhal concluded: “The key question is how the growth of small- to mid-ticket leases will pan out.”

Corruption crackdown Another development that is likely to have a significant impact on the leasing industry was brought up by Paul Errington of Connaught Finance Investments, namely the crackdown on corruption by the authorities which may, perhaps surprisingly, be a potential brake on growth.

The move was begun three years ago by the President, Xi Jinping. Errington elaborated: “Some 250,000 government cadres have been either arrested or interrogated. These cadres have not only held government positions but also head up some of the largest state-owned enterprises (SOEs) in China. This unprecedented crackdown represents substantial threats to foreign Paul Errington investors, as it disrupts long-standing networks and business relationships when political protection is removed.

“Uncertainty about potential investigations will affect confidence for foreign companies already in China or considering starting operations.

GlaxoSmithKline was fined US$500 million for illegal activity in 2014, with directors given prison sentences.”

He continued: “Poor auditing of SOEs’ assets has weakened some markets and increased the uncertainty for foreign investors. The major sectors that have been affected by the anti-corruption campaign are energy and banking,” and he warned: “The risks must therefore be addressed by all foreign enterprises.”

Following this, the panel was asked to consider the main near- and medium-term challenges that face the equipment and vehicle leasing markets in China.

Don Chan of specialist consultancy IAAAdvisory said that there will be more lessors coming into the market, and although they will introduce new asset classes, “the main challenge will be margin compression, due to intense competition from the many new entrants.”

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Challenges for lessors

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY A medium-term challenge in the opinion of Jeff Chen will be “credit information accessibility”, a point taken up by Markus Weinseiss, who commented: “Overall economic uncertainties make it harder to assess the long-term creditworthiness of customers.”

For Richard Taylor, leasing companies in China continue to be challenged to develop risk assessment processes compared to other parts of the world, due to differences in data sources and data availability. He explained: “As the industry matures, and in line with other parts of the globe, pressure on margins will challenge the industry, in light of increased competition. Players will be challenged accordingly in the future to develop platforms to increase operational effectiveness and improve speed of processes and risk approaches appropriate for the market in order to remain competitive.”

This issue was also highlighted by Diwakar Singhal as part of the challenge faced by all Chinese leasing companies − both domestic and foreign – in building the operational framework to run a leasing business. He expanded on this, saying: “There is a need to invest in building professional skills, capabilities and creating the right ‘endto-end’ operating models. The developing leasing market in China is unique, although with some structural deficits like the limited availability of credit bureau scores. Lessors need to strike a fine balance between aggressively pursuing growth versus credit quality and creating the right operating and technology models – the key question is what lessors should retain and what functions they should manage through professional third party vendors. The answer lies in understanding the difference between ‘core’ and ‘non-core’ parts of the end-to-end leasing life cycle. This can be achieved through a combination of an effective process framework (both originations and servicing), market analytics and selecting the right technology platform.”

In terms of sector challenges, David Chen foresees particular problems for the construction industry over the next 1−2 years. He stated: “With the CNY4 trillion infrastructure stimulation plan introduced in 2008, most construction equipment manufacturers aggressively expanded production capacity and there were lots of newcomers due to the booming market, but there has been an oversupply in construction equipment, including earth-moving equipment, and also mining since 2011. It may take some time to deal with the overcapacity in the local market.”

However, he added that central government initiatives may relieve pressure on the domestic market. He was alluding in particular to the ‘One Belt, One Road’ strategy launched by Chairman Xi and Premier Li in 2014, the basic premise of which is a network of regional infrastructure projects covering overland road and rail routes, oil 24

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White Clarke Group’s Colin Fleischmann was also keen to emphasize the need to have the right platform. He said: “Leasing companies need to put in place systems that not only provide end-to-end credit processing and administration, but which are flexible and adaptable in changing conditions. As the market grows and competition intensifies, especially in the auto sector, there is a great Colin Fleischmann deal of scope for lessors in China to make mistakes with their operating framework.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY and natural gas pipelines, and other infrastructure projects, as well as port and maritime infrastructure projects – all aimed at providing international connectivity and cooperation whilst exporting excess production.

As David Chen said: “Some Chinese manufacturers are already keeping an eye open for overseas market opportunities, following the new ‘One Belt, One Road’ country strategy.”

Portfolio and credit quality Given the tenor of comments about creditworthiness, Asset Finance International asked the panel if they thought that portfolio quality is improving, and likewise the provision of credit information.

The consensus view was rather negative, with Jeff Chen giving a straight response: “No, for both.”

The system has inherent problems, as noted by Don Chan: “The provision of credit information for most Chinese lessors is not transparent, as the delinquency ratio and write-off are not standardized.”

This lack of standardization was picked up

by Diwakar Singhal, who stated: “Credit data continues to be highly fragmented; while big players have compiled their own databases, smaller players are forced to make judgments based on limited information.”

David Chen stressed the need to concentrate on quality as part of adjusting to the ‘new normal’ economic situation: “With the Diwakar Singhal economic slowdown, portfolio quality becomes more a priority for many leasing players,” adding a more positive note from his perspective that “credit information provision is increasing slightly, although some industries could be more serious, such as the construction sector.” He concluded that “more and more leasing companies are trying to adjust their industry focus and relocate their resources accordingly.”

The situation can be improved by forming closer partnerships, according to Richard Taylor: “Working closely with vendor partners will improve access to reliable credit information and therefore allow leasing companies to better evaluate risks and proactively manage their portfolio.”

The arrival of new entrants to the leasing market has been touched on above, and the phenomenal growth in the number of lessors is acknowledged by all. As covered earlier in this survey, the majority of so-called new ‘foreign’ leasing businesses are in fact Chinese companies using their Hong Kong operations as foreign partners, but are there opportunities for genuine foreign lessors to move in?

Opinions varied on this topic, although most agreed that, despite moves from the authorities to lower entry barriers, the increasingly competitive environment will be tough for foreign-owned ventures starting up in China.

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New market entrants

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Markus Weinseiss commented: “There are opportunities for foreign lessors, but the ‘easy money’ is gone. The market is now very competitive and establishing a new leasing company will be a much longer and more costly process.”

The fact that the great majority of leasing companies licensed by MOFCOM are foreign invested was qualified by David Chen, who observed that “frankly speaking, around a third of them may not be really active after establishment.”

In his opinion, there is potential for those with the right credentials: “Considering the huge market, the shortage of financing and more customers accepting leasing, there is definitely a good opportunity for foreign lessors that have deep know-how, a mature business model and sufficient funding resources to explore the local equipment and asset finance market.”

He added: “Foreign invested leasing companies should also study the local market carefully to understand it fully, and then ‘localize’ accordingly − by establishing the appropriate organization, finance offer, credit policy, operational process and risk sharing mechanism, etc − in order to adapt to China’s market before entering into it.

Otherwise, they may pay a ‘tuition fee’ by suffering losses if they purely duplicate their Western model into China.”

Richard Taylor pointed to measures by Chinese regulatory authorities to tighten legislation and policies governing the leasing market, but stated: “Foreign lessors with a strong brand can offer reassurance and stability to customers, which can be the foundation for developing opportunities in the Chinese market. SFS in China has worked hard to focus on delivering excellent customer service by ensuring close proximity Richard Taylor to its customer base. It is vital that foreign lessors understand local market dimensions and the importance of local proximity.”

Diwakar Singhal agreed about the value of government measures: “Positive regulatory moves to promote the industry, along with the fast growing market, will continue to make the Chinese market an attractive leasing destination and this will attract new players, both domestic and foreign.”

From a specialist viewpoint, Jeff Chen of Dell stated: “Although greater competition is expected from local lessors, foreign lessors with rich industry experience still have a competitive advantage,” adding: “For example, while everyone loves large deals, these tend to be made at the expense of sacrificing margins. Lessors with a good IT system infrastructure and business flow will benefit as they can make quick decisions on transaction deals which have a higher margin rate. I believe foreign lessors will have an advantage here because they can leverage their profound experience and well-designed system infrastructure currently being used in the developed countries.”

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He referred to government programmes such as the ‘One Belt, One Road’ framework which, he said, “is expected to provide Chinese manufacturers with equipment export opportunities and expand the global market, which will require the expertise and experience of lessors with a track record in international asset financing.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Opportunities for captives The discussion moved on to the opportunities for manufacturers’ captive finance operations, and whether this helps small and mediumsized enterprises (SMEs). Don Chan of IAA-Advisory has provided his views in the special article ‘The Chinese captive market’ earlier in this survey, and here he summed up the generally positive view, saying: “Captive finance operations in China have performed relatively well, especially in helping small and medium-sized businesses.”

Connaught Finance’s Paul Errington agreed, stating: “More captives are emerging as the general awareness of equipment leasing increases and foreign-owned suppliers with overseas success in captive finance enter the market.”

Richard Taylor of SFS described the current state of the market: “Asset finance is now well accepted in China and manufacturers are aware of the benefits of having a leasing capability that can be a value-adding differentiator in the market. At the same time, government policy in China has supported the growth in the leasing market, which has resulted in many manufacturers establishing their own asset finance capabilities. This will increase choice for those SMEs seeking asset finance, though obtaining credit for some SMEs will continue to be a challenge.”

There is certainly a need to help SMEs more, as the market has tended to concentrate on big ticket finance, as described by David Chen of SGEF: “Lots of leasing companies prefer big ticket deals such as aircraft, shipping, infrastructure and big project financing; however, for most manufacturers, promoting sales by satisfying their SMEs’ or microbusiness clients’ needs is not being covered in the financing market currently. So captive leasing could be one of the options for companies focusing on SME business.”

Of course, the prominent sector in which original equipment manufacturer (OEM) captives play a large part is the vehicle market, as outlined by Genpact’s Diwakar Singhal. He described a buoyant sector: “The auto sector, driven by OEM captives, will lead the advance of the small ticket leasing industry in China. All of the major auto players have a captive presence in China already and they are improving their operational efficiencies by bringing in international best practices.”

He continued: “China is the manufacturing hub of the world. Chinese OEMs now see the advantage of launching financial/operating leasing options through their captive financing arms to drive product sales, in both international and domestic markets. Some key OEMs already have captive finance arms, which play a predominant role in pushing their international presence. This trend is here to stay and will create further traction in SME leasing.”

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Jeff Chen

The value of captive finance depends on the industry, as pointed out by Jeff Chen, who noted that “for industries with less independent lessor focus, manufacturers’ captives can play a more important role in designing a tailored leasing solution and better residual value position.” However, in his view, “manufacturers’ captives focus on strategic deals and they do not help SMEs too much because their credit information is even harder to access.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Market forecasts Asset Finance International next asked the panel which asset finance sectors offer the best future prospects.

The most frequently cited area of expansion was infrastructure, although the degree to which this continuing boom will affect other sectors such as construction equipment and trucks was disputed.

Agricultural equipment, IT, healthcare, and renewables were also on most lists.

CIT’s Markus Weinseiss stated: “Infrastructure projects are strong prospects for future leasing demand − everything from power plants to roads and airports,” adding that “renewable energy is also a big business and leasing will play an important role in it.”

Better prospects for leasing should lie in sectors where penetration rates are currently low, suggested Don Chan, who explained: “The penetration rates in construction machinery and medical equipment are high at over 50%. New sectors like agricultural machinery, IT equipment and passenger vehicles will have the best future prospects, as the leasing penetration in these sectors is below 5%.”

In Paul Errington’s opinion, “infrastructure will continue to grow, although at a slower pace. Manufacturing similarly will grow to feed the domestic market, but cheaper labour in Vietnam, Cambodia and the Philippines is seeing some international companies move their plants out of China. IT will grow substantially, as the bulk of equipment finance currently is in yellow goods, construction and large mining equipment.

IT finance has never reached the levels of finance that we see in developed markets such as US, Australia and Europe.”

Renewable energy Looking more specifically at the prospects for the renewable energy sector, opinions were sought on the importance of combatting China’s very evident pollution problem and the need to reduce carbon emissions.

As alluded to above, this should increase opportunities in the renewable energy equipment leasing sector such as solar/photovoltaic (PV) and wind, but there will inevitably be hindrances.

White Clarke Group’s Brendan Gleeson commented on the pressure on government, saying: “The importance of renewable energy is recognized by the authorities, as in the first quarter of 2015, 5GW of solar panels were installed, which is equivalent to all the solar installations in France, and China plans to install 20GW this year. There are obviously great opportunities for green power, but at the same time you can’t ignore the fact that there are 26 nuclear power stations already in operation and a further 24 plants under construction.”

The problem lies with government itself, as more than one of the panel of experts doubted the enthusiasm for policing the commitment to reduce pollution. However, Diwakar Singhal was optimistic, stating: 28

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As Don Chan noted, “Chinese lessors are playing an important role in providing lease finance for renewable energy equipment, especially in wind.” However, he added: “The return for renewable operators is low. As a result, Chinese lessors are very cautious in providing lease financing, especially to private operators.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY “China’s 12th five-year plan includes ambitious goals to lower air pollution, reduce reliance on fossil fuels and significantly expand the use of renewable energy, especially solar and wind.”

He pointed out: “There is absolutely a tremendous opportunity for renewable energy leasing in China, due to two factors. First, there are adequate initiatives being driven by the government to enable renewable energy growth; and second, China happens to be the manufacturing hub of some of the largest solar PV manufacturers of the world. There is immediate potential for leasing equipment in the larger ticket size deals and commercial ventures.”

Others voiced some caution. Richard Taylor observed: “Tackling air pollution is a top priority for the Chinese government. So the need and appetite for renewable energy is growing quickly.” However, he added: “There are signs that this market has peaked in China, so it is important for leasing companies to carefully assess the opportunities as the market undergoes a period of restructuring.”

And Markus Weinseiss stated: “The Chinese government is focused on combating pollution and reducing carbon emissions and there should be substantial opportunities in the future. However, the leasing product for very large projects is quite risky and the lessor needs to assess a substantial number of factors very carefully.”

Government incentives In economies with developing leasing markets, one can expect there to be incentives from government for lessors to invest. How effective have Chinese government initiatives been for foreign lessors, and also for Chinese financial institutions to expand overseas?

In a country and economy as exceptional as China, moves by the authorities might be expected to be restricting; however, the panel’s response was overwhelmingly positive.

David Chen began by saying that “China’s government keeps a positive view and encourages investors in the local leasing market.

The thresholds, including registered capital and authorization levels, have been lowered, which will improve the efficiency of the relevant investment accordingly.”

Don Chan agreed, adding: “The Chinese government has played a major role in the development of the leasing industry by reducing regulation, especially in the area of licensing.” He also noted the promotion of international development, stating: “The Premier of China has encouraged Chinese lessors to provide cross-border leasing to support the export of large tickets such as ships, power plant, rail, construction machinery and renewable energy equipment.”

As Richard Taylor observed, a particular innovation has been the development of free trade zones (FTZs), where lessors can benefit from tax reductions. He also made the point that “MOFCOM, one of the key regulators of China’s leasing industry, has issued various favourable regulations to foster the development of the industry.”

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He continued: “Meanwhile, with the increasing internationalization of the yuan and the ‘One Belt, One Road’ strategy, Chinese financial institutions won’t slow down their pace on exploring overseas markets.”

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Leasing regulation Finally, Asset Finance International raised the issue of the effect of national and local legislation and regulation on leasing operations, and whether these can be improved upon.

The overall view was that some things are moving in the right direction, but many problems still exist. There are anomalies, as illustrated by Paul Errington, who said: “The opportunity for sale and leasebacks is greatly restricted, as a substantial amount of equipment that is imported attracts tax relief such as no VAT, but if subsequently a user decides to arrange a sale and leaseback, then 17% VAT must be paid.

Improvements in this area would have a massive positive impact on the levels of equipment finance.”

Don Chan commented: “The major obstacles facing lessors are the ability to file a registration on the leased assets to protect the title, and for many asset classes such as construction machinery, trucks, medical equipment and agricultural equipment, the title of the leased assets must be registered under the lessee’s name. As a result, the ability to repossess the leased assets and claim against third party buyers is difficult to enforce.”

He added: “Despite the China leasing industry lobbying hard for an improvement in these areas, there is no immediate solution to mitigate these risks. This is one of the major reasons preventing foreign lessors from aggressively expanding into China with a solution to protect the leased assets.”

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A hopeful outlook was promoted by White Clarke Group’s Colin Fleischmann, who suggested that “with more investors and especially state-owned capital coming into the market, and with leasing becoming increasingly visible in its contribution to GDP, regulatory and legislative improvements will surely follow.”

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Taxation update on leasing in China

By Lachlan Wolfers and Simon Liu, Partners, and Conrad Turley, Senior Manager, KPMG in China This article considers, in the context of the current rapid expansion of asset leasing in China, how China’s direct and indirect taxation regimes are evolving in line with this growth.

Direct taxes The Chinese Corporate Income Tax (CIT) regime and allied incentives continue to favour, in many instances, the use of a Chinese domestic leasing vehicle over cross-border leasing into China. This is a function of both (i) the fact that leasing payments made from China to foreign lessors will be subject to CIT on a ‘gross’ basis, with the full revenue stream being subject to withholding tax (WHT), as opposed to the ‘net’ basis CIT for local Chinese entities which taxes the residual profit arising; and (ii) the possibility for Chinese leasing vehicles to obtaining certain supporting financial subsidies, such as those offered in the Free Trade Zones (FTZ).

Cross-border leases Cross-border lease rentals are subject to WHT under domestic law at the rate of 10%, with the tax base being the full rental payment for those characterized, in the lessee’s accounts under Chinese accounting principles, as operating leases and the interest element of the lease rentals for those characterized as finance leases.

Since 2010, access to DTA relief has been contingent on the Chinese local tax authorities getting comfortable with the ‘commercial substance’ at the level of the lessor entity (in terms of staff, premises and business operations) prior to granting relief pre-approval.

However, the upcoming move to a new PRC DTA relief system, where no tax authority pre-approval is required, may see improvements in access to relief.

The tax efficiency of such cross-border lease arrangements can be enhanced by the low level of tax imposed in the favoured overseas lessor jurisdictions. This may be at much lower rates than the 25% Chinese CIT rate imposed on leasing income of Chinese domestic entities, while the Chinese lessee can claim tax deductions at the 25% rate.

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The WHT can be reduced to lower levels under double tax agreements (DTA) between the lessor jurisdiction and China, with the WHT on operating lease rentals typically dealt with under the royalties article of DTAs. For example, a 6% royalties WHT rate applies under the DTAs with Ireland and Singapore, popular locations for aircraft leasing into China. A 5% royalties WHT rate applies under the new protocol to the Hong Kong DTA (signed April 2015), meaning that Hong Kong stands to become a very attractive lessor location, if certain Hong Kong domestic law tax changes can be put into effect. The Hong Kong DTA also offers the most attractive interest WHT rate amongst China’s DTAs (relevant if the lease is treated as a finance lease) at 7%.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Domestic leases Domestic leasing does not provide the possibilities that cross-border leasing does for benefiting from lower effective CIT rates in other jurisdictions, but certain features of the CIT rules for domestic leasing entities, and financial subsidies, can offer superior tax treatment to domestic lessors.

For a domestic lessor the tax basis for CIT at 25% is (i) in the case of an operating lease the full lease rental less tax depreciation on the equipment and (ii) for finance leases (including typical sale and leaseback arrangements) the accounts-basis financing return. For finance leases it is the lessee who can claim the tax depreciation.

Under basic tax rules either the operating lessor or the finance lessee will avail of the tax depreciation rates as follows: aircraft, trains, ships, machinery − 10 years; tools, utilities, furniture − 5 years; other transport − 4 years; electronic devices − 3 years.

SAT Circular 75 [2014] introduced further accelerated depreciation allowances (60% of the timeframes above) for enterprises in six key industries (including the pharmaceutical and IT industries, and transport, telecoms, electronics and instruments manufacturing) as well as straight expensing of R&D-related equipment. Some of the best growth prospects for the leasing industry are seen to be in these industries. However, the nature of this relief is such that it would exclude operating leases (the favoured approach for many smallticket items). As the Circular 75 benefits should be available to lessees under finance leases, the new rules may favour finance leasing over operating leases.

Use of the FTZs is another key factor in domestic leasing. Financial subsidies can be provided to lessors based in the FTZs up to the amount of CIT revenue allocated to the regional government (as opposed to the central government) and these can return some of the CIT levied on the profits of the lessor, as well as the WHT levied on the lessor’s outbound payments from China. An important consideration, though, is that if an FTZ-based lessor must set up branches in its market locations within China for regulatory reasons (e.g. in car leasing for local car registration) then some profit must be attributed to these separate tax jurisdictions and subsidies will not be available for the CIT on these profits.

Cross-border and domestic leasing in comparison

On the WHT front, as Chinese lessees have progressively become more resistant to lessors ‘grossing up’ rentals for WHT, the WHT has become a real cost for lessors. Whether WHT at 5/6/10% is a greater burden than the 25% CIT on net income for domestic lessors is a function of the leasing margins, and in some instances the WHT burden may be relatively lighter. However, a tough tax authority approach to policing DTA relief claims can lead to the 10% rate applying and so tax leakages may be at the higher end.

The new Circular 75 depreciation policy may also disadvantage crossborder lessors to the extent that they may need to use operating leases to access tax benefits in their own jurisdictions.

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Leasing cross-border into China faces a number of disadvantages relative to domestic leasing.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY This being said, there has been a ‘stop-start-stop’ national initiative to phase out local tax incentives which are not aligned with national tax policies and so caution is required if a foreign enterprise is to set up a local leasing entity to access the local incentives. The capital requirements to access such incentives may also be large.

Ultimately, CIT preference for a foreign or local leasing vehicle will turn on the nature of the lease (operating/finance), the nature of the leased property and the industry of the lessee, the sustainability of DTA relief claims, as well as the tenability of local financial incentives.

Indirect taxes The Chinese government has recently replaced Business Tax (BT) with a Value Added Tax (VAT) for asset leasing activities. This is part of a broader nationwide reform which is designed to have VAT apply in place of BT for all sectors of the economy by the end of 2015.

During 2012 and 2013, the VAT policies affecting asset leasing were in a state of flux. However, things have settled down somewhat following the release of Circular Caishui [2013] 106. In this article we outline the key VAT policies currently applicable to asset leasing activities:

• The VAT rate for asset leasing is 17% − this applies whether the asset is subject to a finance lease or an operating lease;

• In calculating its VAT liability, the lessor under a finance lease

may be entitled to apply the ‘net basis’ method, which means it can deduct from its gross revenue the purchase price of the equipment, bond interest expenses and vehicle purchase taxes (but not Customs duty and consumption taxes payable on importation). However, this policy only applies if the registered capital of the leasing company in China is CNY170 million or more.

• The effect of the ‘net basis’ method applicable to finance leases is, broadly speaking, that VAT applies to interest income only – this aligns more with the economic substance of finance leasing transactions;

• The previous VAT ‘levy first and refund later’ policy, which meant

that VAT was initially levied at the rate of 17% and then refunded if the effective tax burden exceeded 3%, is to be phased out for the finance leasing industry by the end of 2015.

It is important to note that the scope of VAT is expected to be expanded by the end of 2015 to financial services activities generally, with a VAT rate of 6% expected to be introduced shortly. China will be amongst the first countries in the world to apply VAT to financial services broadly, including interest income. However, it is similarly proposed that for a “temporary period” the borrower will not be eligible to claim an input VAT credit for its interest expense, even if it is a general VAT taxpayer.

The inclusion of financial services within the VAT net, including its proposed application to interest income, raises a potential policy mismatch which will need to be addressed. That is, with finance leases subject to VAT at 17%, but interest income expected to be subject to VAT at the lower rate of 6% (albeit not creditable to the lessee), 33

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Future changes

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY a policy realignment may need to occur. Otherwise, there will be a clear incentive to engage in one form of financing arrangement over another, depending on the VAT status of the lessee. For example:

• For B2C transactions, an asset mortgage may be preferred

because the ‘real’ VAT cost is 6% rather than 17% under a finance lease;

• For B2B transactions, a finance lease may be preferred even

though the VAT rate is higher at 17%, because the VAT should be creditable to the borrower.

It is understood that the VAT rate applicable to the interest component under a finance lease may be reduced to 6% once the VAT reforms for the financial services sector are implemented. Furthermore, in the longer-term it is understood that the policymakers are aiming to shift from a multiple rate VAT system to a single rate VAT system.

Foreign v domestic lessors As always, in China the devil often lies in the implementation detail. By way of example, the effect of the above policies is that foreign lessors will generally be unable to apply the ‘net basis’ method set out above on the grounds that they will not have registered capital (in China) of CNY170 million or more. This means that the VAT applies to both the principal and interest payments due under the lease.

Furthermore, for foreign lessors the VAT is collected on a ‘withholding basis’, which means they need to be aware of the Chinese VAT position and ensure they gross up for withholding VAT purposes – otherwise, they will be out of pocket. Foreign lessors also cannot access the VAT ‘levy first and refund later’ policy, though this is of limited duration now even for domestic lessors.

A further example of implementation issues we have encountered concerns whether local branches can access the ‘net basis’ method where the registered capital of the lessor entity exceeds the CNY170 million threshold, but not that of the branch individually. This view accords with notices issued by both the Shanghai and Beijing State Tax Bureaus and as such, these preferential policies can sometimes be difficult to access even for local branches.

Other indirect tax changes affecting aircraft leasing

From a VAT perspective, the previous 4% VAT liability payable on importation of aircraft exceeding 25 tons has been replaced with a 5% VAT liability, in accordance with Circular Caiguanshui [2013] 53.

Importantly though, the VAT should be creditable to the domestic lessee, provided it is the importer of record.

However, from a Customs perspective, at the same time as Circular Caiguanshui [2013] 53 was issued, Notice 31 was promulgated by the State Council Tariff Commission. Notice 31 provides that the previous 1% import duty rate has been abolished and replaced by a 5% duty rate. The 5% import duty rate applies to certain passenger and cargo 34

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A further point to consider, especially in the context of aircraft leasing, is that the VAT in respect of the asset lease operates in addition to, and not a substitute for, the VAT and Customs duties on the importation of the aircraft. In other words, effective double taxation.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY aircraft, depending on the Customs HS code of the aircraft. The import duty is payable in instalments to Customs, effectively as and when the rental is due under the lease.

The net effect of these changes in many cases is to preserve a ‘real’ 5% cost on importing aircraft (being the Customs duty payable), while the VAT is typically a cashflow burden only.

Lachlan Wolfers Partner, KPMG (HKSAR) lachlan.wolfers@kpmg.com

Simon Liu Partner, KPMG (Beijing) simon.liu@kpmg.com

Conrad Turley Senior Manager, KPMG (Beijing)

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conrad.turley@kpmg.com

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

Accounting for leases in China Joh Sim Khuang of LehmanBrown details the different accounting treatments of leases

Classification of leases A lessee and a lessor shall classify a lease as a finance lease or an operating lease on the lease beginning date.

• The term ‘finance lease’ refers to a lease that has transferred

in substance all the risks and rewards related to the ownership of an asset. The ownership of it may or may not eventually be transferred.

Where a lease satisfies one or more of the following criteria, it is recognized as a finance lease: (1) The ownership of the leased asset is transferred to the lessee when the term of lease expires; (2) The lessee has the option to buy the leased asset at a price which is expected to be far lower than the fair value of the leased asset at the date when the option becomes exercisable. Thus, on the lease beginning date, it can be reasonably determined that the option will be exercised; (3) Even if the ownership of the asset is not transferred, the lease term covers the major part of the use life of the leased asset; (4) In the case of the lessee, the present value of the minimum lease payments on the lease beginning date amounts to substantially all of the fair value of the leased asset on the lease beginning date; in the case of the lessor, the present value of the minimum lease receipts on the lease beginning date amounts to substantially all of the fair value of the leased asset on the lease beginning date; and (5) The leased assets are of a specialized nature that only the lessee can use them without making major modifications.

• The term ‘operating lease’ refers to a lease other than a finance lease.

Accounting treatments of lessees in finance leases 1. On the lease beginning date, a lessee records the leased asset at the lower of the fair value and the present value of the minimum lease payments, recognizes the amount of the minimum lease payments as long-term account payable, and treats the balance between the recorded amount of the leased asset and the longterm account payable as unrecognized financing charges.

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Joh Sim Khuang

In China Accounting Standards (CAS) No. 21 Leases, the classification, accounting and presentation in financial statements for leases have been specified in detail. In general, a lease with which the risks and rewards of the assets have been transferred in substance would be classified as a finance lease, otherwise would be classified as an operating lease. The details of CAS 21 are illustrated below.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY

The initial direct costs incurred, such as commissions, attorney’s fees, travelling expenses and stamp duties that are directly attributable to the process of lease negotiating and signing the leasing agreement are recorded in the asset value of the current period.

The lease beginning date refers to the date on which the lessee begins to have the right to use the leased asset.

2. When a lessee calculates the present value of the minimum lease payments, if it can obtain the lessor’s interest rate implicit in the lease, it adopts the interest rate implicit in the lease as the discount rate. Otherwise, it adopts the interest rate provided in the lease agreement as the discount rate. In case the lessee cannot obtain the lessor’s interest rate implicit in the lease and no interest rate is provided in the lease agreement, the lessee adopts the borrowing interest rate of the bank for the same period as the discount rate.

3. The expression “interest rate implicit in the lease” refers to the discount rate that, on the lease beginning date, makes the aggregate present value of the minimum lease payments and the unguaranteed residual values equal to the sum of the fair value of the leased asset and the initial direct costs of the lessor.

4. The term “guaranteed residue value” refers to, in the case of a lessee, the residual value of the asset which is guaranteed by the lessee or by a third party related to the lessee; and in the case of a lessor, the guaranteed residual value from the standpoint of the lessee plus the residual value of the asset which is guaranteed by a third party independent from both the lessor and the lessee.

The term “residual value of the asset” refers to the fair value of the leased asset when the term of lease expires as estimated on the lease beginning date. The term “unguaranteed residue value” refers to the residual value of the leased asset minus the guaranteed residual value of the lessor.

6. In calculating the depreciation of a leased asset, the lessee should adopt a depreciation policy for leased assets consistent with that for depreciable assets which are owned by the lessee. If it is reasonable to be certain that the lessee will obtain the ownership of the leased asset when the lease term expires, the leased asset should be fully depreciated over its useful life. If it is not reasonable to be certain that the lessee will obtain the ownership of the leased asset at the expiry of the lease term, the leased asset should be fully depreciated over the shorter one of the lease term or its useful life.

7. Contingent rents are recognized as an expense in the period in which they are actually incurred.

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5. The unrecognized financing charge is amortized to each period during the lease term. The lessee adopts the effective interest rate method to calculate and recognize the financing charge in the current period.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY Accounting treatments of lessors in finance leases 1. On the beginning date of the lease term, a lessor recognizes the sum of the minimum lease receipts on the lease beginning date and the initial direct costs as the entering value in an account of the finance lease values receivable, and records the unguaranteed residual value at the same time. The balance between the sums of the minimum lease receipts, the initial direct costs and the unguaranteed residual value, and the sum of their present values are recognized as unrealized financing income.

2. The unrealized financing income is allocated to each period during the lease term. The lessor calculates the financing income at the current period by adopting the effective interest rate method.

3. The lessor shall, at least at the end of each year, re-examine the unguaranteed residual values. No adjustment may be made if the unguaranteed residual value increases. Where there is evidence showing a reduction in the unguaranteed residual value, the interest rate implicit in the lease is recalculated and the associated reduction of the net investment in the lease is recognized as a loss for the current period. The financing incomes for subsequent periods are recognized on the basis of the revised net investment in the lease and the recalculated implicit interest rate. The net investment in the lease is the difference between the sum of the minimum lease receipts and the unguaranteed residual value in a finance lease and unrealized financing incomes. Where the unguaranteed residual value for which a loss has been recognized previously is subsequently recovered, the reversal of the loss is limited to the amount of the loss recognized, and the interest rate implicit in the lease is recalculated. The financing incomes for subsequent periods are determined based on the revised net investment in the lease and the re-calculated implicit interest rate.

4. Contingent rents are recorded into the profits and losses of the period in which they actually arise.

Accounting treatments of lessees in operating leases 1. The rents from operating leases are recorded by the lessee in the relevant asset costs or the profits and losses of the current period by using the straight-line method over each period of the lease term, unless there are other more reasonable methods.

2. The initial direct costs incurred by a lessee are recognized as the profits and losses of the current period.

Accounting treatments of lessors in operating leases 1. The lessor includes the assets subject to operating leases in relevant items of its balance sheets in light of the nature of the asset.

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3. The contingent rents are recorded into the profits and losses of the current period in which they actually arise.

CHINA ASSET AND AUTO FINANCE COUNTRY SURVEY 2. The rents from operating leases are recorded in the profits and losses of the current period by using the straight-line method over each period of the lease term, unless there are other more reasonable methods.

3. The initial direct costs incurred to a lessor are recorded into the profits and losses of the current period.

4. As for the fixed assets subject to operating leases, the lessor calculates the depreciation of it by adopting depreciation policy for similar assets. As for other leased assets, systematic and reasonable methods should be adopted for its amortization.

5. The contingent rents are recorded in the profits and losses of the period in which they actually arise.

Joh Sim Khuang Partner LehmanBrown International Accountants, Beijing, China Tel: +86 10 85321720 Email: jksim@lehmanbrown.com

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