(Reuters)
Updated: 2007-08-08 09:06

China is tightening its grip once more on foreign investors in Chinese real estate, banning them from borrowing offshore in the latest effort to tame property prices and cool the economy.

The new rule, set out in a circular from the State Administration of Foreign Exchange , could squeeze foreign investors who take advantage of lower interest rates outside China.

Some may find it especially difficult to fund projects as Beijing has told its banks to cut back on loans for the construction industry. The central bank ordered Chinese banks to stop lending for land purchases as far back as 2003.

"The only alternative is to fund the entire equity," said Andrew McGinty, a partner at the law firm Lovells in Shanghai.

"But that's not a very favoured method, because your internal return on investment goes down dramatically."

Property funds operating in China tend to borrow to fund at least 50 percent of a project's value.

The circular, which the currency regulator sent to its local branches in early July but has not yet published on its Web site, also increases red-tape for foreign property investors.

Investors seeking to bring capital into China to set up a real estate company must now lodge documents with the Ministry of Commerce in Beijing -- not just with local branches of the ministry, according to the new circular with de facto effect from June 1.

That process could take a month or more, said an official at the Ministry of Commerce, declining to be identified.

"What we mean is very clear: First we are targeting foreign real estate firms that are illegally approved by local governments," a SAFE official said.

McGinty said the new rule would reduce foreign investment in the real estate sector, but the real impact would depend on how it is enforced.

UNCERTAIN IMPACT

China has applied a raft of measures to rein in property investment, including interest rate rises and rules to discourage construction of luxury homes.

Some steps have specifically targeted foreign investors, who account for less than 5 percent of total investment in the property sector. Foreign investors must now secure land purchases before setting up joint ventures or wholly owned foreign enterprises in China.

However, funds such as those run by ING Real Estate, Morgan Stanley , Hong Kong's Sun Hung Kai Properties , Henderson Land Development and Singapore's CapitaLand Ltd. are pouring more money than ever into China to tap a middle class hunger for new homes and rising capital values.

China's urban property inflation rose to 7.1 percent in June, compared with a year earlier, from 6.4 percent in May.

McGinty said some foreign investors may eventually quit China for more interesting markets if an inability to employ leverage reduces their internal rate of return.

However, others said they would stay on.

"We are not too worried about it. Cooling measures won't stay forever," said Robert Lie, Asia chief executive for ING Real Estate, which has raised a $350 million fund to build housing in China.

ING Real Estate borrows locally, partly to hedge its currency risk. Most other foreign investors in China do the same. Some foreign property firms that have been in China for many years have strong connections with local lenders -- Chinese banks as well as international banks incorporated in China.

"There is still strong interest in China, although there will be some form of slowdown in the number of transactions," said Grey Hyland, head of investment at Jones Lang LaSalle in Shanghai.

He said the new approval rules would further dampen the ability of foreigners to compete with local rivals.

"It's still early to say how, because these rules are still very new and being tested," Hyland said.

One consequence, he added, could be to drive foreign property investors inland to second- and third-tier cities that the authorities are eager to develop and where approval is therefore easier to obtain.