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Harnessing liquidity in China

Chinese style bridge

Previous articles in this series have looked at the dramatic changes in the regulatory structure for the renminbi and the burgeoning us of the currency. Last month we dealt with the basics of renminbi cash management in mainland China. In this article we look at the development of liquidity management in China, the tools and techniques that can be used and the options open to treasurers looking to invest their excess liquidity.

Getting to grips

Where cash management in China is concerned, getting to grips with the different types of bank accounts required to operate in the country, as well as the banking and trade settlement regime, is just the beginning. From a distance, cash management in China might look familiar to treasurers with no experience of the country – after all, many of the tools and techniques have the same names as their western counterparts. But on closer inspection, local regulatory requirements have often resulted in important differences in the way that these techniques can be used.

While cash management techniques like physical cash pooling can be achieved in China, it is important for treasurers to understand the restrictions that exist and the unique structures that have been developed in response to these. In other cases, some traditional cash management techniques practiced elsewhere, such as notional pooling are simply not permitted in China.

China’s liquidity management landscape is still developing rapidly, and companies new to the market should seek up-to-date advice on what is and is not achievable before undertaking a liquidity management project.

Since liquidity management was introduced in China less than a decade ago, the demand for such techniques and the level of sophistication on offer has grown steadily, according to Yigen Pei, Product Head, China, Treasury and Trade Solutions for Citi’s Global Transaction Services. “If you look back, liquidity management first came to the market in 2004,” says Pei. “That’s also when we saw more multinational corporations becoming present in China, and on a larger scale, setting up treasury centres and shared service centres in the country.

“These multinationals have been coming to China for years and many of them have now passed the investment stage and are at the so-called ‘harvester’ stage. In other words, they are cash rich and they are now looking to take control, improve their visibility over company cash, and consolidate the treasury function.”

Pei observes that global integration of liquidity management solutions is another key trend, with companies looking to make the most of surplus cash across the group. Meanwhile, the liquidity management structures on offer have become more sophisticated in response to increased demand from corporates.

Diagram 1: Have you used cash pooling in China
Diagram 1: Have you used cash pooling in China

Source: KPMG, Cash Matters: Cash and working capital management in China

In addition, where liquidity management is concerned, multinational companies had in the past focused their attention on wholly foreign owned enterprises (WFOEs). This is now changing as corporations look to bring their joint ventures into their liquidity management structures. In order to do so, companies must also consider the risk involved in working with their joint venture (JV) partners in such a structure.

The path to efficient liquidity management is not always straightforward. Although cash pooling continues to become more widespread in China, the complexity of such structures – or the perceived complexity – remains a significant obstacle.

A 2009 survey of 180 corporates in China by KPMG found that 44% of respondents had undertaken cash pooling in China – and that of the 56% who had not done so, a third had been primarily deterred by a lack of understanding of the concept. (Administrative burden and costs were found to be the next biggest objections.)

While the liquidity management structures in place in China are often described as ‘cash pooling’, in reality they are structured quite differently to the equivalent structures used in other countries. See Diagram 1.

Cash pooling in China: the basics

In many cases the unique liquidity management techniques used in China have come into being as a direct result of the country’s regulatory restrictions.

The first and foremost of these restrictions is that direct inter-company lending is prohibited in China. Only funds transfers made on the basis of genuine transactions are permitted, specifically trade-related transactions, service payments and royalty fees.

Diagram 2: If no, what was the main reason why?
Diagram 2: If no, what was the main reason why?

Source: KPMG, Cash Matters: Cash and working capital management in China

As a result of this restriction, cash concentration structures – in which funds from different legal entities within the group are pooled up to a single header account in order to maximise interest or reduce overdraft charges – cannot be carried out in China in their traditional form. However, a similar structure can be achieved using entrusted loans.

An entrusted loan (also known as entrust or entrustment loan) is the method used by corporates in China to achieve inter-company lending. The principle is as follows:

A financial institution is appointed as an intermediary between the borrower and lender. The lender deposits cash with the bank and the bank lends it to the borrower according to the terms specified by the lender. The interest rate must be set at arm’s length and all of the credit risk remains with the borrower – the bank receives a commission and takes none of the risk.

Basic entrusted loan structure

The concept of the entrusted loan was introduced in 2001, but it was not until 2004 that companies were allowed to use these as the basis for a physical cash pooling structure.

Individual entrusted loans are somewhat cumbersome as they can only be made on a bilateral basis and separate documentation must be produced each time a loan is made. They are also expensive, incurring business tax on the interest income (5%) and stamp duty (0.005% of the value of the contract).

In order to set up a pooling arrangement using entrusted loans, companies need to forge an entrusted loan agreement with their bank. The header account is usually held by a China holding company and balances can be swept between the header and participating accounts on a daily basis using entrusted loans.

Diagram 3: Basic entrusted loan structure
Diagram 3: Basic entrusted loan structure

Entrusted loan pooling structure

RMB cash pooling is now widely used in China and as the practice becomes more mature, more sophisticated solutions are being introduced. For example, some of the recently introduced pooling solutions have focused on addressing the tax considerations associated with entrusted loan structures. “The tax considerations are sometimes very complicated,” comments Pei. “To help clients reduce business tax and stamp duty, we are starting to provide tax efficient solutions in the market to lower the business tax for liquidity solutions.”

Diagram 4: Entrusted loan pooling structure
Diagram 4: Entrusted loan pooling structure

Recent developments

The increasing trend for corporations to include their joint ventures in their liquidity management structures is also leading to product innovation, according to Pei: “In order to control and mitigate the risk of the JV partners, sometimes we have to introduce more sophisticated structures.”

“As companies increasingly require their joint ventures to join their cash pooling, they may have some concerns,” adds Cline Zhang, Business Development and Liquidity and Investments Head, China, Treasury and Trade Solutions for Citi’s Global Transaction Services. “They don’t want the JV to use up all the money of the group, so they set lending limits to ensure that the JV can only borrow a certain amount.”

Beyond the domestic pooling of RMB, the internationalisation of the currency is leading to new opportunities for concentrating RMB funds offshore. “Outside of China, companies have more options for managing their liquidity in less regulated countries,” says Zhang.

“They can use a range of techniques such as:

  • Standard cash pooling.

  • Notional pooling.

  • Interest optimisation.

But if the account owner is a China entity, the payables and receivables scope of this RMB account might be monitored by an onshore regulator, so companies need to pay attention to this.”

Meanwhile, cross-border pooling arrangements which seek to concentrate funds from China to offshore accounts are still subject to Chinese regulation.

“Many corporates try to find a way of arranging their pool to enable the intercompany lending and borrowing of RMB between onshore and offshore entities,” says Zhang. “However, they have to seek regulatory approval on a case by case basis.”

Foreign currency pooling

As with RMB pooling, foreign currency pooling – usually USD pooling – can be undertaken in China using the entrusted loan structure. Foreign currency entrusted loans were permitted in 2004 and foreign currency pooling has been possible since 2005.

This structure was made significantly more straightforward in 2009 when it became possible to make foreign currency entrusted loans on a multilateral basis, whereby a number of loans are covered by a single set of documentation. The conditions for this are set out in the Administrative Rules on Foreign Exchange Cash Pooling of Group Members of Enterprises in China, issued by SAFE in October 2009, which apply to foreign exchange pooling within China but not to cross-border pooling.

“Some companies do use USD pooling or other foreign currency pooling to manage their foreign currency funding in China,” comments Zhang. “However, RMB is still the most popular pooling currency in China. This is because corporates still need to obtain SAFE approval for such arrangements on a case by case basis.

While banks may be able to obtain such approval on behalf of the customer, the customer will still need to wait several months for this. Consequently foreign currency pooling is not used as widely as RMB pooling.”

Rules for foreign currency pooling in China

According to the Administrative Rules on Foreign Exchange Cash Pooling of Group Members of Enterprises in China (the ‘Rules’), participation in a foreign currency cash pool is permitted for the following parties:

  • The parent company.

  • Subsidiary which is at least 51% owned by the parent.

  • Companies of which the parent and subsidiaries jointly or separately own at least 20%.

  • Company in which the parent, subsidiary or both are the largest shareholder.

  • Non-business organisations owned by the parent or subsidiary.

Approval for such structures must be obtained from the local SAFE office.

Alternatively cash pooling may be set up via a finance company based in China and can be done so without approval from SAFE as receiving deposits and making loans to members are classed as the usual business of a finance company.

Investing surplus cash

Cash concentration is only the first step in liquidity management – once funds have been concentrated, the next step is to invest them in line with the company’s requirements and investment policy. In China, bank deposit accounts, such as call and time deposit accounts, remain the most widely used investment vehicle.

“Some corporate treasurers are also looking at higher yielding investment products, such as money market funds and structured deposits,” says Zhang. “However, most treasurers still want to take a conservative approach to their investments. Risk and liquidity remain the most important priorities.”

Another investment opportunity which is specific to China is the third party entrusted loan. Third party entrusted loans are a technique whereby a cash rich corporation can lend funds to another, unrelated, corporation for a profit. Like a standard entrusted loan, the credit risk is retained by the lending corporation and a bank must be used as an intermediary. Two different banks must act on behalf of the lender and borrower.

Typically corporations lending funds in this way receive a higher yield than that offered by bank deposits. During the financial crisis, demand for this type of funding increased significantly as bank lending was cut back and the rates increased accordingly.

The demand for transactions of third party entrusted loans has increased along with the lending control in the China market recently. But so far this structure remains niche and a variety of issues must be considered – not least of all the difficulty of matching two companies who are respectively looking to borrow and lend the same amount of cash for the same period and at the same time.

Another obstacle is the stipulation that such loans must be placed for a minimum of six months. Negotiating the cost of borrowing can present another obstacle, according to Zhang, who concludes that “third party entrustment loans are not very popular in China.”

The future of liquidity management in China

As a relatively new discipline, liquidity management in China is still evolving steadily and current trends can give an indication of the likely shape of future developments.

“With the trend of the RMB becoming more international, and also the trend toward the relaxation of foreign exchange regulations, the prospect of combining RMB and foreign currency liquidity management structures becomes more feasible,” says Pei.

“Another trend is that with China entities (also called ‘emerging Chinese multinationals’) expanding globally, they have more interest in managing their funding on a global basis outside of China. Some corporates have set their global treasury centre in some deregulated countries, and the global liquidity management and cash management demand will be further developed in the next couple of years.”

Liquidity management in China has come a long way since its introduction less than a decade ago – but the rate of development shows no signs of slowing, as new solutions continue to meet the specific needs of corporations operating in China.

Numbers never lie

In November 2010, Treasury Today conducted the largest Benchmarking Study of its kind among corporate treasurers in China with 250 corporate respondents. Key findings highlighted that domestic cash pooling using entrusted loans is the most popular liquidity management solution in the country, with over half of respondents using that structure. Interestingly, as many as 15% of respondents were also using cross-currency cash pooling. While the latter can be difficult to achieve, only 1% of respondents had outsourced their liquidity management to a third-party provider.

Treasury Today’s Best Practice Handbook on Banking and Cash Management in China also provides additional insight into the challenges and solutions associated with managing liquidity in China.

To obtain copies of either of these reports contact Sarah Arter on +44 (0)1304 629015 sarah.arter@treasurytoday.com

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