Will China Embrace Competition?
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Foreign Equity in Telecoms Hangs in the Balance
Pacific Telecommunications Council (PTC)
Honolulu, HI - January 17, 1999
By Ken Zita
It takes nerve to be an investor in China's telecoms services market. China has steadfastly restricted foreign ownership, management or operations of telecommunications network services. The government has pursued a conservative approach to sector reform, protecting the interests of the dominant carrier, China Telecom, and maintaining maximum sovereign control over what it regards as strategic infrastructure assets.. The ban confounds global investors. Telecoms services revenues have grown at an astonishing 40% annually in recent years, to approximately $24 billion in 1998, making China the sixth or seventh largest market in the world. Investors have circumvented the prohibition on direct foreign investment policy by adopting legal, if tenuous, joint venture schemes with China Unicom, the nascent second carrier. The indirect financing arrangements, known as Chinese-Chinese-Foreign (CCF) structures, have funneled $1.4 billion into Unicom local joint ventures since 1994, providing nearly three-quarters of capital investment to date. While imperfect, the CCF approach established the sole loophole enabling foreign participation in China's telecoms (see box).
In October 1998 the central government dropped a commercial bomb. News spread that the government planned to terminate the CCF investment vehicle by 2000, effectively closing the door on foreign investment without offering a replacement. Minutes from a State Council session, known as Decision 98, began to circulate among a narrow circle of international observers. The document indicated Premier Zhu Rongji's intent to end the CCF mechanism. The story emerged obliquely, almost by chance. No official announcement was made. And no representative of the central government nor the Ministry of Information Industry (MII) issued a statement to announce what was fast emerging as a proposed sea change in national policy.
Investors in Unicom joint ventures were startled that China would take such abrupt action, without at least notifying foreign partners. Some were aware that discontent with the CCF policy was brewing among different factions in the leadership. The MPT and newly constituted MII had been intensifying its campaign to have CCF quashed. In March 1998, for example, the State Planning Commission issued a recommendation paper reflecting MII views, Resolution 405, suggesting that CCF arrangements be phased out. Few foreign firms were consulted about the SPC position, or subsequent discussions at the State Council. Indeed, many foreign Unicom partners only learned of the impending policy shift from the international press. Firms scrambled to make sense of the ensuing confusion, dispatching executives to Beijing, summoning ambassadors, and conferring with one another in effort to piece together yet another Chinese puzzle.
Chinese-Chinese-Foreign (CCF) financing structures were invented by Unicom in 1994 to circumvent China's long-standing prohibition on foreign ownership, operation and management of telecoms enterprises. Direct investment in telecoms is off limits to foreigners. With CCF, a Build-Transfer-Operate (BTO) or Build-Lease-Service (BLS) finance and management arrangement is created. A Chinese company licensed to operate a network such as a local Unicom branch creates a joint venture that serves as an investment clearing house. Complex 3-way management contracts between the operator (Chinese), joint venture company (Chinese), and investor (Foreign) combine equipment leasing, royalties, consulting and license fees in a network supply contract in lieu of direct equity investment. 44 CCF contracts with local Unicom contracts have been signed, of which about 20 are active. Major Partners include Bell Canada, France Telecom and Sprint. The Unicom have earned less than 5% cellular market share from China Telecom to date. See Figure 1:
Figure 1:
Typical CCF Revenue Structure
Rumors -- the quasi-official channel for the leadership to test new ideas -- permuted wildly. Foreigners would be kicked out. Foreigners could stay if contractual capital commitments were paid in. CCF over-extended China in the WTO negotiations, forcing the government's hand. Investment positions in JV companies would be capped at 25%. Unicom could stay in mobile, but not in local or long distance. Sources of all stripes had contrasting interpretations of events. Official silence from the government only fed speculation that investments made through CCF vehicles might not be protected.
Policy on the Fence
The circumspect manner in which the government position became manifest, through leaked impressions of a policy shift, has made explicit simmering ambiguities surrounding China's telecoms. Indeed, with the CCF crisis, the historical absence of transparency in telecoms policy, which has been discounted as culturally ‘inscrutable' in the past, has increasingly emerged as a tangible political risk to foreign investment.
Faced with a cloud of doubt, a group of 16 Unicom venture partners sent a letter to Minister Wu expressing concern about the CCF matter. The letter was copied to key decision-makers in the senior leadership. This multi-firm, multi-lateral effort is unprecedented in the telecoms sector in China. For the first time, foreign investors acted in unison to obtain clarification of government policy; the effort became, in effect, a collective appeal from shareholders to protect their interests. Reports suggest that the letter had a significant impact on Zhu, who directed MII to explore a solution that serves all interests involved.
The letter and government reaction reveals a new sophistication in the marketplace. The leadership under Zhu has demonstrated a new willingness to enter into a dialog with investors on fundamental policy issues (albeit after the fact). There is also tacit acknowledgment that resolution of the financing question for competitive telecoms infrastructure is an extremely difficult matter. The leadership seems prepared to consider the experience of its foreign partners to help resolve asset valuation and equity conversion issues. From the foreign perspective, investors are taking a more assertive role in influencing government decisions, rather than simply waiting for policy missives from Beijing.
From Indirect to Rational Financing
As the financial lifeline for China Unicom, CCF is more than a creative solution to financing new telecom ventures: it has become the symbol of competition in the domestic marketplace. Like high yield debt in the West, it has provided ample funding for new service providers intent on competing with the entrenched monopoly. Other aspiring carriers, including companies controlled by the People's Liberation Army, broadband cable television networks operated by the former Ministry of Radio, TV and Film (MRTVF), and fledgling entrepreneurs, all expected to employ CCF to launch competitive enterprises. Terminating this financial mechanism thus becomes an attack on market deregulation itself.
CCF pioneered competition in China's telecommunications sector, but the scheme has not really satisfied anyone. China Telecom opposes the arrangements on principle, as an affront to its administrative authority. Chinese operating companies, while thankful to be in business at all, are afraid of running afoul of ambiguous regulatory rules. Foreign partners resent being treated like commercial banks, with little opportunity for leverage. Most important, CCF is not specifically protected under existing statutes. The system was due for change. See Figure 2.
The worst fears about the wind-up of CCF – that foreigners will be summarily dismissed from the market, or forced to sell existing positions – will almost certainly not come to pass. Beijing no doubt recognizes the liability of abruptly changing course and will not risk losing face by abandoning over a billion dollar trust that has been built with telecom investors over the past five years. The danger is that conservative voices responsible for creating the CCF crisis will continue to command the internal debate on the role of foreign investment will play in China's telecoms.
Figure 2
Contrasting Views on CCF
Pro
Con
MII &
China Telecom
Has stemmed introduction of equity investment in competitors Threat to administrative authority
"Violation" of investment rules
Encourages unfair extension of private network operating rights
Encourages redundancy of network assets
Enables cream-skimming of most lucrative urban areas
Unicom & PLA
Enables access to foreign technology and capital
Virtually risk-free borrowing
Network assets revert to Chinese partner at end of term
No explicit management obligations to foreign partner No regulatory protection
No legal recourse without Telecoms Law
Central Government
Brings investment without surrendering equity or management control
Enables limited introduction of competition
Keeps telecom profits at home Interim structure that does not serve long-term reforms
No control over individual contracts at local level
Source of continual conflict between MII and other ministries
Foreign Investors
Only vehicle enabling investment in telecom services sector No equity
No direct management control
Minimal regulatory protection
No clear routes for exit
Double taxation
The most insular factions question why China needs to engage foreign equity at all. They cite a long list of home-grown achievements that justify keeping the market closed: China Telecom's spectacular success modernizing its network; recent advances in domestic high tech manufacturing; the buoyancy of internal sources of capital even in the wake of the Asian financial crisis (at least for the monopoly, China Telecom). Further, they reason, even if competition is to be speeded up why should foreigners be allowed to reap the rewards of market deregulation? These opinions typically come from within China Telecom and the MII, and from party stalwarts who believe in the economic rationality of preserving monopolies – or at least Chinese dominance – in strategic sectors. Significantly, telecoms modernization is one of the most visible success stories of the economic reforms. Nationalist pride in the sector serves the leadership's domestic political agenda as proof of its mandate to positively transform society, and capacity to lead the nation through the Information Revolution.
Though a one-party political system, China is anything but a command economy. No one entity has absolute ability to dictate the direction of an industry, including the MII which has unquestioned administrative oversight of telecommunications. Instead, a bargaining takes place between traditional forces and reformers. Indeed, this is how Unicom got started. Unicom was created over the strenuous objections of the former MPT. Unicom's founding shareholders earned the right to provide limited telecom services in 1976, and extended these mandates to incorporate as an alternative carrier in 1994. The PLA and the rump MRTVF followed a similar course. China's "policy of exceptions" allowed numerous instances of competitive services. CCF is a direct evolution of this ad hoc policy environment. That is, an official ban on foreign direct investment has always been in place but CCF allowed legal exception to the rule by employing indirect capital flows.
Options for Transition
The hoped-for resolution to the CCF crisis is that the government will use the intensity of debate to rationalize telecoms investment policy and allow the lease-oriented CCF contracts to be converted to equity positions. Reappraisal of CCF presents an excellent opportunity for the government to permit direct foreign investment and accelerate the transition to a market economy. Investors clearly prefer equity – to enable multiple returns on investment, a voice in management, legal protection, and a tangible exit strategy. While leading the MPT, Minister Wu repeatedly indicated the government's willingness to allow foreign investors an opportunity to reap "equity-like" returns through creative financing schemes. To date, "equity-like" has referred only to profit sharing based on proportional investment and has stopped abruptly short of actual ownership of local telecommunications enterprises. Pessimists speculate that the timing of the CCF crisis was engineered to deprive the JVs of due compensation. That is, as the Unicom ventures approach critical mass through an expanding infrastructure and an anticipated "hockey stick" revenue growth, foreigners will hit a glass ceiling that may compromise expected rewards.
Zhu Rongji is believed to support a fast-track plan to IPO the local Unicom companies, a move that would fundamentally reshape the landscape for ownership of telecom assets. The appeal of the approach is obvious. The successful $4 billion flotation of China Telecom (HK) in 1997 made clear that share listings would become the preferred future for Chinese telecoms financing. The CTHK sale generated significant funds for investment and expansion without relinquishing management control. Importantly, CTHK is the only Chinese telecommunications venture approved by the MII for flotation on the Hong Kong or other international exchanges. Unicom ventures, therefore, will be listed in Shanghai or Shenzhen.
The ownership of the Unicom companies is more convoluted than the assets contributed to CTHK by China Telecom. Each Unicom JV has a unique contract, with different rates of capital participation, terms of profit repatriation, and varying long term liabilities, among other factors. Moreover, in the CCF arrangements, network infrastructure is typically leased to a joint venture company. Strictly speaking, the physical assets are owned by the foreign party, not by the joint venture. A formula is required to equate the book value of the lease and management contracts into equity. Some investors believe these assets need to be treated as high risk speculative investments in any pricing negotiations, equivalent to early stage venture capital. If provisions are not made for current partners to be adequately compensated in the transformation of CCF contracts, demand for new Unicom issues could suffer.
Conversion of CCF arrangements to equity prior to a flotation, should that occur, will involve haggling over time-sensitive components of existing contracts. All existing contracts stipulate that the physical network be transferred to the local party at the end of the term, typically 15 years. Premature termination or re-negotiation of the CCF agreements could potentially deprive foreigners of the opportunity to yield profits in the out years of the term. None of the Unicom CCF joint ventures are profitable to date; net rewards are expected to accrue only in the later years, after a network is fully deployed and when operating margins are expected to improve dramatically. Any fundamental changes will also have to overcome operational audits of the Unicom ventures ordered by the MII. Minister Wu has publicly indicated that some ventures will be scrutinized for having violated development laws, and that these JVs would be "cleaned up one-by-one." He specifically cited the widely adopted practice of using installation fees as a component of revenues that may be ultimately repatriated to foreign partners.
Public listings of the Unicom ventures would enable the leadership to yield significant structural adjustments and achieve "synchronization" with other macro-economic reforms. Major telecoms companies dominate stock exchanges around the world and China could inject considerable value into its domestic bourses. The entire financial services industry – brokers, investment bankers, institutional investors – would get a lift from a score of new telecom properties on the local capital markets. As State Development Planning Commission official Zheng Xinli recently quipped, "Telecoms…is a good piece of meat and everyone wants to have a bite."
Restructuring the Unicom CCF ventures could have a similarly positive impact on domestic banking. China's bank portfolios are burdened by politically directed lending to ailing state owned enterprises. Balance sheets would be improved greatly by blending quality investments to more stable (and invariably profitable) telecoms enterprises with existing non-performing loans. The government clearly sees the broader economic benefit of tying the health of the banks to properties many consider to be rising stars. The Bank of China has extended a 22 billion renminbi ($2.7 billion) line of credit to Unicom to accelerate domestic borrowing in the sector. Timing of the credit appears to be anything but coincidence. Local Unicom operating companies may be obliged to tap the debt pool to displace the quirky CCF arrangements with foreigners, or perhaps dilute existing foreign positions.
With Unicom's capital supply suddenly in turmoil, local bank branches may begin competing with one another to underwrite telecom loans – just as the Bank of China itself had to compete with other state banks to win the business with Unicom. This competition could signal greater flexibility in the domestic capital market. From a macro-economic perspective, linking the banks to core infrastructure spending makes sense. But the abrupt shift to debt financing from indirect equity flows is radical surgery for China's new operators. Even if the banks pay out the credits, which is uncertain given Unicom's tormented political history, local ventures will need to find other sources of capital. Debt funding alone would unreasonably burden the fledgling Unicom companies. Stock listings may be the only practical course to achieve healthy debt/equity ratios, and support the broader ambition to buttress the banks.
The Equity Equation
The supplemental -- and from the foreign view, desired -- approach to improving the liquidity of Unicom joint ventures is to allow direct foreign investment. Foreign equity would become blended with domestic equity and debt, providing Unicom financial planners with a range of tools to underwrite capital expansion. State Council officials are keenly aware of foreign wishes to participate directly in China's telecoms. Some also appreciate the economic rationality of turning Unicom JVs into mature corporations, in part by allowing diversified ownership.
MII Minister Wu, by contrast, reportedly opposes conversion of CCF lease arrangements to equity on the basis that the time is not "ripe" to allow foreign participation. The chief reasons for not allowing direct foreign investment and widespread competition, summarized briefly, include:
Unicom does not have universal service obligations, and with foreign help could cream-skim lucrative urban markets while ignoring rural areas;
aggressive support for alternative access networks would encourage network redundancy, and misallocate "scarce" investment resources;
tariffs in China are still set by decree and not market forces;
profits from China Telecom continue to cross-subsidize postal operations, reportedly $16.4 billion in 1997, and erosion of China Telecom's profitability would be a threat to the postal system;
a telecom law has not yet been adopted to ensure fair competition.
And, while rarely expressed openly, there is an apparent provincialism and fear in certain circles of foreign exploitation: a fear that if the doors to ownership are opened, superior western technology and operational capability would gain the upper hand over domestic institutions. China often plays the shrinking violet in international forums, a poor developing country that needs to protect itself. With the second largest network in the world, these somewhat suspect assumptions can be more accurately described as protectionism.
Despite the conservatives' view that global capital is not required in China telecoms, the government leadership clearly wants Unicom to succeed – and some dimension of foreign funding will be required. International bankers for years warned darkly that, without privatization, China Telecom would fail to meet its ambitious development targets. They were wrong. China Unicom, by contrast, owes its existence to private funding and foreign know-how. The company will succeed only if allowed to employ a rational, market-oriented business model, with the discretion to apply capital and operating alliances as it sees fit.
The World Waits
The timing of the CCF issue and tabling of scenarios for conversion of Unicom contracts to equity appear linked to China's negotiations for accession to the World Trade Organization (WTO). The WTO telecommunications accord was signed by 68 countries in early 1997, though China did not present an accession offer at that time. Membership in the WTO confers free trading status among member countries, and is the penultimate measure of integration into the global economy. China's policy of opening to the world demands it be a full-fledged member of the multilateral agreement. Telecommunications (along with financial services) is a strategic stumbling block.
China needs to agree to a schedule of allowing transparent access to the telecoms sector in line with WTO expectations. Key elements of the proposal, agreed through informal vetting among trading partners, include: terms and operating parameters for introducing competition; the degree and timetable to which direct foreign investment is allowed; creation of and constitutional support for an independent regulator; and removal of non tariff trade barriers such as cross subsidization to hide economic inefficiencies or predatory interconnection fees by the dominant carrier.
China's preliminary offer under consideration includes allowing direct foreign ownership of up to 25% of mobile voice providers, up to 35% in value added data providers, and perhaps 100% for paging networks. Oddly, terms of the mobile offer do not include mobile data, suggesting that market opening may be restricted to current second generation network technologies, not future growth areas. Also, China may seek to limit private equity to only one mobile venture per city. While incorporating equity would be a significant step forward, the terms proposed may actually downgrade rather than boost the financial opportunity already available to foreigners in the market. Many Unicom existing CCF deals allow profit sharing at ratios far higher than the mooted maximum of 25%. The final terms China produces will ultimately be a compromise between the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), which seeks to maintain positive relations with foreign governments, and the MII, famous for doggedly protecting its parochial interests. Consensus will be achieved with the State Council, State Planning Commission and others, with approval made at the very top of government. The end result will be telling. Within the offer will be clues indicating whether China is truly ready to endorse the openness and diversity of information access demanded by the information age.
The wind-up of CCF presents the first tangible opportunity to accelerate restructuring of China's telecoms services environment. All eyes are on the leadership to articulate a vision to protect China's sovereign interests while continuing to open to the world.
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