roject finance, as a means to finance large infrastructure projects, generated a fair amount of interest in the People's Republic of China about a decade ago. The economy was booming and there was a widespread step that supply, particularly for utilities, transportation systems, telecoms and other infrastructure capacity, would fall short of demand by a large margin. At the same time, the government, which had been the main provider of the country's infrastructure, was short of resources to finance the construction of new infrastructure projects.

The concept of project finance, which, with all its promises of recourse by lenders limited to project assets, bankruptcy-remoteness and off-balance sheet benefits, immediately caught the imagination of the community of project sponsors, bankers and the various government agencies as a solution for the shortages. For example, almost every major investment bank and law firm in Hong Kong had a team of professionals dedicated to project finance in China and all the major international independent power developers were represented in the region. During this rash of activity, seminars and conferences on project finance were held frequently throughout China, various Chinese government agencies issued special regulations on project finance, and a few projects were actually structured and started in China with limited recourse financing.

Then, with the advent of the Asian financial crisis in 1997, project finance disappeared in China as quickly as it had appeared. First to go were the foreign investors, as countries in the region became frightened of foreign debt, which was widely seen as the cause of their financial difficulties. Chinese banks and non-bank financial institutions fared no better; since as bad debts mounted they were under siege and retreated in droves from risky and complex transactions. As a result, few projects were financed on a project finance or limited recourse basis. Even today, the consequences of the boom-bust cycle in project finance are still palpable in many parts of the country.

Apart from the financial difficulties that dampened the enthusiasm for limited recourse financing, at least two other factors explain the dearth of project finance projects in China. Firstly, project finance was perceived as more complex than other means of finance, with the attendant consequence of higher transactional costs and a longer time to conclusion. The second factor involved a legal issue: The legacy of state ownership of the country's economy sometimes made it difficult, conceptually and legally, to isolate assets and cash flows of a project from the hands of the government or semi-governmental corporations. At the same time, the law did not allow creditors to take over failed projects and repossess project assets on their own without the intervention of the Chinese court. Both contributed to the undoing of project finance in China.

Recently, however, there seems to be a renewed interest in project finance in China and a few projects have been, or plan to be, financed on a limited recourse basis. For example, the summer of 2002 saw the successful conclusion of a limited recourse financing of a 2 x 330 MW coal fired power project in Huangshi, Hubei Province, the first of its kind in many years. The project itself was a survivor of the vicissitudes of project finance in China: It was started eight years ago by a consortium of Chinese and foreign sponsors, and was to be financed with loans from a syndicate of Chinese and foreign banks. As foreign lenders retreated while the economic woes of the region grew, the project was left in limbo. It was not until 2000 that the project was resurrected when China Development Bank agreed to be the sole lender of approximately $300 million to the project company.

No sooner did Huangshi come to a successful conclusion than a number of other projects in different parts of China planned to raise financing on a limited recourse basis. These projects include water treatment, a container port, petrochemical manufacturing facilities and a nuclear power plant. Once again, the concept and virtues of project finance are being discussed and practised. A brief analysis of the forces behind the renaissance is in order.

Firstly, demand is strong. China's economy continues to expand at a higher rate than most in the world, pushing to the limit the capacity of some of the existing infrastructure. For example, Hubei Province experienced severe power shortages in the summer of 2002 while the financing of the Huangshi power project was being assembled. Hubei was not alone, and neither was the shortage confined to the power sector. The deficiency of infrastructure, which contributed to the boom of project financings a decade ago, seems to be at work again to encourage innovative means to finance new infrastructure projects and may give a new impetus to project finance in China.

Secondly, competition now forces Chinese banks to look more favorably at limited recourse financing. Chinese banks are flush with cash today and are looking for projects to finance, a stark contrast to the state of affairs a decade ago, but they are lending more carefully than before in order to improve the quality of their loan portfolios, as a result of tighter regulatory control and more competition from other Chinese and foreign banks. As a result, there is often more cash available than creditworthy projects. This gives borrowers with robust cash flows unprecedented bargaining power to force banks to accept limited recourse projects with security restricted to the assets of the project company, without any support from either the parent of the project company or any other third party. Until recently, banks in China would generally shy away from projects without such support.

Thirdly, the benefits of off-balance sheet financing have become widely appreciated by both project sponsors and lenders alike. In the past, when state ownership was prevalent and the isolation of assets and cash flows difficult, the parties involved in a project would often use the balance sheet of a project sponsor, invariably a large state-owned company, to buttress the creditworthiness of the project. Guarantees of projects' debts were the preferred means of support. After years of economic reforms, credit support of this kind is no longer as forthcoming as before. Sponsors are reluctant to provide guarantees as the state of their own creditworthiness is at stake. At the same time, new laws and regulations have been passed over the past 10 years that restrict the amount of debt, including contingent liabilities, that a company may incur. Government agencies (with few exceptions) may not issue guaranties, neither may companies with higher than legally permitted debt-to-equity ratios. All of these factors seem to have rekindled the interest of project participants in examining the feasibility of off-balance sheet projects and the pros and cons of limited recourse financing.

Fourthly, legal remedies to lenders have been tried and proven available and, as a result, lenders have become more comfortable in enforcing security interests set in place to secure the repayment of their loans. Indeed, since the Asian financial crisis which also saw the collapse of several major Chinese non-bank financial institutions (e.g., GITIC), Chinese banks have been resorting to Chinese courts regularly to establish their claims, repossess secured assets and otherwise enforce their rights against various borrowers and other debtors. Their success and experience with Chinese judicial remedies have given Chinese banks a new level of confidence in lending to limited recourse projects.

Of course, project finance is not all roses in China. There are still a number of major issues that need to be resolved before project finance can truly establish itself in China. Again, the first is a legal issue. As mentioned above, under the current Chinese legal regime, lenders may not repossess project assets over which they have established a security interest without the intervention of a Chinese court, even when the debtors do not contest the repossession. According to China's Guaranty Law, parties may not agree in their guaranty agreements to the effect that lenders could directly repossess the borrowers' assets. Instead, they are required to negotiate, post default, the value and the methods of disposition of the assets. Lenders may resort to the court for relief only after the parties have failed to reach an agreement as to the value and disposition of the assets. This requirement is likely to add complexity and uncertainty, eroding the lenders' confidence in the protection of their rights in the event of borrowers' default.

In addition, certain sectors of the country's economy are off limits to foreign investors or require that Chinese equity interests in certain types of projects constitute the controlling interest. Although China has lifted many of such restrictions over the past 10 years, particularly in the run-up to its accession to the World Trade Organization, the remaining restrictions need to be examined carefully to ascertain if they prohibit lenders, particularly foreign lenders, from enforcing their security interests, including taking over failed projects.

Recent reform of China's power sector may also add some uncertainty in the project financing of power plants. At core of the process is the competitive pricing of electricity to be wheeled through the regional or national grids. The traditional take-or-pay power purchase agreement, which has been the cornerstone of limited recourse financing for power projects, is at odds with the reform effort. Indeed, when the financing of the Huangshi power project concluded last summer, observers were predicting that it might be the last of its kind featuring a take-or-pay power purchase agreement. Although it is still premature to assess the extent to which power project financing will be affected by the pricing reform, some changes to the traditional take-or-pay agreement are called for in order to comply with the reform requirement and to ensure the bankability of a project.

With a few exceptions, foreign banks have been absent from the recent project finance activities in China. Because foreign banks provide not only cash to the projects, but also the expertise and legal discipline necessary to make the projects successful, their active participation is very much needed to make the project finance market in China mature and attractive. In this connection, the pressure of using Chinese law as the governing law for the financing documents may also add to the anxieties of foreign lenders. As mentioned above, Chinese banks have abundant funds to lend, in Renminbi (the official Chinese currency) or in foreign currencies. One of the corollaries of this phenomenon is that Chinese banks are likely to insist that Chinese law be the governing law for the financing documents, particularly when, as often is the case today, the Chinese banks constitute the majority in terms of the amount lent to a project. For various reasons, foreign banks have seldom agreed in the past to be governed by Chinese law even when they lend through a syndicate of Chinese and foreign banks.

Similarly, Chinese construction companies have also gained some inroads into the project finance area, helped in part by the ascendancy of the Chinese banks, but the quality and reliability of many of them are still unknown to many international lenders and equity investors. It is uncertain whether their participation, particularly if they are responsible for a turnkey project, would dampen the interest of foreign lenders and developers in participating in project finance in China. Recent and future financings should provide a wealth of experience and a few answers to these questions.