When the C2C Asian submarine cable project was financed at the beginning of the year, the buzz in the international market was largely over Industrial and Commercial Bank of China (ICBC)'s involvement in the deal. What caught the attention of other project bankers was not so much the size of ICBC's loan (substantial though it was) but rather the speed at which the bank acted. ?It seemed to take them only a matter of days from when the information memorandum arrived on their desk to agree to a loan. They signed up just like that,? says a banker in Singapore.

Behind the eagerness of ICBC and the other big Chinese banks to participate in project finance deals outside of the People's Republic of China (PRC) lies high foreign currency liquidity and the replacement of policy-driven lending guidelines with market-oriented lending practices.

Chinese banks have set their sights on improving return on equity and asset quality, partly through participation in substantial project financings. Involvement in large scale project finance in mainland China is not new, ?we've been providing project loans in the power and energy sector for a number of years,? says Ren Li, a manager at Bank of China (BOC)'s corporate banking department in Singapore, ?but we've now taken that onshore experience and transplanted it into the international domain.?

According to Ren's counterpart at Bank of China in Hong Kong, Barry Mok, the bank has acted as arranger, adviser and debt provider for several major infrastructure projects in the Special Administrative Region (SAR). With this experience, the Hong Kong office has led other BOC branches into project finance transactions on several occasions. ?Its partly because of the limited opportunities in the Hong Kong market that we are increasingly focusing on more domestic PRC project transactions and US Dollar deals in the overseas project market,? Mok says.

China's banking system enjoyed a $75 billion foreign currency surplus from 1999 to 2001. Although the volume of foreign currency deposits has both risen and fallen in recent years, it is highly unlikely that foreign currency liquidity is just a temporary phenomenon. The level of foreign currency deposits is driven by complex forces and not simply the increasing trade China enjoys with the outside world.

According to Guonan Ma, an economist at the Bank of International Settlements (BIS) which keeps track of the evolution of China's financial sector, a key source of rising foreign currency deposits has been remittances from overseas Chinese, accounting for reported net current transfers of over $8 billion in 2001. Ma adds that the easing of restrictions on foreign travel by Chinese residents led to 12 million reported travelers in 2001, each entitled to convert domestic currency into foreign currency. Importantly to the development of Chinese banks' foreign currency capabilities, Ma says, ?competitive interest rates on domestic dollar deposits have served to domesticate what might otherwise have been capital flight.?

From mid-1999 to late 2000, the 12-month US Dollar to Renminbi interest rate spread widened to as much as 300 basis points in favour of onshore dollar deposits, which Ma speculates spurred the accumulation of foreign currency deposits. But with changing interest rate levels the phenomenon has not all been one way. When the Federal Reserve in the US eased Dollar rates in 2001, the situation reversed, and the interest rate differential turned decisively in favour of Renminbi deposits. Chinese depositors apparently reacted by allowing the ratio of Dollar to Renminbi deposits to fall.

At the moment, the interest rate outlook, particularly given the fragile stay of the US economy, is unclear, but Ma says: ?an eventual return to higher dollar interest rates could lead to a resurgence of growth in foreign currency deposits in China.?

Ma also believes that policy shifts such as that in February 2001 to allow Chinese individuals to invest their existing foreign currency deposits in the Chinese B share market (they were previously formally banned from investing in the market) are also paradoxically helping to spur liquidity rather than acting as a means to soak up foreign currency funds. In the short term, after the government's decision to open the market to the mainland retail market, foreign currency deposits did drop (by $2.5 billion in February and March 2001). ?However,? says Ma, ?over the medium term, the policy shift could increase Chinese demand for such deposits if investors anticipate that foreign currency holdings might tend to enjoy advantages in the course of further liberalization.?

A source at ICBC in Beijing believes that foreign currency concerns have also been an important factor in determining the amount of foreign currency held by Chinese banks since the Asian crisis (this is also validated by BIS findings). Forex fluctuations might seem an odd factor to include, given that the Renminbi has been effectively pegged to the US Dollar, but the anticipation of a possible change in the value of the Renminbi (and a relaxation of currency controls) is the key issue. ?When companies and individuals see that other Asian countries are depreciating against the Dollar, they know that the Chinese government will be under pressure to allow the Renminbi to do the same. In that scenario there is an incentive to put money into Dollars.?

Over the last three years, local Chinese companies' preference for Renminbi rather than US Dollar loans (given the lower interest rates on Renminbi borrowings) has forced Chinese banks to look increasingly to foreign currency lending opportunities in overseas markets. Between 1999 and 2001, falling Renminbi lending rates relative to Dollar rates induced Chinese companies to switch to local currency loans, says Ma. As a result onshore dollar loans fell by more than $25 billion between 1999 and 2001. Just as exchange rate concerns have led Chinese savers to deposit in Dollars, heightened perceptions of currency depreciation have also encouraged Chinese firms to reduce exposure to Dollar obligations.

Ample liquidity does not necessarily mean a large volume of loans, project finance or otherwise. Not all foreign currency funds flowing into the international arena have been lent. Official reserve managers at the PRC banks, who needed to find uses for over $140 billion between 1999 and 2001, channeled a good proportion of this amount into international banks and the US debt markets.

In addition the financial and operational health of Chinese banks needs to be taken into account. Dominic Chan, an analyst of Chinese financial stocks at Deutsche Bank in Hong Kong, acknowledges that the Chinese banks are enjoying strong liquidity, ?Bank of China in Hong Kong has a loans to deposits ratio quite similar to Hang Seng Bank, that's to say very liquid compared to US and UK banks, but this does not by itself imply an appetite for very aggressive lending.? The Chinese banks operate with higher liquidity partly because their risk management techniques are less sophisticated than leading western banks.

Bank of China, ICBC and other Chinese banks are also hampered by operating inefficiencies. Bank of China Hong Kong is still dealing with the aftermath of its merger with other mainland Chinese banking operations in the SAR, each with its own lending policy. ?They are still in the process of aligning the lending regimes of the merged entities,? says Chan. The implication is that if and when Chinese bank operations are more streamlined they will be even more active players in the investment banking market, including in project finance.

In the domestic Chinese project market, Chinese banks' foreign currency capabilities have constricted opportunities for the international banking community. ?Local banks are very competitive on terms and pricing in both local and foreign currency financings. For the most part, international banks are being restricted to advisory work,? says one foreign financier. If opportunities still present themselves for foreign banks, it is largely thanks to the volume and scale of projects on the drawing board.

More clearly than any other recent deal, BP and Sinopec's $1.8 billion equivalent Shanghai Ethylene Cracker financing highlighted Chinese banks' lending capabilities and appetite. The three tranches: a $708 million US dollar term tranche; a Rmb 8.12 billion local currency term tranche and a Rmb 963 million working capital tranche were funded by the Chinese financial market. The US dollar tranche constituted the first time that the local bank market had provided a greenback loan to a project of this type.

The deal was also noteworthy for the tenors that domestic banks were prepared to extend to. In the Renminbi loan tenor stretched to 20 years. For the financing of Shell and CNOOC's Nanhai petrochemical plant (which is in the market now), financiers say tenor is likely to be 18 years.

But Shell and CNOOC's financing will show that Chinese banks are still eager to see international banks participate in the mega transactions, if only to limit risk. This out and out project financing, not a corporate guaranteed deal on the lines of the BP transaction, will feature a $300 million uncovered foreign currency tranche (to be taken up by international banks) and a $400 million ECA tranche, also syndicated in the international market. ?The financing shows that it is still optimal to have international banks playing to their strengths and providing the foreign currency, offshore finance and PRC banks playing to their strengths by doing the onshore piece,? says Simon Dodd at IntesaBCI, one of the lead arrangers of the financing. The Nanhai deal should sign and close before the end of the year.

Lending policy guidelines for Chinese banks have undoubtedly relaxed but how free are the Chinese banks to pursue project finance transactions in the overseas market?

According to Ren at Bank of China, there are no hard and fast rules indicating which industries are the prime targets. ?We do have country limits like all other institutions but we can look at projects across all industry segments,? she says. From its Singapore office, BOC has yet to be involved in a large scale project in South East Asia, simply because there are not that many project opportunities at the moment. However, the bank is keenly interested in upcoming oil and gas projects in Indonesia and is likely to kick start its South East Asian project lending activities in this arena.

The key question is whether a Chinese or Hong Kong sponsor, supplier or offtaker is a necessary feature of projects and a precondition before Chinese banks can participate. Both Ren and Mok state that Chinese corporate involvement is preferred but not vital. That said, Project Finance is not aware of any large scale project deal that a Chinese bank has participated in, which did not have some Chinese corporate involvement. As one international financier comments, ?Chinese banks may consider every project but it certainly makes it easier to sell the deal to head office if there is a Chinese component. Simply in order to allocate resources efficiently they tend to follow a rule of concentrating on deals with a Chinese flavour.?

Chinese accession to the World Trade Organization is not expected to radically change the competitive position of Chinese banks in the project finance business ? in the short term. Foreign banks will gain a stronger foothold in the domestic PRC market, but at the same time, WTO regulations give Chinese banks greater access to foreign financing opportunities. In addition, WTO trade rules will spur on China's export boom, potentially pulling more hard currency into the domestic banking system.

International banks are now able to apply for banking licenses in the PRC, with the Chinese government obliged to dole out licenses under the terms agreed during WTO negotiations. The key impact will be on local currency, rather than foreign currency lending. ?One thing these licenses permit is for foreign banks to provide Renminbi loans to Chinese companies. But our ability to do that will still be very constrained by our capital base and limited number of branches in mainland China,? says a US banker. For Chinese projects, international banks will continue to be out-priced because of their risk weighting of China. ?We will continue to demand a higher yield as a trade off for the risk, but Chinese banks naturally take a far more favourable view of the risks involved.?

As with any relaxation of barriers between two markets, convergence is the likely long-term trend, the key question being the time frame involved. ?WTO regulations will certainly encourage convergence between the onshore PRC bank market with the international market,? says Dodd, ?but the process is going to be a lengthy one.?