Implications of China’s Latest Five-Year Plan on Mergers and Acquisitions

April 10, 2011. On March 14, the Chinese government passed its twelfth Five-Year Plan that spelt out the broad economic policy for China from 2011 to 2015. With it came a new state-level investment review body and a renewed focus on domestic consumption, wealth distribution and local industry consolidation via mergers and acquisitions (M&A) and joint ventures. How will foreign firms with M&A interests be affected?

We speak with

Nicolas Pechet

, Managing Director, China as well as analyst

Daniel Ruth

, from M-Brain (formerly Global Intelligence Alliance) Group in Shanghai.

What are the implications of China’s latest Five-Year Plan on Chinese M&A?

Ruth: “The ambitious targets of 8% GDP growth and 7% annual growth of per capita income set in the Five-Year Plan are hardly exceptional for a country that has been posting similar growth rates consistently for the past 20 years – GDP growth has been at an unprecedented 7-14% since 1991. What has been noteworthy is that experts are touting the next five years as a watershed period in the history of economic growth of China.

The Central Committee laid out four major tasks for the future “” the acceleration of M&A being one of them.

With inflation rates likely topping 5% in March after 4.9% CPI in February, the new economic plan is representative of China’s attempts to maintain stability in a volatile and recovering global market by rebalancing its economy. This means creating more jobs, keeping prices stable and most notably, increasing household consumption. Considering China’s historically frugal household saving proclivities, the latter goal is especially vital to China’s plans to lessen the income gap and spread wealth out from coastal regions to support rural and inland industry development.

According to the CPC’s Central Committee, the household consumption ratio will rise and coordinated development in rural and urban regions will be enhanced as part of the new Five-Year Plan. This will be done in conjunction with efforts to universally raise people’s incomes at a relatively fast rate in line with the pace of economic growth and labor productivity.

What this means for the Central Committee’s approach to M&A in China over the next five years is not entirely transparent, but the announcement does offer some clues for what to expect for upcoming M&A pursuits in China. The committee’s plan to address rising inequality means an emphasis on rural and inland areas that have not experienced the same booming growth that has been characteristic of coastal areas and their Special Economic Zones since the early 1980s. For M&A, this likely means a highly protective stance toward growing domestic companies in heavy industry, mining and metal industries that makes up the majority of economic output from inland regions “” particularly in booming cities like Chengdu and Chongqing.

China, which dominated the global mining and metal industries in 2009, will likely consolidate its M&A activity domestically and seek to strengthen its current industry leaders vis-à-vis this amalgamation. Though this does not necessitate the exclusion of foreign firms in all M&A activity, the government will undoubtedly favor deals that will advance domestic firms’ performance and growth.

In 2010, government-led domestic consolidation in the steel and coal sectors drove the value of domestic deals up 89 percent to US$8 billion in 2010 with industry experts predicting domestic M&A in these sectors to materialize at an even faster pace in 2011. As the government plans to build multi-sector mining conglomerates out of consolidated domestic firms, state-owned enterprises in other industries will likely take a backseat””at least in terms of resources used to vet the quality of M&A deals.

In 2010, the number of M&A transactions in these industries increased 29 percent with 57 outbound transactions, 53 domestic, and 13 inbound. And while China faces tough competition from India and Brazil in the mining and metals industry, China’s demand for raw materials will likely continue to drive offshore investment in mining and metals in 2011 which will make it more difficult for foreign firms to invest in the same industries in China.”

What new regulations/regulating bodies are in place to oversee M&A?

Pechet: “Currently, a number of industries in China are plagued by low concentration levels, lack of competitiveness and thin profit margins, which inhibit industrial restructuring.

As the new plan hashes out, over the next five years the government will make greater efforts to promote mergers and acquisitions to enhance industry dynamics and efficiency. To ensure effective industry restructuring, more regional market barriers will be removed and private investment will be allowed to enter industries that were previously inaccessible.

In order to remove these market barriers and increase efficiency, the new Five-Year Plan outlines China’s plans to continuously deepen reform and open access. One of the vehicles designed to ensure this restructuring and removal of market barriers is a new state-level investment review body to check that merger and acquisition deals pursued by foreign firms does not endanger “national security”.

While this sounds counter-intuitive for a country intending to remove barriers and red-tape and increase efficiency, the new regulation body, which came into effect in March 2011, is meant to increase transparency and efficiency of M&A deal processes. Foreign investments in military, agriculture, energy and resources, transport systems, key technology sectors and “important equipment manufacturers” will be subject to reviews. The reviews will be conducted by a “foreign investment security review board” that consists of members of the National Development and Reform Commission, the Ministry of Commerce, and other agencies deemed relevant to the company and industry in question.

Though China asserts the new regulations will make the process more transparent, some countries worry that the new review body is meant to reciprocate other countries’ refusal of China’s M&A and joint venture investments on the grounds of national security. A prime example of this was China state-owned oil firm CNOOC Ltd. having to withdraw a US$18.5 billion bid for U.S. oil firm Unocal after the U.S. Senate blocked it on the grounds of national interest.

That is not to say China has had a relaxed stance on similar bids by foreign firms on the mainland. Coca-Cola’s 2009 bid for China juice maker Huiyuan was rejected as was ArcelorMittal’s bid for a majority stake in China Oriental group in 2007. However, the Central Committee insists that the new measures will foster growth and cooperation by improving the quality of M&A deals””albeit while being more restrictive.

According to the new regulation, Chinese government agencies, competitors, suppliers, trade associations and other related parties can apply for the start of a review of a foreign-related M&A deal. The process involves a “general review”, which, if not passed, will lead to a “special review” that may last up to 60 days. If the government finds a deal that could potentially threaten national security by exposing state and commercial secrets, Beijing can terminate the deal.

How will foreign firms with M&A interests be affected?

Pechet: “There is no doubt that the range and weight of influence in M&A activity, both domestically and abroad, has swayed in China’s direction in recent years. As China’s position in the global economy becomes more prominent, its ability to regulate and restrict deals has become more pronounced in a range of industries. However, with a newfound focus on developing interior regions and their relevant industries in heavy industry and mining, China seems poised to be more self-sufficient in terms of financing and growing their domestic companies.

That said, this is hardly a new trend as China’s economic authorities have long been utilizing consolidation with foreign firms as a means to learn the ropes and to ultimately become self-reliant and develop their industries domestically and organically.

So while China has indicated an intensified domestic focus with the announcement of the Twelfth Five-Year Plan and a new review body, it is unlikely that there will be a drop in inward M&A activity – at the most, perhaps a reduced rate of growth. After all, M&A activity involving Chinese targets has already reached US$27 billion so far through the first two and a half months of 2011, a 16 percent increase from the same time last year and China’s best annual start yet.

Given such staggering figures, it would be prudent to surmise that the commencement of a new Five-Year Plan provided Beijing with just the opportunity to address and quell such significant increases in inward M&A (with the establishment of its National Security review committee) under the guise of standard and incremental economic reforms.

Furthermore, China managed to take up 30 percent of Asia’s M&A volume in 2010 primarily driven by energy and natural resources. As China diversifies quickly and other industries develop – particularly in advanced technologies, automotive, aeronautical, and energy – Chinese M&A targets will invariably increase and foreign firms will be knocking at China’s door in record numbers and with record bids to get involved.”

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