Shipping and ship finance The China effect

Berwin Leighton Paisner LLP

Foreword

Contents
Foreword ............................................................................................................01 At a glance .......................................................................................................02 Dominant role for China ...........................................................................03 From boom to bust .....................................................................................04 The road to recovery...................................................................................06 Chinas advantages today: the price advantage..........................08 Quality perceptions changing................................................................09 Technology advances..................................................................................10 Ship finance from western banks remains important..................11 Top 20 shipping finance banks................................................................12 Doing business in China.............................................................................. 14 Regulatory environment............................................................................. 15 Our view of the future.................................................................................. 16 Methodology..................................................................................................... 16 Shipping contacts...........................................................................................17

China is emerging from the economic doldrums with a leaner and more technologically adept shipbuilding industry. Its financial institutions are also beginning to flex their muscles. We examine the steady progress of China towards outright leadership of an industry that makes and markets the most essential tools of international commerce.
Tom Budgett Partner, London

The Chinese Governments five-year plan for its shipbuilding industry is simple to dominate the sector by 2015 with annual shipbuilding exports in excess of US$80bn. That it will achieve such dominance is widely regarded as inevitable. However, the exact speed of this development will be a function of worldwide trade and this will be led, ironically, by demand in China. It is entirely predictable that a drive to maximise the export of ships is accompanied by the export of financial services. And, as industrial output has increased, so has the appetite of Chinese financial institutions to support their nations ambitious shipbuilding programme. But China, by virtue of its regulatory infrastructure, is very different from Japan in this regard and the development of a cross-border banking and leasing industry for big-ticket items may take longer to mature. The rapid emergence in the past decade of China as a shipbuilding heavyweight to challenge Japan and South Korea has been a product of the low cost of Chinese labour and a seemingly endless demand for new tonnage worldwide. However, the merry-go-round was interrupted by the financial crisis of 2007/8. Since then a more critical appraisal of Chinas influence has emerged with concerns about its contribution to over-capacity in certain markets, a perception of poor quality from some of its yards and the threat of excessive bureaucracy as an inhibitor to further development. In terms of global ship finance, despite the diminished activity of many banks in the sector, our research shows that those institutions from the US and Western Europe that are deeply embedded in the industry will continue to set the benchmark for the newer market entrants. This report examines the development of both the shipbuilding and ship finance industries in China and their future significance for the global shipping market. I am grateful to the experts who have agreed to be interviewed for this publication and for their authoritative remarks. These have provided the insight upon which the conclusions of this report are based.

Tom Budgett Partner, London tom.budgett@blplaw.com

Shipping and ship finance /01

At a glance

Dominant role for China

Ship Finance snapshot

At a glance
Key statistics to set the scene

Dominant role for China

Chinese shipping companies making losses of up to 158% from the previous year
(Cansi)

Chinese shipping to remain strong over the next five years and beyond

So, where will China go from here?

Chinese revenue from yards down from the first 11 months of 2012

China has already eclipsed South Korea to become the worlds largest shipbuilder. Its market share has increased five-fold in just ten years. The Governments five-year plan calls for yet further growth, but sheer volume of tonnage is only one measure of industrial leadership. China must continue to compete in other areas, such as quality and innovation, if it is to achieve its stated goal of becoming the worlds most important and technically advanced shipbuilding nation. However, the progress to date is genuinely impressive and, perhaps, a harbinger of more extraordinary developments to come. It is clear, in the current economic climate that the recent exponential growth in Chinese shipbuilding cannot continue. The last thing that the industry needs just now is for Chinese Government policy to exacerbate the problem of oversupply.

We believe that Chinas shipbuilding industry will continue to grow, but at a more sedate pace than it has to date. The cost of labour in the shipyards will remain comparatively low, resulting in a Chinese product that is consistently price competitive.

The pace of growth in China cannot continue. China is the biggest importer, but not the biggest owner or financier. There will be change.
Xu Wei, CMB Financial Leasing Co

Chinese financial institutions have been very active domestically, but we anticipate that they will now become increasingly involved in cross-border transactions for ships built in China. Whilst those western banks that have remained committed to the industry will continue to benefit from long-standing relationships with traditional clients, the retreat from the market by others has created a funding gap which is likely to continue well into the markets recovery phase. Although there is some evidence that the current distress of the shipping industry is attracting interest from private equity that is trying to call the bottom of the market, such alternative investors will plug only a small part of the gap. There is then an opening for Chinas banks and leasing companies and, although they seem rather slow to respond, we expect that they will cautiously embrace this opportunity in the medium term.

Chinese yards licensed to build LNG ships but only two with experience of building them

operating costs up over the same period the previous year

of Chinese yards had no orders placed in 2012

(Lloyds List / ICAP)

2008

2011

China has been at the centre of the growth of the shipping industry for the last ten years certainly.
Paul Taylor, Socit Gnrale Corporate and Investment Banking

>13

>123

7m

>19 m

>15m

change in gross tonnage produced (2008-2011)

02/ Shipping and ship finance

amount China has lent to nonChinese shipping clients since 2009 (Lloyds List)
Shipping and ship finance /03

From boom to bust

Medical device company funding: a quick introduction

From boom to bust

That China had potential as a shipbuilder first became evident in the 1980s. Cheap labour and readily available finance propelled China to a position over the last three decades, in which it could first challenge and then surpass its rivals to become the worlds biggest shipbuilding nation. The boom was encouraged by Government policy and closely related to the rapid development of Chinas foreign trade.

The global financial crisis has changed the landscape considerably. Too many smaller, privately-owned shipyards were established to ride the crest of the boom. Now a considerable proportion of those companies are seeking to merge and restructure to survive. New orders are scarce (two-thirds of Chinese yards are reported as having no new orders beyond 2013-2014), the cost of raw materials has increased and the funding gap means that finance has become less readily available. Competition on price has driven many yards down the value chain, with the result that too many inexpensive but low value-added large ships are being produced.

Once seen as a positive influence China is now accused by some commentators as being largely responsible for the oversupply of shipping globally, with a consequent collapse in asset values and freight rates.

Over the last decade China sucked in dry cargo and then exported manufactured items. It has been remarkable and in many ways a salvation to the shipping community, though of course it added to the overheating of the industry.
David Capps, Capco Trust Jersey Limited

The expansion of shipyards in China over the last ten years from a few hundred to over a thousand has had a negative impact on the market. Supply grew much too fast, Chinas growth was initially a positive, but the supply overtook the rise in demand.
Yiannos Mouzouris, Interorient

The impact of China has been massive. The increase we have seen in seaborne trade since 1999 is one of the highest since records began.
Claudio Chiste, Investec Bank

04/ Shipping and ship finance

BLP Ship Finance report /05

The road to recovery

The road to recovery

The road to recovery

At the peak of the shipbuilding boom in China, there were approximately 1,600 shipyards (some say even twice that number), many of them small and privatelyowned. It is estimated that no more than 300 will survive the current spate of bankruptcies and consolidation within the industry. In view of the dearth of new orders, the Government is encouraging consolidation with a view to concentrating shipbuilding capacity in the large state-owned groups, such as China State Shipbuilding and China Shipbuilding Industry and the pick of the private enterprises, such as China Rongsheng Heavy Industries.

We believe that the Chinese shipbuilding industry will emerge from the current global economic recession more competitive and robust than ever before and with the capability to realise the five missions articulated in the twelfth five-year development plan. These missions are to promote technological innovation and progress, speed up industrial restructuring, implement brand building and business improvement strategies, create an efficient shipbuilding system and optimize the industrial layout.

In general we believe that many of the smaller yards in China will close and, on a worldwide basis there will be fewer yards outside China, Korea and Japan.
Thomas Zachariassen, Nordea Bank

The plan identifies shipping as a key development area and sets out to Promote the upgrading of the three main vessel types of bulk vessel, oil tanker and container vessel according to new international shipbuilding standards. Improve the ship equipment industry and loading rate. Give priority to the development of large liquefied natural gas (LNG) and liquefied petroleum gas (LPG) vessels, ocean-going fishing

vessels, luxury liners, and other high-tech and high-added-value vessels. Accelerate the independent design and manufacture of mobile marine drilling platforms, floating production systems, marine engineering work ships, auxiliary ships, and key supporting equipment and systems.

The establishment of three massive shipyards located in Bohai Bay and the estuaries of the Yangtze River and Pearl River has revved up the formation of industrial clusters with economies of scale so that shipbuilding costs can be greatly reduced.
Zhen Hong, Secretary General of Shanghai International Shipping Institute, Professor of Shanghai Maritime University

06/ Shipping and finance report

Shipping and finance report /07

Chinas advantages today: the price advantage

Quality perceptions changing

Chinas advantages today: the price advantage

Quality perceptions changing

The most often-cited reason for Chinas dominance is price. The countrys low labour costs and state support are perceived as the main advantages that it has over its rivals. As the Chinese shipbuilding industry progresses the price advantage derived from lower labour rates will be lost, though this seems at least a decade away.

The price advantage is partly offset by a perception that particularly in smaller yards in China there is a quality trade-off. This trade-off is less evident in low-value-added ships than it is where cutting edge technology is required. The perception of quality is also gradually changing, possibly as a consequence of consolidation and the drive for fewer but more technically advanced shipyards.

I think that for plain vanilla ships, such as bulkers and tankers, they (Chinese ships) do what is required. Standard ships for trade of commodities clearly work. The more sophisticated vessels are not so tried and tested.
Kevin Bourque, DVB Bank

$5.4bn $3.4bn

bulker vessel sales 2012

tanker vessel sales 2012

Many of the advantages of China are all price-related: e.g. capacity and demand appetite. China has the ability and capacity to be cheaper than anywhere else currently, so can mould the competition.
Paul Taylor, Socit Gnrale Corporate and Investment Banking

Overall the perception is that buildquality and reliability are improving and the yards ability to move up the value chain is increasing. There are a lot of similarities to the growth of Korea in ship building. It took time for them also to emerge as a credible contender and move up the value chain.
Sven Dybdahl, DVB Group Merchant Bank (Asia)

08/ Shipping and finance report

Shipping and ship finance /09

Technology advances

Ship finance from western banks remains important

Technology advances

Ship finance from western banks remains important

China has seven yards licensed to construct LNG vessels but only two with actual experience of having done so. China is actively seeking out opportunities to collaborate with other countries for the purpose of technology transfer. Much of the maritime technology being transferred to Chinese companies comes from Europe, particularly Germany and Scandinavian countries, although joint ventures with both Japanese and Korean yards have also been effective in enabling Chinese builders to acquire technology, engineering skills and production know-how.

In order to accelerate its technical capability, China has been importing advanced production methods and key equipment including complete production lines, as well as using foreign sourced hardware and software for computer-aided design and computer-aided manufacturing. This has enabled Chinese naval architects to become more proficient in the design of ship hulls, compartment layouts and propeller-rudder combinations that improve speed, efficiency and structural integrity. As a separate but equally important development, considerable emphasis is now being placed on fuel efficiency and industrial policies that promote green shipping. Those surveyed in this report see greater international technology sharing as the best route for China to compete with Japan and South Korea in relation to the most complex vessel types.

Although the leading positions of South Korea and Singapore in marine engineering equipment, LNG ships and other hi-tech business seem unshakeable in the short run, China is expecting a gradual increase in the share of high-end shipbuilding markets by dint of its rising competitiveness.
Zhen Hong, Secretary General of Shanghai International Shipping Institute, Professor of Shanghai Martime University

It would be helpful if the Chinese banks were to invest more in shipping, but it isnt clear if they will do so now. I think the Chinese banks may become more involved in the longer term, but mostly with Chinese operators. So far, the Chinese banks have Where it is very difficult for not had a big impact on ship owners to get finance, lending to the sector. David Capps, some Chinese banks are Capco Trust Jersey Limited willing to give support.
Ben Zhang, Binghua, Accord Marine Service

In difficult markets for ship finance, such as those that have prevailed since the onset of the financial crisis, some banks make for the exit and the remainder concentrate on quality. The core western ship finance banks are busy with top quality transactions which are frequently over-subscribed. There is, however, a funding gap generally and we have considered, for the purposes of this report, whether this might be plugged to some extent by the Chinese financial institutions, such as Bank of China, China Development Bank and ICBC, that have so enthusiastically taken to cross-border aircraft finance. There is no concrete evidence, however, that these institutions are yet committed to international ship finance on a global scale.

Within the industry, views vary widely about incentives and pressures on China in ship finance. There is a widespread understanding that while shipping is important to the country, steelmaking and energy are more important to the future of the Chinese economy.

I have seen Chinese and Japanese yards working together to collaborate on technology. I think China will increasingly collaborate internationally, but more so with Germany, Norway and Singapore.
Xu Wei, CMB Financial Leasing Co

In 2010, the shipping community was encouraged by statements from the then Prime Minister Wen Jiabao to believe that Chinese lenders were ready to ride to the rescue of the industry. A sum of US$5bn was pledged to Greek ship owners ordering from Chinese yards and this was, for some, an indication of intent. In fact, the progress of the Chinese institutions in these markets has been cautious. Predictably, China Eximbank has been one of the most active and, together with Sinosure and other leading Chinese banks, there has now been approximately US$13bn of Chinese support for 40 nonChinese ship owners (Source: Lloyds List). This trend should continue as the relationships between foreign ship owners and the Chinese institutions deepen and as the yards themselves bulk out their order books. For instance, in early 2013 ICBC Financial Leasing has announced a financing of 51 vessels for the French OSV Operator Bourbon in an amount of US$1.5bn. But it would be unwise for too much reliance to be placed upon China as the immediate answer to the current shortfall in available funding. Chinese liquidity is not a cure-all.

10/ Shipping and ship finance

Shipping and ship finance /11

Top 20 shipping finance banks

Top 20 shipping finance banks

Top 20 shipping finance banks

Shipping finance continues to be dominated by a core group of well established banks.

Norway DNB US$26bn

Norway Nordea US$17.5bn

Germany HSH Norbank US$39bn

Germany Commerzbank US$25.5bn

Germany KfW US$118bn

Germany Nord LB US$15bn

Germany DVB US$14.7bn

UK RBS US$18bn

France BNP Paribas US$14bn

Japan BTMU US$16.5bn

USA Citibank US$12bn

France Credit Agricole US$11bn

Japan SMBC US$10bn

Switzerland Credit Suisse US$10.8bn

Korea Korea Exim US$14bn

Hong Kong HSBC US$13bn

Chinese liquidity will be important. If building ships in Chinese yards, Chinese liquidity will be a major source, but not a complete panacea. The bigger issue is who, save for the Export Credit Agencies, will finance all the ships being built in Korea and Japan?
Nigel Anton, Standard Chartered Bank

Italy Unicredit US$9bn

China China Exim US$14bn

China ICBC US$15.5bn

China Bank of China US$16.5bn

Source: Lloyds list

12/ Shipping and ship finance

Shipping and ship finance/13

Doing business in China

Regulatory environment

Doing business in China

Regulatory environment

Despite the international importance of China as a shipbuilding nation, it is still seen as a jurisdiction in which there are unique challenges for the conduct of business. Cultural differences sometimes frustrate or even present insurmountable barriers for the western businessman. But there are success stories and the patient investment of time to build key relationships is usually rewarded. One such example is the Graig Shipping Group which has been building ships in China since 1995 and supervising the construction of newbuilds for others, including most recently for Chinese owners such as Minsheng Financial Leasing Co. and Shanghai Xiang An Electric Power Shipping Co.

It is an important pre-requisite for success in China that the western businessman carefully identifies the appropriate decision makers or those capable of influencing the outcome of negotiations. Considerable time and effort should then be spent on establishing the level of trust required to move forward in the business relationship. There must be give as well as take and a willingness to be generous in the sharing of expertise. A rigid attitude towards contractual matters may not always be rewarding.

When you do business with enterprises, in particular major state owned enterprises (in China) you had better make sure that you make enough money to cover unexpected contingencies.
A former Beijingbased banker for J.P. Morgan

There are both general and local regulatory issues for shipbuilding and ship finance in China. Capital adequacy is of particular concern for banks. On the technical side and in terms of the local regime, relative lack of regulation in the shipbuilding industry in China has led to the proliferation of private yards with the attendant problems mentioned above. We may expect a stronger guiding hand from Government as the industry enters its phase of consolidation and rationalisation. In order to encourage ship finance by Chinese institutions, a more liberal environment is called for with, perhaps, tax

incentives to encourage crossborder leasing, a relaxation of rules governing foreign exchange and foreign currency clearance, improved facilities for the registration of security interests in ships, (both during and following the construction phase) and encouragement for foreign financial institutions to invest in Chinese operations. The development of free trade zones in Tianjin and Shanghai is an interesting first step towards liberalisation of various aspects relating to shipping and may in time provide a suitable platform for cross-border ship finance.

The one thing that may have changed permanently for banks is regulation, with Basel III penalising banks if they do not have the right amount of tier one capital set aside. This is prejudicial for longer term asset finance in general, to the extent that the number of participants may reduce lower.
Paul Taylor, Socit Gnrale Corporate and Investment Banking

A disadvantage of working in China is that it is more complicated and there are complex cultural issues. I am familiar with China, but for many people it is like comparing a Mac with a PC the two are fundamentally different.
Yanir Yakutiel, Delta Shipping

A trial of Chinas first free trade zone will be launched in Shanghais Pudong New Area as early as the end of this year (2013). Pudong authorities have accelerated preparations to consolidate the three bonded zones in the Waigaoqiao port, Yangshan DeepWater port and Pudong International Airport into the free trade zone.
(China.org.ch)

14/ Shipping and ship finance

Shipping and ship finance /15

Our view of the future

Shipping contacts

Our view of the future

Shipping contacts

China will continue to be among the worlds biggest and most important manufacturing forces in global shipping. The development of its role in cross-border ship finance may be less immediate, though it should become increasingly influential in years to come. Western European banks will continue, for the foreseeable future, to be the main liquidity providers for the industry, and may be augmented to some extent from alternative sources, such as private equity. However, consolidation of the Chinese shipbuilding sector is materialising rapidly and, whilst

the economy continues to grow, the demand for new and more technically advanced shipping will be met in China with increasing efficiency by a rationalised industry whilst, at the same time, the Chinese financial institutions will address the demand for greater access to finance for export of ships to foreign owners. BLPs own view is based on experience in advising clients as they take advantage of the opportunities created by the burgeoning evolution of shipbuilding and ship finance in China.

Our research has shown that, whilst China aspires to the No.1 position in shipbuilding, it still has a way to go to eclipse its nearest rivals fully. The same is true of international ship finance where there really is no substitute for depth of experience.
Tom Budgett Berwin Leighton Paisner Parter

TOM BUDGETT Partner, Asset Finance T: +44 (0)20 3400 4972 tom.budgett@blplaw.com

RUSSELL CLIFFORD Partner, Asset Finance T: +44 (0)20 3400 4141 russell.clifford@blplaw.com

JAMIE WISEMAN-CLARKE Partner, Asset Finance T: +44 (0)20 3400 4813 jamie.wiseman-clarke@blplaw.com

DAVID BROTHERTON Partner, Asset Finance T: +65 6571 7306 david.brotherton@blplaw.com

JUHO RANTA-AHO Senior Associate, Asset Finance T: +65 6571 6623 juho.ranta.aho@blplaw.com

SIMON SPELLS Associate, Asset Finance T: +44 (0)20 3400 4037 simon.spells@blplaw.com

Methodology
Berwin Leighton Paisner commissioned the BD Consultancy to conduct interviews with a range of respondents from the shipping and shipping finance industry over a six month period in 2012/2013. In total 25 interviews were conducted. While some interviewees expressed the right to anonymity in their opinions which we offered them, many of our interviewees declared themselves happy to stand behind the views which they aired by being specifically quoted in the body of the report. We are very grateful to all those who took the time to take part in the production of this report.

This firms asset finance and structured finance group continues to be recognised as a significant player in the market.
Chambers 2012

KIERAN HEALY Associate, Asset Finance T: +44 (0)20 3400 2270 kieran.healy@blplaw.com

ANNA BURY Associate, Asset Finance T: +65 6571 6606 anna.bury@blplaw.com

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Getting in touch When you need a practical legal solution for your next business opportunity or challenge, please get in touch. Berwin Leighton Paisner LLP Adelaide House, London Bridge London EC4R 9HA England Tom Budgett Tel: +44 (0)20 3400 4972 tom.budgett@blplaw.com

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