Treasury Today Country Profiles in association with Citi

BAD news for corporate cash flow

Pile of Renminbi notes

Many corporates in China are finding their cash flow disrupted due to the increasing use of bank acceptance drafts (BADs). Their use has increased as the economy has slowed and credit conditions have tightened, and they now act as a secondary currency, allowing companies to meet their payment obligations.

Picture the scene. It is the first day of the month and payment is due on a significant customer order. Instead of receiving the cash, however, the treasury is presented with a piece of paper, guaranteed by a bank, promising payment in six months’ time.

This is a daily occurrence for many corporates in China who are increasingly receiving bank acceptance drafts (BADs) as payment instead of cash. As we touched on in a previous Insight, a BAD is rather like a post-dated cheque with a bank guarantee, and the Bank of China estimated these totalled RMB 9 trillion in 2013. Originally BADs were intended to help facilitate trade, although they are now being widely used by companies as a secondary currency and to help raise funding, ultimately helping them meet their payment obligations. The drafts can be issued in two forms: either electronically, with a maximum maturity date of one year; or they can be paper-based, which is the most popular form, with a maximum maturity date of six months.

Chart 1: Virtual currency

Acceptance drafts, a kind of guaranteed IOU, are playing a bigger role in China.

Chart 1: Virtual Currency

Notes: Total acceptance drafts include those issued by both banks and large companies; 100 trillion yuan = $16.12 trillion
Source: People’s Bank of China The Wall Street Journal

Popularity

There are two main reasons for the current popularity of BADs in China. One is the slowing of the economy. “When an economy slows down, consumption decreases, leaving companies with a shortfall in cash,” says Matthew Lowenstein, analyst and Chinese economic expert at bespoke research firm J Capital Research. “The drafts create an easy source of funding for companies which can not only be used to facilitate trade but also as an alternative to a loan.” Lowenstein explains that companies are able to bend the rules and set up ghost trades. For example, company A will trade company B 100 headsets for $100 and vice versa, seeing no gain or loss for either company. The bank will be happy to fund this through a draft, which is off the books and isn’t included in their lending quota. Once the trade is complete, all that will be left is the drafts for each company of $100, which can be used as they see fit.

Other than being recoded off the books, banks are also willing to issue BADs because of the deposits they bring. “China has created a lot of dead investments which are funded by debt,” says Lowenstein. “Banks must therefore roll over and fund this dead credit and because of the slowing economy there is not enough organic growth and therefore deposits being made. The best method to get round this is to print your own money, and this is what is essentially done when a bank issues a BAD.”

Corporate challenges

The increasing popularity of BADs as a method of payment is having a number of implications for treasury operations in the country. “The main impact is that it affects your cash flow,” says Jessie Li, Greater China Treasury Manager at AkzoNobel. “These drafts are not cash and therefore cannot be used to pay wages or fund other business costs. This potentially causes a problem for companies operating in China, who are already tight for cash.”

“If you receive a BAD as payment, you essentially have three options,” says Li. “Firstly, you can discount the BAD and turn it into cash at a cost. Alternatively you are able to wait for the maturity date to come and then deposit the draft for cash. Or finally you can try and pass it on to your suppliers.”

“None of these options is ideal for a corporate that is in need of cash to pay its staff,” says Lowenstein. “Discounting is the most immediate option to ensure cash flow. However, the charge associated with this causes the company’s funding costs to increase, causing further problems.” The rate for discounting a BAD with a major bank in China is around 6%, although this can fluctuate. “Corporates are also facing another problem in this area, as many banks are now reluctant to discount BADs”, says Lowenstein. Corporates that need to discount a BAD will therefore need to turn to the ‘grey market’, comprised of small financial institutions, which are willing to discount the draft. “The rates at these fluctuate more greatly than the banks,” says Lowenstein, “so corporates may find themselves having to shop around to find places which will accept the draft and for the best price.”

Developments in Chinese money market funds (MMFs), however, may represent a reprieve for corporates looking to discount a draft. “MMFs such as Alibaba’s are proliferating in China,” claims Lowenstein. “Some of these are able to buy BADs, which could be a positive for treasurers who are having trouble offloading them. It will offer one large depository and prevent them having to shop around. While this won’t solve the underlying problem, it may certainly help constrained corporates.”

“Waiting for your draft to mature is only really an option if the company is cash-rich,” says Akzo Nobel’s Li. And this can also bring its own challenges for corporates. “Although electronic drafts are used, the most popular form is still paper,” says Li. “If we wish to wait for these to mature they have to be kept safe.” For Li, further issues arise once the maturity date arrives. “Once matured, the draft is required to be deposited into the bank and it is not unheard of for it to be lost at this stage. If this happens the company will be required to claim this money in court, causing further delay to payment and further constraints on the company’s cash. Following this you will need to go to the original issuing bank to claim the money.” Corporates can therefore wait for up to year for the cash to arrive in their account.

The final option open to corporates is to use the note to pay suppliers. “This is the ideal scenario for corporates,” says J Capital Research’s Lowenstein. “If a corporate receives payment in the form of a draft then they won’t want to part with hard cash to pay their suppliers.” However, again there are challenges in using this method. “If the draft is paper-based, which the majority are,” says Li, “then the payment amount shown on the draft will need to match the amount owed to the supplier.” Paper-based drafts cannot be split up, so if you have a BAD of $10,000 but only owe $5,000, then you would have trouble using the BAD without making a deal with the supplier.

Escaping the BAD

The recent popularity of BADs is not a new problem in China. During the 2000 cash crunch they became popular as companies were heavily indebted and unable to make payments. In the end the government stepped in to remedy the problem with large-scale bailouts. “The recent upsurge in the use of drafts has caught the regulator’s attention,” says Lowenstein. “They are beginning to make noise that they want to crack down on BADs.” However, this may not solve the underlying problem. “Banks are nervous about this, so they are already looking at alternative methods in case they have to move away from the drafts, which will just see the problem continue in a different guise.”

“The way to solve the problem, and begin to reduce the use of BADs, would be for banks to firstly take the loss and stop financing the legacy non-preforming loans,” says Lowenstein. “Once this happens the negative impact felt by corporates will begin to decline. However, this is not what we are seeing at the moment; there is no real incentive to change and banks are trying to obtain as much capital as they can, through tools such as BADs. They are then just throwing the money right back into the hole they have dug. I see it all ending in large losses for the banks, which will certainly affect corporates.”

“Currently it is a vicious circle,” says Jessi Li. “Once a company receives a BAD then it is more likely they will have to use one themselves to meet their obligations.” They are also one of the key factors contributing to the increase in overdue payments companies are experiencing in China. “With further credit tightening expected, I think from the corporate perspective that we can expect to see further increases in the use of BADs,” says Li.